By Anthony Diosdi
Schedule Q is used to report a controlled foreign corporation’s (“CFC”) income, deductions, and assets by CFC income groups. A CFC shareholder required to complete Schedule Q is required to disclose subpart F income in functional currency by relevant country. In particular, the CFC shareholder must disclose dividends, rents, royalties, net gains from certain property, net gain from commodities, and net currency gains. It will also be necessary to disclose foreign base company sales income, foreign base company services income, insurance income, international boycott income, bribes, kickbacks, and recaptured subpart F income on Schedule Q. Each of these aforementioned items of subpart F income will be required to be categorized into a number of different categories. Schedule Q also requires the CFC shareholder to categorize tested income into a number of different groups. Finally, CFC shareholders are required to account and disclose any foreign income on Schedule Q that was excluded from U.S. federal tax under global intangible low-tax income or “GILTI” and subpart F high-tax exclusions. This article will take a deep dive into each column and line of 2021 Schedule Q of the Form 5471. The article is based on the instructions promulgated by the Internal Revenue Service (“IRS”).
Who Must Complete the Form 5471 Schedule Q
Anyone preparing a Form 5471 knows that the return consists of many schedules. Schedule Q is just one schedule of the Form 5471. Whether or not a CFC shareholder is required to complete Schedule J depends on what category of filer he or she can be classified as. For purposes of Form 5471, CFC shareholders are broken down by the following categories:
Key Terms
U.S. person: A U.S. person is generally a citizen or resident of the United States, a domestic partnership, a domestic corporation, or a domestic trust or estate. A tax-exempt U.S. entity may have a Form 5471 filing obligation.
U.S. Shareholder: A U.S. shareholder is a U.S. person who owns (directly, indirectly, or constructively, within the meaning of of Section 958(a) and Section 958(b)), 10% or more of either the total combined voting power of all classes of voting stock of a foreign corporation or the value of all the outstanding shares of a foreign corporation.
Controlled foreign corporation (CFC): A CFC is a foreign corporation with U.S. shareholders that own (directly, indirectly, or constructively, within the meaning of Section 958(a) and 958(b)) on any day of its taxable year, more than 50% of either 1) the total combined voting power of all classes of its voting stock, or 2) the total value of its stock.
Section 965 Specified Foreign Corporation (SFC): A CFC, or any foreign corporation with one or more 10% domestic corporation shareholders. Passive foreign investment companies or (“PFICs”) are not included in this definition.
Category 1 Filer
A Category 1 filer is a U.S. shareholder of a SFC at any time during any taxable year of the SFC who owned that stock on the last day in that year on which it was an SFC. A foreign corporation is an SFC if it is either a CFC or a foreign corporation with at least one corporate U.S. shareholder.
Category 2 Filer
A Category 2 filer is a U.S. citizen or resident who is an officer or director of a foreign corporation in which there has been a change in substantial U.S. ownership – even if the change relates to stock owned by a U.S. person who is not an officer or director. A substantial change in U.S. ownership is when any U.S. person (not necessarily the U.S. citizen or resident who is the officer or director) acquires stock that causes him or her to own a 10% block, or acquires an additional 10% block, of stock in that corporation. More precisely, if any U.S. person acquires stock, which, when added to any stock previously owned, causes him or her to own stock meeting the 10% stock ownership requirement, the U.S. officers and directors of that foreign corporation must report. A disposition of shares in a foreign corporation by a U.S. person does not create filing obligations under Category 2 for U.S. officers and directors. Stock ownership is a vote or value test.
Category 3 Filer
A U.S. person is a Category 3 filer with respect to a foreign corporation for a year if the U.S. person does any of the following during the U.S. person’s year:
1. Acquires stock in the corporation, which, when added to any stock owned on the acquisition date, meets the Category 2 filer 10% stock ownership requirement.
2. Acquires additional stock that meets the 10% stock ownership requirement.
3. Becomes a U.S. person while meeting the 10% stock ownership requirement.
4. Disposes of sufficient stock in the corporation to reduce his or her interest to less than 10% stock ownership requirement.
5. Meets the 10% stock ownership requirement with respect to the corporation at a time when the corporation is reorganized.
Stock ownership is a vote or value test. Constructive ownership includes certain family members, such as brothers or sisters, spouse, ancestors, and lineal descendants.
Category 4 Filer
A U.S. person is a Category 4 filer with respect to a foreign corporation for a taxable year if the U.S. person controls the foreign corporation. A U.S. person is considered to control a foreign corporation if at any time during the person’s taxable year, such person owns: 1) stock possessing more than 50% of the total combined voting power of all classes of stock entitled to vote; or 2) more than 50% of the total value of shares of all stock of the foreign corporation.
