By Anthony Diosdi
Schedule J of Form 5471 tracks the earnings and profits (“E&P”) of a controlled foreign corporation (“CFC”) in its functional currency. 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. For the 2021 tax year, Schedule J was revised. This article will take a deep dive into each column and line of 2021 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:
U.S. person: A U.S. person is generally a citizen or resident of the United States, a domestic partnership, a domestic corporation, or a domestic trust or estate. A tax-exempt U.S. entity may have a Form 5471 filing obligation.
U.S. Shareholder: A U.S. shareholder is a U.S. person who owns (directly, indirectly, or constructively, within the meaning of of Section 958(a) and Section 958(b)), 10% or more of either the total combined voting power of all classes of voting stock of a foreign corporation or the value of all the outstanding shares of a foreign corporation.
Controlled foreign corporation (CFC): A CFC is a foreign corporation with U.S. shareholders that own (directly, indirectly, or constructively, within the meaning of Section 958(a) and 958(b)) on any day of its taxable year, more than 50% of either 1) the total combined voting power of all classes of its voting stock, or 2) the total value of its stock.
Section 965 Specified Foreign Corporation (SFC): A CFC, or any foreign corporation with one or more 10% domestic corporation shareholders. Passive foreign investment companies or (“PFICs”) are not included in this definition.
Category 1 Filer
A Category 1 filer is a U.S. shareholder of a SFC at any time during any taxable year of the SFC who owned that stock on the last day in that year on which it was an SFC. A foreign corporation is an SFC if it is either a CFC or a foreign corporation with at least one corporate U.S. shareholder.
Category 2 Filer
A Category 2 filer is a U.S. citizen or resident who is an officer or director of a foreign corporation in which there has been a change in substantial U.S. ownership – even if the change relates to stock owned by a U.S. person who is not an officer or director. A substantial change in U.S. ownership is when any U.S. person (not necessarily the U.S. citizen or resident who is the officer or director) acquires stock that causes him or her to own a 10% block, or acquires an additional 10% block, of stock in that corporation. More precisely, if any U.S. person acquires stock, which, when added to any stock previously owned, causes him or her to own stock meeting the 10% stock ownership requirement, the U.S. officers and directors of that foreign corporation must report. A disposition of shares in a foreign corporation by a U.S. person does not create filing obligations under Category 2 for U.S. officers and directors. Stock ownership is a vote or value test.
Category 3 Filer
A U.S. person is a Category 3 filer with respect to a foreign corporation for a year if the U.S. person does any of the following during the U.S. person’s year:
1. Acquires stock in the corporation, which, when added to any stock owned on the acquisition date, meets the Category 2 filer 10% stock ownership requirement.
2. Acquires additional stock that meets the 10% stock ownership requirement.
3. Becomes a U.S. person while meeting the 10% stock ownership requirement.
4. Disposes of sufficient stock in the corporation to reduce his or her interest to less than 10% stock ownership requirement.
5. Meets the 10% stock ownership requirement with respect to the corporation at a time when the corporation is reorganized.
Stock ownership is a vote or value test. Constructive ownership includes certain family members, such as brothers or sisters, spouse, ancestors, and lineal descendants.
Category 4 Filer
A U.S. person is a Category 4 filer with respect to a foreign corporation for a taxable year if the U.S. person controls the foreign corporation. A U.S. person is considered to control a foreign corporation if at any time during the person’s taxable year, such person owns: 1) stock possessing more than 50% of the total combined voting power of all classes of stock entitled to vote; or 2) more than 50% of the total value of shares of all stock of the foreign corporation.
For Category 4 purposes, U.S. persons include those individuals who make a Section 6013(g) or (h) election to be treated as resident aliens of the United States for income tax purposes.
The constructive ownership rules of Section 318 are applied, with few modifications, to determine if the U.S. person “controls” the foreign corporation.
Category 5 Filer
A Person is a Category 5 filer if the person: 1) is a U.S. shareholder of a CFC at any time during the CFC’s taxable year; and 2) owns stock of the foreign corporation on the last day in the year in which that corporation is a CFC. For category 5 purposes, constructive ownership is determined under Section 318 as modified by Section 958(b). Pursuant to Section 958(b), there is no attribution from a nonresident alien relative.
