Demystifying the New IRS Form 5471 Schedule M Used to Report CFC Transactions with Related Parties

Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations) is used by certain U.S. persons who are officers, directors, or shareholders in respect of certain foreign entities that are classified as corporations for U.S. tax purposes. Form 5471 and its schedules are used to satisfy the reporting requirements of Internal Revenue Code Sections 6038 and 6046.

Substantively, Form 5471 backstops various international sections of the Internal Revenue Code, including Sections 901 and 904 (foreign tax credits), Section 951(a) (subpart F income), Section 951A (global intangible low-taxed income or “GILTI”), Section 965 (one-time transition tax on a U.S. shareholder’s deferred foreign income), and Section 482 (transfer pricing). Other forms associated with Form 5471 include Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation), Form 5713 (International Boycott Report), Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund), and Forms 1116 and 1118 (Foreign Tax Credit).

Form 5471 includes 12 schedules. This article discusses the Schedule M of Form 5471. This schedule is used to report transactions between controlled foreign corporations and shareholders or other related persons.

Key Terms for Form 5471

Form 5471 provides for five general categories of filers, numbered 1 through 5. Two of these general categories are subdivided into three subtypes each, with each subtype being a separate filer category as well. The filer category that a taxpayer falls under dictates the schedule or schedules that the taxpayer must include with the form. In order to understand how these filer categories work, it is helpful to review some basic terms.

U.S. Person

Only U.S. persons who own stock in a foreign corporation can have a Form 5471 filing obligation. 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, each as defined in Internal Revenue Code Section 7701(a)(30)(A) through (E). A tax-exempt U.S. entity may have a Form 5471 filing obligation. In addition, an individual who relies on the residency provision of an income tax treaty to reduce his or her U.S. income tax liability (and files Form 8833) remains a U.S. person for purposes of Form 5471. See Treas. Reg. Section 301.7701(b)-7(a)(3). There are some slight modifications to the definition of a U.S. person which will be discussed in more detail below. All of the Form 5471 filer categories apply to U.S. persons.

U.S. Shareholder

Internal Revenue Code Section 951(b) defines a “U.S. shareholder” as a U.S. citizen, resident alien, corporation, partnership, trust, or estate that owns 10 percent or more of the total combined voting power of all classes of voting stock of a foreign corporation, or 10 percent or more of the total value of all the outstanding stock of a foreign corporation. All forms of stock ownership, — i.e., direct, indirect (ownership through intervening entities), and constructive (attribution of ownership from one related party to another) — are considered in applying the 10 percent test.

Controlled Foreign Corporation (“CFC”)

A foreign corporation is a CFC if, on any day during its taxable year, all of its U.S. shareholders, taken together as a group, own more than 50 percent of the combined voting power of all classes of the foreign corporation’s voting stock, or more than 50 percent of the total value of all of the foreign corporation’s outstanding stock. See IRC Section 957(a). Only U.S. persons who constitute U.S. shareholders are considered in applying the 50 percent test. Just as in the case of the 10 percent test for determining whether a U.S. person is a U.S. shareholder, direct, indirect, and constructive ownership of stock are all considered in applying the 50 percent test for CFCs. The term “foreign,” when applied to a corporation, means a corporation that is not domestic — i.e., a corporation that is not incorporated in a U.S. state or the District of Columbia. See IRC Section 7701(a)(5).

Treasury Regulations 301.7701-2(b)(8) provides a list of foreign entities that are conclusively treated as “per se” corporations for U.S. tax purposes. An individual preparing a Form 5471 should be aware that abbreviations in an entity name such as “Ltd.” and “S.A.” do not always stand for “Limited” or “Sociedad Anonima” (or “Societe Anonyme”). The preparer should confirm what the unabbreviated terms are, preferably from a charter or other official document from the relevant jurisdiction. If a foreign entity is not in the list of per se corporations, Treasury Regulations Section 301.7701-3(b)(2) provides that, unless a contrary election is made, the foreign entity will be treated as (1) an association taxable as a corporation if all its members have limited liability, (2) a partnership it it has two or more members (at least one of which does not have limited liability), or (3) a disregarded entity if it has a single owner who does not have limited liability.

Section 965 Specified Foreign Corporation (“SFC”)

An SFC is a foreign corporation that either is a CFC or has at least one U.S. shareholder that is a domestic corporation. See IRC Section 965(e)(1). The term SFC includes not only CFCs, but also entities commonly referred to as “10/50 corporations.” These foreign corporations have at least one U.S. shareholder, but are not CFCs because U.S. shareholders do not collectively own more than 50 percent of the corporation’s stock either by vote or value.

Stock Ownership

For purposes of Form 5471, a U.S. person can own stock in a corporation in three possible ways. First, the person can own the stock “directly.” For example, owning stock in a brokerage account constitutes direct ownership of the stock. Second, the U.S. person can own the stock “indirectly” through an intervening entity, such as a corporation, partnership, estate, or trust, in which the U.S. person owns an interest. In these cases, the stock owned by the intervening entity is typically considered to be owned proportionately by its shareholders, partners, or beneficiaries, as the case may be. For example, if a U.S. person directly owns 40 percent of the stock of a corporation and that corporation, in turn, directly owns 50 percent of the stock of a second corporation, then the U.S. person is considered to own indirectly 20 percent (i.e., 40% × 50%) of the stock of the second corporation. Indirect stock ownership can extend through several layers of intervening entities, where each intervening entity directly owns an interest in the one immediately below it. The third way that a U.S. person can own stock is by “constructively” owning the stock due to a relationship with another person. This relationship most commonly involves family members. For example, if a U.S. citizen mother directly owns 6 percent of a corporation’s stock and her U.S. citizen daughter directly owns 5 percent of the same corporation’s stock, then each of them is considered to own constructively the shares of the other. As a result, the mother and daughter are each considered to own 11 percent of the corporation’s stock. Another less common relationship involves sister entities. This form of constructive ownership (referred to as downward attribution) arises when an individual or entity parent directly or indirectly owns stock in a corporation and, at the same time, owns an interest in another entity. Under downward attribution, the corporation’s stock that the parent owns is attributed downward from the parent to the second entity. As a result, the second entity is considered to own constructively the same stock owned by the parent. Generally, the stock that is owned constructively by one person due to family or downward attribution cannot be further owned constructively by another.