For Category 4 purposes, U.S. persons include those individuals who make a Section 6013(g) or (h) election to be treated as resident aliens of the United States for income tax purposes.
The constructive ownership rules of Section 318 are applied, with few modifications, to determine if the U.S. person “controls” the foreign corporation.
Category 5 Filer
A Person is a Category 5 filer if the person: 1) is a U.S. shareholder of a CFC at any time during the CFC’s taxable year; and 2) owns stock of the foreign corporation on the last day in the year in which that corporation is a CFC. For category 5 purposes, constructive ownership is determined under Section 318 as modified by Section 958(b). Pursuant to Section 958(b), there is no attribution from a nonresident alien relative.
New Categories
Categories 1 and 5 have been expanded to 1a, 1b, 1c, 5a, 5b, and 5c in order to separate those filers who are under some relief and may not need to file the same schedules.
1a- Category 1 filer who is not defined in 1b or 1c. This means a greater than 50% owner of the SFC.
1b- Unrelated Section 958(a) U.S. shareholder. This means an unrelated person would not control (more than 50% vote or value) the SFC or be controlled by the same person which controls the SFC.
1c- Related constructive U.S. shareholder- This means an entity controlled by (more than 50% vote or value) the same person which controls the SFC and files only due to this downward attribution.
5a- Category 5 filer who is not defined in 5b or 5c – This means a greater than 50% owner of the CFC.
5b- Unrelated Section 958(a) U.S. shareholder- This means an unrelated person would not control (more than 50% vote or value) the CFC or be controlled by the same person which controls the CFC.
5c- Related constructive U.S. shareholder- This Means an entity controlled by (more than 50% vote or value) the same person which controls the CFC and files only due to this downward attribution.
These new categories will distinguish those 5471 filers who only need to file a Form 5471 due to downward attribution caused by the repeal of Section 958(b)(4) and will therefore not be required to attach certain schedules to their Form 5471s.
CFC shareholders that are classified as Category 1a, 1b, Category 3, Category 4, Category 5a, and Category 5b filers must complete and attach Schedule Q to their Form 5471.
Name of Person Filing Form 5471
The name of the person filing Form 5471 is generally the name of the U.S. person described in the applicable category or categories of filers. However, in the case of consolidated returns, the name of the U.S. parent in the field for “Name of person filing Form 5471.”
Lines A, B, C, and D
Line A
Schedule Q begins by asking the preparer to complete Lines a and b. Line a specifically asks the preparer to enter the category code of each category of income. Unlike Schedule J, Schedule E, and Schedule P, Schedule Q only has three categories of income. The three categories of income are as follows:
Code Category of Income
PAS Passive Category Income
901j Section 901(j) Income
GEN General Category Income
Below is a definition of each category of foreign source income provided by the instructions to Schedule Q:
Passive Category Income
Passive income is generally the following:
- 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 a dividend under Section 1248.
- Any amount includible in gross income under Section 1293 (which relates to certain passive foreign investment companies (“PFICs”).
Section 901(j) Income
Section 901(j) is income that is earned from a country sanctioned by the U.S..
General Category Income
The general income category includes all income not described in one of the categories discussed above.
Line B
If category code “PAS” is entered in Lina a, a separate Schedule Q must be completed for each applicable grouping for Line b. In Line b, the preparer enter the code from following groups:
Code Passive Group
I All passive income received during the tax year that
year that is subject to a withholding tax of 15% or
greater must be treated as one item of income.
ii All passive income received during the tax year that
year that is subject to a withholding of less than 15%
(but greater than zero) must be treated as one item of
income.
iii All passive income received during the tax year that is
subject to no withholding tax or other foreign tax must
be treated as one item of income.
iv All passive income received during the tax year that is
subject to no withholding tax but is subject to foreign tax
other than a withholding tax must be treated as one item of
income.
Line C
For Line c, the preparer must check for either foreign source income or U.S. source income for the income being discussed on the Schedule Q. A separate Schedule Q must be prepared for U.S. source income and foreign source income.
Line D
For line d, the preparer must complete a separate Schedule Q for foreign oil and gas extraction income (“FORGEI”) and foreign oil related income (“FORI”). If the Schedule Q is being prepared to report FOGEI or FORI of a CFC, the preparer should check the box for item D.
