Our Blog

Demystifying the Form 1118 Part 6. Schedule F-1 Determining the Tax Consequences of Dividends from First-Tier Foreign Corporation and Inclusions of the Earnings of a First or Lower Tier Foreign Corporation Prior to Tax Reform

Demystifying the Form 1118 Part 6. Schedule F-1 Determining the Tax Consequences of Dividends from First-Tier Foreign Corporation and Inclusions of the Earnings of a First or Lower Tier Foreign Corporation Prior to Tax Reform

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 sixth 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 F-1

Schedule F-1 is designed to figure the tax deemed paid by a domestic corporation for first-tier corporation and inclusions of earnings from a first or lower tier foreign corporation prior to the Tax Cuts and Jobs Act of 2018. Schedule F-1 is applicable to dividends or inclusions for taxable years of foreign corporations beginning on or before December 31, 2017. If a domestic corporation does not have such dividend or inclusion, the Form F-1 should not be completed.

Part I- Dividends and Deemed Inclusions From Post-1986 Undistributed Earnings

Column 1a. Name of Foreign Corporation

For column 1a, the preparer must enter the name of the foreign corporation (or DISC or Former DISC) whose earnings were distributed to, or included in income by, the domestic corporation filing the return.

Column 1b. EIN

For column 1b, the preparer must enter the EIN of the foreign corporation whose earnings was distributed or included in income by the domestic corporation.

Column 1c. Reference ID Number

For column 1c, the preparer must enter the reference ID number for the foreign corporation of the foreign corporation whose earnings was distributed or included in income of the domestic corporation.

Column 2. Tax Year End

For column 2, the preparer must enter the year and month in which the foreign corporation’s U.S. tax year ended using format YYYMM whose earnings was distributed or included in income of the domestic corporation.

Column 3. Country of Incorporation

For column 3, the preparer must enter the applicable two-letter codes from the list at IRS.gov/CountryCodes of the foreign corporation whose earnings were distributed or included in income of the domestic corporation.

Column 4. Post-1986 Undistributed Earnings (in functional currency)

Column 4 requires the preparer to report the foreign corporation’s “post 1986 undistributed earnings pool” whose earnings were distributed or included in income of the domestic corporation. According to the IRS’ instructions, a foreign corporation’s earnings and profits equals its taxable income, plus or minus various adjustments (such as taxes) designed to make earnings and profits a better measure of the corporation’s economic income. Examples of the required adjustments include adding back tax-exempt income, adding back the excess of accelerated depreciation over straight-line depreciation, and subtracting foreign income taxes. See Treas. Reg. Section 1.902-1(a)(9)(iii).

The Internal Revenue Code provides that the “post-1986 undistributed earnings” of a foreign corporation are the total earnings for years starting in 1987 through the end of the tax year in which a dividend is distributed (prior to the 2018 tax year), undiminished by any dividend distributions made during that year. See Former IRC Section 902(c)(1); Treas. Reg. Section 1.902-1(a)(9)(i). 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). The corporation’s pool of post-1986 foreign taxes were reduced to reflect the portion of taxes deemed paid with respect to such dividends for purposes of computing Section 902 credits in subsequent tax years.

Please see Illustration 1 below for an example calculating “post-1986 undistributed earnings”

Illustration 1.

Gamma S.A., a corporation under the laws of Country M, is a wholly owned subsidiary of American Gamma Corporation, a U.S. 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 Foreign Taxes

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

Total 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 Foreign Taxes Paid Total

$600,000              – $180,000 = $420,000

Gamma S.A.’s post-1986 undistributed earnings as of year 4 would be $420,000.

If a U.S. corporation includes an amount in income under Section 951(a) with respect to a lower-tier foreign corporation, under the previously taxed income rules, the retained earnings of the lower-tier corporation will be treated as having been previously income in income of the U.S. corporation. See IRC Section 959(a).

The post 1986 undistributed earnings of the domestic corporation in functional currency must be entered in column 4.

