By Anthony Diosdi
Schedule G is designed to disclose a broad range of transactions of a controlled foreign corporation (“CFC”). This is the ninth 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 G of IRS Form 5471. This article will go line by line through Schedule G of Form 5471.
Who Must Complete Schedule G
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 Filers Must File Schedule G
Schedule G must be filed by all category filers.
Questions Asked on Schedule G “Other Information”
Line 1.
Line 1 asks the CFC shareholder if the CFC owns at least 10 percent interest, directly or indirectly, in any foreign partnership.
If the CFC owned at least 10 percent interest, directly, or indirectly in any foreign partnership, a statement must be attached to the Form 5471 listing the following information for each foreign partnership owed by the CFC:
1. Name and EIN (if any) of the foreign partnership.
2. Identify which, if any, of the following forms the foreign partnership filed for its tax year ending with or within the corporation’s tax year: Form 1042, 1065, or 8804.
3. Name of the partnership representative (if any).
4. Beginning and ending dates of the foreign partnership’s tax year.
Line 2.
Line 2 asks the CFC shareholder if during the tax year did the CFC own an interest in any trust. The CFC shareholder must provide a “yes” or “no” answer to this question.
Line 3.
Line 3 asks the CFC shareholder to check “yes” if the CFC is the owner of any foreign entities that were disregarded as separate from the owner under Regulations 301.7701-2 and 301.7701-3 or did the foreign corporation own any foreign branches. These are known as foreign disregarded entities. It is necessary to understand what a disregarded entity is for federal income tax purposes to answer this question. Under the income tax regulations, a taxpayer is permitted to elect to have a business entity treated as a separate corporation or a fiscally transparent entity (i.e., treated, for U.S. tax purposes, as a partnership or disregarded as an entity separate from its owner). See Treas. Reg. Sections 301.7701-2, and 3.
Not all business entities may elect their classification for U.S. tax purposes. Certain entities are treated as “per se” corporations for U.S. tax purposes. The types of entities that are treated under the regulations as per se corporations include entities incorporated under state law incorporation statutes and certain foreign entities listed in the regulations. See Treas. Reg. Section 301.7701-2.
Business entities not treated as per se corporations are called “eligible entities” and may elect their classification for tax purposes. If the entity has two or more members, it can elect to be classified for U.S. tax purposes as either an association taxable as a corporation or a partnership. If the entity has only a single owner, it can elect to be classified as an association taxable as a corporation or to be disregarded as an entity separate from its owner. See Treas. Reg. Section 301.7701-3(a).
If no election is made, default rules in the regulations apply. Under those default rules, if no entity classification is made, a U.S. eligible entity is treated as a partnership if it has two or more members or is disregarded as an entity separate from its owner if it has a single owner. If the entity is a foreign eligible entity and no election is made, the foreign entity is 1) treated as a partnership if it has two or more members and at least one member does not have limited liability, 2) treated as an association taxable as a corporation if all members have limited liability or 3) disregarded as an entity separate from its owner if it has a single owner that does not have limited liability. See Treas. Reg. Section 301.7701-3(b).
If the CFC is the owner of a foreign disregarded entity discussed above, the CFC shareholder must check “yes” for Line 3. This question not only asks the CFC shareholder to disclose the existence of any disregarded entity, Line 3 asks the CFC to disclose the existence of any foreign branches held by the CFC. A foreign branch is simply an extension of a corporation to another country.
If the CFC is the owner of any foreign disregarded entities or foreign branches, the CFC shareholder is a Category 4 or 5 filer, the CFC shareholder must attach a statement to the Form 5471 in lieu of Form 8858.
This statement must list the names of the foreign disregarded entity, country under whose laws the foreign disregarded entity was organized, and EIN (if any) of the foreign disregarded entity.
Line 4a.
Question 4 asks the CFC shareholder if during the tax year the CFC paid or accrued any base erosion payment under Section 59A(d) to the foreign corporation or did the CFC have a base erosion tax benefit under Section 59A(c)(2) with respect to a base erosion payment made or accrued to the foreign corporation.
In order to answer this question, the CFC shareholder must understand the meaning of a base erosion payment and base erosion tax benefit. The 2017 Tax Cuts and Jobs Act introduced the base erosion and anti-abuse tax (“BEAT”) as codified under Internal Revenue Code Section 59A, which is designed to prevent base erosion in the crossborder context by imposing a type of alternative tax, which is applied by adding back to taxable income certain deductible payments, such as interest and royalties, made to related foreign persons. The BEAT applies to corporations with gross receipts of at least $500 million over a three-year testing period and a “base erosion percentage” (as defined in Section 59A(c)(4)(A)) for the taxable year of at least 3 percent. A 2 percent threshold applies for banks and registered securities dealers. Unless, the CFC at issue has gross receipts of over $500 million over a three-year testing period, the questions raised in Lines 4a, 4b, and 4c will not apply to the CFC shareholder.
