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Income Inclusions for U.S. Shareholders of Controlled Foreign Corporations (CFCs)

In the ever-evolving tax environment, many taxpayers and tax professionals are seeking guidance on the intricate international tax compliance and reporting obligations for U.S. shareholders of Controlled Foreign Corporations (CFCs).

CFCs are entities that are majority controlled, directly or indirectly, by a U.S.-based parent company, but are incorporated under foreign law. For U.S. income tax purposes, they are treated as corporations, and they typically do not have U.S. operations.

Operating outside their home country’s tax jurisdiction, CFCs can serve as a means for businesses to circumvent paying taxes in their own countries. A CFC Analysis is a crucial tool used to ascertain whether a company is utilizing a CFC both legally and efficiently.

The first step in the process involves identifying all foreign entities owned by the company. This includes any investments in joint ventures or partnerships with other companies. The information gathered should detail the extent of ownership each entity holds and the type of business activities it undertakes. Once these details are collected, it’s essential to verify that the operations comply with the legal framework of the applicable laws and regulations.

The subsequent part of the CFC Analysis evaluates the profit generated from each entity compared to the likely earnings if it were subject to domestic taxation. Evidence of significant profits resulting from tax avoidance could indicate potential system abuse. Additionally, transactions between related parties warrant careful examination as they might constitute a tax avoidance strategy known as transfer pricing manipulation.

Lastly, it’s crucial to look for signs of potential misuse, such as fictitious transactions or improper payments made to the company’s officers or directors involved in the transaction. It’s also vital to investigate whether any illegal practices, such as money laundering, were used when establishing a CFC structure.

Calculating the ASC 740 Provision for Taxable Income from Controlled Foreign Corporations

A Controlled Foreign Corporation (CFC) is required to compute separate current, deferred, and noncurrent ASC 740 income tax provisions for each jurisdiction where it is taxable.

Under ASC 740, it is presumed that a subsidiary’s earnings will eventually be repatriated to its parent. As a result, any deferred taxes that would arise from the repatriation are accounted for in the period when the earnings are generated, not when the earnings are repatriated.

Therefore, practitioners should calculate the U.S. tax effects associated with the repatriation of a CFC’s earnings based on the anticipated manner of repatriation, which is often a dividend. The Dividends Received Deduction (DRD) under Sec. 245A mitigates the U.S. impact of any foreign dividends from CFCs. This DRD is occasionally referred to as the “exempt basket.” The provision calculation should incorporate any foreign tax credit and foreign exchange impacts that would be triggered upon repatriation.

Accounting for Deferred Tax Assets and Liabilities from Controlled Foreign Corporation Earnings

A deferred tax liability is recorded to the extent that the repatriation of earnings would result in additional income tax to the U.S. parent of the CFC. This deferred tax liability must take into account the following components:

  • Withholding tax imposed on the dividend
  • State tax associated with the dividend
  • Section 986 foreign exchange gain or loss

A deferred tax asset related to unrepatriated earnings is recognized only to the extent it is expected to reverse in the foreseeable future. In practice, the foreseeable future is typically understood to be less than one year from the balance sheet date.

Indefinite Reversal Exception to Recognizing Deferred Tax Liabilities

ASC 740 permits a specific exception to the recognition of a deferred tax liability on the outside basis difference/U.S. tax consequences of repatriating the historic earnings of a foreign corporation or foreign corporate joint venture if the earnings are expected to be permanently reinvested outside of the U.S. To meet the indefinite reversal criteria, a company must have a plan for reinvesting its foreign earnings.

A company can make distributions out of current-year earnings without contradicting an assertion that it is permanently reinvested with respect to historic earnings. Although the indefinite reversal criteria are most often applied to the earnings of a CFC owned by a U.S. parent, the permanent reinvestment assertion is available to any corporation and corporate joint venture that would be considered a foreign entity from the perspective of its parent.

The repatriation of historic earnings from a foreign entity that has asserted the indefinite reversal criteria does not constitute positive evidence when considering the need for a valuation allowance against a deferred tax liability.

