Is it too late to comply with the “965 Hammer” (aka the “Transition” or “Repatriation” Tax) for USCs Residing Overseas?
For more background on how Section 965 works, please see, The “965 Hammer” (aka the “Transition” or “Repatriation” Tax) for USCs Residing Overseas, which explains how U.S. citizens (USC) residing overseas may owe U.S. federal income tax on “phantom income”. I call it phantom income as it does not need to be received (nor does the USC) need to have any right to it for it to be taxed.
The tax is calculated with reference to (1) the type of assets held in the USC’s foreign corporation (cash or not), and (2) the previously un-taxed earnings of the foreign corporation owned by the USC.
The IRS has a dedicated page on their website to the Section 965 Transition Tax that provides a basic overview. The rules are complex and the IRS addressed a set of Q&As to help taxpayers understand how they must report on their tax return; see, Questions and Answers about Reporting Related to Section 965 on 2017 Tax Returns
Normally, USCs combined with other “U.S. persons” need to have greater than 50% of the shares of the foreign corporation to be subject to the 965 Hammer/Repatriation tax. The following example shows how U.S. individuals combined to own 51% cause the foreign corporation to be a “controlled foreign corporation” (CFC) and therefore a “specified foreign corporation” (SFC) that causes the USCs to be subject to the tax on “phantom income” to the extent the company has previously un-taxed earnings.
In contrast, a USC that owns 10% (or 21% or 30%) should not be subject to this tax, as long as the foreign corporation is not a CFC and/or there is no U.S. corporate shareholder that owns 10% or more of the foreign corporation. The following example (Example 2) shows how a USC that owns 15% and another USC who owns 20% of a foreign corporation, will not be subject to the 965 Hammer, since it is neither a CFC or a SFC.
Compare that scenario to the following example (Example 1) that shows the somewhat “capricious” nature of how a USC that only owns 10% in a different fact pattern of ownership, can still be subject to the 965 Hammer repatriation tax. This is true, even when other U.S. owners have a mere 11% ownership (but in this case it is a U.S. corporate owner with >=10%), causing it to be a SFC and therefore triggering the 965 Hammer/repatriation tax:
In this last example, the USC owns only 10% of the shares of the foreign corporation, but since a U.S. corporate shareholder owns at least 10% of the shares of the same foreign corporation, all U.S. shareholders are subject to the 965 Hammer/repatriation tax.
There are some silver linings to this tax.
First, the tax rate applicable (8% in the case of non-cash assets) can be much lower than the normal statutory rate on dividend distributions.
Second, since the tax is mandatory (hopefully at a lower rate as cash and cash equivalents carry out a 15.5% higher tax rate), it can provide an opportunity to restructure and/or repatriate profits of the foreign corporation. This can give liquidity in the hands of the USC shareholder who was otherwise deterred from making actual dividend distributions or investing in U.S. property (which is in itself normally deemed a dividend to the USC shareholder) for foreign corporations that are “CFCs.”
Maybe USCs residing overseas will want to restructure their business operations to obtain specific tax advantages from the federal tax reform (e.g., 21% or 13.25% corporate tax rates that can be applicable for U.S. corporate taxpayers)?
Third, the statute allows the taxpayer to make a timely election (under Section 965(h)(1)) to defer the payment of the tax over many an eight (8) year period as follows:
There are no circumstances where a USC would not want to defer the payment of the tax over time? Why pay for something today, when you can pay it tomorrow without an interest carrying charge?
For instance, if the total 965 Hammer/repatriation tax is US$200,000 for a USC, why would she not want to pay only 8% or US$16,000 in 2017/2018 and defer the rest of the US$200,000 tax payments over time?
The payments are “back-loaded” in later years and do not carry an interest charge.
Also, the IRS granted further relief for individuals who owe less than US$1M of 965 Hammer/repatriation tax. This relief allows the payment/deferral of the first installment otherwise due in 2017 until 2018 (and will not trigger the full amount immediately due), provided all of the following are satisfied:
- a timely election under Section 965(h)(1) needs to have been made, which is typically extends the return due date until October 15, 2018 (USCs residing outside the U.S., the extension due date was June 15th, 2018 and requires the filing of a specific automatic extension form (IRS Form 4868) by that date); and
- pays the first installment by the due date of of the 2017 tax return, without regard to extensions (which will typically be June 15th, 2018 provided the USC is residing overseas).
Bottom line: a USC who has timely filed an extension to file their IRS Form 1040 individual income tax return by June 15th, still has time to timely file the election under Section 965(h)(1) to defer the payment of the 965 Hammer/repatriation tax.
Incidentally, the Treasury published proposed regulations at the beginning of last month on Section 965 – Treasury Announces Guidance on One-Time Repatriation Tax on Foreign Earnings