All three kinds of stock ownership apply when determining which Form 5471 filer category or categories a taxpayer falls under, but there are variations among the categories. For example, in Categories 2 and 3, constructive family ownership includes attribution of stock from siblings, grandparents, and nonresident aliens, whereas the other three categories do not allow for these attributions. Categories 1, 4, and 5 define indirect ownership to mean only indirect ownership through foreign intervening entities, and include indirect ownership through intervening U.S. entities as constructive upward attribution. Categories 2 and 3 specifically provide for indirect ownership, but only through entities that are foreign corporations or partnerships, and refer to this type of non-direct ownership as both indirect and constructive ownership. Constructive ownership in the form of downward attribution does not exist in Categories 2 and 3, but exists in Categories 1, 4, and 5. Category 4’s version of downward attribution prohibits attribution of stock from a foreign entity to a U.S. person. Category 1 and 5’s version, however, contains no such prohibition due to the Tax Cuts and Jobs Act of 2017 (the “TCJA”). All these variations, as well as others not described above, will need to be taken into account when preparing a Form 5471.

Filer Categories

Form 5471, together with its applicable schedules, must be completed (to the extent required on the form) and filed by the taxpayer according to the taxpayer’s filer category. What follows is a description of each filer category.

Category 1 Filer

A Category 1 filer is a U.S. shareholder of a foreign corporation that is an SFC at any time during the corporation’s taxable year. However, to be classified as a Category 1 filer, the U.S. shareholder of the SFC must also own the SFC’s stock on the last day of the SFC’s taxable year.

The stock ownership rules applicable to Category 1 (including Categories 1a, 1b, and 1c) are contained in Internal Revenue Code Section 958, which incorporates and modifies the constructive stock ownership rules of Section 318(a). For Category 1 purposes, if a person does not directly own stock, the person can own stock as follows:

• Indirect stock ownership through an intervening entity. The intervening entity (i.e., a corporation, partnership, estate, or trust) can only be a foreign entity. The person, who is to become the indirect owner of stock through the intervening entity, is not required to hold a minimum ownership interest (i.e., stock, partnership interest, or beneficial interest) in the intervening foreign entity.
• Constructive stock ownership from another person.
  • Attribution from family members. A person can only be attributed stock owned by his or her parent, spouse, child, or grandchild. However, no attribution is permitted from a nonresident alien to a U.S. citizen or resident.
  • Upward attribution from entities. The attributing entity can be either a U.S. or foreign entity. However, if the attributing entity is a corporation, the person to whom the stock is to be attributed must own at least 10 percent (by value) of the attributing entity’s stock. Furthermore, if the stock to be attributed upward constitutes more than 50 percent of a corporation’s voting stock, then the stock is deemed to constitute 100% of the corporation’s voting stock when it gets proportionately allocated among the attributing entity’s owners.
  • Downward attribution from persons. The attributing person can be either an individual or entity. However, if the stock is to be attributed downward to a corporation, the attributing person must own at least 50 percent (by value) of that corporation’s stock.

Category 1a, 1b, and 1c Filers

Category 1 is subdivided into Categories 1a, 1b, and 1c. Category 1a is a catchall category and applies to Category 1 filers who do not otherwise fall under either Category 1b or 1c. Categories 1b and 1c were added to Form 5471 as the result of Revenue Procedure 2019-40, which the IRS issued in response to the repeal of provisions in Section 958(b) that previously disapplied the constructive downward attribution rules of Section 318(a)(3) to the extent that they attributed stock owned by a foreign person to a U.S. person.

Categories 1b and 1c specifically apply to those SFCs that are considered to be foreign-controlled for purposes of Form 5471. Such an SFC, referred to herein as a “Foreign-Controlled SFC,” is a foreign corporation that, although classified as an SFC, would not be so classified if the determination were made without applying Section 318(a)(3)’s downward attribution rules so as to consider a U.S. person as owning the stock owned by a foreign person.

A Category 1b filer is a U.S. shareholder who owns, directly or indirectly under Section 958(a) (but not constructively under Section 958(b)), the stock of a Foreign-Controlled SFC and is not related (within the meaning of Section 954(d)(3)) to that Foreign-Controlled SFC. Section 954(d)(3) defines two persons as being “related” to each other in terms of “control,” where one person controls or is controlled by the other, or is controlled by the same person or persons who control the other. Here, control over a corporation means directly or indirectly owning more than 50 percent of the corporation’s stock by either vote or value. A Category 1b filer is typically a shareholder who owns, directly or indirectly, stock in a foreign corporation but is not related to the foreign corporation because the common parent of both the shareholder and the foreign corporation does not control the foreign corporation.

A Category 1c filer is a U.S. shareholder who does not own, either directly or indirectly, the stock of a Foreign-Controlled SFC but is related (within the meaning of Section 954(d)(3)) to that Foreign-Controlled SFC. A Category 1c filer is typically a shareholder that owns the stock of a foreign corporation only because of constructive stock ownership under Section 318(a)(3) and the shareholder is related to the foreign corporation because each of them is under the control of a common parent.

A U.S. shareholder who does not own, either directly or indirectly, the stock of a Foreign-Controlled SFC and is not related (within the meaning of Section 954(d)(3)) to that Foreign-Controlled SFC, is neither a Category 1b nor 1c filer. Such U.S. shareholder is deemed not to fall under the Category 1a catchall and is exempt from the obligation to file Form 5471.

