By Anthony Diosdi
In 2017, Congress enacted the 2017 Tax Cuts and Jobs Act. The 2017 Tax Cuts and Jobs Act dramatically changed the way cross-border transactions are taxed and reported to the Internal Revenue Service (“IRS”). Nowhere is this more true than with Schedule J of Form 5471. Schedule J is used to report accumulated earnings and profits (“E&P”) of controlled foreign corporations. This article will compare the pre-2017 Tax Cuts and Jobs Act Schedule J with the post-2017 Tax Cuts and Jobs Act Schedule J.
I. Pre-2017 Tax Cuts and Jobs Act Schedule J
Introduction
Prior to 2018, Category 4 and 5 filers of a “controlled foreign corporation” (“CFC”) had to attach a Schedule J to their Form 5471. Section 957(a) defined a CFC as a foreign corporation of which more than 50 percent of the total combined voting power of all classes of stock entitled to vote was owned, directly, indirectly, or constructively under the Section 958 ownership rules, by “US shareholders” on any day during the foreign corporation’s tax year. In addition, if a U.S. shareholder owned at least ten percent of the foreign corporation’s voting stock, the foreign corporation was a CFC.
If a foreign corporation was classified as a CFC, the US shareholder was required to include his or her portion of the corporation’s subpart F income (or earnings in US property) as taxable income on his or her individual US tax liability. However, subpart F was not intended to be a system of double taxation. Internal Revenue Code Section 951 required a US shareholder to be taxed on his or her pro rata share of all or some portion of the CFC’s earnings even though the CFC has not made any actual distributions to the shareholder. Thus, to avoid double taxation of the US shareholder’s share of the CFC’s earnings, actual distributions from the corporation to a US shareholder were tax-free to the extent attributable to amounts already taxed under Internal Revenue Code Section 951(a). Similar tax-free treatment applied to constructive distributions resulting from an investment of the CFC’s earnings in US property under Section 951(a)(1)(A).
959 Ordering Rules Prior to the 2017 Tax Cuts and Jobs Act
Section 959 established ordering rules to keep track of a CFC’s earnings and profits to prevent double taxation by dividing a CFC’s earnings and profits into three categories, known as:
1. Under Section 959(c)(1) an account was established for Section 956 inclusions to E&P that were required in prior years to be included as investments in U.S. property and investments in excess passive assets.
2. Under Section 959(c)(2) an account was established for allocations made to earnings and profits that were required in prior years as subpart F income.
3. Under Section 959(c)(3) an account was established for all other earnings and profits.
Under the 959 ordering rules, an actual distribution was treated as made first out of the Section 959(c)(1) account, then out of the Section 959(c)(2) account, and finally out of Section 959(c)(3) account. Within each Section 959(c) account, PTI was considered distributed on a last-in, first out (“LIFO”) basis.
Below, please see Illustration 1 regarding the taxation and ordering rules of PTIs prior to the 2017 Tax Cuts and Jobs Act.
Illustration 1.
USP, a U.S. corporation, owns 100 percent of CFC1, a CFC. CFC1 owns CFC2, another CFC. CFC2 has owned 100 percent of DC, a U.S. corporation, since year 1. CFC2 has an adjusted basis of $3 in its DC stock. CFC2 has E&P of $10 in year 1. During year 2, CFC1 earns subpart F income of $50 to USP on June 1; CFC2 makes a distribution of $6 to CFC1 on December 1.
Year 1
CFC2’s ownership of shares in DC constitutes an investment in U.S. property under Section 956, giving USP a Section 956 inclusion to the extent of the lesser of 1) CFC2’s E&P or 2) the adjusted basis of CFC2 in DC stock, which is $3 in year 1. This 956 inclusion in year 1 becomes CFC’s PTI in year 2 as a Section 959(c)(1) PTI.
Year 2
Typically, under Section 959(f)(2) actual distributions during the year are taken into account before current year Section 956 inclusions. Therefore, $3 of the December 1, year 2, distribution of $6 from CFC2 to CFC1 should be treated as made out of PTI from the year 1 Section 956 inclusion, and the remaining $3 of that distribution should be excepted from subpart F income as per Section 954(c)(6). CFC 1’s Section 959(c)(1) PTI account is increased to $3 (the year 1 Section 956 PTI), while CFC’s Section 959(c)(1) PTI account is reduced to zero before considering the year 2 Section 956 inclusion. See Example in Section 956 and subpart F Inclusions, Actual Distributions and Previously Taxed Income, by Hui Yu, June 30, 2014, The Tax Advisor.
