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Demystifying the All New 2020 Tax Year IRS Form 5471 Schedule E Reporting and Tracking Foreign Tax Credits

Demystifying the All New 2020 Tax Year IRS Form 5471 Schedule E Reporting and Tracking Foreign Tax Credits

  By Anthony Diosdi


Introduction

Schedule E of Form 5471 is used to report taxes paid or accrued by a foreign corporation for which a foreign tax credit is allowed and taxes for which a credit may not be taken. Like Schedule J, Schedule E (mostly because of Schedule E-1) has given tax practitioners fits the last two tax seasons. Much of this confusion is the result of the Section 959 ordering and basketing rules. Things are not likely to improve next tax season. On August 25, 2020, the IRS issued a draft for Schedule E (without any instructions) for the 2020 tax year. Although the 2020 Schedule E is only in “draft” format, we do not anticipate many if any changes to the form before next tax season.

The IRS has added an entirely new section to Schedule E for “taxes deemed paid under Section 960(b)” along with all associated PTEPs otherwise known as “Previously Taxed Earnings and Profits.” The IRS also completely revised Schedule E-1. Since we are still a couple months away from the 2020 tax season, the timing is perfect to dissect the new Schedule E. This article will dive into each column and line of the new 2020 draft Schedule E. We will also attempt to provide guidance as to how to prepare this incredibly complicated return.

Who Must Complete the Form 5471 Schedule E?

Anyone preparing a Form 5471 knows that the return consists of many schedules. Schedule E is just one schedule of the Form 5471. Whether or not a shareholder of a controlled foreign corporation (“CFC”) is required to complete Schedule E depends on what category of filer he or she can be classified as. For purposes of Form 5471, CFC shareholders are broken down by the following categories:

Category 1- includes a US shareholder of a Section 965 “specified foreign corporation” at any time during any tax year of the foreign corporation, and who owned that stock on the last day in that year. A specified foreign corporation includes: 1) a controlled foreign corporation, or 2) any foreign corporation with respect to which one or more domestic corporations are a US shareholder.

Category 2- US persons who are officers or directors of a foreign corporation in which since the last time Form 5471 was filed, a US person has acquired a ten percent or greater ownership or acquired ten percent or greater ownership.

Category 3- A US person who (a) has acquired a cumulative ten percent or greater ownership in the outstanding stock of the foreign corporation, (b) since the last filing of Form 5471 has acquired an additional ten percent or greater ownership in such stock, (c) owns ten percent or greater of the value of the outstanding stock of the foreign corporation when it is reorganized, or (d) disposes of sufficient stock in the foreign corporation to reduce the value of his ownership of stock in that corporation to less than ten percent, or who becomes a US person while owning ten percent, or who becomes a US person while owning ten percent or greater in value of the outstanding stock of the foreign corporation.

Category 4- a US person who had “control” of a foreign corporation for an uninterrupted period of at least 30 days during the foreign corporation’s annual accounting period. Control means more than 50 percent of the voting power or value of the CFC applying the Section 958 attribution rules.

Category 5- A US person who is a ten percent or greater shareholder in a corporation that was a CFC for an uninterrupted period of thirty days during its annual accounting period and who owned stock in the CFC on its last day of its annual accounting period.

Category 1, Category 4, and Category 5 filers need to complete Schedule E.

Lines a and b

Schedule E begins by asking the preparer to complete lines a and b. Line a specifically asks the preparer to determine the category of income and enter the applicable corresponding code. In order to answer the question on Line a, the preparer must reference the instructions to IRS Form 1118. IRS Form 1118 states that there are six categories of foreign source income to be reported on Schedule E and assigns codes to each category of income. The preparer may select from the applicable categories of income and codes listed below:

Code Category of Income

951A Section 951A Category Income

FB Foreign Branch Category Income

PAS Passive Category Income

901j Section 901(j) Income

RBT Income Re-Sourced by Treaty

GEN General Category Income

Below is a definition of each category of foreign source income:

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:

  1. 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.
  2. Any amount includible in gross income under Section 1293 (which relates to certain passive foreign investment companies (“PFICs”).

Section 901(j) Income

Section 901(j) income is income earned from a sanctioned country.

Income Re-Sourced by Treaty

If a sourcing rule in an applicable income tax treaty treats any U.S. source income as foreign source, and the corporation elects to apply the treaty, the income will be treated as foreign source.

General Category Income

This category includes all income not described above.

Line b

Line b states that if Code 901j is entered on Line a, the country code for the sanctioned country using the two-letter codes (from the list at IRS.gov/countrycodes) must be entered.

Part 1. Taxes for Which a Foreign Tax Credit is Allowed

Section 1 – Taxes Paid or Accrued Directly by Foreign Corporation

Schedule 1 is designed to report any foreign taxes paid or accrued directly by a CFC. The preparer must not only disclose the amounts of foreign taxes paid by the CFC, the preparer must also properly convert the foreign taxes paid to U.S. dollars.

Column (a)

Column (a) asks the preparer to list the name of the foreign corporation or pass-through entity (partnership or disregarded entity) that paid the foreign tax.

Column (b)

Column (b) asks the preparer to enter the employer identification number (“EIN”) or reference ID number of the payor of the foreign tax.

Column (c)

Column (c) asks the preparer to enter the two-letter codes of the foreign country the foreign tax was paid. Country Codes are available at irs.gov/countrycodes.gov. If taxes were paid or accrued to more than one country with respect to the same income, the preparer should include an attachment listing applicable countries.

Column (d)

Column (d) asks the preparer to disclose any tax accounting timing discrepancies between the U.S. and foreign tax years. For example, the foreign tax year under foreign law may not be the same as the U.S. tax year of the foreign corporation.

Column (e)

Column (e) asks the preparer to disclose the U.S. tax year of the foreign corporation to which the tax relates.

Column (f)

Column (f) asks the preparer to enter the income subject to tax in the foreign jurisdiction of the corporation.

