Code Section 965 of the Tax Cuts and Jobs Act requires some US shareholders to pay a one-time transition tax on the untaxed foreign earnings of certain specified foreign corporation (“SFC”) as if those earnings had been repatriated to the US. Very generally, section 965 of the Code allows taxpayers to reduce the amount of such inclusion based on deficits in earnings and profits with respect to other SFCs.

On January 15, 2019, the final regulations of the transition tax under Section 965 were released. The final regulations are fundamentally the same as the proposed regulations (with some modifications) and apply to the last taxable year of a specified foreign corporation (“SFC”) beginning before January 1, 2018 with respect to a US shareholder.  For 2017 calendar year SFCs, the transition tax is calculated in 2017, and for fiscal year SFCs ending in 2018, the transition tax applies to the 2018 tax year.

It is important to note the anti-abuse provisions of the transition tax, which also remain similar to the proposed regulations, with some modifications.  Under the anti-abuse provisions, a transaction is disregarded when determining the “section 965 element” if each of the following conditions are met:

  1. Any part of the transaction occurs on or after November 2, 2017;
  2. The purpose of the transaction is to change the amount of a “section 965 element” of the US shareholder; and
  3. The transaction, in fact, changes the amount of the section “965 element” of the US shareholder.

The final regulations define “section 965 element” as any of the following amounts:

  1. The US shareholder’s section 965(a) inclusion (i.e. reduces earnings or increases a deficit) amount with respect to the SFC;
  2. The aggregate foreign cash position (i.e. reduction to cash position) of the US shareholder; or
  3. The amount of the foreign income taxes (i.e. increase in foreign taxes paid) of a SFC deemed paid by the US shareholder under the provisions of Sec. 960 as result of the section 965(a) inclusion. The deemed foreign tax credit is only available to US corporate shareholders that own at least 10% of a SFC and is not applicable to individual US shareholders.

According to the regulations, the transactions that may change the “section 965 element” include accounting methods, entity classification elections, specified payment and double counting rule, and certain cash reduction transactions.

Due to higher Canadian tax rates, one option is for individual US shareholders to create excess foreign tax credits in the year after the transition tax year that are sufficient enough to carryback to the previous year and offset the transition tax.  For US tax purposes, a foreign tax credit for Canadian taxes paid can be carried back one year.

For example, a significant bonus can be paid in 2018 for a 2017 transition tax year (or 2019 for a 2018 transition tax year for fiscal year SFCs), a dividend distribution can be taken, or some combination of both. However, any Canadian tax paid on a dividend distribution to reduce previously taxed income (i.e. income inclusion for transition tax purposes) is subject to a reduction in foreign tax credits that is equal to the ratio of the participation exemption deducted against total earnings and profits subject to transition tax. The participation exemption is the amount of exclusion that is applied against the earnings and profits.

It is not clear if the payment of a salary would also be subject to a reduction in foreign tax credits if it reduces pre-taxed cumulative earnings and profits.

In summary, we believe that increasing the foreign tax credit for carryback to recoup the transition tax is not within the scope of the anti-abuse provisions of the regulations.

There are many Canadian companies that have been doing business in the US for years and never reported their sales or service activities to the federal or state governments.  Very few are completely oblivious to the requirements.  However, the majority are aware that they need to, at the very least, do something.  Instead they sit quietly, hoping they won’t get caught, not wanting to “open a can of worms” that may turn into endless, expensive reporting.

As US tax preparers we are frequently asked in the context of risk is whether officers have personal liability for a company’s tax obligations when remittance is not made.  The answer to this is “YES”.  States do not “discriminate” from imposition of various procedures to levy taxes, including assessing personal judgements against owners, directors, officers, partners or even employees of an entity

A recent New York State case is a reminder that officers can be held personally liable for their company’s unpaid taxes.  In Matter of Martin M. Hopwood Jr. DTA Nos. 825756 and 825757, et al. (NYS Tax App. Trib., Aug 3, 2012), the petitioner, Mr. Hopwood Jr., became CFO of the family-owned corporation after serving as legal counsel for years.  56% of the company’s stock was equally divided between him and his older brother, the company’s President, with a lesser portion allocated to other family members.  When a large multimillion dollar contract went awry in 2008, the business hit hard times when their invoices went unpaid and the costs for the work proved to be extremely underestimated.   The brother, the President, left the business and the petitioner stepped into the vacant seat to try to save it.

Additional factors from the project further drove costs up, complicating paying debts.  Contractual requirements forced the company to hire workers from a subcontractor who abused the overtime billing system. To save the business, Mr. Hopwood Jr. claimed to have invested close to $2,000,000 of his own money.  However, in April 2009, the company filed for bankruptcy protection while drawing up a suit against the project manager and the subcontractor for fraud, breach of contract and several other actions.

In 2012, a notice of deficiency asserting withholding tax penalties and a notice of determination for unpaid sales and use tax were issued to the petitioner as the party responsible for collection and remittance of the company’s taxes.  Both notices were then sustained in the court by an Administrative Law Judge in the fall of 2015.  In early 2017, the Tax Appeals Tribunal upheld the ruling based on NYS tax law 1133(a) which states “every person required to collect any tax imposed by this article shall be personally liable for the tax imposed, collected or required to be collected…”  The provision further clarifies that such person can be “an officer, director or employee of a corporation or of a dissolved corporation, any employee of a partnership or any employee of an individual proprietorship who as such officer, director or employee is under a duty to act for the corporation, partnership or individual proprietorship in complying with any requirement of this article; and any member of the partnership.”  As a former CFO and a new President, the petitioner was the person required to collect and remit taxes for the business.  It was determined that he had been signing corporate tax returns for the period leading up to and during the bankruptcy filing thereby taking responsibility.

To further support their position, the Tribunal cited Matter of Constantino (NYS Tax App. Trib. Sept. 27, 1990) to assert that the petitioner had sufficient authority and control over the corporation’s affairs while receiving significant economic benefit.  At this point, Mr. Hopwood Jr. chose not to give testimony but referred to records from a prior hearing which challenged the “responsible person” status.  The case presented earlier had placed the onus for lack of payment on financial hardship first and foremost.  Ultimately, the Tribunal found nothing in the records to release him from his responsibility.

This case serves as a warning that even if your business hits hard times, state tax authorities will still hold you liable for corporate tax obligations.



expanding into the US

The US market offers enormous opportunities for foreign investors and ambitious business owners. Canadian or other foreign businesses may operate in the US through a variety of legal forms, including self-proprietorships, corporations, general and limited partnerships, limited liability companies (LLCs) and US branches. A choice of a business structure is often influenced by tax and non-tax reasons, which may include legal, fiscal, and financial considerations.

The US rules regarding the formation, operation and dissolution of a business are generally defined by the state rather than federal law. This often increases the administrative burden and the tax cost for non-US businesses as bi-lateral tax treaty protection designed to mitigate taxation at the federal level may not be recognized at the state level. Considering that there are 50 states and the District of Columbia with their own income, property and sales tax provisions and practices often with a lack of integration amongst them, careful attention to each specific rule and each appropriate jurisdiction may be required.

A foreign investor doing business or expanding into the US should have advanced knowledge to properly plan and execute their investment strategy as well as the willingness to face rigorous US tax obligations.

To read more about this topic see  What is a Treaty-Based Return and Why Shall I File It?