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Published:   |   Last Updated: February 8, 2024

IRS Administration of the Section 965 Transition Tax Contravenes Congressional Intent and Imposes Unintended Burden on Taxpayers

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When Congress passes legislation as comprehensive and technical as the Tax Cuts and Jobs Act (TCJA), drafting and implementation glitches inevitably arise. This week, I will discuss one that largely affects corporate taxpayers, particularly shareholders of Controlled Foreign Corporations. Spoiler alert: This is a case where Congress enacted a provision with a transition rule intended to be extremely taxpayer-favorable, and the IRS is administering the provision in a way that seemingly runs contrary to congressional intent. It relates to the administration of Internal Revenue Code (IRC) § 965(h). Some of the background is a bit technical, so bear with me.

Prior to tax reform, the United States imposed a relatively high maximum federal corporate income tax rate of 35 percent. According to the House Ways and Means Committee, “many domestic companies were reluctant to reinvest foreign earnings in the United States, when doing so would subject those earnings to high rates of corporate income tax rates.” As a result, those companies “accumulated significant untaxed and undistributed foreign earnings.” In other words, they left their earnings parked overseas.

The TCJA reduced the maximum federal corporate income tax rate from 35 percent to 21 percent, in part to make reinvesting foreign earnings in the U.S. more attractive, and as part of the legislation, it imposed a tax on certain accumulated foreign earnings by deeming them to be repatriated (i.e., taxing them whether they were repatriated or not). See IRC § 965. This tax is widely referred to as the “transition tax.”

In some cases, accumulated foreign earnings and the resulting transition tax are significant, so the House bill “provided procedures for payment and collection of the transition tax that mitigate the burden on taxpayers.” Specifically, the House bill would have allowed U.S. shareholders to pay the transition tax over eight years in equal installments.

The Senate bill was even more generous than the House bill, and the Senate version was enacted into law. It provided that payments for each of the first five years would equal eight percent of net tax liability, the payment for the sixth year would equal 15 percent of net tax liability, the payment for the seventh year would equal 20 percent of net tax liability, and remaining balance of 25 percent of net tax liability would be payable in the eighth year. In stark contrast to installment agreements and most other taxes paid over time, the law even provided that taxpayers electing to pay over eight years would not have to pay interest.

Thus, congressional intent here seems pretty clear: The bad news for affected U.S. shareholders is that the United States plans to collect tax on the value of accumulated foreign earnings whether or not funds are actually repatriated. The good news is that taxpayers will have eight years to pay the liability – with smaller payment amounts in the early years and no interest charges at all.

With that background, let’s get to the issue some corporate taxpayers are rightly upset about. The TCJA was enacted on December 22, 2017 – after the fourth estimated tax payment was due for calendar-year filers. In mid-March, the IRS posted “FAQ 10” on its website, advising affected taxpayers to pay their Section 965 tax liabilities separately from their non-Section 965 tax liabilities and to place a “designated payment code” on Section 965 tax payments so they can be separately tracked. Many taxpayers followed that direction and assumed their Section 965 tax payments would be separately tracked and treated separately – a pretty reasonable assumption.

But on Friday, April 13 – just two business days before the filing and estimated tax payment deadline – the IRS posted new FAQs (FAQs 13 and 14) clarifying that it would not be treating Section 965 tax payments separately. If a taxpayer had made an overpayment of estimated tax, it would be kept and applied against future-year transition tax installment payments “unless and until the amount of payments exceeds the entire unpaid 2017 income tax liability, including all amounts to be paid in installments under section 965(h) in subsequent years.”

The FAQs posted on April 13 seemed inconsistent with the FAQ posted in mid-March. One of the “Big 4” accounting firms opined as follows:

Taxpayers who planned to elect the installment option provided by section 965(h) and accounted for their first annual section 965 liability installment in their estimated taxes paid for 2017 prior to the IRS’s issuance of the original FAQs issued on March 13, 2018, found themselves in a dilemma when the original FAQs were issued, requiring two separate and distinct payments of tax—one for regular tax liability and one for section 965 liability. In other words, the original FAQs implied that taxpayers were (1) precluded from applying estimated tax payments to the section 965 liability, and (2) required to make a new, separate payment with respect to their section 965 liability.

