Are you planning to repatriate earnings from a foreign subsidiary before year-end or do you have plans to do so in 2011? Earnings and profits (E&P), foreign tax pools, and basis in foreign subsidiaries all need to be in order. Getting documentation and schedules together simultaneous to year-end close will cut down on time, stress and potential errors when it is tax return-filing time next year.
Form 5471, Schedules H and J assists in tracking current and accumulated E&P, but it is useful to have a more detailed recordkeeping system of specific items that comprise the E&P balance. It is critical to properly track E&P for determining the taxable amount of actual distributions and deemed distributions under Subpart F and Section 956 (investment in U.S. property). Keeping records of how much E&P is previously taxed earnings is vital when planning for actual distributions. Utilizing tax software or electronic spreadsheets can be useful not only for your tax records, but also in the tax planning process for “what if” scenarios. E&P adjustments should be calculated and documented, including depreciation adjustments, book tax provision versus foreign taxes paid or accrued, and other required adjustments.
Foreign taxes paid or accrued are reported on Form 5471, Schedule E in functional currency and converted to U.S. dollars based on the average exchange rate for the year. However, tax balances need to be maintained by year for foreign tax credit purposes (tax pool). The tax pool is reduced for any indirect credit utilized (referred to as a “deemed paid credit”). Correct tracking of tax pool layers can help to maximize foreign tax credit on repatriated earnings. The tax pool is made up of creditable taxes, defined as those taxes that are based on income. Creditable taxes do not include capital or asset taxes. Note that even some taxes based on income are not creditable if the taxes are not designated for the “general” revenue fund. Again, utilizing software or electronic spreadsheets to keep detailed records of tax pools can assist in planning and during an audit. Documentation for taxes paid or accrued (tax receipts, tax assessments, or tax return copies) should be maintained along with the tax pool details. Performing this step before you file your return will save you time (and potential loss of foreign tax credits if you do not have the documentation) if you are later audited. Remember, foreign tax credit calculation requires separate “baskets” (separate foreign tax credit limitation calculations) for passive and general types of income.
Basis in your foreign subsidiary is not important only on a sale or liquidation of the subsidiary. The basis is important when distributions occur, as a distribution in excess of E&P is a return of capital and reduces the basis. Of course if the distribution would be in excess of the basis, capital gain results. Maintaining the basis calculation in a subsidiary is also necessary to determine average tax basis of foreign assets for purposes of properly allocating interest expense for foreign tax credit calculation purposes. The basis computation includes the original contribution to capital plus subsequent contributions and earnings, and is reduced by any distributions.
It is valuable to gather information necessary to compute earnings and profits, taxes paid or accrued, and basis in foreign subsidiaries on a contemporaneous basis. The computation can assist in the tax planning process, smooth the tax return preparation process, help to ensure more accurate compliance, and save time if an audit arises.
If you would like further guidance on how to clean up your foreign subsidiary files, contact Cynthia Hoffman, Director, International Tax Advisory, at firstname.lastname@example.org.
Schneider Downs provides accounting, tax, wealth management, technology and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA and Columbus, OH.
This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.