Column (g)

Column (g) asks the preparer to check the applicable boxes if taxes are paid on U.S. source income. This is a brand new column for the 2020 tax year.

Column (h)

Column (h) asks the preparer to enter the code of the country in which local tax is paid.

Column (i)

Column (i) asks the preparer to enter the tax paid or accrued in the local currency in which the tax is payable and not the functional currency of the CFC. Internal Revenue Code Section 985(b)(1)(A) states the general rule that the functional currency will be “the dollar.”

Columns (j) and (k)

Columns (j) and (k) ask the preparer to enter the exchange rate in column (j) and the translated dollar amount in column (k). The preparer should translate the taxes entered in column (f) into dollars at the average exchange rate for the tax year to which the tax relates unless one of the exceptions below applies:

1. The tax is paid before the beginning of the year to which the tax relates;

2. The accrued taxes are not paid before the date of two years after the close of the tax year to which such taxes relate;

3. There is an election in effect under Section 986(a)(1)(D) to translate foreign taxes using the exchange rate in effect on the date of payment; or

4. The CFC reports on a cash basis, the exchange rate must be reported using the “divide-by conversion rate” (in other words, the units of foreign currency that equals one unit foreign currency).

Column (l)

Column (l) asks the preparer to enter the foreign tax in functional currency. Section 985(b)(1)(A) states the general rule that the functional currency will be “the dollar.” However, the functional currency of a QBU will be “the currency of the economic environment in which a significant part of such unit’s activities is “conducted and is used by such unit in keeping its books and records.” On column (l), the preparer will need to enter the foreign taxes paid or accrued in U.S. dollars. However, if a unit of the CFC is a QBU that conducts its business in a foreign currency, the taxes paid or accrued should be determined in the functional currency of the CFC.

Line 5.

For Line 5, the preparer should combine Lines 1 through 4 of Column K.

Line 6.

For Line 6, the preparer should combine Lines 1 through 4 of Column l.

Section 2 – Taxes Deemed Paid (Section 960(b))

Section 2 is a brand new category for Schedule E that needs to be completed for the 2020 tax year. Section 2 requires the preparer to disclose the foreign taxes and associated PTEP for each entity. Section 2 takes into consideration situations when a CFC pays foreign taxes for a subsidiary or another foreign entity it owns. To avoid double tax on foreign income, the IRS allows the CFC parent to claim a deemed paid foreign tax credit. Section 2 is somewhat similar to IRS Form 1118.

Column (a)

Column (a) asks the preparer to list the name of the related foreign corporation or pass-through entity (partnership or disregarded entity) that the foreign tax was paid.

Column (b)

Column (b) asks the preparer to enter the EIN or reference ID number of the related payor of the foreign tax.

Column (c)

Column (c) asks the preparer to enter the two-letter codes of the foreign country the foreign taxes were paid. Country Codes are available at irs.gov/countrycodes.gov. If taxes were paid or accrued to more than one country with respect to the same income, the preparer should include an attachment listing the applicable countries.

Column (d)

Column (d) asks the preparer to disclose each applicable PTEP group for the associated foreign tax paid. Where the E&P of a CFC consists in whole or in part of PTEP, special rules under Section 959 will determine the ordering and taxation of each distribution of PTEP. Column (d) will require the preparer to classify the income associated with each Section 960(b) foreign tax credit into a PTEP and disclose the PTEP in column (d). It is likely that the IRS will assign codes to each PTEP in the future and the preparer will disclose the PTEP as a code on column (d) of Part 2.

Column (e)

Column (e) asks the preparer to state the annual PTEP account. On November 28, 2018, the Department of Treasury and the IRS released proposed regulations related to the determination of foreign tax credits. The proposed regulations require the maintenance of a system to track each PTEP. The IRS will require the preparer to disclose the annual amount of the PTEP account which the foreign tax is paid.

Column (f)

Column (f) asks the preparer to state (in functional currency) the PTEP distributed.

Column (g)

Column (g) asks the preparer to (in functional currency) the total amount of PTEP in the PTEP account which a distribution was made.

Column (h)

Column (h) asks the preparer state the total amount of the PTEP group taxes with respect to PTEP groups in U.S. dollars.

Column (i)

Column (i) asks the preparer to state the foreign taxes properly attributable to PTEP and not previously deemed paid in U.S. dollars. Expressed formulatically

(column (f) divided by column (g) x column (h))

Part II Election

Part II asks if Section 986(a)(1)(D) has been made to translate taxes using the exchange rate on the date of payment. The 2004 JOBS Act added a new election in Section 986(a)(1)(D) for a taxpayer that otherwise is required under Section 986(a)(1)(A) to translate foreign taxes into U.S. dollars using the average exchange rate for the tax year. This provision allows such a taxpayer to elect to use the exchange rate at the time the foreign taxes are paid instead of the average exchange rate for the tax year. Once elected, this provision applies to the tax year for which it was made and all later years unless revoked with the IRS’s consent. Note, however, that this election applies only to the translation of foreign taxes and foreign tax adjustments; it does not apply to the translation of a foreign corporation’s earnings and profits or to the translation of dividends through constructive inclusions. Part II asks the preparer to state the date of the election if a Section 986(a)(1)(D) election has been made.

Part III. Taxes for Which a Foreign Tax Credit is Disallowed

Part III of Schedule E asks the preparer to report foreign taxes of a CFC that were paid but for which no foreign tax credits were allowed. The purpose of disclosing foreign tax on Part III of Schedule E is to disclose foreign taxes of the CFC’s E&P. However, foreign taxes that cannot be claimed as a foreign tax credit due to the anti-splitter or foreign deficit rule should not be disclosed on Part III of Schedule E. These rules will be discussed in more detail below.

Columns (a) and (b)

Column (a) asks the preparer to list the name or names of the foreign corporation or pass-through entity (partnership or disregarded entity) that paid the foreign tax and a foreign tax credit was disallowed.

