A guide to foreign corporation.

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.

Generally, earnings and profits (E&P) represents a corporation's economic profits. E&P is not the same as financial earnings or taxable income. A foreign corporation's E&P is most frequently associated with the foreign tax credit (FTC) (Secs. 902 and 960) and Subpart F income (Sees. 951(a)(1)(A) and 952(c)).

E&P also applies in assessing the effects on (1) gain from the sale of a con trolled foreign corporation's (1) (CFC's) 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 corporation's stock.

Generally, a CFC's 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. shareholder's income due to an increase in the CFC's 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) 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 corporation's 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 hyper-inflationary, E&P is kept in foreign currency, not U.S. dollars. (5) Exhibit 1 on p. 292 provides a summary schedule of common adjustments to arrive at a foreign corporation's 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 CFC's 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 property's 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 rise 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 CFC's 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 corporation's 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 CFC's 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 CFC's 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 CFC's 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 corporation's 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 corporation's 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:

* Passive income (e.g., dividends and interest) . (9)

* High-withholding-tax interest (i.e., withholding tax of 5% or greater). (10)

* Shipping income (including income from operating aircraft on the high seas and in space).

* Financial services income (i.e., banking, finance or a similar business and certain insurance investment income).

* Dividends from noncontrolled Sec. 902 corporations (11) (at least 10%, but not more than 50% ownership).

* Dividends from a domestic international sales corporation (DISC) or former DISC.

* Dividends from a foreign sales corporation (FSC) or a former FSC.

* Taxable income attributable to foreign trade earned by an FSC.

* Foreign oil and gas extraction income.

* Other income (the general limitation). (12)

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 CFC's income baskets. The lookthrough rules are summarized below.

* Subpart F income is generally treated as income in separate baskets in the same proportion as the CFC's underlying income baskets. (14)

* Interest received by a U.S. shareholder from a CFC (related-person interest) is generally treated as income in separate baskets to the same extent that the interest deduction is allocated to the CFC's income baskets. Under Regs. Sec. 1.904-5(c)(2)(ii), such interest is generally first classified as passive income to the extent of the CFC's passive income, after deducting directly related expenses.

* Rents and royalties received from a CFC are treated as income in separate baskets to the same extent such expenses are allocated to the CFC's income baskets (Regs. Sec. 1.904-5(c)(3)).

* Dividends paid by a CFC are treated as income in separate baskets in the same proportion as the CFC's E&P in each basket bears to its total E&P. However, dividends from a CFC allocable to its passive income can be included in the general limitation basket, if the IRS is satisfied that the passive income was subject to an effective foreign tax rate greater than 90% of the maximum U.S. corporate tax rate (Regs. Sec. 1.904-5(d)(2)).

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.

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

(1) A foreign corporation is a CFC if more than 50% of its stock's vote or value is owned directly, indirectly or constructively by U.S. shareholders. A U.S. shareholder is a person who owns directly, indirectly or constructively at least 10% of the foreign corporation's voting stock; see Secs. 951 (b), 957(a) and 958.

(2) A CFC's investment in U.S. property is treated as a repatriation of earnings to its U.S. shareholders. If an increase in earnings invested in U.S. property is attributable to previously taxed Subpart F income, such amounts are not taxed again; see Sees. 956(a)(l)(B) and 959(a)(2). Under Sec. 956(c), "U.S. property" includes tangible property located in the U.S., any stock or obligation of a related U.S. person (i.e., a 10% U.S. shareholder or a 25% related U.S. corporation), and any right to use certain intangibles (e.g., patents and copyrights) acquired or developed by the CFC for use in the U.S. However, U.S. property does not include U.S. obligations, U.S. bank deposits, stock in unrelated U.S. corporations and tangible property purchased and located in the U.S. for export.

(3) Subpart F income is income immediately taxable to a U.S. taxpayer, even though it is not repatriated. It is generally passive income and income earned by a CFC outside its country of incorporation from certain transactions involving related parties. E&P can operate to limit Subpart F income taxable in a tax year; see Secs. 951 (a) and 952(c)(1)(A). For a discussion of Subpart F income, see Lau, Auster and McCotter, "Entity Decisions for Overseas Operations After TRA 97," 25 J. Corp. Tax'n 149 (1998).

(4) A U.S taxpayer is taxed on its worldwide income. To prevent double taxation of income earned overseas (foreign-source income), a U.S. taxpayer can credit foreign income taxes against its U.S. tax liability. E&P plays a major role in determining the foreign income tax attributable to a dividend paid (or deemed paid) by a foreign corporation raider Secs. 901, 902 and 960.

(5) For tax years beginning after Aug. 24, 1994, however, E&P of a foreign corporation that operates in a hyperinflationary currency environment is generally kept in U.S. dollars. A hyperinflationary currency is the currency of a country in which its cumulative compounded inflation rate is at least 100% over a 36-month period preceding the current calendar year; see Regs. Secs. 1.985-1(b)(2)(ii) and 1.964-1(a), and Temp. Regs. Sec. 1.964-1T(g).

