By Anthony Diosdi
Schedule P of Form 5471 is used to report PTEP of the U.S. shareholder of a controlled foreign currency (“CFC”) in the CFC’s functional currency. The term PTEP refers to earnings and profits (“E&P”) of a foreign corporation. In most cases, special ordering rules under Section 959 of the Internal Revenue Code apply in determining how E&P is reported on Schedule P. This article will take a deep dive into each column and line of 2021 Schedule P of the Form 5471.
Who Must Complete the Form 5471 Schedule P
Anyone preparing a Form 5471 knows that the return consists of many schedules. Schedule P is just one schedule of the Form 5471. Whether or not a CFC shareholder is required to complete Schedule P 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:
U.S. person: A U.S. person is generally a citizen or resident of the United States, a domestic partnership, a domestic corporation, or a domestic trust or estate. A tax-exempt U.S. entity may have a Form 5471 filing obligation.
U.S. Shareholder: A U.S. shareholder is a U.S. person who owns (directly, indirectly, or constructively, within the meaning of of Section 958(a) and Section 958(b)), 10% or more of either the total combined voting power of all classes of voting stock of a foreign corporation or the value of all the outstanding shares of a foreign corporation.
Controlled foreign corporation (CFC): A CFC is a foreign corporation with U.S. shareholders that own (directly, indirectly, or constructively, within the meaning of Section 958(a) and 958(b)) on any day of its taxable year, more than 50% of either 1) the total combined voting power of all classes of its voting stock, or 2) the total value of its stock.
Section 965 Specified Foreign Corporation (SFC): A CFC, or any foreign corporation with one or more 10% domestic corporation shareholders. Passive foreign investment companies or (“PFICs”) are not included in this definition.
Category 1 Filer
A Category 1 filer is a U.S. shareholder of a SFC at any time during any taxable year of the SFC who owned that stock on the last day in that year on which it was an SFC. A foreign corporation is an SFC if it is either a CFC or a foreign corporation with at least one corporate U.S. shareholder.
Category 2 Filer
A Category 2 filer is a U.S. citizen or resident who is an officer or director of a foreign corporation in which there has been a change in substantial U.S. ownership – even if the change relates to stock owned by a U.S. person who is not an officer or director. A substantial change in U.S. ownership is when any U.S. person (not necessarily the U.S. citizen or resident who is the officer or director) acquires stock that causes him or her to own a 10% block, or acquires an additional 10% block, of stock in that corporation. More precisely, if any U.S. person acquires stock, which, when added to any stock previously owned, causes him or her to own stock meeting the 10% stock ownership requirement, the U.S. officers and directors of that foreign corporation must report. A disposition of shares in a foreign corporation by a U.S. person does not create filing obligations under Category 2 for U.S. officers and directors. Stock ownership is a vote or value test.
Category 3 Filer
A U.S. person is a Category 3 filer with respect to a foreign corporation for a year if the U.S. person does any of the following during the U.S. person’s year:
1. Acquires stock in the corporation, which, when added to any stock owned on the acquisition date, meets the Category 2 filer 10% stock ownership requirement.
2. Acquires additional stock that meets the 10% stock ownership requirement.
3. Becomes a U.S. person while meeting the 10% stock ownership requirement.
4. Disposes of sufficient stock in the corporation to reduce his or her interest to less than 10% stock ownership requirement.
5. Meets the 10% stock ownership requirement with respect to the corporation at a time when the corporation is reorganized.
Stock ownership is a vote or value test. Constructive ownership includes certain family members, such as brothers or sisters, spouse, ancestors, and lineal descendants.
Category 4 Filer
A U.S. person is a Category 4 filer with respect to a foreign corporation for a taxable year if the U.S. person controls the foreign corporation. A U.S. person is considered to control a foreign corporation if at any time during the person’s taxable year, such person owns: 1) stock possessing more than 50% of the total combined voting power of all classes of stock entitled to vote; or 2) more than 50% of the total value of shares of all stock of the foreign corporation.
For Category 4 purposes, U.S. persons include those individuals who make a Section 6013(g) or (h) election to be treated as resident aliens of the United States for income tax purposes.
The constructive ownership rules of Section 318 are applied, with few modifications, to determine if the U.S. person “controls” the foreign corporation.
