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 seventh 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-2
Schedule F-2 is designed to compute the tax deemed paid by a first-tier foreign corporation with respect to dividends received from a second-tier foreign corporation prior to the Tax Cuts and Jobs Act of 2018. Schedule F-2 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 a dividend or inclusion, the Form F-2 should not be completed.
Part I- Tax-Deemed Paid by First Tier Foreign Corporation
Section A- Dividends Paid Out of Post-1986 Undistributed Earnings
Column 1a. Name of Foreign Corporation
For column 1a, the preparer should enter the name of the second-tier foreign corporation and the name of the first-tier foreign corporation to which it paid a dividend out of post-1986 undistributed earnings. For example, the domestic corporation filing the return owns all of the stock of CFC1 and CFC2. CFC1 and CFC2 each own 50 percent of the stock of CFC3. In 2017, CFC3 pays a dividend to CFC1 and CFC2. Use one line to report dividends from CFC3 to CFC1 and another to report dividends from CFC3 to CFC2.
Column 1b. EIN
For column 1b, the preparer must enter the EIN of the foreign corporation for the second-tier foreign corporation that paid dividends out of post-1986 undistributed earnings.
Column 1c. Reference ID Number
Enter the reference ID number for the second-tier foreign corporation that paid dividends out of post-1986 undistributed earnings.
Column 2. Tax Year End
Enter the year and month in which the second-tier foreign corporation’s U.S. tax year ended using format YYYYMM that paid dividends out of post-1986 undistributed earnings.
Column 3. Country of Incorporation
For column 3, the preparer must enter the applicable two-letter codes from the list at IRS.gov/CountryCodes for the second-tier foreign corporations that paid dividends out of post-1986 undistributed earnings.
Column 4. Post-1986 Undistributed Earnings (in functional currency)
For column 4, the preparer must enter the second-tier corporation’s post 1986 undistributed earnings pool (in functional currency) for the separate category for which this schedule is being completed.
The second-tier corporation’s post-1986 undistributed earnings and profits is computed as of the close of the corporation’s taxable year in which it distributes the dividends. This equals the cumulative amount of the foreign corporation’s undistributed earnings and profits for taxable years beginning after December 31, 1986 to December 31, 2017. 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 a dividend distribution or any other inclusion in a shareholder’s income for the current taxable year. See Former IRC Section 902(c)(1) and Treas. Reg. Section 1.902-1(a)(9).
A second-tier foreign corporation’s earnings and profits equals its taxable income, plus or minus various adjustments (such as taxes). Examples of 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 IRC Section 312; Treas. Reg. Section 1.902-1(a)(9)(iii). In all cases, a foreign corporation’s post 1986 earnings and profits are determined according to substantially the same U.S. tax accounting principles that apply to domestic corporations. See Goodyear Tire & Rubber Co., 493 U.S. 132 (1989). The same pooling mechanism applies to dividends paid by second-tier foreign corporations if they constitute a controlled foreign corporation (“CFC”) and the U.S. parent corporation is a United States shareholder in the foreign corporation. As a consequence, second-tier corporate financial statements should be adjusted to make them consistent with U.S. accounting principles.
Column 5. Opening Balance Post 1986 Foreign Income Taxes
For column 5, the preparer must enter the opening balance of the second-tier corporation’s post 1986 foreign income taxes pool. This is the foreign income taxes paid, accrued, or deemed paid (in U.S. dollars) by the second-tier foreign corporation for prior years beginning after 1986 and ending before 2018, reduced by foreign taxes attributable to distributions or deemed inclusions of earnings in prior years.
Column 6a. Foreign Taxes Paid and Deemed Paid for Tax Year Indicated
For column 6a, the preparer must enter the foreign taxes paid or accrued by the second-tier corporation, 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 (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., income inclusions under subpart F), regardless of whether those other shareholders were eligible to claim a deemed paid credit. See Former IRC Section 902(c); Treas. Reg. Section 1.902-1(a)(8).
The term “foreign income taxes” had the same meaning for purposes of the deemed paid credit as it does for purposes of the direct foreign tax credit. First, the levy must be a tax (as opposed to a payment in exchange for a specific economic benefit) that is paid to a foreign country. Second, the predominant character of the tax must be that of an income tax in the U.S. sense.
