Treasury and IRS Issue Proposed Regulations under Section 965

Summary

On August 1, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) published proposed regulations (REG-104226-18, hereinafter, the Proposed Regulations) implementing Section 965 of the Internal Revenue Code as amended by the Tax Cuts and Jobs Act, which was enacted on December 22, 2017. The Proposed Regulations affect U.S. persons with direct or indirect interests in certain foreign corporations.

 

Details

Section 965 applies in the case of the last taxable year of a deferred foreign income corporation (DFIC) that begins before January 1, 2018. Treasury previously issued guidance announcing regulations intended to be issued under Section 965.  See Notice 2018-07 along with our January Tax Alert for a summary discussion of Notice 2018-07, Notice 2018-13 along with our January Tax Alert for a summary discussion of Notice 2018-13, and Notice 2018-26 along with our April Tax Alert for a summary discussion of Notice 2018-26. See also Rev. Proc. 2018-17 and our February Tax Alert for a summary discussion of Rev. Proc. 2018-17.
 
The Proposed Regulations under Section 965 are divided into nine sections.

• Prop. Reg. §1.965-1 provides general rules and definitions under Section 965.
• Prop. Reg. §1.965-2 provides rules relating to adjustments to E&P and basis to determine and account for the application of Section 965 and a rule that limits the amount of gain recognized in connection with the application of Section 961(b)(2).
• Prop. Reg. §1.965-3 provides rules regarding the determination of Section 965(c) deductions.
• Prop. Reg. §1.965-4 sets forth rules that disregard certain transactions for purposes of Section 965.
• Prop. Reg. §§ 1.965-5 and 1.965-6 provide rules with respect to foreign tax credits.
• Prop. Reg. §1.965-7 provides rules regarding elections and payments.
• Prop. Reg. §1.965-8 provides rules regarding affiliated groups including consolidated groups.
• Prop. Reg. §1.965-9 provides dates of applicability.

 
In addition, the Proposed Regulations include rules under Sections 962 and 986(c).

 

• Prop. Reg. §§ 1.962-1 and 1.962-2 provide rules relating to Section 962 elections.
• Prop. Reg. §1.986(c)-1 provides rules regarding the application of Section 986(c) in connection with Section 965.

 
The Proposed Regulations contain the rules related to Section 965 described in the prior Notices, with certain modifications, as well as additional guidance related to Section 965. Certain key items included as additional guidance or clarifications in the Proposed Regulations and the preamble to the Proposed Regulations (the Preamble) are summarized below.

 