Category 2 Filer

A Category 2 filer is a U.S. person who is an officer or director of a foreign corporation in which there has been a substantial change in its U.S. ownership. A U.S. person can be a Category 2 filer even if the change relates to stock owned by another U.S. person and regardless of whether or not that other U.S. person is an officer or director of the foreign corporation. For Category 2 purposes, a U.S. person is defined as a U.S. citizen, resident alien, corporation, partnership, estate, or trust. However, Category 2 also expands the definition of a U.S. person to include a bona fide Puerto Rico resident, a bona fide possessions resident, and a nonresident alien as to whom a Section 6013(g) or (h) election is in effect (i.e., where a nonresident alien spouse has made an election to be taxed as a U.S. person). In regard to the definition of an officer or director, there is no clear answer as to what constitutes an officer or director for purposes of a Category 2 filer. Treasury Regulations Section 1.6046-1(d) provides that “persons who would qualify by the nature of their functions and ownership in such associations, etc., as officers, directors, or shareholders thereof will be treated as such for purposes of this section without regard to their designations under local law.”

For purposes of Category 2, a substantial change in U.S. ownership in a foreign corporation occurs when any U.S. person (not necessarily the U.S. citizen or resident who is the officer or director) either (1) acquires stock that causes that U.S. person to own a 10 percent block of stock in that foreign corporation (by vote or value) or (2) acquires an additional 10 percent block of stock in that corporation (by vote or value). More precisely, if any U.S. person acquires stock that, when added to any stock previously owned by that U.S. person, causes the U.S. person to own stock meeting the 10 percent 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, however, does not create filing obligations under Category 2 for U.S. officers and directors of that foreign corporation.

The stock ownership rules applicable to Category 2 are contained in Internal Revenue Code Section 6046(c) and Treasury Regulations Section 1.6046-1(i). For Category 2 purposes, if a person does not directly own stock, the person can own stock as follows:

• Constructive stock ownership from another person.
  • Attribution from family members. A person can only be attributed stock owned by his or her brother, sister, spouse, ancestors, and lineal descendants. Attribution from nonresident aliens is permitted.
  • Upward attribution from entities. The attributing entity can be either a foreign corporation or a foreign partnership. The person, who is to become the constructive/indirect owner of stock through the attributing foreign corporation or partnership, is not required to hold a minimum ownership interest (i.e., stock or partnership interest) in the attributing foreign corporation or partnership. By negative implication, there is no attribution of stock from U.S. entities, or from foreign estates or trusts. Nevertheless, stock owned by U.S. entities that are not treated as entities separate from their owners for U.S. income tax purposes (i.e., grantor trusts and disregarded entities) should be attributable to their owners.

Category 3 Filer

A U.S. person who owns stock in a foreign corporation is a Category 3 filer if any one of the following events occurs during the taxable year:

1. The U.S. person acquires stock in the corporation that, when added to any stock already owned by the person, causes the person to own at least 10 percent (by vote or value) of the corporation’s stock.
2. The U.S. person acquires stock that, without regard to any stock already owned by the person, constitutes at least 10 percent (by vote or value) of the corporation’s stock.
3. The U.S. person becomes a U.S. person while owning at least 10 percent (by vote or value) of the corporation’s stock.
4. The U.S. person disposes of sufficient stock in the corporation to reduce the person’s interest to less than 10 percent (by vote or value) of the corporation’s stock.
5. The U.S. person owns at least 10 percent (by vote or value) of the corporation’s stock when the corporation is reorganized.

For Category 3 purposes, a U.S. person is defined as a U.S. citizen, resident alien, corporation, partnership, estate, or trust. However, Category 3 also expands the definition of a U.S. person to include a bona fide Puerto Rico resident, a bona fide possessions resident, and a nonresident alien as to whom a Section 6013(g) or (h) election is in effect (i.e., where a nonresident alien spouse has made an election to be taxed as a U.S. person).

The stock ownership rules applicable to Category 3 are the same as the ones applicable to Category 2, as described above under “Filer Categories–Category 2 Filer.” These rules are contained in Internal Revenue Code Section 6046(c) and Treasury Regulations Section 1.6046-1(i).

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. For Category 4 purposes, a U.S. person is defined as a U.S. citizen, resident alien, corporation, partnership, estate, or trust. However, Category 4 also expands the definition of a U.S. person to include a bona fide Puerto Rico resident, a bona fide possessions resident, and a nonresident alien as to whom a Section 6013(g) or (h) election is in effect (i.e., where a nonresident alien spouse has made an election to be taxed as a U.S. person). See Treas. Reg. Section 1.6038-2(d).

A U.S. person is considered to “control” a foreign corporation for purposes of Category 4 if at any time during the person’s taxable year, such person owns more than 50 percent of the combined voting power of all classes of the foreign corporation’s voting stock, or more than 50 percent of the total value of all of the foreign corporation’s outstanding stock. See IRC Section 6038(e)(2). It is important to note that the concept of control here for Category 4 filers is distinct from the one in the definition of CFC, a term used for Category 1 and Category 5 filers. There, control over a foreign corporation exists when more than 50 percent (by vote or value) of the corporation’s stock is owned by one or more U.S. shareholders, each of whom individually owns at least 10 percent of the corporation’s stock. By contrast, a Category 4 filer is a single U.S. person who individually owns more than 50 percent (by vote or value) of the foreign corporation’s stock.

