INSIGHT: Choose Your Own Adventure: The Basis-Shifting Election of the Proposed Section 965 Regulations

The recently released proposed tax code Section 965 transition tax regulations generally adhere closely to the Notices issued in anticipation of the regulations. However, one new item of interest relates to the basis consequences that flow from treating earnings and profits (E&P) that are offset by shared deficits in determining a taxpayer’s net accumulated E&P subject to tax under Section 965 as previously taxed income (PTI) for purposes of Section 959. The statutory language under Section 965 is unclear as to whether a U.S. shareholder is entitled to increase its basis in a specified foreign corporation (SFC) for the amount of such E&P. As a practical matter, this could preclude a U.S. shareholder from repatriating cash held by its SFC without incurring taxable gain in the U.S., particularly if the U.S. shareholder has a low basis in the shares of its SFC.

In perhaps tacit recognition that the absence of a Section 961 basis adjustment for PTI resulting from deficit sharing may discourage the repatriation of earnings held by an SFC, the proposed regulations include an election (in Proposed Treasury Regulation 1.965-2(f)) to adjust the basis in stock of relevant foreign corporations to reflect the sharing of deficits under Section 965(b). While the election approach is a welcome one, and we hesitate to look a gift horse in the mouth, most taxpayers must make their election by mid-October or sooner. Because the election has consequences for the 2017 tax return and a continuing impact going forward that is not entirely certain, many taxpayers are left to evaluate in a very short period the expected and alternative possible outcomes in order to make their election … and then hope for the best. This article first explains what is at stake (without getting into the weeds of Section 965 more broadly), then discusses the election as set out in the proposed regulations including the relevant examples, and finally discusses the implications of the proposed regulations not providing basis adjustments down the chain of foreign corporations.

[If you’ve already got a solid grounding in the working of Section 965 and the previously taxed income rules, skip to The Basis-Shifting Election Provided by the Proposed Section 965 Regulations, below. Otherwise, read on.]

OVERVIEW OF SECTION 965

Section 965 of the Internal Revenue Code (tax code), as amended by Public Law 115-97, commonly known as the Tax Cuts and Jobs Act, imposes a one-time transition tax on a U.S. shareholder with respect to its investment in controlled foreign corporations (CFCs) and certain other 10 percent-owned foreign corporations (collectively, specified foreign corporations or SFCs). The tax is generally imposed on the net aggregate amount of the U.S. shareholder’s pro rata shares of the previously untaxed foreign E&P of such SFCs. The mechanism for applying the tax, as provided in Section 965(a), is to increase each SFC’s subpart F income by the amount of the SFC’s positive relevant E&P, if any (and to treat an SFC that is not a CFC as a CFC for purposes of including such Subpart F income in the income of U.S. shareholders). An SFC with positive relevant E&P is referred to as a deferred foreign income corporation, or “DFIC.”

Section 965(b)(1) operates to reduce the amount of the inclusion with respect to each DFIC by an allocable share of the aggregate E&P deficit of the U.S. shareholder’s SFCs with E&P deficits, referred to as an E&P deficit foreign corporation, or “E&PDFC.” Thus, a U.S. shareholder’s share of E&P deficits in E&PDFCs offsets the U.S. shareholder’s share of positive E&P in DFICs, so that only the net positive amount is included, and the reduction in the inclusion that results from the sharing of deficits is allocated among the DFICs pro rata. The regulations apply the rules for allocating deficits by treating all members of a consolidated group as a single U.S. shareholder, meaning this pro rata sharing of E&P deficits applies across U.S. shareholders that are members of a single consolidated group. For U.S. shareholders that are part of an affiliated group that does not file consolidated returns, pursuant to Section 965(b)(5), a net deficit in one U.S. shareholder is allocated to reduce the Section 965(a) inclusion of affiliated U.S. shareholders with net positive inclusion amounts.

