By Anthony Diosdi
Introduction
Schedule E of Form 5471 is used to report taxes paid or accrued by a foreign corporation for which a foreign tax credit is allowed and taxes for which a credit may not be taken. Schedule E-1 of Form 5471 tracks the earnings and profits (“E&P”) of a controlled foreign corporation (“CFC”). In most cases, special ordering rules under Section 959 of the Internal Revenue Code apply in determining how E&P is reported on Schedule J. Shortly after the Tax Cuts and Jobs Act was enacted in 2017, the Internal Revenue Service (“IRS”) and the Department of Treasury (“Treasury”) announced they will withdraw the proposed regulations for Internal Revenue Code Section 959. As a result of these changes, the IRS dramatically changed Schedule E and E-1 of Form 5471 for the 2018 tax year. The following columns or categories were added to Schedule E-1:
1) Post-2017 E&P Not Previously Taxed (post-2017 Section 959(c)(3) balance.
2) Hovering Deficit and Deduction for Suspended Taxes.
3) PTI from Section 965(a) Inclusion (Section 959(c)(1)(A)).
4) PTI from Section 965(b)(4)(A) (Section 959(c)(1)(A)).
5) PTI from Section 951A Inclusion (Section 959(c)(1)(A)).
6) PTI from Section 965(a) Inclusion (Section 959(c)(2)).
7) PTI from Section 965(b)(4)(A) (Section 959(c)(2)), and
8) PTI from Section 965(b)(4)(A) (Section 959(c)(2)), and
9) PTI from Section 951A Inclusion (Section 959(c)(2)).
Recently, Schedule E was revised again. This article will take a deep dive into each column and line of 2020 Schedule E and E-1 of the Form 5471.
Who Must Complete the Form 5471 Schedule E?
Who Must Complete the Form 5471 Schedule E
Anyone preparing a Form 5471 knows that the return consists of many schedules. Schedule J is just one schedule of the Form 5471. Whether or not a CFC shareholder is required to complete Schedule E depends on what category of filer he or she can be classified as. For purposes of Form 5471, CFC shareholders are broken down by the following categories:
Category 1- includes a US shareholder of a Section 965 “specified foreign corporation” at any time during any tax year of the foreign corporation, and who owned that stock on the last day in that year. A specified foreign corporation includes: 1) a controlled foreign corporation, or 2) any foreign corporation with respect to which one or more domestic corporations are a US shareholder.
Category 2- US persons who are officers or directors of a foreign corporation in which since the last time Form 5471 was filed, a US person has acquired a ten percent or greater ownership or acquired ten percent or greater ownership.
Category 3- A US person who (a) has acquired a cumulative ten percent or greater ownership in the outstanding stock of the foreign corporation, (b) since the last filing of Form 5471 has acquired an additional ten percent or greater ownership in such stock, (c) owns ten percent or greater of the value of the outstanding stock of the foreign corporation when it is reorganized, or (d) disposes of sufficient stock in the foreign corporation to reduce the value of his ownership of stock in that corporation to less than ten percent, or who becomes a US person while owning ten percent, or who becomes a US person while owning ten percent or greater in value of the outstanding stock of the foreign corporation.
Category 4- a US person who had “control” of a foreign corporation for an uninterrupted period of at least 30 days during the foreign corporation’s annual accounting period. Control means more than 50 percent of the voting power or value of the CFC applying the Section 958 attribution rules.
Category 5- A US person who is a ten percent or greater shareholder in a corporation that was a CFC for an uninterrupted period of thirty days during its annual accounting period and who owned stock in the CFC on its last day of its annual accounting period.CFC shareholders that are classified as Category 1, Category 4, and Category 5 filers must complete and attach Schedule E and E-1 to their Form 5471.
Lines a and b
Schedule E begins by asking the preparer to complete Lines a and b. Line a specifically asks the preparer to determine the category of income and enter the applicable corresponding code. In order to answer the question on Line a, the preparer must reference the instructions to IRS Form 1118. IRS Form 1118 states that there are six categories of foreign source income to be reported on Schedule E and assigns codes to each category of income. The preparer may select from the applicable categories of income and codes listed below:
| Code | Category of Income |
| 951A | Section 951A Category Income |
| FB | Foreign Branch Category Income |
| PAS | Passive Category Income |
| 901j | Section 901(j) Income |
| RBT | Income Re-Sourced by Treaty |
| GEN | General Category Income |
Below is a definition of each category of foreign source income provided by the instructions to Schedule E:
Section 951A Category Income
Section 951A (GILTI inclusions) category income is any amount includible in gross income under Section 951A (other than passive category income).
Foreign Branch Category Income
Foreign branch income is defined under Internal Revenue Code Section 904(d)(2)(j)(i) as the business profits of a U.S. person which are attributable to one or more Qualified Business Units (“QBUs”).
Passive Category Income
Passive income is generally the following:
- Any income received or accrued that would be foreign personal holding company income if the corporation were a CFC. This includes any gain on the sale or exchange of stock that is more than the amount treated as a dividend under Section 1248.
- Any amount includible in gross income under Section
1293 (which relates to certain passive foreign investment companies
(“PFICs”).
Section 901(j) Income
Section 901(j) is income that is earned from a country sanctioned by the U.S..
Income Re-Sourced by Treaty
As suggested by its name, income re-sourced by treaty applies to income that is sourced as a result of a tax treaty.If a sourcing rule in an applicable income tax treaty treats any U.S. source income as foreign source, and the corporation elects to apply the treaty, the income will be treated as foreign source. The U.S. source income reclassified as foreign source as a result of a treaty comes under this category.
General Category Income
The general income category includes all income not described in one of the categories discussed above.
Line b
Line b states that if Code 901j is entered on Line a, the country code for the sanctioned country using the two-letter codes (from the list at IRS.gov/countrycodes) must be entered.
Part 1. Taxes for Which a Foreign Tax Credit is Allowed
Section 1 – Taxes Paid or Accrued Directly by Foreign Corporation
Schedule 1 is designed to report any foreign taxes paid or accrued directly by a CFC. The preparer must not only disclose the amounts of foreign taxes paid by the CFC, the preparer must also properly convert the foreign taxes paid to U.S. dollars.
Column (a)
Column (a) asks the preparer to list the name of the foreign corporation or pass-through entity (partnership or disregarded entity) that paid the foreign tax.
Column (b)
Column (b) asks the preparer to enter the employer identification number (“EIN”) or reference ID number of the payor of the foreign tax.
Column (c)
Column (c) asks the preparer to enter the two-letter codes of the foreign country the foreign tax was paid. Country Codes are available at irs.gov/countrycodes.gov. If taxes were paid or accrued to more than one country with respect to the same income, the preparer should include an attachment listing applicable countries.
Column (d)
Column (d) asks the preparer to disclose any tax accounting timing discrepancies between the U.S. and foreign tax years. For example, the foreign tax year under foreign law may not be the same as the U.S. tax year of the foreign corporation.
Column (e)
Column (e) asks the preparer to disclose the U.S. tax year of the foreign corporation to which the tax relates.
Column (f)
Column (f) asks the preparer to enter the income subject to tax in the foreign jurisdiction of the corporation.
Column (g)
Column (g) asks the preparer to check the applicable boxes if taxes are paid on U.S. source income.
Column (h)
Column (h) asks the preparer to enter the code of the country in which local tax is paid.
Column (i)
Column (i) asks the preparer to enter the tax paid or accrued in the local currency in which the tax is payable and not the functional currency of the CFC. Internal Revenue Code Section 985(b)(1)(A) states the general rule that the functional currency will be “the dollar.”
Columns (j) and (k)
Columns (j) and (k) ask the preparer to enter the exchange rate in column (j) and the translated dollar amount in column (k). The preparer should translate the taxes entered in column (f) into dollars at the average exchange rate for the tax year to which the tax relates unless one of the exceptions below applies:
1. The tax is paid before the beginning of the year to which the tax relates;
2. The accrued taxes are not paid before the date of two years after the close of the tax year to which such taxes relate;
3. There is an election in effect under Section 986(a)(1)(D) to translate foreign taxes using the exchange rate in effect on the date of payment; or
4. The CFC reports on a cash basis, the exchange rate must be reported using the “divide-by conversion rate” (in other words, the units of foreign currency that equals one unit foreign currency).
