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 third of a series of articles designed to provide a basic overview of the new Schedule E of the Form 5471. A controlled foreign corporation (“CFC”) paying a foreign tax and/or claiming a foreign credit must complete Schedule E of the Form 5471. This article is heavily based on the instructions to Schedule E of the Form 5471.
Who Must Complete the Form 5471 Schedule E
Individuals with interests in CFCs that pay foreign taxes and/or claim foreign tax credits must complete Schedule E of the Form 5471.
Part 1- Taxes for Which a Foreign Tax Credit is Allowed
Part 1 of Schedule E asks you to list foreign taxes that are credible. Part 1 of Schedule E specially prohibits you from including any foreign taxes that are disallowed under Internal Revenue Code Section 901 or the anti-splitter rules of Internal Revenue Code Section 909.
In order to properly complete Part 1 of Schedule E, you must understand the limitations of Sections 901 and 909 on foreign tax credits. Under Internal Revenue Code Section 901(b)(1), U.S. citizens and U.S. corporations are entitled to a foreign tax credit for “the amount of any income, war profits, and excess profits taxes paid or accrued during the year to any foreign country or any possession of the United States.” In order to be credible under Internal Revenue Code Section 901, a foreign levy must be a “tax.” A levy is a tax “if it requires a compulsory payment pursuant to the authority of a foreign country to levy taxes.” This means that the CFC’s payment of a foreign tax must be compulsory and not voluntary. In addition, under Internal Revenue Code Section 901, a foreign tax credit is allowed only to the extent that the creditable foreign tax is “paid or accrued.” An amount of tax is not considered paid to the extent that “it is reasonably certain that an amount will be refunded, credited rebated, abated, or forgiven.”
Under Internal Revenue Code Section 909, where there is a “foreign tax credit splitting event” with respect to foreign income tax paid or accrued by a CFC, the foreign income tax 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 CFC. The definition of “foreign tax credit splitting event” is broad and could reach a variety of situations such as disregarded payments, transfer pricing adjustments, contributions of property resulting in a shift of deductions and timing differences under U.S. and foreign law. Specifically, a “foreign tax credit splitting event” arises with respect to a foreign income tax if the related income is taken into account for U.S. tax purposes by a “covered person.” A “covered person” is defined as any entity in which the payor holds, directly or indirectly, at least 10 percent ownership interest (determined by vote or value); any person that holds, directly or indirectly, at least a 10 percent ownership interest by vote or value) in the payor; and “any other person specified by the IRS.”
The instructions to Part I also specifically states that adjustments to foreign tax credits under Internal Revenue Code Section 905(c) may require the filing of an amended tax return and Schedule E to Form 5471. Internal Revenue Code Section 905(c) governs situations in which the amount of foreign taxes claimed as a credit is subsequently adjusted, increased, or refunded. In these cases, there is a need for Section 905(c) because of the “relation back doctrine” that is applied to accrual of foreign taxes and the “contested taxes” doctrine.
Unlike other liabilities, a contested tax liability is accrued for the underlying foreign assessment year, not the year in which the tax is finally determined. See IBM Corp v. United States, 38 Fed. Cl. 661 (1997). When the liability ultimately is fixed, it “relates back” to the year of the original assessment and is deemed to arise as a foreign income tax expense in the original assessment year. Similarly, if a foreign tax that has been paid is refunded, the refund is treated as reducing foreign tax expenses in the earlier years. Under Internal Revenue Code Section 905(c), the amount of the foreign tax credit for the earlier year generally must be adjusted up or down for the amended return.
Column (a)
Column A asks you to list the name of the foreign corporation or pass-through entity (partnership or disregarded entity) that paid the foreign tax.
Column (b)
Column B asks you to enter the employer identification number (“EIN”) or reference ID number of the payor of the foreign tax.
Column (c)
Column C asks you to enter the two-letter codes of the foreign country the foreign tax was paid. You must enter a country code available at irs.gov/countrycodes.gov. If taxes were paid or accrued to more than one country with respect to the same income, you should include an attachment listing the applicable countries.
Column (d)
Column D asks you to disclose any tax accounting timing discrepancies between the U.S. and foreign tax years. For example, the foreign tax year under foreign law may not be the same year as the U.S. tax year of the foreign corporation. If the tax is attributable to a pass-through entity owned by a foreign corporation within which such pass-through entity’s year ends should be reported on this line.
