Firm Seeks Relief From NII Tax on Some Undistributed Earnings

February 28, 2018

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Lafayette G. "Chip" Harter III
Deputy Assistant Secretary (International Tax)
Department of the Treasury
1500 Permsylvania Avenue, NW
Washington, DC 20220

Marjorie Rollinson
Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Holly Porter
Associate Chief Counsel (Passthroughs & Special Industries)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Applicability of Code Section 1411 to Code Section 951(a) Inclusions Triggered by Code Section 965(a)

Dear Messrs. Kautter and Harter, Ms. Rollinson, and Ms. Porter:

We are writing to you in regard to a matter of significant and immediate importance to U.S. individuals, estates, and trusts who are United States shareholders of deferred foreign income corporations (“DFICs”) within the meaning of Section 965(d)(1) of the Internal Revenue Code of 1986, as amended (the “Code”). We are concerned that such individuals, estates, and trusts will face not only liabilities for the transition tax under Code Section 965(a), but also liabilities for the 3.8 percent net investment income tax on the undistributed earnings of DFICs under Code Section 1411(a), if such individuals, estates, and trusts are engaged in a trade or business that is a passive activity with respect to the taxpayer. Because the transition tax may be paid over eight years (if the proper election is made), but the net investment income tax would be payable immediately with respect to all of the taxpayer's share of accumulated post-1986 deferred foreign income, the net investment income tax may be of greater immediate concern to some U.S. individuals, estates, and trusts than the transition tax. That being the case, it is critically important that the government provide guidance regarding, and possibly relief from, immediate taxation under Code Section 1411 where Code Sections 965(a) and 1411 interact.

Public Law No. 115-97, commonly known as the Tax Cuts and Jobs Act, created a transition tax on certain accumulated foreign earnings of DFICs. Code Section 965(a) implements the transition tax by increasing a DFIC's subpart F income by the greater of (1) the accumulated post-1986 deferred foreign income of such corporation determined as of November 2, 2017, or (2) the accumulated post-1986 deferred foreign income of such corporation determined as of December 31, 2017. The increase in the DFIC's subpart F income is added to the gross income of the DFIC's United States shareholders under Code Section 951(a). A deduction under Code Section 965(c) reduces the effective rate of the transition tax, and taxpayers may elect under Code Section 965(h) to pay the transition tax in installments over eight years.

Because individual United States shareholders may pay tax at a higher rate than corporate United States shareholders, and because individual United States shareholders are not automatically eligible for foreign tax credits with respect to earnings that are subject to the transition tax, individual United States shareholders are more severely impacted by the transition tax than are U.S. corporations. The direct impact of the transition tax on individual United States shareholders has been well publicized, and we will not focus on it here.

What may be a more serious issue for United States shareholders of DFICs who are individuals (or that are estates or trusts) is the potential impact of the Code Section 1411 net investment income tax on the additional subpart F income triggered by Code Section 965(a). In the case of an individual, Code Section 1411(a)(1) imposes a 3.8 percent tax on the lesser of (1) the individual's net investment income or (2) the excess (if any) of the individual's modified adjusted gross income over a threshold amount. Net investment income is the excess (if any) of (A) the sum of (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income that is derived in the ordinary course of a trade or business not described in Treasury Regulation Section 1.1411-5, (ii) other gross income derived from a trade or business described in Treasury Regulation Section 1.1411-5, and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in Treasury Regulation Section 1.1411-5, over (B) certain deductions which are properly allocable to such gross income or net gain. A trade or business is described in Treasury Regulation Section 1.1411-5 if such trade or business involves the conduct of a trade or business, and such trade or business is either a passive activity with respect to the taxpayer or is the trade or business of a trader trading in certain financial instruments or commodities.

Treasury Regulation Section 1.1411-10 governs the applicability of the Code Section 1411 net investment income tax to amounts included in gross income under Code Section 951(a). A close reading of the regulation, as well as the preamble to Treasury Decision 9644, indicates that a gross income inclusion under Code Section 951(a) is subject to tax under Code Section 1411, regardless of whether the underlying earnings are distributed, if the income is derived from a trade or business that is a passive activity. In the case of an individual, including one that owns an interest in a passthrough entity (for example, a partnership or S corporation), the determination of whether income is derived in a trade or business (that is a passive activity with respect to the taxpayer) is made at the individual level.

The resulting interaction of Code Sections 965(a) and 1411 can have serious consequences for an individual United States shareholder of a DFIC where the individual is engaged in a trade or business that is a passive activity with respect to the taxpayer under Treasury Regulation Section 1.1411-5. Such an individual United States shareholder would be subject to a 3.8 percent tax on his or her entire share of the accumulated post-1986 deferred foreign income of the DFIC, even if there is no distribution of cash sufficient to pay the tax. The imposition of the Code Section 1411 tax on such an individual seems especially unfair in light of the fact that an individual engaged in a trade or business that is not a passive activity with respect to the taxpayer, or no trade or business, would generally be permitted to defer his or her Code Section 1411 tax until he or she receives a distribution of the DFIC's earnings. Moreover, because only 8% of the transition tax is due with an individual's first installment on April 17, 2018, and because much of the transition tax should be imposed on an individual at a 9.05% effective rate, the tax under Code Section 1411 may be a multiple of the initial transition tax installment. We should add that some individual taxpayers may make an election under Code Section 962, in an effort to offset the transition tax with foreign tax credits, but it is not clear that an election under Code Section 962 would have any impact on an individual taxpayer's Code Section 1411 liability (since Code Section 962 applies to the tax imposed under Chapter 1 of the Code, while Code Section 1411 appears under Chapter 2 A of the Code).

Because individual United States shareholders will generally have to pay their Code Section 1411 tax liabilities and initial transition tax installments in little more than six weeks from now, it is urgent that the government provide guidance to United States shareholders that are individuals, trusts, or estates on the potential impact of Code Sections 965(a) and 1411 on them. In particular, the government should issue guidance providing that a U.S. individual, trust, or estate is not subject to a Code Section 1411 tax on earnings of a DFIC until such earnings are actually distributed, regardless of whether the individual, trust, or estate is engaged in a trade or business that is a passive activity with respect to the individual, trust, or estate.

We thank you for your consideration of our request.

Respectfully submitted,

Andrew H. Lee
Jacob J. Miles
Kelley Drye & Warren LLP
New York, NY

cc:
Adrienne M. Mikolashek
Office of Associate Chief Counsel (Passthroughs & Special Industries)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224