The stock ownership rules applicable to Category 4 are contained in Internal Revenue Code Section 6038(e)(2), which incorporates and modifies the constructive stock ownership rules of Section 318(a). For Category 4 purposes, if a person does not directly own stock, the person can own stock as follows:

• Constructive stock ownership from another person.
  • Attribution from family members. A person can only be attributed stock owned by his or her parent, spouse, child, or grandchild. Attribution from nonresident aliens is permitted.
  • Upward attribution from entities. The attributing entity can be either a U.S. or foreign entity. However, if the attributing entity is a corporation, the person to whom the stock is to be attributed must own at least 10 percent (by value) of the attributing entity’s stock. Furthermore, because Section 6038(e)(2) defines control for purposes of Category 5 as owning more than 50% (by vote or value) of a corporation’s stock, if a person controls a corporation that, in turn, owns more than 50% (by vote or value) of the stock of a second corporation, then such person will be treated as in control of the second corporation as well.
  • Downward attribution from persons. The attributing person can be either an individual or entity. However, if the stock is to be attributed downward to a corporation, the attributing person must own at least 50 percent (by value) of that corporation’s stock. Furthermore, no downward attribution is allowed if it results in a U.S. person constructively owning stock that is owned by a foreign person (as the attributing person).

Category 5 Filer

A Category 5 filer is a U.S. shareholder of a foreign corporation that is a CFC at any time during the corporation’s taxable year. However, to be classified as a Category 5 filer, the U.S. shareholder of the CFC must also own the CFC’s stock on the last day of the CFC’s taxable year.

The stock ownership rules applicable to Category 5 (including Categories 5a, 5b, and 5c) are the same as the ones applicable to Category 1 (including Categories 1a, 1b, and 1c), as described above under “Filer Categories–Category 1 Filer.” These rules are contained in Internal Revenue Code Section 958, which incorporates and modifies the constructive stock ownership rules of Section 318(a).

Category 5a, 5b, and 5c Filers

Category 5 is subdivided into Categories 5a, 5b, and 5c. Category 5a is a catchall category and applies to Category 5 filers who do not otherwise fall under either Category 5b or 5c. Categories 5b and 5c were added to Form 5471 as the result of Revenue Procedure 2019-40, which the IRS issued in response to the repeal of provisions in Section 958(b) that previously disapplied the constructive downward attribution rules of Section 318(a)(3) to the extent that they attributed stock owned by a foreign person to a U.S. person.

Categories 5b and 5c specifically apply to those CFCs that are considered to be foreign-controlled for purposes of Form 5471. Such a CFC, referred to herein as a “Foreign-Controlled CFC,” is a foreign corporation that, although classified as a CFC, would not be so classified if the determination were made without applying Section 318(a)(3)’s downward attribution rules so as to consider a U.S. person as owning the stock owned by a foreign person.

A Category 5b filer is a U.S. shareholder who owns, directly or indirectly under Section 958(a) (but not constructively under Section 958(b)), the stock of a Foreign-Controlled CFC and is not related (within the meaning of Section 954(d)(3)) to that Foreign-Controlled CFC. Section 954(d)(3) defines two persons as being “related” to each other in terms of “control,” where one person controls or is controlled by the other, or is controlled by the same person or persons who control the other. Here, control over a corporation means directly or indirectly owning more than 50 percent of the corporation’s stock by either vote or value. A Category 5b filer is typically a shareholder who owns, directly or indirectly, stock in a foreign corporation but is not related to the foreign corporation because the common parent of both the shareholder and the foreign corporation does not control the foreign corporation.

A Category 5c filer is a U.S. shareholder who does not own, either directly or indirectly, the stock of a Foreign-Controlled CFC but is related (within the meaning of Section 954(d)(3)) to that Foreign-Controlled CFC. A Category 5c filer is typically a shareholder that owns the stock of a foreign corporation only because of constructive stock ownership under Section 318(a)(3) and the shareholder is related to the foreign corporation because each of them is under the control of a common parent.

A U.S. shareholder who does not own, either directly or indirectly, the stock of a Foreign-Controlled CFC and is not related (within the meaning of Section 954(d)(3)) to that Foreign-Controlled CFC, is neither a Category 5b nor 5c filer. Such U.S. shareholder is deemed not to fall under the Category 5a catchall and is exempt from the obligation to file Form 5471.

Reporting Transactions on Schedule M

Every person described in Category 4 must file Schedule M to report the transactions that occurred during the foreign corporation’s annual accounting period ending with or within the U.S. person’s tax year.

Schedule M categorizes transactions in multiple ways. First, shareholders of a CFC must provide information about the magnitude of both inflows to and outflows from the CFC. Second, CFC shareholders must provide inflows and outflows separately for multiple types of transactions including inventory transfers, royalty payments, etc. Third, the columns of Schedule M separately identify transactions between the CFC and various related entities including the U.S. person filing the return and any domestic corporation or partnership controlled by the U.S. person filing the return. Finally, the regulations of Internal Revenue Code Section 482 should apply to value inflows and outflows of the CFC for purposes of Schedule M reporting.

Columns of Schedule M

Schedule M requires shareholders of CFCs to disclose transactions with related parties such as the individual filing the informational return and other related entities. Each transaction the CFC conducts with a related party must be disclosed by categories stated in each column of the schedule. Schedule M contains six columns numbered (a) through (f). Column (a) describes the transactions being reported by the taxpayer (The categories for Schedule (a) will be discussed in more detail below.

The preparer of Schedule M must enter the totals for each type of translation listed under Column (a) that occurred during the annual accounting period being disclosed on the Form 5471 by the CFC and the persons listed in columns (b) through (f). All amounts must be stated in U.S. dollars translated from functional currency (functional currency refers to the main currency used by a business or unit of a business) at the average exchange rate for the foreign corporation. The preparer must enter the functional currency and the exchange rate used on the third line of the Schedule M.

Columns (b) through (f) are broken down as follows:

(b) U.S. person filing this return

If the CFC entered into a transaction or transactions with the U.S. person filing the Form 5471, the transactions must be listed under column (b). A U.S. person is defined as a U.S. citizen or a U.S. resident under either the “green card” or “substantial presence” tests.

(c) Any domestic corporation or partnership controlled by a U.S. person filing this return

If the CFC entered into a transaction or transactions with a domestic corporation or partnership controlled by a U.S. person, the transactions must be listed under column (c). The directions to Schedule M do not define the terms “any domestic corporation or partnership controlled by a U.S. person.” The definition of a domestic controlled corporation or partnership likely is the same as the definitions provided in Sections 951(b) and 958 of the Internal Revenue Code. The definitions of these code sections are defined below.

