A guide to foreign corporation E&P.

EXECUTIVE SUMMARY

* After allocating gross income to the proper baskets, deductions and taxes must be allocated and apportioned to gross income to arrive at E&P for each FTC basket.

* A CFC's related-person interest and other expenses are allocated and apportioned to the gross income of separate baskets in a four-step process.

* Each separate income basket includes the foreign income taxes related to the income in that basket.

This two-part article provides a quick guide to the key steps in computing a foreign corporation's earnings and profits (E&P). Part II discusses the allocation and apportionment of interest, expenses and taxes to the foreign tax credit (FTC) baskets.

A foreign corporation's earnings and profits (E&P) generally must be broken out into 10 foreign tax credit (FTC) income categories. After allocating gross income to the proper baskets, deductions and taxes must be allocated and apportioned to gross income to arrive at the E&P for each FTC basket. Part I of this two-part article, in the May 2004 issue, described the E&P computation, the allocation of income to the FTC baskets and the look-through rules. Part II, below, discusses how to allocate and apportion interest, expenses and foreign taxes to the FTC baskets.

Expense Allocation and Apportionment Rules

Generally, deductions related to a particular income class are subtracted from that income. Under Kegs. Sec. 1.861-8(b)(2), deductions are related if they are incurred as a result of, incident to, or in connection with an activity or property from which the income is derived. Deductions related to all gross income (or not related to any gross income) are ratably apportioned to all gross income under Regs. Sec. 1.8618(b)(1).

After deductions have been allocated to a class of gross income, they are apportioned among separate FTC baskets using an apportionment base that reasonably reflects the factual relationship between expenses and gross income. Potential apportionment bases include unit sales, gross sales or receipts, cost of goods sold, profit contributions, expenses incurred, assets used, salaries paid, space used, time spent and gross income, according to Temp. Regs. Sec. 1.861-8T(c)(1).

Regs. Sec. 1.861-8(e) provides specific allocation and apportionment rules for the following deductions:

* Interest;

* Research and experimental expenditures;

* Stewardship expenses;

* Legal and accounting fees and expenses;

* Income taxes;

* Losses on a sale, exchange or other disposition of property;

* Net operating loss deduction;

* Deductions not definitely related;

* Special deductions; and

* Charitable contributions.

In short, expenses are first allocated to a class of gross income and then apportioned to separate baskets (if appropriate) using one or more apportionment bases that reasonably reflect the factual relationship between the expenses and gross income, subject to specific allocation and apportionment rules for the expenses listed above and identified in Regs. Sec. 1.861-8(e). If an expense is related to all gross income (or not related to any class of gross income), it is ratably apportioned to all income.

CFC Allocations

Regs. Secs. 1.904-5(c) and 1.954-1(c) provide the basic rules for allocating and apportioning a controlled foreign corporation's (CFC's) expenses. Interest paid (or accrued) by a CFC to its U.S. shareholders (or any related person) is first allocated to the CFC's passive income. (15) Under Regs. Sec. 1.904-5(c)(2)(ii)(B)-(E), related-person interest (i.e., interest paid to U.S. shareholders or related persons) and other CFC expenses are allocated and apportioned to the gross income of the separate baskets in four steps:

1. Expenses (other than interest) definitely related to one or more (but not all) classes of gross income are allocated to such related classes and then apportioned to separate baskets. An expense is definitely related to a class of gross income if the CFC incurs it as a result of, incident to, or in connection with an activity or property from which the class of gross income is derived. An example of a definitely related expense is royalty payments, which are directly allocable to the income derived from the use of the technology or know-how. Rental expenses are also directly related to the class of gross income derived from the use of the property.

Interest expense is not included in this step unless it is unrelated-person interest (i.e., interest not prod to related parties), directly allocable to income from a specific property. Generally, this specific interest allocation has limited application, as it only applies to certain qualified nonrecourse debt and some integrated financial transactions. (16)

2. Related-person interest is allocated to reduce passive foreign personal holding company income (FPHCI) (i.e., passive income) to the extent that such passive income remains available after the expense allocation of Step 1 above. (17)

3. Any remaining related-person interest (after Step 2) is apportioned to other income baskets based on either gross income or asset value, as provided in Temp. Regs. Sec. 1.861-9T(g) and (j). Exact formulas are provided in Regs. Sec. 1.904-5(c)(2)(ii). Basically, the formula provides a pro-rata apportionment based on the basket's gross income (or asset value) relative to the total gross income (excluding passive income) or total asset value (excluding passive assets). Adjustments are needed when there are multiple tiers of CFCs.

