Although the term "earnings and profits" (E&P) is common in the realm of international tax, it is all too often misconceived, misapplied, or even ignored. The importance of E&P in the international tax arena should not be underestimated. E&P is the foundation for the cross-border income inclusion regimes that apply to controlled foreign corporations, or CFCs (e.g., Subpart F income, Sec. 956 income), and passive foreign investment companies, or PFICs (e.g., qualified electing funds, or QEFs). This item provides a high-level overview of E&P of foreign corporations and several common misconceptions that directly affect a foreign corporation's E&P.
What Is Foreign E&P?
E&P is a long-standing concept that forms the basis for characterizing corporate distributions to direct shareholders of the distributing corporation for U.S. federal income tax purposes (e.g., dividend, return of capital). At its core, E&P represents the economic earnings and losses of a corporation that may be distributed to shareholders in the form of a dividend.
E&P is not specifically defined in the Code or Treasury regulations. Instead, E&P has taken shape over the years through various case law, administrative guidance, and other authorities.
Sec. 964 and the accompanying regulations dictate the procedures for foreign corporations to calculate E&P. Sec. 964(a) states that foreign corporations' E&P is determined in substantially the same manner as domestic corporations' E&P. Although key differences between domestic and foreign corporations arise out of the regulations promulgated under Sec. 964, the central themes and calculation mechanisms remain relatively congruent. Thus, tax practitioners need to have a strong grasp on basic Subchapter C concepts (e.g., reorganization effects on E&P, tax accounting methods) before layering on the international tax E&P concepts to calculate a foreign corporation's E&P.
A foreign corporation's current E&P is an annual calculation, with accumulated E&P generally being the sum of prior-year calculations with necessary adjustments (e.g., reduction for dividends). The annual calculation of a foreign corporation's E&P is generally based on a three-step approach (see Regs. Sec. 1.964-1(a)). These steps are:
Step 1: Prepare a local country profit-and-loss statement (P&L) for the year from the books of account regularly maintained by the corporation for the purpose of accounting to its shareholders.
Step 2: Make the accounting adjustments necessary to conform the foreign P&L to U.S. GAAP.
Step 3: Make the further adjustments necessary to conform the U.S. GAAP P&L to certain U.S. tax accounting standards.
Additional adjustments may be required to adjust for items such as currency translation, certain exchange gain or losses, blocked deductions, and blocked income.
Why Is Foreign E&P Important?
The general rule is that a foreign corporation's income is not taxed in the United States until the foreign corporation pays a dividend to its U.S. shareholder(s). The foreign corporation's dividend income is then subject to tax in the hands of its U.S. shareholder(s). Accordingly, a foreign corporation's earnings from abroad may remain outside of the U.S. tax net for extended periods (or perhaps indefinitely) and be redeployed globally without the burden of U.S. federal income tax. The benefit of deferred U.S. federal income taxation of a foreign corporation's earnings until a dividend is paid to its U.S. shareholder is referred to as "U.S. tax deferral."
Several rules curtail U.S. tax deferral. These rules include the CFC regime and the PFIC regime. These regimes look to prevent U.S. tax deferral on certain types of foreign earnings in situations perceived as abusive (e.g., "portable" or "passive" income).
A foreign corporation generally is a CFC when more than 50% of its stock (by vote or value) is owned by U.S. shareholders. "U.S. shareholder" has a specific meaning under the CFC regime. A U.S. shareholder is a U.S. person that owns directly or indirectly (including by attribution) 10% or more of the total combined voting power of all classes of stock entitled to vote in the foreign corporation.
The CFC regime prevents U.S. tax deferral by requiring a U.S. shareholder to include in current income its pro rata share of certain types of income (e.g., Subpart F income, Sec. 956 income) as a deemed dividend. This deemed dividend income is often referred to as "phantom income," as the U.S. shareholder has a U.S. income inclusion with no corresponding receipt of cash. Importantly, the U.S. shareholder's deemed dividend inclusion is limited to the foreign corporation's E&P. For example, Subpart F income is limited to current E&P (Sec. 952(c)(1)(A)), and Sec. 956 income is limited to "applicable earnings," which generally includes both current and accumulated earnings (Sec. 956(b)(1)).