Column (l)
Column (l) asks the preparer to enter the foreign tax in functional currency. Section 985(b)(1)(A) states the general rule that the functional currency will be “the dollar.” However, the functional currency of a QBU will be “the currency of the economic environment in which a significant part of such unit’s activities is “conducted and is used by such unit in keeping its books and records.” On column (l), the preparer will need to enter the foreign taxes paid or accrued in U.S. dollars. However, if a unit of the CFC is a QBU that conducts its business in a foreign currency, the taxes paid or accrued should be determined in the functional currency of the CFC.
Line 5.
For Line 5, the preparer should combine Lines 1 through 4 of Column K.
Line 6.
For Line 6, the preparer should combine Lines 1 through 4 of Column l.
Section 2 – Taxes Deemed Paid (Section 960(b))
Section 2 is a brand new category for Schedule E that needs to be completed for the 2020 tax year. Section 2 requires the preparer to disclose the foreign taxes and associated previously taxed earnings and profits (“PTEP”) for each entity. The purpose of Section 2 is to track deemed-paid foreign income taxes with respect to current year PTEP distributions from lower-tier foreign corporations to the foreign corporation with respect to which this Schedule E is being completed.
The preparer should report a PTEP distribution by a lower-tier foreign corporation in Section 2 only if foreign income taxes are deemed paid under Section 960(b) by the CFC with respect to such PTEP distribution. The preparer should also include deemed paid taxes related to PTEP distributions from lower-tier foreign corporations in tax years of foreign corporations beginning before January 1, 2018.
The only foreign taxes of the distributing foreign corporation that may be treated under Section 960(b) are foreign taxes paid, accrued, or deemed paid by the distributing foreign corporation with respect to the receipt of a PTEP distribution from another lower-tier foreign corporation below the distributing foreign corporation. Any foreign income taxes paid or accrued (but not deemed paid) by the foreign corporation with respect to a PTEP distribution from a lower-tier foreign corporation (whether or not such PTEP distribution is reported in Section 2), such as withholding taxes imposed on the PTEP distribution, are reported in Section 1.
Section 2 takes into consideration situations when a CFC pays foreign taxes for a subsidiary or another foreign entity it owns. To avoid double tax on foreign income, the IRS allows the CFC parent to claim a deemed paid foreign tax credit. Section 2 is somewhat similar to IRS Form 1118.
Column (a)
Column (a) asks the preparer to list the name of the related foreign corporation or pass-through entity (partnership or disregarded entity) that the foreign tax was paid.
Column (b)
Column (b) asks the preparer to enter the EIN or reference ID number of the related payor of the foreign tax.
Column (c)
Column (c) asks the preparer to enter the two-letter codes of the foreign country the foreign taxes were paid. Country Codes are available at irs.gov/countrycodes.gov. If taxes were paid or accrued to more than one country with respect to the same income, the preparer should include an attachment listing the applicable countries.
Column (d)
Column (d) asks the preparer to disclose each applicable PTEP group for the associated foreign tax paid. Where the E&P of a CFC consists in whole or in part of PTEP, special rules under Section 959 will determine the ordering and taxation of each distribution of PTEP. Column (d) will require the preparer to classify the income associated with each Section 960(b) foreign tax credit into a PTEP and disclose the PTEP in column (d). The preparer applicable PTEP group code in Column (d) as follows:
| Taxes related to previously taxed E&P | PTEP Code |
| Reclassified Section 965(a) PTEP | R965a |
| Reclassified Section 965(b) PTEP | R965b |
| General Section 959(b) PTEP | 959c1 |
| Reclassified Section 951A PTEP | R951A |
| Reclassified Section 245A(d) PTEP | R245Ad |
| Section 965(a) PTEP | 965a |
| Section 965(b) PTEP | 965b |
| Section 951A PTEP | 951A |
| Section 245A(d) PTEP | 245Ad |
| Section 951(a)(1)(A) PTEP | 951a1A |
Column (e)
Column (e) asks the preparer to state the annual PTEP account. For column (e), the preparer must enter the year in which the CFC shareholder included income of the lower-tier foreign corporation under Section 951(a) or 51A and established the PTEP account to which the distribution is attributed.
Column (f)
Column (f) asks the preparer to state (in functional currency) the PTEP distributed by the CFC. For column (f), the preparer must enter the PTEP distribution with respect to the PTEP group within the annual PTEP account identified in column (d) and column (e) in functional currency of the distribution related to more than one PTEP group within an annual PTEP account. A separate line must be completed for each PTEP account.
Column (g)
Column (g) asks the preparer to (in functional currency) the total amount of PTEP in the PTEP account which a distribution was made. The preparer must enter the total amount of a lower-tier foreign corporation’s PTEP in the PTEP group within the annual PTEP account identified in column (d) and column (c). The amounts should be entered in the functional currency of the distribution.
Column (h)
Column (h) asks the preparer state the total amount of the PTEP group taxes with respect to PTEP groups in U.S. dollars. For column (h), the preparer should enter the total amount of the lower-tier foreign corporation’s PTEP group taxes with respect to the PTEP within the annual PTEP account identified in column (d) and (e). This amount should be entered in U.S. dollars using the appropriate translation rates stated in Section 9869a).
Column (i)
Column (i) asks the preparer to state the foreign taxes properly attributable to PTEP and not previously deemed paid in U.S. dollars. Expressed formulatically
(column (f) divided by column (g) x column (h))
Part II Election
Part II asks if Section 986(a)(1)(D) has been made to translate taxes using the exchange rate on the date of payment. The 2004 JOBS Act added a new election in Section 986(a)(1)(D) for a taxpayer that otherwise is required under Section 986(a)(1)(A) to translate foreign taxes into U.S. dollars using the average exchange rate for the tax year. This provision allows such a taxpayer to elect to use the exchange rate at the time the foreign taxes are paid instead of the average exchange rate for the tax year. Once elected, this provision applies to the tax year for which it was made and all later years unless revoked with the IRS’s consent. Note, however, that this election applies only to the translation of foreign taxes and foreign tax adjustments; it does not apply to the translation of a foreign corporation’s earnings and profits or to the translation of dividends through constructive inclusions. Part II asks the preparer to state the date of the election if a Section 986(a)(1)(D) election has been made.
Part III. Taxes for Which a Foreign Tax Credit is Disallowed
Part III of Schedule E asks the preparer to report foreign taxes of a CFC that were paid but for which no foreign tax credits were allowed. The purpose of disclosing foreign tax on Part III of Schedule E is to disclose foreign taxes of the CFC’s E&P. However, foreign taxes that cannot be claimed as a foreign tax credit due to the anti-splitter or foreign deficit rule should not be disclosed on Part III of Schedule E. These rules will be discussed in more detail below.
Columns (a) and (b)
Column (a) asks the preparer to list the name or names of the foreign corporation or pass-through entity (partnership or disregarded entity) that paid the foreign tax and a foreign tax credit was disallowed.
Column (b) asks the preparer to enter the EIN or reference number of the payor of the foreign tax.
Column (c)
Column (c) asks the preparer to enter the foreign income taxes that are disallowed under Section 901(j), which generally applies to certain sanctioned countries.
Column (d)
Column (d) asks the preparer to enter the foreign taxes that are disallowed under Internal Revenue Code Section 901(k). This generally applies to certain foreign taxes paid on dividends if the minimum holding period is not met with respect to the underlying stock, or if the CFC is obligated to make related payments with respect to positions in similar or related property. Section 901(k) cross-reference the rules of Section 246(c). This generally means a deduction for a dividend is not allowed if the dividend was paid in the next preceding taxable year of the corporation or the corporation is tax exempt under Section 501.
