By Anthony Diosdi
Schedule P is used to report the Previously Taxed Earnings and Profits (“PTEP”) of the U.S. shareholder of a controlled foreign corporation (“CFC”) in the CFC’s functional currency (Part I) and in U.S. dollars (Part II). This schedule is also used to report the PTEP of the U.S. shareholder of a specified foreign corporation (“SFC”) that is only treated as a CFC for limited purposes under Internal Revenue Code Section 965(e)(2). This is the seventh of a series of articles designed to provide a basic overview of the Internal Revenue Service (“IRS”) Form 5471. This article is designed to supplement the IRS’ instructions to Schedule P of IRS Form 5471. This article will go column by column and line by line through the attachment to Form 5471.
Who Must Complete Schedule P
Form 5471 and appropriate accompanying schedules must be completed and filed by the following categories of persons:
Category 1 Filer
U.S. persons who are officers, directors or ten percent or greater shareholders in a CFC. Category 1 includes U.S. shareholder of a Section 965 “specified foreign corporation” at any tax year of the foreign corporation, and who owned that stock on the last day in that year. A SFC includes 1) a CFC, or 2) any foreign corporation with respect to which one or more domestic corporations is a U.S. shareholder (these entities are commonly referred to as 10/50 companies – those which have at least one U.S. shareholder, but which are not CFCs because U.S. shareholders do not own more than 50 percent by vote or value).
Category 2 Filer
U.S. persons who are officers or directors of a foreign corporation in which, since the last time Form 5471 was filed, a U.S. person has acquired a ten percent or greater ownership or acquired an additional ten percent or greater ownership.
Category 3 Filer
A category 3 filer is a U.S. 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 strock, (c) 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 U.S. person while owning ten percent or greater in value of the outstanding stock of the foreign corporation.
Category 4 Filer
Category 4 filers are U.S. persons 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 Section 958 of the Internal Revenue Code attribution rules applying.
Category 5 Filer
Before the enactment of the 2017 Tax Cuts and Jobs Act, Category 5 filers were U.S. persons who are ten percent or greater shareholders 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 the last day of its annual accounting period.
What Category of Filer Must File Attach a Schedule P to their Form 5471
Schedule P must be completed by Category 1, Category 4 and Category 5 filers of the Form 5471. However, Category 1 and 5 filers who are related constructive U.S. shareholders are not required to File Schedule P.
Lines a and b
Line a asks the preparer to enter a “Separate Category” code. Line a of Schedule P is identical to Line a of Schedule J of the Form 5471. In order to answer this question, the preparer must reference the instructions to IRS Form 1118. IRS Form 1118 states that there are six categories of foreign source income that need to be reported on Schedule P and assigns codes to each category of income. The categories of income and the applicable codes are listed below:
Code Category of Income
951A Section 951A Category Income
FB Foreign Branch Category Income
PAS Passive Category Income
901j Section 901(j) Income
RBT Income Re-Sourced by Treaty
GEN General Category Income
Below are the definitions to each category of foreign source income that may need to be disclosed on Line a.
1. Section 951A Category Income
Section 951A category income is any amount includible in gross income under Section 951A (other than passive category income). Section 951A defines global intangible low-taxed income (“GILTI”).
2. Foreign Branch Category Income
Foreign branch income is defined under Internal Revenue Code Section 904(d)(2)(j)(i) as the business profits of a U.S. person which are attributable to one or more QBUs.
3. 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 dividend under Section 1248.
2) Any amount includible in gross income under Section 1293 (which relates to certain passive investment companies (“PFICs”).
4. Section 901(j) Income
Section 901(j) income is income earned from a country sanctioned by the United States. As of February 2020, sanctioned countries include the Balkans, Belarus, Burundi, Cuba, Democratic Republic of Congo, Iran, Iraq, Libya, North Korea, Somalia, Sudan, Syria, and Zimbabwe.
5. Income Re-Sourced by Treaty
If a sourced rule in an applicable income tax treaty treats any U.S. income as foreign source, and the corporation elects to apply the treaty, the income will be treated as foreign source.
6. General Category Income
This category includes all income not described above.
