Section 965 Transition Tax: Stock Basis Adjustment Election

| 10/4/2018
The proposed regulations for the transition tax provide an election for U.S. shareholders to adjust their basis in controlled foreign corporations (CFCs) for allocated losses to reflect the parallel impact on previously taxed income accounts. The following example illustrates how the stock basis adjustment and elections work:
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example 1
USP, a domestic corporation, owns all of the stock of CFC1 located in Country X and CFC2 located in Country Y. USP, CFC1, and CFC2 all have taxable years ending Dec. 31, 2017. CFC1 and CFC2 both have a testing date of Dec. 31, 2017. On that date, CFC1 had $200 of undistributed earnings and profits (E&P), and CFC2 had a $100 deficit in E&P. USP in aggregate will have a $100 Section 965(a) inclusion ($200 from CFC1 less CFC2’s deficit allocated to CFC1 under Section 965(b)). CFC1’s previously taxed income (PTI) account will increase by $200 ($100 for the 965(a) inclusion under Section 1.965-2(c) and $100 for the 965(b) loss allocation under Section 1.965-2(d) of the proposed regulations). CFC2’s PTI account will reflect $0, but its undistributed earnings account will increase by the 965(b) loss allocation under Section 1.965-2(d).

Without application of the stock basis adjustment election, USP’s stock basis in CFC1 will be increased by only $100 ($200 earnings less $100 deficit) under Section 1.965-2(e) and (f)(1), despite having a previously taxed income account of $200. Furthermore, CFC2 would retain its stock basis despite the allocation of deficits to CFC1. This creates a potential for taxing CFC1’s PTI in the event of a sale or distribution of PTI that exceeds basis.

Under Section 1.965-2(f)(2) of the proposed regulations, a stock basis election can be made to adjust the stock basis of the CFCs to match each CFC’s PTI account under certain circumstances. If made for the example provided earlier, USP’s basis in CFC1 would increase by an additional $100 for a total increase of $200, allowing the increase in USP’s basis in CFC1 to match the increase in CFC1’s PTI. CFC2’s basis would be reduced by $100. 

These are important items to consider when making this election:
  • The proposed regulations called for the election to be made by the extended due date for the return or Oct. 9, 2018, when the due date falls before Sept. 10, 2018. But Notice 2018-78, released Oct. 1, 2018, announced that Treasury and the IRS intend to allow taxpayers to make that election within 90 days of the finalization of the proposed regulations. Consequently, taxpayers should not rush to elect until the potential effect is known.
  • The U.S. shareholder will need to attach a statement, signed under penalties of perjury, to its return. The statement must include the U.S. shareholder’s name, taxpayer identification number, and a statement that the U.S. shareholder and all related persons make the election.
  • The provision includes a conformity requirement, meaning all U.S. shareholders must make the same election.
  • The election will be applicable only to first tier CFCs, although deficits attributable to lower-tier CFCs will be included in the amount applied. As a result, CFCs that generate losses allocated to profitable CFCs in the same chain of ownership will not benefit from the election.
  • Generally, the election is advisable if a sale of a profitable CFC or distribution of PTI in excess of a CFC’s basis is being contemplated.
  • Generally, the election is inadvisable if the decrease to basis at the CFC that has a loss is greater than its adjusted basis before the Section 965 basis adjustment. 
While the election might prove advisable in limited circumstances, it also might result in a surprise gain realization in other circumstances. Taxpayers should model the potential impact of the election before making any election.

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Joe Callero
Brent Felten
Brent Felten
Partner, Washington National Tax