Part I: Introduction – What Is The Transition Tax?

"The Little Red Transition Tax Book" – Everything you need to know about the 965bmandatory repatriation tax but didn't know to ask. A horrific abuse of #Americansabroad in a @citizenshiptax and #FATCA world! https://t.co/j7v1Asreek

— U.S. Transition Tax – Subpart F and #GILTI (@USTransitionTax) June 26, 2023

“Tell me who you are. Then I’ll tell you how the law applies to you!” I’ll also tell you whether you are a “winner” or a “loser” under this law.

At the end of 2017, Congress was enacting the TCJA. A major purpose of the TCJA was to lower U.S. corporate tax rates from 35% to 21%. This was a huge benefit to U.S. multinationals. One Congressional concern was how to find additional tax revenue in order to compensate the Treasury Department for the reduction in tax revenue which would result in lower receipts from corporations. Congress needed to find some additional tax revenue. They found this additional tax revenue by creating “new income” from the past and taxing that newly created income in the present. In fact, Congress said:

“Let there be income! And there was income …“

Significantly, Congress didn’t create any real income. No taxpayer actually received any income to pay tax on. The income created by Congress was not “real income”. Rather it was “deemed income”. But, this “deemed income” was intended to appear on tax returns. Real tax was payable on this “deemed” income.

Such, is the beginning of the story of the IRC 965 Transition Tax. The Transition Tax was a benefit to U.S. multinationals and destroyed the lives of individual U.S. citizens living outside the United States who organized their businesses, lives and retirement planning (as did their neighbours) through small business corporations.

This post identifies different groups impacted by the Transition Tax and the “winners” and “losers”.

Introducing the IRC 965 U.S. Transition Tax

26 U.S. Code § 965 – Treatment of deferred foreign income upon transition to participation exemption system of taxation

(a) Treatment of deferred foreign income as subpart F income

In the case of the last taxable year of a deferred foreign income corporation which begins before January 1, 2018, the subpart F income of such foreign corporation (as otherwise determined for such taxable year under section 952) shall be increased by the greater of—

(1) the accumulated post-1986 deferred foreign income of such corporation determined as of November 2, 2017, or
(2) the accumulated post-1986 deferred foreign income of such corporation determined as of December 31, 2017.

https://www.law.cornell.edu/uscode/text/26/965

Part II: The Reader’s Digest Version – The Six Faces Of The Transition Tax

The six “faces” of the 965 transition tax include the faces of five different kinds of “U.S. Persons”. The sixth face is the country where a U.S. citizen was living. Some are winners and some are losers. A list of winners and losers includes:

Three Winners

1. Winner: A U.S. C corp: Typically a U.S. multinational – Received value in return for being subjected to the transition tax

2. Winner: The individual shareholder of a U.S. S corp: Can opt to have the “deemed income inclusion” of 965 to NOT apply – Escaped the application of the transition tax

3. Winner: Green Card holder who is a “treaty nonresident”: Can escape U.S. taxation on “foreign source income – Escaped the application of the transition tax

Three Losers:

4. Loser: A U.S. resident individual (U.S. citizen or resident): The Moores – Subject to the transition tax, received nothing in return and likely subject to double taxation

5. Biggest Loser: A U.S. citizen living outside the United States who is a tax resident of another country: More of a loser than the Moore’s – what if the Moores had lived in British Columbia Canada? – Subject to the transition tax, received nothing in return, likely subject to double taxation and likely had their pension confiscated

6. Indirect Loser: The countries where overseas Americans are resident were also damaged by the transition tax: Many countries (example Canada) incentivize the creation of private pension plans through the use of private corporations. The effect of the transition tax was effectively to “loot” the retained earnings of those private corporations that were intended to be pension plans for residents of other countries. This is a particularly ugly manifestations of U.S. citizenship taxation and is a graphic example of how US citizenship taxation operates to extract working capital from other sovereign countries.

Significantly the biggest losers in the application of the 965 transition tax are Americans living outside the United States!

The transition tax confiscated the retained earnings of their local business corporations. Because they are tax residents of other countries, there was no prospect of the corporation’s earnings being repatriated to the United States. The corporation’s earnings were the pension/retirement plans for those individuals.