Line b states if Code 901j is entered on Line a, the country code for the sanctioned country using the two-letter codes (from the list at IRS.gov/countrycodes) must be entered.
It should be noted that Lines a and b must be completed for each separate category of income. This means that Category 1, 4, and 5 filers may need to attach multiple Schedule Ps to their Form 5471 if the filer has more than one category of foreign source income.
Part 1. Previously Taxed E&P in Functional Currency
Part 1 of Schedule P asks the SFC or CFC shareholders to categorize previously taxed foreign source income into a number of different columns. For columns (a) through (q), the amounts stated in each column must be in the functional currency of the SFC or CFC. The remaining columns should be stated in U.S. dollars. Just in the way of background, 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.” See IRC Section 985(b)(1)(B). Internal Revenue Code 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.” A SFC or CFC can be classified as a QBU. If the SFC or CFC is a QBU that keeps its books and records in a foreign currency, columns (a) through (q) of Part 1 of Schedule P should be prepared in foreign currency of the business.
Part 2. Previously Taxed E&P Should be Stated in U.S. Dollars
Part 2 of Schedule P asks the SFC or CFC shareholders to categorize previously taxed foreign source income into a number of different columns. For columns (a) through (q) of Part 2 of Schedule P, the amounts stated in the applicable columns should be in U.S. dollars.
How to Complete the Columns of Schedule P
Schedule P requires SFC or CFC shareholders to establish an annual account for each item of previously taxed income (“PTEP”) into Section 904 baskets. Within each account, a SFC or CFC must assign PTEP to one of ten different PTEP groups in each relevant Section 904 basket based on the SFC or CFC shareholder’s underlying income inclusions, while also accounting for any PTEP reclassification as a result of Section 956 inclusions. (IRS Notice adds an additional six PTEP groups to the ten PTEP groups. Thus, SFC or CFC shareholders will need to classify 16 groups of PTEPs for tax purposes).
Once each item of PTEP has been properly classified, these items of income are subject to the ordering rules of Internal Revenue Code Section 959.
I. Classifying of Income in PTP Baskets
The term PTEP refers to earnings and profits (“E&P”) of a foreign corporation attributable to amounts which are, or have been, included in the gross income of a U.S. shareholder. PTEPs must be allocated to following items of income as per the Internal Revenue Code:
a. Section 965(a) inclusions.
b. Section 965(b)(4)(A) inclusions.
c. Section 956 inclusions.
d. Section 951A inclusions.
e. Section 245A(e)(2) inclusions.
f. Section 959(e) inclusions.
g. Section 964(e)(4) inclusions.
h. Section 951(a)(1)(A) inclusions.
i. Sections 951(a)(1)(C) and 956A Earnings invested in Excess Passive Assets.
These items of income can be defined below as follows:
a. Section 965(a)
Internal Revenue Code Section 965 imposed a one-time transition tax on a U.S. shareholder’s share of deferred foreign income on certain foreign corporations. Internal Revenue Code Section 965 accomplishes the transition tax by increasing the Subpart F income of each SFC (defined above) in the SFC’s last taxable year that began before January 1, 2018.
b. Section 965(b)(4)(A)
Internal Revenue Code Section 964(b)(4)(A) discusses the treatment of E&P in future years. For purposes of applying Section 959 in any proceeding year beginning with the taxable year described in section (a), with respect to any U.S. shareholder of a deferred foreign corporation, an amount equal to such shareholder’s reduction under paragraph (1) which is allocated to such deferred foreign income corporation under this subsection shall be treated as an amount which was included in gross income of the U.S. shareholder.