Column (b) asks the preparer to enter the EIN or reference number of the payor of the foreign tax.

Column (c)

Column (c) asks the preparer to enter the foreign income taxes that are disallowed under Section 901(j), which generally applies to certain sanctioned countries.

Column (d)

Column (d) asks the preparer to enter the foreign taxes that are disallowed under Internal Revenue Code Section 901(k). This generally applies to certain foreign taxes paid on dividends if the minimum holding period is not met with respect to the underlying stock, or if the CFC is obligated to make related payments with respect to positions in similar or related property. Section 901(k) cross-reference the rules of Section 246(c). This generally means a deduction for a dividend is not allowed if the dividend was paid in the next preceding taxable year of the corporation or the corporation is tax exempt under Section 501.

Column (e)

Column (e) asks the preparer to list any foreign taxes on a covered asset acquisition and enter the disqualified portion of the tax. A covered asset involves three types of transactions: 1) a qualified stock purchase with a Section 338 election (Section 338 provides that if a purchasing corporation (“P”) purchase 80 percent or more of the stock of a target corporation (“T”) within 12 months or loss, it may elect within a specified time period to treat the target as having sold all of its assets for their fair market value in a single transaction); 2) any acquisition treated as a purchase of assets for U.S. tax purposes, but an acquisition of stock is disregarded for foreign tax purposes; or 3) the purchase of a partnership interest with a Section 754 election (to avoid taxing the buying partner on the appreciation of his proportionate  share of partnership assets prior to the date of purchase, the partnership may make an election under Section 794 of the Internal Revenue Code.

Column (f)

Column (f) asks the preparer to enter the amount of foreign taxes paid or accrued by the CFC in functional currency.

Column (g)

Column (g) asks the preparer to enter the amount of foreign taxes for which a foreign tax credit is disallowed other than those in columns (c) through (f) in functional currency.

Column (h)

Column (h) asks the preparer to enter the total amount for each payor in columns © through (g) in functional currency.

Line 3.

Line 3 asks the preparer to total each amount in column (h) and enter the total in functional currency.

Line 4.

Line 4 asks the preparer to translate the amount listed on Line 3 in U.S. dollars (translated at the average annual exchange rate).

Schedule E-1 Taxes Paid, Accrued, or Deemed Paid on Earnings and Profits of Foreign Corporation

Schedule E-1 requires the preparer to disclose the earnings and profits of a foreign corporation attributed to foreign taxes to use the special ordering rules of Section 959 to determine the ordering and taxation of each PTEP. This all matters because of one significant purpose – the calculation of available foreign tax credits against U.S. income is determined by the Section 959 ordering and basketing rules. For example, any foreign taxes paid or accrued on GILTI income or allocated to a special GILTI basket cannot be used to offset income in another category of foreign source income. 
Where the earnings and profits of a CFC consists in whole or in part of PTEP, special rules under Section 959 apply in determining the ordering and taxation of distributions of such PTEP. A PTEP distribution is generally sourced in the following order: 1) PTEP attributable to investments in US 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, and subject to recent PTEP guidance discussed below, a distribution is generally attributed to E&P according to the “last in first out” method (“LIFO”) based on the year income was earned. For example, a distribution is treated as if it were first made out of a CFC’s current year E&P, and then the CFC’s prior year accumulated E&P.

In 2018, the IRS and the Department of Treasury announced Notice 2019-01. This Notice indicated the IRS’s and Department of Treasury’s intention to withdraw prior proposed regulations under Section 959 and issue new proposed regulations. As of this date, new regulations for Section 959 have not been promulgated by the IRS and Department of Treasury. Instead, in Notice 2019-01, the IRS and Department of Treasury described new rules related to the maintenance of PTEP accounts and new rules associated with the ordering of PTEPs. Below, we will analyze the ordering rules discussed in Notice 2019-01 in order to complete Schedule E-1

Below, please find Illustration 1 which (based on the example stated in IRS Notice 2019-01) provides how to report “Previously Taxed E&P” in accordance with Internal Revenue Code Section 959(c)(1)(A).

Illustration 1.

USP, a domestic corporation, wholly owns FC, a foreign corporation that has the U.S. dollar as its functional currency. Both USP and FC use the calendar year as their taxable year. Before 2018, the PTEP of FC was maintained in annual accounts. As of December 31, 2018, FC’s $300x of E&P (before taking into account distributions made or inclusions under Section 951(a)(1)(B) in 2018) applicable to USP’s interest in FC are classified under Notice 2019-01 as Section 3.01 as follows:

Section 959(c)(1)     Section 959(c)(2)

Year 965(a)  965(b)  951(a)(1)(B)   965(a)  965(b)  951A  951(a)(1)(A)    959(c)(3)
2018         50x     30x
2017       100x    50x                           20x
2016   25x         25x
Total                 25x 255x         20x

In 2018, FC has an amount described in Section 956(a) (“section 956(a) amount”) of $125x, without considering the application of Section 959(a)(2). In 2019, FC earns $25x of current E&P, and the amount of USP’s income inclusion under Section 951A(a) that is allocated to FC under Section 951A(f)(2) and proposed Treasury Regulation Section 1.951A-6(b)(2) is $20x. FC also makes a distribution of $195x in 2019. In 2020, FC earns no current E&P, but FC makes a distribution of $60x. For all years, the PTEP of FC in each PTEP group is described in a single 904 category, and all Section 959(c)(3) E&P of FC are described in a single Section 904 category.

