US Tax Cuts and Jobs Act: Transition Tax

As you may be aware, the US Government passed significant tax reforms in late 2017, and one of the major reforms was the wholesale conversion of its system of taxing corporate business income from a worldwide taxation system to a territorial taxation system. Under the old worldwide taxation system, business profits earned in a foreign subsidiary and repatriated to a US parent corporation were taxable in the US, with credit being provided for the foreign taxes paid by the foreign subsidiary. This meant that business profits earned in a lower tax jurisdiction would be subject to a “top-up” tax on repatriation to the US. Under the new territorial taxation system, business profits earned in a foreign subsidiary may be repatriated to the US without additional US income tax being applied.

This brought the US in line with other countries, including Canada, but it created a need to transition previously unrepatriated and untaxed earnings and profits of foreign subsidiaries into the new system. A “Transition Tax” was thus enacted, which effectively added the unrepatriated earnings and profits to the US taxable income of the US shareholder. Unfortunately, this Transition Tax applies not only to US parent corporations of foreign subsidiaries, but any US shareholder of a “Controlled Foreign Corporation”, including US individuals. As well, the Transition Tax is also applicable to any foreign corporation with respect to which one or more domestic US corporations is a US shareholder.

The mechanics of this Transition Tax are laid out below.

Controlled Foreign Corporation (“CFC”)

The Transition Tax applies to earnings and profits of a Controlled Foreign Corporation (“CFC”). Under the revised US tax legislation, a CFC includes any foreign corporation of which a US shareholder owns directly or indirectly more than 50 percent of the shareholdings. There are also specific share attribution rules applicable for non-resident related parties. A US shareholder is defined as a US person that directly, indirectly, or constructively owns 10 percent or more of the foreign corporation’s shareholdings.

Transition Tax

The Transition Tax is applicable for the last taxable year which begins before January 1, 2018. For CFCs that do not have a calendar year fiscal year, the income inclusion for the Transition Tax will not be realized until 2018. It is based on the greater of the accumulated post-1986 deferred foreign income (earnings and profits or “E&P”) as of: (a) November 2, 2017 or (b) December 31, 2017. The Transition Tax rates applicable are: (i) 15.5% for aggregate foreign cash (and cash equivalents) and (ii) 8% for the remainder of the income inclusion.

It is important to note that the E&P for either of the measurement dates cannot be reduced by declaring dividends. Provisions under the legislation will only allow a reduction if the dividends are paid-out to another corporation subject to the Transition Tax.

Foreign tax credits can be used to offset the Transition Tax, but the foreign tax credit category follows the same character as the income inclusion. For example, for corporations generating active income, the US shareholder is able to claim any current and carryover foreign tax credits under the General Income Category basket. As well, the amount of foreign tax credits that may be claimed will be subjected to a pro-ration calculation, such that more than $1 of foreign tax will be required to offset $1 of Transition Tax.

Although the Transition Tax is added onto the US shareholder’s 2017 or 2018 income tax return (depending on the fiscal year end of the CFC), there is an election available to pay the net tax liability over an 8-year period. The election must be made on a timely basis by the filing deadline for the US shareholder (without any extensions). For individual US shareholders, the filing deadline is April 15th. The instalment schedule is specified as:

  • 8% of the total Transition Tax amount for the first 5 years;
  • 15% for the sixth year;
  • 20% for the seventh year; and
  • 25% for the eighth year

Finally, the amount subjected to the Transition Tax would be considered Previously Taxed Income (“PTI”), and dividends later paid out of PTI would not be further subject to US taxation.

Closing Comments

If the new US rules impact you, your personal income tax liability for 2017 or 2018 may be considerably higher than in prior years. An election is available to pay the Transition Tax in instalments over an 8-year period, but that election must be filed on a timely basis.

Please contact your advisor at D&H Group LLP if you believe you may be affected by the new US rules.