By Anthony Diosdi
Schedule M is designed to measure Controlled Foreign Corporation (“CFC”) intercompany payments. Schedule M requires the majority U.S. owner to provide information on transactions between the CFC and its shareholders or other related persons. This article is designed to provide a basic overview of the Internal Revenue Service (“IRS”) Form 5471, Schedule M.
Who Must Complete Schedule M
Anyone preparing a Form 5471 knows that the return consists of many schedules. Schedule M is just one schedule of the Form 5471. Whether or not a CFC shareholder is required to complete Schedule M 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 4 filers must complete and attach Schedule M to their Form 5471.
Reporting Transactions on Schedule M
Schedule M categorizes transactions in multiple ways. First, shareholders of a CFC must provide information about the magnitude of both inflows to and outflows from the CFC. Second, CFC shareholders must provide inflows and outflows separately for multiple types of transactions including inventory transfers, royalty payments, etc. Third, the columns of Schedule M separately identify transactions between the CFC and various related entities including the U.S. person filing the return and any domestic corporation or partnership controlled by the U.S. person filing the return. Finally, the regulations of Internal Revenue Code Section 482 should apply to value inflows and outflows of the CFC for purposes of Schedule M reporting.
Columns of Schedule M
Schedule M requires shareholders of CFCs to disclose transactions with related parties such as the individual filing the informational return and other related entities. Each transaction the CFC conducts with a related party must be disclosed by categories stated in each column of the schedule. Schedule M contains six columns numbered (a) through (f). Column (a) describes the transactions being reported by the taxpayer (The categories for Schedule (a) will be discussed in more detail below.
The preparer of Schedule M must enter the totals for each type of translation listed under Column (a) that occurred during the annual accounting period being disclosed on the Form 5471 by the CFC and the persons listed in columns (b) through (f). All amounts must be stated in U.S. dollars translated from functional currency (functional currency refers to the main currency used by a business or unit of a business) at the average exchange rate for the foreign corporation. The preparer must enter the functional currency and the exchange rate used on the third line of the Schedule M.
Columns (b) through (f) are broken down as follows:
(b) U.S. person filing this return
If the CFC entered into a transaction or transactions with the U.S. person filing the Form 5471, the transactions must be listed under column (b). A U.S. person is defined as a U.S. citizen or a U.S. resident under either the “green card” or “substantial presence” tests.
(c) Any domestic corporation or partnership controlled by a U.S. person filing this return
If the CFC entered into a transaction or transactions with a domestic corporation or partnership controlled by a U.S. person, the transactions must be listed under column (c). The directions to Schedule M do not define the terms “any domestic corporation or partnership controlled by a U.S. person.” The definition of a domestic controlled corporation or partnership likely is the same as the definitions provided in Sections 951(b) and 958 of the Internal Revenue Code. The definitions of these code sections are defined below.
(d) Any other foreign corporation or partnership controlled by U.S. person filing this return
If the CFC entered into a transaction or transactions with a foreign corporation or partnership controlled by a U.S. person, the transactions must be listed under column (d). In determining whether a U.S. person meets the definition of a U.S. shareholder and whether a foreign corporation meets the Section 957(a) definition of a CFC, Section 958 applies direct, indirect, and constructive ownership rules to determine stock ownership in the foreign corporation. Stock ownership under all three types of rules counts for purposes of determining whether a foreign corporation or partnership is “controlled.” A CFC or foreign partnership is controlled if more than 50 percent of the combined voting stock or value of the entity is controlled by U.S. persons.
(e) 10% or more U.S. shareholder of controlled foreign corporation (other than the U.S. person filing Form 5471)
If the CFC entered into a transaction or transactions with 10% or more U.S. shareholders of a CFC with an individual who is a 10% shareholder, but not a U.S. person, the transactions must be reported under column (e).
