By Anthony Diosdi
In order to provide the Internal Revenue Service (“IRS”) with a foreign corporation’s current earnings and profits (“E&P”) for US tax purposes, each year certain US person with interests in foreign corporations must attach a Schedule H to IRS Form 5471 otherwise known as “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” This is the 12th of a series of articles designed to provide a basic overview of Form 5471. This article is designed to supplement the IRS instructions to the Form 5471.
Who Must Complete Schedule H
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 4 and Category 5 filers need to complete Schedule H. However, Category 5 filers who are unrelated Section 958(a) US shareholders are not required to file Schedule H for foreign-controlled corporations.
Lines a and b income Classification
Schedule H 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 IRS Form 1118. IRS Form 1118 states that there are six categories of foreign source income to be reported on Schedule H and assigns codes to each category of income. A separate Schedule H should be prepared for each category of income. The category of income a preparer can select from when preparing a Schedule H 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 51A 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 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.
Lines 1 through 5c.
Entries on lines 1 through 5c must be made in functional currency. Section 985(b)(1)(A) states the general rule that the functional currency will be the dollar. However, the functional currency of a “qualified business unit” (“QBU”) will be “the currency of the economic environment in which a significant part of the unit’s activities” is “conducted and which is used by such unit in keeping its books and records.” See IRC Section 985(b)(1)(B). Section 989(a) defines a QBU as “any separate and clearly identified unit of a trade or business of a taxpayer which maintains separate books and records.” Thus, a corporation is a QBU. A foreign branch operation of a US corporation would also in most instances be a QBU. The branch must, however, be conducting activities that constitute a trade or business and maintain a separate set of books and records with respect to such activities.
Line 1. Current Year Net Income or (loss) Per Foreign Books of Account
The preparer must enter the CFC’s net income or (loss) per foreign books of account. A foreign corporation’s current E&P is an annual calculation, with accumulated E&P generally being the sum of prior-year calculations with necessary adjustments (e.g., reduction for dividends). The annual calculation of a foreign corporation’s E&P is generally based on a three-step approach. These steps are: 1) prepare a local country profit-and-loss statement (“P&L”) for the year from the books of accounts regularly maintained by the corporation for the purpose of accounting to its shareholders; 2) make the accounting adjustments necessary to conform the foreign P&L to US GAAP; 3) make the further adjustments necessary to conform the US GAAP P&L to US tax accounting standards.
Additional adjustments may be required to adjust for items such as currency translation, certain exchange of gain or losses, blocked deductions, and blocked income.
If the CFC uses DASTM methods of accounting (when a QBU uses a functional currency that becomes “hyperinflationary” for US federal income tax purposes), the QBU must use the US dollar as its functional currency for US federal income tax purposes. However, the QBU must translate its P&L statement and balance sheet into US dollars in a manner that adjusts for the embedded inflation of the local currency.
2a. Capital Gains or Losses
On line 2a, the preparer should enter any adjustments made to the foreign corporation’s current E&P as the result of capital gains or losses.
2b. and 2c. Depreciation and Amortization
On line 2b and 2c, the preparer should enter any adjustments made to the CFC’s current E&P as the result of depreciation and amortization. Generally, depreciation, depletion, and amortization allowances must be based on the historical cost of the underlying asset, and depreciation must be figured according to Section 167. (Section 167(a) provides as a depreciation deduction a reasonable allowance for the exhaustion and wear and tear of property used in a taxpayer’s trade or business). However, if 20 percent or more of the CFC’s gross income is from US sources, the CFC must use a straight line basis of depreciation discussed in Treasury Regulation Section 1.312-15.
2d. Investment or Incentive Allowance
On line 2d, the preparer should enter any adjustments made to the CFC’s current E&P as the result of investment or incentive allowance.
2e. Changes to Statutory Reserves
On line 2e, the preparer should enter any adjustments made to the CFC’s current E&P as a result of changes to statutory reserves. The term “statutory reserves” are defined in Internal Revenue Code Section 807(d)(6) as “the aggregate amount set forth in the annual statement with respect to items described in Section 807(c).” The “annual statement” is defined in Treasury Regulation Section 1.6012-2T(c)(5) as “the form..which is approved by the National Association of Insurance Commissioner (“NAIC”) which is filed by an insurance company for the year with the insurance departments of States, Territories, and the District of Columbia.”For the most part, line 2e applies to the current E&P of insurance companies and captive insurance companies.
2f. Inventory Adjustments
On line 2f the preparer should enter the adjustments taken into account according to the rules of Internal Revenue Code Section 471. Before the Tax Cuts and Jobs Act, CFCs were required to account for inventories whenever the production, purchase, or sale of goods was an income producing factor. The Tax Cuts and Jobs Act modified these rules to exclude certain CFCs from the requirement to account for inventories. Now CFCs meeting a $25 million gross receipts test is not required to account for inventories under Section 471 and may follow a method of accounting that either 1) treats inventories as non incidental materials and supplies, or 2) conforms to the CFC’s applicable financial statement.
In cases where a CFC gross receipts are less than $25 million, the CFC can account for their inventories under the uniform capitalization rules (“UNICAP”). The UNICAP rules require certain direct and indirect costs allocable to real or personal tangible property produced by the CFC to be either included in inventory or capitalized into the basis of the property produced, as applicable. CFCs with long-term contracts generally determine the taxable income from those contracts should be accounted for under the percentage-of-completion method (“PCM”). Under the PCM, a CFC must include in gross income for the tax year an amount equal to the product of the gross contract price and the percentage of the contract completed during the tax year is determined by comparing contract costs incurred before the end of the tax year with estimated total contract costs.
