Update: On August 1, 2018, the IRS and the Treasury issued proposed regulations on Section 965. Learn more at irs.gov.
Internal Revenue Code Section 965 as enacted by the Tax Cuts and Jobs Act imposes a one-time transition tax on the deferred earnings and profits of certain foreign corporations owned by U.S. persons. This provision was enacted as a result of the United States transitioning to a quasi-territorial tax system. As a way of lessening the impact of this acceleration of income tax on previously untaxed foreign earnings, Congress allowed the Section 965 tax liability to be deferred and paid over an eight-year period with the first installment due on April 17, 2018. However, in regulatory guidance issued just three days before that due date, the Internal Revenue Service announced that it would apply a taxpayer’s overpayment of regular tax to the overall unsatisfied installment liability. This IRS position, which is inconsistent with the plain language of Section 965 and congressional intent, creates problems for both individual and corporate taxpayers.
Section 965 background
Section 965 imposes a federal income tax on the accumulated post-1986 earnings of a deferred foreign income corporation in the case of the last taxable year which begins before Jan. 1, 2018. A deferred foreign income corporation includes any U.S. shareholder that owns an interest in a controlled foreign corporation or any foreign corporation which has at least one domestic Subchapter C corporation as a shareholder. In such situations, the U.S. shareholder must include as a Subpart F inclusion the greater of the accumulated post-1986 deferred foreign income of this foreign corporation as of Nov. 2, 2017 or as of Dec. 31, 2017. The deemed inclusion is taxed at a special rate ranging from 8 percent to 15.5 percent for Subchapter C corporations and from 9.05 percent to 17.5 percent for individuals.
As a way of easing the tax impact to affected taxpayers, Congress provided exceptions to the immediate taxation of the foreign earnings. The most common exception is Section 965(h) which provides that an affected U.S. shareholder may elect to pay the Section 965 liability in installments over an eight-year period. No interest is imposed over this extended window for paying the tax. The first installment payment was required to be paid on the due date — determined without extensions — of the tax return for the affected taxpayer. Therefore, an individual subject to the Section 965 tax year had an obligation to make the first installment payment on or before April 17, 2018. Congress also provided for the acceleration of the entire Section 965 tax in limited scenarios.
Treasury and IRS guidance
The U.S. Department of the Treasury and IRS issued three notices in early 2018 providing guidance as to the Section 965 tax and its intent to issue regulations. On March 13, 2018, the IRS published administrative guidance on its website in the form of “Frequently Asked Questions.” These FAQs announced that a taxpayer should segregate the payment associated with such 965(h) installment apart from the regular income tax liability for the 2017 tax year. On April 6, 2018, the IRS issued Publication 5292 to assist taxpayers with the calculation of the tax and making the various allowable elections.
However, just three days before the due date of the payment for the Section 965(h) installment, the IRS updated the FAQs to address overpayments made by a taxpayer. In FAQ 13, the IRS declared that any estimated tax payments made for the 2017 tax year that exceeded the regular tax liability would be used to satisfy the unpaid transition tax deferred under Section 965(h). Further, FAQ 14 reflected that any excess of regular tax for the 2017 tax year and the first installment paid by the taxpayer would not be refunded to the taxpayer or credited to the 2018 tax year. Rather, the excess would be applied to the unsatisfied liability under Section 965.
FAQs 13 and 14 are counter to the plain language of Section 965, congressional intent and even initial guidance issued by the IRS. Like many other practitioners, we believe there is no support for the proposition that an overpayment made by a taxpayer be essentially seized and used to offset the deferred tax under Section 965(h). It is a common practice for taxpayers to be conservative when calculating their regular tax liability and pay additional tax to the U.S. Treasury. To the extent the amount paid to the U.S. Treasury exceeds the ultimate income tax liability for a given tax year, the excess may be applied to the subsequent tax year or even refunded to the taxpayer. Taxpayers that were conservative in calculating their 2017 income tax liability with the expectation that an overpayment could be applied to the 2018 tax year may now be subject to penalties for not paying estimated taxes for the 2018 tax year.
What can be done?
Tax practitioners were surprised by the IRS position taken in FAQ 13 and 14 and its timing — just three days before the due date of the first Section 965(h) installment payment. The American Institute of Certified Public Accountants sent a letter to the commissioner of the IRS requesting that the IRS reconsider FAQ 13 and 14 so that taxpayers can apply an overpayment from the 2017 tax year to the 2018 or receive a refund. It is possible the IRS may change its position or withdraw FAQ 13 and 14. Absent such action, a taxpayer can assert that the IRS has exceeded its authority in administering the collection of the Section 965 tax in a situation where a taxpayer has elected to pay it in installments. A challenge to this IRS position could be made by filing a protest that an overpayment from the 2017 tax year should be applied to the 2018 or be refunded, as opposed to being used to offset the unsatisfied Section 965 liability. Presuming the IRS refused to do so, the taxpayer could challenge this decision in U.S. Tax Court. Since at that point the Section 965 tax has already been collected, using the U.S. District Court or U.S. Court of Federal Claims to seek a refund of the overpayment may also be an option.