(f) 10% or more U.S. shareholder of any corporation controlled the foreign corporation
If the CFC entered into a transaction or transactions with a 10% or more U.S. shareholder of a CFC, the transactions must be reported under column (f). A U.S. shareholder is a U.S. person who owns, or is considered as owning at least 10 percent of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation. See IRC Section 951(b). In determining whether a person is a 10 percent U.S. shareholder, the Internal Revenue Code looks at direct ownership, indirect ownership, and constructive ownership. Thus, a U.S. person is constructively treated as owning stock in a foreign corporation that is owned by certain entities or individuals related to the U.S. person. For example, if a U.S. person’s father owns 7 percent of a foreign corporation and his U.S. citizen son owns another 5 percent of the same foreign corporation, they will each be considered ten percent U.S. shareholders.
Transactions that Must be Disclosed on Schedule M
Schedule M requires the CFC shareholder or related party to disclose a number of different transactions. We will next go through the questions asked on each line of the schedule. Anyone completing Schedule M must understand that the IRS will utilize certain information disclosed on this informational return to ensure that the CFC shareholders and related parties report and pay tax on their actual share of income arising from so-called controlled transactions. To this end, the regulations under Internal Revenue Code Section 482 adopt an arm’s length standard for evaluating the appropriateness of each transaction under the transfer pricing rules. This article will apply these regulations to the relevant questions listed on Schedule M. This way the parties involved in the controlled transaction have a reference point as to how to report these transactions on Schedule M.
Line 1 and Line 14. Sales of Stock in Trade Inventory/Purchases of Stock in Trade Inventory
Line 1 and Line 14 of Schedule M asks the CFC shareholder to value the sale and purchases of sales of stock in trade. Stock in trade refers to any merchandise or equipment kept on hand and used in carrying on a business. It includes the collection of goods, inventories and merchandise, maintained by a business entity for the purpose of using them for processing, making salable goods or for selling to the customers with an intention to make profit from such deals. Since a sale or purchase of stock in trade between a CFC and a shareholder of the CFC or related party is subject to manipulation, the transaction reported on Schedule M must reflect an arm’s length standard for purposes of the sale and purchase of the stock in trade. The reliability of a pricing method is determined by the degree of comparability between the controlled and uncontrolled transactions, as well as the quality of the data and the assumptions used in the analysis.
As a practical matter, comparable transactions often are not readily available for inventory sales between affiliated companies (i.e. related parties or CFC shareholders). As a consequence, the appropriate arm’s length price for the sale or purchase of stock in trade is ambiguous. To establish an arm’s length price for the sale or purchase of stock in trade, the shareholders of a CFC should obtain at least one if not two transactions between unrelated parties to establish an arm’s length range of prices for the sale and purchase of the sales of stock in trade. These transactions can serve as a model for valuing the sale or purchase of stock in trade transactions for Schedule M reporting purposes.
Line 2 and Line 15. Sales/Purchases of Tangible Property Other Than Stock in Trade
Question 2 and 15 asks the CFC shareholder to list the sale and purchases of any tangible property. Tangible property includes both personal and real property. In the context of international transactions, tangible gifts typically refer to goods sold in commerce. The sale or purchase of tangible goods should be reported on Schedule M at arm’s length range of prices. Valuing transactions involving tangible property in controlled transactions is complex. This is because there are five specific methods for estimating an arm’s length charge for transfers of tangible property:
1. The comparable uncontrolled price method;
2. The resale price method;
3. The cost plus method;
4. The comparable profits method, and:
5. The profit split method.
The CFC shareholder completing Schedule M must select and apply the method that provides the most reliable estimate of an arm’s length price between the related parties. In addition to the five methods stated above, the CFC shareholder can use an unspecified method to value the transaction.
Comparable Uncontrolled Price Method
The first enumerated method is characterized as the “comparable uncontrolled price method,” referred to as the “CUP” method. The basic approach is to examine comparable sales where the parties are unrelated. These may include sales by a member of the controlled group to an unrelated party, sales by an unrelated party to a member of the controlled group and sales made in which neither party is a member of the controlled group. See Treas. Reg. Section 1.482-3(b).