(d) Any other foreign corporation or partnership controlled by U.S. person filing this return

If the CFC entered into a transaction or transactions with a foreign corporation or partnership controlled by a U.S. person, the transactions must be listed under column (d). In determining whether a U.S. person meets the definition of a U.S. shareholder and whether a foreign corporation meets the Section 957(a) definition of a CFC, Section 958 applies direct, indirect, and constructive ownership rules to determine stock ownership in the foreign corporation. Stock ownership under all three types of rules counts for purposes of determining whether a foreign corporation or partnership is “controlled.” A CFC or foreign partnership is controlled if more than 50 percent of the combined voting stock or value of the entity is controlled by U.S. persons.

(e) 10% or more U.S. shareholder of controlled foreign corporation (other than the U.S. person filing Form 5471)

If the CFC entered into a transaction or transactions with 10% or more U.S. shareholders of a CFC with an individual who is a 10% shareholder, but not a U.S. person, the transactions must be reported under column (e).

(f) 10% or more U.S. shareholder of any corporation controlled the foreign corporation

If the CFC entered into a transaction or transactions with a 10% or more U.S. shareholder of a CFC, the transactions must be reported under column (f). A U.S. shareholder is a U.S. person who owns, or is considered as owning at least 10 percent of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation. See IRC Section 951(b). In determining whether a person is a 10 percent U.S. shareholder, the Internal Revenue Code looks at direct ownership, indirect ownership, and constructive ownership. Thus, a U.S. person is constructively treated as owning stock in a foreign corporation that is owned by certain entities or individuals related to the U.S. person. For example, if a U.S. person’s father owns 7 percent of a foreign corporation and his U.S. citizen son owns another 5 percent of the same foreign corporation, they will each be considered ten percent U.S. shareholders.

Transactions that Must be Disclosed on Schedule M

Schedule M requires the CFC shareholder or related party to disclose a number of different transactions. Anyone completing Schedule M must understand that the IRS will utilize certain information disclosed on this informational return to ensure that the CFC shareholders and related parties report and pay tax on their actual share of income arising from so-called controlled transactions. To this end, the regulations under Internal Revenue Code Section 482 adopt an arm’s length standard for evaluating the appropriateness of each transaction under the transfer pricing rules. This article will apply these regulations to the relevant questions listed on Schedule M.

Line 1 and 16. Sales of Stock in Trade Inventory/Purchases of Stock in Trade Inventory

Line 1 and 16 of Schedule M asks the CFC filer to value the sale and purchases of sales of stock in trade. Stock in trade refers to any merchandise or equipment kept on hand and used in carrying on a business. It includes the collection of goods, inventories and merchandise, maintained by a business entity for the purpose of using them for processing, making salable goods or for selling to the customers with an intention to make profit from such deals. Since a sale or purchase of stock in trade between a CFC and a shareholder of the CFC or related party is subject to manipulation, the transaction reported on Schedule M must reflect an arm’s length standard for purposes of the sale and purchase of the stock in trade. The reliability of a pricing method is determined by the degree of comparability between the controlled and uncontrolled transactions, as well as the quality of the data and the assumptions used in the analysis.

As a practical matter, comparable transactions often are not readily available for inventory sales between affiliated companies (i.e. related parties or CFC shareholders). As a consequence, the appropriate arm’s length price for the sale or purchase of stock in trade is ambiguous. To establish an arm’s length price for the sale or purchase of stock in trade, the shareholders of a CFC should obtain at least one if not two transactions between unrelated parties to establish an arm’s length range of prices for the sale and purchase of the sales of stock in trade. These transactions can serve as a model for valuing the sale or purchase of stock in trade transactions for Schedule M reporting purposes.

Line 2 and 17. Sales/Purchases of Tangible Property Other Than Stock in Trade

Line 2 and 17 asks the filer to list the sale and purchases of any tangible property. Tangible property includes both personal and real property. In the context of international transactions, tangible gifts typically refer to goods sold in commerce. The sale or purchase of tangible goods should be reported on Schedule M at arm’s length range of prices. Valuing transactions involving tangible property in controlled transactions can be complex. This is because there are typically five specific methods for estimating an arm’s length charge for transfers of tangible property:

1. The comparable uncontrolled price method;

2. The resale price method;
   3. The cost plus method;
   4. The comparable profits method, and:
   5. The profit split method.The filer completing Schedule M may select and apply the method that provides the most reliable estimate of an arm’s length price between the related parties. In addition to the five methods stated above, the filer can use an unspecified method to value the transaction.

   Comparable Uncontrolled Price Method

   The first enumerated method is characterized as the “comparable uncontrolled price method,” referred to as the “CUP” method. The basic approach is to examine comparable sales where the parties are unrelated. These may include sales by a member of the controlled group to an unrelated party, sales by an unrelated party to a member of the controlled group and sales made in which neither party is a member of the controlled group. See Treas. Reg. Section 1.482-3(b).

   Resale Method

   The second is the “resale price method.” Under this approach the price for the controlled transaction is equal to the resale price to an uncontrolled buyer, less an “appropriate gross profit.” The appropriate gross profit is determined by multiplying the applicable resale price by the “gross profit margin” (expressed as a percentage of total revenue derived from sales) earned in comparable uncontrolled transactions. See Treas. Reg. Section 1.482-3(c)(2)(iii). The regulations state that a typical situation where the resale price method may be useful is one “involving the purchase and resale of tangible property in which the reseller has not added substantial value to the tangible goods by physically altering the goods” or through use of an intangible. See Treas. Reg. Section 1.482-3(c)(1).