Column (e)
Column (e) asks the preparer to list any foreign tax credits disallowed related to Section 901(m). Section 901(m) denies a foreign tax credit for the “disqualified portion” of any foreign income covered asset acquisition (“CAA”). A covered asset involves three types of transactions: 1) a qualified stock purchase with a Section 338 election (Section 338 provides that if a purchasing corporation (“P”) purchase 80 percent or more of the stock of a target corporation (“T”) within 12 months or loss, it may elect within a specified time period to treat the target as having sold all of its assets for their fair market value in a single transaction); 2) any acquisition treated as a purchase of assets for U.S. tax purposes, but an acquisition of stock is disregarded for foreign tax purposes; or 3) the purchase of a partnership interest with a Section 754 election.
Under Section 901m(3), the disqualified portion of foreign income taxes is computed by multiplying the foreign income taxes for the year by the fraction that is equal to aggregate basis difference (“ABD”) allocated to the year over the foreign income for the year. For example, assume that the ABD for the year equals $10x, and the CFC earns $20x of foreign income subject to 30 percent foreign tax rate. Before applying Section 901(m), the CFC would have $4x of income and $6x of foreign tax. Section 901(m) would disallow 50 percent of the $3x foreign tax as a credit (i.e., $6x of tax for the year x $10x ABD/$20x foreign income).
Column (f)
Column (f) asks the return preparer to enter the amount of taxes paid or accrued by a CFC to the U.S.
Column (g)
Column (g) asks the preparer to report the foreign corporation’s current year foreign income taxes paid or accrued with respect to E&P described in Section 959(c)(3) that are attributable to the residual group. For example, CFC1, a foreign corporation, wholly owns the only class of stock of CFC2, a foreign corporation, CFC2 does not have PTEP. CFC2 distributes Section 959(c)(3) E&P to CFC1 which is treated as a dividend for U.S. tax purposes. For foreign purposes, the distribution is also characterized as a dividend. As CFC1 and CFC2 are located in different countries, a withholding tax is levied by CFC2’s country of residence on the distribution. Under the principles of Treasury Regulation 1.904-6, the distribution is assigned to the statutory or residual grouping to which the corresponding U.S. item is assigned. In this case the corresponding U.S. item is Section 959(c)(3) E&P, which is in the residual group. Therefore, the withholding taxes are properly attributed to the residual group and such taxes are not deemed paid for any taxable year and therefore are reported in column (g). See IRS instructions to Schedule E.
Column (h)
For column (h), the preparer must enter taxes for which a foreign tax credit is disallowed other than those stated in columns (c) through (g).
Column (i)
For column (i), the preparer must enter the total amount for each payor in columns (c) through (h).
Line 3.
Line 3 asks the preparer to total each amount in column (h) and enter the total in functional currency.
Line 4.
Line 4 asks the preparer to translate the amount listed on Line 3 in U.S. dollars (translated at the average annual exchange rate).
Schedule E-1 Taxes Paid, Accrued, or Deemed Paid on Earnings and Profits of Foreign Corporation
As its name suggests, Part E-1 of Schedule E tracks the accumulated E&P of a CFC. Schedule E-1 of Form 5471 is similar to Schedule J of Form 5471. By the way of background, where the E&P of a CFC consists in whole or in part PTEP, special rules under Section 959 apply in determining the ordering and the taxation of distributions of such previously taxed PTEP. A PTEP distribution is generally sourced in the following order: 1) PTEP attributable to investments in U.S. property under Section 959(c)(1); 2) PTEP attributable to subpart F income under Section 959(c)(2); and general and accumulated E&P under Section 959(c)(3). For section 959 purposes, a distribution is generally attributable to E&P according to the “last in first out” method (“LIFO”) based on the year the income was earned.
On November 28, 2018, the Treasury and the IRS released proposed regulations related to the determination of the foreign tax credit. In addition, the issuance of Notice 2019-01 announced the Treasury’s and IRS’s intention to withdraw prior proposed regulations for Section 959 and the intent to issue new proposed regulations for Section 959 and Section 961. The new proposed regulations described in Notice 2019-01 include rules related to the maintenance of PTEP in annual accounts and within specified groups and the ordering of PTEP attribution to a distribution and require the maintenance of a system to track the various forms of PTEP.
Under the proposed foreign tax credit regulations, CFCs are required to establish an annual account for PTEP for each so-called Section 904 basket. Within each account, a CFC must assign PTEP to one of ten different PTEP groups in each of the relevant Section 904 baskets based on the CFC shareholder’s income inclusion, while also accounting for any PTEP reclassification. Notice 2019-01 added an additional six PTEP groups to the groups described in the foreign tax credit regulations.
The preparer of Schedule J must categorize accumulated income into the baskets described in Section 959, the proposed foreign tax credit regulations, and Notice 2019-01. Each item of income is then allocated to the appropriate column stated on Schedule E-1. Sounds simple enough. However, the proposed foreign tax credit regulations do not address the ordering of PTEP distributions and the compliance requirements for the ordering of PTEP distributions on Schedule E-1. This leaves us with Notice 2019-01 as the only guidance which addresses the ordering of PTEP distributions.
The framework described in Notice 2019-01 is complex. Below, please find Illustration 1 which (Taken from the example stated in IRS Notice 2019-01) provides how to report “Previously Taxed E&P” in accordance with Internal Revenue Code Section 959(c)(1)(A).
Illustration 1.
USP, a domestic corporation, wholly owns FC, a foreign corporation that has the U.S. dollar as its functional currency. Both USP and FC use the calendar year as their taxable year. Before 2018, the PTEP of FC was maintained in annual accounts. As of December 31, 2018, FC’s $300x of E&P (before taking into account distributions made or inclusions under Section 951(a)(1)(B) in 2018) applicable to USP’s interest in FC are classified under Notice 2019-01 as Section 3.01 as follows:
Section 959(c)(1) |
Section 959(c)(2) | |||||||
| Year | 965(a) | 965(b) | 951(a)(1)(B) | 965(a) | 965(b) | 951A | 951(a)(1)(A) | 959(c)(3) |
| 2018 | 50x | 30x | ||||||
| 2017 | 100x | 50x | 20x | |||||
| 2016 | 25x | 25x | ||||||
| Total | 25x | 255x | 20x | |||||
In 2018, FC has an amount described in Section 956(a) (“section 956(a) amount”) of $125x, without considering the application of Section 959(a)(2). In 2019, FC earns $25x of current E&P, and the amount of USP’s income inclusion under Section 951A(a) that is allocated to FC under Section 951A(f)(2) and proposed Treasury Regulation Section 1.951A-6(b)(2) is $20x. FC also makes a distribution of $195x in 2019. In 2020, FC earns no current E&P, but FC makes a distribution of $60x. For all years, the PTEP of FC in each PTEP group is described in a single 904 category, and all Section 959(c)(3) E&P of FC are described in a single Section 904 category.
Analysis for 2018
As of December 31, 2018, before considering FC’s Section 956(a) amount, FC has total Section 959(c)(2) PTEP of $255x. Under Section 959(a)(2) and (f)(1), because FC’s Section 959(c)(2) PTEP exceeds its Section 956(a) amount, USP does not include any amount in income under Section 951(a)(1)(B). However, under Section 959(c)(1)(A), $125x of FC’s Section 959(c)(2) earnings must be reclassified as Section 959(c)(1) PTEP. The reclassified PTEP remains in the 2017 annual PTEP account. Thus, in FC’s 2017 annual PTEP account, FC’s reclassified Section 965(a) PTEP is increased by $100x and its Section 965(a) PTEP is decreased by $100x. Additionally, FC’s reclassified Section 965(b) PTEP is increased by $25x and its Section 965(b) PTEP is decreased by $25x. Accordingly, as of December 31, 2018, FC’s E&P applicable to USP’s interest in FC.