Columns of the Pre-2018 Schedule J
Column (a) Post-1986 Undistributed Earnings (Post-86 Section 959(c)(3) Balances)
Column (a) requires the preparer to report the opening balance, current year additions and subtractions, and the closing balance in a CFC’s post-1986 undistributed earnings pool. In order to report Section 959(c)(3) balances in Column (a), it is necessary for the preparer to determine the “post-1986 undistributed earnings pool.” The “post-1986 undistributed earnings pool” of a foreign corporation is the total earnings for years starting in 1987 through the end of 2017 in which a dividend was distributed, undiminished by any dividend distributions made during the year. See Former IRC Section 902(c)(1). Dividend distributions did not reduce the pool of earnings taken into account in subsequent years. See Treas. Reg. Section 1.902-1(a)(9)(i). Moreover, the corporation’s pool of post-1986 foreign income taxes were reduced to reflect the portion of the taxes deemed paid with respect to such dividends for purposes of computing foreign tax credits in subsequent years.
Please see Illustration 2. for a simple example of calculating a “post-1986 undistributed earnings pool.”
Illustration 2.
Gamma S.A., a corporation organized under the laws of Country M, is a wholly owned subsidiary of American Gamma Corporation, a U.S. corporation. Gamma S.A’s post-1986 undistributed earnings (after payment of foreign taxes) and foreign taxes paid for years 1 through 3 were as follows:
Post-1986
Undistributed
Earnings Pool Foreign Taxes
Year 1…………………………………………………………$100,000 $30,000
Year 2…………………………………………………………$200,000 $60,000
Year 3…………………………………………………………$300,000 $90,000
Pools as of 12/31 of Year 3………………………………. $600,000 $180,000
Gamma S.A. paid a dividend of $400,000 to America Gamma on December 1 of year 3.
| Undistributed Earnings Pool | Foreign Taxes Paid | Total |
| $600,000 | $180,000 | $20,000 |
Gamma S.A.’s post-1986 “undistributed earnings pool” as of year 4, would be $20,000.
Column (b) Pre-1987 Pre-1987 E&P Not Previously Taxed (Pre-87 Section 959(c)(3) Balance)
Column (b) was used to report the aggregate amount of the foreign corporation’s pre-1987 E&P accumulated since 1962 and not previously distributed or deemed distributed. In order to correctly report Section 959(c)(3) pre-1987 E&P accumulated earnings, it was necessary to understand how earnings and profits were determined before 1987. Before 1987, the earnings and profits of a foreign corporation were calculated year by year. This income was matched with foreign taxes paid or accrued each year. If a dividend exceeded the earnings of a specific year, the excess of the dividend was deemed to be paid out of the after-tax accumulated earnings of the preceding year. If the remaining portion of the dividend exceeded the after-tax accumulated earnings of the preceding year, the dividend was treated as paid from accumulated earnings of the next preceding year and so on until the dividend had been completely covered by accumulated earnings to the extent available.
Column (c) Previously Taxed E&P (Sections 959(c)(1) and (2) Balances
Column (c) was utilized to report the running balance of the CFC’s PTI or subpart F inclusions. Column (c) of the former Schedule J was broken down into three subcategories as follows:
Column (c)(i) Earnings in U.S. Property
The preparer of the pre-2018 Schedule J was required to disclose in column (c)(i) PTI attributable to or reclassified as investments in US property. Under Internal Revenue Code Section 951(a)(10(B), a United States shareholder of a CFC is required to include in gross income his pro rata share of such corporation’s increase in earnings invested in United States property during the taxable year. Section 956(a)(1) provides that the amount of the earnings of a CFC invested in United States property for the taxable year is the aggregate amount of such property held, directly or indirectly, at the close of the taxable year but only to the extent that the amount thereof would have constituted a dividend if such amount had been distributed during the year. See Treas. Reg. Section 1.956-1(a). Internal Revenue Code Section 956(c) defines US property to include four four types of property. First, US property includes tangible property located in the US. Section US property includes stock of a US corporation. Third, US property includes obligations of US persons. Fourth, US property includes any right to use parents, knowhow, copyrights, or similar property in the United States.
Any inclusion of PTI attributable to 956 income was classified as Section 959(c)(1) PTI for purposes of the ordering rules and reporting on Schedule J.