4. All remaining expenses (including unrelated-person interest) are apportioned. Unrelated-person interest is apportioned based on either the gross income method or the asset value method.

Choice of Method

For the gross income method, unrelated-person interest is apportioned based on the amount of gross income in an income basket relative to total gross income. The total gross income amount is reduced by any related-person interest allocated to passive income. The gross income of the passive income basket is also reduced by related-person interest.

The same concept applies in apportioning unrelated-person interest under the asset value method. In determining the total value of assets, related-person debt allocable to passive assets is subtracted from total assets. Similarly, assets in the passive income basket are reduced by allocable related-person debt. That debt is the total related-person debt multiplied by the ratio of related-person interest allocated to passive income in Step 2 to total related-person interest. Total related-person debt is the CFC's total debt owed to U.S. shareholders or related persons. Any other expense is allocable to all gross income and may be apportioned among all classes of gross income based on gross income, asset value or possibly other apportionment methods, under Temp. Regs. Sec. 1.861-8T(c)(1).

The election to use either the gross income or asset value method can be made on a yearly basis; however, the same apportionment method must be used by all CFCs. If no timely elections were made, the CFC is deemed to have elected the asset method under Temp. Regs. Sec. 1.861-9T(f)(3) and Notice 89-91. (18)

Under the gross income method, the CFC's interest expense is allocated based on its own gross income, if it does not own stock in a lower-tier CFC. When multiple tiers of CFCs exist, the upper-tier CFC must include in gross income its allocable share of the classes of gross income (as modified) of lower-tier CFCs, under Temp. Regs. Sec. 1.861-9T(j)(2).

Under the asset method in Temp. Regs. Sec. 1.861-9T(g), interest expense is apportioned to various income baskets based on the average value (i.e., adjusted tax basis) of assets held by the CFC in each basket. Assets are attributed to a basket based on the source and type of income they generate or may reasonably be expected to generate.

For the asset method, adjustments are made to the tax basis of any 10%-owned corporation under Temp. Regs. Sec. 1.861-12T(c)(2). The tax basis of the stock of a 10%-owned corporation is increased (or decreased) by the increase (or decrease) in the share of E&P of such corporation attributable to the stock and accumulated during the period the CFC held (directly or indirectly) 10% or more of the voting stock. A 10%-owned corporation is any corporation (foreign or domestic) in which the CFC owns, directly or indirectly, 10% or more of the voting stock.

Expense Allocation Examples

The following examples show how expenses are apportioned to various income baskets.

Example 1: P, a C corporation, has a wholly owned CFC with the following income, expenses, assets and liabilities in 2004:

Passive income                       $20,000
Subpart F business gross income      150,000
Non-Subpart F business gross income  150,000
Interest expense paid to P
 (related-party interest)
 for a $160,000 loan
 (related-person debt)                16,000
Interest expense paid
 to unrelated parties                 20,000
Passive income assets                200,000
Subpart F business assets            500,000
Non-Subpart F business assets        500,000
Noninterest expenses
 (not directly related expenses)      80,000

No foreign income tax is assessed (on the income. The asset method of interest allocation is used.

In determining the income baskets in which P's interest income, Subpart F income and non-Subpart F income should be reported, Regs. Sec. 1.904-5(c)(2)(ii) and (iii) provide the following rules:

1. P characterizes the $16,000 related-party interest from the CFC as passive income, because the CFC allocated all the interest against its passive income (Regs. Sec. 1.904-5(c)(2)(ii)(C)).

2. All related-person debt ($160,000) is allocated to passive assets under Regs. Sec. 1.904-5(c)(2)(iii)(B).

3. The $20,000 unrelated-party interest is apportioned between passive and general limitation baskets. The general limitation basket is further divided between Subpart F and non-Subpart F groups. Under the asset method, the interest is apportioned based on the ratio of the value of the CFC's assets in each basket over total assets. For purposes of this computation, both total assets and assets in the passive income basket are reduced by the $160,000 related-person debt (Regs. Sec. 1.904-5(c)(2)(ii)(E)).