Analysis for 2018

As of December 31, 2018, before considering FC’s Section 956(a) amount, FC has total Section 959(c)(2) PTEP of $255x. Under Section 959(a)(2) and (f)(1), because FC’s Section 959(c)(2) PTEP exceeds its Section 956(a) amount, USP does not include any amount in income under Section 951(a)(1)(B). However, under Section 959(c)(1)(A), $125x of FC’s Section 959(c)(2) earnings must be reclassified as Section 959(c)(1) PTEP. The reclassified PTEP remains in the 2017 annual PTEP account. Thus, in FC’s 2017 annual PTEP account, FC’s reclassified Section 965(a) PTEP is increased by $100x and its Section 965(a) PTEP is decreased by $100x. Additionally, FC’s reclassified Section 965(b) PTEP is increased by $25x and its Section 965(b) PTEP is decreased by $25x. Accordingly, as of December 31, 2018, FC’s E&P applicable to USP’s interest in FC.


Section 959(c)(1)     Section 959(c)(2)

Year 965(a)  965(b)  951(a)(1)(B)   965(a)  965(b)  951A  951(a)(1)(A)    959(c)(3)
2018         50x     30x
2017 100x   25x                   25x                                         20x
2016   25x         25x
Total                 150x 130x         20x


2019 Year Adjustment

During 2019, FC earns $25x of current E&P, and the amount of USP’s income inclusion under Section 951A(a) that is allocated to FC under Section 951A(f)(2) and proposed Treasury Regulation Section 1.951A-6(b)(2) is $20x. Thus, before taking into account USP’s income inclusion with respect to FC and any distributions by FC, FC’s Section 959(c)(3) E&P is initially increased by $25x. As a result of USP’s income inclusion under Section 951A. FC’s Section 951A PTEP increases by $20x and FC’s Section 959(c)(3) E&P is decreased by $20x. Accordingly, as of December 31, 2019, FC’s E&P (before taking into account distributions made in 2019) applicable to USP’s interest in FC are classified as follows:

Section 959(c)(1)     Section 959(c)(2)

Year 965(a)  965(b)  951(a)(1)(B)   965(a)  965(b)  951A  951(a)(1)(A)    959(c)(3)
2019         20x    
2018               50x      30x                25x
2017   100x   25x                                          25x
2016   25x         25x
Total                 150x 150x         25x


Distribution

FC’s distribution of $195x is from PTEP because the entire distribution would be a dividend under Section 316(a) without regard to Section 959 that is, for the purpose of Section 316, at the end of 2019, FC has $325x of E&P (without regard to this distribution), $25x of which is current E&P). Under Section 959(c), the distribution is first treated as attributable to Section 959(c)(1) PTEP.

Section 959(c)(1) PTEP

The distribution is first sourced from reclassified Section 965(a) PTEP and then from reclassified Section 965(b) PTEP, and then pro rata from the remaining PTEP groups that contain Section 959(c)(1) PTEP under a last-in, first-out (“LIFO”) approach. Thus, in FC’s 2017 annual PTEP account, FC’s reclassified Section 965(a) PTEP is decreased by $100x and its reclassification Section 965(b) PTEP is decreased by $25x. In FC’s 2016 annual PTEP account, FC’s Section 951(a)(1)(B) PTEP is reduced by $25x. Thus, of the distribution of $195x, $150x is treated as attributable to Section 959(c)(1) PTEP ($100x + $25x + $25x).

Section 959(c)(2) PTEP

After the Section 959(c)(1) PTEP is exhausted, the remaining portion of the distribution ($45x) is treated as attributable to Section 959(c)(2) PTEP, to the extent thereof. The distributions are first sourced from Section 965(a) PTEP and then from Section 965(b) PTEP, and then pro rata from the remaining PTEP groups that contain Section 959(c)(2) PTEP under a LIFO approach. Thus, in FC’s 2017 annual PTEP account, FC’s Section 965(b) PTEP is decreased by $25x. In FC’s 2019 annual PTEP account, FC’s Section 951A PTEP is decreased by $20x. Because the entire distribution has been accounted for, the remaining PTEP groups that contain Section 959(c)(2) PTEP and FC’s Section 959(c)(3) E&P are not affected. Accordingly, as of December 31, 2019, FC’s E&P applicable to USP’s interest in FC are classified as follows:

Section 959(c)(1)     Section 959(c)(2)

Year 965(a) 965(b)  951(a)(1)(B)   965(a)  965(b)  951A  951(a)(1)(A)    959(c)(3)
2019            
2018               50x      30x                25x
2017                                                 
2016           25x
Total                 150x         25x


2020

FC’s distribution of $60x is from PTEP because the entire distribution would be divided under Section 316(a) without regard to Section 959 (that is, for purposes of Section 316, at the end of 2020, FC has $130x of E&P (without regard to the distribution), all which is accumulated E&P). Under Section 959(c), the distribution is first treated as attributable to Section 959(c)(1) PTEP; however, FC has no Section 959(c)(1) PTEP. Additionally, FC has no Section 965(a) PTEP or Section 965(b) PTEP. This distribution is sourced pro rata from the remaining PTEP groups that contain Section 959(c)(2) PTEP under a LIFO approach. Thus, in FC’s 2018 annual PTEP account, FC’s Section 951A PTEP is decreased by $37.5x ($60x x $50x/$80X) and its Section 951(a)(1)(A) PTEP is decreased by $22.5x ($60x x $30x/$80x). Because the entire distribution has been accounted for, the remaining PTEP groups that contain Section 959(c)(2) PTEP and FC’s Section 959(c)(3) E&P are not affected. Accordingly, as of December 31, 2010, FC’s E&P applicable to USP’s interest in FC are classified as follows:

Section 959(c)(1)     Section 959(c)(2)

Year 965(a) 965(b)  951(a)(1)(B)   965(a)  965(b)  951A  951(a)(1)(A)    959(c)(3)
2019            
2018               12.5x   7.5x
2017                                                          25x
2016           25x
Total                 45x         25x

Now since we reviewed the basic rules governing Section 959 and the ordering of PTEPs, we will now discuss the categories of PTEPs of Schedule E-1. The 2019 Schedule E-1 consisted of the following 20 columns for PTEPs:

1. Post 2017 E&P Not Previously Tax (post-2017 Section 959(c)(3) balance);

2. Post-1986 Undistributed Earnings (post-1986 and pre-2018 Section 959(c)(3) balance);

3. Pre-1987 E&P Not Previously Taxed (pre-1987 Section 959(c)(3));

4. Hovering Deficit Suspended Taxes;

5. Section 965(a) Inclusion (Section 959(c)(1)(A));

6. Section 965(b)(4)(A) (Section 959(c)(1)(A));

7. Earnings in U.S. Property (Section 959(c)(1)(A))

8. Section 951A Inclusion (Section 959(c)(1)(A));

9. Section 245(e)(2) (Section 959(c)(1)(A));

10. Section 959(e)(Section 959(c)(1)(A));

11. Section 964(e)(4) Inclusion (Section 959(c)(1)(A);

12. Section 951(a)(1)(A) Inclusion (Section 959(c)(1)(A);

13. Earnings Invested in Excess Passive Assets (Section 959(c)(1)(B);

14. Section 965(a) Inclusion (Section 959(c)(2));

15. Section 965(b)(4)(A)(Section 959(c)(2);

16. Section 951A Inclusion (Section 959(c)(2);

17. Section 245(e)(2) Inclusion (Section 959(c)(2);

18. Section 959(e)(Section 959(c)(2);

19. Section 964(e)(4) Inclusion (Section 959(c)(2);

20. Section 951(a)(1)(A) Inclusion (Section 959(c)(2).

For 2020 tax year, the IRS reduced the columns listed on Schedule E-1 to the following columns for PTEPs:

1. Current E&P;

2. Post-1986 Undistributed Earnings (Post-1986 and Pre-2018 Section 959(c)(3) balances);

3. Pre-1987 E&P (pre-1987 Section 959(c)(3) balance);

4. Hovering Deficit and Suspended Taxes;

5. Reclassified Section 965(a) PTEP;

6. Reclassified Section 965(b) PTEP;

7. General Section 959(c)(1) PTEP;

8. Reclassified Section 951A PTEP;

9. Reclassified Section 245A(d) PTEP;

10. Section Section 965(a) PTEP;

11. Section 965(b) PTEP;

12. Section 951A PTEP;

13. Section 245A(d) PTEP;

14. Section 951(a)(1)(A) PTEP.

Not only did the IRS reduce number of columns for PTEPs from 20 to 15, the IRS eliminated the PTEP classification for “Post 2017 E&P Not Previously Taxed (post-2017 Section 959(c)(3) balance)” and replaced it with a category for “current E&P.” It will be interesting to read the IRS guidance as to how taxpayers will reclassify PTEPs from categories that have been eliminated to new PTEP categories. In the meantime, we will walk through each PTEP column that will likely be on the 2020 Schedule E-1.

Column (a). Current E&P

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. A foreign corporation’s current E&P is an annual calculation with necessary adjustments. The annual calculation of a foreign corporation’s E&P is generally based on a three-step approach. These steps are:

Step 1: Prepare a local country profit and loss statement for the year from the books of account regularly maintained by the corporation for the purpose of accounting to its shareholders.

Step 2: Make the further adjustments necessary to confirm the U.S. GAAP P&L to certain U.S. tax accounting standards.

Step 3: Make the further adjustments necessary to conform the U.S. GAAP P&L to certain U.S. tax accounting standards.

Additional adjustments may be required to adjust for items such as currency translation.

Column (b). Post-1986 Undistributed Earnings

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). Dividend distributions did not reduce the pool of earnings taken into account in subsequent years. See Treas. Reg. Section 1.902-1(a)(9)(i). Moreover, the corporation’s pool of post-1986 foreign income taxes were reduced to reflect the portion of taxes deemed with respect to such dividends for purposes of computing foreign tax credits in subsequent years.

Please see Illustration 2 below for a very simple example calculating a “post-1986 undistributed earnings pool.”

Illustration 2.

Gamma S.A., a corporation under the laws of Country M, is a wholly owned subsidiary of American Gamma Corporation, a US corporation. Gamma S.A.’s post-1986 undistributed earnings (after payment of foreign taxes) and foreign taxes paid for years 1 through 3 were as follows:

Post-1986
Undistributed
Earnings Pool Foreign Taxes

Year 1……………………….$100,000 $30,000
Year 2………………………$200,000 $60,000
Year 3……………………….$300,000 $90,000

Pools as of 12/31 of Year 3   $600,000 $180,000

Gamma S.A. paid a dividend of $400,000 to American Gamma on December 1 of year 3.

Undisclosed Earnings Pool Foreign Taxes 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). Hovering Deficit and Suspended Taxes

Column (d) is used to report hovering deficits and deductions for suspended taxes. Historically, a hovering deficit arose when two foreign corporations engaged in a transaction in which E&P and taxes carried over under Section 381 and either corporation had a deficit in Post-1986 undistributed earnings in one or more foreign tax credit baskets.

1. The deficit and associated taxes hover and can only be offset by earnings “accumulated” after the Section 381 transaction in the same basket; taxes are released proportionately as the deficit is earned out.

2. The hovering deficit rules applied even if both corporations had a deficit in the same foreign tax credit basket.

A deficit was not taken into account in determining the current or accumulated earnings and profits of the surviving corporation for any purpose, including for purpose of determining dividends under Section 316 and for determining foreign tax credits. However, any such pre-transaction deficits in earnings and profits could be used to offset a foreign surviving corporation’s accumulated (but not current) post-transaction earnings and profits in the same basket as the deficit. Most of the guidance on cross-border corporate acquisitions in the context of hovering deficits use post-1986 income.

