By Anthony Diosdi
Schedule J 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 J of Form 5471 for the 2018 tax year. The following columns or categories were added to Schedule J:
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 J was revised again. This article will take a deep dive into each column and line of 2020 Schedule J of the Form 5471.
Who Must Complete the Form 5471 Schedule J
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 J 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 J to their Form 5471.
Lines a and b
Schedule J 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 provided by the instructions to Schedule J:
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- Accumulated E&P of Controlled Foreign Corporation
U.S.
Check the Box if Person Filing Return Does Not Have all U.S. Shareholders’ Information to Complete an Amount in Column (e)
After completing Lines a and b, the preparer will move onto Part 1 of Schedule J. The first question asks the preparer to “check the box if [the] person filing [the] return does not have all U.S. Shareholders’ information to complete columns (e)(ii)-(e)(iv) and (e)(vii)-(ix).” Anyone preparing Schedule J must understand checking this box will likely invite an IRS audit. Thus, the preparer of the J should do everything possible to obtain all the CFC books and records needed to accurately prepare the Schedule J.
The Importance of Categorizing Accumulated E&P of a CFC
As its name suggests, Part 1 of Schedule J tracks the accumulated E&P of a CFC. By the way of background, where the E&P of a CFC consists in whole or in part of previously taxed earnings and profits (“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 Part 1 of Schedule J. 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 J. 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 walk through the columns of Part 1 for Schedule J.
Part 1 Columns
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 unit’s activities” is “conducted and which is used by such unit in keeping its books and records.” See IRC Section 985(b)(1)(B).
Column (a)
Column (a) asks for a CFC’s opening balance, current year additions and subtractions, and the closing balance in the foreign corporation’s E&P described in Section 959(c)(3) must be disclosed. In general, this is E&P of the foreign corporation which has not been included in gross income of a U.S. person under Section 951(a)(1). Thus, any post 2017 E&P that has not been taxed which is classified as a Section 959(c)(3) balance, that E&P should be reported under column (a).
Column (b)
Column (b) requires the preparer to report undistributed post 1986 and pre-2018 Section 959(c)(3) balances. This is the opening balance, current year additions and subtractions, and the closing balance in a CFC’s post 1986 undistributed earnings pool. 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). 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 simple example for 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
In column (c), the preparer should report pre-1987 E&P not previously taxed Section 959(c)(3) balances. In order to correctly report Section 959(c)(3) pre-1987 E&P accumulated earnings, it is necessary to understand how earnings and profits of a CFC were determined prior to 1987. 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)
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 J 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 J reporting purposes, the hovering deficit in 2018 is 50u and suspended foreign taxes associated with the hovering deficit is $5.
Column (e)(i)
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) must be stated under Column (e)(i).
Column (e)(ii)
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)
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)
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)
A CFC shareholder will use Column (e)(v) to report PTEPs attributable to reclassification Section 245A(d) PTEP under Section 959(c)(1).
Prior to the 2017 Tax Cuts and Jobs Act, dividends from foreign corporations out of foreign earnings that had not been previously taxed were usually taxed to the shareholder. 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 should be disclosed under Column (e)(v).
Column (e)(vi)
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)
A CFC shareholder will use Column (e)(viii) to report PTEPs attributable to Section 965(b) classified under Section 959(c)(2).
Column (e)(viii)
A CFC shareholder will use Column (e)(viii) to report PTEPs attributable to Section 951A classified under Section 959(c)(2).
Column (e)(ix)
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)
A CFC shareholder will use Column (e)(x) 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
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 J.
Line 1b.
Line 1b states if there is a difference between last year’s ending balance on Schedule J 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. A preparer must not include adjustments required to be reported on line 6 or 12.
Line 2a.
Line 2a asks the preparer to disclose unsuspended taxes under Section 909 of the Internal Revenue Code. In order to disclose the unsuspended taxes on Line 2a, the CFC have taken into account the related income. 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 or person 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 US tax principles, resulting in a separation or “splitting” of foreign income to which the taxes relate. In some cases, this “splitting” can result in foreign tax credits following up to an individual without the associated income being subject to US tax. Congress enacted Internal Revenue Code Section 909 for this situation. Under Internal Revenue Code 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 US tax purposes before the tax year in which the related income is taken into account by the CFC.
