Treatment of Deferred Foreign Income Upon Transition to Participation Exemption System of Taxation
Note: Most analyses of this new transition tax are made from the perspective of a U.S. corporation with a foreign subsidiary. In this case, the "repatriation" of foreign profits to the U.S. can result in a 100% elimination of the transition tax through the operation of the dividends received deduction. Since most of our clients are individuals who own a private corporation, this analysis addresses only the situation as it relates to U.S. citizen shareholders of a CFC.
A transition tax has been imposed on accumulated post-1986 foreign earnings determined as of either November 2, 2017 or December 31, 2017, without requiring an actual distribution, upon the transition to the new participation exemption system. The transition rule requires mandatory inclusion of such deferred foreign income as subpart F income by U.S. shareholders of deferred foreign income corporations. The included amount is taxed at a reduced rate that depends on whether the deferred earnings are held in cash or other assets (Code Sec. 965, as amended by the Tax Cuts and Jobs Act (P.L. 115-97)). Although this may be an unintended result, it would appear that the retained earnings of an active business corporation owned by a U.S. shareholder residing in Canada would be subject to this new tax.
The former mechanism to deal with the deferral of income in foreign corporations are the subpart F rules (Code Secs. 951-965). Under these subpart F rules, U.S. shareholders of a controlled foreign corporation (CFC) are currently taxed on their pro rata shares of the CFC’s subpart F income without regard to whether the income is distributed to the shareholders (Code Sec. 951(a)). A CFC generally is any foreign corporation in which U.S. shareholders own more than 50 percent of the corporation’s stock (measured by vote or value) (Code Sec. 957). For this purpose, a U.S. shareholder is a U.S. person who owns at least 10 percent of the voting stock of the foreign corporation (Code Sec. 951(b)).
With certain exceptions, subpart F income generally includes passive income and other income that is readily movable from one taxing jurisdiction to another (Code Sec. 952). A U.S. shareholder of a CFC may exclude from its income actual distributions of the CFC’s earnings and profits that were previously included in the shareholder’s income under subpart F (Code Sec. 959). Foreign base company services income is income from the performance of services outside of the CFC's country of incorporation, or for or on behalf of a related party.
The subpart F income included in the gross income of any U.S. shareholder is reduced by the amount of the shareholder's pro rata share of any qualified deficit. The term “qualified deficit” means any deficit in earnings and profits of the CFC for any prior tax year that began after December 31, 1986, and for which the CFC was a CFC, but only to the extent the deficit (i) is attributable to the same qualified activity as the activity giving rise to the income being offset, and (ii) has not previously been taken into account (Code Sec. 952(c)(1)(B)).
Where a foreign entity is not controlled by U.S. persons, the Passive Foreign Investment Company (PFIC) rules are used to prevent the deferral of income. PFIC's are discussed here.
In order to understand the implications of the new rules, it is important to define some terms used in the legislation:
A deferred foreign income corporation (DFIC) with respect to any U.S. shareholder is any "specified foreign corporation" of the U.S. shareholder that has accumulated post-1986 deferred foreign income as of November 2, 2017, or December 31, 2017, greater than zero (Code Sec. 965(d)(1), as amended by the 2017 Tax Cuts Act).
A specified foreign corporation is (1) a CFC, or (2) any foreign corporation in which a domestic corporation is a U.S. shareholder.
Therefore, insofar as an individual U.S. citizen shareholder who resides in Canada and who has accumulated retained earnings in a controlled corporation, the transition tax appears to be applicable to the entire amount of earnings retained since 1986, even though these earnings were not considered subpart F income in all prior years because they were from active business income carried out in Canada.
The mechanism for the imposition of the transition tax is subpart F income. Therefore for the last tax year beginning before January 1, 2018 the subpart F income of a deferred foreign income corporation is increased by the accumulated post 1986 deferred foreign income (net of certain deficits) of the corporation as of either November 2, 2017, or December 31, 2017, without regard to the nature of the income accumulated.
Many U.S. citizen residents of Canada who have operated active business corporations in Canada have taken advantage of the Canadian tax planning system, in which active business income earned in Canada up to an annual maximum is taxed at a low corporation tax rate. Many such corporations retain the annual maximum earnings each year, and pay the balance of the profit out to shareholders. This results in an accumulation of retained earnings over time. Under the former subpart F rules, active business income was not immediately taxed, unless a distribution of the income was made to the shareholders.
This new transition tax therefore has the effect of accelerating the taxation of all income earned in a foreign corporation and retained therein as a result of favorable Canadian tax rates.
This may be an unintended result of the new legislation which may be corrected by further regulations which may be issued by the Treasury Department on this topic. The Treasury has asked for input from practitioners and others on this subject and this firm has made a submission on this matter.
For futher reference excerpts from Internal Revenue Code Section 965 are available here.