c. Section 956 (Earnings invested in U.S. Property)
Generally, a U.S. shareholder must state his income and his pro rata share of the CFC’s increase in its E&P invested in U.S. property for the taxable year. For purposes of Internal Revenue Code Section 956, U.S. property includes most tangible and intangible property owned by a CFC that has a US situs such as the right to use a patent, copyright, or other forms of intellectual property in the United States if acquired or developed by the CFC for that use. A CFC is also treated as owning a proportionate interest in U.S. property owned by a partnership in which the CFC is a partner. Exceptions include U.S. government obligations; money, or bank deposits; trade or business obligations; stock or debt obligations of a domestic corporation that owns less than ten percent of the CFC and that is less than 25 percent by the CFC’s U.S. shareholders; debt obligations of states, state agencies, U.S. possessions and local governments; cash deposits or securities made or received on commercial terms by a U.S. or foreign securities or commodities dealer in the ordinary course of its business to the extent the deposits are made or received as collateral or margin for 1) a securities loan, principal contract, options contract, forward contract or futures contract or 2) any other financial transaction the Internal Revenue Service (“IRS”) determines is customary to post collateral or margin; and debt of a U.S. person to the extent the principal amount of the debt doesn’t exceed the fair market value of readily marketable securities sold or purchased under a sale and repurchase agreement or otherwise posted or received as collateral for the debt by a U.S. or foreign securities or commodities dealer in the ordinary course of its business.
d. Section 951A Inclusion
Internal Revenue Code Section 951A refers to global intangible low-taxed income (“GILTI”). GILTI is defined as the residual of a CFC’s income above a 10 percent return on its investment in tangible depreciable assets (defined as “qualified business asset investment” or QBAI). Effectively, these rules presume that tangible property should provide an investment of no greater than 10 percent. Thus, the Internal Revenue Code assumes income earned in excess of a 10 percent return on a CFC’s QBAI is generated from intangible property.
e. Section 245A(e)(2)
Prior to the 2017 Tax Cuts and Jobs Act, dividends from foreign corporations out of foreign earnings that had not been previously taxed were usually taxable to the shareholder. The 2017 Tax Cuts and Jobs Act provided for new Internal Revenue Code Section 245A, which allows for certain foreign income of a domestic corporation that is a U.S. shareholder by means of a 100 percent dividends received deduction (“DRD”) for the foreign-source portion of dividends received from “specified 10-percent owned foreign corporation” by certain domestic corporations that are U.S. shareholders of those foreign corporations within the meaning of Internal Revenue Code Section 951(b). Effective for distributions made after December 31, 2017, Internal Revenue Code Section 245A(a) allows C corporations that are U.S. shareholders a deduction equal to the foreign-source portion of a dividend received from a specified 10 percent foreign corporation (Section 245A DRD). The 100 percent DRD is only available to domestic C corporations that are neither real estate investment trusts nor regulated investment companies, and, as such, this deduction is not available to individual shareholders.
The term “specified 10 percent foreign corporation” is defined as any foreign corporation with respect to which any domestic corporation owns at least 10 percent.
f. Section 959(e)
For purposes of the PTEP rules of Section 959, amounts included in gross income as a dividend under Internal Revenue Code Section 1248 are treated as if they had been included in prior years as Subpart F income. See IRC Section 959(e).
Before the addition to the Code of Section 1248, U.S. shareholders could “cash in” on and realize the economic benefit of the accumulated earnings of a CFC at long-term capital gains rates. Section 1248 prevents this result by, under specified circumstances, treating the gain recognized on sale or exchange (or through liquidation or redemption) of the U.S. shareholder’s stock as a dividend to the extent that the gain reflects the shareholder’s interest in undistributed earnings attributable to the stock sold or exchanged
g. Section 964(e)(4)
For purposes of Internal Revenue Code Section 964(e), a SFC or CFC is treated as having sold or exchanged stock in a foreign corporation if, under any income tax provision in the Internal Revenue Code, the SFC or CFC is treated as having gained from the sale or exchange of the stock in the foreign corporation. This gain may be treated as a deemed dividend to the SFC or CFC under Section 964(e) which, in turn, constitutes foreign personal holding company income. For example, suppose that a SFC or CFC distributes to its U.S. shareholder stock that a SFC or CFC distributes to its U.S. shareholder stock that the SFC or CFC owns in another foreign corporation. If the CFC recognizes gain as if the stock were sold to the U.S. shareholder for its fair market value, the SFC or CFC is treated as having sold or exchanged the stock for purposes of Section 964(e) and the recognized gain may be treated as a deemed dividend to the corporation under Section 964(e).