In order to comply with the instruction provided in the original FAQs, some taxpayers—taking a reasonable and conservative approach—then made a second, separate payment to the IRS representing their section 965 liability assuming that the resulting overpayment of estimated taxes could be refunded to them or credited to tax year 2018 estimated taxes. FAQ 14 now effectively operates to deny these taxpayers the ability to obtain a refund or make a credit elect, and instead the estimated tax overpayment for tax year 2017 will be applied by the IRS to taxpayers’ future annual section 965 installments until no 2017 overpayment remains. This is a particularly harsh result for taxpayers, such as individual taxpayers, who may have limited options available to remediate.

Similarly, the AICPA noted in an April 19 letter to the IRS leadership: “It is common practice for taxpayers to take a conservative approach when estimating their tax liability for purposes of estimated tax payments or a payment submitted with an extension request. Taxpayers take this action to ensure timely payment of their ultimate tax liability with the intention of either applying the resulting overpayments toward the subsequent year’s estimated tax payments or requesting a refund.”

In light of the FAQ issued in March directing taxpayers to submit separate designated payments, the AICPA further wrote: “Compliant taxpayers who abided by this guidance submitted a second payment for that amount. They had reasonably expected to have the ability to request a refund or direct the application of that additional and unexpected overpayment from their January estimated payment.” Thus, taxpayers who thought they would be receiving refunds were suddenly facing unexpected liquidity problems because FAQs 13 and 14 forced them to apply what would otherwise be overpayments to the transition tax installments they were planning to pay in future years, as Section 965(h) allows. This seeming about-face raises serious taxpayer rights concerns, notably concerns about fairness and detrimental reliance, including the rights to be informed and to pay no more than the correct amount of tax.

In an effort to recover overpayments before the tax was assessed so as to preserve the benefit of the election to pay in installments, at least one Big 4 accounting firm posted advice on April 14 recommending that corporate taxpayers file Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax, no later than April 17, 2018 – the last day the form could be filed by calendar-year taxpayers. To date, at my request, the IRS has delayed processing these “quick refund” requests from taxpayers who had made separate estimated tax payments for Section 965 liabilities, as the IRS had instructed.

On August 2, after my office strongly urged the IRS Office of Chief Counsel to provide a public explanation for its decision, it released a memorandum that supplies its reasoning. First, it stated that “section 6402(a) does not grant the Service the legal authority to credit or refund any amount except to the extent that an overpayment exists with respect to a liability.” Second, based on its interpretation of judicial opinions, it said there was no overpayment in these cases because “[t]he amount of income tax properly due for the 2017 tax period is the entire income tax liability for that period, even though a taxpayer may have the ability to elect to pay that liability in installments.” Third, Section 6403 provides that “if the taxpayer has paid as an installment of the tax more than the amount determined to be the correct amount of such installment, the overpayment shall be credited against the unpaid installments, if any.” The IRS compared the extra estimated tax payments by those planning to make a Section 965(h) election to extra payments of estate tax by an estate that has elected under Section 6166 to pay estate taxes in installments, noting that these payments must be applied to future installments under Section 6403.

In other words, the memo concluded that the full amount of the Section 965 liability becomes due immediately – not ratably over the eight-year period the law gives taxpayers the option to make payments. As a result, any “overpayment” of non-Section 965 liabilities over the 8-year period cannot be refunded or applied as estimated tax for a future period until the full Section 965 liability is paid in full.

As a practical matter, this interpretation sharply limits the value of Section 965(h), and in some cases, it may even render it meaningless. Large corporations frequently overpay their estimated taxes for a variety of reasons, including to minimize the risk they may become liable for underpayment interest. Some may even have “overpaid” by most or all of their Section 965 liability. According to the IRS’s interpretation, those corporations will not receive any of the benefits Congress provided by enacting Section 965(h).

It may be that the IRS’s interpretation is legally correct, and congressional tax-writers failed to consider the interaction of IRC 965(h) with existing provisions governing refunds and credits. Some in the private sector generally agree that the IRS cannot pay refunds after a return is filed and the tax has been assessed, but they have suggested that – before the liability is assessed – the IRS may at least pay the estimated tax refunds requested on Form 4466. I have requested the Office of Chief Counsel to take another look at the issue and consider alternative approaches. Where Congressional intent is clear, it is the job of administrative agencies to give effect to that intent to the extent feasible. In some cases, that may require adopting a plausible interpretation, even if it not the “best” interpretation.