Column 5. Opening Balances in Post-1986 Foreign Income Taxes

For column 5, the preparer must enter the opening balance in the distributing corporation’s post-1986 foreign income taxes pool for the tax year indicated. According to the “pool rules,” prior to 2018, a foreign corporation would pool its undistributed earnings and profits and foreign income taxes. Post-1986 undistributed earnings and profits is computed as of the close of the foreign corporation’s taxable year in which it distributes the dividend and equals the cumulative amount of the foreign corporation’s undistributed earnings and profits for taxable years beginning after December 31, 1986. Post-1986 undistributed earnings and profits is reduced by actual dividend distributions from prior taxable years, as well as any prior year inclusions of the foreign corporation’s earnings and profits in a shareholder’s income (e.g., income inclusions under subpart F). However, post-1986 undistributed earnings and profits are not reduced by the dividend distribution or any other inclusions in a shareholder’s income for the current taxable year. See IRC Section 902(c)(1); Treas. Reg. Section 1.902-1(a)(9).

The opening balance that should be entered on column 5 equals the earnings and profits as determined at the close of the previous tax year that utilized the post-1986 foreign income tax pools.

Below, please see Illustration 2 for an example of how a foreign corporation’s post-1986 pooling rules operates.

Illustration 2.

USAco, a domestic corporation, owns 100 percent of EURco, a foreign corporation. EURco’s earnings and profits, foreign income taxes, and dividend distributions for its first two years of operation are as follows:

Pre-tax Foreign Effective Earnings &     Dividend
Year   earnings income taxes foreign rate   profits          distributions

1 $10 Mill $2 mill 20% $8 mill     $0

2 $10 Mill $4 Mill 40% $6 mill   $3 mill

Because the foreign tax rate on EURco’s earnings increase from 20 percent in year 1 to 40 percent in year 2, the last-in, first-out method would pull out more foreign taxes than the pooling method, as discussed below.

Last-in, first out method: Under a last-in, first-out tracing rule, the $3 million dividend represents a distribution of 40 percent of EURco’s year 2 earnings and profits of $6 million and, therefore, the dividend pulls out foreign income taxes of $2 million [50% x $4 million of year 2 foreign income taxes].

Pooling method: Prior to the dividend, EURco has undistributed earnings and profits of $14 million [$8 million + $6 million] and foreign income taxes of $6 million [$2 million + $4 million]. Therefore, under a pooling approach, the $3 million dividend pulls out foreign income taxes of roughly $1,285,714 [$6 million of foreign income taxes x ($3 million dividend divided by $14 million of earnings and profits].

A pooling approach is required for post-1986 dividends, whereby a domestic corporation that receives a dividend from a 10 percent or more owned foreign corporation is deemed to have paid the following portion of the foreign corporation’s foreign income taxes:

Foreign corporation’s Dividend
post-1986 foreign X foreign corporation’s
Income taxes post-1986 undistributed E&P

Post-1986 foreign income taxes equal the cumulative amount of a foreign corporation’s foreign income taxes for taxable years beginning after December 31, 1986 (including the foreign income taxes for the year of the dividend), reduced by the amount of foreign income taxes related to prior year dividend distributions or other inclusions of the foreign corporation’s earnings and profits in a shareholder’s income (e.g., inclusion under subpart F) regardless of whether those other shareholders were eligible to claim a deemed paid credit.

Column 6. Foreign Taxes Paid and Deemed Paid for Tax Year Indicated

Column 6a. Taxes Paid

For column 6a, the preparer must enter the foreign taxes paid or accrued by the foreign corporation for the tax year indicated, translated into U.S. dollars using the exchange rates specified in Section 986(a). Post-1986 foreign income taxes equal the cumulative amount of a foreign corporation’s foreign income taxes for taxable years beginning after December 31, 1986, reduced by the amount of foreign income taxes related to prior year dividend distribution or other inclusions of the foreign income taxes related to prior-year dividend distributions or other inclusions of the foreign corporation’s earnings and profits in a shareholder’s income (e.g., income inclusions under subpart F), regardless of whether those other shareholders were eligible to claim a deemed paid credit. See IRC Section 902(c); Treas. Reg. Section 1.902-1(a)(8).

