A simple explanation of tested interest expense for IRC §951AAugust 25, 2020 - Phil HodgenAmerican Business Abroad, Form 5471
Here is a simple explanation of “tested interest expense” — one of the variables you will compute when calculating how much global intangible low-taxed income will be included in a U.S. shareholder’s gross income because of IRC §951A(a).
The example will show you how to prepare both forms, and what the numbers mean, including how to deal with the interest deduction and its later add-back into the calculations.
Completed sample Form 5471, Schedule I-1 and Form 8992 can be found within my August 2020 International Tax Lunch slides.
IRC §951A(a) makes a U.S. shareholder include (most of) a CFC’s net income in the shareholder’s U.S. gross income, and therefore inflates the shareholder’s U.S. income tax bill.
When there is active financing activity (i.e., this is the business of the CFC, as a finance company or insurance company), borrowing can distort the amount of the CFC’s tested income that is excluded from the shareholder’s gross income. And by that I mean the CFC can artificially inflate its “Deemed Tangible Investment Return”.
The government might reasonably want to stop this.
Here’s the game. The CFC borrows a lot of money and generates income that falls within the “gross tested income” category — thus creating potential income inclusion under IRC §951A.
Now the CFC has two tax deductible expenses that can reduce net profit (and therefore the inclusion amount that appears on the shareholder’s U.S. income tax return):
- Interest expense (the loan proceeds are used to buy a bunch of depreciable assets); and
- Depreciation expense (e.g., the CFC has a lot of depreciable assets bought with borrowed money).
IRC §951A fixes the problem in a “The Lord giveth, the Lord taketh away” manner. You can see it in action on Form 5471, Schedule I-1, line 5 (for the interest expense deduction allowed) and 9b (for the interest add-back).
From the preamble to the Final Regulations published to cover this topic:
“The reduction for qualified interest expense and qualified interest income is intended to neutralize the effect of interest expense and interest income attributable to the active conduct of a financing or insurance business on a U.S. shareholder’s net DTIR. For example, absent the rule for qualified interest expense, the third-party interest expense of a captive finance company—to the extent its interest expense exceeds its interest income—could inappropriately increase specified interest expense (and thus reduce the net DTIR) of its U.S. shareholder.”
Guidance Related to Section 951A (Global Intangible Low-Taxed Income) and Certain Guidance Related to Foreign Tax Credits, 6/19/2019, 84 FR 29288.
Take this as an example.
A CFC has one U.S. shareholder who owns 100% of its stock.
The CFC starts the year with a clean balance sheet: no assets, no liabilities, no capital contributions.
The CFC borrows $20,000 to buy equipment. It uses the equipment to generate gross income of $20,000.
The CFC ends the year with a balance sheet consisting of:
- Cash = $19,000
- Equipment = $20,000
- Less deprecation ($2,000)
- Total assets = $37,000
- Loan payable = $20,000
- Total liabilities = $20,000
- Capital contribution = $0
- Retained earnings = $17,000
- Total equity = $17,000
The profit and loss statement for the CFC is:
- Gross income = $20,000
- Less interest expense = ($1,000)
- Less depreciation expense = ($2,000)
- Net income = $17,000
Form 5471, Schedule I-1
Let’s prepare Form 5471, Schedule I-1 and Form 8992 with a specific aim of highlighting how you deal with the interest expense. First, let’s do Form 5471, Schedule I-1.
Line 1. Gross Income
Start with the CFC’s gross income: $20,000.
Just so you know, the way you compute a CFC’s gross income is by pretending it is a domestic corporation and doing your tax accounting magic. Regs. §1.951A-2(c)(2)(i) tells you to apply Regs. §1.952-2, and Regs. §1.952-2(a)(1) tells you to treat a CFC like a domestic corporation to compute its gross income.
Lines 2, 3. Exclusions from Gross Income
The gross income in this example will not be included in any of the categories listed on Form 5471, Schedule I-1, lines 2a through 2e, by heroic assumption. Otherwise, we would be here all day, chasing squirrels.
Line 4. Gross Tested Income
As a result, the CFC has $20,000 of gross tested income on Form 5471, Schedule I-1, line 4.