In this context, a “U.S. shareholder” is a U.S. person who owns, or is considered as owning, 10% or more of the total voting power or stock value of the CFC (Sec. 951(b)). The U.S. international reporting requirements for these shareholders have dramatically expanded in recent years, largely due to the enactment of the 2017 law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. This law introduced several new categories of foreign income inclusions — including the transition tax under Sec. 965 and the global intangible low-tax income (GILTI) regime under Sec. 951A.

Its primary purpose is to provide additional clarity and insight into the various categories of income inclusions a U.S. shareholder of a CFC may need to consider to the extent of its current-year earnings and profits (E&P) or deficits. It also aims to guide on how to properly report and track any foreign inclusions related to E&P on Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations.

Background on the TCJA’s Changes

Before delving into the current tax rules, it may be beneficial to remind readers about the changes brought about by the TCJA.

Pre-TCJA: Prior to the passing of the 2017 legislation, a U.S. shareholder could, in general, defer its offshore E&P indefinitely to the extent the CFC did not violate the so-called U.S. anti-deferral regime. This regime consisted of the Subpart F income provisions under Sec. 952 and the investment in U.S. property provisions under Sec. 956. Thus, in the absence of an actual dividend distribution, a U.S. shareholder could defer its offshore E&P indefinitely, provided the U.S. anti-deferral rules were not applicable.

However, if a U.S. shareholder was required to include in U.S. taxable income the earnings of a CFC related to Subpart F income, investment in U.S. property income, or actual dividend distributions paid to U.S. shareholders from E&P, the annual E&P balances of the CFC would need to be tracked. This was to ensure the corresponding previously taxed earnings and profits (PTEP) were properly maintained so that the U.S. shareholder would avoid double taxation on the same item of income on future distributions from the CFC. Specifically, the U.S. shareholder would report the current-year and accumulated E&P or deficits of the CFC along with the corresponding PTEP accounts and non-previously taxed E&P on Schedule J, Accumulated Earnings & Profits (E&P) of Controlled Foreign Corporation, and Schedule P, Previously Taxed Earnings and Profits of U.S. Shareholder of Certain Foreign Corporations, both of Form 5471.

Post-TCJA: The TCJA introduced an additional U.S. anti-deferral regime under Sec. 951A, commonly referred to as GILTI. This regime is intended to impose a minimum tax with respect to a U.S. shareholder’s foreign-source income earned in low-tax jurisdictions. GILTI was designed to prevent U.S. persons from shifting profits from the United States to low-tax jurisdictions by transferring intellectual property or other intangible proprietary assets offshore. With the enactment of GILTI and other similar global initiatives such as the European Union’s anti–tax avoidance directive (ATAD) and the Organisation for Economic Cooperation and Development’s base-erosion and profit-shifting (BEPS) initiatives, many taxpayers have discovered that the days of deferring meaningful amounts of offshore E&P from current U.S. taxation are over. Accordingly, with the many ways by which E&P of a CFC can be included into U.S. taxable income of U.S. shareholders, the corresponding reporting for these inclusions and PTEP accounts on Form 5471 has become much more intricate and integral, as discussed next.

Common Foreign Income Inclusions of U.S. Shareholders

U.S. shareholders of a CFC typically must include each of the following in their gross income:

  1. Subpart F Income Per Section 952, Subpart F income generally includes the U.S. shareholder’s proportionate share of a CFC’s earnings and profits (E&P) attributable to certain income-generating activities:
  1. Foreign Base Company Income (FBCI) under Section 954, which consists of:
    1. Sec 954 (a) (1) Foreign Personal Holding Company Income (FPHCI): This represents the net passive income of a CFC, typically comprising dividends, interest, royalties, rents, annuities, and certain gains from currency transactions.
    2. Sec 954 (a) (2) Foreign-Based Company Sales Income (FBCSI): This income is derived from a CFC’s transactions involving a related party, where personal property is purchased or sold, and the goods are manufactured and used outside the CFC’s country of incorporation.
    3. Sec 954 (a) (3) Foreign-Based Company Services Income: This income pertains to services performed by a CFC for a related party outside the CFC’s country of incorporation.
  2. Insurance Income under Section 953(a): This is income associated with the issuance or reinsuring of insurance or annuity contracts that would be taxable under Subchapter L if it were the income of a domestic insurance company.
  3. Income from International Boycotts under Section 952(a)(3): This refers to income earned by a CFC as a participant in an international boycott as outlined in Section 999.
  4. Section 956 Investment in U.S. Property Income Section 956(a) mandates U.S. shareholders to include their share of the CFC’s investment in U.S. property, measured as the average quarterly amount held. This inclusion, akin to Subpart F income, is considered a deemed dividend and is designed to prevent the deferral of untaxed E&P. It reflects the CFC’s adjusted basis in U.S. property, reduced by any liabilities.

