How to determine a CFC’s accounting period

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How to determine a CFC’s accounting period

You are preparing Form 1040 for a U.S. individual who (of course) has a December 31 taxable year. The taxpayer has a Form 5471 filing because he is a U.S. shareholder of a controlled foreign corporation. The CFC prepares its books with a June 30 fiscal year end.

How do you fill in those blanks? Do you use December 31 (the shareholder’s taxable year) or June 30 (the CFC’s taxable year) as the accounting period when preparing Form 5471?

The accounting period is essential because it controls the date of income inclusion for the U.S. shareholder. Subpart F income (IRC §951(a)) and net CFC taxable income (IRC §951A(a)) is deemed to be received by a U.S. shareholder on the last day of the CFC’s accounting period.

You will either determine the accounting period for the CFC using IRC §441 or IRC §898. Here is how it works.

The general rule: IRC §441

The Code refers to a taxpayer’s accounting period (for tax purposes) as its “taxable year,” and for our purposes you can use the two phrases interchangeably.

The general rule for selecting a taxpayer’s taxable year is in IRC §441.

The default taxable year is the normal accounting period for the taxpayer. IRC §441(b)(1). This could be a calendar year or fiscal year. (I’m ignoring the weird stuff, like the 52-53 week fiscal year).

Unless specified otherwise, a corporation simply uses “the annual accounting period . . . on the basis of which the taxpayer regularly computes its income in keeping its books.” Treas. Reg. §1.441-1(b)(1)(iii).

Override to the general rule: IRC §898

The general rule has a number of exceptions—some types of taxpayers have a required taxable year.

For a certain type of foreign corporation—a “specified foreign corporation”—an override rule applies. Such corporations determine their accounting period using IRC §898. Reg. §1.441-1(b)(2)(K).

A controlled foreign corporation is not necessarily a “specified foreign corporation.” Thus, it is entirely possible that you will be preparing Form 5471 for a CFC that is not a “specified foreign corporation,” and therefore you must determine its accounting period using IRC §441.

However, a “specified foreign corporation” is always a CFC so will always trigger a Form 5471. If the foreign corporation is a specified foreign corporation, you will be preparing Form 5471 and determining its accounting period using IRC §898.

Why IRC §898 exists

IRC §898 exists to prevent deferral of income inclusion by gaming the accounting periods of CFCs and their U.S. shareholders.

Remember that a U.S. shareholder includes subpart F income and net CFC tested income on the last day of the CFC’s taxable year. If the CFC adopted an accounting period ending one month after the U.S. shareholder’s taxable year, it could achieve 11 months of income inclusion deferral for the U.S. shareholder.

IRC §898 forces some—but not all—CFCs to use a required taxable year. IRC §898(a) states:

Notwithstanding section 441, the taxable year of any specified foreign corporation shall be the required taxable year determined under this section.

N.B. “Specified foreign corporation” is a phrase used for two very different reasons and describing two very different types of foreign corporations in both IRC §898 and IRC §965. Completely ignore anything to do with IRC §965. A foreign corporation can be a “specified foreign corporation” for IRC §965 purposes without being a “specified foreign corporation” for IRC §898 purposes.

Does IRC §898 apply? The two-prong “specified foreign corporation” test

A foreign corporation is an SFC only if two conditions are met—a corporate classification test and an ownership test:

• The foreign corporation is a CFC. IRC §898(b)(1)(A).
• One or more U.S. shareholders “own . . . more than 50 percent (by vote or value) of the stock . . . on each testing day.” IRC §898(b)(2).

Note that the Code tells you exactly when to figure out whether the foreign corporation is a CFC. It’s just a free-floating requirement. The ownership test, on the other hand, is determined as of precisely-defined dates: “each testing day.”

As a practical matter this does not matter, because the critical factor for application of the required accounting period rules of IRC §898 is the ownership test: do you have at least one U.S. shareholder who owns a majority of the foreign corporation’s stock? You can easily have a CFC without a majority U.S. shareholder. But you can never have a majority U.S. shareholder without causing the foreign corporation to be classified as a CFC.

Example 1: not a specified foreign corporation
Two unrelated U.S. persons each own 40% of the stock of the foreign corporation. Both are United States shareholders because they own more far more than the threshold 10% required for U.S. shareholder status. IRC §951(b).
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An unrelated nonresident alien owns the other 20% of the foreign corporation’s stock.
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The foreign corporation is a controlled foreign corporation because collectively the two U.S. shareholders own more than 50% of the foreign corporation’s stock. IRC §957(a).
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However, no single shareholder owns “more than 50%” of the foreign corporation’s stock. Therefore, the CFC is not an “specified foreign corporation” for IRC §898 purposes.
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Because both conditions are not met, IRC §898 does not define the foreign corporation as a specified foreign corporation. IRC §898 will not impose a required accounting period on the CFC.
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You will determine the CFC’s accounting period using the rules of IRC §441.
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Example 2: specified foreign corporation
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Two U.S. persons are parent and child. Each owns 40% of the stock of the foreign corporation. Both are United States shareholders because they own more far more than the threshold 10% required for U.S. shareholder status. IRC §951(b). Specifically, each U.S. shareholder is considered to own 80% of the stock of the foreign corporation: 40% is directly owned. IRC §958(a). Additionally, each U.S. shareholder constructively owns the other’s 40% under the family attribution rules. IRC §958(b).
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An unrelated nonresident alien owns the other 20% of the foreign corporation’s stock.
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The foreign corporation is a controlled foreign corporation because collectively the two U.S. shareholders own more than 50% of the foreign corporation’s stock, directly or constructively. IRC §957(a).
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The foreign corporation is also a specified foreign corporation for IRC §898 purposes because it has two U.S. shareholders that each own 80% of the foreign corporation’s stock. Therefore, it has two U.S. shareholders who own more than 50% of the stock.
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You will determine the CFC’s accounting period using the rules of IRC §898.