Categories 1 and 5 have been expanded to 1a, 1b, 1c, 5a, 5b, and 5c in order to separate those filers who are under some relief and may not need to file the same schedules.
1a- Category 1 filer who is not defined in 1b or 1c. This means a greater than 50% owner of the SFC.
1b- Unrelated Section 958(a) U.S. shareholder. This means an unrelated person would not control (more than 50% vote or value) the SFC or be controlled by the same person which controls the SFC.
1c- Related constructive U.S. shareholder- This means an entity controlled by (more than 50% vote or value) the same person which controls the SFC and files only due to this downward attribution.
5a- Category 5 filer who is not defined in 5b or 5c – This means a greater than 50% owner of the CFC.
5b- Unrelated Section 958(a) U.S. shareholder- This means an unrelated person would not control (more than 50% vote or value) the CFC or be controlled by the same person which controls the CFC.
5c- Related constructive U.S. shareholder- This Means an entity controlled by (more than 50% vote or value) the same person which controls the CFC and files only due to this downward attribution.
These new categories will distinguish those 5471 filers who only need to file a Form 5471 due to downward attribution caused by the repeal of Section 958(b)(4) and will therefore not be required to attach certain schedules to their Form 5471s.
CFC shareholders that are classified as Category 1a, Category 4, and Category 5a filers must complete and attach Schedule J to their Form 5471.
Name of Person Filing Form 5471
The name of the person filing Form 5471 is generally the name of the U.S. person described in the applicable category or categories of filers. However, in the case of consolidated returns, the name of the U.S. parent in the field for “Name of person filing 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.
There is a new code “TOTAL” for the 2021 tax year that is required for Schedule J filers if a foreign corporation has more than one category of income. In this case, the filer must complete and file a Schedule J using code “TOTAL” that aggregates all amounts listed each line and column in Part 1 of all other Schedule J. In addition, a separate Schedule J should not be completed for SEction 951A category. SEction 951A PTEP that is in the Section 951A category should be reported on the general category Schedule J.
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
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
Where the E&P of a CFC consists in whole or in part of previously tax earning and profits (“PTEP”), special rules under Section 959 apply in determining the ordering and taxation of distributions of such PTEP. Amounts included in the gross income of a U.S. shareholder as GILTI or subpart F income are not included in gross income again when such amounts are distributed to the shareholder, directly, indirectly, or through a chain or ownership. A PTEP distribution is generally allocated in the following order: 1) PTEP attributable to investments in U.S. property under Section 959(c)(1); 2) PTEP attributable to subpart F income under Section 959(c)(2); and (3) general current and accumulated E&P under Section 959(c)(3). For Section 959 purposes, a distribution is generally attributable to E&P according to the “last in first out” method (“LIFO”).
On November 28, 2018, the Department of Treasury and the IRS released proposed regulations related to the determination of the foreign tax credit (the Proposed Regulations). Under the Proposed Regulations, CFCs are required to establish an annual account for PTEP for each of the Section 904 baskets. Within each account, a CFC is required to assign a PTEP to one of ten different PTEP groups in each of the relevant Section 904 basket based on the U.S. shareholder’s underlying income inclusion, while also taking into account PTEP reclassifications as a result of a Section 956 inclusion.
Under the proposed regulations, PTEP taxes are as follows: 1) foreign taxes deemed paid by the CFC under Internal Revenue Code Section 960(a) for a current year income inclusion in a PTEP group; 2) the foreign income taxes paid or accrued by a CFC as a result of a Section 959(b) distribution that was allocated and apportioned to a PTEP group; and 3) for a reclassified PTEP group of foreign income taxes that were paid, accrued, or deemed paid for an amount that was initially included in a Section 959(c)(2) PTEP group which was reclassified as a Section 959(c)(1) PTEP group. PTEP group taxes are reduced by the amount of foreign taxes in that particular group paid by the U.S. shareholder under Section 960(b)(1) or by another CFC under Section 960(b)(2) that have been reclassified to a Section 959(c)(1) PTEP.