Category 5 Filer
A Person is a Category 5 filer if the person: 1) is a U.S. shareholder of a CFC at any time during the CFC’s taxable year; and 2) owns stock of the foreign corporation on the last day in the year in which that corporation is a CFC. For category 5 purposes, constructive ownership is determined under Section 318 as modified by Section 958(b). Pursuant to Section 958(b), there is no attribution from a nonresident alien relative.
Categories 1 and 5 have been expanded to 1a, 1b, 1c, 5a, 5b, and 5c in order to separate those filers who are under some relief and may not need to file the same schedules.
1a- Category 1 filer who is not defined in 1b or 1c. This means a greater than 50% owner of the SFC.
1b- Unrelated Section 958(a) U.S. shareholder. This means an unrelated person would not control (more than 50% vote or value) the SFC or be controlled by the same person which controls the SFC.
1c- Related constructive U.S. shareholder- This means an entity controlled by (more than 50% vote or value) the same person which controls the SFC and files only due to this downward attribution.
5a- Category 5 filer who is not defined in 5b or 5c – This means a greater than 50% owner of the CFC.
5b- Unrelated Section 958(a) U.S. shareholder- This means an unrelated person would not control (more than 50% vote or value) the CFC or be controlled by the same person which controls the CFC.
5c- Related constructive U.S. shareholder- This Means an entity controlled by (more than 50% vote or value) the same person which controls the CFC and files only due to this downward attribution.
These new categories will distinguish those 5471 filers who only need to file a Form 5471 due to downward attribution caused by the repeal of Section 958(b)(4) and will therefore not be required to attach certain schedules to their Form 5471s.
CFC shareholders that are classified as Category 1a, 1b, 4, 5a, and 5b filers must complete and attach Schedule P to their Form 5471.
Lines a and b
Schedule P 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 J 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|
|FAS||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:
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) income is income earned from a sanctioned country.
Income Re-Sourced by 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.
General Category Income
This category includes all income not described above.
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 Previously Taxed E&P in Functional Currency
Part 1 and Part 2 of Schedule P requires the preparer to report the PTEP of the U.S. shareholder of a CFC in the CFC’s functional currency. The amounts entered under each column must be in the CFC’s functional currency. Section 985(b)(1)(A) of the Internal Revenue Code states the general rule that the functional currency will be “the dollar.” However, the functional currency of a “qualified business unit” (“QBU”) which could be a CFC will be “the currency of the economic environment in which a significant part of such a unit’s activities” is “conducted and which is used by such a unit in keeping its books and records.” See IRC Section 985(b)(1)(B).
These amounts are subject to special ordering rules of Section 959 of the Internal Revenue Code. Where the E&P of a CFC consists in whole or in part of previously tax earning and profits (“PTEP”), special rules under Section 959 apply in determining the ordering and taxation of distributions of such PTEP. Amounts included in the gross income of a U.S. shareholder as GILTI or subpart F income are not included in gross income again when such amounts are distributed to the shareholder, directly, indirectly, or through a chain or ownership. A PTEP distribution is generally allocated 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 (3) general current 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”).
On November 28, 2018, the Department of Treasury and the IRS released proposed regulations related to the determination of the foreign tax credit (the Proposed Regulations). Under the Proposed Regulations, CFCs are required to establish an annual account for PTEP for each of the Section 904 baskets. Within each account, a CFC is required to assign a PTEP to one of ten different PTEP groups in each of the relevant Section 904 basket based on the U.S. shareholder’s underlying income inclusion, while also taking into account PTEP reclassifications as a result of a Section 956 inclusion.
Under the proposed regulations, PTEP taxes are as follows: 1) foreign taxes deemed paid by the CFC under Internal Revenue Code Section 960(a) for a current year income inclusion in a PTEP group; 2) the foreign income taxes paid or accrued by a CFC as a result of a Section 959(b) distribution that was allocated and apportioned to a PTEP group; and 3) for a reclassified PTEP group of foreign income taxes that were paid, accrued, or deemed paid for an amount that was initially included in a Section 959(c)(2) PTEP group which was reclassified as a Section 959(c)(1) PTEP group. PTEP group taxes are reduced by the amount of foreign taxes in that particular group paid by the U.S. shareholder under Section 960(b)(1) or by another CFC under Section 960(b)(2) that have been reclassified to a Section 959(c)(1) PTEP.