The tax on amounts included in income under Section 965 is imposed at an effective rate of 15.5 percent to the extent of the amount of cash and deemed cash equivalents held by SFCs, and 8 percent for any amount in excess thereof. The tax applies to the taxable year of the U.S. shareholder within which the SFC’s last taxable year beginning before Jan. 1, 2018, ends. Thus, a taxpayer that owns one or more SFCs that have taxable years that differ from the taxpayer’s own taxable year may have inclusions under Section 965 in more than one year. Taxpayers may elect to pay the tax owed by reason of Section 965 over eight years.

PREVIOUSLY TAXED INCOME AND SECTION 961 BASIS

Background

Section 959 provides rules to prevent PTI, generally E&P of a CFC that is or has been included in the taxable income of a U.S. shareholder under Subpart F, from being subject to U.S. tax again when distributed to such U.S. shareholder or through a chain of foreign corporations owned by such U.S. shareholder. The principle is plain enough—these earnings should not be subject to U.S. tax twice.

As a corollary, Section 961(a) provides that, under regulations, the U.S. shareholder’s basis in the stock of the foreign corporation to which the inclusion under Subpart F was attributable is increased, or, if the stock of such corporation is not held directly by the U.S. shareholder, the U.S. shareholder’s basis in the stock or other asset through which the U.S. shareholder is attributed ownership of the relevant foreign corporation is increased by the amount included. Here, again, the purpose is to avoid double taxation of the U.S. shareholder on the same income, in this case by preventing tax on the value corresponding to the PTI if the stock is sold before the PTI is distributed to the U.S. shareholder. In order to prevent a double benefit being realized from such basis, Section 961(b)(1) provides, again under regulations, for a basis reduction whenever PTI is distributed to a U.S. shareholder. If a distribution of PTI exceeds the available stock basis, Section 961(b)(2) requires gain to be recognized by the U.S. shareholder in an amount equal to such excess.

Section 961(c) provides that, under regulations, adjustments similar to those provided in Section 961(a) and (b) are to be made with respect to the stock of a CFC to which an inclusion under Subpart F was attributable if such CFC is owned through a chain of one or more other CFCs, and to the basis of upper-tier CFCs, excluding the CFC directly owned by the U.S. shareholder (which is subject to Section 961(a) and (b) as described above). The statute provides that such adjustments are to be made only for purposes of determining the amount included under Subpart F in the gross income of such U.S. shareholder. Although Section 961(c) was added to the tax code over 20 years ago, no final regulations have ever been issued implementing it. Regulations implementing Section 961(a) and (b) have been in place and unmodified since 1965. Proposed regulations that would have revamped these rules (and incorporated Section 961(c) rules) were proposed in 2006, but did not progress. Government officials have indicated that guidance under Sections 959 and 961 is to be issued this fall.

Interaction With Section 965

Because the inclusion in a U.S. shareholder’s income pursuant to Section 965(a) is effected through the mechanism of Subpart F, included E&P is treated as PTI by operation of Section 959. Moreover, Prop. Treas. Reg. 1.965-2(e)(1) confirms that Section 961(a) operates normally to increase a U.S. shareholder’s basis in the stock of a DFIC (or the property through which the U.S. shareholder is attributed ownership of the DFIC) to reflect the Subpart F inclusion resulting from the application of Section 965(a).

In addition, Section 965(b)(4) provides that E&P that would have been included in a U.S. shareholder’s income under Section 965(a), but was not so included due to the sharing of an E&P deficit pursuant to Section 965(b)(1), is treated as PTI for purposes of applying Section 959 (Section 965(b) PTI), even though such E&P was not actually subject to tax. Prop. Treas. Reg. 1.965-2(d)(1) restates this rule and extends it to E&P offset under Section 965(b)(5) by a net deficit of another member of an unconsolidated affiliated group. However, because such amounts are not actually included in the U.S. shareholder’s income, Section 961 does not apply by its terms to increase the U.S. shareholder’s basis in the relevant stock or other assets by the amount of the constructive PTI. Section 965, similarly, does not require a basis adjustment in this case.

