When foreign investments exist in the portfolio
Section 965 of the Internal Revenue Code is focused on imposing a one-time tax on the accumulated earnings and profits of foreign investments.
Historical background and Context
“In 2004, Congress passed the American Jobs Creation Act to boost the economy. As part of this Act the US government implemented what was referred to as a repatriated tax break. This tax break provided US multinational corporations a one-time tax break on money earned in foreign countries. The tax break allowed foreign earnings to be taxed at a rate of 5.25%, which is significantly lower than the usual corporate tax rate of 35% [at the time of the ruling]. Previously much of the earnings derived from foreign countries was not transferred back to the US because multinationals could defer paying taxes on foreign earnings until they decided to send the earnings back in the form of a dividend.” Investopedia, March 6, 2018
The government thought American multinationals would use the untaxed foreign earnings to create more US jobs or expand foreign operations into the United States. Critics of the bill believed at the time the American Jobs Creation Act did not require companies to reinvest earnings into the US to create additional jobs and therefore the bill would not accomplish its objectives. The bill had some embedded restrictions around how the monies saved from the reduced tax rate were used, specifically preventing companies from using monies for executive compensation, dividends or stock investments although it appears that would be difficult to trace as money can be fungible. They were also concerned this type of tax ruling would set a bad precedent providing US multinationals with an incentive to withhold future earnings while expecting the US would come out with more repatriation tax breaks in the future.
What is Section 965 of the 2018 Tax Reform Act?
Section 965 is what is being referred to as a “deemed repatriation tax” or “transition tax”. The US government is imposing a one time tax on US taxpayers who have monies in a foreign investment. The goal of Section 965 is to transform the US tax system into more of a jurisdiction focused system so US corporations will not be continuously taxed when receiving future distributions of profits from their overseas subsidiaries.
In order to transition to this new taxation process the US government is imposing a one time repatriation tax to shareholders of foreign investments on past earnings that foreign corporations have accumulated over the years since 1986. Repatriation tax in this context refers to applying a tax to monies that are invested in a foreign investment as if they were monies invested in the US and subject to US tax. Since the monies reside in what is commonly referred to as accumulated earnings and profits (AE&P) they are deemed earnings but not actually distributions to the US shareholder. It is worthy to note given this one time repatriation tax for AE&P, if the earnings are paid out to the shareholder in the future the US will not impose tax on those future foreign distributions.
Who is impacted by this repatriation tax?
Any shareholder who is invested in a “deferred foreign income corporation” (DFIC) and deemed a taxpayer of the United States must pay this one time repatriation tax. DFIC’s — also referred to as a specified foreign corporation (SFC) — apply to C corporations, S corporations and pass-through entities. S Corporations have the option to defer the payment of the tax indefinitely unless a trigger event occurs such as when the S corporation:
- ceases to maintain its S Corporation status
- ceases to exist
- is liquidated or sells substantially all of its assets
- transfers any of its shares to another party through a sale
Once the trigger event occurs, the shareholder may file an election to pay the transition tax over eight years, beginning in the year of the trigger event.
In context to Section 965 a US shareholder can be a US citizen, a green card holder, a resident due to an elongated presence in the US or any United States entity that owns 10% or more of a corporation by vote or in terms of value.
What is an SFC? A specified foreign corporation is any controlled foreign corporation (CFC) or any foreign corporation that has one or more domestic US corporations which are US shareholders, regardless of whether that foreign corporation is a CFC. PFICs (passive foreign investment corporations) are not always considered CFCs.
How is the tax calculated?
The US is applying a tax to US shareholders based on the shareholder’s pro rata share of the AE&P of the foreign corporation. The US has a specific way to calculate the AE&P which may differ from how other countries compute it. The measurement date of the AE&P is based on November 2, 2017 or December 31, 2017, whichever generates a higher AE&P balance unless the US shareholder elects an alternative date for their 2017 tax return pursuant to IRS Notice 2018-13.
The rates of tax from Section 965 are complex and can vary. The basic components are if cash can be associated to the AE&P it is taxed at a 15.5% elected corporate tax rate. If no election is made the cash is taxed at a 17.54% tax rate for the individual shareholders. All other earnings or assets are taxed at an 8% elected corporate tax rate or a 9.05% tax rate for individual shareholders if no election was made. The calculation is based on the highest rate of tax applicable to corporations in the inclusion year. It is important to note that foreign entities are not allowed to change their year end to reduce, defer or avoid the tax implications of Section 965.
When will shareholders have to pay the tax?
Shareholders have the option to file an election with their 2017 tax return to pay this repatriation tax over an 8 year period through an installment plan. If the election was not made then the tax was deemed due and payable as of April 18, 2018. If a timely election was made the tax would be due and payable over 8 years. Years 1-5 would require 40% of the total tax to be paid whereby each year the taxpayer would pay 8% of the total outstanding amount per year. Years 6-8 would require the shareholder to payoff the remaining 60% as 15%, 20% and 25% respectively in years 6, 7 and 8.