Under the proposed regulations, a CFC’s current year taxes are associated with a PTEP group for Section 960(b) purposes only if the receipt of Section 959(b) distribution causes an increase in a PTEP group. The increased PTEP group is treated as an income group to which current-year taxes are imposed solely by reason of the Section 959(b) distribution. Taxes that are allocated and apportioned to a PTEP group by reason of a CFC’s receipt of Section 959 distribution are allocated and apportioned to the PTEP group under Treasury Regulation Regulation 1.904-6 principles.
Section 960- Deemed Paid Credits on Distributions of PTEP
For any distributions of PTEP, the ordering rule determines the type of PTEP that is distributed. Such determination is particularly important for purposes of determining the creditability of any foreign taxes that are imposed by the CFC’s country on the PTEO distributions.
Prior to the enactment of the TCJA, former Internal Revenue Code Sections 902 and 960(a)(1) permitted a corporate U.S. CFC shareholder to claim a credit for foreign taxes paid by a CFC when the related income was either distributed to the shareholder as a dividend or included in the shareholder’s income as a subpart F inclusion. This would result in the amount of paid foreign taxes based on multi-year “pools” of E&P, with the shareholder generally deemed to have paid the same proportion of the CFC’s post-1986 foreign income taxes as the amount of the dividend or subpart F inclusion as it related to the CFC’s post-1986 undistributed earnings.
TCJA repealed Section 902 and modified Internal Revenue Code Sections 904 and 960. TCJA eliminated the multi-year pooling system and introduced a “properly attributable standard” for the purposes of crediting foreign taxes. Under Section 960(a) and (b), a corporate U.S. shareholder can claim a deemed paid credit for foreign income taxes that are properly attributable to current subpart F and GILTI inclusions. In addition, under Section 960(b), a CFC shareholder is deemed to have paid foreign income taxes that are properly attributable to distributions of PTEP received from a first-tier CFC or from a lower-tier CFC.
Treasury and the IRS determined that adherence to Treasury Regulation 1.904-6 created the need to track and account for several new groups of PTEP because Section 959(c)(2) PTEP (and related deemed paid foreign tax credits) may arise by reason of income inclusions under Sections 951(a)(1)(A), 245A(e)(2), Section 951A(f)(1), 959(E), 964(e)(4), and 965(a), or by reason of the application of Section 965(b)(4)(A). Also, because Section 959(c)(c)(2) PTEP may be reclassified as Section 959(c)(1) PTEP as a result of Sections 956 and 959(a)(2), PTEP groups for Section 959(c)(1) PTEP must be maintained. Finally, PTEP subaccounts must be maintained for each Section 904 foreign tax credit category. See Curtail U.S. PTEP Reporting Complexity: Know Your P’s and Q’s, by Lewis J. Greenwald, Brainard L. Patton, and Brendan Sinnott, Volume 172, Number 5, August 2, 2021.
IRS Notice 2019-01
Notice 2019-01 announced Treasury and IRS’s intention to withdraw prior proposed regulations under Internal Revenue Code Section 959 and issue new proposed regulations under Internal Revenue Code Sections 959 and 961.The proposed regulations discussed in Notice 2019-01 included rules related to the maintenance of PTEPs in annual accounts, in specific groups, and the ordering of PTEPs when distributed or reclassified. Notice 2019-01 added an additional six PTEP groups to the ten PTEP groups described in the proposed regulations. Thus, within each basket, PTEP is allocated up to sixteen groups to be determined on an annual basis.
Notice 2019-01 describes regulations that the Treasury intended to propose that involve PTEP ordering upon distribution. Generally, and subject to a special priority rule for PTEP arising from Section 965(a) and (b), the notice applies a LIFO approach to the sourcing of distributions from annual PTEP accounts. Thus, subject to the special priority rule, Section 959(c)(1) PTEP in the most recent annual PTEP account is treated as distributed first, followed by the second most recent PTEP account, and continued through each annual PTEP account under Section 959(c)(1) until each account is exhausted. The same approach will then apply to Section 959(c)(2) PTEP. Finally, the remaining amount of any distributions are sourced from Section 959(c)(3), to the extent thereof.
