IRC Section 965 Transition Tax Audits: Don’t Be Caught Off-Guard
By Ronald Kalungi, Drucker & Scaccetti, P.C.
The Tax Cuts and Jobs Act (TCJA) of 2017 amended section 965 of the Internal Revenue Code (IRC) by imposing a one-time tax on US persons owning stock in certain foreign corporations with untaxed earnings as of the date the TCJA came into force. At the time of its enactment, this transition tax was estimated by Congress’s Joint Committee on Taxation to raise USD 338.8 billion in tax revenue during the fiscal years 2018 through 2027. The revenue yield from this tax has actually been much lower than expected. The Tax Inspector General for Tax Administration (TIGTA) reported that as of 08 November 2018, taxpayers had reported only USD 30.2 billion in section 965 tax and paid only USD 11.2 billion (deferring USD 22.7 billion). This poor revenue yield has made the transition tax one of the principal focal areas of audit compliance efforts by the Internal Revenue Service (IRS) – efforts that shouldn’t catch affected taxpayers off guard.
IRC Section 965, as amended by the TCJA, required US shareholders of “specified foreign corporations” (SFCs) to pay a one-time tax on the SFC’s earnings as if those earnings had been repatriated to the United States in the SFC’s last tax year beginning before 01 January 2018. Section 965 required taxpayers to include in gross income their share of the SFC’s undistributed and previously untaxed post-1986 earnings and profits. For corporate taxpayers, foreign earnings attributable to cash and cash equivalents were taxed at a 15.5% rate; foreign earnings attributable to all other (non-cash) assets were taxed at an 8% rate for the taxable year 2017.
To soften the cash flow burden payment of the transition tax would impose on affected taxpayers, Congress permitted those taxpayers to pay the tax in interest-free instalments over eight years: 8% of the tax in years 1 through 5; 15% in year 6; 20% in year 7 and 25% in year 8. Unpaid instalments are accelerated and due if an instalment payment is missed, the taxpayer liquidates or sells substantially all of its assets, or the business ceases operation.
Key IRS Audit Compliance Focus Areas
The IRS section 965 transition tax audit compliance campaign will likely encompass every aspect of this tax. Highlighted below are some of the likely key focus issues for this campaign.
Form 5471 Filers: Taxpayers who filed Form 5471 (Information Return of US Persons With Respect to Certain Foreign Corporations) for the taxable years 2017 and 2018 but did not report the section 965 transition tax should be prepared to explain to the IRS why they were not subject to the transition tax in those years. A taxpayer who filed Form 5471 but did not report the transition tax may have a good explanation for the nonreporting: The foreign corporation may not be an SFC, in which case it would fall outside of the scope of the transition tax. If an SFC, the foreign corporation triggering the Form 5471 reporting may not have had untaxed earnings and profits, or had accumulated losses in the 2017 and 2018 taxable years, and therefore no section 965 income inclusion in either case. It is important for each Form 5471 filer to take a step back and review the reason(s) why they did not report the section 965 tax in the relevant years because the IRS is expected to target these filers first when scoping the pool of taxpayers subject to its section 965 tax audit compliance campaign.
Taxpayers who reported the section 965 Transition Tax: Taxpayers who reported and paid the section 965 transition should expect inquiries from the IRS about the transition tax, and many such taxpayers should expect an audit of their section 965 tax. An audit of the section 965 tax could be costly – potentially forcing companies to go through 31 years of earnings and profits and foreign taxes paid or accrued in order to prove to the IRS that the section 965 tax was computed correctly. The section 965 tax audits will likely focus on two computational issues: (1) the post-1986 accumulated earnings and profits (E&P), and (2) the amount of foreign earnings attributable to cash and cash equivalents. The E&P amount determines the amount of the tax due, and its computation involves many complicated issues, including the netting of positive and negative balances for different SFCs. In addition, since the section 965 tax was designed to treat cash (and cash equivalents) assets differently from non-cash assets, the IRS is likely to examine which foreign earnings are attributable to cash and cash equivalents, and which foreign earnings are attributable to non-cash assets, and it will focus particularly on companies that elected to use a date to calculate earnings and cash position other than 02 November 2017 or 31 December 2017. Recordkeeping will be key for taxpayers who decide to challenge IRS audits on these issues. Consultation with professional advisors will be equally important. The complexities inherent in various section 965 transition tax issues leave little room, if any, for a “go it alone” approach.
Taxpayers who elected to pay the section 965 Transition Tax in Instalments: For taxpayers who elected to pay the transition tax in eight (8) annual instalments, the IRS will be examining how well they are complying with the instalment payment agreement: Whether they are paying the annual instalments; whether there has been an acceleration event that triggers payment of all the remaining instalments, and, for transfers of equity interests by taxpayers subject to the instalment payment agreement, whether the IRS’s approval was sought and received.
In a nutshell, taxpayers should not assume that the section 965 transition tax is a thing of the past. It is not. Innumerable issues regarding this tax will remain bones of contention between taxpayers and the IRS for the next several years.
Ronald KalungiGGI member firm
Drucker & Scaccetti, P.C.
Advisory, Auditing & Accounting, Corporate Finance, Fiduciary & Estate Planning, Tax
Philadelphia (PA), USA
Ronald Kalungi is an International Tax Director at Drucker & Scaccetti, P.C. In his role, Ronald provides tax planning, tax compliance and business consulting services to a broad base of clients, including multinational corporations, partnerships, S corporations and high net-worth individuals.
Published: GGI Insider, No. 115, September 2021 l Photo: pabrady63 - stock.adobe.co