Introducing the IRC 965 U.S. Transition Tax
26 U.S. Code § 965 – Treatment of deferred foreign income upon transition to participation exemption system of taxation
(a) Treatment of deferred foreign income as subpart F income
In the case of the last taxable year of a deferred foreign income corporation which begins before January 1, 2018, the subpart F income of such foreign corporation (as otherwise determined for such taxable year under section 952) shall be increased 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.
Part II: The Reader’s Digest Version – The Six Faces Of The Transition Tax
The six “faces” of the 965 transition tax include the faces of five different kinds of “U.S. Persons”. The sixth face is the country where a U.S. citizen was living. Some are winners and some are losers. A list of winners and losers includes:
Three Winners
1. Winner: A U.S. C corp: Typically a U.S. multinational – Received value in return for being subjected to the transition tax
2. Winner: The individual shareholder of a U.S. S corp: Can opt to have the “deemed income inclusion” of 965 to NOT apply – Escaped the application of the transition tax
3. Winner: Green Card holder who is a “treaty nonresident”: Can escape U.S. taxation on “foreign source income – Escaped the application of the transition tax
Three Losers:
4. Loser: A U.S. resident individual (U.S. citizen or resident): The Moores – Subject to the transition tax, received nothing in return and likely subject to double taxation
5. Biggest Loser: A U.S. citizen living outside the United States who is a tax resident of another country: More of a loser than the Moore’s – what if the Moores had lived in British Columbia Canada? – Subject to the transition tax, received nothing in return, likely subject to double taxation and likely had their pension confiscated
6. Indirect Loser: The countries where overseas Americans are resident were also damaged by the transition tax: Many countries (example Canada) incentivize the creation of private pension plans through the use of private corporations. The effect of the transition tax was effectively to “loot” the retained earnings of those private corporations that were intended to be pension plans for residents of other countries. This is a particularly ugly manifestations of U.S. citizenship taxation and is a graphic example of how US citizenship taxation operates to extract working capital from other sovereign countries.
Significantly the biggest losers in the application of the 965 transition tax are Americans living outside the United States!
The transition tax confiscated the retained earnings of their local business corporations. Because they are tax residents of other countries, there was no prospect of the corporation’s earnings being repatriated to the United States. The corporation’s earnings were the pension/retirement plans for those individuals.
To put it simply:
The Treasury Department – via IRC 965 – effectively “looted” the retained earnings of small business corporations located outside the United States. The justification for the “looting” was that more than 50% of the shares were “owned” by U.S. citizens. The 2017 US Transition Tax was the ugliest face of the Transition Tax and a particularly ugly manifestation of U.S. citizenship taxation!
Part III: Further Commentary – The Six Faces Of The Transition Tax
1. Winner: A U.S. C corp: Typically a U.S. multinational – – Received value in return for being subjected to the transition tax
In return for a reduced tax rate from 35% to 21% they pay a one time tax (paid in installments over eight years) at a reduced rate. They also benefit from IRC 245A (restricted in application to corporations) which which means that future distributions of “foreign income” will not be subject to U.S. taxation. Note that individual shareholders do NOT have the benefits of 245A.
2. Winner: The individual shareholder of a U.S. S corp: Can opt to have the “deemed income inclusion” of 965 to NOT apply – Escaped the application of the transition tax
With respect to individual shareholders of an S corp, an IRS training unit individual shareholders IRC 965(i) states:
An election by S corporation shareholders to defer payment of the section 965 net tax liability with respect to such S corporation until a triggering event.
This confirms that individual shareholders of an S corp will be taxed ONLY on distributions as they are made. It’s as though the “transition tax” never happened. Here is a post that describes how an exemption from the 965 Transition Tax was created for individuals who were shareholders of an S corp. (A follow up post argues that Americans abroad should NOT be treated worse than individuals who are shareholders of S corps).
The lobbying efforts of the S corp association are reflected in the following document:
To put it simply:
Because of their lobbying INDIVIDUALS who are shareholders of an S corporation where effectively exempted from the 965 transition tax!!!
3. Winner: Green Card holder who is a “treaty nonresident” – can escape U.S. taxation on “foreign source income – Escaped the application of the transition tax
U.S. tax treaties typically include a residence tie break provision which allows “U.S. residents” but NOT “U.S. citizens” to be treated as nonresident aliens for U.S. income tax purposes.
