A Step-by-Step Guide to Calculating the Tax on Deferred Income

In the aftermath of passage of the Tax Cuts and Jobs Act (P.L. 115-97), the toll charge on deferred foreign income is now a first order of business for many tax professionals. The application of these new and complex rules with such short deadlines can be daunting. Thankfully, the IRS released Notice 2018-7,¹ providing much needed guidance. And the week before, the SEC issued Staff Accounting Bulletin No. 118, providing some timing leniency. This is a welcome and impressive response time by both agencies, especially during the holiday season.

This article identifies required information and breaks down the toll charge calculation into 10 steps, which are applied to a sample fact pattern as a guide for assessing the time, resources, and information necessary to calculate the transition tax (toll charge) under the act. The facts assumed in our example will be different for each taxpayer, which will result in different outcomes. Further, the underlying rules we have applied are subject to change — for example, with the issuance of regulations or other guidance.

I. The Sample Fact Pattern

A. Basic Facts

This article uses the example of a U.S. shareholder (USSH) that holds interests in three specified foreign corporations (SFCs): a 100 percent interest in SFC 1 with positive earnings and profits, a 100 percent interest in SFC 2 with an E&P deficit, and a 40 percent interest in SFC 3 with positive E&P. Our analysis includes various caveats we will discuss as we move through the steps. For example, we assume that the USSH’s interests in the SFCs have not fluctuated during the course of ownership. We also assume there are no intercompany transactions or balances between the SFCs and that all entities have a tax year ending on December 31, 2017. Basic facts and U.S. dollar amounts are depicted in the chart below. All stated amounts are in U.S. dollars, as converted with appropriate exchange rates.

Table 1

USSH Company Profile
2017 taxed income without toll charge	$100,000
Net operating loss carryforward	$20,000
FTC carryforward	$10,000
Foreign subs (directly owned by USSH)	SFC 1	SFC 2	SFC 3
Earnings and tax pools
Ownership percentage	100%	100%	40%
E&P at Nov. 2, 2017	$140,000	-$25,000	50,000
E&P at Dec. 31, 2017	$150,000	-$30,000	60,000
ECI E&P	$20,000	—	—
Pre-2017 previously taxed income	$25,000	—	—
2017 traditional subpart F income	$10,000	—	—
2017 actual cash distributions	$5,000	—	—
Tax pool at Dec. 31, 2017	$50,000	$10,000	$15,000
Cash position
Cash equivalents at Dec. 31, 2015	$45,000	$25,000	$5,000
Cash equivalents at Dec. 31, 2016	$50,000	$20,000	$10,000
Cash equivalents at Dec. 31, 2017	$60,000	$15,000	$5,000

B. Step One: Calculate Section 965(a) Earnings

To calculate the USSH’s section 965(a) earnings amount, or the accumulated deferred foreign income (ADFI) amount, the USSH should first calculate the post-1986 E&P of each SFC as of November 2, 2017, and December 31, 2017. Those amounts are then reduced by any effectively connected income, pre-2017 previously taxed income (PTI), and PTI from 2017 subpart F income. The USSH then determines its own pro rata share of the ADFI for each SFC (by multiplying the ADFI from each SFC by its ownership percentage) and aggregates the ADFI of the deferred foreign income corporations (DFICs), or SFC’s with positive ADFI. Therefore, USSH aggregates its share of ADFI in SFC 1 and SFC 3.

At this point, compare the results for each measurement date (November 2, 2017, and December 31, 2017). The greater amount will be used. In our example, the ADFI from the December 31 measurement date yields the greater number.

Table 2

	SFC 1	SFC 2	SFC 3
E&P as of Nov. 2, 2017	$140,000	-$25,000	$50,000
Less: ECI E&P	-$20,000	—	—
Less: Pre-2017 PTI	-$25,000	—	—
Less: PTI from 2017 subpart F income	-$10,000	—	—
ADFI as of Nov. 2, 2017	$85,000	-$25,000	$50,000
Ownership percentage	100%	100%	40%
USSH’s pro rata share of ADFI as of Nov. 2, 2017	$85,000	-$25,000	$20,000
Deferred foreign income corporation	Yes	No	Yes
E&P as of Dec. 31, 2017	$150,000	-$30,000	$60,000
Less: ECI E&P	-$20,000	—	—
Less: Pre-2017 PTI	-$25,000	—	—
Less: PTI from 2017 subpart F income	-$10,000	—	—
ADFI as of Dec. 31, 2017	$95,000	-$30,000	$60,000
Ownership percentage	100%	100%	40%
USSH’s pro rata share of ADFI as of Dec. 31, 2017	$95,000	-$30,000	$24,000
Deferred foreign income corporation	Yes	No	Yes
Greater ADFI of DFICs	$95,000	—	$24,000
Section 965(a) earnings amount	—	—	$119,000