Section 956 income is capped at the CFC’s applicable E&P and does not apply to earnings previously taxed in the U.S. (Previously Taxed Earnings and Profits or PTEP) as delineated in Section 959(a). Notably, Section 956 is not applicable to CFCs with U.S. shareholders that are C corporations.

  1. Global Intangible Low-Taxed Income (GILTI) The Tax Cuts and Jobs Act (TCJA) introduced Section 951A GILTI rules, an anti-deferral mechanism aimed at curbing profit shifting to low-tax jurisdictions via intangible property. GILTI approximates a CFC’s intangible income by assuming a 10% return on tangible assets, with any surplus regarded as intangible income.

GILTI necessitates U.S. shareholders to consolidate their share of net income and losses from all CFCs to ascertain their “net tested income,” which is subject to U.S. taxation. The GILTI inclusion for a tax year is the surplus of the shareholder’s share of net CFC tested income over a 10% return on tangible assets.

Net tested income is the collective share of tested income minus tested losses from all CFCs (not below zero). Net Deemed Tangible Income Return (net DTIR) is 10% of the shareholder’s share of aggregate Qualified Business Asset Investment (QBAI) of their CFCs, minus specific interest expenses. QBAI is the average quarterly tax basis in depreciable tangible property used for producing tested income.

It’s crucial to note that GILTI inclusion is not Subpart F income and is not dependent on a CFC’s E&P.

  1. Other Inclusions: Sections 1248 and 245A While less frequent, U.S. shareholders may be obliged to include gains from the sale of CFC stock, reclassified as dividend income, into their taxable income. Under Section 1248(a), gains from the sale or exchange of stock in a CFC during the five-year period preceding the sale are partially or entirely treated as dividends to the extent of the CFC’s E&P.

Section 245A(e) precludes the dividends-received deduction for any hybrid dividend received by a U.S. shareholder of a CFC. It also categorizes hybrid dividends between CFCs with a common U.S. shareholder as Subpart F income. A hybrid dividend is an amount received from a CFC that is deductible in a foreign country but treated as equity or dividend income in the U.S. An example is a Convertible Preferred Equity Certificate (CPEC), deductible in Luxembourg but considered equity in the U.S. Nonetheless, Section 245A(e) disallows the deduction and treats the dividend as Subpart F income for U.S. tax purposes.

Utilizing Schedules J and P for Foreign Income Inclusions

This discussion focuses on Schedules J and P of Form 5471, which are instrumental in tracking the accumulated earnings and profits (E&P) and previously taxed earnings and profits (PTEP) of a controlled foreign corporation (CFC) on an annual basis. Accurate tracking of E&P and PTEP is crucial, as errors can lead to significant tax implications for taxpayers over the lifespan of a CFC. These figures play a key role in classifying distributions from a CFC to U.S. shareholders—whether as dividends, returns of capital, or capital gains distributions—following the ordering rules outlined in Section 301 (c).

On December 14, 2018, the IRS issued Notice 2019-1, providing guidance on the treatment of PTEP and the ordering rules under Section 959. While this notice extends beyond the scope of this item, it’s important to recognize that proper accounting for a CFC’s E&P and PTEP related to U.S. inclusions has a direct impact on all subsequent distributions from a CFC, ultimately affecting the taxable income of a U.S. shareholder.

The descriptions and examples that follow are based on the revised December 2020 versions of Schedules J and P, along with the tax year 2021 Form 5471 instructions. We will highlight how these schedules are utilized for specific types of foreign income inclusions.

Subpart F Income E&P amounts identified as Subpart F inclusions for U.S. shareholders are calculated at the CFC level. Typically, Subpart F income inclusions necessitate the reclassification of E&P to designated columns on Schedules J and P to track PTEP.