Column (e)
Column E asks you to you to disclose the U.S. tax year of the foreign corporation to which the tax relates.
Column (f)
Column F asks you to enter the income subject to tax in the foreign jurisdiction of the CFC.
Column (g)
Column G asks you to enter the tax paid or accrued in the local currency in which the tax is payable and not the functional currency of the CFC. Internal Revenue Code Section 985(b)(1)(A) states the general rule that the functional currency will be “the dollar.”
Columns (h) and (i)
Columns (h) and (i). Columns (h) and (i) ask you to enter the exchange rate in column (h) and the translated dollar amount in column (i). According to the instructions for Schedule (h) and (i), you should translate the taxes entered in column (g) into dollars at the average exchange rate for the tax year to which the tax relates unless one of the exceptions below applies. See IRC Section 986(a). However, in cases where: 1) the tax is paid before the beginning of the year to which the tax relates; 2) the accrued taxes are not paid before the date two years after the close of the tax year to which such taxes relate; 3) there is an election in effect under Section 986(a)(1)(D) to translate foreign taxes using the exchange rate in effect on the date of payment; or 4) the CFC reports on a cash basis, the exchange rate must be reported using the “divide-by convention rate” (in other words, the units of foreign currency that equals one unit foreign currency).
Column (j)
Column J asks you to enter the tax in functional currency. Internal Revenue Code Section 985(b)(1)(A) states the general rule that the functional currency will be the “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). On line (j), you will need to enter the foreign taxes paid or accrued in U.S. dollars. However, if a unit of the CFC is a QBU that conducts its business in a foreign currency, the taxes paid or accrued should be determined in the functional currency of the CFC.
Line 8
Line 8 asks you to total of the amounts listed in column (i) on this line 8. This total also should be reported on Schedule E-1, line 4.
Line 9
Line 9 asks you to report the total of the amounts listed in column 9(j) on this line 9. This total also should be reported on Schedule H, line 2g, as a net subtraction from E&P, and the originally reported income tax expense per the foreign books of account should be reported as a net addition to E&P.
Below please see the Illustration below taken from the IRS instructions which provides an example how to calculate Schedule E-1 of the Form 5471.
Illustration 1.
CFC1, a foreign corporation with reference ID number 1000123, pays or accrues tax of 10u = $10 to Country X on 50u of Country X taxable income ending December 31, 2018. CFC1 has a December 31 tax year end for both foreign and U.S. tax purposes. Also, CFC1 receives in the tax year ending December 31, 2018, a refund of 3u from Country X on 15u of income with respect to CFC1’s tax year ending December 31, 2015, translating to equal $5, and on which the original liability was $7. Therefore, the revised tax liability is $2. All taxes relate to general category income. Also assume for both years that the local currency in which the tax was paid was the same as the foreign corporation’s functional currency. The country code for Country X is XX.
The following entries should be made on the 2018 Form 5471 Schedule E for CFC1.
Line 1, column (a): CFC1
Line 1, column (b): 1000123
Line 1, column (c): XX
Line 1, column (d): 2018/12/31
Line 1, column (e): 2018/12/31
Line 1, column (f): 50u
Line 1, column (g): 10u
Line 1, column (h): 1.0000
Line 1, column (i): $10
Line 1, column (j): 10u
An amended 2015 Form 5471 Schedule E-1 for CFC1 must be filed with the following entries.
Line 1, column (a): CFC1
Line 1, column (b): 1000123
Line 1, column (c): XX
Line 1, column (d): 2015/12/31
Line 1, column (e): 2015/12/31
Line 1, column (f): 15u
Line 1, column (g): 1.20u
Line 1, column (h): 1.6667
Line 1, column (i): $2
Line 1, column (j): 1.20u
Part III- Taxes for Which Foreign Tax Credit is Disallowed
The instructions to Part III of Schedule E asks you to report foreign taxes of a CFC that were paid but for which no foreign tax credits were allowed. The purpose of disclosing foreign tax on Part III of Schedule E is to disclose foreign taxes for purposes of the CFC’s E&P. With that said, foreign taxes that cannot be claimed as a foreign tax credit due to the anti-splitter or foreign deficit rules should not be disclosed on Part III of Schedule E. These rules are discussed above.