THE BASIS-SHIFTING ELECTION PROVIDED BY THE PROPOSED SECTION 965 REGULATIONS

Background

Section 965(o)(1) provides that the Treasury Secretary shall prescribe regulations or other guidance “to provide appropriate basis adjustments.” The conference report reflects that Congress had in mind basis adjustments related to the sharing of deficits between SFCs:

“The conferees recognize that basis adjustments (increases or decreases) may be necessary with respect to both the stock of the deferred foreign income corporation and the E&P deficit foreign corporation and authorizes the Secretary to provide for such basis adjustments or other adjustments, as may be appropriate. For example, with respect to the stock of the deferred foreign income corporation, the Secretary may determine that a basis increase is appropriate in the taxable year of the section 9[65] inclusion or, alternatively, the Secretary may modify the application of section 961(b)(1) with respect to such stock. Moreover, with respect to the stock of the E&P deficit corporation, the Secretary may require a reduction in basis for the taxable year in which the U.S. shareholder’s pro rata share of the earnings of the E&P deficit corporation are increased.”

Without statutory basis adjustments, some taxpayers were concerned that Section 965(b) PTI might be effectively trapped, because without Section 961 basis resulting from an inclusion under Subpart F or historic ordinary basis to support a distribution, a distribution of such PTI would result in gain taxable at the full U.S. rate. Such a result would perpetuate the “lockout effect” with respect to such earnings, as a distribution of the earnings would generally subject the U.S. shareholder to a greater amount of tax than if deficit sharing had not been permitted and the earnings had been taxed under Section 965 at the reduced rate, resulting in a corresponding Section 961(a) basis increase.

The Treasury Department and the Internal Revenue Service, in the preamble to the proposed regulations, stated the reasonable view that an increase in the stock basis to reflect Section 965(b) PTI is appropriate only if there is a corresponding reduction in basis to reflect the utilization of the deficit of the E&PDFC. However, they said, requiring such basis adjustments for all taxpayers would be overly burdensome for some, noting that the basis reductions could give rise to taxable gain. In a welcome move, the proposed regulations let taxpayers decide whether to both increase and reduce basis in the relevant respective stock or other assets or not, provided a consistent approach is taken by all related U.S. taxpayers (based on the relationships described in Sections 267(b) and 707(b)). The catch is that this decision generally must be made in connection with the filing of the taxpayer’s tax return for the taxable year that includes Dec. 31, 2017, which for calendar-year taxpayers that filed an extension is due Oct. 15, 2018. This leaves limited time to analyze the consequences and make a reasoned decision.

Scope of the Election

Prop. Treas. Reg. 1.965-2(f)(1) provides, “[e]xcept as provided in paragraph (f)(2) of this section, no adjustments to basis of stock or property are made under section 961 (or any other provision of the Code) to take into account the reduction” to a U.S. shareholder’s inclusion under Section 965(a) due to the sharing of deficits pursuant to Section 965(b) (emphasis added). Paragraph (f)(2) then provides an election to adjust a U.S. shareholder’s basis in the stock or other relevant property owned by the U.S. shareholder to reflect the sharing of deficits pursuant to Section 965(b). Specifically, an electing U.S. shareholder’s basis in the stock of a DFIC (or the property through which the U.S. shareholder is attributed ownership of the DFIC) is increased by the amount of constructive PTI created by operation of Section 965(b) and Prop. Treas. Reg. 1.965-2(d)(1). Correspondingly, an electing U.S. shareholder’s basis in the stock of an E&PDFC (or the property through which the U.S. shareholder is attributed ownership of the E&PDFC) is reduced by the amount of the deficit shared to reduce the U.S. shareholder’s inclusion with respect to one or more DFICs. If there is not adequate basis available to support the required reduction, taxable gain is recognized currently by the U.S. shareholder on the last day of the E&PFDC’s relevant taxable year to the extent of the shortfall.

