On Aug. 1, Treasury and the IRS issued long-awaited proposed regulations under Section 965 of the IRC, including guidance on the impact on private foundations.
In general, Section 965, enacted by the Tax Cuts and Jobs Act of 2017, imposes a mandatory, one-time transition tax (Section 965 transition tax) on the undistributed foreign earnings of specified foreign corporations by requiring U.S. shareholders to include their pro rata share of the undistributed foreign earnings in their income under the Subpart F regime (Section 965 inclusion). The foreign earnings are included in the income of the U.S. shareholder on the last day of the taxable year of the foreign corporation beginning before Jan. 1, 2018. As such, if the specified foreign corporation’s taxable year ends on Dec. 31, 2017, the undistributed income will be included in the U.S. shareholder’s 2017 U.S. tax return.
For purposes of Section 965, “specified foreign corporation” includes both controlled foreign corporations and other foreign corporations with at least one 10 percent U.S. corporate shareholder. Of importance, Section 965 includes a participation exemption regime, which allows a deduction (the Section 965 deduction) against the mandatory Section 965 inclusion for corporate U.S. shareholders. The effect of the Section 965 deduction is reduced effective tax rates of 15.5 percent and 8 percent for corporate U.S. shareholders’ aggregate foreign cash positions and residual holdings, respectively.
Section 965 guidance requires tax-exempt organizations to attach a Section 965 transition tax statement to Form 990-T, “Exempt Organization Business Income Tax Return,” to report the information necessary to compute the potential tax liability related to Section 965. The proposed regulations do not explicitly confirm that the Section 965 inclusions should be excluded from the calculation of unrelated business income. As such, the proposed regulations still leave several unanswered questions about the impact on tax-exempt organizations. Based on the lack of guidance, tax-exempt organizations might need to compute and report the Section 965 inclusion and related information even if there is not an ultimate income tax impact for them. This might require additional effort to gather information on foreign investments held directly and indirectly.
Excise tax on net investment income
One question that the proposed regulations answered affirmatively is whether the Section 965 inclusion should be included in net investment income for private foundations for purposes of the excise tax under Section 4940.
Section 4940 imposes an annual excise tax on the net investment income of most U.S. private foundations. Net investment income is derived by reducing the sum of the entity’s gross investment income and capital gains by certain allowable deductions. Historically, gross investment income has included the gross amount of income, dividends, interest, rents, and royalties (among other items).
The preamble to the proposed regulations makes clear that in determining the net investment income subject to the excise tax, any Subpart F inclusion, including the Section 965 inclusion, is included in deriving gross investment income. However, to the extent the amount is included in deriving the unrelated business income tax under Section 511, it is not included in deriving gross investment income and, therefore, is not subject to the net investment income tax. Furthermore, the proposed regulations expressly state that the Section 965 deduction is not an allowable deduction and may not reduce a private foundation’s gross investment income, as that amount is not treated as an ordinary and necessary expense for purposes of Section 4940.
In practice, the gross amount of the Section 965 inclusion generally will be subject to the net investment income tax. As such, private foundations that hold direct or indirect foreign investments might see a significant increase in tax liability for the taxable year. Furthermore, tax-exempt taxpayers receive no reprieve, as the proposed regulations prohibit private foundations from making the eight-year election, available to other taxpayers, to pay the Section 965 transition tax liability in eight annual installments.
In general, Section 965, enacted by the Tax Cuts and Jobs Act of 2017, imposes a mandatory, one-time transition tax (Section 965 transition tax) on the undistributed foreign earnings of specified foreign corporations by requiring U.S. shareholders to include their pro rata share of the undistributed foreign earnings in their income under the Subpart F regime (Section 965 inclusion). The foreign earnings are included in the income of the U.S. shareholder on the last day of the taxable year of the foreign corporation beginning before Jan. 1, 2018. As such, if the specified foreign corporation’s taxable year ends on Dec. 31, 2017, the undistributed income will be included in the U.S. shareholder’s 2017 U.S. tax return.
For purposes of Section 965, “specified foreign corporation” includes both controlled foreign corporations and other foreign corporations with at least one 10 percent U.S. corporate shareholder. Of importance, Section 965 includes a participation exemption regime, which allows a deduction (the Section 965 deduction) against the mandatory Section 965 inclusion for corporate U.S. shareholders. The effect of the Section 965 deduction is reduced effective tax rates of 15.5 percent and 8 percent for corporate U.S. shareholders’ aggregate foreign cash positions and residual holdings, respectively.
Section 965 guidance requires tax-exempt organizations to attach a Section 965 transition tax statement to Form 990-T, “Exempt Organization Business Income Tax Return,” to report the information necessary to compute the potential tax liability related to Section 965. The proposed regulations do not explicitly confirm that the Section 965 inclusions should be excluded from the calculation of unrelated business income. As such, the proposed regulations still leave several unanswered questions about the impact on tax-exempt organizations. Based on the lack of guidance, tax-exempt organizations might need to compute and report the Section 965 inclusion and related information even if there is not an ultimate income tax impact for them. This might require additional effort to gather information on foreign investments held directly and indirectly.
Excise tax on net investment income
One question that the proposed regulations answered affirmatively is whether the Section 965 inclusion should be included in net investment income for private foundations for purposes of the excise tax under Section 4940.
Section 4940 imposes an annual excise tax on the net investment income of most U.S. private foundations. Net investment income is derived by reducing the sum of the entity’s gross investment income and capital gains by certain allowable deductions. Historically, gross investment income has included the gross amount of income, dividends, interest, rents, and royalties (among other items).
The preamble to the proposed regulations makes clear that in determining the net investment income subject to the excise tax, any Subpart F inclusion, including the Section 965 inclusion, is included in deriving gross investment income. However, to the extent the amount is included in deriving the unrelated business income tax under Section 511, it is not included in deriving gross investment income and, therefore, is not subject to the net investment income tax. Furthermore, the proposed regulations expressly state that the Section 965 deduction is not an allowable deduction and may not reduce a private foundation’s gross investment income, as that amount is not treated as an ordinary and necessary expense for purposes of Section 4940.
In practice, the gross amount of the Section 965 inclusion generally will be subject to the net investment income tax. As such, private foundations that hold direct or indirect foreign investments might see a significant increase in tax liability for the taxable year. Furthermore, tax-exempt taxpayers receive no reprieve, as the proposed regulations prohibit private foundations from making the eight-year election, available to other taxpayers, to pay the Section 965 transition tax liability in eight annual installments.