Section 959(c)(1) |
Section 959(c)(2) | |||||||
| Year | 965(a) | 965(b) | 951(a)(1)(B) | 965(a) | 965(b) | 951A | 951(a)(1)(A) | 959(c)(3) |
| 2018 | 50x | 30x | ||||||
| 2017 | 100x | 25x | 25x | 20x | ||||
| 2016 | 25x | 25x | ||||||
| Total | 150x | 130x | 20x | |||||
2019 Year Adjustment
During 2019, FC earns $25x of current E&P, and the amount of USP’s income inclusion under Section 951A(a) that is allocated to FC under Section 951A(f)(2) and proposed Treasury Regulation Section 1.951A-6(b)(2) is $20x. Thus, before taking into account USP’s income inclusion with respect to FC and any distributions by FC, FC’s Section 959(c)(3) E&P is initially increased by $25x. As a result of USP’s income inclusion under Section 951A. FC’s Section 951A PTEP increases by $20x and FC’s Section 959(c)(3) E&P is decreased by $20x. Accordingly, as of December 31, 2019, FC’s E&P (before taking into account distributions made in 2019) applicable to USP’s interest in FC are classified as follows:
Section 959(c)(1) |
Section 959(c)(2) | |||||||
| Year | 965(a) | 965(b) | 951(a)(1)(B) | 965(a) | 965(b) | 951A | 951(a)(1)(A) | 959(c)(3) |
| 2019 | 20x | |||||||
| 2018 | 50x | 30x | 25x | |||||
| 2017 | 100x | 25x | 25x | |||||
| 2016 | 25x | 25x | ||||||
| Total | 150x | 150x | 25x | |||||
Distribution
FC’s distribution of $195x is from PTEP because the entire distribution would be a dividend under Section 316(a) without regard to Section 959 that is, for the purpose of Section 316, at the end of 2019, FC has $325x of E&P (without regard to this distribution), $25x of which is current E&P). Under Section 959(c), the distribution is first treated as attributable to Section 959(c)(1) PTEP.
Section 959(c)(1) PTEP
The distribution is first sourced from reclassified Section 965(a) PTEP and then from reclassified Section 965(b) PTEP, and then pro rata from the remaining PTEP groups that contain Section 959(c)(1) PTEP under a last-in, first-out (“LIFO”) approach. Thus, in FC’s 2017 annual PTEP account, FC’s reclassified Section 965(a) PTEP is decreased by $100x and its reclassification Section 965(b) PTEP is decreased by $25x. In FC’s 2016 annual PTEP account, FC’s Section 951(a)(1)(B) PTEP is reduced by $25x. Thus, of the distribution of $195x, $150x is treated as attributable to Section 959(c)(1) PTEP ($100x + $25x + $25x).
Section 959(c)(2) PTEP
After the Section 959(c)(1) PTEP is exhausted, the remaining portion of the distribution ($45x) is treated as attributable to Section 959(c)(2) PTEP, to the extent thereof. The distributions are first sourced from Section 965(a) PTEP and then from Section 965(b) PTEP, and then pro rata from the remaining PTEP groups that contain Section 959(c)(2) PTEP under a LIFO approach. Thus, in FC’s 2017 annual PTEP account, FC’s Section 965(b) PTEP is decreased by $25x. In FC’s 2019 annual PTEP account, FC’s Section 951A PTEP is decreased by $20x. Because the entire distribution has been accounted for, the remaining PTEP groups that contain Section 959(c)(2) PTEP and FC’s Section 959(c)(3) E&P are not affected. Accordingly, as of December 31, 2019, FC’s E&P applicable to USP’s interest in FC are classified as follows:
Section 959(c)(1) |
Section 959(c)(2) | |||||||
| Year | 965(a) | 965(b) | 951(a)(1)(B) | 965(a) | 965(b) | 951A | 951(a)(1)(A) | 959(c)(3) |
| 2019 | ||||||||
| 2018 | 50x | 30x | 25x | |||||
| 2017 | ||||||||
| 2016 | 25x | |||||||
| Total | 150x | 25x | ||||||
2020
FC’s distribution of $60x is from PTEP because the entire distribution would be divided under Section 316(a) without regard to Section 959 (that is, for purposes of Section 316, at the end of 2020, FC has $130x of E&P (without regard to the distribution), all which is accumulated E&P). Under Section 959(c), the distribution is first treated as attributable to Section 959(c)(1) PTEP; however, FC has no Section 959(c)(1) PTEP. Additionally, FC has no Section 965(a) PTEP or Section 965(b) PTEP. This distribution is sourced pro rata from the remaining PTEP groups that contain Section 959(c)(2) PTEP under a LIFO approach. Thus, in FC’s 2018 annual PTEP account, FC’s Section 951A PTEP is decreased by $37.5x ($60x x $50x/$80X) and its Section 951(a)(1)(A) PTEP is decreased by $22.5x ($60x x $30x/$80x). Because the entire distribution has been accounted for, the remaining PTEP groups that contain Section 959(c)(2) PTEP and FC’s Section 959(c)(3) E&P are not affected. Accordingly, as of December 31, 2010, FC’s E&P applicable to USP’s interest in FC are classified as follows:
Section 959(c)(1) |
Section 959(c)(2) | |||||||
| Year | 965(a) | 965(b) | 951(a)(1)(B) | 965(a) | 965(b) | 951A | 951(a)(1)(A) | 959(c)(3) |
| 2019 | ||||||||
| 2018 | 12.5x | 7.5x | ||||||
| 2017 | 25x | |||||||
| 2016 | 25x | |||||||
| Total | 45x | 25x | ||||||
Now since we reviewed the basic rules governing Section 959 and the ordering of PTEPs, we will now discuss the categories of PTEPs of Schedule E-1. The 2019 Schedule E-1 consisted of the following 20 columns for PTEPs:
1. Post 2017 E&P Not Previously Tax (post-2017 Section 959(c)(3) balance);
2. Post-1986 Undistributed Earnings (post-1986 and pre-2018 Section 959(c)(3) balance);
3. Pre-1987 E&P Not Previously Taxed (pre-1987 Section 959(c)(3));
4. Hovering Deficit Suspended Taxes;
5. Section 965(a) Inclusion (Section 959(c)(1)(A));
6. Section 965(b)(4)(A) (Section 959(c)(1)(A));
7. Earnings in U.S. Property (Section 959(c)(1)(A))
8. Section 951A Inclusion (Section 959(c)(1)(A));
9. Section 245(e)(2) (Section 959(c)(1)(A));
10. Section 959(e)(Section 959(c)(1)(A));
11. Section 964(e)(4) Inclusion (Section 959(c)(1)(A);
12. Section 951(a)(1)(A) Inclusion (Section 959(c)(1)(A);
13. Earnings Invested in Excess Passive Assets (Section 959(c)(1)(B);
14. Section 965(a) Inclusion (Section 959(c)(2));
15. Section 965(b)(4)(A)(Section 959(c)(2);
16. Section 951A Inclusion (Section 959(c)(2);
17. Section 245(e)(2) Inclusion (Section 959(c)(2);
18. Section 959(e)(Section 959(c)(2);
19. Section 964(e)(4) Inclusion (Section 959(c)(2);
20. Section 951(a)(1)(A) Inclusion (Section 959(c)(2).
For 2020 tax year, the IRS reduced the columns listed on Schedule E-1 to the following columns for PTEPs:
1. Current E&P;
2. Post-1986 Undistributed Earnings (Post-1986 and Pre-2018 Section 959(c)(3) balances);
3. Pre-1987 E&P (pre-1987 Section 959(c)(3) balance);
4. Hovering Deficit and Suspended Taxes;
5. Reclassified Section 965(a) PTEP;
6. Reclassified Section 965(b) PTEP;
7. General Section 959(c)(1) PTEP;
8. Reclassified Section 951A PTEP;
9. Reclassified Section 245A(d) PTEP;
10. Section Section 965(a) PTEP;
11. Section 965(b) PTEP;
12. Section 951A PTEP;
13. Section 245A(d) PTEP;
14. Section 951(a)(1)(A) PTEP.
Not only did the IRS reduce number of columns for PTEPs from 20 to 15, the IRS eliminated the PTEP classification for “Post 2017 E&P Not Previously Taxed (post-2017 Section 959(c)(3) balance)” and replaced it with a category for “current E&P.” We will now walk through each PTEP column of Schedule E-1.