Resale Method
The second is the “resale price method.” Under this approach the price for the controlled transaction is equal to the resale price to an uncontrolled buyer, less an “appropriate gross profit.” The appropriate gross profit is determined by multiplying the applicable resale price by the “gross profit margin” (expressed as a percentage of total revenue derived from sales) earned in comparable uncontrolled transactions. See Treas. Reg. Section 1.482-3(c)(2)(iii). The regulations state that a typical situation where the resale price method may be useful is one “involving the purchase and resale of tangible property in which the reseller has not added substantial value to the tangible goods by physically altering the goods” or through use of an intangible. See Treas. Reg. Section 1.482-3(c)(1).
Cost Plus Method
The third is the “cost plus method.” Under this approach the transfer price is generally equal to the cost of production plus an amount determined by the application of a “gross profit markup” to that cost. Under the cost plus method, the arm’s length price is the manufacturing cost incurred by the related manufacturer, increased by the arm’s length profit markup for such manufacturers and adjusted for any material differences that exist between the controlled and uncontrolled transactions. The gross profit realized by independent manufacturers (or related manufacturers) on similar uncontrolled sales provides an estimate of the arm’s length gross profit markup, which is expressed as a percentage of the manufacturing costs. See Treas. Reg. Section 1.482-3(d)(2) and (d)(3)(ii)(C).
The Comparable Profits Method
The fourth is the “comparable profits method” (“CPM”). This method determines an arm’s length result based on profit level indicators derived from similarly situated uncontrolled taxpayers. See Treas. Reg. Section 1.482-5(a). The controlled party that has the least complex, readily available and accurate financial data from which to draw a comparison will be the party to whom the test is applied and is called the “tested party.” See Treas. Reg. Section 1.482-5(b)(2)(i). Comparability for these purposes is heavily dependent on resources employed and risks assumed and not necessarily product similarity. Adjustments must be made for all material differences between the tested party and the uncontrolled taxpayers serving as the basis for comparison. Under the CPM, the arm’s length price is calculated by applying a profit level indicator (derived from a comparable taxpayer) to the “financial data related to the tested party’s most narrowly identifiable business activity” which includes the controlled transaction. See Treas. Reg. Section 1.482-5(b)(1). Acceptable profit level indicators (which measure the ratio of profits to either costs incurred or resources employed) include the rate of return on capital employed and financial ratios. See Treas. Reg. Section 1.482-5(b)(2). Other indicators are not precluded from use if they would profit an accurate estimate of profits. The appropriate profit level indicator depends upon the characteristics the tested party and the comparable party share.
Profit Split Method
The fifth is the “profit split method.” The profit split method evaluates whether the allocation of the combined operating profit attributable to a controlled transaction is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined profit. See Treas. Reg. Section 1.482-6(a). The value of each party’s contributions is to be based upon “the functions performed, risks assumed, and resources employed.” See Treas. Reg. Section 1.482-6(b).
The division can be accomplished in one of two ways: the comparable profit split or the residential profit split. Under the comparable profit split method, the allocation of the combined operating profit between two controlled taxpayers is based on how uncontrolled taxpayers engaged in similar activities under similar circumstances allocate their joint profits. See Treas. Reg. Section 1.482-6(c)(2). Under the residual profit split method, the comparative profits method is used to estimate and allocate an arm’s length profit for the routine contributions made by each controlled taxpayer. Routine contributions ordinarily include contributions of tangible property and services. The residual profit not allocated on the basis of routine functions is then allocated between the two controlled taxpayers on the basis of the relative value of the intangible property contributed by each party.
The Unspecified Method
The sixth is the “unspecified method,” described in Treasury Regulation Section 1.482-3(e)(1). The method selected is to be applied in accordance with Treasury Regulation Section 1.482-1, and should take into account the general principle that all of the “realistic alternatives” should be considered when valuing these transactions.