To put it simply:

The Treasury Department – via IRC 965 – effectively “looted” the retained earnings of small business corporations located outside the United States. The justification for the “looting” was that more than 50% of the shares were “owned” by U.S. citizens. The 2017 US Transition Tax was the ugliest face of the Transition Tax and a particularly ugly manifestation of U.S. citizenship taxation!

Part III: Further Commentary – The Six Faces Of The Transition Tax

1. Winner: A U.S. C corp: Typically a U.S. multinational – – Received value in return for being subjected to the transition tax

In return for a reduced tax rate from 35% to 21% they pay a one time tax (paid in installments over eight years) at a reduced rate. They also benefit from IRC 245A (restricted in application to corporations) which which means that future distributions of “foreign income” will not be subject to U.S. taxation. Note that individual shareholders do NOT have the benefits of 245A.

2. Winner: The individual shareholder of a U.S. S corp: Can opt to have the “deemed income inclusion” of 965 to NOT apply – Escaped the application of the transition tax

With respect to individual shareholders of an S corp, an IRS training unit individual shareholders IRC 965(i) states:

An election by S corporation shareholders to defer payment of the section 965 net tax liability with respect to such S corporation until a triggering event.

This confirms that individual shareholders of an S corp will be taxed ONLY on distributions as they are made. It’s as though the “transition tax” never happened. Here is a post that describes how an exemption from the 965 Transition Tax was created for individuals who were shareholders of an S corp. (A follow up post argues that Americans abroad should NOT be treated worse than individuals who are shareholders of S corps).

The lobbying efforts of the S corp association are reflected in the following document:

http://www.citizenshipsolutions.ca/wp-content/uploads/2018/11/S_Corporation_Association_WG_Comment_2.pdf

To put it simply:

Because of their lobbying INDIVIDUALS who are shareholders of an S corporation where effectively exempted from the 965 transition tax!!!

3. Winner: Green Card holder who is a “treaty nonresident” – can escape U.S. taxation on “foreign source income – Escaped the application of the transition tax

U.S. tax treaties typically include a residence tie break provision which allows “U.S. residents” but NOT “U.S. citizens” to be treated as nonresident aliens for U.S. income tax purposes.

This post describes how a “treaty tie break” can allow a Green Card holder to cease to be a U.S. tax resident for U.S. income tax purposes.

4. Loser: A U.S. resident individual (U.S. citizen or resident) – The Moores – Subject to the transition tax, received nothing in return and likely subject to double taxation<

There is a forced deemed income inclusion of the shareholder’s proportionate interest in the CFC’s profits going back to 1986. This results in:

– a real mandatory tax levied retroactively on deemed income which the shareholder may never receive (example the Moore’s)

– once the tax has been paid, that share of the profits becomes previously taxed income and will be subject to no further U.S. taxation (although it could be subject to a dividend withholding tax) in the country where the CFC is located

– on the other hand the cost basis in the shares will increase by the amount of the deemed income inclusion.

– the conceivable effect of the transition tax would be: (1) a tax paid on the investment in the CFC with (2) no return from the investment in the CFC (like the Moore’s)

Note that individuals receive NO benefits in return for being subjected to the transition tax. Specifically:

– individuals get NO REDUCED tax rate

– individuals do NOT GET THE benefits of 245A

The best case scenario for individuals is that they will either be subject to double taxation or may be able to use the 962 election to mitigate the effects of the transition tax.

5. Biggest Loser: A U.S. citizen living outside the United States who is a tax resident of another country (More of a loser than the Moore’s – what if the Moores had lived in British Columbia Canada?) – Subject to the transition tax, received nothing in return, likely subject to double taxation and likely had their pension confiscated

In addition to the issues that impact a U.S. citizen residing in the United States, – a US citizen living outside the United States will be subject to “double taxation” when dividends are paid to the shareholder. This is because:

1. The 965 transition tax is a U.S. levy on “deemed (without a realization event) income” and no realization event in the other country which would trigger tax; and

2. A non-US tax payable in the country of residence when there is an actual distribution/realization event.

Because the U.S. tax and the foreign tax liabilities are not triggered at the same time there is no opportunity to use the U.S. transition tax paid as a tax credit against the foreign tax paid. The likely result is double taxation.

