By Anthony Diosdi
In order to provide the Internal Revenue Service (“IRS”) with the information necessary to claim a foreign tax credit, a U.S. corporation claiming a foreign tax credit must attach Form 1118 otherwise known as “Foreign Tax Credit – Corporations,” to its tax return. This is the fifth of a series of articles designed to provide a basic overview of the Form 1118. This article is designed to supplement the instructions for the Form 1118 promulgated by the IRS.
Introduction to Schedule E
Schedule E is designed to report taxes deemed paid by the domestic corporation under Section 960(b) with respect to previously taxed earnings and profits (“PTEP”) distributions. Taxes reported on this schedule are with respect to foreign taxes levied on distributions of PTEP from a lower-tier foreign corporation to an upper-tier foreign corporation when those taxes are subsequently deemed paid by the domestic corporation.
Part I- Foreign Corporation’s Tested Income and Foreign Taxes
Part 1 of Schedule E is used to report the tax deemed paid by the domestic corporation with respect to distributions of previously taxed earnings from foreign corporations under Internal Revenue Code Section 960(b).
Column 1a. Name of Foreign Corporation
For column 1a, the preparer must state the names of each first-tier foreign corporation that had foreign income properly attributable to PTEP distributions to a domestic corporation that were not previously deemed paid by a domestic corporation. For distributions of PTEP that originated in lower-tier corporations, enter a unique alphabetic character before the name of the distributing foreign corporation to identify the source of the PTEP distribution.
Column 1b. Tax Year End
For column 1b, the preparer must state EIN or reference number of the lower-tier foreign corporation.
Column 2. Tax Year End
For column 2, the preparer must enter the year and month in which the CFC’s U.S. tax year ended using the format YYYYMM.
Column 3. Country of Incorporation
For column 3, the preparer should enter the applicable two-letter codes from the list at IRS.gov/CountryCodes to enter the CFC’s country of incorporation.
Column 4. Distribution of Previously Taxed Income
For column 4, the preparer should enter the previously taxed earnings and profits (“PTEP”) distribution by PTEP group within an annual PTEP account as defined in Regulation Section 1.9060-3(c)(2) in the functional currency of the first-tier foreign corporation. If there is a PTEP distribution related to more than one PTEP group within an annual PTEP account, complete a separate line for each PTEP group within an annual PTEP account.
In order to answer column 4, the preparer should have an understanding of the basketing and ordering rules for PTEP distributions. Where the earnings and profits of a CFC consists in whole or in part of PTEP, special rules under Internal Revenue Code 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 such as subpart F or GILTI are not included in gross income again when such amounts are distributed to that U.S. shareholder, directly or indirectly through a chain of ownership of a CFC. A PTEP distribution is generally sourced in the following order: 1) PTEP attributable to investments in U.S. property under Section 959(c)(1); 2) PTEP attributable to subpart F income under Section 959(c)(2); and 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 the 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.
On November 28, 2018, the Department of Treasury and the IRS released proposed regulations related to the ordering rules of foreign tax credits. In addition, Notice 2019-01 announced the Treasury and the IRS’ intention to withdraw prior proposed regulations under Section 959 and issue new proposed regulations. The new proposed regulations described in Notice 2019-01 include rules related to the maintenance of PTEPs in annual accounts and within specified groups and the ordering of PTEPs upon distribution and reclassification. Thus, the proposed regulations would vary the ordering of PTEP attributable to a distribution and require the maintenance of a system to track the various forms of PTEP.
There are also separate basket limitations provided under Internal Revenue Code Section 904(d) to prevent foreign taxes paid on highly-taxed foreign income from being used to offset residual U.S. tax on low-taxed foreign income. Section 904(d) provides for specific baskets for passive, GILTI, foreign branch, and one general, catall basket for active business income. The domestic corporation must properly classify and allocate each item of foreign source income.
In order for the preparer to complete column 4, it is important for the preparer to determine if the domestic corporation has one or more PTEPs that need to be disclosed on Schedule E. Below, please see Illustration 1, which provides an example of disclosing a PTEP on column 4.
Illustration 1.
USC is a domestic corporation. CFC1, a Country Y corporation, wholly owns Country X corporations CFC2 and CFC3. The U.S. tax year for USC, CFC1, CFC2, and CFC3 ends on December 31. During the U.S. tax year ending December 31, 2019, CFC2 and CFC3, both second-tier CFCs, each distribute 100u, comprising all of their respective Section 965(a) PTEP within the annual PTEP account for the 2017 tax year within the general category, to CFC1, a first-tier CFC. CFC1 pays 40u equal to $40 of taxes to Country X on the 200u PTEP distributions, reducing the 2017 Section 965(a) PTEP to 160u. In that same year, CFC1 distributes all 160u of the 2017 Section 965(a) PTEP to USC. CFC1 does not have any other PTEP balances.
USC will make an entry of 160u for column 4.
