The Section 965 Transition Tax And IRS Audits

Section 965 audits are on the rise.  Taxpayers under section 965 transition tax audits often face significant potential liability exposure.  The IRS previously announced an active “campaign” specifically targeting unpaid section 965 transition tax liability resulting from amendments to section 965 under the Tax Cuts & Jobs Act.  For taxpayers with ownership in foreign corporations, that could mean increased exposure to an IRS audit.

On December 22, 2017, Congress amended the Internal Revenue Code (“IRC”) Section 965 through the Tax Cuts & Jobs Act (“TCJA”).  As amended, Section 965 required that certain taxpayers include a “Section 965 inclusion” in income as part and parcel of the transition to a participation-exemption tax system (or, at least, a quasi participation-exemption system).  The Section 965 inclusion is an amount based on the accumulated post-1986 deferred foreign income of certain foreign corporations directly or indirectly owned by the taxpayer.  Notably, taxpayers can have Section 965 inclusions due to ownership of deferred foreign income corporations (“DFICs”) indirectly held through pass-through entities that are themselves U.S. shareholders of DFICs.

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IRS Alerts Taxpayers On Section 965 Transition Tax

Communication

IRS is working to alert potentially impacted taxpayers about new tax filing and tax payment obligations arising under recently revised Internal Revenue Code section 965.[1] An overview of section 965 is discussed below.

What is section 965?

Section 965 requires United States shareholders (as defined under section 951(b)) to pay a transition tax on the untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the United States. Very generally, a specified foreign corporation means either a controlled foreign corporation, as defined under section 957 (“CFC”), or a foreign corporation (other than a passive foreign investment company, as defined under section 1297, that is not also a CFC) that has a United States shareholder that is a domestic corporation. Section 965 allows U.S. shareholders to reduce the amount of the income inclusion based on deficits in earnings and profits with respect to other specified foreign corporations. The effective tax rates applicable to income inclusions are adjusted by way of a participation deduction set out in section 965(c). A reduced foreign tax credit applies to the inclusion under section 965(g). Taxpayers may elect to pay the transition tax in installments over an eight-year period.

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John Richardson On Sec 965 Transition Tax

A lawsuit alleging that the Section 965 transition tax is unconstitutional affords the opportunity to write Part 33 in my series of posts about the U.S. Transition Tax.

Part 22 of this series included a discussion of a paper by Sean P. McElroy which argued that the Section 965 repatriation tax was unconstitutional for the following reasons explained in the abstract:

Abstract

In late 2017, Congress passed the first major tax reform in over three decades. This Essay considers the constitutional concerns raised by Section 965 (the “Mandatory Repatriation Tax”), a central provision of the new tax law that imposes a one-time tax on U.S.-based multinationals’ accumulated foreign earnings.

First, this Essay argues that Congress lacks the power to directly tax wealth without apportionment among the states. Congress’s power to tax is expressly granted, and constrained, by the Constitution. While the passage of the Sixteenth Amendment mooted many constitutional questions by expressly allowing Congress to tax income from whatever source derived, this Essay argues the Mandatory Repatriation Tax is a wealth tax, rather than an income tax, and is therefore unconstitutional.

Second, even if the Mandatory Repatriation Tax is found to be an income tax (or, alternatively, an excise tax), the tax is nevertheless unconstitutionally retroactive. While the Supreme Court has generally upheld retroactive taxes at both the state and federal level over the past few decades, the unprecedented retroactivity of the Mandatory Repatriation Tax — and its potential for taxing earnings nearly three decades after the fact — raises unprecedented Fifth Amendment due process concerns.

It appears that the plaintiffs in this case are making precisely these two arguments.

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John Richardson

Recently, I received a message from a person who says that he was assessed a Section 1411 Net Investment Income Tax assessment on the amount of the Section 965 transition tax. Although not intended as legal advice, I would like to share my thoughts on this. I don’t see how the transition tax could be subject to the NIIT.

Let’s look at it this way:

Why Section 965 Transition Tax Inclusions Are NOT Subject To The Sec. 1411 Net Investment Income Tax

A – The Language Of The Internal Revenue Code – NIIT Is Not Payable On Transition Tax Inclusions

I see no way that the language of the Internal Revenue Code leads to the conclusion that the transition tax can be subject to the NIIT.

My reasoning is based on the following two simple points:

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Nina Olson, National Taxpayer Advocate On Section 965 Transition Tax

When Congress passes legislation as comprehensive and technical as the Tax Cuts and Jobs Act (TCJA), drafting and implementation glitches inevitably arise. This week, I will discuss one that largely affects corporate taxpayers, particularly shareholders of Controlled Foreign Corporations. Spoiler alert: This is a case where Congress enacted a provision with a transition rule intended to be extremely taxpayer-favorable, and the IRS is administering the provision in a way that seemingly runs contrary to congressional intent. It relates to the administration of Internal Revenue Code (IRC) § 965(h). Some of the background is a bit technical, so bear with me.

Prior to tax reform, the United States imposed a relatively high maximum federal corporate income tax rate of 35 percent. According to the House Ways and Means Committee, “many domestic companies were reluctant to reinvest foreign earnings in the United States, when doing so would subject those earnings to high rates of corporate income tax rates.” As a result, those companies “accumulated significant untaxed and undistributed foreign earnings.” In other words, they left their earnings parked overseas.

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