The unrelated-party interest is apportioned as follows:

Passive basket = $20,000 x ($200,000 - $160,000)/($1,200,000 - $160,000) = $769

General limitation basket = $20,000 x ($1,000,000/($1,200,000 - $160,000)) = $19,231, equally divided between Subpart F and non-Subpart F groups

The $80,000 of noninterest expenses can also be apportioned based on the ratio applied above, as follows:

Passive basket = $80,000 x ($200,000 - $160,000)/($1,200,000 - $160,000) = $3,077

General limitation basket = $80,000 x ($1,000,000/($1,200,000 - $160,000)) = $76,923, equally divided between Subpart F and non-Subpart F groups

In summary, P includes (1) $16,000 interest income in the passive basket, (2) $154 ($20,000 passive income--$16,000 interest expense--$769 unrelated-party interest--$3,077 other expenses) Subpart F income in the passive basket and (3) $101,922 ($150,000 business income--$9,616 unrelated-party interest--$38,462 other expenses) Subpart F income in the general limitation basket. The other $101,922 non-Subpart F general limitation income ($150,000 business income--$9,616 unrelated-party interest--$38,462 other expenses) is not taxable to P.

Example 2: The facts are the same as Example 1, except that P elects the gross income method of interest allocation.

Under Regs. Sec. 1.904-5(c)(2)(ii) and (iii), the results are:

1. P still characterizes the $16,000 related party interest from the CFC as passive income. That amount is allocated to the CFC's passive income.

2. The $20,000 unrelated-party interest is apportioned between the passive and general limitation baskets, with the latter basket further divided between Subpart F and non-Subpart F groups. Under the gross income method, interest is apportioned based on the ratio of the gross income in each basket to the CFC's total gross income. For this computation, both total gross income and passive income are reduced by the $16,000 related-party interest. The $20,000 unrelated-party interest is apportioned as follows:

Passive basket = $20,000 x ($20,000 - $16,000)/($320,000 - $16,000) = $263

General limitation basket = $20,000 x ($300,000/($320,000 - $16,000)) = $19,737, equally divided between Subpart F and non-Subpart F groups

3. The $80,000 noninterest expense is apportioned based on the same ratio applied above, as follows:

Passive basket = $80,000 x ($20,000 - $16,000) /($320,000 - $16,000)) = $1,053

General limitation basket = $80,000 x ($300,000/($320,000 - $16,000)) = $78,947, equally divided between Subpart F and non-Subpart F groups

In summary, based on the gross income method, P includes (1) $16,000 interest income in the passive basket, (2) $2,684 ($20,000 passive income--$16,000 interest expense--$263 unrelated-party interest--$1,053 other expenses) Subpart F income in the passive basket and (3) $100,657 ($150,000 business income--$9,869 unrelated-party interest--$39,474 other expenses) Subpart F income in the general limitation basket. The other $100,657 non-Subpart F general limitation income ($150,000 business income--$9,869 unrelated-party interest--$39,474 other expenses) is not taxable to P.

Examples 1 and 2 demonstrate that the two apportionment methods generally provide different interest and expense apportionments, which spread different amounts of net income among the FTC baskets.

Income Tax Allocation

Foreign income taxes paid or accrued for a separate income basket include only amounts related to the income in that basket. Under Regs. Sec. 1.904-6(a) and (c), taxes are related to the income if the income is included in the income base for assessing the foreign income tax. For example, no foreign tax would be allocated to an income item if such income is exempt from such tax. If foreign tax is imposed on an income item that is not income for U.S. purposes, the tax would be treated as allocable to the general income basket, under Regs. Sec. 1.904-6(a)(1)(iv). If foreign tax is imposed on an amount of income deferred for U.S. tax purposes, the tax is allocated and apportioned for U.S. purposes in the year imposed.

Generally, the same allocation of foreign taxes is used for computing a CFC's E&P in each separate income basket and determining the CFC's foreign tax pools by separate basket. The deduction of foreign taxes in determining the CFC's E&P is kept in the CFC's functional currency (Sec. 986(b)(1)), but the CFC's pools of foreign taxes for FTC purposes are kept in U.S. dollars (See. 986(a)(l)). For post-1997 years, foreign income taxes are generally converted to U.S. dollars at the average rate for the year in which the taxes were accrued (Sec. 986(a)(1)). Prior to 1998, they were translated using the exchange rate for the date the taxes were paid.