The regulations describe five methods for judging the arm’s length of the acceptability for the sale of tangible property, along with a sixth category called “unspecified methods.” They include: the comparable uncontrolled price, resale price, cost plus methods, augmented by the comparable profits and the profit split methods, the regulations do not prescribe an order of preference among the alternative methods. The regulations however are explicit in that adjustments must be made to reflect the differences between the controlled transactions and the uncontrolled transactions to which comparisons are being made. Thus, a careful analysis should be made of the regulations and the related party transaction involving the sale or purchase of tangible property to properly reflect the valuation for purposes of Schedule M.
Line 3, Line 8, Line 16, Line 21. Sales/Purchases of Property Rights (patents, trademarks, etc), Rents, Royalties, and License Fees Paid
Line 3 and line 8 asks the CFC shareholder to disclose the sale and purchase of intellectual property rights such as patents, trademarks, and copyrights. Line 8 and Line 21 asks the CFC shareholder to disclose the rents, royalties received or paid to a related party. The CFC must select and apply the method which provides the most reliable estimate of an arm’s length price. There are three specific methods for estimating an arm’s length charge for transfers of intangibles: 1) the comparable uncontrolled transaction method; 2) the comparable profits method; and 3) the profits split method. In addition to the three specified methods, the CFC also has the option of using an unspecified method.
Comparable Uncontrolled Transaction Method
The comparable uncontrolled method (“CUT”) is analogous to the CUP method used for transfers of tangible property. Therefore, under the comparable uncontrolled transaction method, the arm’s length charge for the transfer of an intangible is the amount charged for comparable intangibles in transactions between uncontrolled parties, adjusted for any material differences that exist between the controlled and uncontrolled transactions. In order for the intangible involved in the controlled transaction, both intangibles must be used in connection with similar products or processes within the same general industry or market and must have similar profit potential. See Treas. Reg. Section 1.482-4(c)(2)(iii)(B)(1). The comparable uncontrolled transaction method ordinarily is the most reliable method for estimating an arm’s length price if there are only minor differences between the controlled and uncontrolled transactions for which appropriate adjustments can be made.
Comparable Profits Method
The same comparable profits methods used to determine arm’s length prices for transfers of tangible property can be used to determine arm’s length sales prices or royalty/rent rates for transfers of intangible property. The methodology for developing arm’s length profit involved in intangible property should involve the following seven steps:
1. Determine the tested party- the tested party should be the participant in the controlled transaction for which most reliable data regarding comparable companies can be located.
2. Search for comparable companies and obtain their financial data- the key factors in assessing the comparability of the tested party to comparable companies are the resources employed and the risks involved.
3. Select a profit indicator (“PLI”)- Examples of PLIs that can be used include the ratio of operating profit to operating assets, the ratio of operating profit to sales, and the ratio of gross profit to operating expenses. This should be done as a multiyear analysis.
4. Develop an Arm’s Length Range of PLIs- the arm’s length range of PLIs is the interquartile range (middle 50 percentile range) of comparable companies. The interquartile range is the range from 25 percent to 75 percentile.
5. Develop an arm’s length range of comparable operating profits- to construct an arm’s length range of comparable operating profits, the selected PLI for the comparable companies in the arm’s length range is applied to the tested party’s most narrowly identified business activity for which data incorporating the controlled transaction is available.
6. Determine if an adjustment must be made- an adjustment is required if the tested party’s reported profit lies outside the arm’s length range of comparable operating profits developed in step 5.
7. Adjust the transfer price for the controlled transaction- if the tested party’s reported profit lies outside the arm’s length range, an adjustment is made equal to the difference between the tested party’s reported profit and the goal arm’s length profit.
Profit Split Method
See the discussion of the split profit method above under “tangible property.”
Although the transfer of intangible property between related parties such as patents, trademarks, and trade secrets can achieved relatively simply by the execution of documents of sale or license coupled with the provision of information, as the foregoing materials indicate, the application of arm’s length standards to these transactions can invoke a very complex analysis. The regulations provide a number of different methods for purposes of determining an arm’s length standard. The regulations provide for the “comparable profits method” and “profit split methods,” which apply a standard of comparable transactions. The CUT method is applied when there are transactions involving the same or comparable intangible properties. Differences in contractual terms or economic conditions present when the transactions are effected may require adjustments. Both comparables must be used in connection with similar products or processes within the same general industry or market and have a similar profit potential.