Line 4a asks the CFC shareholder to state “yes” or “no” if the CFC paid a base “erosion tax payment” or if the CFC received a “base erosion payment.” According to the instructions for Schedule G, the term “base erosion payment” generally means any amount paid or accrued by the CFC filer of a foreign corporation that is a related party to the CFC shareholder within meaning of Section 59A(g) and with respect to which a U.S. deduction is allowed. (The term “related party” means: 1) any 25-percent owner of the taxpayer; 2) any person who is related (within the meaning of Section 267(b) or 707(b)(1) to the taxpayer or any 25-percent owner of the taxpayer; and 3) any other person who is related (within the meaning of Section 482) to the taxpayer). Base erosion payments also include amounts received or accrued by the CFC in connection with the acquisition of depreciable or amortizable property, reinsurance payments, and certain payments relating to expatriated entities.
The term “base erosion tax benefit” generally means any U.S. deduction for the tax year with respect to any base erosion payment.
Line 4b.
Line 4b asks the CFC shareholder to enter the total amount of base erosion payments.
Line 4c.
Line 4c asks the CFC shareholder to enter the total amount of base erosion tax benefit.
Line 5a.
Line 5a asks the CFC shareholder if the foreign corporation paid or accrued any interest or royalty for which the deduction was not allowed under Internal Revenue Code Section 267A. The 2017 Tax Cuts and Jobs Act introduced Internal Revenue Code Section 267A. This rule denies a deduction for certain royalty and interest payments to related parties known as “disqualified related party amounts” if paid or accrued either 1) pursuant to a “hybrid transaction” or 2) by or to a “hybrid entity.” A “hybrid transaction” is any transaction, series of transactions, agreements, or instrument where payments are treated as interest or royalties for federal income tax purposes and which are not so treated for purposes of the tax law of the foreign country of the recipient. A hybrid entity is an entity that is “fiscally transparent” for U.S. tax purposes but not fiscally transparent for foreign tax purposes.
When Section 267A applies, the deduction generally is disallowed to the extent the related party does not include the amount in income or is allowed a deduction with respect to the amount. However, the deduction is included in the gross income of a U.S. shareholder under Internal Revenue Code Section 951(a).
Line 5a asks if the CFC paid or accrued any interest or royalty for which the deduction is not allowed under Section 267A. The CFC must answer this question with a “yes” or “no.”
Line 5b.
Line 5b asks the CFC shareholder to state the total amount of the Section 267A disallowed deduction.
Lines 6a, 6b, 6c, 6d.
Line 6a asks the CFC shareholder if they are claiming a foreign-derived intangible income (“FDII”) deduction under Section 250 with respect to any amounts listed on Schedule M.
A discussion of Schedule M is beyond the scope of this article. In order to answer this question, the CFC shareholder must determine if a Section 250 deduction was claimed on Schedule M. Internal Revenue Code Section 250 allows a domestic C corporation a deduction for a portion of the domestic corporation’s FDII. The CFC shareholder must answer “yes” or “no” to question stated on Line 6a. If the CFC shareholder answers “yes” to question 6a, the CFC shareholder is directed to complete Lines 6a, 6b, 6c, and 6d.
Line 6b asks the CFC shareholder to enter gross income derived from sales, leases, exchanges, or other dispositions (but not licenses) from transactions with foreign corporations that the filer included in its computation of foreign-dervived deduction eligible income (“FDDEI”). This is determined based on a multi-step calculation. First, a domestic corporation’s gross income is determined and then reduced by certain items of income, including amounts included in income under Subpart F, dividends received from CFCs and income earned in foreign branches. This amount is reduced by deductions (including taxes) properly allocable to such income, yielding deduction eligible income.
Second, the foreign portion of such income is determined. This amount includes any income derived from the sale of property to any foreign person for a foreign use. The term “sale” is specially defined for this purpose to include any lease, license, exchange, or other disposition. “Foreign use” is defined to mean “any use, consumption, or disposition which is not within the United States.” Qualifying foreign income also includes income derived in connection with services provided to any person not located within the United States, or with respect to property that is not located in the United States. The services may be performed within or outside the United states. The gross foreign sales and services income is reduced by expenses properly allocated to such income. The sum of these two amounts yields FDDEI. This amount must be translated from functional currency for the CFC’s tax year.