Foreign corporations (such as second-tier foreign corporations) usually conduct a significant part of their activities in an economic environment in which a foreign currency is used and usually keep their books and records in a foreign currency. This may create currency translation issues for the domestic corporation completing the Form 1118. This is addressed in Internal Revenue Code Section 986. Under Internal Revenue Code Section 986, a corporation that uses the accrual method to account for foreign taxes for purposes of the foreign tax credit generally translates foreign 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 for the liability which 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. This election allows corporate taxpayers to utilize the exchange rate at the time foreign taxes are paid instead of the average exchange rate for the tax year. The second-tier foreign corporation must utilize one of the exchange rates discussed above.
Column 6b. Taxes Deemed Paid
For column 6b, the preparer must state the taxes deemed paid by the second-tier corporation for a first tier corporation. This is generally the amount(s) from Schedule F-2, Part 1, Section A, column 10, and Section B, column 8(b). When determining deemed paid taxes under Section 960(a) related to a subpart F inclusion from a lower-tier foreign corporation (that is, a corporation, below the first-tier foreign corporation), the amounts of taxes deemed paid must be taken into consideration for each lower-tier foreign corporation.
Foreign income taxes paid by a second-tier foreign corporation pass up to the 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).
Thus, the deemed foreign taxes is counted as part of the taxes paid by the recipient when it, in turn, pays the tax at the next level. At each level there must be ownership of at least ten percent of the voting stock of the next level subsidiary.
Below, please find illustration 1 which provides an example of determining the deemed paid credits of a first and second tier foreign corporation prior to 2017 Tax Reform.
Illustration 1.
USAco (a domestic corporation) owns 100 percent of F1, and F1 owns 100 percent of F2. F1 and F2 are both foreign corporations. At the end of the current year, the undistributed earnings and foreign taxes of F1 and F2 are as follows:
F1 F2
Post-1986 undistributed earnings and profits $18 million $6 million
Post-1986 foreign income taxes $4 million $3 million
During the current year, F2 distributes a $2 million dividend to F1 and F1 distributes a $2 million dividend to USco. The $2 million dividend from F2 removes $1 million of deemed paid taxes for F1 [$3 million of post-1986 foreign income taxes x ($2 million dividend divided by $6 million of post-1986 undistributed earnings)]. After taking into account the $2 million dividend from F2, F1’s post-1986 undistributed earnings and profits increase to $20 million [$18 million + $2 million] and (assuming F2’s dividend is exempt from local taxation in F1’s country) F1’s post-1986 foreign income taxes increase to $5 [$4 million + $1 million]. As a consequence, USco’s receipt of a $2 million dividend from F1 removes deemed paid taxes of $500,000 [$5 million of post-1986 undistributed earnings)] and USAco must recognize dividend income of $2.5 million.
Column 7.
For column 7, the preparer must add columns 5, 6(a), and 6(b).
Column 8. Dividends Paid Out
Column 8a. Dividends of Second-Tier Corporation
For column 8a, the preparer must enter the dividends of a second-tier corporation. A dividend of a second-tier foreign corporation is counted as part of the taxes paid by the recipient (a first-tier foreign corporation) when it, in turn, pays a dividend to the next level. As with foreign tax credits, at each level of payment of a dividend there must be ownership of at least ten percent of the voting stock of the next level subsidiary. Assuming these rules are satisfied, the dividends of the second-tier corporation paid out of its post-1986 undistributed earnings should be entered on column 8a.
Column 8b. Dividends of First-Tier Corporation
For column 8b, the preparer must enter the sum of column 8(a) amounts translated into the functional currency of the first-tier foreign corporation at the spot rate of exchange in effect on the date of each distribution. A spot exchange rate is the current price level in the market to directly exchange one currency for another, for delivery on the earliest possible value date.
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.