Anytime intangible property is transferred between related parties, a careful analysis of the regulations must be done to assure the proper valuation of such a transaction for purposes of Schedule M disclosures.
Line 4 and Line 17. Platform Contributions
Lines 4 and 17 asks the CFC shareholder or related party to disclose the sale or purchase of platform contributions. A platform contribution is any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity that is reasonably anticipated to contribute to developing cost shared intangibles. Platform contributions include the goodwill of a controlled participant. The exact method of valuing platform contributions is currently unsettled.The IRS has taken the position that the arm’s length standard requires that the specific attributes of the buyer and seller be taken into consideration. The Tax Court and the Ninth Circuit Court adopted the so-called “behavioral” rule, meaning that the arm’s length standard looks to the behavior of the uncontrolled taxpayer to test the controlled transaction for purposes of reporting the transaction.
According to the instructions for Schedule M, platform contribution transaction payments received and paid by the CFC (without giving effect to any netting payments due and owed) are reported on Line 4 and Line 17. The CFC is required to complete both lines only if the CFC provides a platform contribution to other controlled participants and is required to make platform contribution transaction payments to other controlled participants that provide a platform contribution to other cost sharing arrangement participants.
Line 5 and Line 18. Cost Sharing Transaction Payments Received
Line 5 and line 18 require the CFC shareholder or related party to disclose cost sharing transaction payments received and paid. Under Treasury Regulation Section 1.482-7, an arrangement called cost sharing is provided as a basic alternative to arm’s length royalty arrangements between related parties with respect to intangibles. In general, a cost sharing arrangement is an agreement between two or more persons to share the costs and risks of research and development as they are incurred in exchange for a specified interest in any intangible property that is developed. Because each participant receives rights to any intangibles developed under the arrangement, no royalties are payable by the participants for exploiting their rights to such intangibles.
According to the instructions for Schedule M, the CFC is required to complete Line 5 only if the CFC itself incurred intangible development costs. If the CFC does not itself incur intangible development costs, then it should only report cost sharing transaction payments made on Line 18.
Line 6, and Line 19. Compensation Received and Paid
Line 6 and 19 asks the CFC shareholder or related party to value services received and services that were paid out to related parties. An arm’s length fee generally must be charged if one controlled entity performs services for the benefit of, or on behalf of, another controlled entity. See Treas. Reg. Section 1.482-2(b)(2). This valuation is not available if the service provided is an integral part of the business activities of the service provider or recipient in the following situations:
1. The service provider or recipient is engaged in the business of rendering similar services to unrelated parties.
2. A principal activity of the service provider is providing such services to related parties.
3. The service provider is peculiarly capable of rendering the service and such services are a principal element in the operations of the recipient, or
4. The recipient receives a substantial amount of services from affiliates during the year.
An exception also applies to services performed by a parent corporation for one of its subsidiaries, where the parent’s services merely duplicate those performed by the subsidiary. A parent CFC need not charge the subsidiary for those services if they are undertaken for the CFC parent’s benefit in overseeing its investment rather than for the subsidiary’s benefit. See Treas. Reg. Section 1.482-2(b)(2)(ii).
Line 7 and Line 20. Commissions Received and Paid
Line 7 and line 20 requires the CFC shareholder to disclose the amount of commissions paid and received. The valuation of commissions requires that the amount charged and received be equivalent to those that would have been charged between independent parties in the same circumstances.
Line 9 and Line 22. Hybrid Dividends Received and Paid
Line 9 and Line 22 require a CFC to report Section 245A(e)(2) hybrid dividends received and paid. A hybrid dividend is an amount received from a CFC if the dividend gives rise to a local country deduction or other tax benefit. According to the instructions for Schedule M, hybrid dividends received by the CFC are reported on Line 9. Hybrid dividends paid out by the CFC must be reported on Line 22. A hybrid dividend refers to a dividend that the U.S. and foreign tax law classify differently for tax purposes.