The term “foreign income taxes” has the same meaning for purposes of the deemed paid credit as it does for purposes of the direct foreign tax credit. As a result, to be credible, a levy paid by a foreign corporation must meet two basic requirements. First, the levy must be a tax (as opposed to a payment in exchange for a specified economic benefit) that is paid to a foreign country or US possession. Second, the predominant character of the tax must be that of an income tax in the US sense. See IRC Section 901(b). If a foreign levy satisfies the first requirement but not the second, the foreign levy may still be credible if the tax is imposed in lieu of an income tax. See IRC Section 903. As will be discussed in column 6b, foreign income taxes also include any taxes that a foreign corporation is deemed to have paid by reason of receiving a dividend from a lower-tier foreign corporation. If two or more commonly controlled foreign corporations file a consolidated foreign income tax return and the corporations are jointly and severally liable for the foreign income tax, then each corporation is treated as having paid a portion of the foreign income tax equal to its proportionate share of the combined income tax base. See Treas. Reg. Section 1.901-2(f)(3).

Under Section 986, a taxpayer that uses the accrual method to account for foreign taxes for purposes of the foreign tax credit generally translates foreign taxes accrued into US 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 in which the liability is denominated in any inflationary currency. See IRC Section 986(a)(1)(B), (C).

The 2004 JOBS Act added Section 986(a)(1)(D) to the Internal Revenue Code. Under this provision, a taxpayer 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. Once made, the election applies to the tax year for which it was made and all later tax years unless revoked with the IRS’ consent.

Column 6b. Taxes Deemed Paid

For column 6b, the preparer must enter the foreign taxes deemed paid (under Section 902(b)) by the corporation for the tax year indicated. This is generally the amount(s) from Schedule F-2, Part 1, Section A, column 10, and Section B, column 8(b). However, when determining deemed paid taxes under Section 960(a) related to a subpart F inclusion from a lower-tier corporation (that is, a corporation, below the first-tier foreign corporation), enter the applicable amounts for that lower-tier foreign corporation. Special rules apply to in cases of multi-tiered entities and claiming deemed paid taxes in these situations.

If the domestic corporation (completing Schedule F-1) operates abroad through multiple layers of foreign corporations. The domestic corporation also can obtain deemed paid credits for taxes paid by second-and third-tier foreign corporations. This is possible because, for purposes of computing the deemed paid credit, a first-tier corporation’s foreign income taxes include not only its foreign income taxes actually paid, but also any foreign income taxes it is deemed to have paid by reason of receiving a dividend from a qualifying lower-tier foreign corporation. See Former IRC Section 902(c)(4).

Foreign income taxes paid by a second-tier foreign corporation pass up to a first-tier foreign corporation if the following requirements are satisfied:

1. The domestic corporation owns 10 percent or more of the voting stock of the first-tier foreign corporation.

2. The first-tier foreign corporation owns 10 percent of the voting stock of the second-tier foreign corporation.

3. The domestic corporation indirectly owns at least 5 percent of the second-tier foreign corporation, determined the percentage ownership at the two levels, and

4. The first-tier foreign corporation receives a dividend from the second-tier foreign corporation. See Former IRC Section 902(b).

If the above rules are satisfied, the domestic corporation can claim a deemed credit from a first or second-tiered corporation.

Column 7.

For column 7, the preparer must add columns 5, 6(a) and 6(b).

Column 8. Dividends and Deemed Inclusions

8a. Functional Currency

For column 8a, the preparer must report the sum (in the foreign corporation’s functional currency) of all dividends paid and deemed inclusions out of post-1986 undistributed earnings for the tax year indicated. Section 964(a) provides that earnings and profits of a foreign corporation is “determined according to rules substantially similar to those applicable to domestica corporations.” See United States v. Goodyear Tire & Rubber Co. 493 U.S. 132 (1989).

Column 8b. U.S. Dollars

For column 8b, the preparer must report the column 8a amounts, translated into U.S. dollars at the appropriate exchange rates (as defined in Section 989(b)). If the foreign corporation’s functional currency is the US dollar, do not complete column 8b.

Column 9.

For column 9, the preparer must divide column 8(a) by column 4.

Column 10.

For column 10, the preparer must multiply column 7 by column 9.

Column 11. Section 960(c) Limitation

For column 11, the preparer must enter foreign income taxes deemed paid during the current year that exceed the limit (with respect to Section 956 inclusions) described in Section 960(c) (as in effect prior to its amendment by the Act).

