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A Guide to Foreign
Corporation E&P
Earnings and profits (E&P) plays a key
role in international taxation, including the foreign tax credit (FTC).
This two-part article provides a quick guide to
the key steps in computing E&P. Part I summarizes the basic E&P
computation, including common tax adjustments, and the FTC income
categories and lookthrough rules.
Paul C. Lau, ABV, CMA, CPA
Editors note: Mr. Lau is a member of the AICPA Tax Divisions International Tax Technical Resource Panel. For more information about this article, contact Mr. Lau at Plau@bkadvice.com.
Executive Summary
Generally, earnings and profits (E&P) represents a corporations economic profits. E&P is not the same as financial earnings or taxable income. A foreign corporations E&P is most frequently associated with the foreign tax credit (FTC) (Secs. 902 and 960) and Subpart F income (Secs. 951(a)(1)(A) and 952(c)). E&P also applies in assessing the effects on (1) gain from the sale of a controlled foreign corporations1 (CFCs) stock under Sec. 1248; (2) investments in U.S. property as dividends under Sec. 956; (3) inbound or foreign-to-foreign reorganizations under Sec. 367(b); (4) interest and other expense allocations among classes of income (e.g., foreign versus U.S.-source income) under Sec. 864(e)(4); and (5) a Sec. 338 deemed asset purchase election on a qualified purchase of a foreign corporations stock. Generally, a CFCs E&P is divided into three separate pools, commonly known as the Sec. 959(c)(1), (c)(2) and (c)(3) pools. The Sec. 959(c)(1) pool represents E&P included in a U.S. shareholders income due to an increase in the CFCs investment in U.S. property determined under Sec. 956.2 The Sec. 959(c)(2) pool maintains E&P taxed to a U.S. shareholder as Subpart F income.3 Both the Sec. 959(c)(1) and (2) pools are referred to as previously taxed income (PTI). Distributions from PTI are generally not taxed again to the shareholders (Sec. 959(a)). E&P not yet subject to U.S. tax resides in the Sec. 959(c)(3) pool. Shareholders are taxed on distributions from that pool. Within each E&P pool, E&P is further broken down into 10 FTC income categories. It is necessary to determine the E&P in each category to determine the amount of foreign tax associated with a dividend distribution.4 This article identifies and discusses the key steps in computing and allocating E&P among the various FTC categories. Part I, below, describes the basic steps in computing E&P, the most common income tax adjustments and the FTC income categories. Part II, in the June 2004 issue, will discuss (and provide examples of) the allocation and apportionment of expenses and taxes to the FTC baskets.
General E&P Computations Regs. Sec. 1.964-1 provides the following steps to compute a foreign corporations E&P: 1. Prepare a local currency profit-and-loss (P&L) statement for the year from the books of account regularly maintained by the corporation for the purpose of accounting to its shareholders. 2. Make the necessary accounting adjustments to conform the foreign P&L statement to generally accepted accounting principles (GAAP). 3. Make adjustments necessary to conform the P&L statement to U.S. tax accounting standards. If a U.S. GAAP financial statement has been prepared in local currency for the foreign corporation, it can be used as a starting point for computing E&P, eliminating the need for steps 1 and 2. The GAAP statement must be in local currency, not U.S. dollars. Unless the foreign currency is hyperinflationary, E&P is kept in foreign currency, not U.S. dollars.5 Exhibit 1 provides a summary schedule of common adjustments to arrive at a foreign corporations current E&P.
Common Tax Adjustments Some common mandatory and elective tax adjustments to conform with U.S. tax accounting standards are discussed below. The tax election must be timely. Generally, tax elections for CFCs are made by their controlling U.S. shareholders. If a foreign corporation is not subject to tax under Sec. 882 (i.e., tax on effectively connected U.S. income), tax elections can be deferred until 180 days after the end of the first tax year in which a significant event occurs, under Regs. Sec. 1.964-1(c)(6) and Temp. Regs. Sec. 1.964-1T(g)(2). A common significant event is when a CFC has reportable Subpart F income under Sec. 951(a). Probably the most common significant event is when a CFCs controlling U.S. shareholder elects a method for allocating interest expense under Sec. 864(e)(4).6 Depreciation: Depreciation is likely one of the largest adjustments in the E&P calculation, because recovery periods for E&P purposes generally differ from the recovery periods for GAAP purposes; see Sec. 312(k) and Regs. Sec. 1.964-1(c)(1)(iii). R&D expenditures: Under Sec. 174, research and development (R&D) expenditures are currently deductible, even if capitalized for book purposes. Construction period carrying charges: Under Sec. 263A(b)(1), direct and indirect costs (e.g., real property taxes) attributable to property construction are capitalized, and do not reduce E&P. Sec. 312(n)(1) also requires capitalization of construction period carrying charges, which include (1) interest on debt incurred or continued to acquire, construct or carry property, (2) property taxes and (3) similar carrying charges to the extent such charges are attributable to the propertys construction period.7 Inventories: Inventories must be adjusted to conform with the uniform capitalization (UNICAP) rules under Sec. 263A. The UNICAP rules require all direct and indirect costs of purchasing, producing and maintaining inventory to be capitalized into cost basis. A foreign corporation may use the U.S. ratio method. To use this method, an election must be made when the UNICAP rules first became applicable. Under the ratio method, additional costs (other than interest) for capitalization in excess of the amount capitalized for financial accounting purposes (additional Section 263A