CFCs: US shareholders’ income inclusions

Editor: Mark G. Cook, CPA, CGMA

With the ever-changing tax landscape, many taxpayers and tax professionals find themselves seeking guidance on the complex international tax compliance and reporting requirements imposed on U.S. shareholders of controlled foreign corporations (CFCs).

For purposes here, 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 attributable to the enactment of the 2017 law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, which added several new categories of foreign income inclusions — including the transition tax under Sec. 965 and the global intangible low-tax income (GILTI) regime pursuant to Sec. 951A.

The primary purpose of this item 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 and 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 exploring the current tax rules, it may be helpful 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, in general, could defer its offshore E&P indefinitely to the extent the CFC did not run afoul of the so-called U.S. anti-deferral regime that consisted then 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 inapplicable.

That said, 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 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 nonpreviously 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 created an additional U.S. anti-deferral regime under Sec. 951A, commonly referred to as GILTI, which 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 way of 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 have come and gone. 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 grown much more intricate and integral, as discussed next.

Common foreign income inclusions of US shareholders

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

Subpart F income: Under Sec. 952, Subpart F income generally includes a U.S. shareholder’s pro rata share of a CFC’s E&P attributable to the following incomegenerating activities:

■ Sec. 954 foreign base company income (FBCI), which comprises:

● Sec. 954(a)(1) foreign personal holding company income (FPHCI): FPHCI represents the net passive income earned by a CFC. This type of Subpart F income typically includes items such as dividends, interest, royalties, rents, annuities, and certain currency/transaction gains.

● Sec. 954(a)(2) foreign-based company sales income (FBCSI): FBCSI represents income derived by a CFC from a purchase or sale of personal property involving a related party in which the goods are manufactured and sold for use/consumption outside the CFC’s country of incorporation.

● Sec. 954(a)(3) foreign-based company services income: This represents the service income earned by a CFC in connection with the specified services that are performed on behalf of a related party and outside the country in which the CFC is incorporated (see Sec. 954(e)).

■ Sec. 953(a) insurance income, which is defined as any income that is attributable to issuing or the reinsuring of an insurance or annuity contract and that would be taxed under Subchapter L if it were the income of a domestic insurance company; and

■ Sec. 952(a)(3), which is certain income earned by a CFC as a person participating in a Sec. 999 international boycott.

Sec. 956 investment in U.S. property income: Under Sec. 956(a), U.S. shareholders of a CFC are required to include in gross income their pro rata share of the average quarterly amount of U.S. property held both directly and indirectly by the CFC. A Sec. 956 income inclusion is similar to Subpart F income in that it does not require a CFC to actually make a distribution out of its E&P to the U.S. shareholder for an income inclusion to occur, but rather, it is treated as a deemed dividend inclusion. The Sec. 956 anti-deferral regime is aimed at preventing the deferral of untaxed E&P in a CFC that is effectively repatriated to the United States in the form of investment in U.S. property, subjecting any amounts to taxation in the current year. Income inclusions by U.S. shareholders under Sec. 956 represent the CFC’s adjusted basis in the U.S. property, decreased by the liabilities attached to that property.

Like Subpart F income, Sec. 956 income is limited under Sec. 956(a)(2) to the applicable E&P of the CFC. Sec. 956 income does not apply to E&P that has already been taxed in the United States if those same earnings have already been included by a U.S. shareholder and taxed by the United States (PTEP), as described in Sec. 959(a). It is important to note that Sec. 956 is effectively inapplicable for CFCs that have U.S. shareholders that are C corporations.

GILTI: As mentioned earlier, the TCJA enacted the Sec. 951A GILTI rules, an anti-deferral tax regime intended to prevent U.S. shareholders in CFCs from shifting profits from the United States to low-tax jurisdictions through the transfer of mobile income from intangible property. Rather than explicitly identifying what intangible income is, the GILTI provisions approximate the intangible income of a CFC by assuming a 10% rate of return on the CFC’s tangible assets (see Sec. 951A(b)(2)), and any income in excess of that “normal return” on assets is effectively treated as intangible income.