Under the proposed regulations, a CFC’s current year taxes are associated with a PTEP group for Section 960(b) purposes only if the receipt of Section 959(b) distribution causes an increase in a PTEP group. The increased PTEP group is treated as an income group to which current-year taxes are imposed solely by reason of the Section 959(b) distribution. Taxes that are allocated and apportioned to a PTEP group by reason of a CFC’s receipt of Section 959 distribution are allocated and apportioned to the PTEP group under Treasury Regulation Regulation 1.904-6 principles.
Section 960- Deemed Paid Credits on Distributions of PTEP
For any distributions of PTEP, the ordering rule determines the type of PTEP that is distributed. Such determination is particularly important for purposes of determining the creditability of any foreign taxes that are imposed by the CFC’s country on the PTEO distributions.
Prior to the enactment of the TCJA, former Internal Revenue Code Sections 902 and 960(a)(1) permitted a corporate U.S. CFC shareholder to claim a credit for foreign taxes paid by a CFC when the related income was either distributed to the shareholder as a dividend or included in the shareholder’s income as a subpart F inclusion. This would result in the amount of paid foreign taxes based on multi-year “pools” of E&P, with the shareholder generally deemed to have paid the same proportion of the CFC’s post-1986 foreign income taxes as the amount of the dividend or subpart F inclusion as it related to the CFC’s post-1986 undistributed earnings.
TCJA repealed Section 902 and modified Internal Revenue Code Sections 904 and 960. TCJA eliminated the multi-year pooling system and introduced a “properly attributable standard” for the purposes of crediting foreign taxes. Under Section 960(a) and (b), a corporate U.S. shareholder can claim a deemed paid credit for foreign income taxes that are properly attributable to current subpart F and GILTI inclusions. In addition, under Section 960(b), a CFC shareholder is deemed to have paid foreign income taxes that are properly attributable to distributions of PTEP received from a first-tier CFC or from a lower-tier CFC.
Treasury and the IRS determined that adherence to Treasury Regulation 1.904-6 created the need to track and account for several new groups of PTEP because Section 959(c)(2) PTEP (and related deemed paid foreign tax credits) may arise by reason of income inclusions under Sections 951(a)(1)(A), 245A(e)(2), Section 951A(f)(1), 959(E), 964(e)(4), and 965(a), or by reason of the application of Section 965(b)(4)(A). Also, because Section 959(c)(c)(2) PTEP may be reclassified as Section 959(c)(1) PTEP as a result of Sections 956 and 959(a)(2), PTEP groups for Section 959(c)(1) PTEP must be maintained. Finally, PTEP subaccounts must be maintained for each Section 904 foreign tax credit category. See Curtail U.S. PTEP Reporting Complexity: Know Your P’s and Q’s, by Lewis J. Greenwald, Brainard L. Patton, and Brendan Sinnott, Volume 172, Number 5, August 2, 2021.
IRS Notice 2019-01
Notice 2019-01 announced Treasury and IRS’s intention to withdraw prior proposed regulations under Internal Revenue Code Section 959 and issue new proposed regulations under Internal Revenue Code Sections 959 and 961.The proposed regulations discussed in Notice 2019-01 included rules related to the maintenance of PTEPs in annual accounts, in specific groups, and the ordering of PTEPs when distributed or reclassified. Notice 2019-01 added an additional six PTEP groups to the ten PTEP groups described in the proposed regulations. Thus, within each basket, PTEP is allocated up to sixteen groups to be determined on an annual basis.
Notice 2019-01 describes regulations that the Treasury intended to propose that involve PTEP ordering upon distribution. Generally, and subject to a special priority rule for PTEP arising from Section 965(a) and (b), the notice applies a LIFO approach to the sourcing of distributions from annual PTEP accounts. Thus, subject to the special priority rule, Section 959(c)(1) PTEP in the most recent annual PTEP account is treated as distributed first, followed by the second most recent PTEP account, and continued through each annual PTEP account under Section 959(c)(1) until each account is exhausted. The same approach will then apply to Section 959(c)(2) PTEP. Finally, the remaining amount of any distributions are sourced from Section 959(c)(3), to the extent thereof.