The IRS and Treasury have yet to issue final or proposed regulations for purposes of reporting hovering deficits on Schedule J. This leaves CFC shareholders involved in merger or acquisition transactions not having real choice other than to utilize pre-2018 Tax Cuts and Jobs Acts rules to report these types of transactions on Schedule J. We attempt to clarify these complicated rules. 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. For example, Section 381 does not specifically take into account source and foreign tax credit issues that arise when earnings and profits move from one corporation to another.

The Treasury has enacted regulations to deal with these perceived problems. For example, Treasury Regulation Section 1.367(b)-7 applies to an acquisition by a foreign corporation (foreign acquiring corporation) of the assets of another foreign corporation (foreign target corporation) in a transaction described in Internal Revenue Code Section 381 (foreign Section 381 transaction) and addresses the manner in which earnings and profits and foreign income taxes of the foreign acquiring corporation and foreign target carry over to the surviving foreign corporation (foreign surviving corporation). These rules typically apply to reorganizations or Section 332 liquidations between two foreign corporations.

The principle Code Sections implicated by the carryover of earnings and profits and foreign income taxes in a foreign Section 381 transaction are Sections 381, 902, 904, and 959. Section 381 generally permits earnings and profits (or deficit in earnings and profits) to carry over to a surviving corporation, thus enabling “the successor corporation to step into the ‘tax shoes’ of its predecessor. * * * [and] represents the economic integration of two or more separate businesses into a unified business enterprise.” See H. Rep. No. 1337, 83rd Cong., 2nd Sess. 41 (1954). However, a deficit in earnings and profits of either the transferee or transferor corporation can only be used to offset earnings and profits accumulated after the date of transfer. See IRC Section 381(c)(2)(B). This is commonly known as the “hovering deficit rule.” The hovering deficit rule is a legislative mechanism designed to deter the trafficking in favorable tax attributes that the IRS and courts had repeatedly encountered. 

Special rules are built into the Internal Revenue Code and its regulations for the “hovering deficit rule.” For example, former Internal Revenue Code Section 902 provides that a deemed paid foreign tax credit is available to a domestic corporation that receives a dividend from a foreign corporation in which it owns 10 percent or more of the voting stock. Below, please see Illustration 3 which provides an illustration how a foreign acquisition transaction may result in a hovering deficit and how such a transaction would be reported to be broken down for U.S. reporting requirements of Schedule J. See Office of Chief Counsel Internal Revenue Service Memorandum, June 9, 2006, Final Regulations Relating to Stock Transfer Rules: Carryover of Earnings and Taxes.

Illustration 3.

On December 31, 2016, foreign corporations A and B have the following post 1986 earnings and post-1986 foreign income taxes:

Foreign Corporation A

Separate Corporation A

Separate Category E&P Foreign Taxes

General 200u $30
Passive (100u) $10
100u $40

Foreign Corporation B

Separate Category E&P Foreign Taxes

General 300u $60
Passive 100u $30
400u $80

On January 1, 2017, foreign corporation B acquired the assets of foreign corporation A in a reorganization described in Section 368(a)(1)(C). Immediately following the foreign Section 381 transaction, foreign surviving corporation is a CFC.

Result

The foreign surviving corporation has the following post-1986 undistributed earnings and post-1986 foreign income taxes:

Earnings and Profits Foreign Taxes

Positive     Foreign Taxes Foreign Taxes
Separate Category E&P Hovering Deficit  Available Assoc with Hovering Def   
General 500u $90
Passive 100u (100u) $30 $10
600u (100u) $120 $10

During the 2017 tax year, foreign surviving corporation does not accumulate any earnings and profits or pay any foreign income taxes. On December 31, 2017, foreign surviving corporation distributes 300u to its shareholders. This distribution reduces its post-1986 undistributed earnings and post-1986 foreign income taxes on a pro rata basis as follows:

Separate Category E&P Foreign Taxes
General 250u $45
Passive 50u $15
300u $60

Immediately after the distribution, foreign surviving corporation has the following post-1986 undistributed earnings and post-1986 foreign income taxes:

Earnings and Profits Foreign Taxes

Positive     Foreign Taxes Foreign Taxes
Separate Category   E&P Hovering Deficit Available Assoc with Hovering Def   
General 250u $45
Passive   50u (100u) $15 $10
300u (100u) $60 $10

Post-transaction earnings- In its taxable year ending on December 31, 2018, foreign surviving corporation accumulates earnings and profits and pays related foreign income taxes as follows:

Separate Category E&P Foreign Taxes
General 100u $20
Passive 50u $10
150u $40

The hovering deficit in the passive category will offset the post-transaction earnings in that category and a proportionate amount of the foreign taxes related to the hovering deficit will be added to the post-1986 foreign income taxes pool. Because the post-transaction earnings in the passive category are half of the amount of the hovering deficit, half of the related taxes are added to the post-1986 foreign taxes pool. According, foreign surviving corporation has the following post-1986 undistributed earnings and post-1986 foreign income taxes on January 1, 2019:

Earnings and Profits Foreign Taxes

Positive     Foreign Taxes Foreign Taxes
Separate Category  E&P Hovering Deficit  Available Assoc with Hovering Def   
General 350u $65
Passive   50u (50u) $30 $5
400u (50u) $95 $5

The above examples use post-1986 income to determine hovering deficits for purposes determining the availability of the credibility of foreign taxes. The Tax uts and Jobs Act of 2017 repealed Internal Revenue Code Section 902 and its associated tax pools. Section 902 has been replaced with a single year indirect credit for the foreign income taxes “attributable to” the item of income under new Section 960(a). At this point, the IRS and Department of Treasury have not issued any guidance exactly how to address a surviving corporation’s earnings and profits after a merger or reorganization for purposes of the hovering deficit rule. This leaves tax professionals with questions as to how to treat a surviving corporation’s accumulated earnings and losses.

