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ForeignIncome & Taxpayers
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 (Secs. 951(a)(1)(A) and 952(c)).
E&P also applies in assessing the effects on (1) gain from the sale of a controlled foreign corporation's1 (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.3 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...