The Final Section 960(b) Regulations
On December 17, 2019, the Treasury and the IRS issued final regulations under Internal Revenue Code Section 960(b) which finalized the proposed regulations. The final Section 960(b) regulations modified the proposed regulations. The PTEP groups have consolidated the 959(c)(2) PTEP groups into five. The five PTEP groups arise under Internal Revenue Code Sections 965(a), 965(b)(4)(A), 951A(f)(2), 245A(d), and 951(a)(1)(A). Section 959(c) requires U.S. shareholders to reclassify Section 959(c)(2) PTEP as Section 959(c)(1) PTEP whenever the CFC has a Section 956 investment in U.S. property that was included in the U.S. shareholder’s gross income under Section 951(a)(1)(A) or would have been included except for Section 959(a)(2). In that case, the Section 959(c)(2) PTEP group is reduced by the functional currency amount of the reclassified PTEP, which is added to the corresponding Section 959(c)(1) PTEP group described in the Section 904 category and same annual PTEP account as the reduced Section 959(c)(2) PTEP group.
The post TCJA Form 5471 Schedule P serves the same purposes as its pre TCJA predecessor. However, the post TCJA version greatly expanded E&P tracking requirements. The post TCJA Form 5471 Schedule P increased the 959(c)(2) PTEP categories to be disclosed on the schedule from one to five. It also expanded 959(c)(1) PTEP categories from one to five. In addition, Schedule P requires untaxed E&P to be allocated into E&P subject to the Section 909 anti-splitter rules, E&P carried over from certain nonrecognition transitions, and hovering deficits under Section 959(c)(3). In addition, the Treasury Regulations under Section 1.960-3 requires that CFC shareholders report PTEP attributions attributable to Section 965 inclusions, 965(b) deficit offsets, Section 956 investments in U.S. property, GILTI inclusions, subpart F inclusions, Section 245A hybrid dividends, and Section 1248 amounts. Within these categories, CFC shareholders must state whether or not the PTEP should be allocated to a Section 959(c)(2) or Section 959(c)(1) PTEP. CFC shareholders must separately track each PTEP according to its foreign tax credit category. In addition, CFC shareholders must track movements of PTEPs between Setions 959(c)(2) and Section 959(c)(1) categories.
Part I Previously Taxed E&P in Functional Currency
For Part I of Schedule P, the CFC shareholder should enter amounts in the functional currency of the foreign corporation. The functional currency is the currency of the economic environment in which a significant part of the CFC’s activities is conducted and which is used in keeping the CFC’s books and records. See IRC Section 985(b)(1)(B).
Column (a). Reclassified Section 965(a) PTEP
A CFC shareholder will use Column (a) 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 (a), the preparer must state previously taxed Section 965(a) E&P reclassified under Section 959(c)(1)(A).
Column b. Reclassified 965(b) PTEP
A CFC shareholder will use Column (b) to report previously taxed income reclassified as Section 965(b) under Section 959(c)(1)(A) (reclassified as investments in U.S. property). Section 965(b) allows U.S. shareholders to reduce the Section 965(a) inclusion amount based on deficits in E&P accumulated by other SFCs. Under Section 965(b), the deferred foreign earnings that would have been included in U.S. shareholder’s income under Section 965(a), but were not so included because of sharing of an E&P deficit pursuant to Section 965(b), increases PTEP for the SFC that had positive earnings. Section 965(b)(4)(B) increases the E&P of an E & P deficit foreign corporation by the amount of the E&P deficit taken into account under Section 965(b).