The Final Section 960(b) Regulations
On December 17, 2019, the Treasury and the IRS issued final regulations under Internal Revenue Code Section 960(b) which finalized the proposed regulations. The final Section 960(b) regulations modified the proposed regulations. The PTEP groups have consolidated the 959(c)(2) PTEP groups into five. The five PTEP groups arise under Internal Revenue Code Sections 965(a), 965(b)(4)(A), 951A(f)(2), 245A(d), and 951(a)(1)(A). Section 959(c) requires U.S. shareholders to reclassify Section 959(c)(2) PTEP as Section 959(c)(1) PTEP whenever the CFC has a Section 956 investment in U.S. property that was included in the U.S. shareholder’s gross income under Section 951(a)(1)(A) or would have been included except for Section 959(a)(2). In that case, the Section 959(c)(2) PTEP group is reduced by the functional currency amount of the reclassified PTEP, which is added to the corresponding Section 959(c)(1) PTEP group described in the Section 904 category and same annual PTEP account as the reduced Section 959(c)(2) PTEP group.
The post TCJA Form 5471 Schedule J serves the same purposes as its pre TCJA predecessor. However, the post TCJA version greatly expanded E&P tracking requirements. The post TCJA Form 5471 Schedule J increased the 959(c)(2) PTEP categories to be disclosed on the schedule from one to five. It also expanded 959(c)(1) PTEP categories from one to five. In addition, Schedule J requires untaxed E&P to be allocated into E&P subject to the Section 909 anti-splitter rules, E&P carried over from certain nonrecognition transitions, and hovering deficits under Section 959(c)(3). In addition, the Treasury Regulations under Section 1.960-3 requires that CFC shareholders report PTEP attributions attributable to Section 965 inclusions, 965(b) deficit offsets, Section 956 investments in U.S. property, GILTI inclusions, subpart F inclusions, Section 245A hybrid dividends, and Section 1248 amounts. Within these categories, CFC shareholders must state whether or not the PTEP should be allocated to a Section 959(c)(2) or Section 959(c)(1) PTEP. CFC shareholders must separately track each PTEP according to its foreign tax credit category. In addition, CFC shareholders must track movements of PTEPs between Setions 959(c)(2) and Section 959(c)(1) categories.
Part 1 Columns- Accumulated E&P of Controlled Foreign Corporation
The amounts entered under each column must be in the CFC’s functional currency. Section 985(b)(1)(A) of the Internal Revenue Code states the general rule that the functional currency will be “the dollar.” However, the functional currency of a “qualified business unit” (“QBU”) which could be a CFC will be “the currency of the economic environment in which a significant part of such a unit’s activities” is “conducted and which is used by such a unit in keeping its books and records.” See IRC Section 985(b)(1)(B).
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) 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 1 below for a simple example for calculating a “post-1986 undistributed earnings pool.”
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:
|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 Paid 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) 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 the 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.
Column (e) is used to report the running balance of the foreign corporation’s PTEP, Section 964(a) E&P accumulated since 1962 that have resulted in deemed inclusions under subpart F, or amounts treated as PTEP under Internal Revenue Code Section 965(b)(4).
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).
A CFC shareholder will use Column (e)(ii) to report previously taxed income reclassified as Section 965(b) under Section 959(c)(1)(A) (reclassified as investments in U.S. property). Section 965(b) allows U.S. shareholders to reduce the Section 965(a) inclusion amount based on deficits in E&P accumulated by other SFCs. Under Section 965(b), the deferred foreign earnings that would have been included in U.S. shareholder’s income under Section 965(a), but were not so included because of sharing of an E&P deficit pursuant to Section 965(b), increases PTEP for the SFC that had positive earnings. Section 965(b)(4)(B) increases the E&P of an E & P deficit foreign corporation by the amount of the E&P deficit taken into account under Section 965(b).
The following example illustrates these rules; USP, a domestic corporation, owns all of the stock of foreign corporations CFC1 and CFC2. USP, CFC1, and CFC2 are calendar year taxpayers. On all measurement dates, CFC1 has accumulated post-1986 deferred foreign earnings of $100, and CFC2 has an E&P deficit of $20. USP in aggregate will have an $80 Section 965(a) inclusion amount ($100 from CFC1 less CFC2’s $20 deficit allocated to CFC1 under Section 965(b)). CFC1’s PTEP account will increase by $100 ($80 for the Section 965(a) inclusion amount and $20 for the Section 965(b) deficit allocated to CFC1). CFC2 will have $0 of PTEP, and its E&P will increase by the $20 of deficit taken into account under Section 965(b)
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 or reclassified investments in U.S. property. Investments in US property include most tangible and intangible property owned by a CFC that has a US situs such as stock of a domestic corporation; an obligation of a US person; and a right to use a patent, copyright, or other forms of intellectual property in the United States if acquired or developed by the CFC for that use. A CFC is also treated as owning a proportionate interest in US property owned by a partnership in which the CFC is a partner.
