Untangling tax reform: individual taxpayers and the applicability of a section 962 election

Untangling tax reform: individual taxpayers and the applicability of a section 962 election

Section 962 allows an individual U.S. shareholder (or trusts or estates) to elect to be taxed at corporate income tax rates on certain subpart F income under section 951(a). While this provision historically has had limited applicability, the new “repatriation tax” under the Tax Cuts and Jobs Act of 2017 (TCJA) may cause individual partners and shareholders of flow-through entities (as well as direct individual shareholders) with controlled foreign corporations (CFCs) that have foreign subsidiaries with earnings and profits (E&P) subject to the repatriation tax to see a tax deferral benefit in making this election.

The TCJA requires that, for the last taxable year beginning before Jan. 1, 2018, any U.S. shareholder of a CFC must include in income its pro rata share of the accumulated post-1986 E&P; the subpart F income of the foreign corporation is increased by the greater of the accumulated post-1986 deferred E&P of the corporation, determined as of Nov. 2, 2017, or as of Dec. 31, 2017 (measurement dates). Section 965 allows a dividends-received deduction against this repatriation inclusion, resulting in the application of a 15.5 percent rate to earnings held in cash or cash equivalents and an 8 percent rate to earnings held in noncash assets. Absent a section 962 election, while an individual shareholder will still obtain the dividends-received deduction under section 965, they will be immediately subject to U.S. tax on the relevant E&P inclusion at their marginal income tax rates (note a special rule permits deferral of the repatriation tax liability for shareholders of an S corporation).

However, in making a section 962 election, the individual is effectively taxed at the U.S. corporate tax rate (which may be higher than the individual’s marginal tax rate), but they are entitled to a credit for the indirect foreign taxes paid by the foreign corporation, by virtue of the mechanics of the section 78 gross-up calculation that applies to corporate shareholders in receipt of foreign dividends from a CFC. This provision increases the income taxable to the shareholder by a pro rata share of the foreign corporate taxes paid by the CFC, but owing the fact that those taxes are then available for credit against the taxpayer’s U.S. tax liability, the net tax result can actually be economically advantageous in the first instance.

It should be noted that upon an actual distribution of the E&P to the U.S. shareholders, the dividend would be taxed at the individual’s marginal U.S. income tax rate, but credit would be given for the taxes previously paid on the E&P inclusion. As such, while the U.S. shareholder would still ultimately pay a commensurate level of tax (subject to income tax rate differences between years), the opportunity exists to defer some portion of that tax until actual receipt of the E&P.

The section 962 election can be made on a year-on-year basis and is made on a timely filed U.S. tax return, but it will apply to ALL appropriate CFCs of the shareholder making the election for the year to which it is made.

For related insights and in-depth analysis, see our Tax Reform Resource Center.

For more information on these topics, or to learn how Baker Tilly tax specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

Ian Halligan

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