Many foreign taxes are related to more than one income class. The following formula in Regs. Sec. 1.904-6(a)(1)(ii) allocates foreign income taxes to a basket when a tax is attributable to more than one income basket:

Foreign tax related to more than one basket x Net income in the separate basket subject to that foreign tax/Net income subject to that foreign tax

To determine the net income in each basket, foreign law is applied to determine gross income. In allocating foreign taxes to income of separate baskets, however, gross income in the passive basket is first reduced by any related-person interest expense allocated to the income (as discussed above), under Sec. 954(b)(5) and Regs. Sec. 1.904-5 (c)(2)(ii)(C). After the adjustment of passive gross income for related party-interest expense, specifically allocable deductions under foreign law are then applied to reduce the gross income of an income category. For deductions not specifically allocable, the taxpayer generally should apportion the deductions under foreign law. For example, if foreign law requires that the expense be apportioned on a gross income basis, then the expenses must be so apportioned. If the foreign law does not allocate or apportion deductions among income categories, the taxpayer generally must follow the U.S. regulations for allocating and apportioning deductions.

Example 3: P, a C corporation, has a wholly owned CFC in Country X, with the following income and expenses in 2004:

Passive income                      $10,000
General limitation income            50,000
Interest expense paid to P
 (related-partly interest)           10,000
Other expanses allocable to general
 limitation under X law              10,000

X imposes a 25% tax on the CFC's net income, amounting to $10,000 of foreign tax.

Under Regs. Sec. 1.904-6(a) (1) (ii), the $10,000 passive income is first reduced by the $10,000 related-person-interest expense for the purpose of allocating X's $10,000 tax, Next, the $50,000 general limitation income is reduced by the $10,000 other expenses, based on foreign law. Thus, the entire $10,000 X tax is allocated to general limitation income.

If there is an adjustment of previously paid or accrued foreign taxes, the CFC's pools of post-1986 foreign taxes and E&P are generally adjusted by the refund or additional taxes owed. (19) If foreign taxes are refunded, the foreign corporation generally reduces its foreign taxes pool in the appropriate separate category by the refund's U.S. dollar amount, translated at the foreign exchange rate in effect on the date that the foreign taxes were paid, according to Temp. Reg. Sec. 1.905-3T(d)(3)(ii). The E&P pool in the appropriate separate category is also increased by the functional currency amount of the foreign tax refund. If additional foreign taxes are assessed, the foreign tax pool in the appropriate separate category, is increased by the U.S. dollar amount of the additional foreign tax paid, translated at the foreign exchange rate in effect for the year on the payment date. The E&P pool in the appropriate separate category is decreased by the functional currency amount of the additional foreign tax paid. (20)

Conclusion

E&P plays a central role in international tax planning and compliance and has no statute of limitations. Taxpayers must understand how E&P is calculated and maintain current documentation for E&P computations. This article provided a quick guide for understanding the steps involved in E&P calculations.

For more information about this article, contact Mr. Lau at [e-mail].

Editor's note: Mr. Lau is a member of the AICPA Tax Division's International Tax Technical Resource Panel.

(15) Generally, related person include CFCs and partnerships more than 50% owned by each other or by the same U.S shareholders; see Regs. Secs. 1.904-5(c)(2)(i) and-5(i)(1). A discussion of the allocation and apportionment roles for all deductions is beyond the scope of this article; see Soltis and Lau, "Foreign Tax Credit Planning for S Corporations," 3 Business Entities 36 (May/June 2001).

(16) See Temp. Regs. Sec. 1.861-10T(b) and (c).

(17) Passive FPHCI generally includes dividends, interest, rents, loyalties, annuities and net gains from certain commodity and currency transactions.

(18) Notice 89-91, 1989-2 CB 408.

(19) See Temp. Regs. Sec. 1.905-3T(d)(2) and Notice 90-26. 1990-1 CB 336. Temp. Regs. See. 1.905-3T was issued before Sec. 986(a)(1) was amended in 1997. Sec. 986(a)(1) provides that accrued foreign taxes (and any adjustment) are converted to U.S. dollars at the average exchange rate for the year of accrual. This article discusses the rules in the temporary regulations, which might not reflect the changes in Sec. 986(a)(1).

(20) In effect no redetermination of U.S. tax is required, unless (1) the foreign tax liability is in a hyperinflationary currency (Temp. Regs. Sec. 1.905-3T(d)(4)(i)); (2) the amount of foreign tax accrued exceeds the amount of foreign tax paid by at least 2% (the IRS in its discretion, can require a redetermination of US. tax liability) (Temp. Regs. Sec. 1.905-3T(d)(4)(ii)); or (3) an adjustment to an FTC credit pool would reduce that pool below zero (Temp. Regs. Sec. 1.905-3T(d)(4)(iv)).

Paul C. Lau, ABV, CMA, CPA

Partner

Blackman Kallick Bartelstein, LLP

Chicago, IL

Sandra Soltis, MST, CFP, CPA

Partner

Blackman Kallick Bartelstein, LLP

Chicago, IL