By Anthony Diosdi
Introduction
Just about all Controlled Foreign Corporations (“CFCs”) generate subpart F income and/or Global Intangible Low-Taxed Income (“GILTI”). In most cases, subpart F and GILTI income become reclassified as Previously Tax Earnings and Profits (“PTEP”). Each PTEP then needs to be placed into a separate Section 904(d) category basket. In addition, each PTEP is subject to a certain set of ordering rules that clarifies how distributions of such a PTEP is treated to each CFC shareholder.
The classification of PTEPs and the ordering rules are important to calculate foreign tax credits and to determine the creditability of foreign taxes allocable to each Section 904(d) basket. It is also important to determine any Section 904(a) limitation with respect to each specific basket. For example, any foreign taxes paid or accrued on GILTI income are allocated to the GILTI basket. If a US shareholder is in an excess credit position with respect to its GILTI basket and any excess foreign taxes that have been allocated to the GILTI basket this income generally cannot be reallocated to another basket.
Schedule E-1 allocates the earnings and profits (“E&P”) of a CFC into a separate category appropriate to determine the eligibility of foreign tax credits. This article will review both Schedule E and Schedule E-1 of the Form 5471. However, this article will focus on Schedule E-1. This article is designed to supplement the IRS instructions.
Who Must Complete Schedule E and Schedule E-1
Form 5471 and its schedules must be completed (to the extent required by each schedule) and filed by the following categories of persons:
Category 1- US persons who are officers, directors or ten percent or greater shareholders in a foreign personal holding company. 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 corporation is 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, © 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 is defined as more than 50 percent of voting power or value, with Internal Revenue Code Section 958 attribution rules applying.
Category 5- A US person who is a ten percent or greater shareholder in a corporation that was a controlled foreign corporation for an uninterrupted period of thirty days during its annual accounting period and who owned stock in the controlled foreign corporation on its last day of its annual accounting period.
Category 1, Category 4, and Category 5 filers need to complete Schedule E. In addition, Schedule E and E-1 are required for unrelated Section 958(a) US shareholders only if the filer claims deed foreign income taxes of the foreign controlled corporation under Section 960 for the filer’s taxable year. Finally, related constructive US shareholders only need to complete Schedule E (they can leave Schedule E-1 blank).
Lines a and b income Classification
Schedule E begins by asking the preparer to complete lines a and b. In order to answer the question on line a, the preparer must reference the instructions to Internal Revenue Service (“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. A separate Schedule E should be prepared for each category of income. The category of income a preparer can select from when preparing a Schedule E are as follows:
Code Category of Income
951A Section 951A Category Income
FB Foreign Branch Category Income
PAS Passive Category Income
901J Section 901(j) income which is sanctioned country income
RBT Income re-sourced by treaty
GEN General Category Income
Below are the definitions for each category of foreign source income for line a.
Section 951A Category Income
Section 951A (GILTI inclusions) category income is any amount in gross income under Section 951A (other than passive category income).
Foreign Branch Category Income
Foreign branch income is defined under Section 904(d)(2)(j)(i) as the business profits of a US person which are attributable to one or more Qualified Business Units.
Passive Category Income
Passive category 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 US 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 code (for the list at IRS.gov/countrycodes) must be entered.
Part 1- Taxes for Which a Foreign Tax Credit is Allowed
Column (a) Name of Payor Entity
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 US and foreign tax years. For example, the foreign tax year under foreign law may not be the same year as the US tax year of the foreign corporation.
Column (e)
Column (e) asks the preparer to disclose the US 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 CFC.
Column (g)
Column (g) asks the preparer to enter the tax paid or accrued in the local currency in which the tax is payable and not functional currency of the CFC. Internal Revenue Code 985(b)(1)(A) states the general rule that the functional currency will be “the dollar.”