The following example illustrates these rules; USP, a domestic corporation, owns all of the stock of foreign corporations CFC1 and CFC2. USP, CFC1, and CFC2 are calendar year taxpayers. On all measurement dates, CFC1 has accumulated post-1986 deferred foreign earnings of $100, and CFC2 has an E&P deficit of $20. USP in aggregate will have an $80 Section 965(a) inclusion amount ($100 from CFC1 less CFC2’s $20 deficit allocated to CFC1 under Section 965(b)). CFC1’s PTEP account will increase by $100 ($80 for the Section 965(a) inclusion amount and $20 for the Section 965(b) deficit allocated to CFC1). CFC2 will have $0 of PTEP, and its E&P will increase by the $20 of deficit taken into account under Section 965(b)
Column c. General Section 959(c)(1) PTEP
A CFC shareholder will use Column (b) to report general Section 959(c)(1) PTEPs. Recall that Section 959(c)(1) are PTEPs attributable to investments in US property or reclassified investments in U.S. 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 d. Reclassified Section 951A PTEP
For column d, the preparer must disclose any PTEPs associated with reclassified (under the Section 959 ordering rules) Section 951A rules. Internal Revenue Code Section 951A refers to global intangible low-taxed income (“GILTI”). GILTI is the residual of a CFC’s income above a 10 percent return on its investment in tangible depreciable assets (defined as “qualified business asset investment” or QBAI).
A U.S. shareholder’s GILTI for a taxable year is the excess, if any, of the U.S. shareholders’ “net CFC tested income” for the taxable year over that shareholder’s “net deemed income return” 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 U.S. shareholder is the excess of the aggregate of the shareholder’s pro rata share of the “tested income” of the CFC over the aggregate of the shareholder’s pro rata share of the “tested loss” of the CFC.
Column e. Reclassified Section 245A(d) PTEP
Column (e) was added to Schedule P to take into consideration the new final and proposed regulations for Section 245A which discuss extraordinary dispositions and extraordinary reductions rules. Section 245A allows domestic corporations a 100 percent dividend received deduction for the foreign source portion of a 10 percent owned SFC provided that certain requirements are satisfied such as a holding period is met and the dividend is not classified as a “hybrid dividend” under Section 245A(e). Recently, the IRS became concerned that the dividends received deduction rules of Section 245A could be used by domestic corporations to shift income to a related foreign entity set up in a low-taxed country, and that income could be shifted back to U.S. shareholders without being subject to U.S. tax.
The IRS issued final and proposed regulations to combat income shifting to low-tax foreign jurisdictions or tax havens to avoid U.S. taxation. The final regulations promulgated by the IRS for Section 245A(d) disallow dividend deductions for the sum of 1) 50 percent of the extraordinary disposition amount, and 2) 100 percent of the extraordinary reduction amount.
Extraordinary Disposition Amount
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.
Extraordinary Reduction Amount
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 1 which (based on Example 3 of the Final Regulations) illustrates a perceived abuse the extraordinary reduction provisions were designed to attack.
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).
Column (f). Section 965(a) PTEP
For column (f), the CFC shareholder must state the total amount that is required to be included in income included in income under Section 965(a) that has been classified as a PTEP.
Column (g). Section 965(b) PTEP
For column (g), the CFC shareholder must disclose any Section 965(b) PTEP for previously taxed earnings generated by the allocation of SFC deficits with a Section 965(a) earnings amount. The 965(b) PTEP listed under column g is E&P deficits that has been classified as a PTEP.
Column (h). Section 951A PTEP
For column (h), the CFC shareholder must disclose any GILTI inclusion that has been classified as a PTEP.
Column (i). Section 245A(d) PTEP
A CFC shareholder will use Column (i) to report PTEPs attributable in three subgroups discussed below (which are aggregated into a single PTEP group).
1. PTEP that is attributable to hybrid dividends under Section 245(e)(2) and reclassified as investments in U.S. property. Internal Revenue Code 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 an Internal Revenue Code Section 245A deduction is allowed.Under Section 245A, an exception is allowed for certain foreign income of a domestic corporation that is a US shareholder by means of a 100 percent dividend received deduction (“DRD”) for the foreign source portion of dividends received from “specified 10-percent owned foreign corporations” by certain domestic corporations that are US shareholders of those foreign corporations within the meaning of section 951(b). Section 245A generally denies the DRD for hybrid dividends (i.e., amounts received from a CFC if the dividend gives rise to a local country deduction or other tax benefit). Any deductions disallowed under Section 245A(d) classified as Section 959(c)(1) PTEP (investment in U.S. property should be disclosed under Column (e)(v).
2. PTEP that is attributable to Section 1248 amounts under Section 959(e) and reclassified as investments in U.S. property. Under Section 1248(a), gain is recognized on a U.S. shareholder’s disposition of CFC stock in cases where there is a deferral of E&P. For purposes of Section 959(e), any amount included in the gross income of any person as a dividend by reason of subsection (a) or (f) of Section 1248 shall be treated as an amount included in the gross income of such person.