If a shareholder elected an installment method but failed to pay the first installment by April 18, 2018, the IRS will waive the late payment penalty, but not the interest, until April 15, 2019. This relief is granted only to those taxpayers whose liability is less than $1 million at the time of the tax assessment. If the April 15, 2019 payment or any other payment thereafter is not paid in a timely manner the total amount outstanding over the 8 year period would become due and payable immediately.
It is important to note that certain states follow the Internal Revenue Code (IRC), yet others do not. If a state follows the IRC then the foreign income generated as a result of Section 965 may be subject to state tax as well. If the state does not follow the IRC then state defined calculations will be imposed on the taxpayer.
How does this impact a divorce?
The marital estate may be subject to the 965 repatriation tax liability
If a couple was married at the time when the repatriation tax was imposed and the foreign investment was deemed part of the marital estate then the marital estate would be subject to the tax liability and subject to an appropriate asset allocation.
Failure to pay the repatriation tax impacts a divorcing party’s tax liability
If the tax was not paid on time one or both divorcing parties could be liable for the total outstanding tax. Only the total amount outstanding would be due; no double payment would be required. If this issue is not properly addressed in the divorce decree there could be much debate over how the tax would be paid to the government. Given the government is usually not patient on receiving its monies there could be severe monetary penalties or interest imposed with possible jail sentences if not paid.
Determining who is liable when MFS is filed and a repatriation tax was imposed
If the couple decided to file MFS yet the tax liability was still part of the marital estate each taxpayer may have had to record the repatriation tax on their separate returns. If one party recorded only part of the repatriation tax and the other did not there could be a penalty imposed for a failure to report the foreign earnings in a timely manner.
Retirement assets allocated to one spouse could be destroyed
It is important to note that retirement assets could be destroyed through the Section 965 repatriation tax. Why? Retirement assets are not shielded from the repatriation tax. Through the asset allocation process the divorcing parties need to be sensitive whether certain assets have tax attributes associated to them, especially relating to the deferred installment plan which could wipe out a significant portion of the retirement assets.
Children’s trusts used as agreed upon compensation but assets have 965 tax attributes
Another issue to take into account is whether the agreed compensation between the parties is directed toward a Trust for the children’s future. Yet if an asset that is in the Trust is subject to the repatriation tax and paid over time then the Trust may not serve its intended purpose to provide funds for the children.
One party passes away before all installment payments are made
Also, what happens when the couple incurred the tax but one of the divorcing parties passes away in future years? Should the surviving party be subject to the entire tax or should it go to the estate of the person who passed away? It may depend on how the divorce decree was written.
State imposed tax when parties are living in separate states
Another issue to address is if the parties are living in separate states and each state imposes a tax on the repatriated earnings. How will the state imposed tax impact the divorce?
These types of issues are important to incorporate into the financial settlement structure. If they are not then the divorcing parties will experience financial consequences and much confusion how to settle these differences. Which “compensation” or payments need to be made first, second and third need to be prioritized to mitigate the risk of mounting unforeseen financial obligations.
About the Author
Larry Smith is a Founding Partner of Divorce Outcomes, a specialized professional services firm that manages all of the financial aspects in a divorce process. Since 2003 he has worked as a trusted financial advisor, financial advocate, divorce architect and technical financial expert; he is not an attorney. He is an alumni of KPMG and Andersen with expertise in technical accounting, forensics, sophisticated taxation, management consulting, risk management, advanced process engineering, business combinations, divorce management, multi-party negotiations, advanced quality analytics and cognitive performance technologies. Since 1986 Larry has been advising individuals and organizations about innovative financial solutions to resolve complex financial challenges that arise in life and in business.
For both personal and business divorces, Larry is considered an expert in divorce strategies, divorce process management, financial divorce architecture, financial risk management, taxation for divorces, financial divorce forensics, advanced divorce analytics, financial divorce negotiations and mediation, business valuations and sophisticated equity structures. He helps clients shape complex financial decisions, manage communication risks and ever-changing negotiating positions to strategically preserve or grow wealth from these types of transactions.
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About Divorce Outcomes
Divorce Outcomes is a specialty services firm that helps people both domestically and internationally manage all of the financial decisions that arise in their divorce process. We are not attorneys. We are financial experts who partner with our clients as their personal financial advocates. We help our clients manage their divorce process, uncover hidden financial risks, architect divorce solutions, manage ever-changing negotiating positions, communicate complex financial matters and close the divorce process as soon as possible with a goal to arrive at the best outcomes possible. Throughout the process we evaluate the current state of our clients’ financial lives with an objective to best reposition their future. We do not sell any products. We simply raise issues that are in our clients best interest. Our clients share with us we:
- unfold, analyze and repackage their financial life so they are well positioned after their divorce
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Learn more about us at divorceoutcomes.com or review our blogs to gain a clearer understanding about our approach and how we maximize the financial outcomes for our clients.
This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute formal advice or a recommended course of action as every person’s situation is unique and different. The information here is not intended to be, and should not be, relied upon by the recipient to make a decision without professional guidance.