Foreign corporation earnings and profits: common misconceptions and pitfalls.

• Author: Perry, Cory

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...