Treasury Provides Additional Guidance Under Section 965 and Guidance in Connection with the Repeal of Section 958(b)(4)

Summary

On January 19, 2018, the Department of the Treasury and the Internal Revenue Service (collectively, “Treasury”) issued Notice 2018-13 (the “Notice”).  The Notice provides additional guidance under Section 965, Treatment of deferred foreign income upon transition to participation exemption system of taxation, as amended by “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” P.L. 115-97 (known as the Tax Cut and Jobs Act), which was enacted on December 22, 2017.  See Notice 2018-07, for prior guidance issued under Section 965 and our January Tax Alert summarizing certain key items in Notice 2018-07.  In addition, the Notice provides guidance in connection with the repeal of Section 958(b)(4).

 

Details

In general, Section 965(a) provides that for the last taxable year of a deferred foreign income corporation (“DFIC”)^[1] that begins before January 1, 2018 (such year of the DFIC, the “inclusion year”), the subpart F income of the corporation (as otherwise determined for such taxable year under Section 952) shall be increased by the greater of (1) the accumulated post-1986 deferred foreign income of such corporation determined as of November 2, 2017, or (2) the accumulated post-1986 deferred foreign income of such corporation determined as of December 31, 2017 (each such date, a “measurement date,” and the greater of the accumulated post-1986 deferred foreign income of the corporation as of the measurement dates, the “Section 965(a) earnings amount”).
 
To calculate its income inclusion under Section 965, a U.S. shareholder will generally need to, among other various items, determine the status of its specified foreign corporations as DFICs or E&P deficit foreign corporations (and in certain situations as neither),^[2] allocate its pro rata share of certain earnings and profits deficits of its E&P deficit foreign corporations to its DFICs in a manner prescribed in Section 965(b), calculate its pro rata share of accumulated post-1986 deferred foreign income of its DFICs as of November 2, 2017, and December 31, 2017, determine its aggregate foreign cash position, and translate certain amounts into U.S. dollar. The Notice provides additional guidance on certain aspects of these items and a summary of the guidance issued in the Notice is provided below.

1. Determination of Status of a Specified Foreign Corporation as a DFIC or an E&P Deficit Foreign Corporation
The Notice provides that Treasury intends to issue regulations providing that, for purposes of determining the status of a specified foreign corporation as a DFIC or an E&P deficit foreign corporation, it must first be determined whether the specified foreign corporation is a DFIC.  If the specified foreign corporation meets the definition of a DFIC, it is classified solely as a DFIC and not also as an E&P deficit foreign corporation, even if such specified foreign corporation otherwise satisfies the requirements of Section 965(b)(3)(B).  If a specified foreign corporation does not meet the definition of a DFIC, the U.S. shareholder must then determine whether it is an E&P deficit foreign corporation.  In some cases, a specified foreign corporation may be classified as neither a DFIC nor an E&P deficit foreign corporation, despite having post-1986 earnings and profits greater than zero or a deficit in accumulated post-1986 deferred foreign income.^[3]

2. Alternative Method for Calculating Post-1986 Earnings and Profits
The Notice provides that Treasury has determined that, for purposes of measuring post-1986 earnings and profits of a specified foreign corporation as of a measurement date, the extent to which an item of income, deduction, gain, or loss is taken into account as of such measurement date must generally be determined under principles applicable to the calculation of earnings and profits, including the application of Sections 312 and 964.
 
For purposes of determining whether a specified foreign corporation is a DFIC and for purposes of determining a DFIC’s Section 965(a) earnings amount, the actual post-1986 earnings and profits of the specified foreign corporation must be determined as of the close of both November 2, 2017, and December 31, 2017.  In addition, for purposes of determining whether a specified foreign corporation is an E&P deficit foreign corporation and for purposes of determining the amount of the specified E&P deficit of an E&P deficit foreign corporation, the actual post-1986 earnings and profits (including a deficit) of the specified foreign corporation must be determined as the close of November 2, 2017.  The Notice provides that Treasury intends to issue regulations providing that an election may be made to determine a specified foreign corporation’s post-1986 earnings and profits as of a measurement date based on the amount of post-1986 earnings and profits (including a deficit) as of another date as provided in section 3.02 of the Notice (the “alternative method”). 
 