C. Step Two: Allocate E&P Deficits

Step two allows E&P deficits to offset the amount determined in step one. The E&P deficits of any SFCs with deficits are aggregated and allocated against the ADFI of the DFICs (the SFCs with positive E&P from step one). The allocation of the aggregate deficit to DFICs is based on the percentage the DFIC’s positive E&P bears to the total ADFI as determined in step one.

Only SFC 2 has negative E&P. Therefore, its deficit is allocated proportionately between SFC 1 and SFC 2. Unlike the rules for ADFI requiring two determination dates, the deficit amount is calculated as of November 2, 2017.

After the allocation, aggregate the SFC’s newly reduced ADFI. This is the section 965(a) inclusion amount.

Table 3

	SFC 1	SFC 2	SFC 3
Specified E&P deficit as of Nov. 2, 2017	No	Yes	No
Specified E&P deficit as of Nov. 2, 2017	—	-$25,000	—
Aggregate foreign E&P deficit	—	—	-$25,000
Allocation of aggregate foreign E&P deficit
Pro rata share of ADFI of DFICs	$95,000	—	$24,000
Percentage share of total ADFI of DFICs	79.8%	0%	20.2%
Allocated foreign E&P deficit	-$19,958	—	-$5,042
ADFI of DFICs after deficit allocation	$75,042	—	$18,958
Section 965(a) inclusion amount	—	—	$94,000

D. Step Three: Calculate Aggregate Foreign Cash

Each SFC will need to determine its foreign cash position in accordance with the code and Notice 2018-7, as of December 31, 2015, December 31, 2016, and December 31, 2017. Depending on the individual circumstances of any specific SFC, this step alone could be an intense exercise.

In general, the foreign cash position (also sometimes called the cash and cash equivalents position) includes the following items and amounts:

• cash and foreign currency;

• net accounts receivables;

• fair market value of actively traded personal property for which an established market exists;

• commercial paper;

• CDs and securities of government bodies;

• any short-term receivables (that is, obligations with terms of less than one year), notably including receivables from U.S. related parties;

• FMV of derivatives (that is, notional principle contracts, futures contracts, etc.) except for bona-fide hedging transactions; and

• any other asset further defined by the Treasury secretary.

Regarding the included receivables above, keep in mind that Notice 2018-7 indicates Treasury’s intent to issue regulations that will provide for some receivables and payables between related SFCs to be disregarded for purposes of this calculation.

Further, some antiabuse rules may ignore transactions intended to manipulate an SFC’s cash position.

Once the foreign cash position of each SFC is calculated, the USSH will determine its pro rata share of the cash position for each SFC as of December 31, 2015, December 31, 2016, and December 31, 2017. The USSH will then calculate what is referred to as the prior two-year aggregate cash position by averaging the cash position as of December 31, 2015, and December 31, 2016, for each SFC, followed by aggregating those averages of all SFCs. The average cash position is then compared to the cash position as of December 31, 2017. The greater amount is deemed to be the foreign cash position and is used moving forward.

Table 4

	SFC 1	SFC 2	SFC 3
Ownership percentage	100%	100%	40%
Pro rata share of cash position as of Dec. 31, 2015	$45,000	$25,000	$2,000
Pro rata share of cash position as of Dec. 31, 2016	$50,000	$20,000	$4,000
Average of prior two years’ cash positions	$47,500	$22,500	$3,000
Aggregate cash position from prior two years	—	—	$73,000
Pro rata share of aggregate cash position as of Dec. 31, 2017	$60,000	$15,000	$2,000
Aggregate cash position from current year	—	—	$77,000
Greater of current cash position of prior two years’ average			$77,000

E. Step Four: Calculate Deemed Paid Taxes (Part 1)

Now that the toll charge inclusion amounts have been determined, the tax pools must be adjusted to correspond with the E&P that has been subjected to U.S. tax. As a precursor to this step, the tax pools available for distribution before 2017 inclusions should be determined for each SFC.