h. Section 951(a)(1)(A)
Internal Revenue Code Section 951(a)(1)(A) requires a Subpart F inclusion if a foreign corporation is a SFC or CFC at “any time” during the taxable year. Subpart F income is defined in Internal Revenue Code Section 952 as the CFC’s sum of:
1. Insurance income;
2. Foreign base company income; and
3. International boycott income and an amount equal to illegal bribe/kickbacks paid on behalf of the SFC or CFC and income derived from any foreign country for which Internal Revenue Code Section 901(j) denies a foreign tax credit for taxes paid to such country.
i. Sections 951(a)(1)(C) and Section 956A “Earnings Invested in Excess Passive Assets (Section 959(c)(2))”
Under the 1993 Act, U.S. shareholders of a CFC were required to include in income their pro rata share of the accumulated post- September 30, 1993 earnings and current-year earnings of the corporation to the extent those earnings were invested in what were called “excess passive assets.” These were passive (rather than active business) assets that exceed 25 percent of the corporation’s total assets. See Former Sections 951(a)(1)(C) and 956A. In 1996, however, after intense lobbying pressure by U.S. multinational corporations, Congress repealed Section 956A, effective for tax years of foreign corporations starting after 1996. Given the time that had transpired since “excess passive assets” income was repealed, this item of income is rarely encountered.
The Ordering Rules of Internal Revenue Code Section 959
In order to avoid double taxation and the calculation of foreign tax credits, PTEPs are subject to the ordering rules of Internal Revenue Code Section 959. This sounds simple. But, unfortunately, the ordering rules are complex. Each PTEP is subject to the ordering rules. Internal Revenue Code Section 959(c) divides each PTEP into one of three categories. First, Section 959(c)(1) attributes PTEPs to Section 956 inclusions. (“Section 959(c)(1) PTEP”). Second, Section 959(c)(2) attributes PTEPs to Subpart F income inclusions and Section 1248 dividend inclusions. (“Section 959(c)(2) PTEP”). Third, Section 959(c)(3) is allocated to non-previously taxed E&P. (“Section 959(c)(3) PTEP”).
SFC or CFC shareholders must account for PTEP with respect to their stock in a CFC, and CFC’s must account for the aggregate amount of PTEP of all shareholders. Under provisions of the 2017 Tax Cuts and Jobs Act, the portion of a shareholder’s included in gross income under Section 951A(a) that is allocated to a SFC or CFC is treated as an amount included in the gross income of a shareholder for purposes of Internal Revenue Code Section 959. Likewise, amounts determined under Section 959(a) with respect to certain increases of Subpart F income and a shareholder’s inclusions of such income. Also, amounts of a U.S. shareholder’s inclusions under Section 965(a) that are reduced by deficits attributable to stock of another SFC or CFC under Section 965(b) are treated as amounts included in the shareholder’s gross income under Section 951(a) for purposes of Section 959. In addition, Section 959 a shareholder must take into consideration Subpart F income inclusions from hybrid dividends as defined under Internal Revenue Code Section 245A(e)(2) and gains on the disposition of the sale of CFC stock.
Under Internal Revenue Code Section 316, distributions are considered first as distributions from current E&P, to the extent thereof, and then as distributions from the most recently accumulated E&P, to the extent thereof. PTEP will be maintained in annual PTEP accounts. To facilitate the rule in Section 959(c), which incorporates the ordering rule of Section 316, requires a “last in, first out” approach to sourcing of distributions from annual PTEP accounts, subject to the special priority rule for PTEP arising by reason of the application of Section 965. Thus, in general, Section 959(c)(1) PTEP in the most recent annual PTEP account will be distributed first (with the exception for Section 965 PTEP), followed by the next most recent annual PTEP account, and so on, after which the same approach will be to Section 959(c)(2) PTEP. Within each annual PTEP account, the PTEP attributable to each group of PTEP earned in that year. Once the PTEP groups relating to Section 959(c)(1) PTEP are exhausted, distributions will be sourced from Section 959(c)(2) PTEP. Once those two PTEP groups are exhausted, under the last-in, first-out approach, distributions are sourced pro rata from the remaining Section 959(c)(2) groups in each annual PTEP account, starting from the most recent annual PTEP account. Finally, once all the PTEP groups have been exhausted, the remaining amount of any distribution will be sourced from Section 959(c)(3) E&P, to the extent thereof.
