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.


Effective for tax years after December 31, 2017, as part of the Tax Cuts and Jobs Act, certain significant changes were made to profits recognition from sales derived from production activities in Canada and furnished to the US (and vice-versa).  Previously, the sales were generally sourced based on a 50/50 method. For Canadian businesses that manufactured inventory (wholly or partially) in Canada and sold to the US, 50% of the sales were sourced to the production location and 50% were sourced to where the sale occurred (i.e., where the title to the inventory passed).

Going forward, the new rule requires that sales be sourced entirely based on location of the production, regardless of where the title shifts from the seller to the buyer.

One would think that under the new law gains, profits and income from the inventory produced in Canada and sold to the US will be all sourced back to Canada and none of it would taxed in the US? Wrong!  When enacting the law, the Congress was focusing on US companies with domestic production and foreign sales.  If there is no permanent establishment in the foreign country where sales happen the US manufacturer would completely escape foreign taxation. Furthermore, even if the US manufacturer has an office in the foreign country which materially participates in sales, the new provision prevents income to be resourced to the foreign country.

The rules applicable to foreign manufacturers with sales to the US happen to work quite differently. For foreign (e.g., Canadian) producers selling to the US, if they have a US office and actively solicit sales in the US, all the income from the sales will be treated as US source despite of the newly enacted source-of-production rule.

This discriminatory treatment is due to an existing overriding section which was in effect under the old method and which was likely not considered given the speed at which the new law was advanced.  Hopefully, this oversight will soon be revised.  Meanwhile, Canadian companies with productions in Canada and sales to the US must revisit their operating strategy to minimize what is brought under the US taxing jurisdiction.

Please consult your Hanson Crossborder tax professional to assist with your tax strategy.