   Cost Plus Method

   The third is the “cost plus method.” Under this approach the transfer price is generally equal to the cost of production plus an amount determined by the application of a “gross profit markup” to that cost. Under the cost plus method, the arm’s length price is the manufacturing cost incurred by the related manufacturer, increased by the arm’s length profit markup for such manufacturers and adjusted for any material differences that exist between the controlled and uncontrolled transactions. The gross profit realized by independent manufacturers (or related manufacturers) on similar uncontrolled sales provides an estimate of the arm’s length gross profit markup, which is expressed as a percentage of the manufacturing costs. See Treas. Reg. Section 1.482-3(d)(2) and (d)(3)(ii)(C).

   The Comparable Profits Method

   The fourth is the “comparable profits method” (“CPM”). This method determines an arm’s length result based on profit level indicators derived from similarly situated uncontrolled taxpayers. See Treas. Reg. Section 1.482-5(a). The controlled party that has the least complex, readily available and accurate financial data from which to draw a comparison will be the party to whom the test is applied and is called the “tested party.” See Treas. Reg. Section 1.482-5(b)(2)(i). Comparability for these purposes is heavily dependent on resources employed and risks assumed and not necessarily product similarity. Adjustments must be made for all material differences between the tested party and the uncontrolled taxpayers serving as the basis for comparison. Under the CPM, the arm’s length price is calculated by applying a profit level indicator (derived from a comparable taxpayer) to the “financial data related to the tested party’s most narrowly identifiable business activity” which includes the controlled transaction. See Treas. Reg. Section 1.482-5(b)(1). Acceptable profit level indicators (which measure the ratio of profits to either costs incurred or resources employed) include the rate of return on capital employed and financial ratios. See Treas. Reg. Section 1.482-5(b)(2). Other indicators are not precluded from use if they would profit an accurate estimate of profits. The appropriate profit level indicator depends upon the characteristics the tested party and the comparable party share.

   Profit Split Method

The fifth is the “profit split method.” The profit split method evaluates whether the allocation of the combined operating profit attributable to a controlled transaction is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined profit. See Treas. Reg. Section 1.482-6(a). The value of each party’s contributions is to be based upon “the functions performed, risks assumed, and resources employed.” See Treas. Reg. Section 1.482-6(b).

The division can be accomplished in one of two ways: the comparable profit split or the residential profit split. Under the comparable profit split method, the allocation of the combined operating profit between two controlled taxpayers is based on how uncontrolled taxpayers engaged in similar activities under similar circumstances allocate their joint profits. See Treas. Reg. Section 1.482-6(c)(2). Under the residual profit split method, the comparative profits method is used to estimate and allocate an arm’s length profit for the routine contributions made by each controlled taxpayer. Routine contributions ordinarily include contributions of tangible property and services. The residual profit not allocated on the basis of routine functions is then allocated between the two controlled taxpayers on the basis of the relative value of the intangible property contributed by each party.

The Unspecified Method

The sixth is the “unspecified method,” described in Treasury Regulation Section 1.482-3(e)(1). The method selected is to be applied in accordance with Treasury Regulation Section 1.482-1, and should take into account the general principle that all of the “realistic alternatives” should be considered when valuing these transactions.

The regulations describe five methods for judging the arm’s length of the acceptability for the sale of tangible property, along with a sixth category called “unspecified methods.” They include: the comparable uncontrolled price, resale price, cost plus methods, augmented by the comparable profits and the profit split methods, the regulations do not prescribe an order of preference among the alternative methods. The regulations however are explicit in that adjustments must be made to reflect the differences between the controlled transactions and the uncontrolled transactions to which comparisons are being made. Thus, a careful analysis should be made of the regulations and the related party transaction involving the sale or purchase of tangible property to properly reflect the valuation for purposes of Schedule M.

Line 3, and Line 18. Sales/Purchases of Property Rights (patents, trademarks, etc), Rents, Royalties, and License Fees Paid

Line 3 and line 18 asks the filer to disclose the sale and purchase of intellectual property rights such as patents, trademarks, and copyrights. Line 8 asks the filer to disclose the rents, royalties received or paid to a related party. The filer must select and apply the method which provides the most reliable estimate of an arm’s length price. There are typically three specific methods for estimating an arm’s length charge for transfers of intangibles: 1) the comparable uncontrolled transaction method; 2) the comparable profits method; and 3) the profits split method. In addition to the three specified methods, the filer also has the option of using an unspecified method.

Comparable Uncontrolled Transaction Method

The comparable uncontrolled method (“CUT”) is analogous to the CUP method used for transfers of tangible property. Therefore, under the comparable uncontrolled transaction method, the arm’s length charge for the transfer of an intangible is the amount charged for comparable intangibles in transactions between uncontrolled parties, adjusted for any material differences that exist between the controlled and uncontrolled transactions. In order for the intangible involved in the controlled transaction, both intangibles must be used in connection with similar products or processes within the same general industry or market and must have similar profit potential. See Treas. Reg. Section 1.482-4(c)(2)(iii)(B)(1). The comparable uncontrolled transaction method ordinarily is the most reliable method for estimating an arm’s length price if there are only minor differences between the controlled and uncontrolled transactions for which appropriate adjustments can be made.

Comparable Profits Method

The same comparable profits methods used to determine arm’s length prices for transfers of tangible property can be used to determine arm’s length sales prices or royalty/rent rates for transfers of intangible property. The methodology for developing arm’s length profit involved in intangible property should involve the following seven steps:

1. Determine the tested party- the tested party should be the participant in the controlled transaction for which most reliable data regarding comparable companies can be located.

2. Search for comparable companies and obtain their financial data- the key factors in assessing the comparability of the tested party to comparable companies are the resources employed and the risks involved.

3. Select a profit indicator (“PLI”)- Examples of PLIs that can be used include the ratio of operating profit to operating assets, the ratio of operating profit to sales, and the ratio of gross profit to operating expenses. This should be done as a multiyear analysis.