A foreign corporation generally is a PFIC if 75% or more of its gross income is of certain types of passive income, or 50% or more of its average percentage of assets consists of assets that produce, or are held for the production of, this passive income. Under the PFIC regime, a U.S. shareholder is a U.S. person that owns any share(s) of stock in a foreign corporation classified as a PFIC. The PFIC regime's default "excess distribution" rule is penal and is intended to approximate the tax that would have been imposed if the income had been distributed currently from the PFIC. Excess distributions include certain dividends and/or gains from dispositions. These excess distributions are taxed at the highest ordinary income tax rates in effect for each year (except the current year), and the Code imposes interest on the deemed taxes from prior years. The PFIC regime includes the QEF rules. If properly elected by the U.S. shareholder, the QEF rules cause a U.S. shareholder to include in income its pro rata share of the PFIC's annual net capital gain income and ordinary earnings. However, the U.S. shareholder's pro rata inclusion is again limited by the PFIC's E&P.
The computation of indirect foreign tax credits from a foreign corporation to a 10% or greater U.S. corporate shareholder also depends upon the proper calculation of the foreign corporation's E&P. For example, the computation of the indirect foreign tax credits carried with a dividend from a corporation to its 10% U.S. shareholder is based pro rata on the dividend amount as compared with the E&P.
The CFC regime, the QEF rules under the PFIC regime, and the foreign tax credit regime generally share a key distinctive trait—these regimes are all computed/limited based on a foreign corporation's E&P. To put it another way, before the U.S. federal income tax consequences resulting from one of the international tax regimes can be determined, the foreign corporation's current and accumulated E&P must be understood and properly computed.
Common Misconceptions and Pitfalls
Despite the importance of a foreign corporation's E&P in the U.S. taxation of international operations, it is often miscalculated due to certain misconceptions. This item seeks to dispel some common E&P misconceptions as well as provide helpful planning techniques to avoid certain E&P pitfalls.
GAAP retained earnings generally do not equal E&P: An all-too-common misconception is that E&P is similar, or even equal to, retained earnings. Although retained earnings may be a proxy to estimate E&P in certain circumstances, timing differences and permanent differences can potentially create material deviations between the two. These timing differences and permanent differences should be accounted for in step three of the E&P computation above, which requires adjusting the GAAP P&L for certain U.S. tax accounting standards. However, practitioners may not always undertake step three.
For example, an issue that commonly arises when relying on GAAP retained earnings as a proxy for E&P is purchase accounting adjustments. If the foreign corporation was acquired, GAAP retained earnings may have been adjusted for purchase accounting. However, depending on how the transaction is treated for tax purposes, E&P (or E&P deficits) may have been inherited as part of the acquisition for U.S. federal tax purposes (see further discussion in "Sec. 338(g) Election" later in this item).
Furthermore, tax-free reorganizations and/or liquidations may cause discrepancies between GAAP retained earnings and E&P. Depending on how transactions involving foreign corporations occur from a U.S. federal income tax perspective, differences can arise between book and tax from the movement of retained earnings and E&P, respectively. For example, a check-the-box election to treat a subsidiary foreign corporation as a disregarded entity of its parent foreign corporation may cause the transfer of E&P (and assets) from a U.S. federal tax perspective. However, from a GAAP perspective, the retained earnings may remain with the original entity, thus creating potentially significant differences between GAAP retained earnings and accumulated E&P for certain entities involved in the reorganization.
Another common misconception is that all income tax adjustments are made when computing a foreign corporation's E&P. Step three of the E&P computation requires adjustments necessary to conform the GAAP P&L statement to U.S. tax accounting standards. The U.S. tax accounting standards are specific to E&P adjustments (e.g., deprecation, inventories, and methods of accounting under Sec. 446), and many general U.S. federal income tax adjustments should not be made when computing E&P. For example, computation of U.S. income for tax purposes may require disallowance of 50% of meals and entertainment under Sec. 274(n). However, the full amount of meals and entertainment should reduce E&P. Again, E&P represents the economic earnings and losses of a corporation that may be distributed to shareholders in the form of a dividend. The meals and entertainment expense reduces the economic earnings of a corporation, irrespective of the fact that only 50% of it may be deductible for U.S. federal tax purposes. These are just a few of the many concepts that need to be taken into account to fully understand and compute a foreign corporation's E&P.