Notably, the election does not provide for any basis adjustments to stock of DFICs or E&PDFCs held by foreign corporations (or to stock of intermediate holding companies) under Section 961(c). In fact, Prop. Treas. Reg. 1.965-2(f)(1) by its terms appears to prohibit such basis adjustments.

Manner of Making the Election

As noted above, the election to shift basis is only effective if each related person that is a U.S. shareholder of an SFC also makes the election. The election is required to be made by the due date (taking into account any extensions) of the taxpayer’s return for the first taxable year that includes the last day of the taxable year of a DFIC or an E&PFDC to which the transition tax applies. Thus, for a calendar-year taxpayer that filed an extension and was a U.S. shareholder with respect to a calendar-year SFC, the election must generally be made by Oct. 15, 2018. If the due date would otherwise be before Sept. 10, 2018 (e.g., the taxpayer did not file for an extension), the taxpayer is given until Oct. 9, 2018, to make the election. The proposed regulations specify that Section 9100 relief is not available to file an election after the due date.

The election is made by attaching a statement to the taxpayer’s return for the relevant year, signed under penalties of perjury. The proposed regulations indicate that other guidance may alter this requirement, leaving open the possibility that taxpayers that have already filed their returns will not be required to file amended returns in order to include the statement.

Examples in the Proposed Regulations

The proposed regulations contain two examples that illustrate the consequences of making the basis-shifting election. In one of the examples (Example 6), a domestic corporation with a calendar taxable year owns 100 percent of two November-30-year-end CFCs and has zero basis in the stock of each before the application of Section 965. For Section 965 purposes, one of the CFCs is a DFIC with 100 of relevant positive earnings and the other is an E&PFDC with a relevant deficit of 100. Thus, the E&P deficit of the E&PDFC reduces the Section 965(a) inclusion that the taxpayer would otherwise have with respect to the DFIC to zero. The DFIC makes a distribution of 100 on Jan. 1, 2018, which is out of Section 965(b) (i.e., “constructive”) PTI.

Without an election, the distribution by the DFIC would result in taxable gain under Section 961(b)(2), because the taxpayer does not have basis to support the distribution of PTI. If an election is made to shift basis, the taxpayer’s basis in the DFIC is increased by 100, resulting in no gain on the distribution because there is now basis available in the DFIC to support the required reduction under Section 961(b)(1). But, because the taxpayer does not have basis in the E&PDFC available to be reduced, the election itself results in the taxpayer recognizing 100 of taxable gain on the stock of the E&PFDC. So on these facts, the election is a lose-lose proposition.

But, what if the DFIC had distributed 100 on Dec. 31, 2017, rather than the following day? In that case, the taxpayer would prefer to recognize gain as a result of the election, on Nov. 30, 2018 (the last day in the E&PFDC’s relevant taxable year), taxable at 21 percent, rather than recognizing gain as a result of the distribution on Dec. 31, 2017, taxable at 35 percent. Even though the election would not reduce taxable gain in that scenario, it would save the taxpayer tax. In other scenarios, the taxpayer might prefer to recognize the gain in 2017, possibly to utilize an expiring capital loss carryforward, or possibly to realize a benefit from a Section 1248 dividend (which would still be possible under the right facts despite the general inclusion of E&P under Section 965).

As another variation on the example, assume the taxpayer had 100 of basis in the E&PDFC before application of Section 965. The taxpayer would still recognize 100 of gain as a result of the distribution if it did not make the election, but if it made the election it would avoid taxable gain. In that case, it would have sufficient basis available in the E&PDFC to be reduced pursuant to the election, and the election would give it sufficient basis in the DFIC to support the distribution of PTI. Conversely, if the taxpayer had 100 of basis in the DFIC rather than the E&PFDC before application of Section 965, it would not recognize any gain if it did not make an election, because it already has sufficient basis to support the PTI distribution. And if it made the election, the taxpayer would recognize 100 of gain, because it does not have basis in the E&PDFC available to be reduced. The taxpayer would have 100 of basis remaining in the DFIC after the distribution of PTI, but it would have paid tax on that amount in order acquire the basis.