Column (c)(ii) Earnings Invested in Excess Passive Assets (also on new Schedule J- column (e)(5))
In column (c)(ii), the preparer of the pre-2018 Schedule J was required to disclose PTI attributable to excess passive assets. Rarely did preparers encounter reporting PTI attributable to excess passive assets. Although under the 1993 Tax Act, U.S. shareholders of a controlled corporation were required to include in income their pro rata share of the accumulated post-September 30, 1993 earnings and current-year earnings of the corporation to the extent those earnings were invested in what were called “excess passive assets.” These were passive (rather than active business) assets that exceed 25 percent of the corporation’s total assets. See Former Sections 951(a)(1)(C) and Section 956A. In 1996, however, after intense lobbying pressure by U.S. multinational corporations, Congress repealed former Section 956A, effective for years of foreign corporations starting after 1996.
(c)(iii) Subpart F Income
In column (c)(iii), the preparer of the pre-2018 Schedule J was required to disclose PTI attributable to subpart F income. The definition of subpart F income has five components. The most important component is “foreign base company income.” The other four components are: 1) income from certain insurance activities; 2) certain international boycott-related income; 3) certain illegal bribes, kickbacks or other payments to government officials, employees or agents; and 4) income from certain ostracized foreign countries to which Section 901(j) applies.
The “foreign base company income” component of subpart F income, in turn has four components: 1) foreign personal holding company income; 2) foreign base company sales income; 3) foreign base company services income and 4) foreign base company oil related income.
Foreign personal holding company income includes with some specific exceptions, such items of passive income as dividends, interest, royalties, rents, annuities, gains from commodity transactions, income from notional principal contracts, gains from sales of property producing passive income or no income and foreign currency gains. It also includes certain personal service contracts.
Foreign base company sales income and foreign base company services income components of subpart F income is business income from transactions in which the controlled foreign corporation is being used by its U.S. shareholders largely as a conduit for diverting income from the United States to a low-tax or no-tax foreign country in which the foreign corporation is organized. Before the 2017 Tax Cuts and Jobs Act, income from the processing of minerals extracted by the taxpayer or another person from oil and gas wells was subpart F income. However, the 2017 Tax Cuts and Jobs Act removed foreign base company oil-related income from the subpart F regime and this category of subpart F income no longer exists.
Any PTI from the inclusion of subpart F inclusion was reported as Section 959(c)(2) PTI for the ordering rules purposes and purposes of Schedule J reporting.
Column (d) Total Section 964(a) E&P
Column (d) of the pre-2018 Schedule J required the preparer to report the opening and closing balance of the foreign corporation’s accumulated earnings and profits. This amount was the sum of post-1986 undistributed earnings, pre-1987 Section 964(a) earnings and profits not previously taxed, and PTI. Section 964(a) provides that earnings and profits (or deficits) of a foreign corporation are to be “determined according to rules substantially similar to those applicable to domestic corporations.” The regulations under Section 964 contain some detailed rules for computing earnings and profits, which allow some leeway by providing that adjustments must be made to the accounts of the foreign corporation only if material. See Treas. Reg. Section 1.964-1. While in general earnings and profits of a US corporation are calculated by using only straight-line depreciation, Section 312(k)(2) exempts from this restriction the calculation of earnings and profits of a foreign corporation that, for the tax year, derives less than 20 percent of its gross income from US sources.
Earnings and profits for purposes of Section 964(a) represented the economic earnings and losses of the foreign corporation that may be distributed to shareholders in the form of a dividend. For column (d) purposes, the foreign corporation’s earnings and profits was an annual calculation, with accumulated earnings and profits generally being the sum of prior-year calculations with necessary adjustments (i.e. reduction for dividends). Under Treasury Regulation Section 1.964-1, the annual calculation of the foreign corporation’s earnings and profits was generally based on a three-step approach:
1. Preparation of a local country profit and loss (“P&L”) statement for the year where the foreign corporation conducted business.
2. An accounting adjustment was necessary to conform the P&L to US GAAP.
3. Make any necessary adjustments to the P&L to reflect currency exchange rates, blocked income, and blocked deductions.
Line of Questions Associated with the Pre-2017 Tax Cuts and Jobs Act Schedule J
Line 1. Balance at the Beginning of the Year
For line 1, the preparer was required to enter the balances at the beginning of the tax year. If there was a difference between last year’s ending balance on Schedule J, line 1, the preparer was required to attach an explanation to the Schedule J.
Line 2a. Current Year E&P
For line 2a, the preparer was required to enter the current year deficit in E&P.
