By Anthony Diosdi
Introduction
Schedule P of Form 5471 is used to report previously taxed earnings and profits (“PTEP”) of a U.S. shareholder of a controlled foreign corporation (“CFC”). The term PTEP refers to earnings and profits (“E&P”) of a foreign corporation. This article will dive into each column and line of the new 2020 Form 5471 Schedule P. We will also attempt to provide guidance as to how to prepare this incredibly complicated return.
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 shareholder of a CFC 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:
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.
Category 1, Category 4, and Category 5 filers need to complete Schedule P.
Schedule P of Form 5471 is similar to Schedule J of Form 5471. If a CFC shareholder wholly owns a CFC, Schedule P should include the same information reported on Schedule J, Part 1, column (e). However, if there is more than one U.S. shareholder, the amounts reported on Schedule P with respect to each CFC shareholder might differ from the amounts reported on Schedule J.
For example, Corporation A, a domestic corporation, owns 50% of only one class of stock of CFC1 and Corporation B, a domestic corporation, owns the remaining 50% of the stock of CFC1. Corporation A wholly owns the only class of stock of CFC2. The functional currency of all corporations is the U.S. dollar. CFC1 has tested income of $100x and CFC2 has tested loss of $30x. Neither Corporation A nor Corporation B has any net deemed tangible income return that would reduce the tested income taken into account by Corporation A or B with respect to CFC1. Corporation A has a Section 951A inclusion of $20 because its pro rata share of CFC1’s tested income ($50x) is offset by its pro rata share of CFC’s tested loss ($30x). Corporation B has a Section 951A inclusion of $50x. On Schedule P of the Form 5471 with respect to CFC1 filed by corporation B has a Section 951A inclusion of $50x. On Schedule P of Form 5471 with respect to CFC1 filed by Corporation B, Corporation B will report on line 7, column (c), $50x of PTEP as a result of its Section 951A inclusion with respect of CFC1. Corporation A will report $20x of PTEP as a result of its 951A inclusion on its Form 5471, Schedule P, line 7, column (c), with respect to CFC1.
The Form 5471, Schedule J, for CFC1 should include PTEP of $70x with respect to the aggregate Section 951A inclusion of Corporation A and Corporation B. However, if Corporation does not know Corporation B’s section 951A inclusion at the time Corporation A files its Form 5471, Corporation A will only be able to complete Schedule J, Part 1 with respect to its PTEP of $20x on line 8, column (e)(x). Similarly, Corporation B will only be able to complete Schedule J, Part 1, with respect to its PTEP of $50x on line 8, column (e)(x). In the following year, Corporation A and Corporation B should each report the other corporation’s PTEP on Schedule J, Part 1, line 1b, column (e)(x). See IRS Form 5471 Schedule P instructions.
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 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.
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 |
| 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:
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
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 of Schedule P tracks the accumulated E&P of a CFC shareholder (in functional currency). Schedule P of Form 5471 is similar to Schedule J of Form 5471. In order to complete Part 1 of Schedule P, the preparer must have an understanding of the Section 959 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 P. The columns listed on Part 1 of Schedule P consist of the following columns:
1. Reclassified Section 965(a) PTEP;
2. Reclassified Section 965(b) PTEP;
3. General Section 959(c)(1) PTEP;
4. Reclassified Section 951A PTEP;
5. Reclassified Section 245A(d) PTEP;
6. Section 965(a) PTEP;
7. Section 965(b) PTEP;
8. Section 951A PTEP;
9. Section 245A(d) PTEP;
10. Section 951(a)(1)(A) PTEP.
We will now walk through each PTEP column of Schedule P.
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 (e)(i), 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). 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 (b).
Column c. General Section 959(c)(1) PTEP
For column c, the preparer must disclose any PTEPs associated with Section 959(c)(1) which is attributable to investments in U.S. property.
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
For column e, 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.
Section 245A(d) reporting requirements may also occur when a CFC disposes of assets. We will discuss such situations 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 2 which (based on Example 3 of the Final Regulations) illustrates a perceived abuse the extraordinary reduction provisions were designed to attack.
Illustration 2.
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
For column (i), the CFC shareholder must disclose any foreign taxes or other deductions disallowed as a result of Section 245A(d) that has generated a PTEP under Section 959(c)(2)..
Column (j). Section 951(a)(1)(A) PTEP
For column (j), the CFC shareholder must disclose any PTEP as a result of a subpart F inclusion from a SFC or CFC. S
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 P.
Line 1b.
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.
Line 1c.
Use line 1c 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 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.
Line 2.
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 as 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. 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 3.
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.
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.
Line 5 asks the SFC or CFC shareholder to make any other necessary adjustments.
Line 6.
Line 6 asks the SFC or CFC shareholder to combine lines 1c through 5.
Line 7.
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.
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.
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 3 for an example regarding reclassifying Section 959(c)(1) E&P from Section 959(c)(2):
Illustration 3.
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 account. 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.
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.
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.
Line 12.
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. Previously Taxed E&P in U.S. Dollars
For Part II of Schedule P, the CFC shareholder duplicates the reporting of Part 1 in U.S. dollars.
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.