Line 1. Subpart F Income Groups
Line 1 is used to report separate subpart F income groups within each applicable Section 904 category of a CFC. The preparer should use lines 1a through 1e to report the passive category foreign personal holding company income of the CFC. Internal REvenue Code Section 954(c) defines foreign personal holding company income for subpart F purposes. Items of income which can constitute foreign personal holding company income for subpart F purposes under Internal Revenue Code Section 954(c) includes dividends, interest, rents, royalties and annuities, except rents and royalties derived in the active conduct of a trade or business and received from a person other than a related person. See IRC Section 954(c)(2)(A). Under Internal Revenue Code Section 954(d)93), a related person with respect to a CFC is an individual, corporation, partnership, trust or estate which is controlled by the same person or persons which control the CFC. Control means direct or indirect ownership of more than 50 percent of total voting power or the value of stock in a corporation, and more than 50 percent by value of the beneficial interest in a partnership, trust or estate.
The preparer should use lines 1a through 1e to enter the passive category foreign personal holding company income under the appropriate income groups (dividends, interest, rents, royalties, and annuities; net gain from certain property transactions; net foreign currency gain; and income equivalent to interest).
The preparer should use lines 1f through 1i to enter the foreign base company sales income, foreign base company services income, full inclusion income, and insurance income. Under Internal Revenue Code Section 954(d), foreign base company sales income is that arising from the purchase or sale of personal property, where 1) the property is both produced outside the CFC’s country of incorporation and sold for use, consumption or disposition outside such country; and 2) the property is either bought from a related person or sold to any person, bought from any person and sold to a related person, or bought or sold on behalf of a related person. Foreign base company services income includes income arising out of the performance by a CFC of technical, managerial or similar services performed for or on behalf of a related person in a country other than the CFC’s country of incorporation. Full inclusion income requires the 100 percent inclusion of the annual subpart F income if the sum exceeds 70 percent of the CFC’s total gross income. The Internal Revenue Code defines insurance income as underwriting and investment income earned by an offshore insurer or reinsurer written primarily for U.S. risks.
On lines 1a through 1i, the preparer should enter for the total for each column by adding the amounts on lines (1), (2), etc., excluding from such total any amounts excluded from subpart F income under the high-tax exception. These amounts are included in the total amount of residual income. These amounts are included in the total amount of residual income, which is reported on line 4. As a result, the amounts included on lines 1a through 1i for each column may equal the sum of the amounts reported in lines (1), (2), etc., for each column because any item excluded from subpart F income by reason of the high-tax election of the summation on line 4 instead of the summations on lines 1a through 1i.
Line 2. Recaptured Subpart F Income
For Line 2, the preparer must enter the income that is recaptured as subpart F income in the current year under Internal Revenue Code Section 952(c)(2). If a CFC has an excess of current E&P over subpart F income to the extent of the prior reductions in subpart F income, the CFC shareholders may have additional current inclusions of income under Section 951(a) as a result of this recharacterization rule. Please Illustration 1 which discusses how this rule applies.
Illustration 1.
DC, a U.S. corporation, owns all the stock of FC, a foreign corporation that is a CFC. During the current year, FC has foreign base company sales income of $100 (determined under Section 954), but its current E&P (as calculated under Section 964) is $80. Thus, Section 952(c)(1)(A) limits FC’s subpart F income to $80 for year 1 and DC would include the $80 in gross income under Internal Revenue Code Section 951(a)(1)(A).
In year 2, FC has foreign base company sales income of $75 (determined under Section 954) and its current E&P are $85. Under the recharacterization rule in Section 952(c)(2), the $10 excess of current E&P of $85 over the subpart F income of $75 is recharacterized as subpart F income. Thus, FC is treated as having subpart F income of $85 and DC must include the $85 in gross income under Section 951(a)(1)(A).
In year 3, FC has foreign base company income of $50 (determined under Section 954) and its current E&P are $80. Under the recharacterization rule in Section 952(c)(2), only $10 of the $30 excess current E&P of $80 over the subpart F income of $50 is recharacterized as subpart F income. This is because the total amount recaptured under Section 952(c)(2) ($10 in year 2 and $10 in year 3) cannot exceed the reduction of subpart F income in year 1 by reason of the limit in Section 952(c)(1)(A) (i.e., $20). See Taxation of International Transactions, Thomson/West, Charles H. Gustafson, Robert J. Peroni, Richard Crawford Pugh (2006).
Line 3. Tested Income Group
The preparer should use line 3 to report the tested income group of the CFC (a “tested income group”). The tested income of a CFC is the excess (if any) of the gross income of the CFC determined without regard to certain items over deductions properly allocable to that gross income. The items excluded from gross income are:
1) Any item of income described in Section 952(b) which is generally any U.S. source income effectively connected with the conduct by such corporation of a trade or business within the United States.