The toll charge is a subpart F inclusion that applies after “traditional” subpart F (that is, subpart F inclusions for USSHs of some controlled foreign corporations without regard to the toll charge). Therefore, we must first determine the amounts of traditional subpart F income, as demonstrated in step one, as a PTI reduction to AFDI. Consistent with that reduction, in this step four, we must also determine the tax pool remaining after any traditional subpart F inclusions for the current year.

F. Step Five: Calculate Deemed Paid Taxes (Part 2)

To determine the amount of the tax pool deemed distributed, the USSH divides the toll charge inclusion (as determined in step two) by the remaining undistributed E&P (that is, after accounting for the traditional subpart F rules discussed above). The resulting percentage is then applied to the remaining tax pools, and the resulting amounts are deemed distributed. Residual amounts in the tax pools remain undistributed and, because of the participation exemption rules going forward, may be available for credit only in future years to the extent of future subpart F income generated by such SFC.

Table 5

	SFC 1	SFC 2	SFC 3
Tax Pool available for distribution before 2017 inclusions	$50,000	$10,000	$15,000
Total E&P pool	150,000	-$30,000	$60,000
Less: Pre-2017 PTI pool	-$25,000	—	—
Undistributed E&P	$125,000	-$30,000	$60,000
Current-year traditional subpart F inclusion	$10,000	—	—
Percentage of E&P deemed distributed	8%	0%	0%
Tax pool deemed distributed	$4,000	—	—
Tax pool remaining after traditional subpart F	$46,000	$10,000	$15,000
Undistributed E&P after traditional subpart F inclusion	$115,000	-$30,000	$60,000
Toll charge subpart F inclusion	$75,042	—	$18,958
Percentage of E&P deemed distributed	65.3%	0%	31.6%
Tax pool deemed distributed	$30,017	—	$4,739
Tax pool remaining after toll charge subpart F	$15,983	$10,000	$10,261

G. Step Six: Classify 2017 Actual Cash Distributions

If actual cash distributions were made by an SFC, determine the extent to which they consist of PTI. That would include traditional subpart F PTI, section 956 PTI, and new section 965 PTI. Because the section 965 tax base includes current-year earnings that were distributed, the only way a current-year distribution could exceed PTI would be if one or more of the following conditions exist: (1) The SFC has any earnings that were taxed as ECI, and the SFC has pre-1987 earnings; or (2) the SFC has earnings from periods when it was not an SFC. Because those categories of income are not included in the section 965 tax base, they would not give rise to PTI because of section 965 (although it’s possible that pre-1987 E&P could include traditional subpart F or section 956 PTI).

So, in many cases current-year distributions will consist entirely of PTI. But for those less common cases — in which the SFC has ECI earnings, pre-1987 earnings, or non-SFC earnings — it is possible that current-year distributions could exceed PTI, in which case they would be taxed at the normal U.S. tax rate for the year of the distribution (for example, 35 percent for dividends received in 2017 by a USSH that is a corporation that has a December 31 year-end).

For purposes of this example, we assume that actual distributions will not exceed PTI.

Table 6

	SFC 1	SFC 2	SFC 3
Actual distributions	$5,000	—	—
Ownership percentage	100%	100%	40%
Pro rata share of actual distributions	$5,000	—	—
Pre-2017 PTI pool	$25,000	—	—
PTI from current-year traditional subpart F	$10,000	—	—
PTI from toll charge subpart F	$75,042	—	$18,958
PTI at end of 2017	$110,042	—	$18,958
Actual distributions in excess of PTI	—	—	—

H. Step Seven: Participation Exemption (Toll Charge)

Now comes the best part: the participation exemption. In other words, the mechanism that allows a USSH to an exemption for a substantial portion of foreign deferred income in computing the toll charge. To determine the participation exemption amount, the inclusion must first be separated into amounts subject to the 15.5 percent and 8 percent rates. An amount equal to cash and other liquid assets is taxed at 15.5 percent (that is, the aggregate foreign cash position as determined in step three). The remaining amount (that is, the amount deemed reinvested in noncash assets) is subject to the 8 percent rate. The remainder is determined by subtracting the aggregate foreign cash position from the toll charge subpart F inclusion as determined in step two.