Section B- Dividends Paid Out of Pre-1987 Accumulated Earnings
Section B of Schedule F-2 is designed to track dividends out of pre-1987 accumulated profits. A preparer should understand the regulations provide special rules for computing foreign taxes deemed paid under Section 902 when there are deficits in a foreign corporation’s post-1986 undistributed earnings or pre-1987 accumulated profits. Treasury Regulation provides that if there is a deficit in post-1986 undistributed earnings of a first or second-tier foreign corporation and the foreign corporation makes a dividend distribution to shareholders, the deficit is carried back to the most recent pre effective date tax year of the first or second-tier corporation with positive accumulated profits determined under the pre-1986 Tax Act version of Section 902. The amount carried back reduces the deficit in the foreign corporation’s pool of post-1986 undistributed earnings, but any foreign income taxes paid with respect to those earnings are not carried back to a tax year starting before 1987.
In computing a Section 902 deemed-paid foreign tax credit for dividends paid in a taxable year of a foreign corporation (for purposes of pre-1987 earnings and profits to post-1986 earnings and profits), the amount of a deficit in earnings and profits (or after-tax accumulated profits) of the foreign corporation accumulated as of the end of the post-1986 undistributed earnings pool. Such amount is carried forward as of the first day of the foreign corporation’s first taxable year beginning after December 31, 1986.
See Illustration 2 which illustrates this rule.
Illustration 2.
Calendar
Taxable
Year
Share Current E&P Post-86 Post-86
Holder After-tax Undistri Foreign Pool of
And Accumulated Current Buted Income Foreign Dec. 31
Foreign Profit Accum Earnings Taxes Income Distri
Corp. (Deficits) E&P Pool (Annual) Taxes Butions
1984 25u 25u 20u 0
1985 (100u) (75u) 5u 0
1986 (25u) (100u) 0 0
1987 200u 100u 100u $100 $100 0
1988 100u 200u 200u $50 $150 200u
1989 100u 100u 100u $50 $50 0
Under Section 316(a), the 1988 dividend distribution of 200u represents all the earnings and profits (current plus accumulated) of the foreign corporation and is made out of the post-1986 undistributed earnings pool. The denominator of the Section 902 fraction for the 1988 distribution is 200u (post-1986 undistributed earnings of 300u reduced by the 100u accumulated deficit carried forward from 1986), and the Section 902 credit is $150. None of the foreign income taxes associated with pre-1987 tax years will be carried forward and included in the post-1986 pool of foreign income taxes.
Column 1a. Foreign Taxes Paid and Deemed Paid for Tax Year Indicated
For column 1a, the preparer must enter the name of the second-tier and its related first-tier corporation for which dividends are paid out of pre-1987 accumulated profits.
Column 1b. EIN of Second-Tier Foreign Corporation
For column 1b, the preparer must list the EIN number of the second-tier foreign corporation.
Column 1c. Reference ID Number
For column 1c, the preparer must enter the reference ID number for the second tier corporation for which dividends are paid out of pre-1987 accumulated profits.
Column 2. Tax Year End
For column 2, the preparer must enter the year and month of the second-tier corporation paying dividends out of pre-1987 accumulated profits using format YYYYMM.
Column 3. Country of Incorporation
For column 3, the preparer must enter the country of incorporation for the second-tier corporation paying dividends out of pre-1987 accumulated profits from the list at IRS.gov/CountryCodes.
Column 4. Pre-1987 Accumulated Profits
For column 4, the preparer must enter the pre-1987 accumulated profits of the third-tier foreign corporation to the second-tier foreign corporation for the tax year which Schedule F-2 is prepared under Section 902. Before 1987, the earnings of a foreign corporation for purposes of computing the Section 902 foreign tax credit were calculated year by year and were matched with foreign taxes paid or accrued each year. If a dividend exceeded the earnings of the current 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 accumulated earnings of the next preceding year and so on until the dividend had been completely covered by accumulated earnings to the extent available. A separate Section 902 calculation of the deemed-paid credit had to be made for each year to which a portion of the dividend was allocated, using the taxes paid and the accumulated earnings of that year.
Prior to 1987, a last-in, first-out rule was used, whereby pre-1987 annual earnings were layered in chronological order and a dividend was allocated out of a layer of earnings in reverse chronological order. See IRC Section 902(c)(6). See Illustration 3 for an example of how to track pre-1987 earnings and profits of a foreign corporation such as a second-tier foreign corporation.
Illustration 2.