If an election to use the alternative method is made, the amount of the post-1986 earnings and profits (including a deficit) of a specified foreign corporation (other than a specified foreign corporation with a 52-53-week taxable year described in Treas. Reg. Section 1.441-2(a)(1)) as of November 2, 2017, will equal the sum of (1) the corporation’s post-1986 earnings and profits as of October 31, 2017, and (2) the corporation’s annualized earnings and profits amount.  For this purpose, the term “annualized earnings and profits amount” means, with respect to a specified foreign corporation, the amount equal to the product of two (the number of days after October 31, 2017, and on or before the measurement date on November 2, 2017) multiplied by the daily earnings amount of the specified foreign corporation. 
 
The term “daily earnings amount” means, with respect to a specified foreign corporation, the post-1986 earnings and profits (including a deficit) of the specified foreign corporation as of the close of October 31, 2017, that were earned (or incurred) during the specified foreign corporation’s taxable year that includes October 31, 2017, divided by the number of days that have elapsed in such taxable year as of the close of October 31, 2017.^[4]  A specified foreign corporation that does not have a 52-53-week taxable year described in Treas. Reg. Section 1.441-2(a)(1) may not determine its post-1986 earnings and profits under the alternative method with respect to the measurement date on December 31, 2017. 
 
In the case of a specified foreign corporation that has a 52-53-week taxable year described in Treas. Reg. Section 1.441-2(a)(1), an election may be made to use the alternative method to determine its post-1986 earnings and profits as of both measurement dates based on the amount of post-1986 earnings and profits (including a deficit) as of the closest end of a fiscal month to each measurement date consistent with the principles of the preceding paragraph.  For example, if the closest end of a fiscal month of a specified foreign corporation that has a 52-53-week taxable year occurs after an applicable measurement date, the annualized earnings amount will be subtracted from (rather than added to) the post-1986 earnings and profits of the specific foreign corporation as of such fiscal month end.  For a specified foreign corporation with a 52-53-week taxable year, in order to use the alternative method for any measurement date, the election must be made for both measurement dates.
 
The Notice provides that the Internal Revenue Service intends to issue forms, publications, regulations, or other guidance that will specify the manner and timing of an election to use the alternative method.

3. Treatment of Deficits
Regarding the treatment of deficits, the Notice provides that Treasury intends to issue regulations providing that, for purposes of determining a U.S. shareholder’s pro rata share of the specified E&P deficit of an E&P deficit foreign corporation that has multiple classes of stock outstanding, the specified E&P deficit is allocated first among the shareholders of the corporation’s common stock and in proportion to the value of the common stock held by such shareholders. 
 
In addition, the Notice provides that consistent with the Conference Report accompanying the Act, Treasury intends to issue regulations clarifying that all deficits related to post-1986 earnings and profits, including hovering deficits, are taken into account for purposes of determining the post-1986 earnings and profits (including a deficit) of a specified foreign corporation.

4. Determination of Aggregate Foreign Cash Position
For purposes of determining the U.S. shareholder’s aggregate foreign cash position, the Notice provides that Treasury intends to issue regulations providing that, for purposes of Section 965(c)(3)(C), the term “accounts receivable” means receivables described in Section 1221(a)(4), and the term “accounts payable” means payables arising from the purchase of property described in Section 1221(a)(1) or 1221(a)(8) or the receipt of services from vendors or suppliers.  Receivables that are treated as accounts receivable within the meaning of Section 965(c)(3)(C)(i) will not also be treated as short-term obligations.
 
In addition, the Notice states that Treasury intends to issue regulations providing that, for purposes of determining a specified foreign corporation’s cash position, a loan that must be repaid on the demand of the lender (or that must be repaid within one year of such demand) will be treated as a short-term obligation, regardless of the stated term of the instrument.

