The IRS has revised Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, and related schedules, effective for filing periods ending on or after December 31, 2007. The draft form and related schedules were released in May 2007, but the finalized version had not yet been released to the public as of early January 2008.
Generally, Form 1120-F must be filed by a foreign corporation that:
1. Was engaged in a trade or business in the United States (whether or not it actually had income from that U.S. trade or business);
2. Had income that was effectively connected with the conduct of a U.S. trade or business under Sec. 864; or
3. Had U.S. source income (FDAP) that was not effectively connected with the conduct of a U.S. trade or business under Sec. 881 even if that income was tax exempt, based on an income tax treaty between the United States and the foreign country, or based on a Code section. “FDAP” refers to the gross amount of U.S. nonbusiness income (or investment-type income) that is “fixed or determinable, annual, or periodic” and is subject to withholding of tax at a rate of 30% (or a lower rate allowed by an income tax treaty between the United States and the applicable foreign country) without the benefit of any deductions (as provided under Secs. 1441 and 1442).
Since many foreign corporations that are required to file Form 1120-F do not have an office or other place of business in the United States, the normal filing deadline for them is June 15, 2008.
The updated 2007 Form 1120-F and new schedules will provide more informational disclosures regarding items such as the direct and indirect allocations of expenses to income that is effectively connected with the conduct of a U.S. trade or business. The IRS anticipates that the increased reporting will enable the service center to better identify compliance actions for foreign corporations.
For tax practitioners, it is now more critical than ever to understand foreign taxpayers’ businesses and structures, since the new forms focus on providing a more transparent understanding of the entities and their ownership structures. For example, new Schedule P, List of Foreign Partner Interests in Partnerships, requires taxpayers to identify their partnership investments and provide more detailed information.
The introduction of Schedule M-3, Net Income (Loss) Reconciliation for Foreign Corporations with Reportable Assets of $10 Million or More, for Form 1120-F is likely to be used as a tool by the IRS to identify selected foreign corporations for audit examinations, because it is currently using Schedule M-3 for domestic corporations to identify selected taxpayers for audits. Compared with the previous required disclosure on Schedule M-1, Reconciliation of Income (Loss) per Books with Income per Return, the new required Schedule M-3 for foreign corporations will provide a more detailed reconciliation of book and taxable income for those entities with U.S. assets of $10 million or more.
The IRS plans to allow taxpayers to file Form 1120-F electronically for tax year 2007; however, it is unlikely that the tax preparation software will be ready to comply immediately, since the forms were just recently finalized. Practitioners with foreign corporation clients should plan on spending additional time this year to prepare Form 1120-F and to apprise their clients of the new information and disclosure requirements.
The salient changes to the 2007 Form 1120-F are summarized as follows:
1. Question V, formerly at the bottom of page 5, regarding whether the foreign corporation is a “qualified resident” of its country of residence or otherwise qualifies for treaty benefits, which will reduce the rate of the U.S. branch profits tax and the U.S. tax on excess interest, was moved parenthetically to line 6 (branch profits tax) and line 10 (tax on excess interest) of section III, page 5.
2. Question T on page 5, disclosing the reason the foreign corporation is claiming a reduction in, or exemption from, the branch profits tax, is now part III of section III on page 5.
3. Questions U, W, and X on page 5 of the old Form 1120-F were moved to page 2.
4. New questions Y and Z were added on page 2 regarding Sec. 482 allocations of income, recognition of interbranch amounts, dealer status under Sec. 475, and use of the mark-to-market method for any securities or commodities held other than by a dealer.
5. Schedules M-1 and M-2, Analysis of Unappropriated Retained Earnings per Books per Return, were removed from the bottom of page 6 and made into separate forms.
6. New Schedule M-3 was added to be used in lieu of Schedule M-1 for those foreign corporations with reportable assets of $10 million or more.
7. Schedule L, Balance Sheets per Books, was expanded to a one-page schedule, and new lines were added for interbranch U.S. and non-U.S. assets and for interbranch and third-party liabilities.
8. New Schedule H, Deductions Allocated to Effectively Connected Income Under Regulations Section 1.861-8, was added to calculate direct and indirect allocation and apportionment of deductions to income effectively connected with the conduct of a U.S. trade or business (ECI) and to disclose the methods and records used to do so. Total deductions so allocated and apportioned to ECI are reported on line 21 of Schedule H and are also entered on section II, line 26 (calculation of ECI) of Form 1120-F.
9. New Schedule I, Interest Expense Allocation Under Regulations Section 1.882-5, was added to calculate interest expense allocable to ECI and the total interest expense deduction. The total interest expense deduction as calculated is reported on line 25 of Schedule I and is also entered on section II, line 18 (calculation of ECI) of Form 1120-F.
10. New Schedule P, List of Foreign Partner Interests in Partnerships, was added to disclose the foreign corporation’s ownership in U.S. partnerships and foreign partnerships with ECI, to reconcile income and expenses to Schedule K-1 of Form 1065, U.S. Return of Partnership Income, and to calculate the foreign corporation’s outside basis in each partnership allocable to ECI.