By Anthony Diosdi
In order to provide the Internal Revenue Service (“IRS”) with the information necessary to ensure compliance with the subpart F rules and global intangible low-taxed income (“GILTI”) provisions, each year certain U.S. persons with interests in foreign corporations must file an IRS Form 5471 otherwise known as “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” This is the second of a series of articles designed to provide a basic overview of the new Schedule C of the Form 5471.
Who Must Complete the Form 5471 Schedule C
Schedule C of a Form 5471 is an income statement of a controlled foreign corporation (“CFC”). The Schedule C is designed to disclose a CFC’s functional currency and transactions in foreign currency. Because foreign currencies are treated as noncash property, the tax consequences of owning and disposing of foreign currencies may involve the realization and recognition of gains and losses in respect of them. Schedule C is designed to report the gains and losses of foreign currencies to the IRS. The Schedule C does not need to be completed by all filers of Form 5471. The Schedule C is only required to be filed Category 3, 4, and 5 filers . The definition of a Category 3, 4, and 5 filer is as follows:
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 stock, (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 is a U.S. 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 is a U.S. person who is a ten percent or greater shareholder in a corporation that was a controlled foreign corporation (“CFC”) for an uninterrupted period of thirty days during its annual accounting period and who owned stock in the CFC on its last day of its annual accounting period.
The Two Columns of Schedule C
Schedule C has two columns that need to be examined. The first column is entitled “Functional Currency.” If you are completing the Form 5471 on behalf of a foreign corporation that conducts its activities in a foreign currency, you must complete the “Functional Currency” column. Section 958(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’s activities is “conducted and which is used by such unit keeping its books and records. If a CFC is a QBU and maintains separate books and records in a foreign currency, the foreign currency will be the functional currency of the CFC. See IRC Section 985(b)(1)(B). This will result in special U.S. tax consequences. For Schedule C compliance purposes, a CFC that can be classified as a QBU must complete column one and column two of the Schedule C. On the other hand, if the functional currency of the CFC is the U.S. dollar, only the second column (the dollar column) of Schedule C must be completed.
Specific Questions that Should be Carefully Considered
The following select questions listed on Schedule C of the Form 5471 should be carefully considered when preparing the form:
Line 8a. Foreign Currency Transaction Gain or Loss- Unrealized
According to the instructions for Schedule C Line 8, foreign currency transaction gain or loss must be disclosed on Lines 8a and 8b. Line 8a asks you to disclose the “unrealized” gain or loss in foreign currency. In order to complete this question, you must understand the definition of an “unrealized” gain or loss of foreign currency. An “unrealized” gain or loss is one or more transactions in foreign currency that has yet to take place. Unrealized gains or losses are recorded in the account of a CFC called accumulated other comprehensive income, which is found in the CFC’s equity section of its balance sheet. These represent gains or losses from the changes in the value of foreign currency or liabilities that have not yet been settled and recognized.
Determining the “unrealized” gains and losses in functional currency requires the weighting of average exchange rates. The weighted exchange rate is determined by calculating an “equity pool” and a “basis pool.” Essentially, the equity pool is the U.S. shareholder’s investment in the CFC stated in the entity’s functional currency.
For example, suppose a U.S. shareholder organizes a CFC in country X that uses the “u” as its functional currency. During year 1, the U.S. shareholder transfers 1000u to the CFC when 1u = $1 and transfers $1000 to the CFC when 1u = $2. At this point, the equity pool is 1,500u and the basis pool is $2,000. In the same year, the CFC has profits of 1,000u which is translated into dollars at the weighted rate for the year of 1u = $2. The equity pool is increased by 1,000u to 2,500u; the basis pool is increased by $2,000 to $4,000. Finally, in year 1, the CFC remits 1,000u to the CFC’s shareholder. For purposes of determining the tax consequences of functional currency, the taxable portion of the remittance is equal to the excess of the dollar value of the remittance at the spot rate ($2,000) minus the portion of the basis pool that is attributable to the distribution. That portion is determined by the following formula:
Remittance in u X basis pool = 1,000u X $4,000 = $1,600
Equity pool 2,500uAccordingly, the Section 987 gain is $400, and the 1,000u remitted is given a basis of $2,000. The equity pool at the end of year 2 is 1,500u (2,500u minus the 1,000u remittance) and the basis pool is $800 ($2,400 minus the $1,600 charge to that pool on the remittance.