Column 5. Foreign Income Taxes Properly Attributable to PTEP and Not Previously Deemed Paid
For column 5, the preparer must enter the U.S. dollar amount of the foreign income taxes properly attributable to the PTEP distribution reported in column 4 and not deemed to have been paid by the domestic corporation for the tax year or any prior tax year. The preparer must also under the appropriate translation of the PTEP distribution as determined by Internal Revenue Code Section 986.
Below, please find illustration 2 which provides an example of disclosing a PTEP on not previously deemed paid tax on column 5.
Illustration 2.
USC is a domestic corporation. CFC1 and CFC2 are Country X corporations, and CFC3 is a Country Y corporation. The U.S. tax year for USC, CFC1, CFC2, and CFC3 ends on December 31. During CFC3’s U.S. tax year ending December 31, 2018, CFC3 distributes 100u, compromising its entire Section 965(a) PTEP within the annual PTEP account for the 2017 tax year (“2017 Section 965(a) PTEP”) within the general category, to CFC2, a CFC that wholly owns CFC3. CFC2 pays tax of 20u to Country X equal to $20 on the 100u PTEP distribution, reducing the 2017 Section 965(a) PTEP to 80u. In CFC2’s U.S. tax year ending December 31, 2019, CFC2 distributes 40u of the 2017 Section 965(a) PTEP to CFC1, a CFC that wholly owns CFC2. CFC1 pays no tax on such distribution, but is deemed to pay $10 of the tax paid by CFC2. The USC pays no tax on such distribution, but is deemed to pay $10 of the tax paid by CFC2.
USC will make an entry of $10 for column 5.
In regards to converting foreign currency to U.S. dollars, under Section 986, a domestic corporation that uses the accrual method to account for foreign taxes for purposes of the foreign tax credit translates foreign income taxes accrued into U.S. dollars at the average exchange rate for the tax year to which the taxes relate (rather than at the exchange rate for the date of payment). See IRC Section 986(a)(1)(A). This rule does not apply to 1) any foreign income taxes paid more than two years after the close of the tax year to which the taxes relate; 2) any foreign income taxes paid before the start of the tax year to which the taxes relate; or 3) any foreign income taxes the liability for which is denominated in any inflationary currency. See IRC Section 986(a)(1)(B), (C). This rule does not apply to a domestic corporation that uses the cash method of tax accounting in regards to foreign taxes. In that case, the average exchange rate for the year must be translated at the exchange rate in effect for the date of the payment of the taxes to the foreign country. See IRC Section 986(a)(2)(A).
Section 986(a)(1)(D) also allows a domestic corporation to translate foreign taxes into U.S. dollars using the average exchange rate for the tax year. This election applies to “any foreign income taxes the liability for which is denominated in any currency other than in the domestic corporation’s functional currency.” Under this provision, a domestic corporation may elect to use the exchange rate at the time that the foreign taxes are paid instead of the average exchange rate for the tax year.
Conversions of foreign currencies become complicated under Section 986 if foreign taxes are refunded or credited to a domestic corporation by a foreign country. In these cases, a redetermination must be made using the exchange rate as of the date of the original payment of the taxes.
Please see illustration 3 which demonstrates a redetermination of a previously paid foreign tax credit.
Illustration 3.
DC, a domestic corporation that uses the accrual method for foreign tax credit purposes, accrues in year 1 100 units of foreign tax owing to Country Y. Country Y’s currency is not inflationary. The year 1 Country Y foreign tax is unpaid at the end of year 1. DC does not make an election under Section 986(a)(1)(D). Under Section 986(a)(1), DC translates the 100 units of Country Y foreign tax into U.S. dollars using the average exchange rate for year 1. If DC pays the 100 units of Country Y foreign tax in year 2 or year 3, DC is not required to redetermine its foreign tax for year 1 even if the dollar value of the foreign tax paid differs from the accrued amount due to foreign currency fluctuations. If, however, any portion of the accrued Country Y tax for year 1 remains unpaid as of the end of year 3, DC must redetermine its accrued foreign tax under Section 905(c) for year 1 to eliminate the accrued but unpaid Country Y tax and reduce its foreign tax credit. If DC pays the disallowed tax in year 4, DC must again redetermine its Country Y foreign tax and foreign tax credit for year 1, but the year 1 tax paid by DC in year 4 is translated into U.S. dollars using the exchange rate in effect for the date of the payment in year 4.
Part II- Tax Paid or Deemed Paid by First and Lower-Tier Foreign Corporations
The purpose of Part II is to track the current year and historical PTEP distributions between foreign corporations and taxes paid, accrued, or deemed paid by upper-tier foreign corporations on such PTEP distributions. These amounts are reported on Part 11 of Schedule E only to the extent that there is a PTEP distribution to the domestic corporation entered in Part 1 of Schedule E.
Column 1a. Name of Distributing Foreign Corporation
For column 1a, the preparer should enter the name of the distributing foreign corporation.
