By Anthony Diosdi
Schedule R will be used to report basic information pertaining to distributions from foreign corporations. According to the instructions for Schedule R, the information reported on the schedule is required by Sections 245A, 959, and 986(c) of the Internal Revenue Code.
Who Must Complete the Form 5471 Schedule R
Anyone preparing a Form 5471 knows that the return consists of many schedules. Schedule R is just one schedule of the Form 5471. Whether or not a CFC shareholder is required to complete Schedule R 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 3 and Category 4 filers must complete and attach Schedule R to their Form 5471.
The Schedule R consists of four columns. Below, we will discuss the meaning of each column.
(a) Description of Distribution
Each CFC shareholder required to complete Schedule R will be required to state whether it received a distribution in cash, non-cash, taxable, or nontaxable distributions from the CFC. The distribution will need to be identified under code sections. For example, “taxable cash dividend eligible for a dividends received deduction under Section 245A” (Section 245A allows an exemption for certain foreign income of a domestic corporation that is a U.S. shareholder by means of a 100% dividends received deduction for the portion foreign-source portion of dividends received from “specified 10-percent owned foreign corporations” by certain domestic corporations that are U.S. shareholders of those foreign corporations within the meaning of Internal Revenue Code Section 951(b)) or “nontaxable cash distribution of previously taxed earnings and profits (“PTEP”). The CFC shareholder should report parts of a distribution on separate rows if the distribution is partially taxable and partially nontaxable by reasons of different Internal Revenue Code sections.
For example, a cash distribution of $100 that is a nontaxable distribution of PTEP under Section 959(a) of $30, a taxable dividend eligible for a dividends received deduction under Section 245A of $15, a taxable dividend under Section 301(c)(1) of $25, a nontaxable distribution applied against basis under Section 301(c)(2) of $10, and a taxable distribution treated as gain from the sale or exchange of property under Section 301(c)(3) of $20, would be reported on five rows.
If non-cash distributions were made, the CFC shareholder should attach a statement and show both the tax basis and fair market value.
(b) Date of Distribution
Under column (b), each CFC shareholder required to complete Schedule R must enter the month, day, and year of distributions received from the CFC.
(c) Amount of Distribution in Foreign Corporation’s Functional Currency
Under Column (c), each CFC shareholder must disclose the amount of any money paid plus the fair market value of any property transferred to the shareholder from the CFC reduced by the following liabilities: 1) any liability of the corporation the shareholder assumes in connection with the distribution; or 2) any liability to which the property is subject immediately after, the distribution. In other words, each CFC shareholder required to complete Schedule R must report whether the distribution made to them was made from either current earnings and profits (“E&P”) or accumulated earnings and profits. If a PTEP (the term “PTEP” refers to E&P of a CFC) was distributed, any currency gains or losses under Section 986(c) must be disclosed on Schedule R.
The distributions must be valued in the CFC’s functional currency. The functional currency is “the currency of the economic environment in which a significant part of such activities” is “conducted and which is used by the [corporation] in keeping its books and records.” See IRC Section 985(b)(1)(B).
(d) Amount of E&P Distribution in Foreign Corporation’s Functional Currency
Under Column (d), the CFC shareholder must report distributions treated as a distribution of earnings and profits in functional currency. An actual distribution is first out of PTEP, if any, and then out of Section 959(c)(3) balances. If PTEP was distributed, any currency gains as per Internal Revenue Code Section 986(c) should be disclosed on Schedule I, line 6. (Under Section 986(c), a foreign currency gain or loss with respect to distribution of PTEP (as described in Section 959 or 1293(c)) attributable to the movements in exchange rates between the times of the deemed and actual distributions is recognized and treated as ordinary income or loss). With respect to foreign currency gain or loss on a distribution of GILTI: For a U.S. corporate shareholder, the shareholder should include the gain or loss as “other income” on Form 1120, line 10, or on the comparable line of other corporate tax returns. For a noncorporate U.S. shareholder, the amount should be included as “Other income” on Schedule 1 (Form 1040), line 8z, or on the comparable line of other non-corporate tax returns. Amounts entered in column (d) are also included on line 9, column (f) of Schedule J and Part I, line 8 of Schedule P.
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.