Column (a). Current E&P
For column (a), the CFC shareholder reports only the foreign income taxes the CFC pays or accrues with respect to all of its current E&P. No amount should be reported in column 9a) on line 1a through 1c, and line 2. The preparer should not include foreign income taxes paid or accrued by the CFC in its tax years beginning after December 31, 2017, or that do not relate to the current tax year. The preparer should also not include foreign income taxes that are disallowed and are reported on Schedule E, Part iii, including taxes related to the residual income group reported in column (g). In addition, the preparer should not include taxes paid or accrued by the CFC with respect to its receipt of a PTEP distribution or taxes deemed paid by the CFC with respect to its receipt of a PTEP distribution.
The preparer should report reductions for the portion of taxes that are deemed by a U.S. shareholder with respect to an inclusion under Section 951(a) or 951A. The preparer should also report reductions for the amount of foreign income taxes paid or accrued with respect to current year E&P that are not deemed paid, which consists of tested foreign income taxes not deemed paid and other foreign income taxes not deemed paid. The balance of foreign income taxes paid or accrued with respect to current year E&P that is entered on line 18 should equal zero after taking into account these reductions.
Column (b). Post-1986 Undistributed Earnings
Column (b) requires that the preparer report the opening balance and any adjustments to post-1986 foreign income taxes, as defined in Section 902(c)(2). In order to report Section 959(c)(3) balances in column (b), it is necessary for the preparer to determine the “post-1986 undistributed earnings pool.” The “post-1986 undistributed earnings pool” of a foreign corporation is the total earnings for years starting in 1987 through the end of 2017 in which a dividend was distributed, undiminished by any dividend distribution made during the year. See Former IRC Section 902(c)(1). Dividend distributions did not reduce the pool of earnings taken into account in subsequent years. See Treas. Reg. Section 1.902-1(a)(9)(i). Moreover, the corporation’s pool of post-1986 foreign income taxes were reduced to reflect the portion of taxes deemed with respect to such dividends for purposes of computing foreign tax credits in subsequent years.
Please see Illustration 2 below for a very simple example calculating a “post-1986 undistributed earnings pool.”
Illustration 2.
Gamma S.A., a corporation under the laws of Country M, is a wholly owned subsidiary of American Gamma Corporation, a US corporation. Gamma S.A.’s post-1986 undistributed earnings (after payment of foreign taxes) and foreign taxes paid for years 1 through 3 were as follows:
| Post-1986 Undistributed Earnings Pool | Foreign Taxes | |
| Year 1 | $100,000 | $30,000 |
| Year 2 | $200,000 | $60,000 |
| Year 3 | $300,000 | $90,000 |
| Pools as of 12/31 of Year 3 | $600,000 | $180,000 |
Gamma S.A. paid a dividend of $400,000 to American Gamma on December 1 of year 3.
| Undisclosed Earnings Pool | Foreign Taxes | Total |
| $600,000 | $180,000 | $20,000 |
Gamma S.A.’s post-1986 “undistributed earnings pool” as of year 4 would be $20,000.
Column (c). Pre-1987 E&P Not Previously Taxes
For column (c), the preparer must report the opening balance and any adjustments to the aggregate amount of the foreign corporation’s foreign income taxes paid or accrued to pre-1987 Section 964(a) E&P accumulated since 1962 and not previously distributed or deemed distributed. Before 1987, the earnings and profits of a foreign corporation were calculated year by year. If a dividend exceeded the earnings of a specified year, the excess of the dividend was deemed to be paid out of the after-tax accumulated earnings of the preceding year. If the remaining portion of the dividend exceeded the after-tax accumulated earnings of the preceding year, the dividend was treated as paid from the accumulated earnings of the next preceding year and so on until the dividend had been completely covered by accumulated earnings to the extent available.
Column (d). Hovering Deficit and Suspended Taxes
Column (d) is used to report hovering deficits and deductions for suspended taxes. For those readers that do not know the definition of a hovering deficit in the context of cross-border transactions, historically, a hovering deficit arose when two foreign corporations engaged in a transaction in which E&P and taxes carried over under Section 381 and either corporation had a deficit in Post-1986 undistributed earnings in one or more foreign tax credit baskets.
1. The deficit and associated taxes hover and can only be offset by earnings “accumulated” after the Section 381 transaction in the same basket; taxes are released proportionately as the deficit is earned out.
2. The hovering deficit rules applied even if both corporations had a deficit in the same foreign tax credit basket.
A deficit was not taken into account in determining the current or accumulated earnings and profits of the surviving corporation for any purpose, including for purpose of determining dividends under Section 316 and for determining foreign tax credits. However, any such pre-transaction deficits in earnings and profits could be used to offset a foreign surviving corporation’s accumulated (but not current) post-transaction earnings and profits in the same basket as the deficit.
Hovering deficits and deductions for suspended taxes associated with hovering deficits must be disclosed under column (d). The problem is that the IRS and Treasury have yet to issue final or proposed regulations for purposes of reporting hovering deficits and associated suspended taxes on a Schedule J. This leaves CFC shareholders of foreign corporations involved in cross-border merger or acquisition transactions being forced to refer to pre-2018 tax law to determine how to report hovering deficits and associated suspended taxes on Schedule J. We will discuss in more detail in the paragraphs below.
CFC shareholders involved in a cross-border corporate acquisition transaction should understand that Section 367 governs corporate restructurings under Sections 332, 351, 354, 355, 356, and 361 (Subpart C nonrecogntion transactions) in which the status of a foreign corporation as a “corporation” is necessary for the application of relevant Subchapter C nonrecognition provisions. Other provisions in Subchapter C (Subchapter C carryover provisions) apply to such transactions in conjunction with the enumerated provisions and detail additional consequences that occur in connection with the transaction. For example, Sections 362 and 381 govern the carryover of basis and E&P from the transferor corporation to the transferee corporation in applicable transactions.
The Subchapter C carryover provisions generally have been drafted to apply to domestic corporations and shareholders. As a result, those provisions often do not fully take into account the cross-border aspects of U.S. taxation. This is because Section 381 does not specifically take into account source and foreign tax credit issues that arise when earnings and profits move from one corporation to another.
The Treasury has enacted regulations to deal with these perceived problems. For example, Treasury Regulation Section 1.367(b)-7 applies to an acquisition by a foreign corporation (foreign acquiring corporation) of the assets of another foreign corporation (foreign target corporation) in a transaction described in Internal Revenue Code Section 381 (foreign Section 381 transaction) and addresses the manner in which earnings and profits and foreign income taxes of the foreign acquiring corporation and foreign target carry over to the surviving foreign corporation (foreign surviving corporation). These rules typically apply to reorganizations or Section 332 liquidations between two foreign corporations.
The principle Code Sections implicated by the carryover of earnings and profits and foreign income taxes in a foreign Section 381 transaction are Sections 381, 902, 904, and 959. Section 381 generally permits earnings and profits (or deficit in earnings and profits) to carry over to a surviving corporation, thus enabling “the successor corporation to step into the ‘tax shoes’ of its predecessor. * * * [and] represents the economic integration of two or more separate businesses into a unified business enterprise.” See H. Rep. No. 1337, 83rd Cong., 2nd Sess. 41 (1954). However, a deficit in earnings and profits of either the transferee or transferor corporation can only be used to offset earnings and profits accumulated after the date of transfer. See IRC Section 381(c)(2)(B). This is commonly known as the “hovering deficit rule.” The hovering deficit rule is a legislative mechanism designed to deter the trafficking in favorable tax attributes that the IRS and courts had repeatedly encountered.