4. Develop an Arm’s Length Range of PLIs- the arm’s length range of PLIs is the interquartile range (middle 50 percentile range) of comparable companies. The interquartile range is the range from 25 percent to 75 percentile.

5. Develop an arm’s length range of comparable operating profits- to construct an arm’s length range of comparable operating profits, the selected PLI for the comparable companies in the arm’s length range is applied to the tested party’s most narrowly identified business activity for which data incorporating the controlled transaction is available.

6. Determine if an adjustment must be made- an adjustment is required if the tested party’s reported profit lies outside the arm’s length range of comparable operating profits developed in step 5.

7. Adjust the transfer price for the controlled transaction- if the tested party’s reported profit lies outside the arm’s length range, an adjustment is made equal to the difference between the tested party’s reported profit and the goal arm’s length profit.

Profit Split Method

See the discussion of the split profit method above under “tangible property.”

Although the transfer of intangible property between related parties such as patents, trademarks, and trade secrets can achieved relatively simply by the execution of documents of sale or license coupled with the provision of information, as the foregoing materials indicate, the application of arm’s length standards to these transactions can invoke a very complex analysis. The regulations provide a number of different methods for purposes of determining an arm’s length standard. The regulations provide for the “comparable profits method” and “profit split methods,” which apply a standard of comparable transactions. The CUT method is applied when there are transactions involving the same or comparable intangible properties. Differences in contractual terms or economic conditions present when the transactions are effected may require adjustments. Both comparables must be used in connection with similar products or processes within the same general industry or market and have a similar profit potential.

Anytime intangible property is transferred between related parties, a careful analysis of the regulations must be done to assure the proper valuation of such a transaction for purposes of Schedule M disclosures.

Line 4 and Line 19. Platform Contributions

Line 4 asks the filer to disclose the sale or purchase of platform contributions. A platform contribution is any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity that is reasonably anticipated to contribute to developing cost shared intangibles. Platform contributions include the goodwill of a controlled participant. The exact method of valuing platform contributions is currently unsettled.The IRS has taken the position that the arm’s length standard requires that the specific attributes of the buyer and seller be taken into consideration. The Tax Court and the Ninth Circuit Court adopted the so-called “behavioral” rule, meaning that the arm’s length standard looks to the behavior of the uncontrolled taxpayer to test the controlled transaction for purposes of reporting the transaction.

Schedule M, platform contribution transaction payments received and paid by the CFC (without giving effect to any netting payments due and owed) are reported on Line 4 and Line 19. The CFC shareholder is required to complete both lines only if the CFC provides a platform contribution to other controlled participants and is required to make platform contribution transaction payments to other controlled participants that provide a platform contribution to other cost sharing arrangement participants.

Line 5 and  Line 20. Cost Sharing Transaction Payments Received

Lines 5 and 20 require the filer to disclose cost sharing transaction payments received and paid. Under Treasury Regulation Section 1.482-7, an arrangement called cost sharing is provided as a basic alternative to arm’s length royalty arrangements between related parties with respect to intangibles. In general, a cost sharing arrangement is an agreement between two or more persons to share the costs and risks of research and development as they are incurred in exchange for a specified interest in any intangible property that is developed. Because each participant receives rights to any intangibles developed under the arrangement, no royalties are payable by the participants for exploiting their rights to such intangibles.

The filer is required to complete Line 5 only if the CFC itself incurred intangible development costs. If the CFC does not itself incur intangible development costs, then it should only report cost sharing transaction payments made on Line 20.

Line 6. Compensation Received and Paid

Line 6 asks the filer to value services received and services that were paid out to related parties. An arm’s length fee generally must be charged if one controlled entity performs services for the benefit of, or on behalf of, another controlled entity. See Treas. Reg. Section 1.482-2(b)(2). This valuation is not available if the service provided is an integral part of the business activities of the service provider or recipient in the following situations:

1. The service provider or recipient is engaged in the business of rendering similar services to unrelated parties.

2. A principal activity of the service provider is providing such services to related parties.

3. The service provider is peculiarly capable of rendering the service and such services are a principal element in the operations of the recipient, or

4. The recipient receives a substantial amount of services from affiliates during the year.

An exception also applies to services performed by a parent corporation for one of its subsidiaries, where the parent’s services merely duplicate those performed by the subsidiary. A parent CFC need not charge the subsidiary for those services if they are undertaken for the CFC parent’s benefit in overseeing its investment rather than for the subsidiary’s benefit. See Treas. Reg. Section 1.482-2(b)(2)(ii).

Line 7 and Line 22. Commissions Received and Paid

Line 7 and Line 22 requires the filer to disclose the amount of commissions paid and received. The valuation of commissions requires that the amount charged and received be equivalent to those that would have been charged between independent parties in the same circumstances.

Line 8 and Line 23. Rents, Royalties, and license Fees

Line 8 and Line 23 requests the filer to disclose payments received and paid for rents, royalties, and license fees. A payment made for the use of tangible or intangible property is classified rent. A payment made for the right to use an asset or property over time is considered royalties. A payment made for the right to use an asset or property for a specific period of time can be classified as a license fee. The valuation of rents, royalties, and license fees requires that the amount charged and received be equivalent to those that would have been charged between independent parties in the same circumstances.

Line 9 and Line 24. Hybrid Dividends Received and Paid

Line 9 and Line 24 requires the filer to report Section 245A(e)(2) hybrid dividends received and paid. With respect to Section 245A(e), this provision is designed to prevent double non-taxation (involving two countries) by disallowing a 100% dividend received deduction for dividends received from a CFC by a U.S. shareholder, or mandating subpart F inclusions for dividends received from a CFC by another CFC, if there is a corresponding deduction or other tax benefit in the foreign country. A hybrid dividend refers to a dividend that the U.S. and foreign tax law classify differently for tax purposes. The filer must report the sum of tiered hybrid dividends received by the foreign corporation during its tax year on Line 9. On Line 24, the filer should report the sum of the hybrid dividends or tiered hybrid dividends paid by the foreign corporation during its taxable year.

