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April 5, 2018 - Haoshen Zhong

Effective Tax Rate Under Section 965 for Individuals

One question we get a lot is this:

My client is a US citizen who has to recognize deferred income from foreign corporations under the new deemed repatriation law. What is the effective tax rate?

The effective tax rate is going to depend on this client’s income and what else he has going on, so it is not particularly effective to tell you the tax rate. Instead, this post tells you how to calculate the participation exemption that applies to the deemed repatriation, so you can plug in some numbers and get the effective tax rate for each client.

Background: deemed repatriation under section 965

A quick introduction to section 965: In December of 2017, Congress passed a law that changes the US taxation of foreign income fairly significantly. One of these is section 965, which requires a deemed repatriation of accumulated earnings from “specified foreign corporations”.

Here is the 2 sentence summary:

  • “United States shareholders” of “specified foreign corporations” must recognize income equal to the “accumulated post-1986 deferred foreign income” of the corporation
  • These “United States shareholders” get a participation exemption deduction

Rufus Rhoades was kind enough to host a workshop on how the deemed repatriation works, so this post does not define these terms. For brevity’s sake, let us assume for this post that the US citizen is a “United States shareholder” of a “specified foreign corporation”, and the foreign corporation has “accumulated post-1986 deferred foreign income”.

The participation exemption is how the US citizen gets a more favorable tax rate than the normal tax rate.

The participation exemption

Summaries on the internet state that because of the participation exemption, the cash position of the accumulated earnings is taxed at 15.5%, and the non-cash position is taxed at 8%. This is not quite true: These rates are for corporate United States shareholders. Individuals are taxed at different rates because of the way the participation exemption works.

This is how the participation exemption works, as given in section 965(c)(1):

In the case of a United States shareholder of a deferred foreign income corporation, there shall be allowed as a deduction for the taxable year in which an amount is included in the gross income of such United States shareholder under section 951(a)(1) by reason of this section an amount equal to the sum of —

the United States shareholder’s 8 percent rate equivalent percentage of the excess (if any) of–

(i)the amount so included as gross income, over
(ii)the amount of such United States shareholder’s aggregate foreign cash position, plus

(B) the United States shareholder’s 15.5 percent rate equivalent percentage of so much of the amount described in subparagraph (A)(ii) as does not exceed the amount described in subparagraph (A)(i).

As you can see, the participation exemption does not exactly work as “apply 15.5% to the cash position, and apply 8% to the rest to get your tax”. Rather, it provides the United States shareholder with a deduction, so that the effective tax rate on the deemed repatriation is lower than the normal rates.

How the Code wants us to calculate the participation exemption

Here is how we calculate the participation exemption, according to section 965(c)(2):

(A)8 percent rate equivalent percentage

The term “8 percent rate equivalent percentage” means, with respect to any United States shareholder for any taxable year, the percentage which would result in the amount to which such percentage applies being subject to a 8 percent rate of tax determined by only taking into account a deduction equal to such percentage of such amount and the highest rate of tax specified in section 11 for such taxable year. In the case of any taxable year of a United States shareholder to which section 15 applies, the highest rate of tax under section 11 before the effective date of the change in rates and the highest rate of tax under section 11 after the effective date of such change shall each be taken into account under the preceding sentence in the same proportions as the portion of such taxable year which is before and after such effective date, respectively.

(B)15.5 percent rate equivalent percentage

The term “15.5 percent rate equivalent percentage” means, with respect to any United States shareholder for any taxable year, the percentage determined under subparagraph (A) applied by substituting “15.5 percent rate of tax” for “8 percent rate of tax”.

The short version of the participation exemption is this:

  • You get a deduction called the participation exemption to reduce the effective tax rate on the deemed repatriation under section 965
  • Pretend you are paying tax at the top corporate tax rate on the amount after the participation exemption
  • The participation exemption is the amount that would take the effective tax rate to 15.5% for cash position and 8% for non-cash position
  • You apply your actual tax rate(s) to the amount after the participation exemption

What are cash position and non-cash position

Sorry, but I will have to leave this to another post. It would make this post too long. For this post, I assume that you already know the cash position and non-cash position of the specified foreign corporation.

Formula for the participation exemption

Assuming you already know the cash position and non-cash position, there is a formula to get the participation exemption:

Ptype = Itype(rcorp – reff) / rcorp

where

Ptype is the participation exemption for cash position or non-cash position, whichever is the one you are calculating.
Itype is the amount of cash position or non-cash position included in income. This matches the type for which you are calculating the participation exemption.
rcorp is the maximum corporate tax rate in effect for the year of inclusion
reff is the target effective rate. It is 15.5% for cash position and 8% for non-cash position.

Now, let us see how we got to this formula.

First, we want the tax on each type of inclusion to be the effective rate: 15.5% effective rate on cash position and 8% effective rate on non-cash position. This is:

Tax = reffItype

But we get to the effective tax rate by taking a deduction against the cash position, then applying the maximum corporate to the difference.

Tax = rcorp(Itype – Ptype)

We want these 2 terms to be the same, so we set them equal to each other:

reffItype = rcorp(Itype – Ptype)

Now, let us apply the distributive property of multiplication:

reffItype = rcorpItype – rcorpPtype

Now, let us move the variables around a bit, so we isolate the term containing Ptype. We can do this by first subtracting from both sides of the equation.

reffItype – rcorpItype = -rcorpPtype

Let us apply the distributive property in reverse:

Itype(reff – rcorp) = -rcorpPtype

Ptype is not quite by itself: We are still multiplying Ptype by -rcorp, so let us divide both sides by that to get Ptype by itself:

Itype(reff – rcorp) / -rcorp = Ptype

Notice there is a negative on the denominator? Let us move it up to the numerator:

-Itype(reff – rcorp) / rcorp = Ptype

I am not a fan of having a negative sign when we can avoid it, so let us use the distributive property, followed by the commutative property of addition, then the distributive property in reverse. In the end, we get:

Ptype = Itype(rcorp – reff) / rcorp

Participation exemptions

We know the formula for calculating the participation exemption for each category of inclusion: cash position and non-cash position.  To get the participation exemption, multiply the type of income inclusion by the corresponding fraction in the table below:

Type of income Inclusion in 2017 Inclusion in 2018
Cash position 39 / 70 11 / 42
Non-cash position 27 / 35 13 / 21

 

Example calculation

Suppose we have a US citizen who owns all shares of a single foreign corporation, and he owns no other foreign corporation. The foreign corporation uses a calendar year. It has $1,050,000 of accumulated post-1986 deferred foreign income. The company’s cash position is $700,000, and its non-cash position is $350,000.

  • Inclusion of income: 1,050,000
  • The inclusion happens in 2017, so we use the participation factors for 2017 in the above table.
  • Participation exemption on cash position: (39 / 70) * 700,000 = 390,000
  • Participation exemption on non-cash position: (27 / 35) * 350,000 = 270,000
  • Net inclusion: 1,050,000 – 390,000 – 270,000 = 390,000

What is the effective tax rate? It will depend on what other income the US citizen has. It is better to drop the numbers into a tax calculation and find the extra tax rather than try to state effective tax rates.

 

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