USAco, a domestic corporation, owns 100 percent of EURco a foreign corporation. EURco’s earnings and profits, foreign income taxes, and dividends for its first two years of operation are as follows:
Pre-tax Foreign Effective Dividend
Year earnings income taxes foreign rate E&P Distribution
Year 1 $10 m $2 m 20% $8 m $0
Year 2 $10 m $4 m 40% $6 m $3 m
Under a last-in, first-out tracing rule (pre-1987), the $3 million dividend represents a distribution of 40 percent of EURco’s year 2 earnings and profits of $60 million and, therefore, the dividend pulls out foreign income taxes of $2 [50% x $4 million of year 2 foreign income taxes].
Column 5. Foreign Taxes Paid and Deemed Paid Under Pre-1987 Accumulated Profits of a Second-Tiered Foreign Corporation
For column 5, the preparer must enter the foreign taxes paid and deemed paid under Section 902(b)(in functional currency) with respect to the accumulated profits entered in column 4 for the pre-1987 tax year indicated in column 2 for the third tier-foreign corporation. Please see Illustration 3 for a discussion regarding the determination of foreign taxes paid and deemed paid out of pre-1987 accumulated profits.
Column 6. Dividends Paid
Column 6a. Dividends Paid of Second-Tiered Corporation
For column 6a, the preparer must enter the foreign taxes paid or accrued by the second-tier foreign corporation (in functional currency) to the third-tier corporation out of the accumulated profits of the pre-1987 tax year indicated in column 2.
Column 6b. Dividends Paid of First-Tier Corporation
For column 6b, the preparer must enter the amount from column 6(a), translated into the first-tier foreign corporation’s functional currency using the spot exchange rate in effect on the date of distribution.
Column 7.
For column 7, the preparer must divide column 6(a) by column 4.
Column 8. Taxes Deemed Paid by First and Second Tiered Foreign Corporations
For column asks the preparer to state the taxes paid on dividends by first and second-tiered foreign corporations. The formula for calculating foreign taxes deemed paid by a first-tier foreign corporation under Section 902(b) with respect to dividends paid by a second-tier foreign corporation in a post-1986 year out of pre-1987 accumulated profits requires that all components (dividends, accumulated profits, and taxes) be mained in the third-tier foreign corporation’s functional currency. Dividends are translated to the second-tier foreign corporation’s functional currency and added to its post-1986 undistributed earnings at the exchange rate in effect on the date of the dividend distribution.
8a. Taxes Paid to a Second Tiered Corporation
For column 8a, the preparer should multiple column 5 by column 7 and enter the result.
Column 8b. Tax Deemed Paid
For column 8b, the preparer should enter the amount from column 8a, translated in U.S. dollars at the spot exchange rate in effect on the date of distribution.
Part II- Dividends Deemed Paid by Second-Tier Foreign Corporation
Section A Dividends Paid Out of Post-1986 Undistributed Earnings
Column 1a. Name of Third-Tier Foreign Corporation and its Related Second-Tier Foreign Corporation
For column 1a, the preparer should enter the name of the third-tier foreign corporation and the name of the second-tier foreign corporation to which it paid a dividend out of post-1986 undistributed earnings.
Column 1b. EIN
For column 2b, the preparer should enter the EIN of the third-tier foreign corporation.
Column 1c. Reference ID Number
For column 1c, the preparer should enter the reference ID number of the third-tier foreign corporation.
Column 2. Tax Year End
For column 2, the preparer should enter the year and month in which the third-tier foreign corporation U.S. tax year ended using format YYYYMM that paid dividends out of post-1986 undistributed earnings.
Column 3. Country of Incorporation
For column 3, the preparer must enter the applicable two-letter codes from the list at IRS.gov/CountryCodes for the foreign corporations that paid dividends out of post-1986 undistributed earnings.
Column 4. Post-1986 Undistributed Earnings
For column 4, the preparer must enter the third-tier corporation’s post 1986 undistributed earnings pool (in functional currency) for the separate category for which this schedule is being completed. The “post-1986 undistributed earnings” of a foreign corporation are the total earnings for years starting in which a dividend is distributed (prior to January 1, 2018), undimished by any dividend distributions made during that year. See Former IRC Section 902(c)(1); Treas. Reg. Section 1.902-1(a)(9)(i).