3. PTEP that is attributable to Section 1248 amounts from gain on the sale of a CFC by a CFC and reclassified as investments in U.S. property.
Column (j). Section 951(a)(1)(A) PTEP
A CFC shareholder will use Column (j) to report PTEPs attributable to Section 951(a)(1)(A) or subpart F income. 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 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 P.
Line 1b states if there is a difference between last year’s ending balance on Schedule P 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.
Use line 1c to reflect adjustments to a U.S. person’s foreign tax credit as a result of determining foreign income taxes. A foreign tax credit is allowed only to the extent that the credible foreign tax is “paid or accrued.” The foreign tax credit generally is limited to a taxpayer’s U.S. tax liability on its foreign-source taxable income (computed under U.S. tax accounting principles). If a U.S. person has appropriately amended the immediate prior year return, including its Schedule P, 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 reflected on line 1c.
Include in columns (c), (d), (h), and (j) 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. Include a negative amount in columns (c), (d), (h), and (j) foreign income taxes related to the current tax year that have been unsuspended due to the rules of Section 909.
Foreign taxes are generally treated as paid by a person on whom foreign law imposes legal liability. Under this rule, the entity who has legal liability for a foreign tax can be different from the entity who realizes the underlying income under U.S. tax principles, resulting in a separation or “splitting” of the foreign income to which the taxes relate. Congress enacted Internal Revenue Code Section 909 to address these situations. The definition of a “foreign tax credit splitting event” is broad and can reach a variety of situations such as transfer pricing adjustments, contributions of property resulting in a shift of deductions and timing differences under U.S. and foreign law. See Foreign Tax Credit Planning – What Every Practitioner Should Know, (2015) Jeffrey L. Rubinger. On Line 2, CFC shareholders should disclose foreign income taxes that have been suspended under Section 909 that have become unsuspended during the tax year.
Line 3 asks the SFC or CFC shareholder to adjust each PTEP to take into consideration E&P attributable to distributions of previously taxed E&P from lower-tier foreign corporations.
Line 4 asks the SFC or CFC shareholder to adjust each PTEP for previously taxed E&P carried over in nonrecognition transactions. A nonrecognition transaction is a nonreclaimable gain or loss. It applies as long as a reorganization occurs solely for stock or securities.
Line 5 asks the SFC or CFC shareholder to make any other necessary adjustments.
Line 6 asks the SFC or CFC shareholder to combine lines 1c through 5.
Line 7 asks the SFC or CFC shareholder to state any Section 959(c)(2) E&P from Section 959(c)(3) E&P. In order to determine how to reclassify E&P from one category to another, IRS Notice 2019-01 describes the process in which a PTEP may be reclassified for Section 959 purposes. According to Notice 2019-01, each PTEP is subject to a special priority rule. Under this special priority rule, a PTEP arising from Section 965(a) and 965(b) have priority over other PTEPs. All other PTEPs are subject to the LIFO approach for the sourcing of distributions from annual PTEP accounts. Thus, subject to the special priority rule, section 959(c)(1) PTEP in the most recent annual PTEP account is treated as distributed first, followed by the second most recent annual PTEP account, and continued through each annual PTEP account under Section 959(c) is exhausted. The same approach will then apply to Section 959(c)(2) PTEP. Finally, the remaining amount of any distributions are sourced from Section 959(c)(3), to the extent thereof.
The special priority rule provides an exception from the general LIFO approach described above for Section 965(a) and (b) PTEP under either Section 959(c)(1) or Section 959(c)(2). Starting with Section 959(c)(1) PTEP, distributions are sourced first from reclassified Section 965(a) PTEP and then reclassified Section 965(b) PTEP. Once these two PTEP groups are exhausted for Section 959(c)(1), the remaining annual PTEP accounts related to Section 959(c)(1) are sourced pro rata under LIFO approach until the Section 959(c)(1) are sourced rata under LIFO approach until the Section 959(c)(1) PTEP, distributions are then sourced from Section 959(c)(2) PTEP. Similarly, applying the special priority rule, distributions are first sourced from Section 965(a) PTEP and then from Section 965(b) PTEP. After exhausting Section 965(a) and (b) PTEP, distributions are then sourced pro rata from the remaining Section 959(c)(2) PTEP under the LIFO approach until such groups are exhausted. Finally, the remaining amount of any distributions are sourced from Section 959(c)(3) E&P, as necessary.
