By Anthony Diosdi
Schedule M is designed to measure intercompany payments. Schedule M requires the majority U.S. owner to provide information on transactions between the CFC and its shareholders or other related persons. This is the eighth 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 M 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 M
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. shareholders 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 M to their Form 5471
Schedule M must be completed by Category 4 filers of the Form 5471 to report the transactions that occurred during the CFC’s annual accounting period ending with or within the U.S. person’s tax year.
Reporting Transactions on Schedule M
Schedule M categorizes transactions in multiple ways. First, shareholders of a CFC must provide information about the magnitude of both inflows to and outflows from the CFC. Second, CFC shareholders must provide inflows and outflows separately for multiple types of transactions including inventory transfers, royalty payments, etc. Third, the columns of Schedule M separately identify transactions between the CFC and various related entities including the U.S. person filing the return and any domestic corporation or partnership controlled by the U.S. person filing the return. Finally, the regulations of Internal Revenue Code Section 482 should apply to value inflows and outflows of the CFC for purposes of Schedule M reporting.
Columns of Schedule M
Schedule M requires shareholders of CFCs to disclose transactions with related parties such as the individual filing the informational return and other related entities. Each transaction the CFC conducts with a related party must be disclosed by categories stated in each column of the schedule. The columns are itemized as follows:
U.S. Person Filing this Return
Any Domestic Corporation or Partnership Controlled by U.S. Person Filing this Return.
Any other Foreign Corporation or Partnership Controlled by U.S. Person Filing this Return.
10 Percent or More U.S. Shareholder of Controlled Foreign Corporation (other than the U.S. person filing this return).
10 Percent or More U.S. Shareholder of any Corporation Controlling the Foreign Corporation.
Transactions that Must be Disclosed on Schedule M
Schedule M requires the CFC shareholder or related party to disclose a number of different transactions. We will next through the questions asked on each line of the schedule. Anyone completing Schedule M must understand that the IRS will utilize certain information disclosed on this informational return to ensure that the CFC shareholders and related parties report and pay tax on their actual share of income arising from so-called controlled transactions. To this end, the regulations under Internal Revenue Code Section 482 adopt an arm’s length standard for evaluating the appropriateness of each transaction under the transfer pricing rules. This article will apply these regulations to the relevant questions listed on Schedule M. This way the parties involved in the controlled transaction have a reference point as to how to report these transactions on Schedule M.
Line 1 and Line 14. Sales of Stock in Trade Inventory/Purchases of Stock in Trade Inventory
Line 1 and Line 14 of Schedule M asks the CFC shareholder to value the sale and purchases of sales of stock in trade. Stock in trade refers to any merchandise or equipment kept on hand and used in carrying on a business. It includes the collection of goods, inventories and merchandise, maintained by a business entity for the purpose of using them for processing, making salable goods or for selling to the customers with an intention to make profit from such deals. Since a sale or purchase of stock in trade between a CFC and a shareholder of the CFC or related party is subject to manipulation, the transaction reported on Schedule M must reflect an arm’s length standard for purposes of the sale and purchase of the stock in trade. The reliability of a pricing method is determined by the degree of comparability between the controlled and uncontrolled transactions, as well as the quality of the data and the assumptions used in the analysis.
As a practical matter, comparable transactions often are not readily available for inventory sales between affiliated companies (i.e. related parties or CFC shareholders). As a consequence, the appropriate arm’s length price for the sale or purchase of stock in trade is ambiguous. To establish an arm’s length price for the sale or purchase of stock in trade, the shareholders of a CFC should obtain at least one if not two transactions between unrelated parties to establish an arm’s length range of prices for the sale and purchase of the sales of stock in trade. These transactions can serve as a model for valuing the sale or purchase of stock in trade transactions for Schedule M reporting purposes.
Line 2 and Line 15. Sales/Purchases of Tangible Property Other Than Stock in Trade
Question 2 and 15 asks the CFC shareholder to list the sale and purchases of any tangible property. Tangible property includes both personal and real property. In the context of international transactions, tangible gifts typically refers to goods sold in commerce. The sale or purchase of tangible goods should be reported on Schedule M at arm’s length range of prices. Valuing transactions involving tangible property in controlled transactions is complex. This is because there are five specific methods for estimating an arm’s length charge for transfers of tangible property:
1. The comparable uncontrolled price method;
2. The resale price method;
3. The cost plus method;
4. The comparable profits method, and:
5. The profit split method.
The CFC shareholder completing Schedule M must select and apply the method that provides the most reliable estimate of an arm’s length price between the related parties. In addition to the five methods stated above, the CFC shareholder can use an unspecified method to value the transaction.
Comparable Uncontrolled Price Method
The first enumerated method is characterized as the “comparable uncontrolled price method,” referred to as the “CUP” method. The basic approach is to examine comparable sales where the parties are unrelated. These may include sales by a member of the controlled group to an unrelated party, sales by an unrelated party to a member of the controlled group and sales made in which neither party is a member of the controlled group. See Treas. Reg. Section 1.482-3(b).