• Prop. Reg. §1.965-2(f)(1) clarifies that, in general, no adjustments to basis of stock or property are made under Section 961 (or any other provision of the Code) to take into account the reduction to a Section 958(a) U.S. shareholder’s pro rata share of the Section 965(a) earnings amount of a DFIC under the reduction rules.  However, the Preamble states that an increase to the basis of stock of DFICs is appropriate only if there is a corollary reduction to the basis of the stock of E&P deficit foreign corporations. Accordingly, Prop. Reg. §1.965-2(f)(2) allows taxpayers to elect to make the relevant basis adjustments, in which case such adjustments must be consistently made with respect to all Section 958(a) stock of specified foreign corporations owned by a Section 958(a) U.S. shareholder and related persons. The relevant basis adjustments are (i) an increase in the Section 958(a) U.S. shareholder’s basis in the Section 958(a) stock of a DFIC or applicable property with respect to a DFIC by an amount equal to the Section 965(b) previously taxed earnings and profits of the DFIC with respect to the Section 958(a) U.S. shareholder, and (ii) a reduction in the Section 958(a) U.S. shareholder’s basis in the Section 958(a) stock of an E&P deficit foreign corporation or applicable property with respect to an E&P deficit foreign corporation by an amount equal to the portion of the Section 958(a) U.S. shareholder’s pro rata share of the specified E&P deficit of the E&P deficit foreign corporation taken into account under the reduction rules. Rules relating to basis adjustments in the case of a Section 962 election are reserved. An election under Prop. Reg. §1.965-2(f)(2) is generally made by attaching a statement, signed under penalties of perjury, to the Section 958(a) U.S. shareholder’s return for the first taxable year that includes the last day of the last taxable year of a DFIC or E&P deficit foreign corporation of the shareholder that begins before January 1, 2018, including the shareholder’s name and taxpayer identification number and a statement that the shareholder and all related persons make the election.^[1]
• The Preamble states that if a taxpayer makes an election to adjust basis under Prop. Reg. §1.965-2(f)(2), the gain reduction rule provided for in Section 3.03 of Notice 2018-07 and with the modification described in Section 4 of Notice 2018-13, will also apply to distributions attributable to Section 965(b) previously taxed earnings and profits, and the amount of gain that would otherwise be recognized by the Section 958(a) U.S. shareholder is also reduced by the amount of the Section 965(b) previously taxed earnings and profits of the DFIC with respect to the Section 958(a) U.S. shareholder. Prop. Reg. §1.965-2(g)(2) provides that the basis in Section 958(a) stock or applicable property must be reduced by the amount that would have been recognized as gain.
• Prop. Reg. §1.965-3(f)(3) provides that for purposes of the Net Investment Income tax (Section 1411 and Treas. Reg. §1.1411-4(f)(6)), a Section 965(c) deduction is not treated as a deduction properly allocable to a corresponding Section 965(a) inclusion. Consistent with the rule of Section 1411, Prop. Reg. §1.965-3(f)(4) provides that a Section 965(c) deduction is not treated as an ordinary and necessary expense paid or incurred for the production or collection of gross investment income for purposes of Section 4940(c)(3)(A).  
• The Proposed Regulations provide that if a person is assessed a deficiency with respect to the person’s Section 965(h) net tax liability, or the person timely files a return increasing the amount of its Section 965(h) net tax liability above the amount taken into account in the payment of the first installment, or the person files an amended return increasing the amount of its Section 965(h) net tax liability, the deficiency or additional amount will be prorated among the installments under Section 965(h)(4). This proration rule does not apply if the deficiency or additional liability is due to negligence, intentional disregard of rules and regulations, or fraud with intent to evade tax, in which case, the proposed regulations clarify that the deficiency is payable on notice and demand.^[2]
• The Preamble confirms that the Section 965(h) installment election may not be made to pay tax imposed under other subchapters or chapters (such as, for example, the Net Investment Income Tax imposed under Section 1411 and the Excise Tax Based on Investment Income imposed under Section 4940).
• The Preamble confirms that no deduction or credit is allowed for the applicable percentage of any withholding taxes imposed on a U.S. shareholder by the jurisdiction of residence of the distribution foreign corporation with respect to a distribution of Section 965(a) previously taxed earnings and profits or Section 965(b) previously taxed earnings and profits. The Preamble also confirms that no deduction or credit is allowed for the applicable percentage of net basis taxes imposed on a U.S. citizen by the citizen’s jurisdiction of residence upon receipt of a distribution of Section 965(a) previously taxed earnings and profits or Section 965(b) previously taxed earnings and profits. 
• The Proposed Regulations provide rules, consistent with Section 3.04 of Notice 2018-26, to prevent the avoidance of Section 965, including an anti-avoidance rule disregarding certain transactions and rules disregarding certain changes in accounting methods and entity classification elections. The Preamble clarifies that the application of the anti-avoidance rule is based on whether there is a “change in the amount of a Section 965 element” rather than a change in the Section 965 tax liability, as described in Notice 2018-26.^[3] For this purpose, generally, there is a change in the amount of a Section 965 element if there is a reduction of a Section 965(a) inclusion amount or aggregate foreign cash position or an increase in deemed paid foreign income taxes as a result of a Section 965(a) inclusion.^[4] The Preamble states that the anti-avoidance rule generally does not apply without a principal purpose of changing the amount of a Section 965 element. Depending on the facts and circumstances, transactions that do not reduce overall tax liability may not meet the principal purpose test described in Prop. Reg. §1.965-4(b)(1).