The significance of "significant" E&P: A key difference between foreign and domestic E&P arises when the entity must adopt accounting methods. A domestic corporation must generally adopt methods in its first tax year or the first time it incurs a certain item that requires a method of accounting. However, from a technical perspective, actions on behalf of a foreign corporation to make certain elections, adopt a tax year, or adopt methods of accounting are not required until E&P is "significant" from a U.S. federal tax perspective. Regs. Sec. 1.964-1(c)(6) defines significant to include, among others, the following events (commonly referred to as a "significant event"):
- An actual distribution from the foreign corporation made to its U.S. shareholders with respect to their stock;
- An amount includible in income under Subpart F or Sec. 956;
- An amount excluded from income under Subpart F by reason of Sec. 952(c);
- The foreign corporation's controlling domestic shareholders use the tax book value (or alternative tax book value) method of allocating interest expense under Sec. 864(e)(4); and
- A sale or exchange of the foreign corporation's stock of the controlling domestic shareholders resulting in the recharacterization of gain under Sec. 1248.
Once E&P becomes significant, the foreign corporation must adopt U.S. tax accounting methods and/or make certain elections (e.g., Sec. 441, Sec. 446, Sec. 471, Sec. 472, Regs. Sec. 1.312-15, etc.). When a significant event occurs, the E&P must be adjusted as if methods had been adopted in the initial year, and accumulated E&P must reflect the proper amount with methods and elections being applied retroactively. Going forward, the foreign corporation must continue to apply the methods and fully compute E&P annually.
A foreign corporation's E&P does not become significant solely from the filing of an information return as required by Sec. 6038 (e.g., Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations). The adoption of a method of accounting does not result solely from reporting the foreign corporation's information on Form 5471, including reflecting certain methods in the computation of E&P reported on the form (Regs. Sec. 1.964-1(c)(6)). With that said, there are risks if E&P is not properly reported on Form 5471 (see further discussion in "Failure to Properly Report E&P" later in this item).
Taxpayers may find that significant events have occurred unknowingly, which resulted in the adoption of accounting methods by a foreign corporation. An often-overlooked significant event is the use of the tax book value method (or alternative tax book value method) of apportioning interest expense under Sec. 864(e)(4). The use of this method of interest allocation would often be a significant event for all wholly owned CFCs, thus requiring the computation of all CFCs' E&P.
In the example above, if the U.S. shareholder allocated interest under the tax book value method but did not properly elect or adopt methods, its foreign corporations are viewed as adopting the accounting methods used in their local books when computing E&P for that year, regardless of whether the controlling U.S. shareholder realized the consequences of its inactions. Correcting an error similar to this example may require method changes, which generally must be requested by filing Form 3115, Application for Change in Accounting Method. For this reason, among others, it is often advantageous for companies to compute E&P proactively. Proactive maintenance of E&P may help companies avoid pitfalls and will also allow for better tax planning.
"Nimble" dividends: Another trap for the unwary is the so-called nimble dividend rule (Sec. 316(a)(2)). A nimble dividend occurs when an entity has current earnings and profits but it remains in an overall accumulated deficit at year end. The nimble dividend rule requires the dividend to come first out of current E&P, which prevents using prior deficits to offset the amount included as a dividend.
Another implication of the nimble dividend rule is that it does not carry indirect foreign tax credits (Regs. Sec. 1.902-1(b)(4)) when the sum of the foreign corporation's current plus accumulated earnings and profits is zero or less. The nimble dividend rule can turn what was thought to be a tax-free return of capital from a foreign corporation into a taxable dividend with no foreign tax credits. The nimble dividend rule also applies to Sec. 956 and Subpart F inclusions. For example, for purposes of computing Subpart F, current-year E&P is not reduced by accumulated deficits (Sec. 952(c)(1)(A); Regs. Sec. 1.952-1(e)). Similarly, Sec. 956 also applies first to current E&P without an offset for deficits in accumulated E&P (Sec. 956(b)(1)(A)).
Careful planning may help mitigate the implications of a nimble dividend. For example, postponing a distribution to a year when the foreign corporation has a current and accumulated E&P deficit may avoid a nimble dividend. Additionally, the distribution may occur in a year with total positive E&P, thus having the foreign corporation's dividend carry an indirect foreign tax credit. Accordingly, a detailed review of E&P and proactive E&P planning may eliminate or reduce the adverse tax consequences associated with a nimble dividend.