Columns (h) and (i)
Columns (h) and (i) ask the preparer to enter the exchange rate in column (h) and the translated dollar amount in column (i). According to the instructions for Schedule H and I for Form 5471, the preparer should translate the taxes entered in column (g) into dollars at the average exchange rate for the tax year to which the tax relates unless one of the exceptions below applies. See IRC Section 986(a). However, in cases where: 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 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 convention rate” (in other words, the units of foreign currency that equals one unit foreign currency).
Column (j)
Column (j) asks the preparer to enter the tax in functional currency. Internal Revenue Code Section 985(b)(1)(A) states the general rule that the functional currency will be “the dollar.” However, the functional currency of a “qualified business unit” (“QBU”) will be “the currency of the economic environment in which a significant part of such unit’s activities” is “conducted and which is used by such unit in keeping its books and records.” On column (j), the preparer will need to enter the foreign taxes paid or accrued in US dollars. However, if a unit of the CFC is a QBU that conducts its business in a foreign in a foreign currency, the taxes paid or accrued should be determined in the functional currency of the CFC.
Line 8.
Line 8 asks the preparer to total the amounts listed in column (j) on line 8.
Line 9.
Line 9 asks the preparer to report the total of the amounts listed in column (j). This total also should be reported on Schedule H, line 2g, as a net subtraction from E&P, and the originally reported income tax expense per the foreign books of account should be reported as a net addition to E&P.
Part II. Election
For tax years beginning December 31, 2004, has an election been made under Section 986(a)(1)(D) to translate taxes using the exchange rate on the date of payment?
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. With that said, 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. The anti-splitter and foreign deficit rules will be discussed in more detail in the Schedule E-1 section of this article.
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 ID 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 foreign income taxes that are disallowed under Internal 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 9019k) 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 Internal Revenue Section 501.
Column (e)
Column (e) asks the preparer to list any foreign taxes paid on a covered asset acquisition and enter the disqualified portion of the tax. A covered asset involves involves three types of transactions: 1) a qualified stock purchase with a Section 338 election (Section 338 provides that if a purchasing corporation (Section 338 provides that if a purchasing corporation (“P”) purchases 80 percent or more of the stock of a target corporation (“T”) within 12 months or less, 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 US 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 754 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 foreign taxes for which a foreign tax credit is disallowed other than those detailed 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 (c) 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 US dollars (translated at the average exchange rate).
Schedule E-1
Introduction
The 2017 Tax Cuts and Jobs Act significantly changed the international landscape including introducing Schedule E-1 of Form 5471. The way in which foreign source income is taxed was dramatically changed. This resulted in the IRS introducing Schedule E-1 to reflect the changes in the tax law. Schedule E-1 consists of the following columns:
1. Post 2017 E&P Not Previously Taxed (post-2017 Section 959(c)(3) balance)
2. Hovering Deficit and Deduction for Suspended Taxes.
3. PTI from Section 965(a) inclusion (Section 959(c)(1)(A)).
4. PTI from Section 965(b)(4)(A) (Section 959(c)(1)(A)).
5. Section 956 earnings invested in U.S. Property (Section 959(c)(1)(A)).
6. Section 951A Inclusion (Section 959(c)(1)(A)).
7. Section 245(e)(2) Inclusion (Section 959(c)(1)(A).
8. Section 959(e) (Section 959(c)(1)(A).
9. Section 964(e)(4) Inclusion (Section 959(c)(1)(A)).
10. Section 951(a)(1)(A) Inclusion (Section 959(c)(1)(A))
11. Earnings Invested in Excess Passive Assets (Section 959(c)(1)(B)).
12. Section 965(a) Inclusion (Section 959(c)(2)).
13. Section 965(b)(4)(A) (Section 959(c)(2).
14. Section 951A Inclusion (Section 959(c)(2)).
15. Section 245(e)(2) Inclusion (Section 959(c)(2)).
16. Section 959(e) (Section 959(c)(2)).
17. Section 964(e)(4) Inclusion (Section 959(c)(2)).
18. Section 951(a)(1)(A) Inclusion (Section 959(c)(2)).
The earnings and profits from a CFC must be classified and tracked utilizing one of the above discussed columns. Tracking the earnings and profits of a CFC is critical to determine the eligibility of a foreign tax credit.
