The first thirteen posts in my “transition tax” series were:
Part 1: Responding to The Section 965 “transition tax”: “Resistance is futile” but “Compliance is impossible”
Part 2: Responding to The Section 965 “transition tax”: Is “resistance futile”? The possible use of the Canada U.S. tax treaty to defeat the “transition tax”
Part 3: Responding to the Sec. 965 “transition tax”: They hate you for (and want) your pensions!
Part 4: Responding to the Sec. 965 “transition tax”: Comparing the treatment of “Homeland Americans” to the treatment of “nonresidents”
Part 5: Responding to the Sec. 965 “transition tax”: Shades of #OVDP! April 15/18 is your last, best chance to comply!
Part 6: Responding to the Sec. 965 “transition tax”: A “reprieve” until June 15, 2018
Part 7: Responding to the Sec. 965 “transition tax”: Why the transition tax creates a fictional tax event that allows the U.S. to collect tax where it never could have before
Part 8: Responding to the Sec. 965 “transition tax”: This small business thought it was saving to invest in business expansion – Wrong, they were saving to be robbed by America!
Part 9: Responding to the Sec. 965 “transition tax”: From the “Pax Americana” to the “Tax Americana”
Part 10: Responding to the Sec. 965 “transition tax”: Individuals subject to U.S. state tax jurisdiction, the response of New York State – It’s about “reasonable cause”!
Part 11: Responding to the Sec. 965 “transition tax”: Letter to the Senate Finance discussing the effects of the transition tax on Americans abroad
Part 12 – Bulletin – June 4, 2018: It appears that the first payment for the @USTransitionTax will be delayed for some
Part 13 – Calculating the Transition Tax: Just Like Dental Work – Painful in More Ways Than One
In Part 13 of this series, Virginia La Torre Jeker introduced the Internal Revenue Code Section 962 election. Her post included:
Individuals can make a certain election under Code Section 962 to be treated as a corporation for purposes of the transition tax. Assuming the maximum tax rates and not making the election under Code Section 962, the tax rate to an individual shareholder would be 17.54% (15.5% for a corporate shareholder) on accumulated E&P attributable to the corporation’s cash and cash equivalents and approximately 9.05% (8% for a corporate shareholder) on the accumulated E&P attributable to the corporation’s non-cash assets.
So, what is the 962 election and how can it reduce the “transition tax”?
(a) General rule Under regulations prescribed by the Secretary, in the case of a United States shareholder who is an individual and who elects to have the provisions of this section apply for the taxable year—
(1) the tax imposed under this chapter on amounts which are included in his gross income under section 951(a) shall (in lieu of the tax determined under sections 1 and 55) be an amount equal to the tax which would be imposed under section 11 if such amounts were received by a domestic corporation, and
(2) for purposes of applying the provisions of section 960  (relating to foreign tax credit) such amounts shall be treated as if they were received by a domestic corporation.
An election to have the provisions of this section apply for any taxable year shall be made by a United States shareholder at such time and in such manner as the Secretary shall prescribe by regulations. An election made for any taxable year may not be revoked except with the consent of the Secretary.
(c) Pro ration of each section 11 bracket amount
For purposes of applying subsection (a)(1), the amount in each taxable income bracket in the tax table in section 11(b) shall not exceed an amount which bears the same ratio to such bracket amount as the amount included in the gross income of the United States shareholder under section 951(a) for the taxable year bears to such shareholder’s pro rata share of the earnings and profits for the taxable year of all controlled foreign corporations with respect to which such shareholder includes any amount in gross income under section 951(a).
(d) Special rule for actual distributions
The earnings and profits of a foreigncorporation attributable to amounts which were included in the gross income of a United States shareholder under section 951(a) and with respect to which an election under this section applied shall, when such earnings and profits are distributed, notwithstanding the provisions of section 959(a)(1), be included in gross income to the extent that such earnings and profits so distributed exceed the amount of tax paid under this chapter on the amounts to which such election applied.
The basic principle behind the Sec. 962 election is that the amount of “transition tax” owing should be reduced by the amount of corporate tax paid on the amount of the “undistributed earnings” that are subject to the “transition tax”. This is a complex provision. The purpose of this post is to alert you to its existence.
Please note that if the 962 Election is used the earnings WILL BE TAXED A SECOND TIME WHEN THEY ARE PAID AS DIVIDEND TO THE INDIVIDUAL SHAREHOLDER. If the 962 election is NOT used then the earnings subject to the transition tax will NOT be subjected to taxation when they are distributed as dividends. The implications of this are huge and need to be discussed with your advisor.