Failure to properly report E&P: If E&P is significant for U.S. federal tax purposes but is not properly computed and reported on Form 5471, the form may not be considered to substantially comply with Sec. 6038. Failure to substantially comply with Sec. 6038 can result in civil and criminal penalties and an extended statute-of-limitation period, as well as a reduction in foreign tax credits for certain categories of filers. If the form does not substantially comply with Sec. 6038, a penalty of $10,000 per Form 5471 per year may also be assessed.
The IRS has recently focused on reviewing items related to Sec. 6038 during exams. This is further demonstrated and discussed in several recently released International Practice Units (IPUs) (see Failure to File the Form 5471—Category 4 and 5 Filers—Monetary Penalty; and Monetary Penalties for Failure to Timely File a Substantially Complete Form 5471—Category 4 & 5 Filers). The IPU addressing failure to timely file a substantially complete Form 5471 specifically notes that "errors . . . significant in amount" in the computation of E&P may result in the taxpayer's not having "substantially complied" with reporting obligations under Sec. 6038. The determination of whether the taxpayer has substantially complied with Sec. 6038 is a facts-and-circumstances analysis, however, so isolated errors may not trigger penalties, but significant understatements or errors may (see FSA 1997 WL 33381431, CCA 200429007, CCA 200645023, and IPU IGA/9560.01_03(2014)).
Sec. 338(g) election: When acquiring stock of a target foreign corporation, a U.S. corporation should perform an analysis to determine if a Sec. 338(g) election is possible and beneficial. Generally, the tax fiction resulting from this election is that the acquirer forms a new target that acquires all the assets, and assumes all the liabilities, of the old target at the beginning of the day after the acquisition date. In other words, the election causes a qualified stock purchase to essentially be treated as an asset acquisition for U.S. federal tax purposes.
Importantly, the Sec. 338(g) election eliminates the target foreign corporation's historic tax attributes, including E&P and foreign tax credit pools. Additionally, the target foreign corporation's assets have a stepped-up basis for U.S. federal tax purposes, which allows for increased depreciation and amortization E&P adjustments. These adjustments can help manage E&P in future years and may be combined with other planning (e.g., debt funding the target foreign corporation) for efficient cash repatriation and/or cash redeployment. However, Sec. 901(m) generally applies to a target foreign corporation for which a Sec. 338(g) election was made. Sec. 901(m) disqualifies as a foreign tax credit all or a portion of the target foreign corporation's eligible foreign taxes based on a ratio using the foreign corporation's original basis in assets for U.S. federal tax purposes and stepped-up basis in assets after the Sec. 338(g) election.
If the Sec. 338(g) election is not made, the target foreign corporation may be acquired with its historic tax attributes, including E&P and foreign tax credit pools. This may cause significant administrative issues. For example, the foreign corporation's E&P may need to be computed for all preacquisition years based on U.S. tax and GAAP principles. Necessary records for this computation may not be available. Furthermore, the foreign corporation's existing E&P may need to be computed on the layered pre-1987 rules if there are no previous U.S. owners (e.g., regulatory authority exists under Sec. 904(d)(4)(C)(i)(II) to require a separate limitation for distributions out of preacquisition earnings; also see CCA 201444039, in which the IRS concluded that foreign tax adjustments made on a CFC's preacquisition years should be accounted for by adjusting the CFC's pre-1987 accumulated profits and foreign income taxes).
A careful analysis should be performed to decide if a Sec. 338(g) election is beneficial. This analysis should take into account the foreign corporation's estimated E&P, anticipated cash flows, anticipated creditable foreign taxes, disqualification of foreign tax credits under Sec. 901(m), and the availability of records. Failing to proactively examine the benefits of a Sec. 338(g) election may be a lost opportunity for a U.S. multinational to decrease its worldwide effective tax rate.
Computing and maintaining foreign E&P may seem simple, but in reality it is often complex with a wide variety of pitfalls for the unprepared. Foreign E&P maintenance may also be viewed as an unwelcome chore. Nonetheless, potential broad, adverse tax implications can result if E&P is not computed properly. It is important to proactively review E&P and be aware of the many complicated issues that can arise in the international context, some of which are highlighted above. Benjamin Franklin once said "an ounce of prevention is worth a pound of cure." Similarly, a small amount of E&P planning may prevent adverse tax issues from arising and can also lead to significant tax savings.
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.