Schedule J:

  • Income identified as Subpart F must be reclassified from post-2017 E&P not previously taxed (column (a)) to column (e)(x), representing PTEP related to Section 951(a)(1)(A) inclusions.
  • If Subpart F income is also subject to Section 956 as income tied to investments in U.S. property, the corresponding PTEP should be reported in column (e)(iii) instead of column (e)(x).

Schedule P:

  • Subpart F income should be listed under Section 951(a)(1)(A) PTEP in column (j), which tracks PTEP related to Section 951(a)(1)(A) inclusions.
  • If Subpart F income is reclassified as Section 956 income due to investments in U.S. property, the relevant PTEP should be reported in column © rather than column (j).

Section 956 Income: E&P amounts classified as Section 956 inclusions for U.S. shareholders, due to CFC investments in U.S. property, are also calculated at the CFC level. Schedules J and P use specific columns to track any PTEP associated with Section 956 inclusions.

    • Schedules J and P:
      • Columns (e)(i) through (e)(v) and columns (a) through (e) track PTEP related to Section 956 inclusions.
      • Column (e)(i) and column (a) monitor PTEP initially tied to inclusions under the Section 965(a) transition tax and reclassified as investments in U.S. property (Section 959 (c) (1)(A) amounts).
      • Column (e)(ii) and column (b) track E&P treated as PTEP under Section 965(b)(4)(A) for deferred foreign income corporations and reclassified as investments in U.S. property.
  • Columns (e)(iii) and (c) include three subgroups:
        • PTEP related to, or reclassified as, investments in U.S. property that would have been deferred if not for Section 956.
        • PTEP related to Subpart F income inclusions not covered by other columns and reclassified as investments in U.S. property under Section 956.
        • PTEP related to inclusions under previous Section 951(a)(1)© for passive foreign investment companies (PFICs) and Subpart F income inclusions reclassified as investments in excess passive assets.
        • Column (e)(iv) and column (d) track PTEP originally tied to inclusions under Section 951A GILTI and reclassified as investments in U.S. property under Section 965.
  • Column (e)(v) and column (e) consist of three subgroups:
      • PTEP related to hybrid dividends under Section 245A(e)(2) and reclassified as investments in U.S. property under Section 965.
      • PTEP related to Section 1248 amounts under Section 959(e) and reclassified as investments in U.S. property under Section 965.
      • PTEP related to Section 1248 amounts from the sale of foreign corporation stock by a CFC and reclassified as investments in U.S. property.

It is evident that if a CFC does not generate Section 956 income, the initial five columns for tracking and reporting PTEP on Schedules J and P are likely not important.

GILTI: Tracking E&P and PTEP for U.S. Shareholders

Earnings and Profits (E&P) amounts that fall under the Global Intangible Low-Taxed Income (GILTI) provisions are calculated at the U.S. shareholder level as per Section 951A. These GILTI inclusions are not limited by the E&P of the Controlled Foreign Corporations (CFCs) and may result in income inclusions despite the presence of E&P deficits across the CFCs owned by the U.S. shareholder.

The GILTI inclusions adopt an aggregated approach, considering both net tested income and losses across all CFCs. This aggregation leads to the question of how to allocate the GILTI inclusion back to each CFC for the purpose of tracking E&P and Previously Taxed Earnings and Profits (PTEP) on Form 5471, Schedules J and P. Taxpayers face a choice: should they reclassify all net CFC tested income to PTEP for each CFC, regardless of whether it was in a net tested income or loss position, or should they select a CFC at random to report the inclusion as PTEP?

The IRS has provided guidance on this issue in Regulations Section 1.951A-5, offering examples of how E&P and PTEP tracking should be conducted. Generally, a GILTI inclusion is treated similarly to Subpart F income, which necessitates tracking any inclusions from a CFC’s E&P and reclassifying them as PTEP on Schedules J and P.

According to Regulations Section 1.951A-5(b), the first step in determining the apportionment of a GILTI inclusion for tracking purposes is to acknowledge that the amount of GILTI apportioned to tested loss CFCs is zero. This is practical because a CFC in a tested loss position would not have earnings subject to taxation and thus would not convert any losses from E&P to PTEP.