Costs allocated to the contract typically include all costs (including depreciation) that directly benefit, or are incurred by reason of, the taxpayer’s long-term contract activities. The allocation of costs to a contract is made in accordance with regulations. Costs incurred on the long-term contract are deductible in the year incurred, as determined using general accrual-method accounting principles and limitations.
Line 2g. Income Taxes
On line 2g, the preparer should enter any adjustments in the CFC’s E&P for income taxes. The entry on line 2g should reflect the differences between the income tax expense reported for book purposes and the income taxes deducted or added to E&P. Such differences include deferred income tax expenses, uncertain tax positions, intraperiod allocations, adjustments made after closing the financial statements (post-closing adjustments) not reflected in income tax expense and the adjustment for a foreign tax redetermination that required a redetermination of the US tax liability.
2h. Foreign Currency Gains or Losses
On line 2h, the preparer should enter any adjustments in the CFC’s E&P for foreign currency gains or losses. Transactions in a foreign currency of a CFC, other than a QBU using foreign functional currency must be translated into dollars on a transaction-by-transaction basis. Most of these transactions are governed under Internal Revenue Code Section 988. Section 988 transactions include four separate categories:
1. Acquisition of a debt instrument or becoming an obligor under a debt instrument (i.e., lending or borrowing a foreign currency).
2. Accrual of an item of gross income or expense that it received or paid later.
3. Disposition of a nonfunctional currency.
“Foreign currency gain” is defined for purposes of Section 988 as “gain from a Section 988 transaction to the extent such gain does not exceed gain realized by reason of changes in exchange rates on or after the booking date and before the payment date.” See IRC Section 988(b)(1). “Foreign currency loss” is defined in Section 988(b)(2). If a CFC has a loss on the overall Section 988 transaction, there is no foreign currency gain even if a favorable change in the exchange rates reduce the amount of the overall loss on the transaction. On the other hand, if the CFC has a gain on the overall Section 988 transaction, there is no foreign currency loss even if an unfavorable change in the exchange rates reduces the amount of the overall gain on the transaction. Below, please see an example of a currency exchange transaction.
A US corporation buys a pound sterling instrument for 100 pounds when one pound = $1.80. The cost and adjusted basis of the instrument are therefore $180.
If the instrument is sold for 200 pounds when one pound = $2, the corporation’s realized gain is $220 ($400 amount realized minus adjusted basis of $180). However, its foreign currency gain is measured by the difference between the exchange rates on the booking and disposition dates and therefore equals $20, calculated by multiplying the $.20 difference in the exchange rates by the original price of the instrument in pound sterling (100 pounds).
If the instrument is sold for 200 pounds when one pound = $.90, i.e., at a price equal to $180, no gain or loss is realized and therefore there is no currency gain or loss.
If the instrument is sold for 200 pounds when one pound = $1.00, i.e., at a price equal to $200, the corporation has a realized gain of $20 on the transaction. However, there is no foreign currency gain because the gain was not realized by reason of changes in the exchange rates but in spite of them. See Taxation of International Transactions, Charles Gustafson, Robert Peroni, Richard Crawford Pugh, Thompson West (2005).
A CFC must attach a statement to Schedule H with a description of currency gains and losses.
Line 2i. Other
On line 2i, the preparer should make an entry for any changes to E&P for any additional adjustments not included on lines 2a through 2h. If necessary, the preparer should include an attachment to Schedule H.
Line 3. Total Net Additions
On line 3, the preparer should include any net additions to the schedule.
Line 4. Total Net Subtractions
On line 4, the preparer should include any net subtractions to the schedule.
Line 5a. Current Earnings and Profits
On line 5a, the preparer must add lines 1 and 3 and minus line 4. Expressed formulatically:
1 + 3 = [X] – 4 = [Y].
Line 5b. DASTM Gain or Loss
On line 5b, the preparer must determine the CFC’s DASTM gain or loss. DASTM gain or loss for a tax year equals the dollar change in the net worth of the QBU for the tax year, as adjusted for certain transfers from or to the QBU that decrease or increase its net worth but do not affect the QBU’s income or loss or its E&P (e.g., dividend distributions and capital contributions). The dollar net worth of the QBU is derived from the books of the QBU translated into dollars at specified rates and is defined as the translated aggregate US dollar amount of assets on the balance sheet at the end of the year, less the translated aggregate dollar amount of liabilities on the balance sheet at the end of the year. For this purpose, certain items on the balance sheet (generally, financial assets and liabilities) are translated at the year-end exchange rate, and other assets (such as inventory and equipment) are translated into dollars at the rate for the period when purchased (historic exchange rate). Items translated at the year-end exchange rate generate DASTM gain or loss, while these translated at the historic exchange rate do not.
Line 5c. Combine lines 5a and 5b
For line 5c, the preparer must combine lines 5a and 5b.
Line 5d. Current Earnings and Profits
To prepare line 5d, the preparer must enter line 5c functional currency amount translated into US dollars at the average exchange rate for the CFC’s tax year.
The rules discussed above regarding determining the E&P of a CFC 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: firstname.lastname@example.org.
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.