The basic principle behind the Sec. 962 election explained:
Monte Silver explains the basic principle behind the Section 962 election: "The @USTransitionTax and the 962 Election for Americans with a U.K. corporation" https://t.co/Un9qyZMBda
— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) September 3, 2018
Mr. Silver’s post includes:
A numerical example is helpful. An American living in the UK has been operating a CPA sole practice or family restaurant for 30 years through a wholly owned UK company. After paying UK corporate income tax on profits over the years, the company has $500,000 in retained earnings in its bank account, which the expat is counting on for retirement. Under the Repatriation tax, the expat is now personally liable for $87,700 (17.54% * $500,000) of that amount.
How is this tax paid? In eight annual payments, with the first payment of 8% (or $7,016) being due June 15, 2019 (as a result of the extension achieved from the U.S. Treasury).
Let’s assume that the expat has no personal foreign tax credits to use to offset to the Repatriation tax. In other words, in previous years the expat has already used all personal income tax paid in the UK to offset U.S. income tax.
Section 962 of the U.S. Internal Revenue Code (“IRC”) may help. Section 962 allows the expat to be treated as a corporation for a specific year (say in 2017) solely for purposes of the Repatriation tax (and other Subpart F income which taxpayers rarely have).
Why does this help? Simple. If we assume an average UK corporate tax rate of 20% over the past 10 years, then approximately $100,000 ($500,000*1.20%) of UK corporate tax has been paid. As the UK corporation never owned U.S. taxes, it never utilized these taxes as credits on any U.S. corporate tax return.
Karen Alpert of @FixTheTaxTreaty provides a detailed example of how the Sec. 962 election can be used to offset the @USTransitionTax https://t.co/gP5jLFZKYH
— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) September 3, 2018
I don’t think the section 962 election is as useless as Monte seems to imply. Yes, the section 965 inclusion does not become “previously taxed income” (except to the extent of any actual tax liability after FTC), but this is not necessarily fatal, especially if the home country has a high dividend tax. With the section 962 election you’re doing a better job of matching foreign tax credits with US tax. However, you need to do the numbers properly, and the numbers above are misleading.
First, a company paying tax at 20% with $500,000 retained earnings must have earned $625,000 and paid $125,000 in tax, not $100,000. Second, section 965 says that you only get to claim a portion of the tax paid by the company. If the company has $500,000 or more in cash, all of the section 965 inclusion is taxed at a 15.5% rate – but this is done by allowing a deduction of 55.71% of the $500,000, so the $125,000 foreign tax paid must also be reduced by the same proportion.
So, that means we have:
Gross Inclusion $500,000
Deduction (55.71%) $278,550
Net Inclusion $221,450
s78 adjustment $ 55,363 = (1-55.71%)*$125,000
Tax at 35% $ 96,884
FTC $ 55,363 = same as s78 adjustment
Net US tax due $ 41,522
Without the section 962 election, tax due would be $221,450*39.6% = $87,694 (not 37% because the tax is computed in 2017 not 2018). So the section 962 election saves $46,172 on the transition tax (which can be spread over 8 years).
On the other end – the UK will charge tax on the $500,000 dividend. A quick search shows that taxpayers with more than £150,000 will pay 38.1% tax on dividends. Using that rate, the UK dividend tax on $500,000 will be $190,500.
Without the section 962 election, there is no US income tax on the dividend, but there is Net Investment Income tax of 3.8% or $19,000. Total tax paid is $190,500 + 19,000 = $209,500.
With the section 962 election, US income tax is paid on all but $41,522 of the dividend. Since the UK has a tax treaty with the US, the dividend should be a qualified dividend taxed at 20%. But, even if it is not a qualified dividend, the UK dividend tax rate exceeds the 2018 maximum US tax rate of 37%, so there will be no additional US tax due after foreign tax credits (except for the Net Investment Income Tax, which cannot be offset by FTC). So the net tax due is the same as computed above without the section 962 election.
What does this tell us? In a high tax country like the UK, there is likely to be no net US tax on the subsequent dividend, therefore the savings generated under the section 962 election is not offset by higher tax on the dividend.
The other takeaway is that, unless the home country tax rate is above 35%, the deemed FTC will not fully offset the section 965 transition tax due to the haircut/grind down of FTC required by section 965.
Finally, FTC can be carried BACK one year. So it is possible that UK tax generated by a 2018 dividend might be available to carry back to offset the transition tax in 2017. This can reduce the benefit of the section 962 election.
Anyone facing this decision must run the numbers using their own facts, FTC carryover, and local tax rates. Fortunately, you have until 15 October (possibly 15 December) if you want to file and elect the 8 year spread.
The purpose of this post has been to alert you to the possibility of the Section 962 election as a way to reduce the “transition tax”. As an old Camel Filter cigarette ad said:
“It’s not for everybody, but it could be for you!”