5. Currency Translation Rules
For purposes of translating certain amounts into U.S. dollar, the Notice provides that Treasury intends to issue regulations providing that, for purposes of determining the Section 965(a) earnings amount of a specified foreign corporation, the accumulated post-1986 deferred foreign income of the specified foreign corporation as of each of the measurement dates must be compared in the functional currency of the specified foreign corporation.  If the functional currency of a specified foreign corporation changes between the two measurement dates, the comparison must be made in the functional currency of the specified foreign corporation as of December 31, 2017, by translating the specified foreign corporation’s earnings and profits as of November 2, 2017, into the new functional currency using the spot rate on November 2, 2017.  For purposes of the Notice, the term “spot rate” has the meaning described in Treas. Reg. Section 1.988-1(d). 
 
In addition, the Notice provides that Treasury intends to issue regulations providing that the appropriate exchange rate under Section 989(b) for translating the section 965(a) earnings amount will be the spot rate on December 31, 2017.  The regulations will also provide that the spot rate on December 31, 2017, will apply for purposes of translating other amounts necessary for the application of Section 965(b), including (1) translating a Section 965(a) earnings amount into U.S. dollars in computing amounts described in Section 965(b)(2)(A) and (B), (2) translating a specified E&P deficit into U.S. dollars in order to determine a U.S. shareholder’s aggregate foreign E&P deficit under Section 965(b)(3)(A), (3) translating a Section 965(a) inclusion amount with respect to a DFIC (if such amount was reduced by an aggregate foreign E&P deficit under Section 965(b)(1)) back into the functional currency of the DFIC for purposes of determining the previously taxed income of the DFIC, and (4) translating the portion of the U.S. dollar-denominated aggregate foreign E&P deficit allocated to a DFIC under Section 965(b)(2) into the functional currency of the DFIC for purposes of determining its previously taxed income under Section 965(b)(4)(A).^[5]
 
The Notice further provides that the regulations will also provide that, for purposes of Section 986(c), foreign currency gain or loss with respect to distributions of previously taxed income described in Section 959(c)(2) by reason of Section 965 will be determined based on movements in the exchange rate between December 31, 2017, and the date on which such previously taxed earnings and profits are actually distributed.
 
The Notice also provides that Treasury intends to issue regulations providing that the cash position of a specified foreign corporation with respect to any cash measurement date must be expressed in U.S. dollars.  Therefore, the amount of a U.S. shareholder’s aggregate foreign cash position will be the greater of the U.S. dollar-denominated aggregate amounts on each cash measurement date described in Section 965(c)(3)(A). 
 
In determining the cash position attributable to net accounts receivable, the amount of accounts receivables and accounts payables (in each case, if not otherwise denominated in U.S. dollars) must be translated into U.S. dollars at the spot rate on the relevant cash measurement date.  The fair market value of assets described in Section 965(c)(3)(B)(iii) must also be determined in U.S. dollars on the relevant cash measurement date.  For example, in the case of foreign currency, the fair market value will equal the currency amount translated at the spot rate on the relevant cash measurement date.

6. Modification to Rule Described in Section 3.03 of Notice 2018-07 Relating to Distributions of Previously Taxed Income
The Notice also clarifies the “gain-reduction rule” described in section 3.03 of Notice 2018-07.  Specifically, the Notice provides that Treasury intends to issue regulations that will provide that if a U.S. shareholder receives distributions through a chain of ownership described under Section 958(a) from a DFIC during the inclusion year that are attributable to previously taxed income described in Section 959(c)(2) by reason of Section 965(a), the amount of gain recognized under Section 961(b)(2) by the U.S. shareholder with respect to the stock or property of any entity in the ownership chain described in Section 958(a) through which the distribution is made will be reduced (but not below zero) by the Section 965(a) inclusion amount of the U.S. shareholder with respect to such DFIC.  The gain-reduction rule will apply similarly to reduce the amount of gain that would otherwise be recognized under Section 961(c) by any controlled foreign corporation in the ownership chain described in Section 958(a) through which the distribution is made to a U.S. shareholder for purposes of determining the amount included under Section 951(a)(1) in the gross income of the U.S. shareholder.^[6]