Line 8b. Foreign Currency Transaction Gain or Loss-Realized
Line 8b refers to the taxable gains or losses from completing one or more transactions in a foreign currency. Realized gains associated with currency gain or losses are defined in Internal Revenue Code Section 988. Internal Revenue Code Section 988 transactions include the following:
- (1) Dispositions of a nonfunctional currency, and
- (2) The following three categories of transactions where the amount the CFC is entitled to receive or required to pay is denominated in a nonfunctional currency.
- (a) Debt Instruments- this includes transactions where the CFC lends or borrows funds through the use of a bond, debenture, note, certification, or other evidence of indebtedness.
- (b) Receivables and payables- this includes transactions where the CFC accrues an item of income or expense which will be received or paid at a future date, including a payable or receivable.
- (c) Forward, futures, and options contracts- this includes transactions where the CFC enters into or acquires a forward contract, futures, option, warrant, or similar financial instrument.
For Schedule C reporting purposes, the entire amount of gain or losses arising from a disposition of a nonfunctional currency is treated as an exchange gain or loss. See IRC Section 988(c)(1)(C)(i)(II). For example, if a CFC buys 1.2 million Mexican pesos when the conversation rate is $1.00 = 6 pesos, the CFC basis in pesos is $200,000. When the pesos are “sold” (i.e. exchanged for dollars), there is a gain or loss if the conversion rate has changed. If the conversion rate changes to $1.00 = 5 pesos, the CFC has a $40,000 gain on the sale of pesos ($240,000 amount realized) on the conversion to dollars minus the $200,000 basis in pesos is a taxable event. For purposes of reporting the transaction on Line 8a, the gain or loss of the foreign currency minus the CFC’s basis should be disclosed. The same is true of any gain or loss arising from a currency forward, futures, or option contract. See IRC Section 988(b)(3). In contrast, a gain or loss arising from a transaction involving a debt instrument, receivable, or payable is treated as a gain or loss only to the extent it is attributable to a change that occurs between the transaction’s booking date and the payment date.
9. Other Income
This question asks the preparer to attach a statement listing all “other income.” It is extremely important that an attachment to the Form 5471 referencing Schedule C Line 9 be prepared disclosing all sources of “other income.” Failure to do so may result in the IRS determining that the Form 5471 is incomplete and assessing significant penalties.
Line 16. Taxes (excluding income tax expenses (benefit)
Line 16 of Schedule C requires the disclosure of transactional taxes. According to the IRS’ instructions for Schedule C, Line 16 is designed to report transaction taxes. You should not report income taxes on Line 16. Income taxes paid by the CFC should be reported on Line 21.
Line 17. Other Deductions
This question asks the preparer to attach a statement listing all “other deductions.” It is extremely important that a statement be attached to the Form 5471 referencing Line 17 of Schedule C list all other deductions. Failure to do so may result in the IRS determining that the Form 5471 is incomplete and assessing significant penalties.
Line 20. Income Tax Expenses
Line 20 asks the preparer of Schedule C to list “unusual or infrequently” occurring items.
The term “unusual or infrequently occurring items” is defined by U.S. GAAP. Examples of unusual or infrequently occurring events include income or losses from a lawsuit; losses or slowdown due to natural disasters; restructuring costs; gains or losses from the sale of assets; and plant shutdowns.
21.a. Income Tax Expenses Current
As stated above on Line 16, income tax expenses are stated on Line 21. If the income tax is currently incurred, the foreign taxes on the income of a CFC must be translated into dollars by the spot exchange rate at the time of payment, or in some cases using an average exchange rate over the taxable year.
21.b. Income Tax Expenses Deferred
If an income tax liability has been accrued or deferred, the amount that should be listed for Line 21B. The income tax disclosed on Line 21b should be based on the exchange rate at the time of the accrual or deferral.
Line 23a. Foreign Currency Translation Adjustments
According to the Instructions for Schedule C Line 23, the IRS expects foreign currency adjustments to be listed on Line 23a. The foreign currency translation adjustment or the cumulative translation adjustment (“CTA”) compiles all the fluctuations caused by varying exchange rates. The entry on Line 23a should allow the IRS to differentiate between the actual day-to-day operational gains and losses and those caused due to foreign currency translation.
Line 23b. Other Income
The instructions to prepare by the IRS for Line 23b asks for a disclosure of comprehensive income such as foreign currency gains or losses on certain hedging transactions, pensions and other post-retirement benefits, and certain investments available-for sale. Income received from these transactions should be disclosed on Line 23b.
Line 24. Comprehensive Income
Comprehensive income is the net change in equity for a period not including any owner contributions or distributions. In other words, it includes all revenues, gains, expenses, and losses incurred during a period as well as unrealized gains and losses during an accounting period. For example, net income does not take into account any unrealized gains or losses because they have not actually occurred yet.
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 international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.