There are a number of approaches that Counsel could explore. The Internal Revenue Code section that governs overpayments of estimated tax by corporations is IRC § 6425. It authorizes the IRS to return estimated tax overpayments based on “the amount which, at the time of filing the application, the corporation estimates as its income tax liability for the taxable year.” These are just estimates – not the actual tax liability. Although the law contemplates a “limited examination” if the refund is based on estimates at the time the form is filed, is the IRS required to look behind those estimates or may it accept them at face value? And under Treas. Reg. § 1.6655-1(g)(2)(iii), those estimates can exclude “a recapture of tax, such as a recapture provided by section 50(a)(1)(A), and any other similar provision.” Can the transition tax be analogized to a recapture provision, such that the estimates do not have to include it?

In addition, Section 965(o)(2) says the Secretary “shall prescribe” guidance “to prevent the avoidance of the purposes of this section.” It is crystal clear that the purpose of Section 965(h) is to allow taxpayers to pay the transition tax over an eight-year period. Does Section 965(o)(2) therefore authorize (or even require) the IRS to issue guidance enabling taxpayers to elect credits or refunds of extra installments under Section 965(h) requested on Form 4466 before assessment, or even after assessment?

Finally, although Code section titles are not dispositive, they are often instructive. I note that the relevant code section here, IRC § 6425, is titled, Adjustment of Overpayment of Estimated Income Tax By Corporation. Similarly, the IRS form corporate taxpayers use to request overpayment adjustments, Form 4466, is titled, Corporation Application for Quick Refund of Overpayment of Estimated Tax. Thus, the focus of this Code section and this form seems clearly on whether there has been an overpayment of estimated tax.

To date, the IRS has acted on the basis of its legal conclusion that the full amount of the tax liability became due in 2017. But let’s consider the significance of distinguishing between the existence of a liability and the existence of an overpayment of estimated taxes with an example.

Assume CORP X has a $100 million non-Section 965 tax liability in 2017 and a $240 million Section 965 tax liability that, to simplify matters, will be paid off in 8 equal annual installments of $30 million. Let’s say CORP X paid estimated tax of $170 million. Assuming CORP X makes the Section 965(h) election – which, with a zero interest rate, any CFO who wants to keep his job will almost always make – CORP X’s tax liability for 2017 will be $340 million. But the amount of estimated tax it must pay to avoid a penalty will only be $130 million. Thus, CORP X has paid $40 million more than it needed to pay to avoid a penalty (i.e., $100 million regular income tax plus $30 million section 965(h) annual installment).

Since Section 6425 and Form 4466 are, by their titles, concerned with whether a corporation has overpaid its “estimated tax,” common sense suggests one should look at the amount of “estimated tax” the corporation was required to have paid and then return the excess upon application (assuming it exceeds the required amount by more than ten percent, as required by Section 6425(b)(3)).

How do we determine the correct amount of estimated tax due? Ordinarily, we look to the amount of tax that ultimately will be due for the year and then check to see whether that amount was paid in four installments. Here, assuming CORP X makes the (h) election, it is only required to pay $130 million in tax for TY 2017. Therefore, it was only required to pay $130 million in estimated tax for TY 2017. While CORP X’s payment of $170 million may not have constituted an overpayment of its tax liability for the year, it did constitute a payment of $40 million more than the $130 million it was required to pay for the year. From a common-sense perspective, if the estimated tax requirement was to pay $130 million, any estimated tax payment above that level would seemingly constitute an “overpayment of estimated tax.”

When we met with senior officials in the Office of Chief Counsel, we were told there are technical definitions of “overpayment” that derive from case law. But precisely because case law is typically fact specific and there is no statute on point, Counsel may have flexibility in applying case law to a fact pattern like this. If we focus on questions like “How much estimated tax was required to be paid to avoid a penalty assuming the (pro forma) Section 965(h) election is made?” and “Don’t IRC § 6426 and Form 4466 focus on overpayments of estimated tax, as their titles state?”, it seems like there may be a way to cut through this thicket.

If the IRS doesn’t think any of the approaches I have suggested here work – and they may not – I encourage it to consider other possible interpretations that would enable it to implement the law consistent with congressional intent. If the IRS ultimately concludes its current approach is the only plausible way to administer the law, then Congress should be aware this interpretation will stand unless it passes further legislation.


The views expressed in this blog are solely those of the National Taxpayer Advocate. The National Taxpayer Advocate presents an independent taxpayer perspective that does not necessarily reflect the position of the IRS, the Treasury Department, or the Office of Management and Budget.

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