In addition, it’s important to understand that the U.S. citizen living outside the United States will (in addition to being taxed as a U.S. resident) will be taxed as a resident of that other country. He will NOT have any access to “reduced withholding” taxes offered by tax treaties.

The sequence of events (described in this post) are described in Appendix A below.

The following post describes why the 965 Transition Tax was far more damaging to Americans abroad than to U.S. citizens living in the United States.

While U.S. resident individuals shareholders of S corps receive an exemption from the 965 Transition Tax, U.S. citizens who are residents of other countries are the worst victims of the tax!

6. Indirect Loser: The countries where overseas Americans are resident were also damaged by the transition tax. Many countries (example Canada) incentivize the creation of private pension plans through the use of private corporations. The effect of the transition tax was effectively to “loot” the retained earnings of those private corporations that were intended to be pension plans. This is a particularly ugly manifestations of U.S. citizenship taxation and is a graphic example of how US citizenship taxation operates to extract working capital from other sovereign countries.

This post describes how the U.S. citizenship taxation interferes with the profits, capital formation and business objectives of non-U.S. companies even if they carry on no business in the United States.

In general:

The U.S. trend toward “deemed income” (income without a realization event) increases the likelihood that U.S. citizens who are tax residents of other countries will be subject to double taxation. Significantly,the 965 Transition tax is just one example of reality. All forms of taxation which impose taxation without an actual “realization event” will exacerbate the problem and make it significantly more difficult for U.S. citizens to live outside the United States.

This post has clearly demonstrated that U.S. citizens living outside the United States as tax residents of other countries were by far the biggest victims of the 965 Transition Tax! Their countries of residence are also victims because the U.S. system of citizenship taxation drains the working capital out of their corporations!

This post describes how the U.S. transition tax and other instances of “deemed income” are particularly damaging to other countries in a world where U.S. citizens, who are subject to citizenship taxation, live in those countries.

Interested in Moore about the § 965 transition tax?

Read “The Little Red Transition Tax Book“.

Appendix A – A Step By Step Description of how the 965 Transition Tax impacted by Canadian residents:

This is a complex problem – in the spirit of helping people understand the context and unfairness of this, here is a summary of what is going on:

1. A Canadian resident individual creates a Canadian Controlled Private Corp.

2. That CDN corp may make some profits.

3. If those profits are paid out to the individual, the individual pays taxes on his personal tax return (wherever he is required to file a return).

4. If the profits earned by the Corp are not paid out to the individual they are (1) taxed to the corp in Canada. The “after tax money” remains in the corp for future investment, or to be distributed to the individual later. Note that in Canada the money is not taxed to the individual until the money is distributed to the individual.

5. Canadians with U.S. citizenship also have to file U.S. tax returns. Those returns disclose existence of the CCPC and the amount of earnings that have not been paid out by the corp.

6. Money left in the corp (to be distributed later) was fully disclosed to the USA, but was NOT subject to US tax when earned. I repeat it was NOT (under US law subject to taxation when it was earned).

7. USA is claiming the right to (1) impose tax on money earned by the corp by (2) pretending that the money was actually earned by the individual (who never received it) – creating fake income!

8. Therefore, this is about (1) the USA imposing retroactive tax on (2) money that was not subject to U.S. tax when earned (3) by pretending that the money was distributed to the CDN shareholder (4) when the money was not distributed.

9. It will expose the individual to double tax in the USA and Canada.

USA is (1) creating fake income (2) imposing real taxation on fake income (3) imposing taxes before Canada can tax it and (4) stealing from Canada.