The second relevant example in the proposed regulations (Example 5) has the same basic facts, except that the E&PDFC owns 100 percent of the DFIC (and has zero basis in its stock). On January 1 of 2018, the DFIC distributes 100 to the E&PFDC and the E&PFDC distributes the 100 to the taxpayer. The analysis in the example indicates that if an election is made, the taxpayer’s basis in the E&PFDC is increased by 100 to reflect the Section 965(b) PTI in the DFIC and is reduced by 100 to reflect the sharing of the E&PFDC. Thus, these adjustments net to zero and 100 of gain is still recognized as a result of the distribution of PTI with no basis to support it.

What the analysis in the example does not address, however, are the consequences of the distribution of Section 965(b) PTI from the DFIC to the E&PFDC. Because the E&PFDC has zero ordinary basis and no Section 961(c) basis in the stock of the DFIC, it would appear that this distribution of PTI without basis to support it could give rise to Subpart F gain in the E&PFDC under Section 961(c), applying an adjustment similar to Section 961(b)(2). If such Subpart F gain were recognized, that should give the taxpayer Section 961(a) basis in the DFIC, preventing duplicative gain on the distribution of the 100 to the taxpayer (even though there is tax under Subpart F on this amount). It is not clear whether the example’s disregard of the consequences of the distribution from the DFIC to the E&PFDC was an oversight or indicates that gain should not be recognized on such distribution because the basis-shifting election is effective to increase the E&PFDC’s basis in the DFIC under Section 961(c) (even though the language of Prop. Treas. Reg. 1.965-2(f)(1) says the only basis adjustments that are made under Section 961 are the elected adjustments).

Uncertainty as to What Is Being Elected

Because it is not entirely clear what the intended rule is with respect to Section 961(c) basis adjustments, taxpayers are put in the difficult position of being required to make an apparently binding election without being fully informed of the consequences (as final regulations could not possibly be issued by the Oct. 15, 2018, filing deadline that many, if not most, corporate taxpayers face). A taxpayer with a significant pool of Section 965(b) PTI in a lower-tier DFIC in a low-basis chain may be inclined to make the election to facilitate repatriation of cash from that DFIC, but if the cash cannot be distributed out of the DFIC itself without a U.S. tax cost, there may be no benefit to the election, which might have other collateral costs. In some cases taxpayers may be able to liquidate the DFIC and any intervening foreign corporations, possibly through check-the-box elections, to move the pool of Section 965(b) PTI up to the top-tier foreign entity without a potential taxable distribution, and thereby eliminate the uncertainty. But in many cases such liquidations would have adverse collateral and continuing consequences that the taxpayer would rather avoid.

Even more broadly, there is uncertainty related to the impact of the basis-shifting election for any particular taxpayer, because the rules for determining the E&P subject to inclusion under Section 965 are of course subject to change in the final regulations. To the extent there are any changes or refinements to the calculation of includable E&P or the sharing of deficits, this could alter a taxpayer’s basis posture both with and without an election, which could directly affect the taxpayer’s analysis of the benefits and costs of making the election.

An election now can have implications for intra-group treasury functions and tax consequences going forward long-term, so taxpayers would be well-advised to consider their choice carefully in the time allowed. While the election is apparently intended to, and generally does, provide taxpayers with beneficial flexibility, it is unfortunate that the election deadline gives taxpayers little time to undertake factual analysis as to offshore cash needs and the anticipated location and timing of future distributions. Because that appears to be the state of play, it is incumbent upon taxpayers to analyze the various possible outcomes of making the election, both with and without Section 961(c) basis adjustments, and taking into account their best guess as to potential refinements to the relevant calculations that may be made in the final regulations.

Aaron M. Payne is a partner at Eversheds Sutherland (US) LLP based in Washington, D.C. where he represents publicly traded global corporations in the area of federal corporate taxation with respect to domestic and international planning, transactions and compliance. The author would like to thank Robb Chase, Eversheds Sutherland (US) LLP, for his invaluable contributions and comments.