Special rules are built into the Internal Revenue Code and its regulations for the “hovering deficit rule.” For example, former Internal Revenue Code Section 902 provides that a deemed paid foreign tax credit is available to a domestic corporation that receives a dividend from a foreign corporation in which it owns 10 percent or more of the voting stock. Below, please see Illustration 3 which provides an illustration how a foreign acquisition transaction may result in a hovering deficit and how such a transaction would be reported on Schedule J. See Office of Chief Counsel Internal Revenue Service Memorandum, June 9, 2006, Final Regulations Relating to Stock Transfer Rules: Carryover of Earnings and Taxes.
Illustration 3.
On December 31, 2016, foreign corporations A and B have the following post 1986 earnings and post-1986 foreign income taxes:
Foreign Corporation A
Separate Corporation A
| Separate Category | E&P | Foreign Taxes |
| General | 200u | $30 |
| Passive | (100u) | $10 |
| 100u | $40 |
Foreign Corporation B
| Separate Category | E&P | Foreign Taxes |
| General | 300u | $60 |
| Passive | 100u | $30 |
| 400u | $80 |
On January 1, 2017, foreign corporation B acquired the assets of foreign corporation A in a reorganization described in Section 368(a)(1)(C). Immediately following the foreign Section 381 transaction, foreign surviving corporation is a CFC.
Result
The foreign surviving corporation has the following post-1986 undistributed earnings and post-1986 foreign income taxes:
Earnings and Profits |
Foreign Taxes |
||||
Positive |
Foreign Taxes |
Foreign Taxes |
|||
| Separate Category | E&P |
Hovering Deficit | Available |
Assoc with Hovering Def |
|
| General | 500u |
$90 |
|||
| Passive | 100u |
(100u) | $30 |
$10 |
|
600u |
(100u) | $120 |
$10 |
||
During the 2017 tax year, the foreign surviving corporation does not accumulate any earnings and profits or pay any foreign income taxes. On December 31, 2017, foreign surviving corporation distributed 300u to its shareholders. This distribution reduces its post-1986 undistributed earnings and post-1986 foreign income taxes on a pro rata basis as follows:
| Separate Category | E&P | Foreign Taxes |
| General | 250u | $45 |
| Passive | 50u | $15 |
| 300u | $60 |
Immediately after the distribution, foreign surviving corporation has the following post-1986 undistributed earnings and post-1986 foreign income taxes:
Earnings and Profits |
Foreign Taxes |
||||
Positive |
Foreign Taxes |
Foreign Taxes |
|||
| Separate Category | E&P |
Hovering Deficit | Available |
Assoc with Hovering Def |
|
| General | 250u |
$45 |
|||
| Passive | 50u |
(100u) | $15 |
$10 |
|
300u |
(100u) | $60 |
$10 |
||
For Schedule E-1 reporting purposes, the hovering deficit in 2017 is 100u and suspended foreign taxes associated with the hovering deficit is $10.
Post-transaction earnings- In its taxable year ending on December 31, 2018, foreign surviving corporation accumulates earnings and profits and pays related foreign income taxes as follows:
| Separate Category | E&P | Foreign Taxes |
| General | 100u | $20 |
| Passive | 50u | $10 |
| 150u | $40 |
The hovering deficit in the passive category will offset the post-transaction earnings in that category and a proportionate amount of the foreign taxes related to the hovering deficit will be added to the post-1986 foreign income taxes pool. Because the post-transaction earnings in the passive category are half of the amount of the hovering deficit, half of the related taxes are added to the post-1986 foreign taxes pool. According, foreign surviving corporation has the following post-1986 undistributed earnings and post-1986 foreign income taxes on January 1, 2019:
Earnings and Profits |
Foreign Taxes |
||||
Positive |
Foreign Taxes |
Foreign Taxes |
|||
| Separate Category | E&P |
Hovering Deficit | Available |
Assoc with Hovering Def |
|
| General | 350u |
$65 |
|||
| Passive | 50u |
(50u) | $30 |
$5 |
|
400u |
(50u) | $95 |
$5 |
||
For Schedule E-1 reporting purposes, the hovering deficit in 2018 is 50u and suspended foreign taxes associated with the hovering deficit is $5.
Column (e)(i). Reclassified Section 965(a) PTEP
A CFC shareholder will use Column (e)(i) to report previously taxed income reclassified as Section 965(a) PTEP under Section 959(c)(1)(A). Section 965(a) imposed a one-time transition tax on a US shareholder’s share of deferred foreign income of certain foreign corporations (“accumulated deferred foreign income” or ADFI or “aggregate ADFI” for a combined ADFI). The ADFI equals post-1986 E&P other than that attributed to effective connected income or Section 959 previously taxed income. For Column (e)(i), the preparer must state previously taxed Section 965(a) E&P reclassified under Section 959(c)(1)(A).
Column (e)(ii). Reclassified Section 965(b) PTEP
A CFC shareholder will use Column (e)(ii) to report previously taxed income reclassified as Section 965(b) under Section 959(c)(1)(A). When a CFC has a positive post-1986 E&P, it must first determine its subpart F income without regard to a Section 965 inclusion. The CFC takes that subpart F income into account by increasing its Section 959(c)(2) E&P (i.e., previously-taxed subpart F income) by the amount of subpart F income of any distribution it made to another CFC before January 1, 2018. As a result, a distributee CFC excludes from the E&P it uses to measure ADFI any portion of the distribution that the CFC included in its ADFI. Third, the CFC determines its Section 965(a) inclusion amount, which the CFC includes in its income under Section 951(a)(1)(A). As a result, if in the inclusion year or any subsequent year, the CFC distributes an amount that the CFC shareholder included in income under Section 965, the distribution is from the CFC’s Section 959(c)(2) E&P (i.e., previously-taxed subpart F income). This is the amount disclosed under Column (e)(ii).
Column (e)(iii). General Section 959(c)(1) PTEP
A CFC shareholder will use Column (e)(iii) to report general Section 959(c)(1) PTEPs. Recall that Section 959(c)(1) are PTEPs attributable to investments in US property. Investments in US property include most tangible and intangible property owned by a CFC that has a US situs such as stock of a domestic corporation; an obligation of a US person; and a right to use a patent, copyright, or other forms of intellectual property in the United States if acquired or developed by the CFC for that use. A CFC is also treated as owning a proportionate interest in US property owned by a partnership in which the CFC is a partner.
Column (e)(iv). Reclassified Section 951A PTEP
A CFC shareholder will use Column (e)(iv) to report PTEPs attributable to Global Intangible Low-Taxed Income, or GILTI reclassified as Section 959(c)(1).A US shareholder’s GILTI for a taxable year is the excess, if any, of the US shareholders “net CFC tested income” for the taxable year over that shareholder’s “net deemed tangible income return” for the taxable year. Net CFC tested income with respect to any US shareholder is the excess (if any) of the aggregate of the shareholder’s pro rata share of the “tested income” of each CFC with respect to the shareholder is a US shareholder the shareholder’s taxable year over the aggregate of that shareholder’s pro rata share of the “tested loss” of each CFC with respect to which the shareholder is a US shareholder for the taxable year of the US shareholder.
GILTI = Net CFC Tested Income – Net Deemed Tangible Income Return = [Tested Loss] – [10% of QBAI – Certain Interest Expense].
Column (e)(v). Reclassified Section 245A(d) PTEP
A CFC shareholder will use Column (e)(v) to report PTEPs attributable to reclassification Section 245A(d) PTEP under Section 959(c)(1).
For column (e)(v), the preparer must disclose reclassified E&P (under the Section 959 ordering rules) divides which deductions are not permitted under Section 245A(d). Column e was added to Schedule P for the 2020 tax year. Section 245A allows an exemption for certain foreign income of a domestic corporation that is a U.S. shareholder by means of a 100 percent dividends received deduction (“DRD”) for the foreign-source portion of dividends received from “specified 10-percent owned foreign corporations” by certain domestic corporations that are U.S. shareholders of those foreign corporations within the meaning of Section 951(b).