2) Any gross income taken into account in determining the subpart F income of such corporation;
3) Any gross income excluded from the foreign base company income and insurance income of such corporation by reason of the high-tax exception;
4) Any dividend received from a related person; and
5) Any foreign oil and gas extraction income of the corporation.
On lines (1), (2), etc., under line 3, enter the name of each tested unit of the CFC (including the CFC tested unit itself), based on the tentative gross tested income attributable to each tested unit (without regard to any amounts excluded under the GILTI high-tax exclusion). If the GILTI high-tax exclusion applies with respect to any tested unit of the CFC, the amounts should be reported for columns (ii) through (xiv) in the total reported for line 4.
Line 4. Residual Income group
The preparer should use line 4 to report the information required in columns (i) through (xiv) that is in a Section 904 foreign tax credit category that is not of a type that is included in one of the subpart F income groups or a tested income group and is therefore assigned to the residual income group. Under the proposed foreign tax credit regulations and the foreign tax credit regulations, CFCs are required to establish an annual account for previously taxed E&P (annual PTEP account) for each Section 904 basket (i.e., foreign branch category, Section 951A category, passive category, or general category).
Column (i)
For column (i), the preparer must report with the reporting requirements on Form 1118 the two-letter code (from the list at IRS.gov/CountryCodes) of each foreign country and U.S. possession within which income is sourced and/pr to which income was paid or accrued.
Column (ii)
For column (ii), the preparer should enter the amount of gross income of the CFC that is assigned to each income group within each Section 904 category.
Columns (iii) through (vii)
For columns (iii) through (vii) the preparer must allocate and apportion to income groups to determine the net income (or loss) in each income group and to identify that related to the income in each income group for Section 960 purposes. This must be done per qualified business unit (“QBU”) or tested unit. 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 corporation is a QBU. A foreign branch operation of a U.S. corporation would also in most instances be a QBU. The branch must. However, be conducting activities that constitute a trade or business and maintain a separate set of books and records with respect to such activities. See Treas. Reg. Section 1.989(a)-1(b)(2)(ii).
Column (viii)
For column (viii), the preparer must report current-year tax imposed on a disregarded payment that is a reattribution payment. Reattribution payments generally means disregarded payments to the extent they result in the reattribution of income from one “taxable unit” to another. Generally, a disregarded payment causes gross income to be attributed from one taxable unit to another to the extent that a deduction for the payment, if regarded, would be allocated against the payor tested unit’s U.S. gross income. Statutory or residual groupings to which foreign gross income of a taxable unit is assigned is determined without regard to any reattribution payments made by the taxable unit. See Prop. Reg. Section 1.861-20(d)(3)(v)(B)(3). As a result, foreign taxes that are imposed on foreign gross income that is subject to these reattribution provisions will not be reattributed on account of the reattribution payment.
With respect to a domestic corporation, a foreign branch and a foreign branch owner are separate taxable units, and Treasury Regulation Section 1.904-4(f) provides rules for reattributing income between a foreign branch owner and a foreign branch. Special rules apply in the case of payments to or from “non-branch taxable units” (disregarded entities that are not foreign branches).
For “reattribution payments” (the portion of a disregarded payment that results in a reattribution of U.S. gross income from the payor taxable unity to the recipient taxable unit), foreign gross income is assigned to the statutory and residual grouping to which the amount of U.S. gross income that is reattributed- “reattribution amount”) is initially assigned upon receipt of a disregarded payment by the taxable unit, before taking into account any reattribution payments made by the recipient taxable unit. See Prop. Reg. Section 1.861-20(d)(3)(v)(B)(1).
Once reattributed, such amounts are subject to certain attribution rules to assign foreign gross income items arising from the reattribution payment to the relevant statutory and residual groupings. For domestic corporations, the attribution rules relating to gross income attributable to the foreign branch category apply, and for foreign corporations, the attribution rules in the high-tax exception proposed regulations apply. See Prop. Reg. Section 1.861-20(d)(3)(v)(B)(2); Treas. Reg. Section 1.904-4(f)(2); and Prop. Reg. Section 1.954-1(d)(1)(iii); Proposed Regulations Provide New Rules for Allocating and Apportioning Foreign Income Taxes Relating to Disregarded Payments, (December 23, 2020) McDermott Will & Emery, Brian Jenn, Bradford LaBonte, Michael Wilder.