Introduction to Section 959 Basketing and Ordering Rules for PTEP Distributions for Purposes of Schedule E-1
Where the earnings and profit 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 PTEPs. Amounts included in the gross income of a US shareholder as subpart F or GILTI are not included in gross income again when such amounts are distributed to that US shareholder, directly or indirectly through a chain of ownership. 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(c)(2); and 4) general current and accumulated E&P under Section 959(c)(3). For Section 959 purposes, 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.
On November 28, 2018, the Department of Treasury and the IRS released proposed regulations related to the determination of the foreign tax credit. The IRS also issued Notice 2019-01 which announced the IRS’ intention to withdraw prior regulation under Section 959 and issue new proposed regulation. Notice 2019-01 also announced 16 new PTEP groups Section 904 categories or baskets. Finally, Notice 2019-01 promulgated new ordering and tracking rules.
Under these rules, CFCs are required to establish an annual account for PTEP (annual PTEP account) for each of the Section 904 baskets. Within each account, a CFC must assign PTEP to one of sixteen different PTEP groups. For any distributions of PTEP, the ordering rule determines the type of PTEP that is distributed. Such determination is particularly important for purposes of determining the credibility of any foreign taxes that are imposed by the CFC’s country on the PTEP distributions. Prior to the 2017 Tax Act, former Sections 902 and 960(a)(1) permitted a corporate US shareholder to claim a credit for foreign taxes paid by a CFC when the related income was either distributed to the shareholder as a dividend or included in the shareholder’s income as a subpart F inclusion. In both scenarios, the amount of deemed paid foreign taxes was based on multi-year “pools” of earnings and taxes, with the shareholder generally deemed to have paid the same proportion of the CFC’s post-1986 foreign income taxes as the amount of the dividend or subpart F inclusion bore to such CFC’s post-1986 undistributed earnings.
The 2017 Tax Act repealed Section 902, modified Sections 904 and 960, and changed the system for determining the deemed credit for multi-year pooling to a “properly attributable” standard. The 2017 Tax Act added two new categories of income (GILTI inclusions and foreign branch income) to Section 904(d), thereby doubling the number of Section 904(d) categories from two (general and passive categories) to four. The new law entirely repealed the section 902 “pooling” mechanism for imputing foreign taxes paid by a CFC to its US shareholders upon a dividend or subpart F inclusion. Instead, deemed paid credits are now governed solely by Section 960, which applies a “properly attributable” standard. Specifically, under new Section 960(a) and (d), a corporate US shareholder can claim a deemed paid credit for foreign income taxes that are properly attributable to current year subpart F income and GILTI inclusions, respectively.
Schedule E-1 Taxes Paid, Accrued, or Deemed Paid on Accumulated Earnings and Profits of Foreign Corporation
Columns (a), (b), and (c)
Columns a, b, and c asks the preparer to report the opening balance, current year additions and subtractions, and the closing balance of the foreign corporation’s foreign income taxes paid or accrued with respect to earnings and profits described in Section 959(c)(3). In general, this is E&P of the foreign corporation which has not been included in the gross income of a US person under Section 951(a)(1). (Section 951 provides if a foreign corporation is a CFC for an uninterrupted period of 30 days or more during any taxable year, every person who is a US shareholder (directly, indirectly, or constructively) must include his or her pro rata share of subpart F income.
Column (a). Post-2017 E&P Not Previously Taxed (Post-2017 Section 959(c)(3) Balance)
In column (a), the preparer must report foreign income taxes paid or accrued with respect to E&P described in Section 959(c)(3) and earned after the repeal of Section 902.