When to determine if a CFC is a “specified foreign corporation”

You figure out if a foreign corporation has a majority U.S. shareholder by looking at stock ownership on “testing days.”

There are two testing days:

• The first day of the foreign corporation’s accounting period every year. Prop. Reg. §1.898-3(a)(5)(i).
• Any day where a stock ownership shift creates a new majority U.S. shareholder. Prop. Reg. §1.898-3(a)(5)(iii).

How to determine if the CFC is a specified foreign corporation

Here is how you do the initial analysis of the testing day of the first day of the foreign corporation’s taxable year:

Step 1: determine default accounting period

First, figure out the foreign corporation’s taxable year using the normal rules of IRC §441. Ignore the application of IRC §898. Prop. Reg. §1.898-3(a)(5)(i). Typically, that is going to be the foreign corporation’s normal accounting period that it uses in its business and tax reporting in its home country. IRC §441(b)(1).

Step 2: determine CFC status at any time during the accounting period

Look at the entire taxable year that you identified at step 1. Was the foreign corporation a controlled foreign corporation at any point during that time period?

• If yes, continue to step 3—there is a possibility but not a certainty that the foreign corporation will be a specified foreign corporation under IRC §898.
• If no, stop. It is impossible for the foreign corporation to be a specified foreign corporation. IRC §898(b)(1)(A). Use the accounting period you identified in Step 1 to fill in the blanks at the top of Form 5471. (You could be filing Form 5471 for a foreign corporation that is not a CFC because of a Category 2 or Category 3 filing requirement).

Step 3: are you required to use the IRC §898 accounting period?

Look once again at the first day of the taxable year that you identified in step 1. On that date, did at least one United States shareholder own more than 50% of the foreign corporation’s stock by vote or value? IRC §898(b)(1)(B), 898(b)(2).

• If yes, the foreign corporation is a specified foreign corporation because it was both a controlled foreign corporation and it had at least one United States shareholder who owned more than 50% of its stock. IRC §898(b). Determine the correct taxable year for the foreign corporation using the rules at IRC §898(c). This is discussed in Step 4.
• If no, the foreign corporation is not a specified foreign corporation (because it does not have a majority U.S. shareholder) even though it is a controlled foreign corporation. Use the foreign corporation’s taxable year as determined under IRC §441 at step 1.

Step 4: identify the IRC §898 accounting period

If you have a specified foreign corporation, IRC §898(c) imposes a simple, mechanical rule: the specified foreign corporation is required to use the same taxable year as its majority U.S. shareholder. IRC §898(c)(1)(A).

• If there is only one United States shareholder who owns more than 50% of the specified foreign corporation’s stock, life is easy: use the United States shareholder’s taxable year and insert it into the top of Form 5471.
• If there are multiple majority U.S. shareholders and they all have the same taxable year, again life is easy: use that taxable year for the specified foreign corporation at the top of Form 5471.
• On the other hand, if you have multiple United States shareholders who each own more than 50% of the specified foreign corporation’s stock (because of constructive ownership rules), proceed to Step 5. You will have to pick the CFC’s taxable year based on a math problem.

Step 5: If two majority owners have different year-ends

Remember that a “majority U.S. shareholder” is any U.S. person who owns > 50 % (vote or value) on every testing day. IRC §898(c)(3).

Through the magic of constructive ownership rules it is easy to see that you might have multiple majority U.S. shareholders. What if they have different taxable years?

The statute punts to the regulations, and Prop. Reg. §1.898-3(a)(4)(i) supplies the tie-breaker rule:

If two or more majority U.S. shareholders have inconsistent taxable years, the required year is the taxable year that results in the least aggregate deferral of income to United States shareholders.

The formula for choosing the correct accounting period for the specified foreign corporation from all of the accounting periods of all of the U.S. shareholders is found at Prop. Reg. §1.898-4(a)(4)(ii).

Another testing day: ownership shift

There is a second testing day: anytime there is a big enough stock ownership shift for the foreign corporation so that it creates a new majority U.S. shareholder. Prop. Reg. §1.898-3(a)(5)(iii).

At that point, you stop and go through the analysis again. This might cause the specified foreign corporation to change its accounting period to match the accounting period of the new majority U.S. shareholder. Look at Prop. Reg. §1.898-3(a)(5)(iii) for how it’s done.

Conclusion

The accounting period for a foreign corporation will either be determined by IRC §441 (the default rule) or by IRC §898 (if the foreign corporation is a “specified foreign corporation”).

An accounting period required by IRC §898 will be the same as the accounting period of the majority U.S. shareholder, if there is only one.

If there are multiple majority U.S. shareholders, a math exercise—designed to minimize deferral of inclusion of income from the specified foreign corporation—will tell you which accounting period to select.

Thank you

This write-up is thanks to a suggestion by Joshua Maya. Thanks for the idea.

See you in a couple of weeks.