Tax Act Hit to U.S. Taxpayers with Equity Ownership (Even Indirect Minority Ownership) in Foreign Entities with Unremitted Earnings

Tax Law Update | January.04.2018

Summary:

  • On December 15, 2017, Congress released its final version of tax reform – the Conference Report Bill (the Bill). The Bill was signed into law by President Trump on December 22, 2017.
  • Statutory language of the Bill may cause an unexpected tax hit on unwary U.S. stockholders who hold 10% or more of a foreign corporation – directly or indirectly. 
  • The tax would be triggered on "deemed," rather than actual, distributions. Accordingly, even if an affected U.S. stockholder/fund has not actually repatriated cash to the U.S., a potentially large tax bill would still arise.  
  • The amount of the inclusion would be based on the greater of the foreign subsidiary earnings as measured on two dates, the first being November 2, 2017, and the other being December 31, 2017.
  • The Bill would trigger taxes at vastly different rates depending upon whether the assets of the foreign corporation are cash or non-cash assets.

Applicable Tax Rate

Under the Bill, in the case of a 10% U.S. shareholder that is a corporation, the rate of tax on the mandatory inclusion will be 15.5% on cash equivalent assets and 8% on non-cash property. In the case of U.S. shareholders who are individuals in the highest tax bracket, these rates would be 9.05% and 17.5%, respectively. For a further discussion of the determination of these rates, as well as the disparate impact to individual members of funds and how to identify which individuals will be subject to these provisions, see prior alert.

Cash and Cash Equivalents versus Non-Cash Property

The determination of the cash amount is based on the aggregate cash position of the U.S. shareholder, which is the greater of (i) the sum of the shareholder's pro rata share of the cash position of each specified foreign corporation with respect to which that shareholder is a U.S. shareholder as of the last day of the last taxable year beginning before January 1, 2018 (December 31, 2017, in the case of a calendar year taxpayer) or (ii) one-half of the sum of (I) the aggregate amount determined as of the close of the last taxable year of each such specified foreign corporation that ends before November 2, 2017, plus (II) the aggregate amount determined as of the close of the taxable year of each such specified foreign corporation which precedes the last taxable year that ends before November 2, 2017, (for example, December 31, 2016, and December 31, 2015, in the case of a calendar year taxpayer).

Given the large difference in the tax rates applied to the inclusion of cash versus non-cash assets, taxpayers will invariably want to know how to quantify such assets.

Specifically, the statute provides that cash assets are the following:

  • Cash held by the foreign corporation;
  • The net accounts receivable of the foreign corporation; plus
  • The fair market value of the following assets held by the foreign corporation:
  • Personal property which is (i) actively traded and (ii) for which there is an established financial market,
  • commercial paper, certificates of deposit, the securities of the Federal government and any state or foreign government,
  • any foreign currency,
  • any obligation with a term of less than one year,
  • any asset which the Secretary of the Treasury identifies as being economically equivalent to any asset described above.

Actively Traded on an Established Financial Market

For purposes of the cash inclusion provision, the meaning of "actively traded" personal property on an "established financial market" is unclear. The legislative history does not provide any guidance as to how this determination is to be made. There is, however, authority in existing Treasury Regulations under section 1273 with respect to debt instruments, which provides that an "established market" exists to the extent:

  • There is a sales price for the property;
  • There are one or more firm quotes for the property; or
  • There are one or more indicative quotes for the property.

To the dismay of taxpayers, these standards appear to be drawn in an extremely broad fashion.

Sales Price

For these purposes, a sales price exists if the price for an executed purchase or sale of the property within the 31-day period ending 15 days after the issue date is reasonably available within a reasonable period of time after the sale. The price of a debt instrument is considered reasonably available if the sales price (or information sufficient to calculate the sales price) appears in a medium that is made available to issuers of debt instruments, persons that regularly purchase or sell debt instruments (including a price provided only to certain customers or to subscribers), or persons that broker purchases or sales of debt instruments.

Firm Quote

A firm quote is considered to exist when a price quote is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or to subscribers) for property and the quoted price is substantially the same as the price for which the person receiving the quoted price could purchase or sell the property. A price quote is considered to be available whether the quote is initiated by a person providing the quote or provided at the request of the person receiving the quote. The identity of the person receiving the quote must be reasonably ascertainable for a quote to be considered a firm quote. Moreover, a quote will be considered a firm quote if the quote is designated as a firm quote by the person providing the quote or if market participants typically purchase or sell at the quoted price.

Indicative Quote

An indicative quote is considered to exist when a price quote is available from at least one broker, dealer, or pricing service (including a price provided only to certain customers or to subscribers) for property and the price quote is not a firm quote as described above.

Installment Election

U.S. persons affected by the mandatory inclusion will likely want to elect to take into account the inclusion under an 8-year installment plan, with 8% of the total liability due during each of the first five years, 15% in year 6, 20% in year 7, and the final 25% in year 8. While the first five years of the schedule would allow for the most modest inclusions (i.e., 8% of the total inclusion), taxpayers will note that the first installment will be due with respect to 2017 – i.e., the cash outlay will be due by March 15, 2018, in the case of a corporation and April 15, 2018, in the case of an individual. Future year installments will also be due on the tax return due date for each applicable year. The mechanism for the election is unclear. It is also unclear who makes the election when a partnership is the U.S. shareholder.

Acceleration Events

Additionally, certain events will act as acceleration events, causing the unpaid portion of all installment payments to become immediately due as of the date of the event. These events include:

  • Failure to timely pay any installment payment;
  • A liquidation or sale of substantially all of the assets of the taxpayer (including in a bankruptcy proceeding) unless the buyer agrees to assume liability for the remaining installment payments;
  • A cessation of business by the taxpayer; and/or
  • Any circumstance similar to the above.

Future Guidance

In a new development, on December 29, 2017, the Treasury Department issued Notice 2018-07 (the Notice), which outlines its intent to promulgate regulations that will serve to clarify various aspects of the inclusion, including how the amount of the inclusion will be determined. The Notice does not address any of the issues discussed above relating to actively traded personal property. However, it states that the Treasury Department and IRS intend to issue regulations that address the treatment of derivative financial instruments for purposes of measuring the cash position of a specified foreign corporation. These regulations will provide that such cash position will include the fair market value of each derivative financial instrument held by the specified foreign corporation that is not a "bona fide hedging transaction." The term "bona fide hedging transaction" means a hedging transaction that both (i) is properly identified as a hedging transaction and (ii) meets the requirements described in Treasury Regulations section 1.954-2(a)(4)(ii).

Potentially affected taxpayers will want to note the above and plan accordingly.

Mitigation Measures:  Tax planning to mitigate these unintended effects is complex and affected entities and individuals are encouraged to seek professional advice.