Line 8 asks the CFC or SFC shareholder to adjust each PTEP to take into account any actual distributions of previously taxed E&P.
Line 9 asks the CFC or SFC shareholder to make adjustments for amounts reclassified from Section 959(c)(2) to Section 959(c)(1) E&P. Below, please see Illustration 2 for an example regarding reclassifying Section 959(c)(1) E&P from Section 959(c)(2):
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 amount as Section 959(c)(2) previously taxed E&P accounts. CFC2 reclassifies such an amount as Section 959(c)(1) previously taxed E&P on Schedule P. Accordingly, $4 of foreign income taxes related to Section 959(c)(2) previously taxed E&P is reclassified to Section 959(c)(1).
Line 10 asks the SFC or CFC shareholder to make an allocation for amounts categorized as earnings invested in U.S. property and reclassified to Section 959(c)(1).
Line 11 asks the SFC or CFC shareholder 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. If applicable, the SFC or CFC shareholder should attach a statement with a description and the amount of any adjustments required for 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.
For line 12, the SFC or CFC shareholder should report the balance at the beginning of the following year. This is done by combining lines 6 through 11.
Part II of Schedule P is identical to Part I. However, for Part II, the CFC shareholder must enter the amounts in U.S. dollars. The CFC shareholder’s U.S. dollar basis in PTEP is generally equal to the U.S. dollar amount of the E&P that the CFC shareholder previously included in gross income. The CFC shareholder’s U.S. dollar basis is used by the U.S. shareholder to determine the amount of foreign currency gain or loss on the PTEP that the CFC shareholder is required to recognize under Internal Revenue Code Section 986(c).
There is a potential for double taxation when a dividend is received from a CFC by a CFC shareholder as to when the shareholder has already realized income from the distribution for U.S. tax purposes. To reduce the probability of double taxation, Internal Revenue Code Section 959 permits an exclusion of U.S. federal tax for any distribution of previously taxed income by a CFC to a CFC shareholder. Internal Revenue Code Section 986(c) applies these same rules to currency gains. Since the originating deemed distribution under, for example, Section 951 is earned and mained as previously taxed income (“PTI”) in a CFC’s functional currency, the distribution of PTI by the CFC must be translated to the U.S. dollar for U.S. federal income tax purposes at the spot rate on the date of actual distribution. If the exchange rate on the date of the actual distribution differs from the exchange rate utilized for the inclusion of the deemed distribution under Section 951, 951A or 965, an exchange gain or loss under Internal Revenue Code Section 986(c) will result. Under Section 986(c), a foreign currency gain or loss with respect to distributions of PTI (as described in Section 959 or 1293(c)) attributable to movements in exchange rates between the times of the deemed and actual distributions is recognized and treated as ordinary income or loss from the same source as the associated income inclusion. See U.S. IRS Release Practice Units on Foreign Currency Gain or Loss, Exchange Rates, Accounting Method Changes, and Foreign Earned Income Exclusion Adjustments (May 12, 2020) The Tax Hub.
The IRS Form 5471 is an incredibly complicated return. Each year an international tax attorney should review direct, indirect, and constructive ownership of the reporting CFC to determine the impact of any changes in percentages, filer categories, and CFC status. Workpapers should also be prepared and maintained for each U.S. GAAP adjustment and foreign exchange. In addition, an accounting should be made for adjustments to prior and current year previously taxed E&P that become PTEPs on Schedule J, E-1, and P.
It is extremely important to work with an international tax specialist to ensure accurate preparation of your Form 5471. Having the wrong professional complete your Form 5471 can result in significant penalties. The Internal Revenue Code authorizes the IRS to impose a $10,000 penalty for failure to file substantially complete and accurate Form 5471 returns on time. An additional $10,000 continuation penalty may be assessed for each 30 day period that noncompliance continues up to $60,000 per return, per tax year. In addition, the IRS can assess a 40 percent accuracy penalty on incorrectly reported income and reduction of foreign tax credits by 10 percent.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
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.