Column (b). Post-1986 Undistributed Earnings (Post-1986 and pre-2018 Section 959(c)(3) Balance)
Column (b) requires the preparer to report foreign income taxes paid or accrued with respect to E&P described in Section 959(c)(3) earned before the repeal of Section 902. 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) balance 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 the taxes deemed paid with respect to such dividends for purposes of computing foreign tax credits in subsequent years.
Please see Illustration 1. below for a simple example calculating a “post-1986 undistributed earnings pool.”
Illustration 1
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 America 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.
(c). Pre-1987 Pre-1987 E&P Not Previously Taxed (Pre-1987 E&P Not Previously Taxed (pre-1987 Section 959(c)(3) Balance)(In Functional Currency)
In column (c), the preparer should report in foreign income taxes paid or accrued with respect to E&P described in Section 959(c)(3) and earned before 1987. Column (c) is used to report the aggregate amount of the foreign corporation’s pre-1987 E&P accumulated associated with foreign income taxes paid or accrued since 1962 and not previously distributed or deemed distributed in functional currency. In order to correctly report Section 959(c)(3) pre-1987 E&P accumulated earnings, it is necessary to understand how earnings and profits were determined before 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 accumulated earnings of the next preceding year and so on until the dividend had been completely covered by accumulated earnings to the extent available.
(d). Hovering Deficit and Suspended Taxes
A preparer must use column (d) to report taxes related to hovering deficits and taxes suspended under Section 909. In order for a preparer to properly prepare column (d), the preparer must understand the meaning of a “hovering deficit” and suspended taxes. Historically, a hovering deficit arose when two foreign corporations engaged in a transaction in which E&P and taxes carry over under Section 381 and either corporation has a deceit 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 under Section 902. However, any such pre-transaction deficits in earnings and profits may be used to offset a foreign surviving corporation’s accumulated (but not current) post-transaction earnings and profits in the same basket as the deficit. Hovering deficits and suspended taxes will be discussed in more detail under explanation for line 5b.
Taxes suspended under Section 909 include “foreign tax credit splitting events.” It also applies to various other foreign tax credit-related offsets, including a limitation on foreign taxes deemed paid with respect to Section 956 inclusions, a provision denying foreign tax credits related to certain covered asset acquisitions, and the creation of a separate foreign tax credit limitation for certain items resourced under treaties.
Column (e) Taxes Related to Previously Taxed E&P
Columns (e)(i) and (e)(ii)
In columns (e)(i) and (e)(ii) the preparer should report foreign taxes paid or accrued with respect to E&P described under Section 965(a) and Section 965(b)(4)(A) respectively, and reclassified as investments in US property under Section 959(c)(1)(A).
Column (e)(iii)
In column (e)(iii), the preparer should report foreign taxes paid or accrued with respect to E&P to earnings invested in the US property under Section 956 under Section 959(c)(1)(A).
Column (e)(iv)
In column (e)(iv), the preparer should report foreign taxes paid or accrued with respect to E&P to Section 951A (GILTI) earnings classified or reclassified as investments in US property under Section 959(c)(1)(A).
Column (e)(v)
In column (e)(v), the preparer should report foreign taxes paid or accrued with respect to E&P to Section 245A(e)(2) which is classified or reclassified as investments in US property under Section 959(c)(1)(A). By way of background, Section 245(e) denies the dividends received under Section 245A with respect to hybrid dividends and Section 267A denies certain interest or royalty deductions involving hybrid transactions or hybrid entities.
Column (e)(vi)
In column (e)(vi), the preparer should report foreign taxes paid or accrued with respect to E&P to Section 959(e) which is classified or reclassified as investments in US property under Section 959(c)(1)(A).
Column (e)(vii)
In column (e)(vii), the preparer should report foreign taxes paid or accrued with respect to E&P to Section 964(e)(4) which is classified or reclassified as investments in US property under Section 959(c)(1)(A).
