Transition tax places 'further burden' on U.S. taxpayers
By AdvocateDaily.com Staff
The 2017 U.S. tax reform imposed a one-time transition tax on earnings of certain foreign corporations — and, for affected U.S. individuals who own shares in these entities, it is critical to determine whether the new tax applies, and comply on a timely basis, U.S. tax accountant Brandon Vucen tells AdvocateDaily.com.
As Vucen, a principal of U.S. Tax IQ, explains, the Tax Cuts and Jobs Act, enacted in December 2017, made a number of critical changes that impact U.S. citizens and Green card holders residing in Canada and outside the United States. One of these provisions is a one-time transition tax — also referred to as mandatory repatriation — imposed by Internal Revenue Code (IRC) Section 965.
IRC Section 965 requires U.S. shareholders to pay a transition tax on the accumulated post-1986 deferred earnings of specified foreign corporations.
The tax, says Vucen, also applies to U.S. citizens and Green card holders who do not live in the United States, and own shares in non-U.S. corporations —called Specified Foreign Corporations (SFCs) that include Controlled Foreign Corporations (CFCs) or other foreign corporations with a 10 per cent domestic corporate shareholder.
The United States discourages a deferral of U.S. tax via several anti-deferral regimes, including Subpart F regime. For example, certain categories of foreign income — such as interest, dividends and foreign-based company services income — may be taxed currently to U.S. shareholders, even when they did not receive a distribution from the CFC.
“The Subpart F income regime may have only affected a small percentage of taxpayers whereas now, with the transition tax, it impacts all of those taxpayers that owned SFCs, as long as the SFCs had earnings and profits,” he adds.
“The impetus behind the Subpart F regime was that IRS didn’t want taxpayers who otherwise may have owned investment assets or conducted business individually to put it in a foreign corporation and then essentially defer the taxation of the income until they otherwise do a distribution,” says Vucen.
Ultimately, when figuring out whether or not the transition tax applies, he says it is critical for taxpayers to determine two things.
“Look at the share ownership to see whether the company is an SFC.
“Once you identify the company as being an SFC, you need to determine the post-1986 accumulated earnings and profits, which is reported on Form 5471 Information Return of U.S. Persons With Respect To Certain Foreign Corporations.
“Schedule J of Form 5471 tracks the accumulated earnings and profits of that foreign corporation, which is the starting point for the IRC Section 965 income inclusion,” says Vucen. Taxpayers are entitled to deduct from the accumulated earnings and profits any previously taxed income. Plus, there a few other exceptions available.
When calculating the transition tax owed, he says taxpayers are entitled to deductions against the income inclusion based on 55.71 per cent of their foreign cash position (assets) and 77.14 per cent of their other assets. Ultimately, an individual shouldn’t pay more than 17.54 per cent tax on the deferred accumulated foreign earnings.
In terms of other possible ways to mitigate the tax, Vucen says an IRC Section 962 election entitles an individual to be taxed at corporate tax rates; however, the advantage of this election needs to be analysed to determine whether it is beneficial from a tax perspective for a taxpayer.
“Depending on certain factors and the amount of the earnings, some taxpayers may want to consider an election which may otherwise result in the lower overall tax hit,” he says.
Ultimately, for U.S. shareholders of foreign corporations with a December 31 year-end, any transition tax owing was due when your tax return was due, says Vucen, which was April 17, 2018, for U.S. resident taxpayers and June 15, 2018, for U.S. persons residing in Canada or elsewhere, provided certain requirements are met.
For U.S. shareholders whose foreign corporations have a fiscal year-end (other than December 31), the transition tax is due with the 2018 tax return.
“Because of the lower corporate tax rate of 21 per cent starting from 2018, the deduction percentage for foreign cash position was adjusted accordingly. So, it doesn’t necessarily change the overall impact.”
Taxpayers can elect to pay transition tax owing over an eight-year period, he says.
“The first five instalments, you have to pay eight per cent of the tax. And then the last three instalments, you would have to pay 15 per cent, 20 per cent and then 25 per cent of the ultimate liability,” he says.
Oakville-based U.S. tax attorney Alexey Manasuev, a principal of U.S. Tax IQ, further added that the IRS provided limited penalty relief for those taxpayers who failed to make timely estimated tax payments or instalment payments by the due date of their 2017 tax return.
The deadline for making first and second instalments, once the taxpayers timely elected to pay the transition tax in instalments, was extended to April 15, 2019 (June 17, 2019 for U.S. persons residing outside the United States, provided certain requirements are met). The IRS would not assess penalties for late payment, but the interest would still accrue.
With respect to instalment payments, he says, the relief applies to those taxpayers whose transition tax liability does not exceed US$1 million. The relief makes sense as there is limited guidance and the Treasury and the IRS have just released proposed regulations under IRC Section 965.
Vucen adds that if taxpayers have filed their U.S. tax return, but failed to follow the requirements related to the reporting and paying the transition tax, they should amend their tax returns to be compliant.