Disclaimer: The new rule on the deemed repatriation tax is complex and will require guidance from Congress or the IRS for additional clarification. Please contact your Lurie advisor to discuss your specific situation.
The recently passed tax act had a few provisions that impacted 2017 tax filings. One of the key changes relates to the deemed repatriation of certain foreign corporation accumulated deferred earnings.
The new provision states that all taxpayers who are U.S. shareholders of Specified Foreign Corporations (SFC) in 2017 will have an income inclusion to the extent they have allocable undistributed earnings from such corporation. While there is a reduced tax rate applicable to this income, at least a portion of the tax is due in 2017 and the liability must be calculated as part of the 2017 tax filing.
Here are the details of the new provision:
All U.S. shareholders of a SFC must include in their 2017 income their pro-rata share of accumulated post-1986 deferred foreign income. This income will be taxed in a manner that should result in the quoted federal effective tax rate on earnings of:
- 5% on cash and cash equivalents and,
- 8% on illiquid assets
The IRS has generously allowed the taxpayer to elect to pay the tax over an 8 year period, starting with the 2017 return, using a specific weighted installment calculation. However, the entire tax liability or the first installment is due by the original due date of the shareholders tax return. S-Corporation shareholders may be eligible to elect to maintain deferral under certain conditions, which are outlined later in this article.
A taxpayer’s pro-rata share of accumulated post-1986 deferred foreign income is considered Subpart F income. For future taxation purposes, this income generally will be considered previously taxed income. Thus, the future actual cash repatriation of these earnings will not trigger any additional tax consequence as the cash will not be considered taxable income.
What is the definition of a U.S. shareholder for this purpose?
A U.S. person who owns (directly, indirectly, or constructively) 10% or more of the total voting stock.
- A U.S. person includes US citizens and residents, domestic partnerships, corporations, estates and trusts.
What is the definition of a Specified Foreign Corporation for this purpose?
- A controlled foreign corporation (CFC), or
- A noncontrolled foreign corporation that has at least one domestic corporate shareholder.
Calculation of Income Inclusion:
The income inclusion amount is the greater of the shareholders share of the accumulated post-1986 deferred income (Earnings and Profit or E&P) as of November 2* or December 31, 2017. Thus, for all U.S. shareholders of SFCs the accumulated E&P will need to be calculated. This will need to be allocated to pre and post-1986 deferred income as applicable and/or pre and post date of becoming an SFC. If there is an accumulated E&P deficit, there are special rules that will allow U.S. shareholders to aggregate their total allocable E&P from all sources for this purpose, but not below zero.
The effective tax rate is achieved via a mechanical calculation. The U.S. shareholder includes the applicable deferred income (E&P) into income but is allowed a deemed dividend, which when the applicable highest corporate tax rate is applied to the income (currently 35%, since this is for the 2017 tax year) the effective federal rate will be 15.5 or 8% on the income inclusion amount. The ultimate tax paid on the income inclusion may be further reduced in certain circumstances due to available foreign tax credits (primarily C Corporations). Given the mechanism of this calculation, should the shareholder be a U.S. individual, the effective federal tax rate may be slightly higher or lower than those applicable to corporate shareholders. Individual shareholders will also need to review the application of net investment income (NIIT) tax to the deemed dividend based on their facts and circumstance. If NIIT is applicable, an additional 3.8% tax will apply at the federal level.
There are some special rules for certain circumstances:
- S-Corporation shareholders may elect to defer the income inclusion provided certain conditions are met, which include:
- Change in S-Corporation status,
- Sale of substantially all of its assets,
- Cessation of business, or
- Electing shareholder transfers of its S-Corporation stock.
- The election must be made with the 2017 tax return. It has been noted that while the shareholder is responsible for the tax, the S-Corporation appears to be jointly and severably liable for payment of the tax and any applicable penalties or additional amounts.
- The IRS has provided special rules if the shareholder is a Real Estate Investment Trust (REIT) or has net operating losses available.
- Individual shareholders have an option to elect to be taxed as a Corporation related to this income inclusion. However, upon the actual repatriation of the cash, the income is considered to be the receipt of a dividend subject to tax. Thus, detailed calculations are necessary to determine whether there is a benefit of such an election.
- The state taxation of this income inclusion and/or deemed dividend application will vary. Based on how the state has historically taxed Subpart F income, it is anticipated this will apply to that situation. Whether the deemed dividend deduction will be allowed will also need to be reviewed.
If you have any questions or would like additional information on how this change could affect you or your business please contact your Lurie advisor.
*IRS Notice 2018-13 provides guidance to assist taxpayers in determining E&P as of the November 2, 2017 date.