Another international provision implicated by the movement of earnings and profits in foreign Section 381 transactions is Section 959. Section 959 governs the distribution of earnings and profits that represent income that has been previously taxed to U.S. shareholders. After studying the interaction of Section 367(b) and the previously taxed income (“PTI”) rules, the Department of Treasury and the IRS determined that more guidance under Section 959 would be useful before issuing regulations to address PTI issues that arise under Section 367(b). As of this date, the IRS or the Department of Treasury have not issued any meaningful guidance on the carryover of earnings and profits and foreign income taxes in a foreign acquisition transaction.

The preamble to the final and temporary regulations under Section 367 acknowledges that the rules regarding carryover or separation of a foreign corporation’s E&P do not adequately consider the international aspects of the Internal Revenue Code, most notably the foreign tax credit. Until the IRS and Treasury promulgate regulations in this area, taxpayers should use a reasonable method (consistent with existing law taking into account the purpose of the foreign tax credit regime) to determine the carryover and separation of earnings and profits and related foreign taxes.” The preamble does not include that the method used must be the “most reasonable” or that it be “as reasonable” as any other available. There is currently no definition to the term “as reasonable” for purposes of allocating the income and losses of an acquired foreign entity for purposes of the hovering deficit rule and Section 959. Until specific guidance is issued, taxpayers should heed the current position of the IRS and Treasury by applying a reasonable method that is consistent with existing law and takes into account the purpose of the foreign tax credit regime. This may include utilizing the now-repealed Section 902 regulations to source the losses of an acquired foreign corporation. See The Tax Advisor, Allocating Previously Taxed Income in Sec. 335 Tax-Free Distribution, by Kyle Colonna and Julia Allen. 

Column (e)(i). Reclassified Section 965(a) PTEP

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. Section 965(a) accomplished the transition tax by increasing the subpart F income of each specified foreign corporation.

Column (e)(ii). Reclassified Section 965(b) PTEP

A CFC shareholder will use Column (e)(ii) to report previously taxed income reclassified as Section 965(b) under Section 959(c)(1)(A). Section 965(b) is a shareholder’s pro rata share of subpart F income of each deferred foreign corporation reduced by the amount of the shareholder’s aggregate foreign E&P deficit allocated to such deferred foreign corporations.

Column (e)(iii). General Section 959(c)(1) PTEP

A CFC shareholder will use Column (e)(iii) to report general Section 959(c)(1) PTEPs. Recall that Section 959(c)(1) are PTEPs attributable to investments in US property. Investments in US property include most tangible and intangible property owned by a CFC that has a US situs such as stock of a domestic corporation; an obligation of a US person; and a right to use a patent, copyright, or other forms of intellectual property in the United States if acquired or developed by the CFC for that use. A CFC is also treated as owning a proportionate interest in US property owned by a partnership in which the CFC is a partner.

Column (e)(iv). Reclassified Section 951A PTEP

A CFC shareholder will use Column (e)(iv) to report PTEPs attributable to Global Intangible Low-Taxed Income, or GILTI reclassified as Section 959(c)(1).

A US shareholder’s GILTI for a taxable year is the excess, if any, of the US shareholders “net CFC tested income” for the taxable year over that shareholder’s “net deemed tangible income return” for the taxable year. Net CFC tested income with respect to any US shareholder is the excess (if any) of the aggregate of the shareholder’s pro rata share of the “tested income” of each CFC with respect to the shareholder is a US shareholder the shareholder’s taxable year over the aggregate of that shareholder’s pro rata share of the “tested loss” of each CFC with respect to which the shareholder is a US shareholder for the taxable year of the US shareholder.

GILTI = Net CFC Tested Income – Net Deemed Tangible Income Return = [Tested Loss] – [10% of QBAI – Certain Interest Expense].

Column (e)(v). Reclassified Section 245A(d) PTEP

A CFC shareholder will use Column (e)(v) to report PTEPs attributable to reclassification Section 245(d) PTEP under Section 959(c)(1).

Prior to the 2017 Tax Cuts and Jobs Act, dividends from foreign corporations out of foreign earnings that had not been previously taxed were usually taxed to the shareholder. Under Section 245A, an exception is allowed for certain foreign income of a domestic corporation that is a US shareholder by means of a 100% 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).

Any foreign tax credits disallowed under section 245(d) classified as Section 959(c)(1) PTEP should be disclosed on column (e)(v).

Column (e)(vi). Section 965(a) PTEP

A CFC shareholder will use Column (e)(vi) to report PTEPs attributable to Section 965(a) classified under Section 959(c)(2).

Column (e)(vii). Section 965(b) PTEP

A CFC shareholder will use Column (e)(vii) to report PTEPs attributable to Section 965(b) classified under Section 959(c)(2).

Column (e)(viii). Section 965(b) PTEP

A CFC shareholder will use Column (e)(viii) to report PTEPs attributable to Section 951A classified under Section 959(c)(2).

Column (e)(ix). Section 245A(d) PTEP

A CFC shareholder will use Column (e)(ix) to report PTEPs attributable to Section 245A(d) classified under Section 959(c)(2).

Column (e)(x). Section 951(a)(1)(A) PTEP

A CFC shareholder will use Column (e)(x) to report PTEPs attributable to Section 951(a)(1)(A)

CFC shareholders will report subpart F income PTEP under Column (e)(x). Subpart f income is defined as the sum of the corporation’s: 1) Insurance income (as defined in Section 953); 2) Foreign base company income; and 3) International boycott income and amounts equal to illegal bribes/kickbacks paid on behalf of the CFC.

Specific Instructions Related to Lines 1 Through 14

Line 1a.

Line 1a asks the preparer to enter the balances for each column at the beginning of the tax year. These balances should equal the amounts reported as the ending balances in the prior year Schedule E-1.

Line 1b.

Line 1b states if there is a difference between last year’s ending balance on Schedule E-1 and the amount which should be last year’s ending balance, include the difference for the difference. If there are multiple differences, include the explanation and amount of each such difference on the attachment.

Line 2.