Schedule P not only requires the SFC or CFC shareholder to apply the Section 959 ordering rules to each PTEP, Schedule P also requires the CFC shareholder to make allocations of each PTEP subject to a number of questions. Below, we will discuss a select of the questions listed on Schedule P.
Line 1a through Line 1c.
Line 1a through Line 1c requires the SFC or CFC shareholder to provide a balance for each PTEP throughout the year subject to a number of adjustments.
Line 2 asks the SFC or CFC shareholder to make a reduction for taxes unsuspended under the anti-splitter rules. If there is a foreign tax credit splitting event with respect to a foreign income tax paid or accrued by a CFC shareholder, such a tax must be taken into consideration for purposes of Schedule P. In order to determine how to make adjustments to take into consideration the “anti-splitter rule,” the rules must first be defined. Under Internal Revenue Code, a corporate or individual may be entitled to the credit that the taxpayer is legally liable to pay under foreign law. This is known as the “technical taxpayer” rule. Under this “technical taxpayer” rule, the person who has legal liability for a foreign tax can be different than the person who realizes the underlying income under U.S. tax principles, resulting in a separation or “splitting” for the foreign income flowing up to the United states without associated income being subject to tax in the United states. Congress enacted Internal Revenue code Section 909 to address this issue.
Under Internal Revenue Code Section 909, where there is a “foreign tax credit splitting event” with respect to foreign income tax it is not taken into account for U.S. tax purposes before the tax year in which the related income is taken into account by the SFC or CFC shareholder. Any foreign tax credit reduction or suspension under a splitting event for each PTEP involved must be accounted for in line 2 of Schedule P.
Line 3 asks the SFC or CFC shareholder to adjust each PTEP to take into consideration E&P attributable to distributions of previously taxed E&P from lower-tier foreign corporations.
Line 4 asks the SFC or CFC shareholder to adjust each PTEP for previously taxed E&P carried over in nonrecognition transactions.
Lines 7 and 9.
Lines 7 and 9 asks the SFC or CFC shareholder to list each item of PTEP that has been reclassified from one Section 959 category to another Section 959 category. The reclassification of a PTEP from one Section 959 category to another Section 959 category is complicated. With that said, IRS Notice 2019-01 describes not only the ordering of PTEPs but the process in which a PTEP may be reclassified for Section 959 purposes. According to Notice 2019-01, each PTEP is subject to a special priority rule. Under this special priority rule, a PTEP arising from Section 965(a) and 965(b) have priority over other PTEPs. All other PTEPs are subject to the LIFO approach for the sourcing of distributions from annual PTEP accounts. Thus, subject to the special priority rule, Section 959(c)(1) PTEP in the most recent annual PTEP account is treated as distributed first, followed by the second most recent annual PTEP account, and continued through each annual PTEP account under Section 959(c)(1) until each account is exhausted. The same approach will then apply to Section 959(c)(2) PTEP. Finally, the remaining amount of any distributions are sourced from Section 959(c)(3), to the extent thereof.
The special priority rule provides an exception from the general LIFO approach described above for Section 965(a) and (b) PTEP under either Section 959(c)(1) or Section 959(c)(2). Starting with Section 959(c)(1) PTEP, distributions are sourced first from reclassified Section 965(a) PTEP and then reclassified Section 965(b) PTEP. Once these two PTEP groups are exhausted for Section 959(c)(1), the remaining annual PTEP accounts related to Section 959(c)(1) are sourced pro rata under LIFO approach until the Section 959(c)(1) PTEP, distributions are then sourced from Section 959(c)(2) PTEP. Similarly, applying the special priority rule, distributions are first sourced from Section 965(a) PTEP and then from Section 965(b) PTEP. After exhausting Section 965(a) and (b) PTEP, distributions are then sourced pro rata from the remaining Section 959(c)(2) PTEP groups under the LIFO approach until such groups are exhausted. Finally, the remaining amount of any distributions are sourced from Section 959(c)(3) E&P, as necessary.
Line 10 asks the SFC or CFC shareholder to make an allocation to PTEPs categorized in Section 959(c)(1) E&P for investments in U.S. property. U.S. property is discussed above in Internal Revenue Code Section 956.
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.