Line 6c asks the CFC shareholder to enter the amount of gross income derived from a license of property of the CFC that was included in the computation of FDDEI. This amount must be translated from functional currency for the CFC’s tax year.
Line 6d asks the CFC shareholder to enter the amount of gross income derived from services provided to the CFC that was included in the computation of FDDEI. This amount must be translated from functional currency for the CFC’s tax year.
Line 7.
Line 7 asks the CFC shareholder if he or she participated in any cost sharing arrangements (“CSA”). In general, a cost sharing arrangement is an arrangement between two or more persons to share the costs and risks of research and development as they are incurred. Line 7 asks the CFC shareholder to provide a “yes” or “no” answer to the question.
Line 8.
Line 8 asks if the CFC became a participant in any CSA. Line 8 asks the CFC shareholder to provide a “yes” or “no” answer to the question.
Line 9.
If the CFC participated in a CSA, Line 9 asks the CFC shareholder if the CSA was in effect before January 5, 2009. Line 9 asks the CFC shareholder to provide a “yes” or “no” answer to the question.
Line 10.
Line 10 says that if the CFC shareholder answered “yes” to Line 7, the CFC shareholder must state if the CFC entered into a CSA to become a participant in any platform contributions (“PCTs”) as defined under Regulation Section 1.482-7(c). In order to answer this question, the CFC shareholder must understand the meaning of a PCT under Treasury Regulation Section 1.482-7(c). A PCT is any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity that is reasonably anticipated to contribute to developing cost shared intangibles.
Treasury Regulation Section 1.482-7(c)(1) states that the present value of nonroutine residual divisional profits or loss in each controlled participant’s division must be allocated among among all of the controlled participants based upon the relative values, determined as of the date of the PCTs, of the PCT payor’s as compared to the PCT payee’s nonroutine contribution consists of the sum of the PCT payor’s nonroutine operating contributions and the PCT payor’s reasonably anticipated benefits (“RAB”) share of the PCT payor’s nonroutine operating contributions and the payor’s RAB share of the PCT payor’s nonroutine platform contributions. For this purpose, the PCT payee’s nonroutine contribution consists of the PCT payor’s RAB share of the PCT payee’s nonrountine platform contribution.
Treasury Regulation Section 1.482-7(c)(2) states that the relative values of the controlled participants’ nonroutine contributions must be determined so as to reflect a reliable measure of an arm’s length result. Relative values may be measured by external market benchmarks that reflect the fair market value of such nonroutine contributions. Alternatively, the relative value of nonroutine contributions may be estimated by the capitalized cost of developing the nonroutine contributions and updates, as appropriately grown or discounted so that all contributions by a controlled participant are also used in other business activities (such as the exploitation of make-or-sell rights described in paragraph (c)(4) of this section), an allocation of the value of the nonroutine contributions must be made on a reasonable basis among all the business activities in which they are used in proportion to the relative economic value that the relevant business activity and such other business activities are anticipated to derive over time as the result of such nonroutine contributions.
Treasury Regulation Section 1.482-7(c)(3) states that any amount of the present value of a controlled participant’s nonroutine residual divisional profit or loss that is allocated to another controlled participant represents the present value of the PCT payments due to that other controlled participant for its platform contributions to the relevant business activity in the relevant division. For purposes of paragraph (j)(3)(ii) of this section, the present value of a PCT payor’s PCT payments under this paragraph shall be deemed reduced to the extent of the present value of any PCT payments owed to it from other controlled participants under paragraph (g)(7). The resulting remainder may be converted to a fixed or contingent form of payment in accordance with paragraph (h).
Treasury Regulation Section 1.482-7(c)(4) states that any routine platform or operating contributions, the valuation and PCT payments for which are determined and made independently of the residual profit split method are treated similarly to cost contributions and cost contributions.
If the CFC shareholder’s CFC entered into a PCT as defined in Treasury Regulation 1.482-7, the CFC shareholder must answer “yes” on Line 10.
Line 11.
According to the directions to Schedule G, if the CFC shareholder answered “yes” on Line 10, the CFC shareholder must enter the CFC’s reasonably anticipated benefits (“RAB”) share of the total present value of all platform contributions made by the CFC.
Treasury Regulation Section 1.482-7(v) provides a number of examples as to how to value the RAB share of the total present value of platform contributions. Below, please see Illustration 1 which demonstrates an example of the RAB share of the total present value of all platform contributions. Illustration 1 is based on one of the examples provided in Treasury Regulation 1.482-7(v).
Illustration 1.