Appendix B – Additional Commentary On The “Faces Of The Transition Tax”

Face 1 – C corps

https://www.irs.gov/forms-pubs/about-form-965

https://www.irs.gov/pub/irs-utl/irc965-transition-tax-overview.pdf

https://www.irs.gov/newsroom/general-section-965-questions-and-answers-including-transfer-and-consent-agreements

Face 2 – Individual shareholders of S Corps 965 (i)

(i) Special rules for S corporation shareholders

(1) In general

In the case of any S corporation which is a United States shareholder of a deferred foreign income corporation, each shareholder of such S corporation may elect to defer payment of such shareholder’s net tax liability under this section with respect to such S corporation until the shareholder’s taxable year which includes the triggering event with respect to such liability. Any net tax liability payment of which is deferred under the preceding sentence shall be assessed on the return of tax as an addition to tax in the shareholder’s taxable year which includes such triggering event.
(2) Triggering event
(A) In generalIn the case of any shareholder’s net tax liability under this section with respect to any S corporation, the triggering event with respect to such liability is whichever of the following occurs first:
(i) Such corporation ceases to be an S corporation (determined as of the first day of the first taxable year that such corporation is not an S corporation).
(ii) A liquidation or sale of substantially all the assets of such S corporation (including in a title 11 or similar case), a cessation of business by such S corporation, such S corporation ceases to exist, or any similar circumstance.
(iii) A transfer of any share of stock in such S corporation by the taxpayer (including by reason of death, or otherwise).

https://www.law.cornell.edu/uscode/text/26/965

Face 3 – Green Card holder using the tax treaty to become a treaty nonresident and therefore not subject to U.S. taxation on foreign source income

By way of example, Paragraph 3 of Article 4 of the 2016 Model U.S. Tax Treaty states:

3. Where, by reason of the provisions of paragraph 1 of this Article, an individual is a resident of both Contracting States, then his status shall be determined as follows:

a) he shall be deemed to be a resident only of the Contracting State in which he has a permanent home available to him; if he has a permanent home available to him in both Contracting States, he shall be deemed to be a resident only of the Contracting State with which his personal and economic relations are closer (center of vital interests);
b) if the Contracting State in which he has his center of vital interests cannot be determined, or if he does not have a permanent home available to him in either Contracting State, he shall be deemed to be a resident only of the Contracting State in which he has a habitual abode;
c) if he has a habitual abode in both Contracting States or in neither of them, he shall be deemed to be a resident only of the Contracting State of which he is a national;
d) if he is a national of both Contracting States or of neither of them, the competent authorities of the Contracting States shall endeavor to settle the question by mutual agreement.

Significantly, the circumstance of U.S. citizenship prohibits an individual from using the residence tie break provision to be taxed by ONLY their country of residence. This prohibition is the result of typical treaty “saving clause” which allows U.S. residents (but NOT U.S. citizens) to be treated as residents of ONLY the country where they reside. U.S. citizens, who are tax residents of countries outside the U.S. are ALWAYS residents of BOTH the United States and their country of actual residence for income tax purposes. This principle is found in Paragraph 4 of Article 1 of the 2016 U.S. Model Tax Treaty:

4. Except to the extent provided in paragraph 5 of this Article, this Convention shall not affect the taxation by a Contracting State of its residents (as determined under Article 4 (Resident)) and its citizens. Notwithstanding the other provisions of this Convention, a former citizen or former long-term resident of a Contracting State may be taxed in accordance with the laws of that Contracting State.

Notably Paragraph 5 does NOT allow U.S. citizens to be treated as nonresidents of the United States income tax purposes

5. The provisions of paragraph 4 of this Article shall not affect:

a) the benefits conferred by a Contracting State under paragraph 3 of Article 7 (Business Profits), paragraph 2 of Article 9 (Associated Enterprises), paragraph 7 of Article 13 (Gains), subparagraph (b) of paragraph 1, paragraphs 2, 3 and 6 of Article 17 (Pensions, Social Security, Annuities, Alimony and Child Support), paragraph 3 of Article 18 (Pension Funds), and Articles 23 (Relief From Double Taxation), 24
(Non-Discrimination) and 25 (Mutual Agreement Procedure); and

b) the benefits conferred by a Contracting State under paragraph 1 of Article 18 (Pension Funds), and Articles 19 (Government Service), 20 (Students and Trainees) and 27 (Members of Diplomatic Missions and Consular Posts), upon individuals who are neither citizens of, nor have been admitted for permanent residence in, that Contracting State.

The text of the 2016 U.S. Model Tax Treaty is here:

https://home.treasury.gov/system/files/131/Treaty-US-Model-2016_1.pdf

Have a question? Contact John Richardson, Citizenship Solutions, Toronto, Canada