The next step involves apportioning the total GILTI inclusion among all tested income CFCs. The portion of the GILTI inclusion amount for the U.S. shareholder should correspond to the ratio of the U.S. shareholder’s pro rata share of tested income for each tested income CFC relative to the total tested income of all tested income CFCs.

Example Illustrations

Example 1:

Facts: USP, a domestic corporation, owns the entire stock of three CFCs—CFC1, CFC2, and CFC3. All entities use a calendar year for their tax year. In year 1, CFC1 reports tested income of $100x, CFC2 reports $300x, and CFC3 has a tested loss of $50x. USP has no net deemed tangible income return (DTIR) for year 1.

Table 1 outlines the initial facts and the resulting GILTI inclusion amount for USP’s ownership of three CFCs in the first example scenario.

.

USP Ownership Tax Year Tested Income (CFC1) Tested Income (CFC2) Tested Loss (CFC3) Net DTIR Net CFC Tested Income GILTI Inclusion Amount
100% Calendar 100x 300x −50x None 350x 350x

Table 1: GILTI Inclusion Components for Example 1:

Analysis: In year 1, USP’s net CFC tested income is $350 ($100 + $300 − $50), and the GILTI inclusion amount is also $350, as there is no net DTIR. The total pro rata share of tested income for USP is $400 ($100 from CFC1 + $300 from CFC2). Consequently, the portion of USP’s GILTI inclusion attributed to CFC1 is $87.50 ($350 × [$100 ÷ $400]), and for CFC2, it is $262.50 ($350 × [$300 ÷ $400]). CFC3 receives no portion as it is a tested loss CFC.

Table 2 demonstrates how the GILTI inclusion amount is distributed among the CFCs, taking into account the tested income and losses.

CFC Pro Rata Share of Tested Income GILTI Inclusion Amount
CFC 1 100x 87.50x
CFC 2 300x 262.50x
CFC 3 -50x 0

Table 2: GILTI Inclusion Apportionment among CFCs for Example 1

Why is this important? The GILTI regulations specifically exclude tested loss CFCs from being apportioned any amount of the GILTI inclusion. This is a critical aspect of the regulation as it affects the calculation of the GILTI inclusion amount.

 To illustrate the impact of this rule, let’s revisit the above example, modify the facts slightly, and explore the scenario where the tested loss CFC apportionment exclusion for GILTI inclusion is not applied.

Example 2:

Facts: The same as Example 1, but with additional details on untaxed E&P before GILTI: CFC1 has $150, CFC2 has $500, and CFC3 has $25.

In the second example, we adjust the facts to include untaxed E&P before GILTI. Table 3 shows the impact of these changes on the GILTI inclusion amount.

USP Ownership Tax Year Tested Income (CFC1) Tested Income (CFC2) Tested Loss (CFC3) Net DTIR Net CFC Tested Income GILTI Inclusion Amount Untaxed E&P Before GILTI (CFC1) Untaxed E&P Before GILTI (CFC2) Untaxed E&P Before GILTI (CFC3)
100% Calendar 100x 300x -50 None 350x 350x 150x 500x 25x

Table 3. GILTI Inclusion Apportionment for Example 2  (Ignoring CFC Loss-Exclusion Rule):

Analysis: In year 1, USP’s net CFC tested income remains $350. If the CFC loss-exclusion rule is ignored, the GILTI inclusion attributed to CFC1 would be $100 ($350 × [$100 ÷ $350]), to CFC2 would be $300 ($350 × [$300 ÷ $350]), and to CFC3 would be -$50 (350×[-50 ÷ $350]). This would result in CFC1 reporting an ending untaxed E&P on Schedule J of $50 ($150 − $100) and PTEP under Section 951A of $100. CFC2 would report $200 ($500 − $300) and PTEP of $300. CFC3 would report an ending untaxed E&P of -$25 ($25 − $50) and PTEP of -$50.

 Meanwhile, Table 4 provides a view of the GILTI inclusion apportionment when the CFC loss-exclusion rule is not applied, highlighting the discrepancies that arise from this oversight.

