Section 965 and Net Investment Income Tax

Question From Section 965 Workshop

We received a question from our March 23, 2018 workshop discussion about Section 965 about the interplay between the new transition tax rules (IRC §965) and the Net Investment Income Tax (IRC §1411). We do these workshops from time to time and publish them in our Newsletter.

The Answer

There is no free lunch. The taxpayer will pay income tax AND Net Investment Income Tax on the income recognized because of new Section 965.

When Income Tax is Paid

Income tax is paid all at once, or over eight years, as the taxpayer chooses.

When Net Investment Income Tax is Paid

The taxpayer will not escape the Net Investment Tax. It is a question of timing only:

• Now. The taxpayer can choose to have income tax and Net Investment Income Tax imposed in the year that the that Section 965 requires deferred earnings and profits to be included in the taxpayer's gross income. There is an election to make that happen.
• When Cash is Distributed. Without the election, Net Investment Income Tax is paid when an actual distribution is made by the foreign corporation of previously taxed earnings and profits.

Section 965 Creates Subpart F Income

Section 965 requires U.S. shareholders¹ of "specified foreign corporations" to recognize an amount of income based on the earnings and profits of the foreign corporation.

The income created by Section 965 is treated as Subpart F income.²

No Net Investment Income Tax on Subpart F Income

Let's ignore all of the crazy shenanigans used to imposed income tax on this Subpart F income at a lower rate. And let's forget about the timing of when this income is recognized.

Just focus on one thing: Section 965 creates Subpart F income.

Now the job is easy. We only have to figure out how does the Net Investment Income Tax³ applies to Subpart F income.

Fortunately, there is an answer. As usual, it's complicated.

Subpart F Income is Not Net Investment Income

The Net Investment Income Tax is imposed on "net investment income".

Income included in income under the Subpart F rules is not net investment income, because it is not a dividend.

Subpart F income is "pretend" income, while a dividend requires an actual change in ownership of something: the corporation must transfer money or property to a new owner--the shareholder.

Here is a Tax Court opinion that explains why this is so:

A section 951 inclusion involves no change in ownership of corporate property. It arises not from any distribution of property by a CFC but from its investment in “United States property held (directly or indirectly) by the controlled foreign corporation”. Sec. 956(a)(1)(A). Because there is no distribution, there is no dividend within the meaning of section 316(a), unless some special rule or qualification applies. The Code and the regulations contain no special rule or qualification to treat a section 951 inclusion as a dividend for purposes of section 1(h)(11).⁴

The taxpayers appealed their loss in Tax Court, and the Fifth Circuit affirmed:

Section 316(a) defines a dividend as “any distribution of property made by a corporation to its shareholders….” 26 U.S.C. § 316(a) (emphasis added). In the same vein, § 1(h)(11)(B)(i) defines “qualified dividend income” as “dividends received during the taxable year….” 26 U.S.C. § 1(h)(11)(B)(i) (emphasis added). These statutory provisions illustrate what case law explicitly states: in determining when a dividend has issued, “[t]he question is not whether a shareholder ends up with ‘more’ but whether the change in the form of his ownership represents a transfer to him, by the corporation.” Comm'r v. Gordon, 391 U.S. 83, 91 n.5 (1968) (emphasis added); see also Jack's Maint. Contractors, Inc. v. Comm'r, 703 F.2d 154, 156 (5th Cir. 1983) (“[A]ll that is necessary [for a dividend] is that the corporation confer an economic benefit on a shareholder without expectation of repayment and that the primary advantage of the transaction be to the shareholder's personal interests rather than to the corporation's business interests.” (emphasis added)).

If Subpart F income (included in gross income by application of IRC §951) is not a dividend, it is not "net investment income".⁵

Therefore, No Net Investment Income Tax on Subpart F Income (Including Section 965)

The Net Investment Income Tax therefore cannot be imposed on Subpart F income, because the Net Investment Income Tax is only imposed on "net investment income".

Since we know that the income recognized by a taxpayer because of Section 965 is Subpart F income, we finally know:

• Income tax is imposed because Subpart F income is included in the gross income of a taxpayer and Section 965 creates Subpart F income; but
• Net Investment Income Tax will not be applied to the income created by Section 965 because the income created by Section 965 is not net investment income.

When Net Investment Income Tax is Paid

Let's now identify the moment in time that the taxpayer will pay Net Investment Income Tax on the income created by Section 965.

The Regulations under Section 1411 tell us exactly how and when to apply the Net Investment Income Tax to Section 951 inclusions (i.e., Subpart F included in gross income):

• If the taxpayer elects to make the Net Investment Income Tax apply; or
• When the foreign corporation makes a distribution of previously taxed earnings and profits attributable to Section 951 inclusions.

It is self-evident when you think about it.

The distribution of previously taxed earnings and profits will not incur an income tax. That money has already been subjected to income tax--when the Section 951 inclusion occurred. That distribution of cash will qualify as a dividend, as defined in Section 316(a). Money has moved out of the corporation and into the taxpayer's hands. So now it can be subject to the Net Investment Income Tax--because it is a dividend, therefore constitutes net investment income.

Election to Pay NIIT Immediately

While as a general rule it is better to pay tax later, there is a considerable value to eliminating cognitive overload from your brain. Sometimes you just pay off a liability to close an open loop in your life.

The taxpayer might want to make an election to pay the Net Investment Income Tax at the time of Subpart F inclusion, so that income tax and NIIT is paid in the same year.

The election is made under Reg. §1.1411-10(g). By following this procedure, the taxpayer simply elects to treat Section 951 inclusions as if they are dividends for purposes of the Net Investment Income Tax. This synchronizes the timing of recognition of income for income tax purposes and for Net Investment Income Tax purposes.

For Section 965 purposes, I would probably not recommend making the election. Section 965 lets you spread the income tax payment over eight years. It does not (as near as I can tell) allow you to spread the Net Investment Income Tax over eight years, too.

Conclusion

The Section 965 transition tax causes inclusion of a certain amount of income in the taxpayer's gross income. This income is treated as Subpart F income under Section 951(a), and the tax can be spread out over eight years. The Net Investment Income Tax, however, will be payable when a distribution is made from the specified foreign corporation to the U.S. shareholder.