The preparer should disclose on line 2a reductions for taxes under the appropriate column that have become unsuspended as a result of the anti-splitter rule. In other words, if the CFC took the foreign source income into account for US tax purposes, the associated foreign tax liability may become eligible for a foreign tax.
Line 2b. Taxes Suspended Under the Anti-Splitter Rules
The CFC shareholder should disclose on line 2b foreign taxes suspended as a result of the anti-splitter rule. One example of such a situation is a “hybrid instrument splitter arrangement,” which involves a U.S. hybrid equity instrument that is treated as equity under US law but as debt for foreign purposes, which permits a deduction for foreign purposes for interest expense but not a corresponding taxable interest payment in the US. Another splitter arrangement is a “reverse hybrid splitter arrangement,” in which an entity that is a corporation for US purposes is treated as a fiscally transparent entity or a branch under the laws of the foreign country imposing the tax.
Line 3.
For line 3, the CFC shareholder must state the current year E&P from line 5c of Schedule H of Form 5471.
Line 4.
For Line 4, the CFC shareholder should report as a positive number E&P attributable to previous taxed income distributions from lower-tier foreign corporations. The E&P of a CFC attributable to amounts which are, or have been, included in the gross income of a U.S. shareholder under Section 951(a), are not, when distributed through a chain of ownership described in Section 958(a), also included in the gross income of another CFC. (Under Section 958(a), stock owned directly or indirectly by or for a foreign corporation, foreign partnership, foreign trust or foreign estate is considered as being owned proportionately by its shareholders, partners or beneficiaries. Stock considered as owned is treated as actually owned for purposes of applying the direct and indirect ownership rules).
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 attach a statement detailing the nature and amount of any adjustments not accounted for in the E&P determined before reduction for reductions for distributions. See Illustration 4 for an example (taken from the IRS instructions for the 2019 Schedule J) of an adjustment on Line 6 regarding a distribution of a PTEP from a lower-tier foreign corporation.
Illustration 4.
Domestic Corporation, a US shareholder, wholly owns the only class of stock of CFC1, in turn, wholly owns the only class of stock of CFC 2, 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 US 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 related to previously taxed subpart F income. Domestic Corporation reports on CFC2’s Form 5471, Schedule J, line 3, as a positive number, the $40 PTEP distribution. Domestic Corporation reports on line 6, on a column (e) a negative number of $4 on the PTEP distribution.
Line 7.
Line 7 asks the preparer to enter on Line 7 E&P as of the close of the tax year before actual distributions or inclusions under Section 951(a)(1) or Section 951A during the year. For dividends paid by certain foreign corporations in US tax years beginning before January 1, 2018, this number in column (b) generally is the denominator of the deemed paid credit fraction under Former Section 902(c)(1) used for foreign tax credit purposes.
Line 8.
Line 8 asks the preparer to enter amounts included in gross income of the U.S. shareholder(s) under Section 951(a)(1)(A) or Section 951A with respect to the CFC.
Line 9.
Line 9 asks the preparer to report actual distributions as negative numbers.
Line 10.
Line 10 asks the preparer to use line 10 to report reclassifications of Section 959(c)(2) PTEP in columns (e)(i) through (e)(x) to Section 959(c)(1) PTEP in columns (e)(i) through 9(e)(x). A potential Section 951(a)(1)(B) inclusion results in a reclassification of Section 959(c)(2) PTEP before reclassification out of the Section 959(c)(3) E&P balance. The amounts reclassified are reported as negative numbers in the appropriate column (e).
Line 11.
Line 11 asks the preparer to use this line to report E&P not previously taxed, which is treated as earnings invested in U.S. property and therefore, reclassified as Section 959(c)(1) PTI (column (e)(i)). The amounts reclassified are reported as negative numbers in columns (a) through (d) and positive numbers in the appropriate column (e).