However, Section 245A(d) generally prohibits taxpayers from claiming credits or deductions for foreign income taxes paid or accrued (or treated as paid or accrued) on dividends for which a Section 245A deduction is allowed. Under Section 245A(e)(3), the same rules apply to foreign income taxes paid or accrued (or treated as paid or accrued) on hybrid dividends (or tiered hybrid dividends). The proposed regulations would disallow a credit or deduction for foreign income taxes attributable to a “specified distribution” or to “specified earnings and profits” of a foreign corporation.
A specified distribution is the portion of a distribution received by a domestic corporation 1) for which a section 245A deduction is allowed; 2) that is a hybrid dividend, or 3) that is attributable to the corporation’s Section 245(d) PTEP. Section 245A(d) PTEP is PTEP of the foreign corporation resulting from 1) a sale or exchange of stock subject to Section 964(e)(4) or Section 1248 for which a Section 245A deduction was allowed or 2) a tiered hybrid dividend that gave rise to an income inclusion to a CFC shareholder.
A foreign corporation’s specified earnings and profits is the E&P that would give rise to a Section 245A deduction, a hybrid dividend, a tiered hybrid dividend, or distribution of a Section 245A(d) PTEP if the foreign corporation distributed cash equal to all of its E&P.
Any PTEP associated with Section 245A(d) should
be disclosed under Column (e)(v).
Section 245A(d) reporting requirements may also arise when a CFC sells assets.
We will discuss these situations in more detail below.
For certain fiscal-year controlled foreign corporations, a gap existed
between the last E&P measurement date for the purposes of the Section 965
transition tax – Dec. 31, 2017 – and the effective date of the GILTI provisions
(the disqualified period). The GILTI provisions are effective as of the first
day of the first year beginning after Dec. 31, 2017. For fiscal year CFCs
having a year-end of November 30, for example, the disqualified period was 11
months long. During this period, the CFC could sell assets to a related foreign
party in a transaction not subject to GILTI. The sales proceeds could then be repatriated
tax-free under the Section 245A dividend received deduction rules. For the
buyer (and subject to the disqualified basis rules discussed below), the sale
would have created a stepped-up tax basis in the assets, thereby resulting in
increased deductions for amortization and depreciation that could reduce the
buyer’s future GILTI by reducing tested income and increasing QBAI.
To prevent this result, the Final Regulations reduce the dividend reduction
deduction allowed to a Section 245A shareholder by the amount equal to 50
percent of the “extraordinary disposition amount” (which is meant to
approximate the 50 percent deduction domestic corporations generally are
eligible for if such earnings were includable as GILTI). For a disposition to
be an extraordinary disposition, the disposition must be: i) a disposition of
specified property (i.e. property that produces gross income that would be
subject to GILTI), by an SFC, ii) made on a date the SFC was also a CFC, iii)
during the SFC’s disqualified period, iv) to a related party, v) that occurs
outside of the ordinary course of the SFC’s business.
Whether a disposition of specified property occurs outside the ordinary course
of an SFC’s business is determined by considering the facts and circumstances, including
the quantity and frequency of the SFC’s past activities, and whether the SFC
regularly disposes of similar property to related parties. The 2019 Regulations
provide a per se rule that a disposition is treated as outside of the ordinary
course of the SFC’s business if the disposition was undertaken with a principal
purpose of generating E&P during the disqualified period or if the
disposition was of intangible property, within the meaning of Section
367(d)(4). The Final Regulations create an exception to the per se rule for
certain intangible property if there was a reasonable expectation that such
property would be re-sold to an unrelated customer within one year of the
transfer. Transfers of trademarks and goodwill, however, are not eligible for this
exception because, in general, these types of intangible property are not
routinely sold to unrelated customers. U.S. shareholders are required to
maintain an extraordinary disposition account to track the extraordinary
disposition amount and distributions of the same.
In addition to extraordinary disposition transactions, which were possible
during the GILTI gap period, the regulations are also concerned with planning
based on the interaction of Section 951(a)(2)(B), which reduces a U.S.
shareholder’s pro rata share of CFC subpart F income or GILTI tested income for
dividends a different taxpayer receives in respect of the same CFC stock, and
the Section 245A dividend reduction deduction. To prevent such planning, the
Final Regulations treat dividends (or deemed dividends) that occur in the same
year as an “extraordinary reduction” ineligible for the dividend received
deduction to the extent of the U.S. shareholder’s pre-reduction, pro rata share
of the CFC’s subpart F income or GILTI tested income. An extraordinary
reduction occurs when a controlled Section 245A shareholder (generally, a U.S.
shareholder that owns more than 50% of the stock of the CFC) transfers more
than 10% of its stock to a CFC or there is a greater than 10% dilution in the
controlling Section 245A shareholder’s overall ownership of the CFC.
Below, please find Illustration 4 which (based on Example 3 of the Final
Regulations) illustrates a perceived abuse the extraordinary reduction
provisions were designed to attack.
Illustration 4.
At the beginning of CFC1s tax year ending on Dec. 31, 2021, US1 owns
all of the stock of CFC1, and CFC1 has no E&P described in Section
959(c)(1) or (2). As of the end of 2022, CFC1 has $160 of GILTI and no other
income, so that CFC1 has $160 of E&P for 2022. On Oct. 19, 2022, US1 sells
all of its CFC1 stock to US2 for $100 in a transaction in which US2 for $100 in
a transaction in which US1 recognizes $90 of gain.
Under Section 1248(a), the entire $90 of gain is included in US1’s gross income
as a deemed dividend, and, under Section 1248(j), the $90 would be treated as a
dividend for purposes of applying Section 245A, dividend received deduction. At
the end of 2022, however, US2 would take into account only $70 of tested
income, calculated as $160 (100% of the $160 of GILTI) less $90, the amount of
dividend deemed received by US1 described in Section 951(a)(2)(B).
In this example, the Section 245A deemed dividend reduction eliminates taxation
of the Section 1248 deemed dividend, which Section 951(a)(2)(B) reduces the
post-sale GILTI tested income by $90 (the amount of the deemed dividend). To
preclude this result, the Section 1248 deemed dividend in the example would
qualify as an extraordinary reduction amount under the Final Regulations.
Consequently, regarding the $90 deemed dividend received by US1, no portion is
eligible for the 245A dividend received deduction. In addition, foreign tax
credits are disallowed with respect to the deemed distribution.
Any deduction (for foreign tax credits) under Section 245A(d) that has been
disallowed and reclassified under the Section 959 ordering rules should be
listed under column (e)(v).
Column (e)(vi). Section 965(a) PTEP
A CFC shareholder will use Column (e)(vi) to report PTEPs attributable to
Section 965(a) classified under Section 959(c)(2).
Column (e)(vii). Section 965(b) PTEP
A CFC shareholder will use Column (e)(vii) to report PTEPs attributable to
Section 965(b) classified under Section 959(c)(2).
Column (e)(viii). Section 965(b) PTEP
A CFC shareholder will use Column (e)(viii) to report PTEPs attributable to
Section 951A classified under Section 959(c)(2).
Column (e)(ix). Section 245A(d) PTEP
A CFC shareholder will use Column (e)(ix) to report PTEPs attributable to
Section 245A(d) classified under Section 959(c)(2).
Column (e)(x). Section 951(a)(1)(A) PTEP
A CFC shareholder will use Column (e)(x) to report PTEPs attributable to
Section 951(a)(1)(A)
CFC shareholders will report subpart F income PTEP under Column (e)(x). Subpart
F income is defined as the sum of the corporation’s: 1) Insurance income (as
defined in Section 953); 2) Foreign base company income; and 3) International
boycott income and amounts equal to illegal bribes/kickbacks paid on behalf of
the CFC.
Specific Instructions Related to Lines 1 Through 14
Line 1a.
Line 1a asks the preparer to enter the balances for each column at the
beginning of the tax year. These balances should equal the amounts reported as
the ending balances in the prior year Schedule E-1.
