Stephen C. Fox, CPA
U.S. International Tax
Stephen C. Fox, CPA, CMA
PO Box 880695
Port Saint Lucie,  FL  34988
+1(973) 610-5669
   International Tax      2017 Tax Changes      Section 965 Inclusion and Deduction

Section 965 Inclusion and Deduction

There's good news and bad news in the new tax bill if you own 10% or more of a foreign corporation. The good news is your share of the foreign earnings can come back to you nearly free of U.S. tax.  The bad news is you must pay at least a small part of it very soon. Inaction can trigger a much bigger amount due.

The most urgent item is mandatory and will require an election to be filed and a tax payment made by March 15 or April 15 for most taxpayers.  

New section 965 applies to anyone who owns 10% or more of a controlled foreign corporation, or CFC. It is not optional.  A CFC is a foreign corporation more than 50% owned by vote or value by U.S. person 10% or more owners on any day during its year. U.S. person includes U.S. individuals, partnerships, LLCs, S corporations and regular corporations.  The new section also applies to 10% shareholders of ANY foreign corporation if a U.S. regular or "C" corporation owns more than 10% of it.

Each such 10% or more owner must include his/her or its share of the foreign corporation's earnings and profits in his/her or its income.  This happens on the last day of the foreign corporation's last year BEGINNING before 2018.  Thus, if John Smith and 4 other Americans each own 11% of Forco Limited, and Forco's year is the calendar year, John must include 11% of Forco's accumulated earnings and profits in his income for 2017.  Earnings and profits or E&P, is a tax concept similar to retained earnings.

This is not as bad as it sounds.  The U.S. shareholder's whole share of the earnings taxed under this rule can come back free of further U.S. tax.  AND the U.S. owner gets a deduction for most of the amount included.  How much deduction depends on the portion of the E&P held in cash positions.  The part held in cash gives rise to a 55% deduction, and the rest to a 77% deduction. Cash positions include cash and foreign currency, bank deposits, traded securities, and accounts and short term notes receivable, less accounts payable.  These deduction amounts apply to individuals and corporations.

The inclusion and deduction are computed on an aggregate basis for each shareholder.  The aggregate inclusion is the shareholder's aggregate of shares of positive E&P reduced by the shareholder's aggregate shares of deficits in E&P.  Where the individual or entity owns part of a lot of foreign corporations, the computations needed can be staggering. <show website>

Here's an easy example. 
John Smith owns 11% of Forco Limited, and 20% of Smallco Limitada.  Each is a tax haven CFC.  Forco had $1 million of E&P, and had $250,000 of cash, accounts receivable, and foreign currency.  It had $50,000 of accounts payable.  Thus, its net cash position is $200,000.  John's share is $110,000 of E&P, and $22,000 of cash position.  Smallco had a cumulative loss of $50,000, and $10,000 of cash and receivables.  John's share of the E&P deficit is $10,000.  Thus, John's aggregate inclusion is $110,000 of Forco E&P less less the Smallco deficit of $10,000.  That's a net total of $100,000.  But it's not all taxable.

John gets a deduction computed like this.  First he computes his aggregate cash position. It is the total of his shares of each CFC's cash position, 11% of $200,000, or $22,000, plus 20% of $10,000, for a total of  $24,000.  This amount is subject to the lower deduction, or $13,371.  The balance of the inclusion, or $76,000, is eligible for the higher deduction, or $58,629.  John thus has an inclusion of $100,000, but gets a deduction of $72,000, whether he itemizes or not.  Thus, his net additional taxable amount is only $28,000.  If his tax rate is 36%, then his incremental tax is about $10,080, if I take a shortcut computing it.

John must pay this amount by April 15, 2018.  But he can defer all but $806, paying the rest over 7 years without interest.  Only 8% of the total incremental tax is due in each of the first 5 years, including 2018, with higher amounts in later years. To get this, John must file an election to defer payment, and pay the $806 and ALL other tax due with his 2017 return by April 15.  This due date cannot be extended.  If he misses it, even by 1 day, then the whole $10,080 is due on April 15.

That 8% payment is good news, and it gets better.  When John ultimately gets dividends from Forco, the first $110,000 is tax free. 

Similar results apply for regular C corporations.

If the shares are owned through a partnership or REIT, then each partner or REIT shareholder must make his own election and payment, just like John.

For S corporations and their shareholders, though, it's even better.  There's an additional election to defer the entire payment indefinitely. The payments become due only on the shareholder selling his or her shares, or the S corporation going out of business.  Additional reporting applies for S corporations and their shareholders.

As you can see from some of the excerpts of the new law that I've displayed, these rules are not simple. You need an experienced international tax specialist to apply them.

So here's what needs to be done for any U.S. individual, flow-through entity, or corporation that owns 10% or more of a foreign corporation:

First, for individuals and flow-throughs, determine if the foreign corporation is a CFC.  If so, the rule is applicable to that foreign corporation for the individual or flow-through.  The rule is also applicable to every foreign corporation for which there is a 10% or more U.S. C corporation shareholder.

Then determine the E&P or deficit of each applicable foreign corporation for the appropriate year, using U.S. tax principles.  Remember, the shareholder's year can be 2017, 2018, or both.

Then determine the foreign corporation's cash position.

Then determine the shareholder's pro rata share of E&P and cash positions.  This can be tricky if there are multiple classes of stock.

Then aggregate each of these for each of the shareholder's tax years, whether 2017 and/or 2018, and net the deficits against the aggregate positive E&P.  If there are both 2017 and 2018 inclusions, then you should count each foreign corporation only once.  <IRS Notice 2018-7>

Then compute the shareholder's tax with and without this net inclusion.  Don't take the shortcut I did in the example.  Calculate tax both ways.

Finally, make the election to defer and make the payment by the shareholder's tax return due date for each of 2017 and/or 2018.

That can be a tough agenda, and getting it done by March 15 or April 15 can be tough.  If you're a CPA or attorney and need help, check my website for contact details.  I can help, but I'll charge for it.

It's your business:  get personal.  Call Steve Fox at  1(973) 610-5669  or  email steve @ sfoxcpa .com
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