For simplicity of calculations in Illustration 1, all flows are assumed to occur at the beginning of each period. USP, a U.S. electronic data storage company, has partially developed technology for a type of extremely small compact storage devices (nanodisks) which are expected to provide a significant increase in data storage capacity in various types of portable devices such as cell phones, MP3 players, laptop computers and digital cameras. At the same time, USP’s wholly-owned subsidiary, FS, has developed significant marketing intangibles outside the United States in the form of customer lists, ongoing relations with various OEMs, and trademarks that are well recognized by consumers due to a long history of marketing successful data storage devices and other hardware used in various types of consumer electronics. At the beginning of Year 1, USP enters into a CSA with FS to develop nanodisk technologies for eventual commercial exploitation. Under the CSA, USP will have the right to exploit nanodisks in the United States, while FS will have the right to exploit nanodisks in the rest of the world. The partially developed nanodisk technologies owned by USP are reasonably anticipated to contribute to the development of commercially exploitable nanodisks and therefore the rights in the nanodisk technologies constitute platform contributions of USP for which compensation is due under PCTs. FS does not have any platform contributions for the CSA. Due to the fact that nanodisk technologies have yet to be incorporated into any commercially available product, neither USP nor FS transfers rights to make or sell current products in conjunction with the CSA.
Because only in FS’s territory do both controlled participants make significant nonroutine contributions, USP and FS determine that they need to determine the relative value of their respective contributions to residual divisional profit or loss attributable to the CSA activity only in FS’s territory. FS anticipates making no nanodisk sales during the first year of the CSA in its territory with revenues in Year 2 reaching $200 million. Revenues through Year 5 are reasonably anticipated to increase by 50 percent per year. The annual growth rate for revenues is then expected to decline to 30 percent per annum in Years 6 and 7, 20% per annum in Years 8 and 9 and 10% per annum in Year 10. Revenues are then expected to decline 10% in Year 11 and 5% per annum, thereafter. The routine costs (defined here as costs other than cost contributions, routine platform and operating contributions, and nonroutine contributions), that are allocable to this revenue in calculating FS’s divisional profit or loss, are anticipated to equal $40 million for the first year of the CSA and $130 and $250 million in Years 3 and 4. Total operating expenses attributable to product exploitable (including operating cost contributions) equal 42% of sales per year. FS undertakes routine distribution activities in its markets that constitute routine contributions to the relevant business activity of exploiting nanodisk technologies. USP and FS estimate that the total market return on these routine costs. FS expects its cost contributions to be $60 million in Year 1, rise to $100 in Years 2 and 3, and then decline again to $60 in Year 4. Thereafter, FS’s cost contributions are expected to equal 10 percent of revenues.
USP and FS determine the present value of the present value of the stream of the reasonably anticipated residuals in FS’s territory over the duration of the CSA Activity of the divisional profit or loss )revenues minus routine costs), minus the market returns for routine contributions, the operating cost contributions, and the cost contributions. USP and FS determine the appropriate discount rate is 17.5% per annum. Therefore, the present value of the nonroutine residual divisional profit is $1,395 million.
After analysis, USP and FS determine that the relative value of the nanodisk technologies contributed by USP to CSA (giving effect only to its value in FS’s territory) is roughly 150% of the value of FS’s marketing intangibles (which only have value in FS’s territory). Consequently, 60% of the nonroutine residual divisional profit is attributable to USP’s platform contribution. Therefore, FS’s PCT Payments should have an expected present value equal to $837 million (.6 x $1,395 million).
The calculations for this example are displayed below:
Time Period Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 Y11
(Y = Year) 0 1 2 3 4 5 6 7 8 9 10
(TV =
Terminal
Value)
Discount 0 200 300 450 675 878 1141 1369 1643 1897 1626
Period
[1] Sales 50% 50% 50% 30% 30% 20% 20% 10% -10%
[2] Growth
Rate
Exploitation
Costs and
Operating 40 130 200 250 351 456 593 712 854 940 846
Cost
Contributions
(52% of
Sales [1])
[4] Return
On [3] (6% 2.4 8 12 15 21 27 36 43 51 56 51
Of [3])
[5] Cost
Contributions
(10% of 60 100 100 60 68 88 114 137 164 181 163
Sales [1]
After Year 5)
[6] Residual
Profit = [1]
Misus {[3] -102 -38 -12 125 235 306 398 477 573 630 567
+ [4] + [5]}
[7] Residual
Profit [6]
Discounted -102 -32 -9 77 124 137 151 154 158 148 113
At 17.5%
Discount rate
[8] Sum of all amounts in [7] for all time periods = $1,395 million
[9] Relative value in FS’s division of USP’s nanotechnology to FS’s marketing intangibles = 150%
[10] Profit 60% = 1.5 x [11]