October 15, 2020

By Joshua Ashman, CPA & Nathan Mintz, Esq.

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“Soft Letter” Warns Foreign Business Owners About IRC Section 965 Transition Tax Enforcement

Taking its cue from previous audit campaign announcements, the IRS has begun sending “soft letters” to U.S. taxpayers owning foreign companies about IRC Section 965 transition tax compliance.

We’ve seen several of these letters sent to clients who previously filed the Form 5471, which indicates to the IRS that the individual owns a foreign corporation and may have had an obligation to pay transition tax for the 2017 and/or 2018 tax years.

In this blog, we give a brief overview of IRC Section 965 and the transition tax, discuss the impact of the Letter 6311 warnings, and give our take on how to respond to the IRS.

IRC Section 965 – A Quick Summary

A major feature of Trump’s 2017 tax reform was the promulgation of new Internal Revenue Code Section 965, which imposed a one-time mandatory “transition tax” on the undistributed, non-previously taxed foreign earnings and profits of US-owned foreign corporations, determined as of the end of 2017 (so-called “deferred foreign income”).

The portion of the earnings and profits (“E&P”) comprising cash or cash equivalents was to be taxed at the rate of 15.5%, while any remaining E&P at the rate of 8%. These rates could be higher in the case of individual U.S. shareholders and in the case of foreign corporations that have a fiscal year end.

The transition tax was added to the Code to essentially clean out the past, enabling the transition to a new “participation exemption” regime, which allows a tax exemption for post-2017 active foreign income (or non-Subpart F income) earned by certain U.S. corporate taxpayers via a foreign corporation.

The tax was to be paid and reported on the shareholder’s 2017 and/or 2018 tax return, depending on whether the foreign corporation has a calendar or fiscal year end. After some initial lag in conforming the transition tax to the reporting rules, the IRS modified the Form 5471 and added a new Form 965 to report the tax.

Audit Campaigns Foreshadowed Letter 6311

Since the enactment of new IRC Section 965, the IRS has launched two audit campaigns to focus on Section 965 compliance enforcement.

The first campaign, added in 2018, focuses on Section 965 compliance for individual taxpayers. When launching the campaign, the IRS foreshadowed the impending Letter 6311 warnings, stating back then, “The Internal Revenue Service will address noncompliance through soft letters and examinations.”

The second and more recent audit campaign focuses more specifically on the calculation and reporting of deferred foreign income.

The launching of the two campaigns relating to Section 965 further indicates that the IRS has shifted its audit and examination focus to international tax issues, especially with respect to foreign company ownership.

Letter 6311 – Soft Letters for IRC Section 965 Compliance

The content of a Letter 6311 does confirm that its purpose is to serve as a “soft” notice rather than a direct opening of an examination or imposition of a “gotcha” penalty, which we’ve seen in other areas, for instance in the case of Form 3520-A reporting of foreign trust ownership.

The Letter 6311 states that the IRS has a Form 5471 on file, which means that the taxpayer may have had a transition tax requirement. It then tells the taxpayer to review its information to see if Section 965 transition tax was missed and, if so, to file an amended return to accurately report and pay the tax.

The Letter 6311 then states that “failure to timely file a complete and accurate return and to pay tax due could result in penalty and interest changes.” This message leaves unclear whether the IRS is giving taxpayers the opportunity to file and pay the Section 965 tax now without penalty and interest, or the opportunity to stop the bleeding, as it were, so penalties and interest don’t continue to accrue.

How to Respond to Letter 6311

If you’ve received a Letter 6311, you’re most likely in one of three situations – either (1) you did not have a Section 965 obligation, (2) you’ve already fulfilled your Section 965 reporting and payment obligations (assuming you have such obligations), or (3) you haven’t fulfilled such obligations.

If you did not have a Section 965 liability, or you did but you fulfilled your obligations, there is no action required according to the Letter 6311. In either case, it still may be prudent to provide the IRS with a response letter explaining why you had no liability, or if appropriate, indicating that you have in fact fulfilled your Section 965 duties, so they will not pursue further action and waste their time and your time on the matter.

If you had a Section 965 liability and weren’t compliant, it’s highly recommended that you do not bury your head in the sand and instead amend your return, since the Form 5471 on record most likely gives the IRS the information it needs to pursue an examination of the Section 965 issue.

How We Can Help

If you own a non-US corporation and missed your transition tax deadline, or you’re unsure if the transition tax applies to you, we can help you come into compliance and ensure the best outcome for your circumstances. We’ve helped a large group of clients with IRC Section 965 transition tax compliance and post-reporting correspondence with the IRS.

Given the new IRS focus on the transition tax, and given that Section 965 is one of the more complex areas of the Code, it’s best to seek the help of a tax professional with Section 965 compliance.

If you are a foreign company owner, please feel free to contact us for more information on Section 965 compliance.

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