A guide to foreign corporation.

• Author: Lau, Paul C.
• Position: Part 1 - Earnings and profits

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...