Internal Revenue Code Section 960, as amended by the 2017 Tax Cuts and Jobs Act, adopts a new “properly attributable to” standard to determine the amount of foreign taxes deemed paid by U.S. shareholders of CFCs with respect to certain income inclusions from CFCs, including amounts included in U.S. shareholder’s gross income under Section 951(a). Section 960(a) now provides that U.S. corporate shareholders that include “any item of income under Section 951(a)(1)” with respect to any CFC shall be deemed to have paid “so much of such foreign corporation’s foreign income taxes as are properly attributable to such item of income.” Thus, as a threshold matter, Section 960(a) provides a basis for deemed-paid credits with respect to inclusions under Section 951(a)(1)(A) (Subpart F inclusions), Section 951A (“GILTI”), and Section 956 inclusions. As part of the price of claiming the Section 960 foreign tax credit, a shareholder must gross up the inclusion by the amount of foreign tax credit, a shareholder must gross up the inclusion by the amount of foreign taxes properly attributable to it pursuant to Section 78.

Column 12.

For column 12, the preparer must subtract column 11 from column 10.

Part II- Dividends Paid Out of Pre-1987 Accumulated Profits

Use a separate line for each dividend paid. If a dividend is paid out of accumulated profits of more than 1 pre-1987 tax year, figure and show the tax deemed paid on a separate line for each year.

Column 1a. Name of Foreign Corporation

For column 1a, the preparer must enter the name of the first-tier foreign corporation (or DISC or Former DISC) that paid dividends out of pre-1987 profits to the domestic corporation filing the return.

Column 1b. EIN

For column 1b, the preparer must enter the EIN number of the first-tier foreign corporation.

Column 2. Tax Year End

For column 2, the preparer must enter the year and month in which the foreign corporation’s pre-1987 tax year ended using the format YYYYMM

Column 3. Country of Incorporation

For column 3, the preparer must enter the applicable two-letter codes from the list at IRS.gov/CountryCodes of the first-tier foreign corporation.

Column 4. Accumulated Profits for the Tax Year

For each line, enter the pre-1987 accumulated profits for the tax year indicated in column 2, computed in functional currency under Section 902.

Between 1987 and 2017, a pooling approach was required to determine the accumulated earnings and profits of a foreign corporation. Prior to 1987, a last in, first out rule was used, whereby pre-1987 annual earnings were layered in chronological order and a dividend pulled out a layer of earnings (and, in turn, a layer of foreign income taxes) in reverse chronological order. See IRC Section 902(c)(1), before amendment in 1986. The portion of a dividend traced to a pre-1987 year’s profits pulls out deemed paid taxes equal to the foreign income taxes for that year multiplied by the ratio of the dividend from that year to the total earnings and profits for that year.

Column 5. Foreign Taxes Paid and Deemed Paid on Earnings and Profits

For column 5, the preparer must enter the foreign taxes paid and deemed paid (in functional currency) out of accumulated profits of the pre-1987 tax year indicated in column 2. This was done by applying a last-in, first-out rule, whereby pre-1987 annual earnings were layered in chronological order and a dividend pulled out a layer of earnings (and in turn, a layer of foreign income taxes) in reserve chronological order. See IRC Section 902(c)(1), before amendment in 1986. The portion of a dividend traced to a pre-1987 year’s profits pulls out deemed paid taxes equal to the foreign income taxes for that year multiplied by the ratio of the dividend from that year to the total earnings and profits for that year.

For column 5, the preparer must enter the foreign taxes paid and deemed paid (in functional currency) with respect to the 1987 accumulated profits rule discussed above.

Column 6. Deemed Inclusion

Column 6a. Functional Currency

For column 6a, the preparer must enter the amount of each dividend paid by the first-tier foreign corporation (or DISC or former DISC) to the domestic corporation (in functional currency) out of the accumulated profits of the pre-1987 tax year indicated in column 2.

Column 6b. U.S. Dollars

Enter the amount from column 6a translate into U.S. dollars using the spot exchange rate in effect on the date of distribution. The income tax regulations define spot rate as one “demonstrating to the satisfaction of the IRS to reflect a fair market rate of exchange available to the public for currency under a spot contract in a free market and involving representative amounts.” In the absence of such a showing by the taxpayer, the regulations state that the IRS may make a determination in its “sole discretion.” See Treas. Reg. Section 1.988-1(d)(1).

