Are You Subject to the One-Time Transition Tax on Deferred Foreign Income?
New Modified Stock Attribution Rules May Cause Certain Foreign Corporations to be Treated as CFCs That Would Not Otherwise Have Been Under the Previous Tax Regime
The Tax Act introduced numerous international tax provisions to the Internal Revenue Code that significantly alter the international tax landscape for many U.S. taxpayers. Arguably, the transition tax requiring many U.S. shareholders of foreign corporations to pay a one-time tax on their deferred foreign income under Section 965 has received the most attention from practitioners and their clients due to its immediate impact (i.e., effective for the 2017 tax year). However, little discussion has been had or initiated over the modified stock attribution rules to determine when a foreign corporation is a CFC and when a U.S. person will be treated as a U.S. shareholder of that CFC. Absent further guidance from the Internal Revenue Service (“IRS”), these modifications have the potential of causing U.S. persons who wouldn’t otherwise be subject to the transition tax to now have to determine their one-time transition tax inclusion.
Specifically, the Tax Act repealed Section 958(b)(4) and further expanded the definition of a U.S. shareholder to include any person who owns 10% or more of a CFC’s stock, by either vote or value. The combination of these two legislative changes made by Congress appears to be in direct response to U.S. shareholders attempting to avoid subpart F inclusions by decontrolling CFCs or engaging in corporate inversion transactions. Therefore, if a foreign parent owns more than 50% of the stock of a foreign subsidiary and more than 50% of the stock of a domestic subsidiary then the domestic subsidiary will be treated as constructively owning more than 50% of the foreign subsidiary.
As mentioned above, these changes could have the disastrous result of causing certain foreign corporations to be “specified foreign corporations” and subject to the one-time mandatory repatriation tax under Section 965. Although Section 951(a)(1) limits subpart F inclusions to U.S. shareholders who own stock in a CFC directly or indirectly, there could be situations where a U.S. shareholder gets caught in Section 965’s net. For example, where a U.S. resident (non-U.S. citizen) owns 25% and a nonresident alien owns 75% of a foreign corporation, and nonresident alien owns 100% of a domestic corporation.
Section 958(b)(4)’s repeal causes the foreign corporation to be treated as a CFC due to the constructive attribution to the domestic corporation of nonresident alien’s ownership in the foreign corporation. Additionally, since foreign corporation is a CFC it will now also be considered a “specified foreign corporation” under Section 965 and subject to the one-time transition tax. Therefore, without the repeal of Section 958(b)(4), U.S. resident would not have had a Section 965 inclusion because foreign corporation would not have been treated as a CFC and there was no domestic corporate shareholder of foreign corporation. However, since foreign corporation is now treated as a CFC, U.S. resident would be required to include its pro rata share of the post-1986 deferred foreign income in its gross income under Sections 951(a)(1)(A) and 965, i.e. 25%, even though domestic corporation would not be required to include into income any portion of foreign corporation’s deferred foreign income since it does not own foreign directly or indirectly.
As a result of Section 958(b)(4)’s repeal, and as identified above, the potential U.S. shareholders with Section 965 inclusions have expanded due to an unintended consequence of HR1 in an attempt to capture lost subpart F income.
On January 19, 2018, the IRS released additional guidance concerning the Section 965 transition tax and the repeal of Section 958(b)(4). Specifically, as it relates to Section 958(b)(4), the IRS provided guidance under the section 863 sourcing rules, and expressed their intent to modify the Form 5471 filing obligations to exclude U.S. persons from having to file Form 5471 under certain circumstances applicable to Section 958(b)(4)’s repeal. However, there was no mention by the IRS of the intent to issue any guidance or regulations regarding the impact of Section 958(b)(4)’s repeal on certain U.S. shareholders’ inclusion of the Section 965 transition tax. Therefore, unless provided otherwise, certain U.S. shareholders of foreign corporations may be required to pay their portion of the transition tax for a CFC that had never before been treated as such.