This post describes how a “treaty tie break” can allow a Green Card holder to cease to be a U.S. tax resident for U.S. income tax purposes.
4. Loser: A U.S. resident individual (U.S. citizen or resident) – The Moores – Subject to the transition tax, received nothing in return and likely subject to double taxation<
There is a forced deemed income inclusion of the shareholder’s proportionate interest in the CFC’s profits going back to 1986. This results in:
– a real mandatory tax levied retroactively on deemed income which the shareholder may never receive (example the Moore’s)
– once the tax has been paid, that share of the profits becomes previously taxed income and will be subject to no further U.S. taxation (although it could be subject to a dividend withholding tax) in the country where the CFC is located
– on the other hand the cost basis in the shares will increase by the amount of the deemed income inclusion.
– the conceivable effect of the transition tax would be: (1) a tax paid on the investment in the CFC with (2) no return from the investment in the CFC (like the Moore’s)
Note that individuals receive NO benefits in return for being subjected to the transition tax. Specifically:
– individuals get NO REDUCED tax rate
– individuals do NOT GET THE benefits of 245A
The best case scenario for individuals is that they will either be subject to double taxation or may be able to use the 962 election to mitigate the effects of the transition tax.
5. Biggest Loser: A U.S. citizen living outside the United States who is a tax resident of another country (More of a loser than the Moore’s – what if the Moores had lived in British Columbia Canada?) – Subject to the transition tax, received nothing in return, likely subject to double taxation and likely had their pension confiscated
In addition to the issues that impact a U.S. citizen residing in the United States, – a US citizen living outside the United States will be subject to “double taxation” when dividends are paid to the shareholder. This is because:
1. The 965 transition tax is a U.S. levy on “deemed (without a realization event) income” and no realization event in the other country which would trigger tax; and
2. A non-US tax payable in the country of residence when there is an actual distribution/realization event.
Because the U.S. tax and the foreign tax liabilities are not triggered at the same time there is no opportunity to use the U.S. transition tax paid as a tax credit against the foreign tax paid. The likely result is double taxation.
In addition, it’s important to understand that the U.S. citizen living outside the United States will (in addition to being taxed as a U.S. resident) will be taxed as a resident of that other country. He will NOT have any access to “reduced withholding” taxes offered by tax treaties.
The sequence of events (described in this post) are described in Appendix A below.
The following post describes why the 965 Transition Tax was far more damaging to Americans abroad than to U.S. citizens living in the United States.
While U.S. resident individuals shareholders of S corps receive an exemption from the 965 Transition Tax, U.S. citizens who are residents of other countries are the worst victims of the tax!
6. Indirect Loser: The countries where overseas Americans are resident were also damaged by the transition tax. Many countries (example Canada) incentivize the creation of private pension plans through the use of private corporations. The effect of the transition tax was effectively to “loot” the retained earnings of those private corporations that were intended to be pension plans. This is a particularly ugly manifestations of U.S. citizenship taxation and is a graphic example of how US citizenship taxation operates to extract working capital from other sovereign countries.
This post describes how the U.S. citizenship taxation interferes with the profits, capital formation and business objectives of non-U.S. companies even if they carry on no business in the United States.
In general:
The U.S. trend toward “deemed income” (income without a realization event) increases the likelihood that U.S. citizens who are tax residents of other countries will be subject to double taxation. Significantly,the 965 Transition tax is just one example of reality. All forms of taxation which impose taxation without an actual “realization event” will exacerbate the problem and make it significantly more difficult for U.S. citizens to live outside the United States.
This post has clearly demonstrated that U.S. citizens living outside the United States as tax residents of other countries were by far the biggest victims of the 965 Transition Tax! Their countries of residence are also victims because the U.S. system of citizenship taxation drains the working capital out of their corporations!
Interested in Moore about the § 965 transition tax?
Read “The Little Red Transition Tax Book“.
Appendices – Next Page
(Appendix A – A Step By Step Description of how the 965 Transition Tax impacted by Canadian residents. Appendix B – Additional Commentary On The “Faces Of The Transition Tax”