After the amounts subject to the two rates are determined, the participation exemption allows a deduction, which for calendar-year taxpayers equals 55.7 percent of the amount subject to the 15.5 percent rate and 77.1 percent of the amount subject to the 8 percent rate. Those percentages will differ for fiscal-year taxpayers because of the change in the corporate rate effective January 1, 2018.

Table 7

	USSH Level
Gross subpart F income under toll charge	$94,000
Amount subject to 15.5% rate (aggregate foreign cash position)	$77,000
Amount subject to 8% rate (remainder)	$17,000
Participation exemption on cash-equivalent E&P
Section 965(a) inclusion amount subject to 15.5% rate	$77,000
Deduction allowable against subpart F	-$42,900
Net taxable income attributable to cash E&P	$34,100
Participation exemption on noncash E&P
Section 965(a) inclusion amount subject to 8% rate	$17,000
Deduction allowable against subpart F	-$13,114
Net taxable income attributable to non-cash E&P	$3,886
Net taxable income attributable to deferred foreign income	$37,986

I. Step Eight: Participation Exemption (Section 78)

Unfortunately, as much as we might like to, we cannot forget our good friend, the section 78 gross-up. To determine the section 78 gross-up on the participation exemption, aggregate the tax pools deemed distributed regarding the toll charge amount in step five. This equals the taxes deemed paid by the USSH on the toll charge subpart F inclusion. Next determine the percentage that the aggregate net taxable amounts (that is, the net amount determined after reduction by the shareholder-level participation deduction) bears to the aggregate section 965(a) inclusion amounts. Multiply that percentage by the deemed paid taxes to determine the portion of the deemed paid taxes that are creditable under section 901 and includable in income under section 78.

For the purposes of the sample, we assume that this USSH would benefit from a credit as compared to a deduction. If a deduction would be more valuable, this step is unnecessary.

Table 8

	USSH Level
Taxes deemed paid by USSH on toll charge subpart F	$34,756
Aggregate section 965(a) inclusion amounts	$94,000
Deductions allowed by section 965(c)	-$56,014
Net income subject to toll charge	$37,986
Proportion of includable amounts that are taxable	40.4%
Deemed paid taxes creditable and includable under section 78	$14,045

J. Step Nine: Calculate Tax From Toll Charge

This step gets our USSH to its isolated toll charge liability by calculating the 2017 tax with and without the toll charge. Because the toll charge liability is technically the increase in tax liability resulting from the toll charge, any increase in the tax liability because of the toll charge becomes the so-called toll charge liability. This designation is important because it represents the amount of tax that is eligible for the interest-free deferred payment election.

As in our example, the tax liability with the toll charge is calculated at $23,066; and without the toll charge at $18,900. Therefore, the toll charge liability is the difference, or $4,166.

As with many aspects of this sample calculation, several circumstances that could affect the total liability are not present in this example. For example, the existence of overall domestic losses or overall foreign losses may affect a USSH’s foreign tax credit limitation, and therefore affect total liability. Alternative minimum taxes could also affect this calculation.

Additional potential considerations and complications are listed after the example.

Table 9

	USSH Level
With toll charge
Taxable income without regard to subpart F	$100,000
Traditional subpart F inclusion (including section 78 gross-up)	$14,000
Toll charge net income (including section 78 gross-up)	$52,031
Taxable income before NOLs	$166,031
Less: NOL carryforward	-$20,000
Taxable income after NOLs	$146,031
Tax rate	35%
U.S. income tax before credits	$51,111
Current-year FTCs	-$18,045
FTC carryforwards	-$10,000
U.S. tax liability	$23,066
Without toll charge
Taxable income without regard to subpart F	$100,000
Traditional subpart F inclusion (including section 78 gross-up)	$14,000
Taxable income before NOLs	$114,000
Less: NOL carryforward	-$20,000
Taxable income after NOLs	$94,000
Tax rate	35%
U.S. income tax before credits	$32,900
Current-year FTCs	-$4,000
FTC carryforwards	-$10,000
U.S. tax liability	$18,900
Increase in tax liability because of toll charge	$4,166

K. Step 10: Calculate Payment Schedule

Congratulations! The USSH’s toll charge liability has now been successfully calculated. And there’s even better news — the toll charge liability doesn’t have to be fully settled immediately. Rather, the USSH may elect an installment plan, for which the election must be filed when the first payment is due. In this example, the USSH’s tax return or extension request is due on April 15. Thus, the election must be filed by that date. This first payment includes the full liability of the company, not just the toll charge liability. The toll charge liability is spread over an eight-year period in the following percentages: 8 percent in years 1-5, 15 percent in year 6, 20 percent in year 7, and 25 percent in year 8.

