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News Analysis: Election to Consolidate Can Affect Transition Tax Liability

Posted on Jan. 28, 2019

The U.S. Treasury released final section 965 regulations (REG 104226-18) earlier this month. Section 1.965-8 specifies how the transition tax applies to affiliated groups (including consolidated groups). The regulations define affiliated groups by reference to section 1504(a) to generally mean chains of U.S. corporations owning at least 80 percent of each other’s vote and value. A consolidated group, as defined in reg. section 1.1502-1(h), is an affiliated group that files a consolidated tax return. An affiliated group’s decision on whether to file a consolidated return can affect the section 965 transition tax.

Section 965(a) requires U.S. shareholders of specified foreign corporations (SFCs) to increase their subpart F inclusions in the last tax year beginning before January 1, 2018, by their accumulated post-1986 deferred foreign income determined as of November 2, 2017, or December 31, 2017. An SFC is a foreign corporation with at least one 10 percent U.S. corporate shareholder, so all CFCs are SFCs, but the reverse isn’t true. A deferred foreign income corporation (DFIC) is an SFC with accumulated foreign earnings that are subject to the section 965(a) inclusion.

Subsequent provisions allow the income inclusion to be reduced, and the reductions can change depending on whether an affiliated group consolidates. Other rules also consider consolidated groups as one U.S. shareholder for some purposes and provide exceptions to accelerating installment payments that are applicable to consolidated groups.

Finally, reg. section 1.965-8(d) cross-references the adjustments to consolidated group members’ earnings and profits for tax allocations in reg. section 1.1502-33(d)(1) and adjustments to their stock bases for income allocations in section 1.1502-32(b)(3).

Reducing Inclusions for E&P Deficits

Section 965(b) generally allows U.S. shareholders to reduce their section 965(a) inclusions with deficits in E&P. Section 965(b)(5) specifically addresses those reductions in the context of an affiliated group, and reg. section 1.965-8(b) provides guidance on the application of section 965(b)(5), which allows netting of E&P deficits and surpluses among U.S. shareholders in the same affiliated group. Generally, when any affiliated group has at least one E&P net surplus U.S. shareholder and one E&P net deficit U.S. shareholder, the section 965(a) inclusion amount is reduced (but not below zero) by all or part of the affiliated group’s aggregate unused E&P deficit. In calculating the section 965(b)(5) reduction, the rules assign an applicable share of the group’s deficit to the U.S. shareholder, and an allocable share of that to the U.S. shareholder’s DFICs.

The term “E&P net surplus shareholder” means any U.S. shareholder that would include a section 965(a) amount greater than zero, while “E&P net deficit shareholder” means any U.S. shareholder whose aggregate foreign E&P deficit exceeds the amount that would be a section 965(a) inclusion.

If the group ownership percentage of any E&P net deficit shareholder is less than 100 percent, the amount of the excess deficit is the group ownership percentage of the amount.

The group ownership percentage is the percentage of the value of the stock of a U.S. shareholder held by other includable corporations in the affiliated group. The group ownership percentage of the common parent is always 100 percent. If used in the context of a rule under which all members of a consolidated group are treated as a single section 958(a) U.S. shareholder, the group ownership percentage is determined by reference to the value of the stock of the group’s common parent held by other includable corporations that aren’t members of the consolidated group.

If an E&P net surplus shareholder is a member of an affiliated group not all of whose members are in the same consolidated group, the section 965(a) inclusion is further reduced by the SFC’s allocable share of the U.S. shareholder’s applicable share of the group’s aggregate unused E&P deficit.

If some members of an affiliated group are members of a consolidated group, the consolidated group is treated as a single member of the affiliated group for reg. section 1.965-1(b)(2) purposes. Reg. section 1.965-1(b)(2) provides that a section 958(a) U.S. shareholder’s section 965(a) inclusion is reduced by its SFC’s allocable share of its foreign E&P deficit.

The practical effect is that section 965(b)(5) allows U.S. shareholders that are members of the same affiliated group to take into account the affiliated group’s aggregate unused E&P deficit. A U.S. shareholder of an affiliated group that has an overall section 965(a) inclusion for all its SFCs can reduce its inclusion by its applicable share of the affiliated group’s aggregate unused E&P deficit, determined by reference to those U.S. shareholders in the group having an aggregate foreign E&P deficit that exceeds their aggregate section 965(a) earnings amount. The amount of the affiliated group’s aggregate unused E&P deficit is the sum of that excess deficit over surplus across the group.

Reg. section 1.965-8(c) contains rules for designating the source of excess aggregate foreign E&P deficits of an affiliated group that’s not also a consolidated group taken into account under section 965(b)(5) and reg. section 1.965-8(b) when the deficit amount exceeds the surplus amount. Each member of the affiliated group that’s an E&P net deficit shareholder must designate the portion of its excess aggregate foreign E&P deficit taken into account under section 965(b)(5) with a statement in its books and records. Reg. section 1.965-8(c) cross-references reg. section 1.965-2(d), which also calls for designating the portion of a section 958 U.S. shareholder’s pro rata share of an E&P deficit taken into account under section 965(b).

Reducing Inclusions to Reduce Tax Rate

Section 965(c) allows further reductions to section 965(a) inclusions that are intended to reduce the effective tax rate applied to the inclusions to 8 percent and 15.5 percent, depending on whether the SFCs own cash or other assets. The regulations provide guidance on calculating an affiliated group’s cash position in order to apply the correct rate to an inclusion.

The aggregate foreign cash position is the U.S. shareholder’s pro rata share of the cash position of each of its SFCs. An SFC’s cash position is the sum of cash, net accounts receivable of foreign corporations, and the fair market value of some liquid assets.

