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Some Things You Need to Know About US Federal Tax Reform (Pt.2) – Transition Tax

In Pt. 1 of this series, we reviewed some of the changes to the US Internal Revenue Code (IRC) implemented by the Tax Cuts and Jobs Act (TCJA) which may be of the most interest to US expats, US tax residents or those with US interests.

Included in this reform are crucial changes to existing international tax provisions and US expats with foreign corporations could see significant changes.

US Transition Tax

The TCJA has changed how the IRS taxes US shareholders of foreign corporations by adding section 965 to the IRC. The shift of US tax policy towards what some have referred to as a “territorial” system of corporate taxes will affect many US expats who own foreign corporations.

In general, section 965 requires United States shareholders who own a controlled foreign corporation (CFC) or at least 10% voting stock or value in a foreign company (specified foreign corporations or SFC) that is not a passive foreign investment company (PFIC) to pay a one-time “transition tax” (or “repatriation tax”) on the undistributed, previously untaxed (or deferred) post 1986 foreign earnings and profits (E & P) as if those E & Ps had been repatriated to the United States.

This provision applies to all types of US persons including US citizens and US resident individuals, domestic estates and trusts, domestic partnerships, S corporations and domestic corporations. The Transition Tax is imposed on US taxpayers irrespective of whether any cash or other property has actually been distributed.

The Transition Tax applies to the greater of the accumulated post-1986 deferred foreign income (i.e. the previously untaxed E & P) of the foreign corporation determined as at 2 November 2017 or as at 31 December 2017.

Tax Rates

The tax rates differ depending on whether the shares are held by an individual or company:

  • Corporate:
    • 5% rate of tax on deferred earnings attributable to cash assets; and
    • 8% rate of tax on non-cash assets.
  • Individual:
    • 5% rate of tax on deferred earnings attributable to cash assets; and
    • 9% rate of tax on non-cash assets.

When is the Transition Tax due?

Payment of the Transition Tax is required to be paid by the original due date of the 2017 tax return (i.e. April 17th). However, please note that a 2-month extension has been granted so that the first instalment is now due 15 June 2018.

Any person that is subject to the new tax in 2017 must pay either 100% of the tax or 8% of the tax if making deferred election by the original due date for filing their tax return.

For those making a deferred election, the Transition Tax payment schedule is:

  • 8% of the net tax liability for each of the first 5 instalments;
  • 15% of the net tax liability for the 6th instalment;
  • 20% of the net tax liability for the 7th instalment; and
  • 25% of the net tax liability for the 8th

Does the US Transition Tax Affect You?

  • If you are US tax resident:
    • For individuals, this is determined by citizenship, green card status, or tax residency as determined by the Substantial Presence Test (SPT). The SPT is a criterion used by the IRS to determine whether an individual who is not a citizen or lawful permanent resident in the recent past qualifies as a “resident for tax purposes” or a “non-resident for tax purposes”. The SPT should be used in conjunction with the Green Card Test. An individual who satisfies either one or both of these tests may be treated as a resident for tax purposes;

AND

  • the answer is “yes” to one of the below questions:
    • Are you a 10% or more shareholder of a foreign corporation and the foreign corporation is considered a CFC?
    • Are you a 10% or more shareholder of a foreign corporation and the foreign corporation has a 10% or more corporate U.S. shareholder?
    • Are you a 10% or more shareholder of a foreign corporation and the foreign corporation owns a US corporation subsidiary and a foreign corporate subsidiary?
    • Are you a 10% or more shareholder of a foreign corporation and together with your spouse, your children, your parents, you own more than 50% of a foreign corporation, you may potentially be affected by the new Transition Tax and should seek professional advice.

The IRS has provided some updated guidance in relation to questions regarding return filing and tax payment obligations related to section 965 of the IRC:

Further questions still to be determined

  • Does the Transition Tax apply to PFICs (passive foreign investment companies, i.e. investment in equities, fixed interest, managed funds, public superannuation fund, etc.) or only to companies with operating businesses?
  • Does this apply to self-managed super funds?
  • Legislative regulations yet to be released, legal challenges, further IRS guidance and interpretations?

Summary

There are still many unanswered questions, lack of guidance, or settled authority in relation to the Transition Tax, specifically, and the TCJA, in general.  Please note that the tax changes are new and are yet to be fully interpreted or clarified by the IRS on how they will be applied. When the law becomes more settled we will be better able to advise you on the new changes. Get in touch with us for a confidential discussion.

 

This material has been prepared for informational purposes only, and is intended for general information purposes only and should not be used as a substitute for professional advice.  It has been prepared without taking into account your objectives, financial situation or needs. Before acting on this advice you should consider the appropriateness of the advice, having regard to your own objectives, financial situation and needs. 

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