Column 5. Opening Balance Post 1986 Foreign Income Taxes
For column 5, the preparer must enter the opening balance of the third-tier corporation’s post 1986 foreign income taxes pool.
Column 6 Foreign Taxes Deemed Paid for Tax Year Indicated
Column 6a. Foreign Taxes Paid
For column 6a, the preparer must enter the foreign taxes paid or accrued by the third-tier corporation, translated into U.S. dollars using the exchange rates in Section 986(a).
Column 6b. Foreign Taxes Deemed Paid
For column 6b, the preparer must enter the amount stated on Schedule F-3, Part 1, column 10.
Column 7. Post 1986 Foreign Income Taxes
For column 7, the preparer must add columns 5, 6(a), and 6(b).
Column 8a. Dividends Paid Third-Tier Corporation
For column 8a, the preparer must enter the dividends of the third-tier corporation. A dividend of a third-tier foreign corporation is counted as part of the taxes paid by the recipient when it, in turn, pays a dividend to the next level. As with foreign tax credits, at each level of payment of a dividend there must be ownership of at least 10 percent of the voting stock of the next level subsidiary. Assuming these rules are satisfied, the dividends of the third-tier corporation paid out of its post-1986 undistributed earnings should be entered on column 8a.
Column 8b. Dividends Paid of Second Tier Corporation
For column 8b, the preparer must enter the sum of column 8(a) translated into the functional currency of the second-tier foreign corporation at the spot rate in effect on each date of each distribution.
Column 9.
For column 9, the preparer must divide column 9(a) by column 4.
Column 10.
For column 10, the preparer must multiply column 7 by column 9.
Section B- Dividends Paid Out of Pre-1987 Accumulated Profits
Column 1a. Name of Third-Tier Foreign Corporation and its Related Second-Tier Foreign Corporation
For column 1a, the preparer must enter the name of the third and its related second-tier foreign corporation.
Column 1b. EIN of the Third-Tier Foreign Corporation
For column 1b, the preparer must list the EIN number of the third-tier foreign corporation.
Column 1c. Reference ID Number
For column 1c, the preparer must enter the reference ID number for the third-tier foreign corporation for which dividends are paid out of pre-1987 accumulated profits.
Column 2. Tax Year End
For column 2, the preparer must enter the year and month of the third-tier corporation paying dividends out of pre-1987 accumulated profits using format YYYYMM.
Column 3. Country of Incorporation
For column 3, the preparer must enter the country of incorporation for the third-tier corporation paying dividends out of pre-1987 accumulated profits from the list at IRS.gov/CountryCodes.
Column 4. Pre-1987 Accumulated Profits
Please see column 4, Part I, Schedule B to Schedule F-3.
Column 5. Foreign Taxes Paid and Deemed Paid for Tax Year Indicated (in Functional Currency)
For column 5, the preparer must enter the foreign taxes paid and deemed paid under Section 902(b)(in functional currency) to the second-tier corporation out of the accumulated profits of pre-1987 tax year indicated in column 2 for the third-tier foreign corporation.
Column 6. Dividends Paid
Column 6a. Dividends Paid of Third-Tier Corporation
For column 6a, the preparer must enter the foreign taxes paid or accrued by the third-tier foreign corporation (in functional currency) to the second-tier foreign corporation out of the accumulated profits of the pre-1987 tax year as indicated in column 2.
Column 6b. Dividends Paid of Second-Tier Corporation
For column 6b, the preparer must enter the amount from column 6(a), translated into the second-tier foreign corporation’s functional currency using the spot exchange rate in effect on the date of distribution.
Column 7.
For column 7, the preparer must divide column 6(a) by column 4.
Column 8. Tax Deemed Paid
Columns 8 (a and b) asks the preparer to state the taxes deemed paid by a third-tier foreign corporation paid on dividends distributed to a second tier-foreign corporation.
The formula for calculating foreign taxes deemed paid by a third-tier foreign corporation under Section 902(b) with respect to a second-tier foreign corporation out of pre-1987 accumulated profits is done through a last-in, first out tracing approach. Under this approach, annual earnings were layered in chronological order and a dividend pulled out a layer of earnings (and, in turn, a layer of foreign 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 8a. Functional Currency
For column 8a, the preparer should multiply 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.
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.