IRS provides guidance on section 965 transition tax

On December 22, 2017, President Trump signed “an Act to provide for reconciliation pursuit to Titles II and V of the concurrent resolution on the budget for fiscal year 2018” (a.k.a. the “Tax Cuts and Jobs Act”)(“the Act”) into law. The Act is the most significant overhaul of America’s tax system in decades and includes fundamental changes to international taxation in the U.S. The vast majority of the statutory changes impact 2018 filing years, and beyond. The most significant component of the Act that impacts 2017 income tax filings is the deemed repatriation of deferred foreign income. The deemed repatriation of deferred foreign income statute is a one-tax tax on certain income earned outside the U.S. The one-time income inclusion related to offshore earnings denotes a point of demarcation from the historic taxing regime to the new taxing regime.

Deemed repatriation of deferred foreign income

Under pre-Act law, U.S. persons were generally not taxed in the U.S. on foreign subsidiary income until it was repatriated in the form of a dividend. Under section 965 of the Act, U.S. shareholders are required to pay a “transition tax” on the untaxed foreign earnings of specified foreign corporations as if those earnings had been repatriated to the U.S. The term “transition tax” is a reference to the aforementioned transition from the old regime to the new regime. Some of the most salient considerations of the new statute include:

• Deferred income held in cash would be effectively taxed at 15.5 percent and any remaining amounts at 8 percent. (Section 965(c)). “Cash” is a defined term and includes other liquid assets.
• An election is available to pay the tax liability over an eight-year period. (Section 965(h)).
• Special rules exist for S-corporations that would allow for continued deferral. The available deferral would generally end when a “triggering event” occurs. “Triggering event” is one of many newly defined terms. A triggering event for section 965 deferral generally occurs when the structure or ownership of the S-corporation is altered in some way.
• The income inclusion amount can be reduced by earnings and profits (E&P) deficits. There is now even greater pressure to be able to document the global E&P position of U.S. taxpayers.
• A reduced foreign tax credit applies to the inclusion. (Section 965(g)). This generally relates to C-corporation taxpayers.

The statute, as drafted, left many significant outstanding questions that needed to be addressed in calendar year 2017 income tax filings. Additionally, the impact of section 965 appears to be wildly inconsistent between the types of U.S. taxpayers (individuals, C-corporations, S-corporation shareholders, etc.). It is unlikely that technical corrections will be available soon and it is equally unlikely that full-blown regulations are in the foreseeable future. Therefore, the Internal Revenue Service (“IRS”) has been working to provide additional guidance in the form of notices. Notices 2018-07 and 2018-13 were issued by the IRS in January. These notices provided some of the much-needed guidance related to the following section 965 application issues:

• Details were provided on how to calculate the potential income inclusion amount, including the measurement of E&P as well as the process to allocate deficit E&P pools against positive E&P pools.
• Details were provided related to the participation exemption amount. The participation exemption will reduce the inclusion amount such that the effective tax rate on the gross inclusion amount will align with the aforementioned 15.5 percent and 8 percent effective tax rates.
• Details were provided on how to measure cash. Cash includes cash, net accounts receivables, the fair market value of actively traded personal property, commercial paper, certificates of deposit, governmental securities, short-term obligations and foreign currency. The cash date of measurement is either the last day of the 2017 year or the average balance of the prior two yearends (whichever amount is higher).
• “Specified Foreign Corporations” (“SFC”) is another newly defined term. SFCs are the entities whose earnings are potentially pulled into the one-time income inclusion amount. SFCs include controlled foreign corporations as well as any foreign corporation with respect to which one or more domestic corporations is a U.S. shareholder (10 percent corporations).

On March 13, 2018, the IRS issued a series of frequently asked questions (FAQs) that outlined how taxpayers subject to the Section 965 transition tax should report and pay the tax liability on their 2017 income tax returns. The FAQs also include information on various elections taxpayers can make under section 965. The FAQs include, in part:

• Which U.S. taxpayers are required to report amounts under section 965 on a 2017 income tax return
• How, and in what format, amounts are reported on 2017 income tax returns
• What elections are available, who can make those elections, how the elections are made and election due dates with respect to section 965 on 2017 income tax returns
• How should a taxpayer pay the tax resulting from section 965 for 2017 income tax returns?
• Expanded Form 5471 filing requirements and disclosure statement guidance.

Also, the FAQs provide several disclosure and election templates for taxpayer reference.

The IRS has promised to continue issuing section 965 guidance throughout the 2017 tax filing season. Additional guidance related to the post-2017 application issues of the Act is also forthcoming.

The IRS has promised to continue issuing section 965 guidance throughout the 2017 tax filing season. Additional guidance related to the post-2017 application issues of the Act is also forthcoming.

Contributed by

Michael Patterson, Rehmann
E michael.patterson@rehmann.com

Tax reform complicates things for foreign partners in US businesses

The new law upends the Grecian Magnesite decision.

Foreign partners structuring an exit of a U.S. partnership interest need to reconsider their strategies.