Entity Tested Income/Loss Accumulated Untaxed E&P Before GILTI Net CFC Tested Income GILTI Inclusion Amount USP’s Pro Rata Share Portion of GILTI Inclusion Ending Untaxed E&P (Schedule J) PTEP Under Sec. 951A
CFC1 $100x $150 $100 $100 ($350 ×  [$100 ÷ $350]) $50 ($150 – $100) $100
CFC2 $300x $500 $300 $300 ($350 ×  [$300 ÷ $350]) $200 ($500 – $300) $300
CFC3 -$50x $25 -$50 -$50 ($350 × [-$50 ÷ $350]) -$25 ($25 – $50) -$50
USP $350 ($100 + [$300 − $50]) $350 ($350 − $0) $350 ($100 + $300 – $50)

Table 4: Hypothetical GILTI Inclusion Apportionment Ignoring Loss Exclusion for Example 2

Notes:

  • The Net CFC Tested Income and GILTI Inclusion Amount are only applicable to USP and are therefore marked with a dash (-) for CFC1, CFC2, and CFC3, as these entities contribute to the calculation but do not have these amounts individually.
  • The USP’s Pro Rata Share is the sum of the tested income from CFC1 and CFC2, minus the tested loss from CFC3.
  • The Portion of GILTI Inclusion for each CFC is calculated based on their respective share of the total tested income.

Implications of Ignoring the Tested Loss CFC Apportionment Exclusion

When the tested loss CFC apportionment exclusion rule is ignored, it erroneously inflates the untaxed E&P of CFC3, which is actually in a tested loss position. This results in an anomalous negative PTEP balance of -$50 for CFC3 at the end of year 1. Not applying the tested loss CFC apportionment exclusion related to Sec. 951A GILTI inclusion leads to irregular outcomes in the tracking and reporting of E&P and PTEP for CFCs.

Despite the example provided using U.S. dollars for the apportionment of GILTI among tested income CFCs, the apportioned inclusion amount must be translated back into the functional currency of each CFC for reporting purposes. This is done on Schedule J and P of Form 5471, using the average exchange rate for the CFC’s inclusion year, as specified in Regs. Sec. 1.951A-5(b)(3).

Where to Report GILTI Inclusion

Regs. Sec. 1.951A-5(b) stipulates that only tested income CFCs are subject to a reclassification of post-2017 E&P not previously taxed:

On Schedule J, CFC income identified as Sec. 951A income under GILTI is reclassified from post-2017 E&P not previously taxed (column (a)) to column (e)(viii), representing PTEP attributable to Sec. 951A inclusions.

On Schedule P, CFC income identified as Sec. 951A GILTI income is reported under Sec. 951A PTEP in column (h), representing PTEP attributable to Sec. 951A inclusions under GILTI.

Other Inclusions Under Sec. 1248 and Sec. 245A

E&P amounts identified as inclusions to U.S. shareholders under Sec. 1248 (sale of stock in a CFC) and Sec. 245A(e)(2) (hybrid dividends) are calculated at the CFC level and tracked as follows:

On Schedule J, inclusions under Sec. 1248 and Sec. 245A(e)(2) are reclassified from post-2017 E&P not previously taxed (column (a)) to column (e)(ix), representing PTEP attributable to these sections.

On Schedule P, these inclusions are tracked using column (i), representing PTEP attributable to Sec. 1248 and Sec. 245A(e)(2).

If any income under Sec. 1248 or Sec. 245A(e)(2) is also subject to Sec. 956 as income related to investments in U.S. property, the PTEP attributable to these inclusions is reported in column (e)(v) on Schedule J and column (e) on Schedule P, instead of their respective original columns.

Navigating the Complexities of U.S. International Tax Compliance

The U.S. international tax compliance and reporting obligations for U.S. shareholders of CFCs have become increasingly burdensome and intricate. This complexity is largely due to the Tax Cuts and Jobs Act (TCJA) and the global trend toward greater transparency in international operations and transactions. It is imperative for U.S. shareholders of CFCs to engage advisors who grasp the subtleties of income inclusions for CFCs and who can accurately track and maintain CFCs’ tax attributes on Schedules J and P of Form 5471.

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