In some countries there is a differential between the official exchange rate and the free market rate. Transactions involving the latter may in some cases be of dubious legality. In a number of developing countries there may be two foreign exchange “windows.” One window will effect exchanges at the official rate for qualified transactions that are encouraged by the government. The other window will use a floating free market rate. Under these circumstances, “the spot rate shall be the rate which most clearly reflects the taxpayer’s income.” Generally, this shall be the free market rate. See Treas. Reg. Section 1.988-1(d)(4)(i). Exchange rates determined over a period of time will be based on “the average exchange rate” for the tax year. This rate is defined by the regulations to be “the simple average of the daily exchange rates (determined by reference to a qualified source of exchange rates), excluding weekends holidays and any other nonbusiness days for the taxable year. See Treas. Reg. Section 1.989(b)-1. 

Column 7.

For column 7, the preparer should divide column 6(a) by column 4.

Column 8. Tax Deemed Paid

Column 8a. Functional Currency

For column 8a, the preparer should multiple column 5 by column 7. This amount should be entered in column 8(a) in functional currency.

Column 8b. U.S. Dollars

For column 8b, the preparer should enter the amount from column 8a translated into U.S. dollars at the spot exchange rate in effect on the date of distribution. See column 6b for a discussion regarding spot exchange rates.

Part III Deemed Inclusions from Pre-1987 Earnings and Profits

Column 1a. Name of Foreign Corporation

For column 1a, the preparer should enter the name of the first or lower-tier foreign whose earnings were deemed included in the income of the domestic corporation filing the return.

Columns 1b and 1c.

See columns 1b and 1c for Parts I and II.

Column 2. Tax Year End

For column 2, enter the year and month in which the corporation’s pre-1987 tax year ended using the format YYYYMM. If the deemed inclusion is from the accumulated E&P of more than one tax year, the preparer should calculate and show the tax deemed paid on a separate line for each year.

Column 3. Country of Incorporation

For column 3, the preparer must enter the two-letter codes from the list at IRS.gov/CountryCodes of the first-tier foreign corporation.

Column 4. E&P for Tax Year Indicated

For column 4, enter the E&P calculated in U.S. dollars under Regulation 1.964-1 translated into functional currency under Notice 88-70 for the tax year indicated in column 2. Prior to the Tax Reform Act of 1986, the earnings and profits of a foreign corporation were computed and translated into dollars under the rules of either Section 902 or Section 964 depending on the reason that the translation was required. The Section 964 method was used for calculating the amount of deemed income inclusions under Sections 951(a), 1248, and 367(b). The Section 964 E&P consisted of the current year’s operating income and foreign exchange gain or losses based on a translation of the foreign corporation’s balance sheet.

The Section 902 method was used for computing the taxable portion of actual dividends (as opposed to deemed income inclusions) as well as the associated deemed paid foreign tax credits under Section 902. Section 902 E&P included only operating income translated into dollars. Notice 88-70 provided for the translation of pre-1987 Section 964 E&P using 1987 functional currency spot rate. Notice 88-70provided that for purposes of computing the Section 960 denominator in such cases, the amount of any accumulated pre-1987 E&P deficit can be brought forward for Section 902 deficit calculation purposes.

For column 4, the preparer should enter the E&P calculated in U.S. dollars under Treasury Regulation 1.964-1 and Notice 88-70.

Column 5. Foreign Taxes Paid and Deemed Paid for Tax Year

For column 5, the preparer should enter the foreign taxes paid and deemed paid (in U.S. dollars) with respect to the E&P entered in column 4.

Column 6. Deemed Inclusions

Column 6a. Functional Currency

For column 6a, the preparer should enter the deemed inclusion E&P of the first-tiered foreign corporation.

Column 6b. U.S. Dollars

For column 6b, enter the amount from column 6a translated into U.S. dollars at the appropriate exchange rates stated in Section 989(b). See column 6a from Part II for a more detailed discussion of Section 989(b).

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.

415.318.3990