Line 1b.
Line 1b states if there is a difference between last year’s ending balance
on Schedule E-1 and the amount which should be last year’s ending balance,
include the difference for the difference. If there are multiple differences,
include the explanation and amount of each such difference on the attachment.
Line 1c.
For Line 1c, the preparer should combine lines 1a and 1b.
Line 2.
According to the instructions for Schedule E-1, line 2 is used to reflect
adjustments to a U.S. person’s foreign tax credit as a result of determining
foreign income taxes. If a U.S. person has appropriately amended the
immediately prior year return, including its Schedule E-1, to redetermine its
U.S. tax liability, no adjustment should be included on this line. This line is
only applicable if a U.S. person appropriately amended a prior year return and
there were intervening years between the amended year return and the current
year return for which an amended return was not filed. If so, an adjustment for
the prior year amended return (and its impact on intervening years) should be
reelected on line 2.
Line 3a.
According to the instructions for Schedule E-1, line 3a is used to include
in column (a), (b), (c), or (e) foreign income taxes paid or accrued by the
corporation during the prior years that were suspended due to the application
of the rules of Section 909 and that are unsuspended in the current year
because related income is taken into account by the foreign corporation,
certain U.S. corporate U.S. corporate owner’s consolidated group. The
applicable rules governing Section 909 and suspended taxes is discussed below
in more detail. This amount is reported as a positive amount on line 3a.
Line 3b.
Include as a positive amount in column (d) foreign income taxes related to the
current tax year that have been suspended due to the rules of Section 909. By
the way of background, a foreign tax credit is deductible only to the extent
that the creditable tax is “paid or accrued.” Foreign taxes are generally
treated as paid by the corporation on whom foreign law imposes legal liability.
Under this “technical taxpayer” rule, the corporation or person who has legal
liability for a foreign tax can be different than the person who realizes the
underlying income under U.S. tax principles, resulting in a separation or
“splitting” of foreign income to which the taxes relate. In some cases, the
“splitting” can result in foreign tax credits following up to an individual
without the associated income being subject to U.S. tax. Congress enacted
Internal Revenue Code Section 909 for this situation. Under Section 909, where
there is a “foreign tax credit splitting event” with respect to foreign income
tax paid or accrued by a taxpayer, the foreign income tax is not taken into
account for U.S. tax purposes before the tax year in which the related income
is taken into account by the CFC.
Line 4.
The total reported on Line 4 should be taken from Schedule E, Part 1, line
5, column (k).
Line 5a.
Line 5a asks the preparer to enter earnings carried over to a surviving
corporation after an acquisition by a foreign corporation of the assets by a
foreign corporation described in Section 381. The tax attributes of a target
corporation (e.g., earnings and profits and net operating losses) generally
carry over to the acquiring corporation under Section 381. The amounts carried
over to the reporting CFC may be negative or positive.
Line 5b.
Line 5b asks the preparer to list any deficit of a foreign surviving
corporation. If the foreign surviving corporation had a deficit prior to the
transaction, the deficit should be recharacterized as a hovering deficit. This
hovering deficit should be disclosed in columns (a),(b), or (c) as a positive
number.
Line 6.
Line 6 asks the preparer to report any taxes reported on Schedule E, Part
1, Section 2, Line 5, column (i). The total reported on Schedule E-1, Part 1,
Section 2, line 5, column (i) should be broken out on Schedule E-1, line 6,
columns (e)(i) through (e)(x) based on the type of PTEP to which such taxes
relate.
Line 7.
Line 7 asks the preparer to attach a statement with a description and the
amount of any adjustments required before taking into account taxes deemed paid
by the foreign corporation. An example of an adjustment entered on line &
is the foreign taxes imposed on receipt of a distribution of PTEP from a
lower-tier foreign corporation.
Line 8.
Line 8 asks the preparer to report any paid or accrued on current
income/E&P or accumulated E&P (combine lines 1c through 7). For Line 8,
column (b), the preparer should report post-1986 income taxes for purposes of
determining the taxes deemed paid on dividends from a foreign corporation in
such corporation’s tax years before January 1, 2018.
Line 9.
Line 9 asks the preparer to report taxes deemed paid with respect to
inclusions under Section 951(a). Amounts reported on line 9 should be negative
numbers.
Line 10.
Line 10 asks the preparer to report taxes deemed paid with respect to
actual distributions under Section 951A. Amounts reported on line 10 should be
negative numbers.
Line 11.
Line 11 asks the preparer to report taxes deemed paid with respect to
actual distributions.
Line 12.
Line 12 asks the preparer to report taxes on amounts reclassified to
Section 959(c)(1) E&P from Section 959(c)(2) E&P. See Illustration 5
(taken for the IRS instructions) below for an example regarding reclassifying
Section 959(c)(1) E&P from Section 959(c)(2):
Illustration 5.
Domestic Corporation, a U.S. shareholder, wholly owns the only class of stock
of CFC1, a foreign corporation. CFC1, in turn, wholly owns the only class of
stock of CFC2, a foreign corporation. CFC2, in turn, wholly owns the only class
of stock of CFC3, a foreign corporation. The functional currency of Domestic
Corporation, CFC1, CFC2, and CFC3 is the U.S. dollar. During Year 1, Domestic
Corporation reports an inclusion under Section 951(a)(1) of $100 as a result of
subpart F income of CFC3. During Year 2, CFC3 distributes $40 to CFC2. CFC2
pays withholding tax of $4 on the distribution from CFC3. Such tax is a tax
related to previously taxed subpart F income and is reported on line 4, column
(e) of Schedule E-1 of CFC2’s Form 5471. In Year 2 CFC2 invests $40 in U.S.
property. At the time of investment in such property, CFC2 continues to
maintain a $36 balance in its Section 959(c)(2) previously taxed E&P
account.
CFC2 reclassifies such amounts as Section 959(c)(2) previously taxed E&P
account. CFC2 reclassifies such amount as Section 959(c)(1) previously taxed
E&P on Schedule J. Accordingly, $4 of foreign income taxes related to
Section 959(c)(2) previously taxed E&P is reclassified to Section 959(c)(1).
Line 13.
For line 13, the preparer should attach a statement with a description and
the amount of any adjustments required before taking into account taxes deemed
paid by the foreign corporation not already taken into account on this
schedule. An example of amounts reported on line 13 include taxes deemed paid
on PTEP distributions to CFC shareholders ineligible to claim a foreign tax
credit.
Line 14.
For line 14, the preparer should report taxes related to hovering deficit
offset of undistributed post-transaction E&P.
Line 15.
For line 15, the preparer should report the balance of taxes paid or
accrued by combining lines 8 through 14 in column a.
Line 16.
For line 16, the preparer should report a reduction for tested income taxes
not deemed paid. This includes taxes attributable to the tested income group
that were not deemed paid as a result of the domestic corporation’s inclusion
percentage or as a result of the application of the 80 percent GILTI foreign
tax credit limitation rule.
Line 17.
For line 17, the preparer should report a reduction for other taxes not
deemed paid. This includes taxes that are properly attributable to a subpart F
income group but were not deemed paid because there was no subpart F income
with respect to that income group in the current year. This does not include
taxes that are properly attributable to the residual income because those taxes
are not reported on Schedule E-1, but on Schedule E, Part III, column (g).
Line 18.
For line 18, the preparer should report the balance of taxes paid or
accrued at the beginning of the following year. Line 18, column (a), must
always equal zero.
Anthony Diosdi is one of several international tax attorneys at Diosdi Ching
& Liu, LLP. As an international tax attorney, Anthony Diosdi provides
international tax advice to closely held and publicly traded entities. Anthony
Diosdi regularly advises CFCs, CFC shareholders, and other tax professionals
regarding Form 5471 compliance requirements. Diosdi Ching & Liu, LLP has offices
in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises
clients in international tax matters throughout the United States. Anthony
Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax
advice, you should immediately consult a licensed attorney.