Line 10 and Line 25. Dividends Received (exclude hybrid dividends)

Line 10 and Line 25 require the filer to disclose dividends (excluding hybrid dividends) received or paid not previously taxed under subpart F in the current year or in any prior year.

Line 11 and 26. Interest Received

Lines 11 and 26 ask the filer to disclose interest received. Controlled entities generally must charge each other an arm’s length rate of interest on any intercompany loans and advances. See Treas. Reg. Section 1.482-2(a)(1)(i). There is an exception, however, for intercompany trade receivables, which are debts that arise in the ordinary course of business and are not evidenced by a written agreement requiring the payment of interest.

Intercompany debt other than a trade receivable generally must bear an arm’s length interest charge. An interest will generally satisfy the arm’s length standard if it is not less than 100 percent and not more than 130 percent of the applicable federal interest rate on debt of comparable maturity. See Treas. Reg. Section 1.482-2(a)(2)(iii)(B).

Related party interest should be disclosed on Line 11 and Line 26.

Line 12 and 27. Premiums Received for Insurance or Reinsurance

Line 12 and Line 27 requires the filer to disclose payments received and paid for reinsurance. CFC companies enter into insurance and reinsurance contracts to protect against loss and other business reasons. These contracts must be judged under the arm’s length rule. Under this approach, a premium is considered appropriate if it is within a range of prices that would be charged by independent parties at arm’s length. These prices must be determined by the most reliable measures. Methods that are applicable to intergroup insurance and reinsurance contracts include: 1) Comparable Uncontrolled Prices (“CUP”); 2) Broker quotes; and 3) Actuarial valuations.

Premiums or reinsurance received from related parties should be reported on Line 12 and Line 27.

Lines 13 and 28. Loan Guarantee Fees Received

Lines 13 and 28 require the filer to disclose loan guarantee fees received on Line 13 and loan guarantee fees paid on Line 28. A loan guarantee fee is a fee paid to protect the lender from losses if a borrower defaults on a loan. A “transfer price” (as provided under Section 482 of the Internal Revenue Code) must be computed if the transaction is between controlled parties.

Lines 14 and 29. Other Amounts Received

The filer reports “other amounts received” on Line 14 and “other amounts paid” on Line 29. If an amount is entered on Line 14, the filer must attach a statement that includes the following information. Column (a) of the attached statement should provide a description of the type of other amounts received during the annual accounting period. Column (b) through (f) should provide the dollar amounts of the specified other amounts received during the annual accounting period by the foreign corporation from the persons listed in the headings for column (b) through (f)). The attached statement must also include a “total” line that ties into the amounts reported in each column of Line 14.

If an amount is entered on Line 29, the filer must attach a statement that includes the following information. Column (a) of the attached statement should provide a description of the type of other amount paid during the annual period. Columns (b) through (f) should provide dollar amounts of the specified other amounts paid during the annual accounting period by the foreign corporation to the persons listed in the headings for columns (b) through (f). The attached statement must include a “totals” line that ties into the amounts reported in each column of Line 29.

Line 15. Add Lines 1 through 14

The filer adds lines 1 through 14.

Line 21. Compensation Paid for Technical, Managerial, Engineering, Construction, or Other Services

The filer reports compensation paid for technical, managerial, engineering, construction, or other services on Line 21 for each applicable column of the schedule. The valuation of the technical, managerial, engineering, construction, and other services requires that the amount charged and received be equivalent to those that would have been charged between independent parties in the same circumstances.

Line 31. Accounts Payable

The filer reports on Line 31 and Line 33 the largest aggregate outstanding accounts received and payable balances during the year with related parties. The filer should report only accounts received or payable arising in connection with the provision of services or the sale or processing of property that the foreign corporation’s books net the accounts payable against the receivable as payment of the accounts receivable.

Lines 32. Amounts Borrowed

The filer should report on Line 32 the largest outstanding balances during the year of gross amounts borrowed from, and gross amounts loaned to related parties. The filer should not report aggregate cash flows, year-end loan balances, average balances, or net balances. The filer should also not include account receivables or payable balance arising in connection with the provision of services or the sale or processing of property if the amount of such balance does not, at any time during the year, exceed what is ordinary and necessary to carry on the trade or business. Any outstanding balance from these transactions should be reported on Schedule F of the Form 5471 or possibility on Lines 31 and 32 of this schedule.

Line 33. Accounts Payable and Accounts Received

Line 27 and Line 29 require the filer to report accounts payable and accounts received. According to the instructions of Schedule M, the CFC shareholder must report the largest aggregate outstanding accounts receivable and payable balances during the year with any related corporation or partnership. Only accounts receivable arising in connection with the provision of services or the sale of processing of property. Only net accounts receivables and payables to the extent that the CFC’s books net the accounts payable against the receivables as payments of the accounts receivables.

Line 34. Amounts Loaned

For Line 34, the filer should disclose the amounts borrowed and loaned by the CFC. Reporting is not limited to the lending of money. Transactions between related parties involving the rental of tangible property may need to be disclosed on Lines 14 and 29. The regulations provide that the application of the arm’s length standard to rental arrangements require a comparison of rental agreements with independent parties “under similar circumstances considering the period and location of the use, the owner’s investment in the property or rent paid for the property, expenses of maintaining the property, the type of property involved, its condition, and all other relevant facts. See Treas. Reg. Section 1.482-2(c)(2)(i).

The filer should report on these lines the largest outstanding balances during the year of gross amounts borrowed from, and gross amounts loaned to, related parties that are corporations or partnerships. The instructions also say do not include an account receivable or payable balance arising in connection with the provision of services or the sale or processing of property if the amount of such balance does not, at any time during the tax year, exceed what is ordinary and necessary to carry one the trade or business.

Conclusion

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.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & 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 tax professionals.

Anthony 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 [email protected].

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.