Column 1b. EIN or Reference ID Number of the Foreign Corporation
For column 1b, the preparer should state the name or reference number ID number of the foreign corporation.The preparer should enter “A CFC1” (to report distributions from CFC1 to the domestic corporation sourced from PTEP distributions from CFC2 and CFC3).
Column 2. Tax Year End
For column 2, the preparer should enter the U.S. tax year of the distributing foreign corporation which includes the date when the foreign corporation distributed the PTEP to the upper-tier foreign corporation. If the PTEP is from a lower-tier foreign corporation and the PTEP was distributed more than one year earlier, the tax deemed paid should be stated on a separate line by the preparer for each PTEP distribution.
Column 3. Country of Incorporation
For column 3, the preparer should enter the applicable two-letter code for the CFC country of incorporation from the list at IRS.gov/CountryCodes.
Columns 4a and 4b.
For columns 4a and 4b, the preparer should enter the name of the name of the applicable CFC and EIN or reference ID numbers for these columns.
Column 5. Tax Year End.
For column 5, the preparer should enter the U.S. tax year of the recipient foreign corporation which includes the date the foreign corporation received the PTEP distribution.
Column 6. Country of Incorporation
For column 6, the preparer should enter the applicable two-letter codes from the list at IRS.gov/CountryCodes to enter the country of incorporation.
Column 7. Previous Taxed Income
For column 7, the preparer should enter the PTEP distributions by PTEP group within an annual PTEP account as defined in Treasury Regulation 1.960-3(c)(2) in functional currency of the CFC. If there is a PTEP distribution related to more than one PTEP group within an annual PTEP account, the preparer should complete a separate line for each PTEP group within an annual PTEP account. The preparer should only report the amount of PTEP that was ultimately distributed to the domestic corporation in the current year, even if the amount of PTEP distributed to the upper-tier foreign corporation is greater than that amount.
Below, please see illustration 4 which provides an example of reporting PTEPs under column 7.
Illustration 4.
USC is a domestic corporation. CFC1 is a Country X corporation, CFC2 is a Country Y corporation, and CFC3 is a Country Z corporation. The U.S. tax year of USC, CFC1, CFC2, and CFC3 ends on December 31. During CFC3’s U.S. tax year ending December 31, 2017, CFC3 distributes 1,000u, comprising all of its subpart F PTEP within the annual PTEP account for the 2016 tax year (“2016 Section 951(a)(1)(A) PTEP”) within the general category, to CFC2, a CFC that wholly owns CFC3. CFC2 pays tax of 100u to Country Y equal to $100 on the 1,000u PTEP distribution, reducing the 2016 Section 951(a)(1)(A) PTEP to 900u. In CFC2’s tax year ending December 31, 2018, CFC2 distributes 250u, compromising all of its Section 951A PTEP within the annual PTEP account for the 2018 tax year (“2018 Section 951A PTEP”), to CFC1, a CFC that wholly owns CFC2. CFC1 pays tax of 25u to Country X equal to $25 on the 250u PTEP distribution, reducing the 2018 Section 951A PTEP to 225u. During CFC2’s tax year ending December 31, 2019, CFC2 also distributes 450u out of its 2016 Section 951(a)(1)(A) PTEP balance of 900u to CFC1. CFC1 pays tax of 45u to Country X equal to $45 on the 450u PTEP distribution, reducing the 2016 Section 951(a)(1)(A) PTEP to 405u. CFC1 is also deemed to pay $50 of the tax paid by CFC2 on the 2017 distribution of the PTEP from CFC3. In the same year, CFC1 distributes 630u to USC, who wholly owns CFC1, which includes all of CFC1’s 2016 Section 951(a)(1)(A) PTEP of 405u and 2018 Section 951A PTEP of 225u. USC pays no tax on such distribution, but is deemed to pay $50 of the tax deemed paid by CFC1 and the $70 tax paid by CFC1 on the 2018 and 2019 distributions of the PTEO from CFC2.
USC makes the following entry on the first line of Schedule E, Part II, Column 7 with respect to general category income: 405u.
USC makes the following entry on the second line of Schedule E, Part II, Column 7 with respect to general category income: 405u.
USC makes the following entry on the first line of Schedule E, Part II, Column 7 with respect to Section 951A (“GILTI”) category income: 225u.
Column 8. Foreign Taxes Properly Attributable to PTEP and Not Previously Deemed Paid
For column 8, the preparer should enter the U.S. dollar amount of the recipient CFC’s income taxes paid, accrued, and deemed paid that are properly attributable to the PTEP distribution reported in column 7 and not deemed to have been paid by the domestic corporation for any prior tax year. As with Part 1, column 5, the Section 986(a) translation rules apply.
Conclusion
Completing Form 1118 for purposes of claiming foreign tax credits is extraordinarily complex. If your domestic corporation is attempting to claim foreign tax credits, you should consult with an attorney well versed in international tax planning and compliance. We provide international compliance assistance and international tax planning services to domestic corporations. We also assist other tax professionals who need guidance regarding international tax compliance matters.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. 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.