A CFC shareholder will use Column (e)(iv) to report PTEP originally attributable to inclusions under Internal Revenue Code Section 951A GILTI, or GILTI reclassified as investments in U.S. property under Section 959(c)(1)(A).
A CFC shareholder will use Column (e)(v) to report PTEPs attributable in three subgroups discussed below (which are aggregated into a single PTEP group).
1. PTEP that is attributable to hybrid dividends under Section 245(e)(2) and reclassified as investments in U.S. property. Internal Revenue Code Section 245A(d) generally prohibits taxpayers from claiming credits or deductions for foreign income taxes paid or accrued (or treated as paid or accrued) on dividends for which an Internal Revenue Code Section 245A deduction is allowed.Under Section 245A, an exception is allowed for certain foreign income of a domestic corporation that is a US shareholder by means of a 100 percent dividend received deduction (“DRD”) for the foreign source portion of dividends received from “specified 10-percent owned foreign corporations” by certain domestic corporations that are US shareholders of those foreign corporations within the meaning of section 951(b). Section 245A generally denies the DRD for hybrid dividends (i.e., amounts received from a CFC if the dividend gives rise to a local country deduction or other tax benefit). Any deductions disallowed under Section 245A(d) classified as Section 959(c)(1) PTEP (investment in U.S. property should be disclosed under Column (e)(v).
2. PTEP that is attributable to Section 1248 amounts under Section 959(e) and reclassified as investments in U.S. property. Under Section 1248(a), gain is recognized on a U.S. shareholder’s disposition of CFC stock in cases where there is a deferral of E&P. For purposes of Section 959(e), any amount included in the gross income of any person as a dividend by reason of subsection (a) or (f) of Section 1248 shall be treated as an amount included in the gross income of such person.
3. PTEP that is attributable to Section 1248 amounts from gain on the sale of a CFC by a CFC and reclassified as investments in U.S. property. With respect to individual U.S. shareholders who sell stock in a CFC recharacterized under Section 1248(a), the gains are realized at ordinary rates. Section 1248(b) provides for a ceiling on the tax liability that may be imposed on the shareholder receiving a Section 1248(a) dividend if the taxpayer is an individual and the stock disposed of has been held for more than one year. The Section 1248(b) ceiling consists of the sum of two amounts. The first amount is the U.S. income tax that the CFC would have paid if the CFC had been taxed as a domestic corporation, after permitting a credit for all foreign and U.S. tax actually paid by the CFC on the same income (the “hypothetical corporate tax”). For example, if a Cayman Islands CFC has $100 of income and pays $0 of foreign tax, and assuming the CFC would be in the 21% income tax bracket for U.S. federal income tax purposes under Section 11 based on its taxable income levels, the hypothetical corporate tax would be $21.
The second amount is the addition to the taxpayer’s U.S. federal income tax for the year that results from including in gross income as long-term capital gain equal to the excess of the Section 1248(a) amount over the hypothetical corporate tax (the “hypothetical shareholder tax”). Continuing with the same example and assuming the shareholder’s gain on the sale is $100, this hypothetical shareholder tax would be 23.8% of 79 ($100 Section 1248(a) amount less the hypothetical corporate tax of $21), or $18.80.
Adding together the hypothetical corporate tax and the hypothetical shareholder tax in this example thus yields $39.80 in tax on the $100 gain, for an effective tax rate of 39.8%. The CFC in this example is not a resident in a treaty country (the United States does not have an income tax treaty with the Cayman Islands), the amount of gain that is recharacterized as a dividend under Section 1248(a). The $100 would be taxable at a maximum federal rate of $40.80 (37% federal rate + 3.8 percent NIT = 40.80 percent). Because this amount is greater than the Section 1248(b) ceiling of $39.80, the ceiling will apply. If these Section 1248 gains can be attributable to the reclassification as investments in U.S. property, the PTEP generated from the sale would be reported in Column (e)(v).