A USSH may elect to not use its NOLs to offset the toll charge liability. This is typically beneficial when the USSH has FTC that can offset the toll charge.

It is critical to note that failure to fully and timely pay any portion of the toll charge installments may result in acceleration of all remaining liability.

Table 10

	USSH Level
Year 1 normal tax liability	$18,900
Year 1 toll charge liability (8%)	$333
Total year 1 tax due	$19,233
Year 2 (8%)	$333
Year 3 (8%)	$333
Year 4 (8%)	$333
Year 5 (8%)	$333
Year 6 (15%)	$625
Year 7 (20%)	$833
Year 8 (25%)	$1,041

II. Additional Issues

There are several potential facts and circumstances not present in our sample fact pattern that may affect the calculation of the toll charge liability. Although not all-inclusive, the following list provides a few facts and circumstances that may require additional calculations when determining the toll charge:

• Section 904 FTC limitation: Some taxpayers may be unable to use FTCs because of limitations, potentially resulting in a higher toll charge liability. Limitations to consider include:

  • current-year foreign source income;

  • overall foreign loss and overall domestic loss recapture; and

  • excess credit position.

• Election to forego NOL utilization: As mentioned in step nine above, taxpayers with NOLs should consider an election to forego offsetting the toll charge income, especially if there are FTCs available as offset.

• Foreign currency issues: When the SFCs operate in currencies other than U.S. dollars, the underlying earnings and taxes require conversion, and could result in functional currency gains or losses that should be considered for purposes of determining total liability (for example, section 986 gain or loss).

• Inconsistent year-ends between USSH or SFCs: Because the toll charge is deemed to occur on the last day of the SFC’s year, inconsistent year-ends between USSH or SFC may affect when the toll charge is reportable and payable.

• Proration of current year ECI E&P (if applicable): If SFC generates ECI during the current year, those amounts should be prorated to determine E&P as of the November 2, 2017, measurement date.

• Intercompany transactions between SFCs between measurement dates (11/2 and 12/31): May be disregarded under Notice 2018-7.

• AMT calculations: As the corporate AMT remains in effect for 2017, its effect should be considered in this analysis.

• Multiple SFC groups: A USSH with ownership in multiple U.S. controlled groups must take all those groups into account for purposes of the toll charge calculation.

• Noncorporate or minority shareholders subject to toll charge: With the modification of the constructive ownership rules, noncorporate or minority shareholders may be unknowingly subject to the toll charge.

• Dividend distributions between SFCs: In some situations, this may be disregarded under Notice 2018-7.

• Fluctuating ownership percentages in SFCs: Changes in SFC percentage ownership before year-end may affect E&P inclusions.

• Excluded E&P: E&P from years that a foreign entity was not an SFC may be excluded from the toll charge calculation.

• Cash and equivalents from noncorporate foreign entities: Cash and equivalents from noncorporate foreign entities that are owned by SFC’s should be included in the aggregate foreign cash position determination.

• Section 902(m) limitation: Foreign tax pools attributable to entities that made section 338 elections may be subject to foreign tax credit limitations.

• State tax effects: This article has dealt strictly with federal income tax. However, USSH’s should consider state tax implications of the toll charge.

III. SEC’s One-Year Extension

The SEC issued Staff Accounting Bulletin No. 118 in December 2017, which provides some companies with up to a one-year window to account for the effect of the act. However, with such a short time frame before the first payment is due, many companies will have already calculated the toll charge. Further, the bulletin requires disclosures that many companies will prefer to avoid making.

IV. Conclusion

Most taxpayers are under tremendous time pressure to calculate and pay the toll charge and to disclose the effect of the Tax Cuts and Jobs Act in their financial statements. While Notice 2018-7 fills gaps on several aspects of the toll charge, it also brings to light many nuances of the toll charge and adds several new mandatory calculations. Further, there has been no indication from the IRS of an extension of time to pay the first installment of the tax. For many companies, the first payment could be due as early as April 15th. We hope that this 10-step approach will help tax professionals quickly organize their plans for tackling the toll charge liability.