Line 2b. Current Deficit in E&P
For line 2b, the preparer was required to enter the current year deficit in earnings and profits. Reporting current year earnings and profits could trigger two challenges. First, a deficit in current earnings and profits could result in a “nimble dividend.” A “nimble deficit dividend” may result if a CFC had a positive amount of current earnings, but had a deficit in the post-1986 undistributed earnings by reason of losses in years before the year of a paid dividend. If a dividend was paid to a ten-percent US corporate shareholder could produce dividend income to the shareholder. However, the income will not carry any deemed paid foreign taxes with it. See Treas. Reg. Section 1.902-2(b)(3), Ex. 2(ii). This result occurs because a distribution made to a shareholder in a year when the distributing corporation had earnings and profits (sometimes called a “nimble dividend”) is treated as a dividend under Internal Revenue Code Sections 301(c)(1) and 316(a)(2), notwithstanding the existence of a deficit in the corporation’s accumulated earnings.
Another problem was when a CFC carried forwarded deficits from pre-1987 earnings and profits to post-1986 earnings and profits for purposes of calculating Section 902 tax credits. In computing the Section 902 deemed-paid foreign tax credit for dividends paid in a taxable year of the foreign corporation beginning after the effective date of the 1986 Tax Act, the amount of a deficit in earnings and profits of the foreign corporation accumulated as of the end of the last pre-effective date taxable year in carried forward and included in the post-1986 undistributed earnings pool. Such amount is carried forward as of the first day of the foreign corporation’s first taxable year beginning after December 31, 1986.
The following example is illustrated in IRS Notice 87-54 in Illustration 3.
Illustration 3.
| Calendar Taxable Year Share- holder And Foreign Corp. | Current E&P After-Tax Accum- ulated Profit (Deficits) | CurrentPlus Accu- mulated E&P | Post-86 Undistrib- uted Earnings Pool | Income Taxes (annual) | Foreig Income Taxes | Dec. 3 Distributions |
| 1984 | 25u | 25u | 20u | -0- | ||
| 1985 | (100u) | (75u) | 5u | -0- | ||
| 1986 | (25u) | (100u) | -0- | -0- | ||
| 1987 | 200u | 100u | 100u | $100 | $100 | -0- |
| 1988 | 100u | 200u | 200u | $50 | $150 | 200u |
| 1989 | 100u | 100u | 100u | $50 | $50 | -0- |
Under Section 316(a), the 1988 dividend distribution of 200u represents all earnings and profits (current plus accumulated) of the foreign corporation and is made out of the post-1986 undistributed earnings pool. The denominator of the Section 902 fraction for the 1988 distribution is 200u (the post-1986 undistributed earnings of 300u reduced by the 100u accumulated deficit carried forward from 1986), and the Section 902 credit is $150. See Rev. Rul. 87-72. None of the foreign income taxes associated with pre-1987 tax years will be carried forward and included in the post 1986 pool of foreign income taxes.
Line 3. Total Current and Accumulated E&P not previously taxed
For line 3, the preparer was required to report the E&P of the CFC as of the close of the tax year, before actual or deemed distributions during the year. This was the denominator of the former deemed-paid credit fraction of Section 902(c)(1) used for foreign tax credit purposes. The denominator of the former deemed-paid credit fraction of Section 902(c)(1) was the foreign corporation’s post-1986 undistributed earnings less any foreign countries corporate taxes attributable to those earnings.
Line 4. Amounts Included Under Section 951(a) or Reclassified under Section 959(c) in Current Year
For line 4, the preparer was required to include in each column amounts under Section 951(a) or amounts that have been reclassified under Section 959(c) in the current year. In completing line 4 of the pre-2018 Schedule J, the preparer should understand that the US shareholder is generally required to include in gross income for US tax purposes its pro rata share of only certain types of undistributed income of the CFC, mostly subpart F income. Prior to 2018, if a foreign corporation was a CFC for an uninterrupted period of at least 30 days during the tax year, each US shareholder of the corporation, who owned stock in the corporation on the last day of the year on which it was a CFC, was required to include in gross income a pro rata share of the corporation’s subpart F income. See IRC Section 951(a)(1)(A)(i). The US shareholder’s pro rata share was determined with reference to the percentage of the corporation’s stock owned by the shareholder on that last day of the year and the portion of the tax year during which the corporation was a CFC.
In addition to requiring that the US shareholder include in income a pro rata share of the CFC’s subpart F income for the tax year, the Internal Revenue Code required that a US shareholder include in income pro rata shares of certain amounts withdrawn by the CFC from favored investment and the earnings of the CFC invested in US property.