Columns (a) and (b)
Column A asks you to list the name of the foreign corporation or pass-through entity (partnership or disregarded entity) that paid the foreign tax.
Column B asks you to enter the employer identification number (“EIN”) or reference ID number of the payor of the foreign tax.
Column (c)
Column C asks you to enter the foreign income taxes that are disallowed under Section 901(k), which generally applies to certain sanctioned countries.
Column (d)
Column D asks you to enter foreign income taxes that are disallowed under Internal Revenue Code Section 901(k). This generally applies to certain foreign taxes paid on dividends if the minimum holding period is not met with respect to the underlying stock, or if the CFC is obligated to make related payments with respect to positions in similar or related property. Section 901(k) cross-references the rules of Section 246(c). This generally means a deduction for a dividend is not allowed if the dividend was paid in the next preceding taxable year of the corporation or the corporation is tax exempt under Internal Revenue Code Section 501.
Column (e)
Column E asks you to list any foreign taxes paid on a covered asset acquisition, enter the disqualified portion of the tax. A covered asset involves three types of transactions: 1) a qualified stock purchase with a Section 338 election (Section 338 provides that if a purchasing corporation (“P”) purchases 80 percent or more of the stock of a target corporation (“T”) within 12 months or less, it may elect within a specified time period to treat the target as having sold all of its assets for their fair market value in a single transaction); 2) any acquisition treated as a purchase of assets for U.S. tax purposes, but an acquisition of stock is disregarded for foreign tax purposes; or 3) the purchase of a partnership interest with a Section 754 election (To avoid taxing the buying partner on the appreciation of his proportionate share of partnership assets prior to the date of purchase, the partnership may make an election under Section 754 of the Internal Revenue Code).
Column (f)
Column F asks you to enter the amount of foreign taxes paid or accrued by a foreign corporation to the United States.
Column (g)
Column G asks you to enter the foreign taxes for which a foreign tax credit is disallowed other than those detailed on columns (c) through (f).
Column (h)
Column H asks you to enter the total amount for each payor in columns (c) through (g).
Line 3
Line three asks you to total each amount in column (h) and enter the total amount in Line 3 in functional currency.
Line 4
Line four asks you to translate the amount listed on Line 3 in U.S. dollars.
Schedule E-1
The purpose of Schedule E-1 to report the cumulative balance of foreign income taxes paid or accrued by a CFC by separate category of income. Schedule E-1 is also used to report the foreign income taxes paid or accrued by specified foreign corporations that are only treated as CFCs for limited purposes under Section 965(e)(2). (Internal Revenue Code Section 965(e)(2) classifies certain foreign corporations as a CFC solely for purposes of taking into account subpart F income).
Columns (a), (b), and (c)
Columns a, b, c asks you to report the opening balance, current year additions and subtractions, and the closing balance of the foreign corporation’s foreign income taxes paid or accrued with respect to E&P described in Section 959(c)(3). In general, this is E&P of the foreign corporation which has not been included in gross income of a U.S. person under Section 951(a)(1). (Section 951 provides if a foreign corporation is a CFC for an uninterrupted period of 30 days or more during any taxable year, every person who is a U.S. shareholder (directly, indirectly, or constructively) must include his or her pro rata share of subpart F income.
In column (a), report foreign income taxes paid or accrued with respect to E&P described in Section 959(c)(3) and earned after the repeal of Section 902.
Column (d)
You use Column D to report taxes related to hovering deficits and taxes suspended under Section 909.
Hovering deficits is a complicated topic and beyond the scope of this article. Hovering deficits are usually taken into consideration in a Section 381 transaction when either the foreign acquiring corporation or the foreign target corporation has a deficit in one or more separate categories of undistributed income.
Taxes suspended under Section 909 include “foreign tax credit splitting events” discussed above. It also applies to various other foreign tax credit-related offsets, including a limitation on foreign taxes deemed paid with respect to Internal Revenue Code Section 956 inclusions, a provision denying foreign tax credits related to certain covered asset acquisitions, and the creation of a separate foreign tax credit limitation for certain items resourced under treaties.
Columns (e)(i) through (e)(ix) Taxes Related to Previously Taxed E&P
Line 1a
Line 1a should equal the amount that was reported as a balance at the beginning of the next year on line 14 of the prior year.
