IRS Notice 2018-13: How it Affects Your Toll Tax Model
By Raymond Wynman and Andrew Wai
On January 19, the IRS issued IRS Notice 2018-13 providing further clarification on the calculation of the Sec. 965 toll tax. In its most relevant sections, the notice provides for when a specified foreign corporation has a deficit and indirectly states that a deficit must be reduced by previously taxed income (PTI) and provides clarification of the exchange rates to be used in calculating Sec. 965. In this update to our previous post on the toll tax, we highlight the key proposals in Notice 2018-13, noting particularly where changes will affect clients’ ongoing work to model the toll tax for end-of-year provision purposes.
Determination of Status of a SFC as a DFIC or an E&P Deficit Foreign Corporation
The notice clarifies the rules for determining whether a specified foreign corporation (SFC) is a deferred income foreign corporation (DFIC) or an E&P deficit foreign corporation (deficit corporation). The first step is to determine whether the SFC is a DFIC. If the SFC is a DFIC, it cannot be a deficit corporation. Second, determine whether the SFC is a deficit corporation. Counterintuitively, it is possible that a SFC can be neither a DFIC nor a deficit corporation.
Example 2 in section 3.01 of the notice clarifies these rules as used throughout Sec. 965. In the example, FS, a SFC, has 100 of Sec. 969(c)(2) PTI and a deficit of 90 Sec. 969(c)(3), non-PTI E&P, determined as of both November 2 and December 31, 2017 testing dates.
- FS has a deficit of 90 in “accumulated post-1986 deferred foreign income” (which excludes ECI and PTI) per Sec. 965(d)(2)and is therefore not a DFIC
- For both testing dates, FS’s “post-1986 earnings and profits” is 10 (100 PTI – 90 deficit of non-PTI E&P)
- Because FS has positive post-1986 earnings and profits as of November 2, FS does not have a “deficit in post-1986 earnings and profits” and is therefore also not a deficit corporation
While the U.S. shareholder of FS will not have a Sec. 965 inclusion from FS, it would also not be able to use any of the deficit in non-PTI E&P to offset the inclusion from its other DFICs. The interpretation adopted in the notice effectively produces a double tax on PTI, as the PTI was first recognized as Subpart F income and then included again to reduce any deficit in the non-PTI portion of post-1986 E&P.
Alternative Method for Calculating Post-1986 E&P
Recognizing the impracticality of determining E&P on November 2, the IRS intends to allow for an election to determine a SFC’s post-1986 earnings and profits by taking the sum of:
- The corporation’s post-1986 earnings and profits as of October 31, 2017; and
- An “annualized earnings and profits amount” which, for a calendar-year SFC, is the E&P earned between the start of the tax year until October 31 times 2 (days between October 31 and November 2) divided by 304 (days between the start of the tax year and October 31).
Although the notice is not completely clear on this point, we believe that the E&P amount determined as of October 31 should be the actual E&P amount calculated using a “hard close” approach rather than an estimate produced by prorating the E&P amount for the entire year. We anticipate that almost all companies will elect to calculate their November 2 E&P using this alternative method.
Determination of Aggregate Foreign Cash Position
The notice clarifies that, for purposes of 965(c)(3)(C), accounts receivable are defined as in Sec. 1221(a)(4) (trade receivables), and accounts payable are payables arising from the purchase of property described in Sec. 1221(a)(1) (inventory) or Sec. 1221(a)(8) (supplies) or the receipt of services from vendors or suppliers. These definitions would seem to exclude, for example, payables accrued for wages or for property other than inventory or supplies. Depending on how narrowly the IRS interprets “vendors or suppliers,” a much broader range of payables related to expenses of a trade or business could also be disallowed. The unfavorable definition of “net accounts receivable,” which does not permit any excess of payables over receivables to reduce other cash amounts, has not been modified by the notice.
The IRS also intends to include in its definition of cash any loan which must be repaid on demand of the lender (or within one year of such demand), regardless of the stated term of the loan.
Translation Rules
The notice provides that, for the purposes of Sec. 986 and 989, Sec. 965 inclusions are treated as distributions on the last day of the taxable year and should be translated from the SFC’s functional currency at the spot rate on December 31, 2017. This rate should also be used to translate the E&P amounts of DFICs and the E&P deficits of deficit corporations on both November 2 and December 31 testing dates. This differs from the treatment of other subpart F inclusions, which are translated at a yearly average rate (Sec. 989(b)(3)). For purposes of determining the aggregate foreign cash position, the applicable translation rates will be the spot rate on each cash measurement date (i.e. December 31 of 2015, 2016, and 2017 for a calendar-year SFC).
Modification to Rule Relating to Distributions of PTI
Notice 2018-13 extends the “gain-reduction rule” of section 3.03 of Notice 2018-07 to distributions from a DFIC through a Sec. 958(a) chain of ownership. As background, Notice 2018-08 provided that if distributions from a DFIC are made out of PTI during the inclusion year by reason of Sec. 965(a), the amount of gain recognized by the U.S. shareholder with respect to the DFIC’s stock under Sec. 961(b)(2) is reduced by the amount of the Sec. 965(a) inclusion. Notice 2018-13 clarifies that this is also true for distributions from a lower-tier DFIC, regardless if the upper-tier SFC is a deficit corporation or is a DFIC with a smaller Sec. 965(a) inclusion amount than the lower-tier DFIC.
Elimination of Form 5471 Filing Obligation for Certain Constructive Owners
With the repeal of Sec. 958(b)(4), “downward attribution” from a foreign person to a U.S. person under Sec. 318(a)(3) will result in many more Controlled Foreign Corporations (CFCs) for U.S. persons by constructive attribution. To ease the administrative burden, the notice indicates that an exception from form 5471 category 5 filing will apply to the owner of a CFC if:
- No U.S. shareholder owns, directly or indirectly within the meaning of Sec. 958(a), stock in the CFC; and
- The CFC is only a CFC because of constructive attribution under Sec. 318(a)(3)
It is important to note that even if this exception applies for a CFC, the U.S. shareholder will still have subpart F inclusions, including Sec. 965 and GILTI from that CFC.
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