Column (e)(viii)
In column (e)(viii), the preparer should report foreign taxes paid or accrued with respect to E&P to Section 951(a)(1)(A) Subpart F inclusions which is classified or reclassified as investments in US property under Section 959(c)(1)(A).
Column (e)(ix)
In column (e)(ix), the preparer should report foreign taxes paid or accrued with respect to earnings in excess passive assets. This is not a common category. Under the 1993 Tax Act, saw US shareholders of a CFC had to disclose the entity’s passive assets if they exceeded 25 percent of the corporation’s total assets. In 1996, Congress repealed this disclosure requirement.
Column (e)(x)
In column (e)(x), the preparer should report foreign taxes paid or accrued with respect to E&P to Section 965(a) which is classified or reclassified as subpart F income under Section 959(c)(2).
Column (e)(xi)
In column (e)(xi), the preparer should report foreign taxes paid or accrued with respect to E&P to Section 965(b)(4)(A) which is classified or reclassified as subpart F income under Section 959(c)(2).
Column (e)(xii)
In column (e)(xii), the preparer should report foreign taxes paid or accrued with respect to E&P to Section 951A which is classified or reclassified as subpart F income under Section 959(c)(2).
Column (e)(xiii)
In column (e)(xiii), the preparer should report foreign taxes paid or accrued with respect to E&P to Section 245(e)(2) which is classified or reclassified as subpart F income under Section 959(c)(2).
Column (e)(xiv)
In column (e)(xiv), the preparer should report foreign taxes paid or accrued with respect to E&P to Section 959(e) which is classified or reclassified as subpart F income under Section 959(c)(2).
Column (e)(xv)
In column (e)(xv), the preparer should report foreign taxes paid or accrued with respect to E&P to Section 964(e)(4) which is classified or reclassified as subpart F income under Section 959(c)(2).
Column (e)(xvi)
In column (e)(xvi), the preparer should report foreign taxes paid or accrued with respect to E&P to Section 951(a)(1)(A) which is classified or reclassified as subpart F income under Section 959(c)(2).
Specific Lines of Questions Schedule E-1
Line 1a. Beginning Corporate Balances
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. Beginning Balance Adjustments
Line 1b asks the preparer to disclose any beginning balance adjustments. If there is a difference between the last year’s ending balance on Schedule E-1 and the amount which should be last year’s ending balance, the preparer should include an attachment to Schedule E-1 with an explanation and amount of each difference.
Line 1c. Adjusted Beginning Balances
Line 1c asks the preparer to disclose any adjusted beginning balance (combined lines a and b). Line c is particularly important for column (d). On line 1c accounts of prior year hovering deficits and associated taxes that have yet to be deducted in prior years are disclosed under column (d). These numbers should be reported as negative numbers.
Line 2. Adjustments for Redetermination of Prior Year US Tax Liability
If an amended tax return was filed redermining a foreign tax credit, the change should be entered on this line and under the appropriate column.
Line 3a. Taxes Unsuspended Under the Anti-Splittler Rules
Line 3a asks the preparer to disclose unsuspended taxes under Section 909 of the Internal Revenue Code. In order to disclose the unsuspended taxes on Line 3a, the CFC must have taken into account the related income. By 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 or person 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 US tax principles, resulting in a separation or “splitting” of foreign income to which the taxes relate. In some cases, this “splitting” can result in foreign tax credits following up to an individual without the associated income being subject to US tax. Congress enacted Internal Revenue Code Section 909 for this situation. Under Internal Revenue Code Section 909, where there is a “foreign tax credit splitting event” with respect to foreign income tax paid or accrued by a taxpayer, the foreign income tax is not taken into account for US tax purposes before the tax year in which the related income is taken into account by the CFC.
The preparer should disclose on line 3a reductions for taxes under the appropriate column that have become unsuspended as a result of the anti-splitter rule. In other words, if the CFC took the foreign source income into account for US tax purposes, the associated foreign tax liability becomes eligible for a foreign tax credit. However, the unsuspended credit must be disclosed under the proper column.