A CFC shareholder will use Column (e)(vi) to report PTEPs attributable to Section 965(a) classified under Section 959(c)(2).
A CFC shareholder will use Column (e)(viii) to report PTEPs attributable to Section 965(b)(4)(A) classified under Section 959(c)(2). For purposes of applying Section 959 in any taxable year, an amount equal to such shareholders of a deferred foreign income corporation.
A CFC shareholder will use Column (e)(viii) to report PTEPs attributable to Section 951A classified under Section 959(c)(2).
A CFC shareholder will use Column (e)(ix) to report PTEPs attributable to Section 245A(d) classified under Section 959(c)(2) (Subpart F income or GILTI). Column (e)(ix) is PTEP described in the following three subgroups (which are aggregated into a single PTEP group).
1. PTEP attributable to hybrid dividends under Section 245A(e)(2). Section 245A(e) generally denies a dividends received deduction (the “DRD”) under Section 245A for hybrid dividends (i.e., amounts received from a CFC if the dividends give rise to a local country deduction or other tax benefit). The final regulations provide that the determination of whether a relevant foreign law allows a deduction (or other tax benefit) is made without regard to foreign hybrid mismatch rules, provided that the amount gives rise to a dividend for U.S. tax purposes or is reasonably expected for U.S. tax purposes to give rise to a dividend that will be paid within 12 months after the taxable period in which the deduction would otherwise be allowed.
Congress enacted Section 245A to neutralize the double non-taxation effects of certain hybrid arrangements. But when a U.S. shareholder has a subpart F or GILTI inclusion with respect to a CFC and the Section 245A provisions also apply, double taxation can occur. To mitigate this concern, Treasury issued proposed regulations that allow for an adjustment of a CFC’s hybrid deduction account to the extent that the CFC’s earnings are included in income under subpart F or GILTI rules. Rather than providing for a dollar-for-dollar reduction in the hybrid deduction account by the amount of the inclusion, the proposed rules require taxpayers to perform a complex calculation that takes into account the potential benefit of foreign tax credits and the Section 250 deduction.
The proposed regulations generally reduce a hybrid deduction account with respect to a share of stock by an “adjusted subpart F inclusion” or an “adjusted GILTI inclusion” with respect to the share. This reduction, however, cannot exceed the hybrid deduction allocated to the share for the taxable year multiplied by the ratio of the subpart F income or tested income, as applicable, of the CFC to the CFC’s taxable income. The regulations also provide ordering rules for when adjustments are required under multiple provisions.
To calculate the adjusted subpart F inclusion, a taxpayer must first determine two amounts, on a share-by-share basis: 1) its pro-rata share of the CFC’s subpart F income included in income in the taxpayer’s current year; and 2) the “associated foreign income taxes” with respect to that subpart F inclusion (determined by allocating foreign taxes to the subpart F income groups under Section 960 and the regulations thereunder). The taxpayer must then follow a two-step process. First, the taxpayer adds the pro share of the subpart F inclusion and the associated foreign income taxes, which is intended to reflect the Section 78 gross-up. From that amount, the taxpayer then subtracts the quotient of the associated foreign income taxes divided by the corporate tax rate (currently 21%), which is intended to equal the amount of income offset by the foreign taxes. The calculation can be expressed as the following equation:
Adjusted Subpart F Inclusion = Subpart F inclusion + Associated Foreign Income Taxes
– Associated Foreign Income Taxes
The adjusted GILTI inclusion calculation follows a similar approach, but has three key differences. First, associated foreign income taxes are calculated by allocating foreign taxes to the tested income group and then multiplying by the taxpayer’s “inclusion percentage.” Second, after the first step, there is an interim step in which the taxpayer multiples the grossed-up inclusion by the difference between 100 and the percentage in Section 250(a)(1)(B)(currently 50%). Third, in the final step, the taxpayer also multiplies the associated foreign income taxes by 80% to account for the GILTI haircut to foreign taxes. See 245A/267A Structures Available and Planning Ideas. (2021), Jeff Rubinger and Summer LePree. The calculation can be expressed as the following equation:
Adjusted GILTI Inclusion = ((GILTI Inclusion + Associated Foreign Income Taxes x 0.5) –
0.8 x Associated Foreign Income Taxes
Depending on the PTEP attributable to hybrid dividends can be classified as subpart F or GILTI, will determine which of the above discussed formulas should be utilized to determine the tax liability and associated PTEP.
