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.
On December 22, 2017 President Trump signed into law, “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” (Public Law 115-97). The legislation had previously been introduced and is informally known as the Tax Cuts and Jobs Act (H.R.1). This legislation is the most significant U.S. tax reform since President Reagan’s Tax Reform Act of 1986 (Public Law 99-514).
A number of provisions deal with International taxation and provide for a transition to an exemption tax system. On a go forward basis, active business income earned in certain foreign corporations will no longer be subject to U.S. taxation when repatriated back to the United States. The media, however, had promoted these changes as impacting U.S. multi-national enterprises (MNEs). For some provisions this description is accurate. For other provisions, not quite so.
The legislation provides for a one time transitional tax and subjects all undistributed post-1986 earnings and profits (E&P) to a deemed repatriation. This deemed repatriation will impact all United States shareholders of “deferred foreign income corporations”. A deferred foreign income corporation is a foreign (non-U.S.) corporation that (i) has at least one “United States shareholder (see below)”; (ii) has post-1986 E&P (other than income effectively connected with a U.S. trade or business, or that has already borne U.S. tax – remember it is untaxed earnings that is the target); (iii) be a controlled foreign corporation (CFC) or have at least one U.S. domestic corporation as a U.S. shareholder; and (iv) not be a Passive Foreign Investment Company (PFIC).
A “United States shareholder” is defined as a U.S. person (which includes a U.S. citizen or lawful permanent resident) who owns, directly or indirectly, 10% or more of the voting stock of all stock of the corporation entitled to vote. A controlled foreign corporation is a non-U.S. corporation where United States shareholders, either by themselves or in aggregate, control more than 50% of the votes of all stock of the company entitled to vote or own stock having more than 50% of the value of the corporation.
As such, for example, a U.S. citizen who is a Canadian resident and who owns 100% of a Canadian corporation will be caught under these rules.
Calculation of Transitional Tax and Payment Options
The deemed repatriation creates additional subpart F income. Historically subpart F income included passive investment income (and capital gains) as well as personal service contract income. Subpart F income is taxed as ordinary income, not as a qualified dividend. As such the income will be taxed at the taxpayer’s marginal tax rates. The amount that will be included in income, in 2017, is the greater of post-1986 E&P as of November 2nd and December 31st. There are, however, special tax rates that will apply. The rules act to impose an effective tax rate of 15.5% on E&P that is represented by cash and near cash accounts (including net A/R and A/P) and an effective tax rate of 8% on the remainder. The actual effective rate, however, will be a function of the individual’s marginal tax bracket. Foreign tax credits may be claimed against this tax.
If there is a tax balance, after claiming any foreign tax credits, the balance due can be paid over 8 years, with 8% being due in each of the first 5 years, 15% in year 6, 20% in year 7 and 25% in year 8. The yearly balance due is due on the return’s normal due date without any extensions.
Though the legislation has been signed into law, full regulations have yet to be issued. In late December the IRS issued IRS Notice 2018-007 but we expect further guidance. We at, Cadesky US Tax, are current on these changes and can provide assistance in assessing the impacts.
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Ever since President Trump announced his candidacy for President, both he and the Republican Party have been pushing for tax reform primarily consisting of massive tax cuts. On September 27, 2017 President Trump released a document entitled “Unified Framework for Fixing Our Broken Tax Code” where he outlined his proposals. On November 2, 2017 the House Republicans released the “Tax Cuts and Jobs Act H.R. 1” which echoed a significant number of President Trump’s proposals. On November 9th, 2017 the staff of the Joint Committee on Taxation released document JCX-51-17, the Description of the Chairman’s Mark of the “Tax Cuts and Jobs Act” which is scheduled for Markup by the Senate Committee on Finance on November 13, 2017 (aka the Senate proposals). There are quite significant differences between the Republican House and the Senate proposals.
The Joint Committee on Taxation is a nonpartisan committee of the United States Congress, originally established under the Revenue Act of 1926. The Joint Committee is chaired on a rotating basis by the Chairman of the Senate Finance Committee, Orrin G. Hatch (R-Utah), and the Chairman of the House Ways and Means Committee, Kevin Brady (R-Texas). The current Chairman is Senator Hatch.
Both the Republican House and Republican Senate plans call for lowering the individual and corporate tax rates, repealing numerous tax credits, eliminating the alternative minimum tax (AMT), enhancing the child tax credit, doubling the estate tax exemption, amongst other items. Assuming that the versions will be reconciled and go to the President for signature and subsequent enactment, the question then becomes “Will these changes be permanent?”
Under current legislation the answer is no (ignoring any Democratic objections, the impact of Roy Moore on the Alabama Senate elections, etc.). There is a provision in the Congressional Budget Act of 1974 process called the “Byrd rule”, named after the late Senator Robert Byrd of West Virginia. This rule allows Senators, during the Reconciliation Process, to block a piece of legislation if it purports significantly to increase the federal deficit beyond a ten-year term or is otherwise an “extraneous matter” as set forth in the Budget Act. A vote of 60 Senators is required to overturn the ruling.
The Joint Committee (JCX-54-17) estimates the static revenue loss from the (House) plan to total US $1.5 trillion over a decade. Whether the increased deficit can be offset by revenue growth, generated by increased business activity in the economy, is a question of fact.
Since the current proposals are not revenue neutral, the legislation can only be made permanent if there are at least 60 votes in the Senate (to override the Byrd rule). Currently the Senate is comprised of 52 Republicans, 46 Democrats and 2 Independents (who caucus with the Democrats). As such the Republicans do not have enough votes to override the Byrd rule. The proposals, as they stand, would require significant changes to make them Byrd-rule compliant. One option is provide sunset provisions of some of the tax cuts after a decade (anyone remember President Bush’s 2001 Economic Growth and Tax Relief Reconciliation Act estate tax provisions?). Clearly the fun is just beginning.
The above information is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of section 10.37(a)(2) of U.S. Treasury Department Circular 230. The contents of this document are intended for general information purposes only.