*Please see the follow-up to this post here.
Here is one question that we saw rather often:
I am a US citizen reporting on a calendar year. I have a fiscal year corporation. When am I subject to the repatriation tax? What is the rate of tax?
This post explains why you might not have a fiscal year corporation under tax law, why a US shareholder of a fiscal year corporation (assuming it is one) takes into account income in 2018, and how the participation exemption works for shareholders of fiscal year corporations.
A quick introduction to section 965: In December of 2017, Congress passed laws that changed the US taxation of foreign income significantly. One of these laws is section 965.
Here is the 2 sentence summary of what section 965 does:
The terms in quotation marks are special terms defined in the Code. To prevent a long digression, let us assume that we have a “United States shareholder”, and the foreign corporation is a “deferred foreign income corporation” with “accumulated post-1986 deferred foreign income”.
Participation exemption is Congress’s jargon for income derived from foreign corporations that is exempt from tax under the new law. In the context of section 965, it takes the form of a deduction from income, which this post will address in more detail toward the end.
Normally, a corporation’s tax year is its annual accounting period. IRC §441(b)(1). If the annual account period is a fiscal year, then the fiscal year is its tax year. But there is a special rule under section 898. IRC §898(a). Let us call these corporations “section 898 corporations”.
A section 898 corporation is a controlled foreign corporation with a majority US shareholder. IRC §898(b).
A majority US shareholder is a United States shareholder who owns more than 50% of the total voting power or more than 50% of the value of the CFC on each testing day. IRC §898(b)(2). The testing date is the first day of the corporation’s annual accounting period. IRC §898(c)(3)(B).
Suppose you have a US citizen who owns 100% of a foreign corporation. He owns more than 50% of the shares, so this foreign corporation is a CFC. IRC §957(a). He is a majority US shareholder. IRC §898(b)(2)(A). This foreign corporation is a section 898 corporation subject to its special rules.
Suppose you have 2 US citizens who are spouses, and each owns 50% of a foreign corporation. Under attribution rules, each is deemed to own 100% of the shares. IRC §898(b)(2)(B). The foreign corporation is a CFC, and both spouses are majority US shareholders. This foreign corporation is a section 898 corporation.
Suppose you have 2 US citizens who are not related to each other in any way, and each owns 50% of a foreign corporation. Their shares are not attributed to each other. The foreign corporation is a CFC, because US shareholders own 100% of the corporation. IRC §957(a). But there is no majority US shareholder, because no single person owns more than 50% of the shares. This foreign corporation is not a section 898 corporation.
If a section 898 corporation has a “majority US shareholder year”, then the corporation must use the majority US shareholder year as its tax year. IRC §898(c)(1)(A).
To determine the majority US shareholder year, we look at the tax year of each majority US shareholder and each person whose stock is attributed to any majority US shareholder. If they have the same tax year, then that tax year is the majority US shareholder year. IRC §898(c)(3)(A).
Suppose a US citizen who reports on a calendar year owns 100% of the shares of a foreign corporation. That foreign corporation’s majority US shareholder year is the calendar year. Therefore, its tax year is the calendar year, regardless of its accounting period.
If there is no majority US shareholder year, then the regulations decide the foreign corporation’s tax year. IRC §898(c)(1)(B). There has not yet been any regulations adopted under section 898, though the proposed regulations require a tax year that results in the least deferral of income. Prop. Treas. Reg. 1.898-3(a)(4). This post does not address how to calculate that tax year.
For the remainder of this post, let us assume that the foreign corporation in fact has a fiscal tax year, and we are looking at a US shareholder who uses the calendar tax year. When does the calendar year US shareholder have income?
The statutes tell us. Here is section 965(a):
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 corporation […] shall be increased by [post-1986 deferred foreign income]. IRC §965(a).
As we can see, section 965 does not say “include this amount in income”. Rather, it says “increase the subpart F income of a deferred foreign income corporation”. The year in which the increase occurs is the last tax year of the foreign corporation that begins before 2018-01-01. For a fiscal year corporation, that tax year begins in 2017 and ends in 2018.
How does the US shareholder have income? That rule is in section 951(a):
If a foreign corporation is a controlled foreign corporation at any time during any taxable year, every person who is a United States shareholder (as defined in subsection (b)) of such corporation and who owns (within the meaning of section 958(a)) stock in such corporation on the last day, in such year, on which such corporation is a controlled foreign corporation shall include in his gross income, for his taxable year in which or with which such taxable year of the corporation ends […] his pro rata share […] of the corporation’s subpart F income for such year… IRC §951(a)(1).
A US shareholder has income for the tax year that includes the last day of the foreign corporation’s tax year. The last day of the foreign corporation’s tax year is a date in 2018. The US shareholder uses a calendar year, so his tax year that includes a date in 2018 is calendar year 2018. This means the US shareholder has income in 2018.
In our previous post, we discussed a participation exemption. This is a deduction against the income a US shareholder has under section 965’s deemed repatriation rules. The participation exemption is designed to reduce the effective tax rate on the deemed repatriated income.
This is how you calculate the participation exemption:
P = C ( rcorp – rC) / ( rcorp ) + N ( rcorp – rN) / ( rcorp )
- P is the participation exemption deduction
- C is the “cash position”
- rcorp is the maximum corporate tax rate in effect
- rC 15.5%, the desired effective tax rate on the cash position
- N is the “non-cash position”
- rN is 8%, the desired effective tax rate on the non-cash position
For this post, I will assume you already calculated the cash position and non-cash position (keep in mind the cash position includes more than just cash in bank). All we need to calculate the participation exemption is the maximum corporate tax rate.
The reason involves a bit of torturous statutory interpretation, which I would like to omit from this post. The short answer is that the participation exemption is designed to take a corporation to the desired effective tax rates, which is why we calculate the participation using the maximum corporate tax rate.
The maximum corporate tax rate was 35% in 2017 and 21% in 2018. The change in tax rate was effective 2018-01-01. The foreign corporation’s tax year spans the change date. Which rate should we use to calculate the participation exemption?
Section 965(c)(2) tells us what happens when there is a change in tax rate:
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 […] in the same proportions as the portion of such taxable year which is before and after such effective date, respectively. IRC §965(c)(2).
We are looking at the tax year of the US shareholder, not the tax year of the corporation, when we determine which maximum corporate tax rate to use. In our scenario, that is the calendar year. Section 15 tells us to use a blended tax rate when there is a change in the tax rate in the middle of a tax year:
If any rate of tax imposed by this chapter changes, and if the taxable year includes the effective date of the change (unless that date is the first day of the taxable year), then [use a blended tax rate]. IRC §15(a).
To determine which rate to use, we look at the tax year of the US shareholder. In our scenario, that is the calendar year. The change in tax rate came into effect on 2018-01-01, which is the first day of the tax year. Section 15 does not apply. We do not use a blended tax rate.
The income inclusion is in 2018, and we do not use a blended rate. This means we use the maximum corporate tax rate in 2018 to calculate the participation exemption: 21%.
Plugging those numbers into the participation exemption gives us this formula:
P = ( 11 / 42 ) x C + ( 13 / 21 ) x N
This is the deduction the US shareholder gets against the income included under section 965.