(6) See Kegs. Sec. 1.964-1(c)(6) and Temp. Regs. Sec. 1.964-1T(g)(2).

(7) Under Sec. 263A(f)(4)(B), the "construction period" begins on the date that construction begins, and ends on the date the property is ready to be placed in service or held for sale.

(8) See Notices 89-67, 1089-1 CB 723 and 88 104, 1988-2 CB 443. For interest capitalization, see Notice 88-99, 1988-2 CB 422.

(9) Passive income generally includes dividends, interest, rents, royalties, annuities, net gains from the sale of assets that produce passive income (or no income), and net gains from certain commodity and currency transaction; see Sec. 904(d)(2)(A)(i) and Regs. Secs. 1.904 4(b)(1) and 1.954-2(a)(1). Passive income also includes income reported under the foreign personal holding company (FPHC) and passive foreign investment company (PFIC) rules; see Sec. 904(d)(2)(A)(ii). It does not include high-taxed income, export financing interest and income included in another basket (e.g., high-withholding-tax interest). High-taxed income is passive income subject to an aggregate foreign income tax (including deemed paid taxes) greater than the highest applicable U.S. tax rate. The high-taxed-income test is applied to net passive income (i.e., after the allocation of expense of the U.S taxpayer to such income): such high-taxed income is excluded from the passive income basket and included in the general limitation basket. Items of passive income are segregated into groups for purposes of determining if they are high taxed income; see Sec. 904(d)(2)(A)(iii) and Regs. Sec. 1.9044(c)

(10) High-withholding-tax interest is ally interest income subject to foreign withholding tax of 5% or more, Under Regs. Sec, 1,904-4(d), all such interest is included in the high withholding tax interest basket, except for export financing interest.

(11) A noncontrolled Sec. 902 corporation is any foreign corporation in which a U.S. taxpayer owns at least 10%. but no more than 50%, of the voting stock. Prior to 2003, a separate limitation basket was required for dividends from each noncontrolled Sec. 902 corporation. For tax years beginning after 2002, dividends from noncontrolled Sec. 902 corporations that are not PFICs are treated as a single limitation category for earnings accumulated prior to 2003 Distributions from earnings accumulated in tax years beginning after 2002 are subject to lookthrough rules; see Sec. 904(d)(l)(E), (d)(2)(E) and (d)(4).

(12) This basket includes income items not included in another basket. Most active trade or business income should fall within this basket. Export financing interest and high-taxed passive income are also included. This basket can have both high and low taxed income; see Regs. Sec. 1.904-4(h).

(13) See Notice 2003-5, IRB 2003-3, 294. for guidance on the new lookthrough rules and transition rules.

(14) If the potential Subpart F income is de minimis (i.e., less than 5% of the CFC's gross income or $1 million, if less), all such income (except financial services income) is general limitation income; see Regs. Secs. 1.904-5(d)(1) and 1.954-1(b)(1).

EXECUTIVE SUMMARY

* A foreign corporation's E&P is computed by making U.S. accounting and tax adjustments to the P&L statements.

* A CFC's E&P is broken down into separate pools, which are further divided into 10 FTC income categories.

* Lookthrough rules ensure that the income a CFC earns retains its character when paid, accrued or distributed to a U.S. shareholder or related entity.

Exhibit 1: Current E&P computation (in foreign currency)

1. Foreign book net income (after income taxes).

2. U.S. GAAP adjustments:

* Adjustments to clearly reflect income.

* Adjustments to reflect recovery (e.g., depreciation) allowances on a historical cost basis.

* Adjustments to eliminate mark up (or mark down) of liabilities (or assets) contrary to GAAP.

* Adjustments to eliminate equalization provisions that distort current income and expenses.

* Foreign currency translations based on U.S. GAAP.

* Other adjustments needed to properly reflect net income under U.S. GAAP.

Equals: Net income under U.S. GAAP.

3. Adjustments to conform with U.S. tax accounting:

* Add book depreciation (amortization) in excess of E&P depreciation (amortization).

* Subtract excess of E&P depreciation (amortization) over book depreciation (amortization).

* Subtract R&D expenditures capitalized for book.

* Add book amortization of R&D expense.

* Adjust deferred book gain on installment sales to E&P gain.

* Adjust deferred gain to percentage completion method of accounting.

* Adjust book gain to E&P gain on sale of assets.

* Add construction period interest, taxes and charges deducted for book.

* Add organizational expenses deducted for book.

* Adjust book start-up expense deducted or amortized.

* Add increase in LIFO reserve or subtract decrease in LIFO reserve.

* Add net increase in UNICAP inventory cost, or deduct net decrease.

* Adjust net increase or decrease in foreign pension, retirement, profit-shoring and employee benefit reserve (or similar compensation provision) not allowable under U.S. tax laws.

* Adjust net increase or decrease in reserve (e.g., bad debt, market write-down, etc.) not allowable fan U.S. tax purposes.

* Adjust foreign income tax provision from book to tax.

* Make any other adjustments to conform with U.S. tax principles.

Equals: Foreign corporation E&P before distributions.

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