Line 3b. Taxes Suspended Under Anti-Splitter Rules
The preparer should disclose on line 3b foreign taxes suspended as a result of the anti-splitter rule. One example of such a situation is a “hybrid instrument splitter arrangement,” which involves a US hybrid equity instrument that is treated as equity under US law but as debt for foreign purposes, which permits a deduction for foreign purposes for interest expense but not a corresponding taxable interest payment in the US.
Another splitter arrangement is a “reserve hybrid splitter arrangement,” in which an entity that is a corporation for US purposes is treated as a fiscally transparent entity or a branch under the laws of the foreign country imposing the tax.
Line 4. Taxes Reported on Schedule E, Part 1, Line 8, column (i)
The total amount reported of tax on Schedule E-1 line 4 should be separated into columns (a) through (e) according to the type of E&P to which such tax relates. Below, please see Illustration 2. which discusses an example for purposes of line 4.
Illustration 2.
Domestic Corporation, a US 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. The functional currency of Domestic Corporation, CFC1, and CFC2 is the US dollar. During Year 1, Domestic Corporation reports an inclusion under Section 951(a)(1) of $100 as a result of subpart F income of CFC2. During Year 2, CFC2 distributes $40 to CFC1. CFC1 pays withholding tax of $4 on the distribution from CFC2. Such tax is a tax related to previously taxed subpart F income and is reported on line 4, column (e)(vi), of Schedule E-1 of CFC1’s Form 5471.
Line 5a. Taxes Carried Over in Nonrecognition Transactions
Line 5a asks the preparer to enter the taxes carried over in a nonrecognition transaction. Nonrecognition transactions apply to a surviving corporation after the acquisition by a foreign corporation described in Section 381 and Treasury Regulation 1.367(b)-7. Section 381 and Treasury Regulation 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 tax free acquisition.
Line 5b. Taxes Reclassified as Related to Hovering Deficit After Nonrecognition Transaction
Line 5b asks the preparer to enter the taxes reclassified as related to hovering deficits after a nonrecognition transaction. This would equal the 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 5b of column (a), (b), or (c). Line 5b asks the preparer to reclassify a deficit in earnings and profits of the CFC as a hovering deficit after a nonrecognition transaction. By the way of background, 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 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 corporation carry over to the surviving foreign corporation (foreign surviving corporation).
Determining the taxes reclassified as related to hovering deficits poses challenges. Historically, the principal Internal Revenue Code sections implicated by the carryover of earnings and profits and foreign income taxes in a foreign Section 381 transaction were Sections 381, 902, 904, and Section 959. Internal Revenue Code Section 381 permitted 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] represent the economic integration of two or more separate businesses into a unified business enterprise.” H. Rep. No. 1337, 83rd Cong., 2nd Sess. 41 (1954). However, a deficit in earnings and profits of either the transferee or transferor corporation could 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 of favorable tax attributes that the IRS and courts had repeatedly encountered. See Commissioner v. Phipps, 366 U.S. 410 (1949). These regulations generally adopt the principles of Section 381 in the crossborder context, but adapt its operation in consideration of the international provisions that address foreign corporations’ earnings and profits and their related foreign income taxes, such as Sections 902, 904, and 959. Former Internal Revenue Code Section 902 provided that a deemed foreign tax credit was 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. This Internal Revenue Code provided for the computation of deemed-paid taxes with regard to dividends from the relevant foreign corporations first out of multi-year pools of earnings and profits accumulated (and related foreign income taxes paid or deemed paid) in taxable years beginning after December 31, 1986, or beginning with the first year in which a domestic corporation owns 10 percent or more of the voting stock of a foreign corporation, whichever is later. See Former IRC Section 902(c). (The Internal Revenue Code and regulations refer to pooled earnings and profits and foreign income taxes as post-1986 undistributed earnings and post-1986 foreign income taxes even though a particular corporation).