Unlike Subpart F income, the inclusion of which is determined at the CFC level, the GILTI rules require U.S. shareholders to evaluate the aggregate of their pro rata share of net income and losses from all CFCs to determine the “net tested income” amount that would be subject to U.S. taxation under Sec. 951A(c). A U.S. shareholder’s GILTI inclusion for the tax reporting year is the excess of the U.S. shareholder’s pro rata share of net CFC tested income of all CFCs that the U.S. shareholder owns, over its 10% normal return on its tangible assets.

Again, a U.S. shareholder’s net CFC tested income is its aggregate pro rata share of tested income from all of its CFCs minus the aggregate pro rata share of tested loss from all CFCs (but not less than zero). Net deemed tangible income return (net DTIR) is defined as 10% of the U.S. shareholder’s pro rata share of aggregate qualified business asset investment (QBAI) of its CFCs, less specified interest expense. A CFC’s QBAI is its average quarterly tax basis in depreciable tangible property used in a trade or business (tracked using the alternative depreciation system method) for the production of tested income (see Sec. 951A(d)). It is important to note that a U.S. shareholder’s GILTI inclusion is not Subpart F income, and, unlike Subpart F income, GILTI is not subject to a CFC’s E&P.

Other inclusions under Sec. 1248 and Sec. 245A: While less common, there are notable ways in which a U.S. shareholder may be required to include into U.S. taxable income the gain recognized on the sale of CFC stock that is recharacterized as dividend income. Specifically, Sec. 1248(a) states that if a U.S. shareholder sells or exchanges stock in a foreign corporation that was a CFC at any time during a five-year period ending on the date of the sale or exchange, then the gain recognized on the sale or exchange of the stock is partly or wholly recharacterized as a dividend to the extent of the E&P of the CFC stock sold. The amount recharacterized as a dividend is limited to the extent of the E&P of the CFC while the U.S. shareholder owned the CFC shares.

Sec. 245A(e) disallows the dividends-received deduction under Sec. 245A(a) for any hybrid dividend received by a U.S. shareholder of a CFC. Moreover, Sec. 245A(e) treats hybrid dividends between CFCs with a common U.S. shareholder as Subpart F income. Note that Sec. 245A(e) defines a “hybrid dividend” as an amount received from a CFC for which a deduction would be allowed under Sec. 245A(a) and for which the CFC received a deduction or other tax benefit in a foreign country. A common example of a hybrid dividend is a convertible preferred equity certificate (CPEC), which is a financial instrument used in connection with Luxembourg financing structures. For Luxembourg tax purposes, the CPEC is treated as debt, and, therefore, the payment is deductible for local country purposes. For U.S. tax purposes, the CPEC is treated as equity or dividend income and therefore would qualify for the Sec. 245A foreign dividends-received deduction. However, Sec. 245A(e) disallows the Sec. 245A deduction and treats the dividend as Subpart F income for U.S. tax purposes.

Using Schedules J and P in connection with foreign income inclusions

This discussion now turns to Schedules J and P of Form 5471. These forms are used to track the accumulated E&P as well as the PTEP of a CFC on a yearby- year basis. Incorrectly tracking the various types of E&P and PTEP generated by a CFC each year could have severe tax consequences to a taxpayer as certain events occur throughout the life of a CFC. E&P and PTEP are used in the classification of distributions from a CFC to U.S. shareholders as dividends, return of capital, and capital gains distributions, in accordance with the Sec. 301(c) ordering rules.

Additionally, on Dec. 14, 2018, the IRS released Notice 2019-1, which provided guidance on the treatment of PTEP and the ordering rules under Sec. 959. While Notice 2019-1 goes beyond the scope of this item, it is important to note that appropriately accounting for a CFC’s E&P and PTEP related to U.S. inclusions directly affects any and all subsequent distributions made out of a CFC and, ultimately, the taxable income of a U.S. shareholder.