costs) are calculated based on the percentage of additional Section 263A costs required to be capitalized by the U.S. shareholder in its U.S. trade or business that most closely resembles the CFCs trade or business.8 Under Sec. 312(n)(4), inventory is computed on a FIFO basis for E&P purposes. Any LIFO recapture (i.e., excess of the corporations FIFO-basis inventory over LIFO-basis inventory) is added back to E&P. However, a special rule applies in computing the E&P for Subpart F income inclusion purposes. The Subpart F income included in income for any given year may not exceed the CFCs E&P for the year. If the Subpart F income is reduced by the current E&P limit, the amount reduced is subject to recapture in subsequent years; see Sec. 952(c)(1)(A) and (c)(2). However, in determining the E&P limit on the Subpart F income inclusion, E&P is calculated based on the CFCs applicable method of calculating income when it uses the LIFO inventory method, the installment sale method or the completed-contract method (Sec. 952(c)(3)). Foreign pension and profit-sharing plans: Generally, pension benefits are deductible when actually paid or when a foreign pension plan meets U.S. qualified retirement plan requirements. A CFC may elect under Sec. 404A to claim a deduction for contributions to its foreign pension plan, even if the plan does not meet the U.S. qualified retirement plan requirements. Sec. 404A only applies to plans maintained primarily for the benefit of nonresident aliens. The deduction is generally limited to the lesser of the amount (1) allowed under foreign law or (2) allowable under standards comparable to U.S. pension rules. Organizational expenses: Organizational expenses are not deductible for E&P purposes under Sec. 312(n)(3), even though they are amortizable or deductible for income tax or book purposes. Installment sale rules: Under Sec. 312(n)(5), the installment sale method is generally not allowed for E&P purposes. However, under Sec. 952(c)(3), it can be used to determine the E&P limit on the Subpart F income inclusion, when it is the CFCs method of calculating income. Statutory reserve: Any statutory reserve under foreign law (e.g., bad debt, inventory and vacation reserve) cannot be deducted for E&P purposes, unless it is deductible under U.S. income tax principles.
E&P and FTCs A domestic C corporation shareholder receives a deemed-paid (or indirect) tax credit for foreign taxes paid by its foreign subsidiaries when the subsidiaries earnings are actually (or deemed) distributed. Under Secs. 902 and 960, this indirect tax credit is generally available to any U.S. corporate shareholder with a 10%-or-more ownership interest (voting power) in the foreign subsidiary. Starting in 1987, the indirect FTC calculations were based on a pool concept (i.e., the foreign corporations pool of post-1986 E&P and foreign taxes); see Sec. 902(a). Under Secs. 902(c)(1) and 986(b), post-1986 E&P for the indirect credit pool is computed and maintained in functional currency. However, under Secs. 902(c)(2) and 986(a), the foreign corporations pool of post-1986 foreign income taxes is determined and maintained in U.S. dollars.
FTC Income Categories Conceptually, the FTC amount a taxpayer can use in any year is limited to the lesser of the actual foreign income taxes paid on the foreign-source income or the U.S. income tax allocable to the income (the FTC limit). To prevent possible manipulation of the FTC limit by combining low-taxed foreign-source E&P with high-taxed foreign-source E&P, Secs. 904(d) and 907(a) list 10 separate FTC categories (baskets). The total E&P must generally be broken down and maintained in the separate FTC baskets. An E&P worksheet may be formatted with a total column and individual columns representing the separate FTC baskets. Each FTC column might also be further broken down into columns representing Subpart F and non-Subpart F income items. The first row of the worksheet would show the gross income of each FTC basket column. Subsequent rows would show the expense items and taxes allocated or apportioned among the basket columns. The last row would show the E&P of the FTC basket columns. The 10 separate baskets under Sec. 904(d) and 907(a) are:
Lookthrough Rules Special lookthrough rules apply to certain payments or income (e.g., Subpart F income) from CFCs. Lookthrough rules also apply to dividends from noncontrolled Sec. 902 corporations, attributable to earnings accumulated in tax years beginning after 2002.13 The primary purpose of the lookthrough rules is to equate the FTC treatment of income earned by a foreign branch with the tax credit treatment of income earned by a CFC. The lookthrough rules ensure that income earned by a CFC retains its character when paid, accrued or distributed to a U.S. shareholder or a related entity. Under the lookthrough rules, Subpart F income and payments (or deemed payments) of interest, rent, royalties and dividends are included in separate baskets by reference to the CFCs income baskets. The lookthrough rules are summarized below.
Regulations also apply the lookthrough rules to distributions and payments between related CFCs. CFCs are related if one CFC owns more than 50% of the total vote or value of the other, or the same U.S. shareholders own more than 50% of the vote or value of both CFCs. The lookthrough rules also apply between a CFC and a partnership and between two partnerships owned more than 50% by the same U.S. shareholders. Under Regs. Sec. 1.904-5(i)(1), these lookthrough rules operate basically in the same manner as the rules for payments to U.S. shareholders. Regs. Sec. 1.904-5(k) provides ordering rules for applying the lookthrough rules when reciprocal payments of interest, rents, royalties and/or dividends are made between related CFCs and partnerships.
Conclusion Part II, in the June 2004 issue, will discuss the allocation and apportionment of expenses and taxes to the FTC baskets, and provide detailed examples of how such rules operate. |