Line 1b.
If the balance on line 14 of the prior year’s tax return was changed as the result of an amended tax return, Line 14 should reflect this change.
Line 2.
If an amended tax return was filed redetermining a foreign tax credit, the change should be entered on this line.
Line 3a.
If foreign income taxes paid or accrued by a CFC were suspended due to the application of Section 909 and were ultimately unsuspended, the change should be reported on lines 3a and 3b.
Line 4.
The total amount reported on Schedule E, column (i), line 8 should be separated into columns (a) through (e) according to the type of E&P to which such tax relates.
For example, Domestic Corporation, a U.S. shareholder, wholly owns the only class of stock of CFC1, a foreign corporation. CFC1, in turn, wholly owns the only class of stock of CFC2, a foreign corporation. The functional currency of Domestic Corporation, CFC1, and CFC2 is the U.S. dollar. During Year 1, Domestic Corporation reports an inclusion under Section 951(a)(1) of $100 as a result of subpart F income of CFC2. During Year 2, CFC2 distributes $40 to CFC1. CFC1 pays withholding tax of $4 on the distribution from CFC2. Such tax is a tax related to previously taxed subpart F income and is reported on line 4, column (e)(vi), of Schedule E-1 of CFC1’s Form 5471.
Line 5a.
Report taxes carried over to foreign surviving corporation after the acquisition by a foreign corporation in a Section 381 transaction.
Line 5b.
An amount equal to the taxes related to a hovering deficit that are reported in column (a), (b), or (c) of line 5a is included as a negative amount on line 5b of column (a), (b), or (c).
Line 6.
Line 6 asks you to attach a statement to the Form 5471 with a description and the amount of any other adjustments taken into account before determining taxes deemed paid during the year. The statement should be properly referred to Line 6.
Line 7, Column (b)
Any post 1986 foreign tax credits used for purposes of determining taxes used for purposes of determining taxes deemed paid on dividends from a foreign corporation is reported on Line 7.
Line 8.
If a domestic corporation was deemed to pay foreign income taxes attributable to inclusions under Internal Revenue Code Section 951(a)(1)(subpart F inclusions), as part of the price of claiming a Section 960 foreign tax credit, a shareholder must gross up the inclusion by the amount of foreign taxes properly attributable to it pursuant to Internal Revenue Code Section 78. The gross up amount of 100 percent of the product paid is limited on this line.
Line 9.
If a domestic corporation holds CFC shares and receives a Section 951A inclusion under Global Intangible Low-Tax Income (“GILTI”) regime, any foreign tax credits limited to the foreign income taxes equal to 80 percent of the product of the aggregate tested foreign income taxes paid or accrued. If there is a GILTI inclusion, 80 percent of any foreign tax credits are listed on Line 9.
Line 10.
A domestic corporation is deemed to pay foreign taxes with respect to undistributed earnings from CFCs. These amounts should be listed on Line 10.
For example, assume the facts are the same as the last example, except that during Year 3, CFC1 distributes $40 to Domestic Corporation. Domestic Corporation is deemed to pay the $4 of withholding taxes paid by CFC1 in Year 2. A negative $4 will be recorded in line 10, column (e)(vii).
Line 11.
Foreign income taxes reclassified from Section 959(c)(2) previously taxed E&P to Section 959(c)(1) previously taxed E&P should be reported as negative numbers in column (e)(vi) through (e)(ix) and as positive numbers in column (e)(i) through (e)(iv).
For example, assume the same facts as above, except during Year 2 CFC1 invests $40 in U.S. property. At the time of investment in such property, CFC1 continues to maintain a $40 balance in its Section 959(c)(2) previously taxed E&P account. CFC1 reclassifies such amount as Section 959(c)(1) previously taxed E&P on Schedule J. Accordingly, $4 of foreign income taxes related to Section 959(c)(2) previously taxed E&P is reclassified to Section 959(c)(1) previously taxed E&P on line 11, column 9e)(i). A negative $4 will be recorded in line 11, column (e)(vii), and a positive $4 will be recorded in line 11, column (e)(i).
Line 12.
Attach a statement with a description and the amount of any other further adjustments related to taxes deemed paid.
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.
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.