The preparer should report current-year taxes allocated and apportioned to the item of gross income for each QBU or tested unit as well as the aggregate amount of such foreign taxes in each group.
Column (ix)
For column (xi), the preparer should report the current tax imposed by reason of the receipt of a disregarded payment other than a reattribution payment. For lines 1 through 4, the preparer should report tax allocated and apportioned to the item of gross income reported to each QBU or tested unit as well as the aggregate amount of suchy foreign taxes.
Column (x)
Column (x) asks the preparer to allocate current year taxes. In general, taxpayers are required to allocate and apportion foreign income taxes to or among the statutory and residual groupings (Section 904 categories) under the following steps: 1) first, assign foreign gross income items to statutory and residual groupings; 2) second, allocate and apportion foreign law tax deductions to the foreign gross income in such statutory and residual groupings. See Treas. Reg. Section 1.861-20(c).
The most substantive and detailed rules for allocating and apportioning foreign taxes relate to the first step of assigning foreign gross income items to statutory and residual groupings. Foreign gross income items are items of income recognized for foreign law purposes, which may or may not correspond to items of income for U.S. federal income tax purposes. Where there is a U.S. gross income item corresponding to a foreign gross income item, the item of foreign gross income is categorized based on the categorization of the corresponding item of U.S. gross income. See Treas. Reg. Section 1.861-20(d)(2)(ii)(A). Where there is no U.S. gross income item corresponding to a foreign gross income item, the proposed and final regulations require the allocation and apportionment of foreign taxes associated with such foreign income items.
For column (x), the preparer should report current-year taxes allocated to the item of gross income reported for each group.
Column (xii)
For column (xii), the preparer should report the foreign taxes for which credit is allowed in U.S. dollars.
Column (xiii)
For column (xiii), the preparer should report foreign income that arises from disregarded payment that is treated as remittance for U.S. tax purposes assigned to an income group reference to the income groups to which assets of the payor taxable unit are assigned under the rules of Treasury Regulation Section 1.861-9 for purposes of apportioning interest expense. This apportionment is based on the asset method provided by the interest expense apportionment rules, but with modifications to 1) treat stock owned by the taxable unit as an asset of the remitting taxable unit; and 2) reallocate asset from a payor taxable unit that gives rise to U.S. gross income that is assigned to a recipient taxable unit to the reattribution rules.
Column (xiv)
The preparer should check the box in column (xiv) of the line corresponding to any item of income with respect to which the subpart F high-tax exception applies. An item of income of a CFC that would otherwise be foreign base company income may qualify for the subpart F income high tax exemption if it is subject to an effective foreign tax rate greater than 90 percent of the maximum U.S. corporate tax rate. This exception applies after reducing the income by deductions (including taxes) that are allocable to the income under Section 954(b)(5). If any amount is excluded under subpart F high-tax exception, it should not be included in the total for line 1a through 1i. Instead, the amount should be added to the total for line 4.
If a GILTI high-tax exclusion under Income Tax Regulation 1.951A-2(2)(7) is used, the preparer should check the box in column (xiv) that corresponds to the item(s) of income to which the exception applies. The 2019 Proposed Regulations and the 2020 Final Regulations set the threshold rate for claiming the GILTI high-tax election at 90 percent of the U.S. federal corporate tax rate. This is currently 18.9 percent (90% of the highest U.S. federal corporate tax rate, which is 21%). If an amount reported on line 3(1), 3(2), etc., is excluded from gross income under the GILTI high-tax exclusion, the preparer should not include it in the total amount for line 3. Instead, the preparer should include the amounts in the total for line 4.
Conclusion
The IRS Form 5471 is an incredibly complicated return. Each year an international tax attorney should review direct, indirect, and constructive ownership of the reporting CFC to determine the impact of any changes in percentages, filer categories, and CFC status. Workpapers should also be prepared and maintained for each U.S. GAAP adjustment and foreign exchange. In addition, an accounting should be made for adjustments to prior and current year previously taxed E&P that become PTEPs on Schedule J, E-1, and P.
It is extremely important to work with an international tax specialist to ensure accurate preparation of your Form 5471. Having the wrong professional complete your Form 5471 can result in significant penalties. The Internal Revenue Code authorizes the IRS to impose a $10,000 penalty for failure to file substantially complete and accurate Form 5471 returns on time. An additional $10,000 continuation penalty may be assessed for each 30 day period that noncompliance continues up to $60,000 per return, per tax year. In addition, the IRS can assess a 40 percent accuracy penalty on incorrectly reported income and reduction of foreign tax credits by 10 percent.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or 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.