Congress enacted the pooling rules because it believed that blending foreign income taxes and earnings and profits into “pools” from which distributions are made was fairer and more appropriate than computing deemed-paid taxes with reference to annual layers of earnings and profits (and foreign income taxes). Averaging foreign income taxes through these blended pools prevented taxpayers from inflating their foreign subsidiary’s effective tax rate for a particular year in order to obtain artificially enhanced foreign tax credits. Averaging also prevents the trapping of foreign income taxes in years in which a foreign subsidiary has no earnings and profits for U.S. tax purposes. However, Congress enacted pooling on a limited basis. Earnings and profits accumulated (and related foreign income taxes paid or deemed paid) in taxable years before the first year a foreign corporation qualifies as a pooling corporation and pre-1987 earnings and profits accumulated (and related foreign income taxes paid or deemed paid) by a pooling corporation are not pooled. Rather, such earnings and profits are maintained in separate annual layers. See Former IRC Section 902(c)(6).
A distribution of earnings and profits was first out of pooled earnings and profits and then, only after all pooled earnings and profits have been distributed, out of annual layers of earnings and profits on a LIFO bases. See Former IRC Section 902(a) and (c). The retention of annual layers beneath pooled earnings and profits limited the need to recreate tax histories. The foreign tax credit limitation ensured that taxpayers could use foreign tax credits only to offset U.S. tax on foreign source income. The limitation was computed separately with respect to different baskets of income derived from different types of activities. (From 1987 through 2006, section 904 provided for eight different baskets of income; for tax years beginning after December 31, 2006, all but two Section 904(d) baskets of income were eliminated. The American Jobs Creation Act of 2004, Public Law 108-357, 118 Stat. 1418 (AJCA), Section 404(a). The purpose of the baskets was to limit taxpayers’ ability to cross-credit taxes imposed with respect to different categories of income. Congress was concerned that, without separate limitations, cross-crediting opportunities would distort economic incentives to invest in the United States versus abroad.
Regarding the application of the hovering deficit rule on a “basket-by-basket” basis, under the regulations, a pre-transaction deficit in a particular basket is generally subject to the hovering deficit rule of Section 381. As a result, that deficit is not taken into account in determining the current or accumulated earnings and profits of the surviving corporation for any purpose, including for purposes of determining dividends under Section 316 and for determining foreign tax credits under the former Section 902. However, any such pre-transaction deficits in earnings and profits may 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.
The purpose of the hovering deficit in the domestic context is to prevent trafficking in deficits in earnings and profits. Absent this rule, a corporation with positive earnings and profits could acquire or be acquired by another corporation with a deficit in earnings and profits and immediately reduce the amount of earnings and profits, thereby reducing the amount of potentially taxable distributions.
The Tax Cuts 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 has not issued any guidance exactly how to address a surviving foreign 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 Previously Taxed Income (“PTI”) rules, the Treasury Department 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 has 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 Code, most notably the foreign tax credit. In addition, the preamble states that “[until] the IRS and Treasury promulgate such regulations, taxpayers should use a reasonable method (consistent with existing law and taking proper account of the purposes of the foreign tax credit regime) to determine the carryover and separation of earnings and profits and related foreign taxes.” The preamble does not indicate 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 a Sec. 335 Tax-Free Distribution, by Kyle Colonna and Julie Allen.
A preparer may consider utilizing the now-repealed Section 902 regulations to determine a hovering deficit after a nonrecognition transaction when completing line 5a.
Line 6. Other Adjustments
Line 6 asks the preparer to attach a statement to Schedule E-1 with a description and the amount of any other adjustments taken into account before determining taxes deemed paid during the year.
Line 7. Taxes Paid or Accrued on Accumulated E&P
Line 7 asks the preparer to determine the total taxes paid or accrued on accumulated E&P. This is determined by combining lines 1c through 6.