The consolidated group aggregate foreign cash position is the aggregate foreign cash position (as defined in reg. section 1.965-1(f)(8)(i)) determined by treating each member of the group that is a section 958(a) U.S. shareholder as a single U.S. shareholder.

For determining the section 965(c) deduction amount of any section 958(a) U.S. shareholder that is a member of a consolidated group, the shareholder’s aggregate foreign cash position is equal to the aggregate section 965(a) amount multiplied by the group cash ratio, or the ratio of cash to the income inclusion.

Reg. section 1.965-3(b) provides rules allowing a section 958(a) U.S. shareholder to disregard some assets in determining its aggregate foreign cash position. To prevent the overstatement of the aggregate foreign cash position, all members of a consolidated group that are section 958(a) U.S. shareholders of a specified foreign corporation are treated as a single section 958(a) U.S. shareholder. That treatment extends to additional specific circumstances, discussed below.

Consolidated Group as Single U.S. Shareholder

Reg. section 1.965-8(e) calls for treating a consolidated group as a single section 958(a) U.S. shareholder or a single person. All members of a consolidated group that are section 958(a) U.S. shareholders of a specified foreign corporation are treated as a single 958(a) U.S. shareholder for purposes of section 965(b). Moreover, all members of a consolidated group are treated as a single person for purposes of section 965(h) (electing installment treatment), (k) (extending the statute of limitations), and (n) (electing to forego the use of net operating losses); and reg. section 1.965-7 (analyzing whether asset or stock transfers will cause installment payments to be accelerated).

The practical effect is that any election governed by section 965(h) and reg. section 1.965-7(b) must be made by the group’s agent (within the meaning of reg. section 1.1502-77) as a single election on behalf of all members of the consolidated group. Similarly, determining whether an asset transfer by one member of the consolidated group to a nonmember constitutes an acceleration event under reg. section 1.965-7(b) involves the consideration of all the group’s assets, meaning all the assets of each member.

However, the rule doesn’t apply to treat all members of a consolidated group as a single section 958(a) U.S. shareholder or a single person in determining the amount of any member’s section 965(a) inclusion, the foreign income taxes deemed paid for a section 965(a) inclusion (under sections 902 or 960), or for any purposes other than those listed in the section 965 regulations.

Examples

Reg. section 1.965-8(g) contains two examples that illustrate the difference in the application of the inclusion reduction and single taxpayer rules to affiliated non-consolidated groups and consolidated groups. The first example features an affiliated group that doesn’t file a consolidated return; the second features an identical affiliated group that does file a consolidated return.

The groups consist of a U.S. parent that wholly owns three U.S. subsidiaries, each of which wholly owns at least one CFC. One U.S. subsidiary owns two CFCs: one with an E&P surplus, and one with a (smaller) E&P deficit. The other two U.S. subsidiaries each own one CFC: one with a surplus, and the other (called “CFC4”) with a $100 deficit. The CFCs have a total of $200 in cash, $50 of which is CFC4’s (see figure).

1.965-8(g) Structure

In Example 1, CFC2’s E&P deficit offsets CFC1’s surplus so that USS1’s inclusion is $200. USS3 is the only E&P net deficit shareholder, and its deficit is allocated between USS1 and USS2 in the same proportion as their DFIC’s section 965(a) inclusions contribute to the total inclusion — that is 2/5 and 3/5, respectively, for a net total inclusion before 965(c) of $400.

In Example 2, the 965(a) and (b) calculations look different, but the total $400 result is the same. The entire surplus of $900 is offset by the entire deficit of $500, and the items are divided between USS1 and USS2 based on their respective shares of the $900 total gross inclusion.

The key difference in the two results involves the cash position of CFC4. When the affiliated group didn’t file a consolidated return, the cash in CFC4 didn’t count toward calculating the group’s section 965(c) deduction. When the group did file a consolidated return, CFC4’s $50 cash affected the group cash ratio, which was the group’s total $200 cash over the $400 sum of the section 965(a) inclusions, or 50 percent. The aggregate foreign cash positions of USS1 and USS2 increased, and so more of the inclusion is taxed at the 15.5 percent rate equivalent, resulting in a smaller section 965(c) deduction (see chart).

1.965-8(g) Calculations

Example 1

Example 2

Not Consolidated

Consolidated

 

USS1

USS2

USS3

Total

USS1

USS2

USS3

Total

965(a)

$200

$300

$0

$500

$600

$300

$0

$900

965(b)

$(40)

$(60)

$0

$(100)

$(333.33)

$(166.67)

$0

$(500)

Net

$160

$240

$0

$400

$266.67

$133.33

$0

$400

965(c)

$102

$174.43

$0

$276.43

$177.14

$88.56

$0

$265.70

Accelerating Installment Payments

Section 965(h) allows a U.S. shareholder to make an election to pay the tax liability in eight installments. However, some events, including a liquidation or sale of substantially all the taxpayer’s assets, will trigger an acceleration of the payments unless the buyer enters into an agreement with Treasury making itself liable for the remaining installments in the same manner as if the buyer were the taxpayer.

Treas. reg. section 1.965-7(b)(3) provides exceptions for avoiding installment payment acceleration. They include:

  • the acquisition of a consolidated group if the acquired consolidated group members join a different consolidated group as of the day following acquisition;

  • when a consolidated group ceases to exist because at least one group member transfers all its assets to other members, with only one member (which is an eligible section 965(h) transferee that may enter into a transfer agreement) remaining; and

  • when the group ceases to exist because an S corporation shareholder of the common parent terminates its subchapter S election and becomes an includable corporation, and for its tax year immediately following termination, joins in filing a consolidated return of a group that includes all the former members of the former group (the agent of the new consolidated group is an eligible section 965(h) transferee).

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