An accurate determination of “earnings and profits” (E&P) of a foreign (i.e., Canadian) corporation is often an overlooked step in U.S. tax reporting for controlled foreign corporations (CFC). In many cases book retained earnings was or is used as a proxy and no adjustments were made to convert book retained earnings to E&P. To the extent that distributions were significantly less than book retained earnings the inaccuracy of the accumulated E&P balance was not a current tax issue assuming there was sufficient “cushion” in the retained earnings balance.
That changed on December 22, 2017 when President Trump signed into law sweeping changes to U.S. tax legislation. The legislation provides for a one time transitional tax, for specified foreign corporations (which includes controlled foreign corporations) and subjects all undistributed post-1986 earnings and profits (E&P), for these entities, to a deemed repatriation. Since all E&P will be distributed the inaccuracy of book retained earnings will now be an issue. This deemed repatriation will result in a potential U.S. tax of 15.5% or 8% (depending on the characterization of the accumulated E&P).
Calculating your E&P accurately
Given the importance of E&P it is not, however, defined in the Internal Revenue Code (IRC). E&P measures a corporation’s overall ability to pay dividends. It is an economic concept based upon and related to (U.S.) taxable income. When determining E&P all facts must be considered. E&P is used to determine whether any distributions are a taxable dividend, a tax free return of capital or a capital gain.
Due to the lack of a statutory definition, one needs to look at the regulations, administrative guidance and other sources to determine it accurately.
IRC Sec. 964 and Regulation. Sec. 1.964-1(a) provides guidance on the three main steps in determining E&P for foreign entities.
- Prepare a profit and loss statement with respect to a year from the books of accounts regularly maintained in the local country. This may be in a foreign currency.
- Make the necessary adjustments to conform such statement to the accounting principles generally accepted in the United States (GAAP).
- Make further adjustments to conform to tax accounting standards of the United States.
Important to note: although retained earnings per foreign country books and GAAP are a good estimate of E&P, they do not include the necessary adjustments to compute E&P.
Current year income per foreign books of accounts in foreign currency are reconciled to current year E&P (per US financial and tax accounting standards) in USD. Some common items that may require adjustment are as follows (the list is not comprehensive):
- Tax-free reorganizations and/or liquidations in the foreign country that are not tax-free for US tax purposes.
- Depreciation, depletion, and amortization allowances must be based on the historical cost of the underlying asset, and depreciation must be computed according to US tax law.
- Inventories must be taken into account according to US tax rules dealing with valuation and capitalization and the related regulations.
- An adjustment needs to be made for meals and entertainment which are non-deductible or only 50% deductible for US tax purposes.
- Income Taxes must be adjusted for temporary and permanent differences between book provisions vs. amounts deductible for tax purposes. The impact of refundable taxes must also be considered.
- Nondeductible fines/penalties are deductible in computing E&P as they represent a cash outlay.
- Foreign Currency Adjustments
- Accrued Bonus, Deferred Compensation and other salary expenses which maybe deductible for book but not tax purposes.
Un-booked adjustments can cause a material variance between book retained earnings and E&P for purposes of US tax reporting of a foreign corporation.
Is the E&P of your foreign corporation accurately stated? If not, please do not hesitate to contact us. At Cadesky U.S. Tax we can help in determining the E&P for a corporation owned by you or related to you.