Line 8. Taxes Deemed Paid with Respect to Inclusions Under Section 951(a)(1)
If a domestic corporation was deemed to pay foreign income taxes attributable to inclusions under Internal Revenue Code Section 951(a)(1), as part of claiming a Section 960 foreign tax credit, a shareholder must gross up the inclusion by the amount of foreign taxes properly attributable to it pursuant to Internal Revenue Code Section 78.
Line 9. Taxes Deemed Paid with Respect to Inclusions Under Section 951A
If a domestic corporation holds CFC shares and receives a Section 951A inclusion under the GILTI regime, any foreign tax credits limited to the foreign income taxes equal to 80 percent of the product of the aggregate tested foreign income taxes paid or accrued. See IRc Section 960(d). A US corporation’s inclusion to the percentage for a tax year means the ratio (expressed as a percentage) of its GILTI inclusion to the aggregate of its pro rata shares of the tested income of its CFCs. Tested foreign income taxes of a CFc are the foreign income taxes paid or accrued by the CFc that are properly attributable to the tested income of the CFC taken into account by the US corporation under Section 951A. This formula can be expressed as follows:
80 percent x Inclusion Percentage x Aggregate tested foreign income taxes paid or accrued = 80% x [GILTI Inclusion / Aggregate Tested Income] x {Foreign income taxes
properly attributable to the tested income of such CFC]
While foreign tax credits deemed paid are only 80 percent of the product determined above, 100 percent of such a product is treated as dividends from the relevant CFCs for purposes of Section 78. If there is a GILTI inclusion, 80 percent of any foreign tax credits are listed on line 9.
Line 10. Taxes Deemed Paid with Respect to Actual Distributions
A domestic corporation is deemed to pay foreign taxes with respect to undistributed earnings from CFCs. These amounts should be listed on line 10. Please see Illustration 3. for an example.
Illustration 3.
Assume the facts are the same as Illustration 2, except that during Year 3, CFC1 distributes $40 to Domestic Corporation. Domestic Corporation is deemed to pay the $4 of withholding taxes paid by CFC1 in Year 2. A negative $4 will be recorded in line 10, column (e)(vii).
Line 11. Taxes on Amounts Reclassified to Section 959(c)(1) E&P From Section 959(c)(2) E&P
Line 11 asks the preparer to disclose amounts reclassified to Section 959(c)(1) from Section 959(c)(2) E&P. Foreign income taxes reclassified from Section 959(c)(2) previously taxed E&P to Section 959(c)(1) previously taxed E&P should be reported as negative numbers in column (e)(vi) through (e)(ix) and as positive numbers in column (e)(i) through (e)(iv). Please see Illustration 4. for an example.
Illustration 4.
Assume the same facts as Illustration 2, except during Year 2 CFC1 invests $40 in US property. At the time of investment in such property, CFC1 continues to maintain a $40 balance in its Section 959(c)(2) previously taxed E&P account. CFC1 reclassifies such amount as Section 959(c)(1) previously taxed E&P on Schedule J. Accordingly, $4 of foreign taxes related to Section 959(c)(2) previously taxed E&P is reclassified to Section 959(c)(1) previously taxed E&P on line 11, column (e)(i). A negative $4 will be recorded in line 11, column (e)(vii), and a positive $4 will be recorded in line 11, column (e)(i).
Line 12. Other
Line 12 asks the preparer to attach a statement with a description of any other further adjustments related to taxes deemed paid.
Line 13. Taxes Related to Hovering Decific Offset of Undistributed Post-Transaction E&P
Line 13 asks the preparer to disclose taxes related to hovering deficit offset of undistributed post-transaction E&P.
Line 14. Balance at Beginning of Next Year
Line 14 asks the preparer to state the balance at the beginning of next year.
Conclusion
The rules discussed above regarding tracking the E&P of CFCs for purposes of claiming foreign tax credits is extraordinarily complex. If you are a shareholder of a CFC, you should consult with an attorney well versed in international tax planning and compliance. We provide international tax planning and compliance to CFC shareholders. 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.