The U.S. Repatriation Tax – IRC §965: Proposed Regulations Issued

Volume No. US-18-19

On August 3, 2018 the IRS issued “final” proposed regulations implementing new section 965 of the Internal Revenue Code.   IRC §965 is the “Treatment of Deferred Foreign Income Upon Transition to Participation Exemption System of Taxation”, aka the “repatriation tax”.

The document came in at 248 pages and attempts to clarify many of the questions proposed by the legislation itself.  The IRS believes that IRC §965 will impact 100,000 taxpayers and that each taxpayer will spend approximately 5 hours complying with the law. Based on our Firm’s experience the 5 hours is vastly understated!  That could, however, be the fact that very few, if any, U.S. citizens resident in Canada, who are “United States shareholders” in controlled foreign corporations, actually tracked earnings and profits (E&P) as required by U.S. tax law.

There is one clarification that will have a negative impact on these taxpayers.

First a little background.  IRC §965 imposes either a 15.5% or 8% tax depending on whether the underlying E&P (tax retained earnings) is reflected on the balance sheet as cash (or near cash) or other assets.

For example, let’s assume that E&P, as of December 31, 2017, was $1,000 and that the cash balance on the balance sheet was $800.  $800 of the $1,000 would be taxed at an effective rate of 15.5% and the remaining $200 would be taxed at an effective rate of 8%.

The U.S. corporate tax rate, however, prior to January 1, 2018 was 35%.  In order to get an effective rate of 15.5% or 8% the legislation introduced a deduction from gross income known as the “participation exemption”. The deductions were computed as follows:

Cash (and near cash) (.35-.155)/.35 = .5571
Other E&P (.35-.08)  /.35 = .7724

For the $800 of cash (near cash) E&P we would include $800 in gross income and then take a “participation exemption” of $446 ($800 x .5571) leaving taxable income of $354.  $354 x 35% = $124.  This is equal to the targeted rate of 15.5% of $800 = $124. A similar computation is done for the remaining E&P of $200. Include $200 in gross income and then take a “participation exemption” of $154 ($200 x .7724) leaving $46 of taxable income.  $46 x 35% = $16.  This is equal to the targeted rate of 8% of $200 = $16.

Since the legislation was introduced one potential form of planning was to pay a large enough dividend in 2018 (assuming the IRC §965 tax was reported on the 2017 U.S. tax return) to create enough Canadian tax that can be used as a foreign tax credit in the US to offset the 2018 U.S. tax, and then carry the excess foreign tax credit back to 2017 and file an amended 2017 U.S. tax return.

When the amount of IRC §965 “income” is included on the 2017 return it goes into a pool called “previously taxed income” or PTI.  Any subsequent actual distributions (dividends) from the company would be tax free from further U.S. tax to the extent that there is a balance in the PTI pool (since the taxpayer has already paid U.S. tax on this income).  If a dividend was paid in 2018 it would be tax free from U.S. tax (since it would first come out of the PTI pool) but be subject to Canadian tax. This would create an excess foreign tax credit position in 2018 since there is no corresponding U.S. income to claim the foreign tax credit against.  At the time the tax community believed that the Canadian taxes could be claimed $1 for $1 as a foreign tax credit. The IRS had not issued any guidance on this issue.

The issued proposed regulations, however, state that is not the case.  For foreign tax credit purposes, if previously taxed income will be claimed as a FTC against the IRC §965 tax, then the foreign taxes must be reduced by the amount of the “participation exemption.”

For example let’s assume that we only had $800 of cash E&P.  As we see above the U.S. tax (pre-FTC) would be $124.  If the taxpayer is at the highest 2018 Ontario marginal tax rate, to create Canadian tax of $124 (we are obviously not considered the foreign exchange issues) the company would need to pay a “non-eligible” dividend of $265. ($265 x 46.84% = $124) or an eligible dividend of $315 ($315 x 39.34% = $124).

Now, however, the amount of actual Canadian tax needs to be “grossed-up” to factor in the participation exemption.  For cash E&P the gross up factor is .4429 (1-.5571) so the Canadian non-eligible dividend would need to be $265/.4429 = $598.

$598 x 46.84% = $280 of Canadian tax.  Multiply this by .4429 = $124 of taxes eligible for FTC treatment against the IRC §965 tax.   The required dividend is more than 2 times what was previously thought.

Many writers have expressed the opinion that this amounts to potential double taxation and is in violation of the Canada-United States Tax Convention (1980).  The CBC also reported (on August 14th) that Finance Minister Bill Morneau revealed that “The Canadian government is talking to the U.S. government about the impact a retroactive tax signed into law by U.S. President Donald Trump is having north of the border.” It is clear, however, that a larger Canadian dividend would also enrich Canadian coffers first!

Whether these talks are successful or not, many U.S. citizens, who are resident in Canada, will now require a potentially larger Canadian tax bill to settle their U.S. taxes to avoid double taxation.  This is potentially forcing taxpayers to take out larger amounts of dividends (and sooner) that what they may have originally planned (so much for saving for retirement)!  Taking a larger dividend could also move them into a higher Canadian tax bracket.

Cadesky U.S. Tax Ltd stays on top of the latest U.S. developments. If you have any questions please do not hesitate to reach out to your Cadesky U.S. Tax contact.

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The material provided in this U.S. Tax Tip is believed to be accurate and reliable as of the date of posting. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither Cadesky Tax nor Cadesky U.S. Tax can accept any liability for the tax consequences that may result from acting based on the contents hereof.