7. Guidance in Connection with the Repeal of Section 958(b)(4) and Application of Section 863  
Section 958 provides rules for determining stock ownership of a foreign corporation for purposes of Sections 951 through 965.  Section 958(b) provides, in relevant part, that Section 318(a) (relating to the constructive ownership of stock) applies, subject to certain modifications, to the extent that the effect is to treat any U.S. person as a U.S. shareholder within the meaning of Section 951(b) or to treat a foreign corporation as a CFC under Section 957.  Effective for the last taxable year of foreign corporations beginning before January 1, 2018, and each subsequent year of such foreign corporations, and for the taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end, the Act repeals Section 958(b)(4).   As in effect prior to repeal, Section 958(b)(4) provided that subparagraphs (A), (B), and (C) of Section 318(a)(3) were not to be applied so as to consider a United States person as owning stock which is owned by a person who is not a United States person. The subparagraphs of Section 318(a)(3) generally attribute stock owned by a person to a partnership, estate, trust, or corporation in which such person has an interest.
 
The Notice states that Treasury has determined that in light of the change to the constructive ownership rules in Section 958(b), further study is necessary to determine whether it is appropriate for the source of income described in Section 863(d) and (e) to be determined by reference to the status of the recipient as a CFC.  Accordingly, for purposes of applying Treas. Reg. Sections 1.863-8 and 1.863-9, taxpayers may determine whether a foreign corporation is a CFC without regard to the repeal of Section 958(b)(4) pending further guidance (which will be prospective, as discussed in the Effective Dates section of this Tax Alert).

8. Guidance in Connection with the Repeal of Section 958(b)(4) and Elimination of Form 5471 Filing Obligation for Certain Constructive Owners
In addition, the Notice provides that the Internal Revenue Service intends to amend the Instructions for Form 5471 to provide an exception from Category 5 filing for a U.S. person that is a U.S. shareholder with respect to a CFC if no U.S. shareholder (including such U.S. person) owns, within the meaning of Section 958(a), stock in such CFC, and the foreign corporation is a CFC solely because such U.S. person is considered to own the stock of the CFC owned by a foreign person under Section 318(a)(3).
 
Lastly, in the Notice, Treasury requested comments on the rules described in the Notice and comments on what additional guidance should be issued to assist taxpayers in applying Section 965.

 

Effective Dates

Section 965 is effective for the last taxable years of foreign corporations that begin before January 1, 2018, and with respect to U.S. shareholders, for the taxable years in which or with which such taxable years of the foreign corporations end.  The Notice provides that Treasury intends to provide that the regulations described in sections 3 and 4 of the Notice  are effective beginning the first taxable year of a foreign corporation (and with respect to U.S. shareholders, the taxable years in which or with which such taxable years of the foreign corporations end) to which Section 965 applies.  Before the issuance of the regulations described in this notice, taxpayers may rely on the rules described in sections 3 and 4 of the Notice.
 
The repeal of Section 958(b)(4) is effective for the last taxable year of foreign corporations beginning before January 1, 2018, and each subsequent year of such foreign corporations and for the taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.  Taxpayers may rely on section 5.01 of the Notice with respect to the last taxable year of foreign corporations beginning before January 1, 2018, and for the taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end, pending the issuance of further guidance (the application of which will be prospective).  Before the change to instructions described in section 5.02 of the Notice, taxpayers may also rely on the exception described in section 5.02 of the Notice for the last taxable year of foreign corporations beginning before January 1, 2018, and each subsequent year of such foreign corporations and for the taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.

 

BDO Insights

The exception provided in the Notice for certain U.S. shareholders that would be considered Category 5 filers of Form 5471 absent the exception described in the Notice should alleviate certain U.S. tax compliance concerns for many U.S. corporations with certain foreign shareholders that also own shares in foreign subsidiaries. The alternative method election described in the Notice should also help taxpayers comply with Section 965 in a practical and administratively viable manner.