The IRS and U.S. Department of the Treasury published final regulations under Section 965 on February 5 permitting taxpayers to make an election to shift adjusted tax basis in the stock of controlled foreign corporations (CFC). Taxpayers that had a §965 income inclusion with their 2017 tax return, or would have had a §965 income inclusion in 2017 if not for deficit offsets, must make the CFC stock basis shift election with an amended 2017 tax return by May 6, which is 90 days after publication of the final regulations. Relief is not available under Regulation §301.9100-2 or §301.9100-3 to file a late election. Except as provided in the regulations, the CFC stock basis shift election is irrevocable. A prior CFC stock basis shift election may be revoked or changed with an amended 2017 tax return filed by May 6. For taxpayers that have a Section 965 income inclusion with their 2018 tax return, the CFC stock basis shift election must be made with their timely filed 2018 tax return or with an amended 2018 tax return filed by May 6 if the 2018 tax return has already been filed without an extension.
General §965 Background
The 2017 tax reform act, better known as the Tax Cuts and Jobs Act, enacted §965 of the Internal Revenue Code requiring all U.S. shareholders of CFCs to pay a one-time deemed repatriation tax on accumulated foreign earnings as of November 2, 2017, or December 31, 2017. Calendar-year U.S. shareholders were required to recognize the income in their 2017 tax returns or, in some cases, their 2018 tax returns if a CFC has a different year-end than the U.S. shareholder.
U.S. shareholders can elect to pay the one-time deemed repatriation tax over an eight-year installment period. Noncorporate U.S. shareholders owning CFCs through an S corporation can elect to indefinitely defer the payment of the deemed repatriation tax until there is a triggering event involving the transfer of S corp stock, sale of S corp assets or conversion of the S corp to a C corporation.
CFC Stock Basis Adjustment Election
Section 965(b) permits U.S. shareholders to net their pro rata share of accumulated deficits in earnings and profits (E&P) of one or more CFCs against their pro rata share of accumulated foreign E&P of other CFCs. A U.S. shareholder treats its entire pro rata share of a CFC’s post-1986 accumulated foreign E&P as of November 2, 2017, or December 31, 2017, as “previously taxed earnings and profits,” including amounts offset by E&P deficits. Previously taxed E&P generally can be repatriated back to the U.S. shareholder as a distribution without being treated as a taxable dividend.
A U.S. shareholder owns 100 percent of two CFCs—CFC 1 has positive accumulated E&P, and CFC 2 has a deficit in E&P. The U.S. shareholder recognizes §965(a) income (before the §965(c) rate differential deduction) with its 2017 tax return in the amount of $600,000, as calculated below:
As provided in §965(b)(4), the U.S. shareholder treats the entire $1,000,000 of CFC 1 E&P as previously taxed E&P even though the U.S. shareholder only picks up $600,000 in income—before the §965(c) deduction—due to the $400,000 CFC 2 E&P deficit offset. However, IRS regulations only permit the U.S. shareholder to increase its adjusted tax basis in CFC 1 stock by the net $600,000 income inclusion. While a distribution of the $1,000,000 previously taxed E&P generally would not be treated as a taxable dividend, a distribution of the previously taxed E&P could result in taxable gain from distribution in excess of basis as illustrated below.
CFC 1 distributes $800,000 of the $1,000,000 previously taxed E&P to the U.S. shareholder during 2018. The U.S. shareholder does not recognize any taxable dividend income from the $800,000 distribution but has taxable gain in 2018 from distribution in excess of basis of $195,000:
To mitigate the effect of a potential distribution of previously taxed E&P in excess of basis, Regulation §1.965-2(f)(2)(ii) permits the U.S. shareholder to elect to increase its adjusted tax basis in the stock of CFC 1, and conversely decrease its adjusted tax basis in the stock of CFC 2, by an amount not to exceed the $400,000 CFC 2 E&P deficit that offset CFC 1 accumulated E&P in the §965(a) income computation. Because the U.S. shareholder only has $100,000 of adjusted tax basis in its CFC 2 stock, an election to increase CFC 1 stock basis by the full $400,000 would result in an immediate $300,000 gain recognition. To prevent an immediate gain recognition, the U.S. shareholder files an amended 2017 tax return by May 6 to make a limited basis adjustment election to shift $100,000 of basis from CFC 2 stock to CFC 1 stock, thereby reducing its 2018 taxable gain by $100,000 from the 2018 CFC 1 distribution:
If a U.S. shareholder owns CFCs through a tiered CFC structure rather than a brother-sister structure, there may be no benefit to making the CFC stock basis election. For instance, in the example above, if the U.S. shareholder owns all the stock of CFC 1 and CFC 1 owns all the stock of CFC 2, then a CFC stock basis election would wash out to a net-zero basis adjustment in the upper-tier CFC stock. Since the U.S. shareholder only directly holds stock of CFC 1, both the increase in basis and the offsetting decrease in basis resulting from the CFC stock basis adjustment election would be applied to U.S. shareholder’s CFC 1 stock. On the other hand, if the U.S. shareholder indirectly owns stock of CFC 1 and CFC 2 through a CFC holding company where CFC 1 and CFC 2 are brother-sister subsidiary companies of the CFC holding company, a CFC stock basis adjustment election may permit the CFC holding company to shift its basis in CFC 2 stock to its CFC 1 stock basis, thereby reducing the potential Subpart F income that could result from the CFC holding company’s receipt of a distribution of previously taxed E&P from CFC 1 in excess of its CFC 1 stock basis.
U.S. shareholders of CFCs that reduce §965 deemed repatriation income through an offset of E&P deficit from one or more loss foreign corporations should consult their tax advisors to consider if a basis adjustment election or limited basis adjustment election may be beneficial. U.S. shareholders that used E&P deficits to reduce the §965 deemed repatriation income with their 2017 tax return have until May 6 to file an amended 2017 return to make the basis adjustment or limited basis adjustment election.
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