2. PTEP attributable to Section 1248 amounts under Section 959(e). Any PTEP attributable under Section 1248 amounts to 959(e) reported under Column (e)(ix).
3. PTEP attributable to Section 1248 amounts from the gain of a CFC by a CFC. Any PTEP attributable under Section 1248 from gain of a CFC by a CFC is reported under Column (e)(ix).
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.
Column (f) is used to report the opening and closing balance of the foreign corporation’s accumulated E&P. This amount is the sum of post-2017 E&P not previously taxed, post-1986 undistributed earnings, pre-1987 E&P not previously taxed, and PTEP.
Specific Instructions Related to Lines 1 Through 14
Line 1a asks the preparer to enter the balances for each column at the beginning of the tax year. These balances should equal the amounts reported as the ending balances in the prior year Schedule J.
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, the preparer should include the explanation and amount of each such difference on the attachment.
Line 2a asks the preparer to disclose unsuspended taxes under Section 909 of the Internal Revenue Code. 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 U.S. tax purposes. The definition of “foreign tax credit splitting event” is broad and could reach a variety of situations such as disregarded payments, transfer pricing adjustments, contributions of property resulting in a shift of deductions and timing differences under U.S. and foreign law. Specifically, a “foreign tax credit splitting event” arises with respect to a foreign income tax if the related income is taken into account for U.S. tax purposes by a “covered person.” A “covered person” is defined as any entity in which the payor holds, directly, or indirectly, at least 10 percent ownership ownership (determined by vote or value); any person that holds, directly, or indirectly, at least a 10 percent ownership interest (by vote or value) in the payor.
This line of column (b) is the unsuspended taxes under Section 909 of the Internal Revenue Code as a result of related income taken into account by the foreign corporation, certain U.S. corporate owners of the foreign corporation, or a member of such U.S. corporate owner’s consolidated group. The preparer should report the unsuspended taxes on line 2a of column numbers on line 2a of column (a), (b), ©, or (e), as applicable.
Line 2b asks the preparer to disclose foreign taxes that are suspended in the current tax year. These amounts should be reported as negative numbers. This includes taxes suspended under Section 909 or under “hybrid instrument splitter arrangements.” 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 2b of column (d) accounts for foreign income taxes that are suspended in the current tax year. These amounts should be reported as negative numbers.
Line 3 asks the preparer to disclose the current year E&P (or deficit in E&P) amount from the applicable line 5c of Schedule H. For example, if the preparer is completing Schedule J, enter the current year E&P (or deficit in E&P) amount from Schedule H, line 5C(ii), in the applicable column. Line 3 should never have an amount entered in column (e).
For Line 4, the preparer 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 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 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 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 2 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.
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 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 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 asks the preparer to report actual distributions as negative numbers.
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 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 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 asks the preparer to list any hovering deficit offset included in column (d) as 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.
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 3 below.
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).
The IRS Form 5471 is an incredibly complicated return. Each year an international tax attorney should review direct, indirect, and constructive ownership of the reporting CFC to determine the impact of any changes in percentages, filer categories, and CFC status. Workpapers should also be prepared and maintained for each U.S. GAAP adjustment and foreign exchange. In addition, an accounting should be made for adjustments to prior and current year previously taxed E&P that become PTEPs on Schedule J, E-1, and P.
It is extremely important to work with an international tax specialist to ensure accurate preparation of your Form 5471. Having the wrong professional complete your Form 5471 can result in significant penalties. The Internal Revenue Code authorizes the IRS to impose a $10,000 penalty for failure to file substantially complete and accurate Form 5471 returns on time. An additional $10,000 continuation penalty may be assessed for each 30 day period that noncompliance continues up to $60,000 per return, per tax year. In addition, the IRS can assess a 40 percent accuracy penalty on incorrectly reported income and reduction of foreign tax credits by 10 percent.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.