Line 10 and Line 23. Hybrid Dividends Received (exclude hybrid dividends, deemed distributions under subpart F, and distributions of previously taxed income)
Line 10 and Line 23 require a CFC shareholder to disclose dividends (excluding hybrid dividends) received or paid. This typically applies to a hybrid dividend received by a CFC from another CFC in a tiered structure to the extent that the amount would be a hybrid dividend if the receiving CFC were a domestic corporation. If a CFC received a tiered hybrid dividend from another CFC, then the tiered hybrid dividend is treated as Subpart F income by the CFC receiving it.
Line 11 and Line 24. Interest Received and Interest Paid
Lines 11 and 30 asks the CFC shareholder to disclose interest received and interest paid. Controlled entities generally must charge each other an arm’s length rate of interest on any intercompany loans and advances. See Treas. Reg. Section 1.482-2(a)(1)(i). There is an exception, however, for intercompany trade receivables, which are debts that arise in the ordinary course of business and are not evidenced by a written agreement requiring the payment of interest.
Intercompany debt other than a trade receivable generally must bear an arm’s length interest charge. An interest will generally satisfy the arm’s length standard if it is not less than 100 percent and not more than 130 percent of the applicable federal interest rate on debt of comparable maturity. See Treas. Reg. Section 1.482-2(a)(2)(iii)(B).
Related party interest should be disclosed on Line 11. Related party interest paid should be reported on Line 24.
Line 12 and Line 25. Premiums Received for Insurance or Reinsurance
Line 12 and Line 25 require the CFC shareholder to disclose payments received and paid for reinsurance. CFC companies enter into insurance and reinsurance contracts to protect against loss and other business reasons. These contracts must be judged under the arm’s length rule. Under this approach, a premium is considered appropriate if it is within a range of prices that would be charged by independent parties at arm’s length. These prices must be determined by the most reliable measures. Methods that are applicable to intergroup insurance and reinsurance contracts include: 1) Comparable Uncontrolled Prices (“CUP”); 2) Broker quotes; and 3) Actuarial valuations.
Premiums or reinsurance received from related parties should be reported on Line 12. Premiums or reinsurance paid to related parties should be reported on Line 25.
Line 27 and Line 29. Accounts Payable and Accounts Received
Line 27 and Line 29 require the CFC shareholder to report accounts payable and accounts received. According to the instructions of Schedule M, the CFC shareholder must report the largest aggregate outstanding accounts receivable and payable balances during the year with any related corporation or partnership. Only accounts receivable arising in connection with the provision of services or the sale of processing of property. Only net accounts receivables and payables to the extent that the CFC’s books net the accounts payable against the receivables as payments of the accounts receivables.
Line 28 and Line 30. Amounts Borrowed and Amounts Loaned
Line 28 and Line 30 requires a CFC shareholder to disclose the amounts borrowed and loaned by the CFC. Reporting is not limited to the lending of money. Transactions between related parties involving the rental of tangible property may need to be disclosed on Line 28 and Line 30. The regulations provide that the application of the arm’s length standard to rental arrangements require a comparison of rental agreements with independent parties “under similar circumstances considering the period and location of the use, the owner’s investment in the property or rent paid for the property, expenses of maintaining the property, the type of property involved, its condition, and all other relevant facts. See Treas. Reg. Section 1.482-2(c)(2)(i).
According to the instructions of Schedule M, the CFC shareholder must report on these lines the largest outstanding balances during the year of gross amounts borrowed from, and gross amounts loaned to, related parties that are corporations or partnerships. The instructions also say do not include an account receivable or payable balance arising in connection with the provision of services or the sale or processing of property if the amount of such balance does not, at any time during the tax year, exceed what is ordinary and necessary to carry one the trade or business.
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.