Note that the descriptions and examples below refer to the December 2020 revised versions of Schedules J and P and the accompanying tax year 2021 Form 5471 instructions. The following discussion highlights how Schedules J and P are used with specific types of foreign income inclusions.

Subpart F: E&P amounts identified as inclusions to U.S. shareholders under Subpart F are calculated at the CFC level. Generally, income inclusions to U.S. shareholders under Subpart F require that E&P be reclassified to one of several columns related to tracking PTEP on Schedules J and P.

■ Schedule J:

● CFC income identified as Subpart F income must be reclassified from post-2017 E&P not previously taxed (column (a) of the form) to column (e)(x), which represents PTEP attributable to Sec. 951(a)(1)(A) inclusions.

● If it is identified that any income under Subpart F is also subject to Sec. 956 as income related to investments in U.S. property, any PTEP attributable to Sec. 951(a)(1)(A) inclusions would alternatively be reported in column (e)(iii) of the form rather than in column (e)(x).

■ Schedule P:

● CFC income identified as Subpart F should be reported under Sec. 951(a)(1)(A) PTEP in column (j) of the form, which represents PTEP attributable to Sec. 951(a)(1)(A) inclusions under Subpart F.

● If it is identified that any income under Subpart F is reclassified as Sec. 956 income as investments in U.S. property, any PTEP attributable to Sec. 951(a)(1)(A) inclusions would alternatively be reported in column (c) rather than column (j).

Sec. 956 income: E&P amounts identified as inclusions to U.S. shareholders under Sec. 956 CFC investments in U.S. property are calculated at the CFC level. Columns (e)(i) through (e)(v) and columns (a) through (e) of Schedules J and P, respectively, are used to track any PTEP related to inclusions under Sec. 956.

■ Schedules J and P:

● Column (e)(i) and column (a):

■ Track PTEP originally attributable to inclusions under Sec. 965(a) transition tax and reclassified as investments in U.S. property (Sec. 959(c)(1)(A) amounts).

● Column (e)(ii) and column (b):

■ E&P treated as PTEP under Sec. 965(b)(4)(A) of deferred foreign income corporations and reclassified as investments in U.S. property.

● Column (e)(iii) and column (c) consist of three subgroups:

■ PTEP attributable to, or reclassified as, investments in U.S. property that would have been deferred if not for Sec. 956;

■ PTEP attributable to Subpart F income inclusions (not described in any other column) and reclassified as investments in U.S. property under Sec. 956; and

■ PTEP attributable to inclusions under previous Sec. 951(a)(1)(C) passive foreign investment companies (PFICs) and Subpart F income inclusions reclassified as investments in excess passive assets.

● Column (e)(iv) and column (d):

■ PTEP originally attributable to inclusions under Sec. 951A GILTI and reclassified as investments in U.S. property under Sec. 965.

● Column (e)(v) and column (e) consist of three subgroups:

■ PTEP attributable to hybrid dividends under Sec. 245A(e)(2) and reclassified as investments in U.S. property under Sec. 965;

■ PTEP attributable to Sec. 1248 amounts under Sec. 959(e) and reclassified as investments in U.S. property under Sec. 965; and

■ PTEP attributable to Sec. 1248 amounts from the gain on the sale of foreign corporation stock by a CFC and reclassified as investments in U.S. property.

It is apparent that to the extent a CFC does not have Sec. 956 income, the first five columns related to tracking and reporting PTEP of the CFC on Schedules J and P are likely not relevant.

GILTI: E&P amounts identified as inclusions to U.S. shareholders under Sec. 951A GILTI are calculated at the U.S. shareholder level. GILTI is also not subject to E&P limitation and may result in income inclusions even if E&P deficits are present across the CFCs the U.S. shareholder owns. Because inclusions related to GILTI take an aggregated net tested income and loss approach across all the CFCs, the question arises as to how a GILTI inclusion of U.S. shareholders should be allocated back to each CFC for purposes of tracking E&P and PTEP balances on Form 5471, Schedules J and P. Should a taxpayer reclassify all net CFC tested income for each CFC to PTEP regardless of whether the CFC was in a net tested income or a net tested loss position, or should the taxpayer choose a CFC at random that will report the inclusion as PTEP?