Use line 2 to reflect adjustments to a U.S. person’s foreign tax credit as a result of determining foreign income taxes. If a U.S. person has appropriately amended the immediately prior year return, including its Schedule E-1, to redetermine its U.S. tax liability, no adjustment should be included on this line. This line is only applicable if a U.S. person appropriately amended a prior year return and there were intervening years between the amended year return and the current year return for which an amended return was not filed. If so, an adjustment for the prior year amended return (and its impact on intervening years) should be reelected on line 2.

Line 3a.

Include in column (a), (b), (c), or (e) foreign income taxes paid or accrued by the corporation during the prior years that were suspended due to the application of the rules of Section 909 and that are unsuspended in the current year because related income is taken into account by the foreign corporation, certain U.S. corporate U.S. corporate owner’s consolidated group. This amount is reported as a positive amount on line 3a.

Line 3b.

Include as a positive amount in column (d) foreign income taxes related to the current tax year that have been suspended due to the rules of Section 909. By the way of background, a foreign tax credit is deductible only to the extent that the creditable tax is “paid or accrued.” Foreign taxes are generally treated as paid by the corporation on whom foreign law imposes legal liability. Under this “technical taxpayer” rule, the corporation or person who has legal liability for a foreign tax can be different than the person who realizes the underlying income under U.S. tax principles, resulting in a separation or “splitting” of foreign income to which the taxes relate. In some cases, the “splitting” can result in foreign tax credits following up to an individual without the associated income being subject to U.S. tax. Congress enacted Internal Revenue Code Section 909 for this situation. Under Section 909, where there is a “foreign tax credit splitting event” with respect to foreign income tax paid or accrued by a taxpayer, the foreign income tax is not taken into account for U.S. tax purposes before the tax year in which the related income is taken into account by the CFC.

Line 4.

The total reported on Line 4 should be taken from Schedule E, Part 1, line 5, column (k).

Line 5a.

Report taxes carried over to a foreign surviving corporation after an acquisition by a foreign corporation of the assets of another foreign corporation in a transaction described in Internal Revenue Code Section 381.

Line 5b.

Report post-1986 foreign income taxes that are related to hovering deficit in a separate category of post-1986 undistributed earnings should only be added to the foreign surviving corporation’s post-1986 foreign income taxes in that separate category on a pro rata basis as the hovering deficit is absorbed. An amount equal to the taxes related to a hovering deficit that are reported in column (a), (b), or (c) of line 5a is included as a negative amount on line (b) of column (a), (b), or (c), respectively. An amount equal to the total taxes related to hovering deficits reported on line 5b of columns (a), (b), and (c) is included as a positive number in column (d) of line 5(b).

Line 6.

Report any taxes reported on Schedule E, Part 1, Section 2, Line 5, column (i).

Line 7.

Attach a statement with a description and the amount of any adjustments required before taking into account taxes deemed paid by the foreign corporation. An example of an adjustment entered on line & is te foreign taxes imposed on receipt of a distribution of PTEP from a lower-tier foreign corporation.

Line 8.

Report any paid or accrued on current income/E&P or accumulated E&P (combine lines 1c through 7).

Line 9.

Report taxes deemed paid with respect to inclusions under Section 951(a).

Line 10.

Report taxes deemed paid with respect to actual distributions.

Line 11.

Report taxes deemed paid with respect to actual distributions.

Line 12.

Report taxes on amounts reclassified to Section 959(c)(1) E&P from Section 959(c)(2) E&P. See Illustration 4 below for an example regarding reclassifying Section 959(c)(1) E&P from Section 959(c)(2):

Illustration 4.

Domestic Corporation, a U.S. shareholder, wholly owns the only class of stock of CFC1, a foreign corporation. CFC1, in turn, wholly owns the only class of stock of CFC2, a foreign corporation. CFC2, in turn, wholly owns the only class of stock of CFC3, a foreign corporation. The functional currency of Domestic Corporation, CFC1, CFC2, and CFC3 is the U.S. dollar. During Year 1, Domestic Corporation reports an inclusion under Section 951(a)(1) of $100 as a result of subpart F income of CFC3. During Year 2, CFC3 distributes $40 to CFC2. CFC2 pays withholding tax of $4 on the distribution from CFC3. Such tax is a tax related to previously taxed subpart F income and is reported on line 4, column (e) of Schedule E-1 of CFC2’s Form 5471. In Year 2 CFC2 invests $40 in U.S. property. At the time of investment in such property, CFC2 continues to maintain a $36 balance in its Section 959(c)(2) previously taxed E&P account.

CFC2 reclassifies such amount as Section 959(c)(2) previously taxed E&P account. CFC2 reclassifies such amount as Section 959(c)(1) previously taxed E&P on Schedule J. Accordingly, $4 of foreign income taxes related to Section 959(c)(2) previously taxed E&P is reclassified to Section 959(c)(1).

Line 13.

Attach a statement with a description and the amount of any adjustments required before taking into account taxes deemed paid by the foreign corporation.

Line 14.

Report taxes related to hovering deficit offset of undistributed post-transaction E&P.

Line 15.

Report the balance of taxes paid or accrued by combining lines 8 through 14 in column a.

Line 16.

Report a reduction for tested income taxes not deemed paid.

Line 17.

Report a reduction for other taxes not deemed paid.

Line 18.

Report the balance of taxes paid or accrued at the beginning of the following year.

Conclusion

Schedule E of Form 5471 is incredibly complicated. Make sure you retain an international tax attorney with many years of experience in international tax compliance to advise you regarding this incredibly complicated return.




Anthony Diosdi is one of several international tax attorneys at Diosdi Ching & Liu, LLP. As an international tax attorney, Anthony Diosdi provides international tax advice to closely held entities and publicly traded corporations. Anthony Diosdi also represents closely held entities and publicly traded corporations in IRS examinations. Diosdi Ching & Liu, LLP has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com


This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.

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