Below, please see Illustration 1 which describes a valuation under the “CUP method.”
A, a domestic corporation, owns 100 percent of M a Mexican corporation. A manufactures auto part equipment at a cost of $500 per unit and sells the equipment to unrelated foreign distributors at a price of $750 per unit. A also sells the equipment to M, which then resells the equipment to unrelated foreign customers for $850 each. The conditions of A’s sales to M are essentially equivalent to those of the sales to the unrelated foreign distributors. A and M should use the CUP method. Under this method, the estimated arm’s length price is $750.
The second is the “resale price method.” Under this approach the price for the controlled transaction is equal to the resale price to an uncontrolled buyer less an “appropriate gross profit.” The appropriate gross profit is determined by multiplying the applicable resale price by the “gross profit margin” (expressed as a percentage of total revenue derived from sales) earned in comparable uncontrolled transactions. See Treas. Reg. Section 1.482-3(c)(2)(iii). The regulations state that a typical situation where the resale price method may be useful one “involving the purchase and resale of tangible property in which the reseller has not added substantial value to the tangible goods by physically altering the goods” or through use of an intangible. See Treas. Reg. Section 1.482-3(c)(1).
Below, please see Illustration 2 which describes a valuation under the “resale method.”
A, a domestic corporation, owns 100 percent of C, a Canadian corporation. A manufactures medical equipment at a cost of $1,000 per unit and sells the equipment to C. The Canadian company resells the medical equipment to unrelated parties for $1,500. Distributors receive 10 percent of the price compared to the products sold by A. Under the resale price method, the estate of the arm length price is $1,350 [$1,000 – (10% x $1,500)].
Cost Plus Method
The third is the “cost plus method.” Under this approach the transfer price is generally equal to the cost of production plus an amount determined by the application of a “gross profit markup” to that cost. Under the cost plus method, the arm’s length price is the manufacturing cost incurred by the related manufacturer, increased by the arm’s length profit markup for such manufacturers and adjusted for any material differences that exist between the controlled and uncontrolled transactions. The gross profit realized by independent manufacturers (or related manufacturers) on similar uncontrolled sales provides an estimate of the arm’s length gross profit markup, which is expressed as a percentage of the manufacturing costs. See Treas. Reg. Section 1.482-3(d)(2) and (d)(3)(ii)(C).
Below, please see Illustration 3 which describes a valuation under the “cost plus method.”
A, a domestic corporation, owns 100 percent of F, a foreign corporation. F manufactures electronics at a cost of $60 each and sells them to A. A attaches its trade name to the electronic goods (which has a significant effect on the good’s resale ability) and resells the electronic goods to unrelated customers in the United States. Independent foreign manufacturers manufacturing similar electronic products receive a gross profit market up of 20 percent. Under the cost plus method, the estimate of the arm’s length price is $72. [$60 + (20% x $60)].
The Comparable Profits Method
The fourth is the “comparable profits method” (“CPM”). This method determines an arm’s length result based on profit level indicators derived from similarly situated uncontrolled taxpayers. See Treas. Reg. Section 1.482-5(a). The controlled party that has the least complex, readily available and accurate financial data from which to draw a comparison will be the party to whom the test is applied and is called the “tested party.” See Treas. Reg. Section 1.482-5(b)(2)(i). Comparability for these purposes is heavily dependent on resources employed and risks assumed and not necessarily product similarity. Adjustments must be made for all material differences between the tested party and the uncontrolled taxpayers serving as the basis for comparison. Under the CPM, the arm’s length price is calculated by applying a profit level indicator (derived from a comparable taxpayer) to the “financial data related to the tested party’s most narrowly identifiable business activity” which includes the controlled transaction. See Treas. Reg. Section 1.482-5(b)(1). Acceptable profit level indicators (which measure the ratio of profits to either costs incurred or resources employed) include the rate of return on capital employed and financial ratios. See Treas. Reg. Section 1.482-5(b)(2). Other indicators are not precluded from use if they would profit an accurate estimate of profits. The appropriate profit level indicator depends upon the characteristics the tested party and the comparable party share.
Profit Split Method
The fifth is the “profit split method.” The profit split method evaluates whether the allocation of the combined operating profit attributable to a controlled transaction is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined profit. See Treas. Reg. Section 1.482-6(a). The value of each party’s contributions is to be based upon “the functions performed, risks assumed, and resources employed.” See Treas. Reg. Section 1.482-6(b).
The division can be accomplished in one of two ways: the comparable profit split or the residential profit split. Under the comparable profit split method, the allocation of the combined operating profit between two controlled taxpayers is based on how uncontrolled taxpayers engaged in similar activities under similar circumstances allocate their joint profits. See Treas. Reg. Section 1.482-6(c)(2). Under the residual profit split method, the comparative profits method is used to estimate and allocate an arm’s length profit for the routine contributions made by each controlled taxpayer. Routine contributions ordinarily include contributions of tangible property and services. The residual profit not allocated on the basis of routine functions is then allocated between the two controlled taxpayers on the basis of the relative value of the intangible property contributed by each party.