Fortunately for all, the IRS has addressed this issue in Regs. Sec. 1.951A-5 and provides examples for how the tracking of E&P and PTEP should work. In general, a GILTI inclusion is treated the same way as Subpart F income, meaning that any inclusions identified out of a CFC’s E&P will need to be tracked and reclassified as PTEP on Schedules J and P. The steps in determining how a GILTI inclusion is apportioned back to each CFC for purposes of tracking untaxed E&P and PTEP are found in Regs. Sec. 1.951A-5(b) and state that, first, the amount of GILTI apportioned to tested loss CFCs is zero (see Regs. Sec. 1.951A-5(b)(2)). This makes practical sense, as a CFC that is in a tested loss position would not carry with it any earnings that would be subject to taxation and, as such, would not reclassify any losses from E&P to PTEP.

Next, the total GILTI inclusion must be apportioned among all tested income CFCs. To do this, the portion of the GILTI inclusion amount of the U.S. shareholder should bear the same ratio to the amount of the U.S. shareholder’s pro rata share of tested income for each tested income CFC as compared with the total tested income of all tested income CFCs. The following example from Regs. Sec. 1.951A-5(b)(2)(ii) should help clear this up:

Example 1:

Facts: USP, a domestic corporation, owns all of the stock of three CFCs, CFC1, CFC2, and CFC3. USP, CFC1, CFC2, and CFC3 all use a calendar year as their tax year. In year 1, CFC1 has tested income of $100x, CFC2 has tested income of $300x, and CFC3 has tested loss of $50x. USP has no net DTIR for year 1.

Analysis: In year 1, USP has net CFC tested income (as defined in Regs. Sec. 1.951A-1(c)(2)) of $350 ($100 + $300 − $50) and, because USP has no net DTIR, a GILTI inclusion amount (as defined in Regs. Sec. 1.951A-1(c)(1)) of $350 ($350 − $0). The aggregate amount of USP’s pro rata share of tested income is $400 ($100 from CFC1 + $300x from CFC2). Therefore, under paragraph (b)(2)(i) of this section, the portion of USP’s GILTI inclusion amount treated as being with respect to CFC1 is $87.50 ($350 × [$100 ÷ $400]). The portion of USP’s GILTI inclusion amount treated as being with respect to CFC2 is $262.50 ($350 × [$300 ÷ $400]). The portion of USP’s GILTI inclusion amount treated as being with respect to CFC3 is $0 because CFC3 is a tested loss CFC.

Now, why is this important? The GILTI regulations specifically omit tested loss CFCs from being apportioned any amount of the GILTI inclusion. Let’s take the above example, change the facts around a bit, and not apply the tested loss CFC apportionment exclusion for GILTI inclusion.

Example 2:

Facts: USP, a domestic corporation, owns all of the stock of three CFCs, CFC1, CFC2, and CFC3. USP, CFC1, CFC2, and CFC3 all use the calendar year as their tax year. In year 1, CFC1 has tested income of $100x, CFC2 has tested income of $300x, and CFC3 has tested loss of $50x. USP has no net DTIR for year 1. CFC1 has accumulated untaxed E&P before GILTI of $150, CFC2 has accumulated untaxed E&P before GILTI of $500, and CFC3 has accumulated untaxed E&P before GILTI of $25.

