On Aug. 1, 2018, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations (the Proposed Regulations) that would implement the one-time transition tax on offshore deferred earnings contained in the recently enacted Tax Cuts and Jobs Act (TCJA). The Proposed Regulations largely follow previous IRS guidance contained in Notice 2018-26, Notice 2018-07, Notice 2018-13 and Rev. Proc. 2018-17; and affirm many of the rules contained in the Frequently Asked Questions posted on the IRS site with respect to the transition tax, with some modifications and offering new guidance on certain key issues. For our analysis of previously released guidance, please see our article IRS releases new guidance relating to the transition tax. Once published in the Federal Register, the proposed regulations will be open for public comment for 60 days, after which, the regulations may be issued as final.
Some of the key takeaways from the Proposed Regulations include:
- Individual taxpayers who elect to be taxed at the lower rates that apply to corporations on their transition tax income may take the special deduction set forth under the TCJA to reduce their current effective tax rates on their deferred offshore income. The availability of this deduction was unclear prior to the issuance of the Proposed Regulations. This election is complex and should be examined carefully to assess whether it will produce beneficial results.
- The Proposed Regulations address an important question regarding whether taxpayers could claim an increased basis in the shares of a foreign corporation with respect to which deferred foreign income is taken into account. To address this uncertainty the Proposed Regulations allow taxpayers to make a special election to make certain adjustments (both up and down) to their basis in such shares; however, such election applies to all foreign corporations subject to the transition tax owned by the taxpayer and should be examined carefully because in some cases taxpayers may be required to recognize gain if a downward adjustment exceeds the taxpayer’s basis in the foreign corporation’s shares.
- U.S. persons that must pay tax under section 1411 (the tax on net investment income) on a section 965(a) inclusion are not entitled to take into account the section 965(c) deduction for purposes of determining the amount of such tax. Thus, such persons must pay the net investment income tax of 3.8 percent on the gross amount of the inclusion taken into account under the rules of the transition tax. In addition, a taxpayer may not elect to defer any net investment income tax due on such amount even if the taxpayer elects to defer payment of any income tax due on amounts subject to the transition tax. The combination of these rules could be quite onerous because it could result in a current net investment income tax liability that exceeds the amount of the income tax due where the taxpayer makes an election to defer transition tax over an eight year period.
- Contrary to the request of many public comments, there will be no de minimis exception with regard to special anti-avoidance rules that disallow taxpayers from giving effect to changes in accounting methods, entity classification elections or other strategies that result in a reduction of transition tax liability if a principal purpose of the strategy is to reduce or avoid the transition tax.
- For purposes of determining whether a foreign corporation is subject to the transition tax stock owned by a partner will not be attributed to the partnership under special downward ownership attribution rules so long as the partner’s interest is less than five percent of the partnership’s capital and profits.
- Generally speaking, taxpayers must calculate the earnings of a foreign corporation using U.S. tax principles, and the Proposed Regulations fail to grant relief to foreign corporations that traditionally have not been required to conform their accounting to U.S. tax principles. Thus, taxpayers must take on the potentially onerous task of calculating earnings of a foreign corporation applying U.S. tax principles using foreign financial statement information.
- The Proposed Regulations contain a variety of rules relating to the calculation of the foreign tax credit. Significantly, the Proposed Regulations do not address transitional issues arising from the introduction of new foreign tax credit limitation baskets. We expect that guidance addressing these issues will be the subject of another regulations package to be issued later this year.
- The Proposed Regulations resolve various uncertainties regarding the election to defer the payment of transition tax over an eight-year period. For example, taxpayers who elect such deferral and who underpay their first installment will not accelerate the due date of the remaining payments so long as certain criteria are met. In addition, a taxpayer that engages in an event that would trigger acceleration of transition tax payments otherwise deferred may preserve deferral treatment if the taxpayer enters into a special agreement with the IRS, as set forth in the Proposed Regulations.
These Proposed Regulations will have a very significant impact on taxpayers subject to the transition tax and will likely affect their tax liability and reporting obligations for the 2017 year (in the case of calendar year taxpayers). Taxpayers should examine them closely with their advisors immediately to develop their response.