The Unspecified Method
The sixth is the “unspecified method,” described in Treasury Regulation Section 1.482-3(e)(1). The method selected is to be applied in accordance with Treasury Regulation Section 1.482-1, and should take into account the general principle that all of the “realistic alternatives” should be considered when valuing these transactions.
The regulations describe five methods for judging the arm’s length of the acceptability for the sale of tangible property, along with a sixth category called “unspecified methods.” They include: the comparable uncontrolled price, resale price, cost plus methods, augmented by the comparable profits and the profit split methods, the regulations do not prescribe an order of preference among the alternative methods. The regulations however are explicit in that adjustments must be made to reflect the differences between the controlled transactions and the uncontrolled transactions to which comparisons are being made. Thus, a careful analysis should be made of the regulations and the related party transaction involving the sale or purchase of tangible property to properly reflect the valuation for purposes of Schedule M.
Line 3, Line 8, Line 16, Line 21. Sales/Purchases of Property Rights (patents, trademarks, etc), Rents, Royalties, and License Fees Paid
Line 3 and line 8 asks the CFC shareholder to disclose the sale and purchase of intellectual property rights such as patents, trademarks, and copyrights. Line 8 and Line 21 asks the CFC shareholder to disclose the rents, royalties received or paid to a related party. The CFC must select and apply the method which provides the most reliable estimate of an arm’s length price. There are three specific methods for estimating an arm’s length charge for transfers of intangibles: 1) the comparable uncontrolled transaction method; 2) the comparable profits method; and 3) the profits split method. In addition to the three specified methods, the CFC also has the option of using an unspecified method.
Comparable Uncontrolled Transaction Method
The comparable uncontrolled method (“CUT”) is analogous to the CUP method used for transfers of tangible property. Therefore, under the comparable uncontrolled transaction method, the arm’s length charge for the transfer of an intangible is the amount charged for comparable intangibles in transactions between uncontrolled parties, adjusted for any material differences that exist between the controlled and uncontrolled transactions. In order for the intangible involved in the controlled transaction, both intangibles must be used in connection with similar products or processes within the same general industry or market and must have similar profit potential. See Treas. Reg. Section 1.482-4(c)(2)(iii)(B)(1). The comparable uncontrolled transaction method ordinarily is the most reliable method for estimating an arm’s length price if there are only minor differences between the controlled and uncontrolled transactions for which appropriate adjustments can be made.
Comparable Profits Method
The same comparable profits methods used to determine arm’s length prices for transfers of tangible property can be used to determine arm’s length sales prices or royalty/rent rates for transfers of intangible property. The methodology for developing arm’s length profit involved in intangible property should involve the following seven steps:
1. Determine the tested party- the tested party should be the participant in the controlled transaction for which most reliable data regarding comparable companies can be located.
2. Search for comparable companies and obtain their financial data- the key factors in assessing the comparability of the tested party to comparable companies are the resources employed and the risks involved.
3. Select a profit indicator (“PLI”)- Examples of PLIs that can be used include the ratio of operating profit to operating assets, the ratio of operating profit to sales, and the ratio of gross profit to operating expenses. This should be done as a multiyear analysis.
4. Develop an Arm’s Length Range of PLIs- the arm’s length range of PLIs is the interquartile range (middle 50 percentile range) of comparable companies. The interquartile range is the range from 25 percent to 75 percentile.
5. Develop an arm’s length range of comparable operating profits- to construct an arm’s length range of comparable operating profits, the selected PLI for the comparable companies in the arm’s length range is applied to the tested party’s most narrowly identified business activity for which data incorporating the controlled transaction is available.
6. Determine if an adjustment must be made- an adjustment is required if the tested party’s reported profit lies outside the arm’s length range of comparable operating profits developed in step 5.
7. Adjust the transfer price for the controlled transaction- if the tested party’s reported profit lies outside the arm’s length range, an adjustment is made equal to the difference between the tested party’s reported profit and the goal arm’s length profit.
Below, please see Illustration 4 and Illustration 5 which describes valuations under the “comparable profits method.”
U, a domestic pharmaceutical company that develops a drug to stop the spread of a deadly virus that recently developed in Asia. U licenses the formula for this new drug to an unrelated pharmaceutical company in Florida for a royalty of 10 percent of sales. U also licenses the formula for this drug to its European production company headquartered in Budapest, Hungary, H. If all the comparability factors between the two licenses are identical, H should pay U a royalty of 10 percent of sales. However, if the two licenses are not comparable in a manner for which the parties cannot make adjustments, the 10 percent return on sales royalty is not a comparable uncontrolled transaction.
E, a European pharmaceutical company, owns 100 percent of U, a domestic corporation. E develops a pharmaceutical “CoronaAway,” the cure for a deadly virus. E licenses the formula to “CoronaAWay” with rights to the use of the “CoronaAWay” trade name in the U.S. to U. U’s average financial’s for the last three years have been:
Sales $20 million
Cost of goods sold $12 million
Operating Expenses $2 million