Analysis: In year 1, USP has net CFC tested income (as defined in Regs. Sec. 1.951A-1(c)(2)) of $350 ($100 + [$300 − $50]) and, because USP has no net DTIR, a GILTI inclusion amount (as defined in Regs. Sec. 1.951A-1(c)(1)) of $350 ($350 − $0). The aggregate amount of USP’s pro rata share of tested income and loss is $350 ($100 from CFC1 + $300x from CFC2 − $50 from CFC3). Therefore, if the shareholder neglects the CFC loss-exclusion rule, the portion of USP’s GILTI inclusion amount treated as being with respect to CFC1 is $100 ($350 × [$100 ÷ $350]). The portion of USP’s GILTI inclusion amount treated as being with respect to CFC2 is $300 ($350 × [$300 ÷ $350]). The portion of USP’s GILTI inclusion amount treated as being with respect to CFC3 is -$50 or ($350 × [$-50 ÷ $350]). CFC1 would report ending untaxed E&P on Schedule J as $50 ($150 – $100) and PTEP under Sec. 951A as $100. CFC2 would report ending untaxed E&P on Schedule J as $200 ($500 – $300) and PTEP under Sec. 951A as $300. CFC3 would report ending untaxed E&P on Schedule J as -$25 ($25 – $50) and PTEP under Sec. 951A as -$50.

As can be seen, ignoring the tested loss CFC apportionment exclusions rule would cause an incorrect mathematical increase to untaxed E&P of CFC3 (even though it was in a tested loss position) and result in a negative PTEP balance of -$50 for CFC3 at the end of year 1. It is apparent that omitting the tested loss CFC apportionment exclusion related to a Sec. 951A GILTI inclusion can create some unorthodox results in tracking and reporting E&P and PTEP of CFCs. Note that although the example above denominated the apportionment of GILTI among tested income CFCs in U.S. dollars, once the apportioned amount is determined for each CFC, the apportioned inclusion amount should be translated from U.S. dollars back into the functional currency of the CFC for reporting on Schedule J and P of Form 5471, using the average exchange rate for the CFC inclusion year of the CFC (see Regs. Sec. 1.951A-5(b)(3)).

That being said, where would the GILTI inclusion be reported on Schedules J and P? We know from Regs. Sec. 1.951A-5(b) that only tested income CFCs should experience a reclassification of post-2017 E&P not previously taxed:

■ Schedule J:

● CFC income identified as Sec. 951A income under GILTI must be reclassified from post-2017 E&P not previously taxed (column (a)) to column (e)(viii), which represents PTEP attributable to Sec. 951A inclusions.

■ Schedule P:

● CFC income identified as Sec. 951A GILTI income should be reported under Sec. 951A PTEP in column (h), which represents 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. Column (e)(ix) and column (i) of Schedules J and P, respectively, are used to track any PTEP related to inclusions under Secs. 1248 and 245A(e)(2).

● Schedule J:

■ U.S. shareholder inclusions identified as Sec. 1248 and Sec. 245A(e)(2) must be reclassified from post-2017 E&P not previously taxed (column (a) of the form) to column (e)(ix), which represents PTEP attributable to Sec. 1248 and Sec. 245A(e)(2).

■ If it is identified that any income under Sec. 1248 or Sec. 245A(e)(2) also is subject to Sec. 956 as income related to investments in U.S. property, any PTEP attributable to these inclusions would alternatively be reported in column (e)(v) rather than in column (e)(ix).

● Schedule P:

■ U.S. shareholder inclusions identified as Sec. 1248 and Sec. 245A(e)(2) must be tracked using column (i), which represents PTEP attributable to Sec. 1248 and Sec. 245A(e)(2).

■ If it is identified that any income under Sec. 1248 or Sec. 245A(e)(2) also is subject to Sec. 956 as income related to investments in U.S. property, any PTEP attributable to these inclusions would alternatively be reported in column (e) rather than in column (i).

Many nuances

The U.S. international tax compliance and reporting obligations for U.S. shareholders of CFCs have become increasingly burdensome and complex, largely attributable to the TCJA and the overall global trend toward greater transparency with respect to international operations and transactions. Therefore, it is critical that U.S. shareholders of CFCs have advisers who understand the nuances associated with the categories of income inclusions for CFCs as well as how to properly track and maintain CFCs’ tax attributes on Schedules J and P of Form 5471.

Editor Notes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif. For additional information about these items, contact Mr. Cook at 949-623-0478 or mcook@singerlewak.com. Contributors are members of or associated with SingerLewak LLP.