Like all those subject to the U.S. tax system, foreign partners of U.S. businesses have long had to navigate a difficult set of rules and regulations when the time comes to divest of their ownership. But just when these partners seemed to have been granted some clarity in the landmark 2017 Grecian Magnesite Mining tax court case, new tax reform legislation reversed these hard fought gains and added new layers of complexity.

As part of the Tax Cuts and Jobs Act, Congress passed two significant provisions:

• First, the proportion of any gain attributable to a U.S. trade or business resulting from the direct or indirect sale, exchange, or other disposition of a partnership engaged in a U.S. trade or business, is subject to U.S. taxation. The gain is reduced by any gain from the sale of a U.S. real property interest subject to taxation under the Foreign Investment in Real Property Act of 1980 (FIRPTA).
• Second, the purchaser or other withholding agent of an interest in a partnership engaged in a U.S. trade or business is required to withhold and remit 10 percent of the gross sale price that is attributable to a nonresident alien’s proportional gain or loss of the sale unless: the purchaser receives an affidavit that the seller is a U.S. person; it is determined that no portion of the gain or loss is attributable to a U.S. trade or business; the IRS agrees to a lower withholding amount; or the partnership is publicly traded.

Before we get to the unanswered questions and difficulties these new provisions impose on foreign partners in U.S. partnerships, it’s helpful to review the previous tax treatment and related rulings that brought us to where we are today.

Resolving the debate over tax-triggering “effectively connected income”

The sale or exchange of a partnership interest in a business is generally treated as the sale or exchange of a capital asset, so any gain or loss will also result in a capital gain or loss. Nonresident aliens are only subject to U.S. income tax on capital gains if those gains are treated as U.S. source income “effectively connected” with a U.S. trade or business.

Although there is no strict definition of what constitutes a U.S. trade or business, U.S. courts have defined it as a profit-oriented activity conducted in the United States by a taxpayer (or his or her agents) that is “considerable, continuous, and regular.” This activity must transcend mere ownership of private property. Nonresident aliens owning an interest in a partnership that does business in the United States are considered to be engaged in a U.S. trade or
business; this subjects the foreign partner to U.S. taxation on his or her share of allocable income.

In 1991, the IRS released Revenue Ruling 91-32, which concluded that any gain resulting from the sale or exchange of an interest in a partnership with a U.S. trade or business that operated through a U.S. fixed location would result in U.S. effectively connected income (ECI). This was deemed so to the extent of the partner’s distributive share of unrealized gain or loss of the partnership that is attributable to property used (or held for use) in the partnership’s U.S. trade or business.

To arrive at this conclusion, the IRS applied an “aggregate” theory approach to partnership taxation. First, the IRS reasoned that a foreign partner is treated as engaged in a U.S. trade or business through his or her ownership in a partnership engaged in a U.S. trade or business. It then reasoned that the fixed place of business of the partnership is attributed to the foreign owner. As a result, the IRS took the position that any gain attributable to the U.S. trade or business resulting from the sale or exchange of the partnership would be U.S.-sourced ECI via the partnership’s fixed place of business. This would then subject the foreign partner to U.S. taxation on the sale of the partnership interest.

From the outset, Rev. Rul. 91-32 proved largely ineffective and unenforceable, mainly because, at the time, the U.S. tax code did not contain any provision that expressly states that gains from the sale or exchange of a partnership interest by a nonresident alien individual or foreign corporation is treated as ECI of a U.S. trade or business.

Undeterred, the IRS continued to enforce Rev. Rul. 91- 32, which culminated in the landmark 2017 case Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner (Grecian Magnesite). Contrary to the IRS’s position, the tax court applied the general partnership rule,
which is to treat the sale or exchange of partnership interest as a sale of personal property. The sale of personal property is sourced based on the residence of the seller; therefore, a foreign owner would not be subject to U.S. tax on any gain from the sale or exchange of a partnership interest engaged in a U.S. trade or business. However, if a portion of the gain is attributable to U.S. real estate, the FIRPTA rules apply, subjecting the foreign partner to U.S. tax on that piece of the gain. The purchaser of the partnership interest would be required to withhold 15 percent of the gross purchase
price associated with the U.S. real property interest. The tax court’s rejection of Rev. Rul. 91-32 seemed to finally put an end to this long-standing dispute.

Tax reform legislation leaves us with many unanswered questions

Unfortunately, the beneficial Grecian Magnesite ruling was short-lived. As part of the recent passage of tax reform legislation, Congress effectively codified Rev. Rul. 91-32, giving the IRS long desired tax law, and puts those involved in these types of transactions back in the difficult position to
comply.

There are several other issues that need to be resolved:

• How to value a partnership’s proportional share of its U.S. trade or business
• How to value assets attributable to a U.S. trade or business
• How the IRS will be able to identify and enforce certain transfers of foreign partnership interests with an active U.S. trade or business
• How the new law will affect current and future income tax treaty negotiations.

Foreign partners structuring an exit from a U.S. partnership interest should carefully consider how to treat any gain and make sure the new provisions are appropriately applied.

Contributed by

Joey Pariseau, CliftonLarsonAllen
E Joey.pariseau@CLAconnect.com
T +1 704-816-8401