Line 12.
Line 12 asks the preparer to attach a statement detailing the nature and amount of any adjustments in E&P not accounted for on lines 8 through 11.
Line 13.
Line 13 asks the preparer to list any hovering deficit offset included in column (d) is reported as a positive number. The same amount entered in column (d) is reported as a negative number in line 13 of column (a) or (b), as appropriate.
Line 14.
For Line 14, the CFC shareholder must state the balance at the beginning of the next year.
Part II Nonpreviously Taxed E&P Subject to Recapture as Subpart F Income
Part II of Schedule J asks the CFC shareholder to disclose nonpreviously taxed E&P subject to recapture as subpart F income in functional currency. In order to complete Part II of Schedule J, the preparer must understand how subpart F income is calculated. The Internal Revenue Code allocates a pro rata share of subpart F income as a constructive dividend. Section 952(c)(1)(A) limits a CFC’s subpart F income to its current E&P. in other words, a corporation’s subpart F income for a tax year is reduced to the amount of its current E&P, thus reducing the amount of the current inclusions to its U.S. shareholders under Section 951(a)(1)(A). Under this rule, a CFC current losses from an activity that would not generate subpart F may, in certain limited circumstances, reduce its subpart F income.
If a CFC has an excess of current earnings and profits over subpart F income, Section 952(c)(2) may recharacterize that excess of current E&P over subpart F income, Section 952(c)(2) may recharacterize that excess as subpart F income to the extent of the prior reductions in subpart F income. Consequently, the US shareholder may have additional current inclusions of income under Section 951(a) in a later year as a result of this recharacterization rule. See illustration 5 below.
Illustration 5.
DC, a US corporation, owns all of the stock of FC, a foreign corporation that is a controlled foreign corporation. During the current year, FC has foreign base company sales income of $100 (determined under Section 954), but its current earnings and profits (as calculated under Section 964) is $80. Thus, Section 952(c)(1)(A) limits FC’s subpart F income to $80 for year 1. Thus, Section 952(c)(1)(A) limits FC’s subpart F income to $80 for year 1 and DC would include the $80 in gross income under Section 951(a)(1)(A).
In year 2, FC has foreign base company sales income of $75 (determined under Section 954) and its current earnings and profits are $85. Under the recharacterization rule in Section 952(c)(2), the $10 excess of current earnings and profits of $85 over the subpart F income of $75 is recharacterized as subpart F income. Thus, FC is treated as having subpart F income of $85 and DC must include the $85 in gross income under Section 951(a)(1)(A).
In year 3, FC has foreign base company sales income of $50 (determined under Section 954) and its current earnings and profits are $80. Under the recharacterization rule in Section 952(c)(2), only $10 of the $30 excess of current earnings and profits of $80 over the subpart F income of $50 is recharacterized as subpart income. This is because the total amount recaputed under Section 952(c)(2) ($10 in year 2 and $10 in year 3) cannot exceed the reduction of subpart F income in year 1 by reason of the limit in Section 952(c)(1)(A) (i.e., $20).
Accumulated deficits in a CFC’s E&P from prior years generally do not reduce its subpart F income for the current tax year, except to the limited extent provided in Section 952(c)(1)(B). Moreover, a deficit of one CFC generally may not be used to reduce the subpart F income of a related CFC. Congress enacted these rules to prevent taxpayers sheltering passive investment income from US tax by moving the passive investments into a CFC with prior deficits. Congress also wanted to restrict loss trafficking be preventing deficits in E&P incurred by a foreign corporation before its acquisition by a US corporation from sheltering post-acquisition subpart F income of the foreign corporation from tax and by preventing a CFC from reducing its subpart F income with deficits of related CFCs attributable to different activities. See Staff of Joint Comm. on Tax’n, 100th Cong., 1st Sess, General Explanation of the Tax Reform Act of 1986, at 972 (1987).
Part II of Schedule J requires CFC shareholders disclose the CFC’s E&P in functional currency and enter any Section 952(c)(2) subpart F recapture amounts.
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 CFC, 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.