• The Preamble confirms that the generally applicable rules of Sections 861 through 865 and the Regulations thereunder for allocating and apportioning deductions to separate categories of income described in Section 904(d)(1) and Treas. Reg. §1.904-4(m) apply for purposes of determining the foreign tax credits allowed by reason of a Section 965(a) inclusion. For purposes of allocating and apportioning any deductible expense, any tax-exempt asset (and any income from such asset) is not taken into account.^[5] The Proposed Regulations confirm that the allowance of a deduction under Section 965(c) with respect to the Section 965(a) inclusion does not result in any portion of the Section 965(a) inclusion being treated as exempt income. In addition, the Preamble confirms that the assets to which the Section 965(a) inclusion relates are not treated as exempt assets under Section 864(e)(3) or Treas. Reg. §1.861-18T(d).
• The Proposed Regulations also include detailed rules relating to acceleration events under Section 965(h). Prop. Reg. §1.965-7(b)(3)(ii) lists the events treated as acceleration event for Section 965(h) purposes which include an addition to tax for failure to timely pay an installment required under Section 965(h), a liquidation or sale of substantially all the assets of the taxpayer (including a title 11 or similar case), a cessation of business by the taxpayer, or any similar circumstance. Prop. Reg. §1.965-7(b)(3)(ii)(B) provides that, in addition to a liquidation or sale of substantially all of the assets of a taxpayer, any exchange or other disposition of substantially all of the assets of a taxpayer constitutes an acceleration event. In addition, Prop. Reg. §1.965-7(b)(3)(ii)(D) provides that any event that results in a person no longer being a U.S. person (including, for example, a resident alien becoming a nonresident alien) is an acceleration event. Prop. Reg. §1.965-7(b)(3)(ii)(E) provides that a person that was not a member of any consolidated group becoming a member of a consolidated group is treated as an acceleration event with respect to the person. Prop. Reg. §1.965-7(b)(3)(ii)(F) provides that when a consolidated group ceases to exist, or otherwise no longer files a consolidated return, that constitutes an acceleration event. The Proposed Regulations also provide an exception (the eligible Section 965(h) transferee exception) pursuant to which the acceleration provisions of Section 965(h)(3) and Prop. Reg. §1.965-7(b)(3)(ii) do not apply (such that the unpaid portion of all remaining installments will not be due as of the date specified therein) to a person with respect to which an acceleration event occurs if the requirements described in Prop. Reg. §1.965-7(b)(3)(iii)(A)(1) (describing the acceleration events eligible for this exception and (2) (setting forth the terms of a required transfer agreement) are satisfied. Only certain acceleration events are eligible for this exception and the exception applies only to the extent that the person with respect to which an acceleration event occurs and an eligible Section 965(h) transferee (generally, a U.S. person that is not a domestic pass-through entity and that satisfies certain requirements set forth in the Proposed Regulations) enter into a transfer agreement described in Prop. Reg. §1.965-7(b)(3)(iii)(B).
• Section 965(i) provides that a shareholder of an S corporation that is itself a U.S. shareholder of a DFIC may elect to defer payment of its net tax liability under Section 965 with respect to such S corporation until the shareholder’s taxable year which includes a triggering event with respect to such liability. The Proposed Regulations also provide some additional guidance regarding how an S corporation shareholder can make a Section 965(i) election and provide guidance on the transfer of liability exception to a triggering event described in Section 965(i)(2)(C).^[6] Prop. Reg. §1.965-7(c)(4)(iv)(B)(4) sets forth the required terms of a transfer agreement.
• The Proposed Regulations also provide rules for an S corporation shareholder to obtain the consent of the Secretary to make a Section 965(h) election in the event of a triggering event that is a liquidation, sale, exchange, or other disposition of substantially all of the assets of the S corporation (including a title 11 or similar case), a cessation of business by the S corporation, or the S corporation ceasing to exist.  To obtain consent, the shareholder intending to make the Section 965(h) election must file the agreement described in Prop. Reg. §1.965-7(c)(3)(v)(D)(4) and must provide, with its timely filed return for the taxable year during which the triggering event occurs (taking into account extensions, if any), the election statement for the Section 965(h) election.^[7]
• Moreover, the Proposed Regulations provide that for purposes of identifying Section 958(a) U.S. shareholders of specified foreign corporations and the Section 958(a) stock of such specified foreign corporations owned by Section 958(a) U.S. shareholders, a domestic partnership is treated as a foreign partnership if certain conditions are satisfied. See Prop. Reg. §1.965-1(e)(1). This is an expansion on the reference in Section 2.13 of Notice 2018-26 to Notice 2010-41(dealing with U.S. partnership blocker transactions of interest identified in Notice 2009-7), which referred to CFCs, whereas the expanded rule includes specified foreign corporations generally.
• Prop. Reg. §1.986(c)-1(c) provides that Section 986(c) does not apply with respect to distributions of Section 965(b) previously taxed earnings and profits. 
• The Proposed Regulations clarify that a Section 965(c) deduction taken into account in determining “taxable income” as used in Section 11 for purposes of computing the tax due as a result of a Section 962 election is not allowed for purposes of determining an individual’s actual taxable income.^[8]

 

The Proposed Regulations generally apply beginning the last taxable year of a foreign corporation that begins before January 1, 2018, and with respect to a U.S. person, beginning the taxable year in which or with which such taxable year of the foreign corporation ends. Taxpayers may choose to apply the rules in Prop. Reg. §1.965-7 in their entirety to all tax years as if they were final regulations.
 
For the avoidance of doubt, Prop. Reg. §1.965-9(b) clarifies that the rules described in Prop. Reg. §1.965-4 apply to all foreign corporation and shareholder taxable years described in Prop. Reg. §1.965-9(b), even if the relevant transaction, the effective date of a change in method of accounting or entity classification, or specified payment occurred in a prior taxable year. This is because the Proposed Regulations affect only the tax consequences in taxable years described in Prop. Reg. §1.965-9(b) and do not affect any prior taxable year.

 

BDO Insights

The Proposed Regulations largely follow the guidance provided in the prior Notices. As detailed in the Preamble, Treasury declined to provide favorable relief to taxpayers subject to Section 965 in many situations. The Proposed Regulations do however provide welcomed guidance and clarification on certain open issues under Section 965.

 

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