Line 5. Allocable Deductions
The CFC has two expense deductions:
- Depreciation on the equipment of $2,000; and
- Interest expense on the loan of $1,000.
Both of these expenses are allocated to the CFC’s gross tested income, because the CFC did not have any other types of income (Form 5471, Schedule I-1, lines 2a through 2e are all zero). Therefore, the CFC’s allocable deductions will be $3,000 on Form 5471, Schedule I-1, line 5.
Line 6. Tested Income
Tested income for the CFC is therefore $17,000. (Form 5471, Schedule I-1, line 6). This is simple subtraction.
This is the first of three numbers that will be important on Form 8992.
A Detour for Context
The amount of global intangible low-taxed income included in the shareholder’s income is “tested income” minus “net deemed tangible investment return”.
The bigger that second number (net deemed tangible investment return) the smaller the amount of income that must be included on the shareholder’s income tax return because of IRC §951A(a).
The shareholder, then, has an incentive to make net deemed tangible investment return as large as possible.
This is where things start to get relevant to the government’s original problem: how to prevent CFCs from borrowing wildly to take an interest expense deduction and over-inflate “net deemed tangible investment return”.
Let’s see how it’s done.
Back to Form 5471, Schedule I-1
Line 7. Tested foreign income taxes
Not part of our example. The CFC is, let’s assume, operating in a tax-free jurisdiction.
Line 8. Qualified Business Asset Investment
This is a number that approximates the adjusted basis of depreciable assets used by the CFC in generating the type of income that ends up being included in a shareholder’s income because of IRC §951A.
I say it that way because the adjusted basis calculation is a quarterly average calculation.
Look at IRC §951(d) and Regs. §1.951A-3 for the details.
For our purposes, however, let’s assume that Qualified Business Asset Investment = $18,000. The depreciable asset cost $20,000 to buy, and the CFC took $2,000 depreciation in the tax year.
(Yes this is wrong. I didn’t do a quarterly average calculation of adjusted basis then take the average of the quarterly adjusted basis calculations. Go see Regs. §1.951A-3(e) if you want to know how to do it right.)
Put $18,000 on line 8.
This is the second of three numbers that will be entered on Form 8992.
Line 9a. Interest Expense Included on Line 5
Finally, we are at the part of the story that we care about: how to deal with interest expense when calculating the global intangible low-taxed income inclusion.
We start with the actual amount of interest expense for the CFC that is included in the deductions allocated to the CFC’s business activities that generated gross tested income. (Form 5471, Schedule I-1, line 9a).
This amount, in our example, is $1,000.
Line 9b. Qualified Interest Expense
Next, we will calculate “qualified interest expense”. This is a fairly benign example of tax law.
Qualified interest expense is defined in Regs. §1.951A-4(b)(1)(iii)(A):
The term qualified interest expense means, with respect to a controlled foreign corporation for a CFC inclusion year, to the extent established by the controlled foreign corporation, the interest expense paid or accrued by the controlled foreign corporation that is allocated and apportioned to gross tested income of the controlled foreign corporation for the CFC inclusion year under §1.951A-2(c)(3), multiplied by a fraction, the numerator of which is the average of the aggregate adjusted bases as of the close of each quarter of the CFC inclusion year of qualified assets held by the controlled foreign corporation, and the denominator of which is the average of the aggregate adjusted bases as of the close of each quarter of the CFC inclusion year of all assets held by the controlled foreign corporation.
That’s some janky prose, isn’t it? Here’s my explanation of “qualified interest expense”:
- Take the interest expense allocated to gross tested income. You will find that number as part of the total that is listed on Form 5471, Schedule I-1, line 5.
- Multiply the interest expense amount you got from line 5 by a fraction: (weirdly calculated adjusted basis for the CFC’s “qualified assets”) / (weirdly calculated adjusted basis for all of the CFC’s assets).
We have a formula, but we have an undefined variable nested deep in that janky sentence from the Regulations: “qualified assets”. Those assets are defined in Regs. §1.951A-4(b)(1)(iii)(B)(1):
Except as provided in paragraph (b)(1)(iii)(B)(2) of this section, the term qualified asset means, with respect to a controlled foreign corporation for a CFC inclusion year, any obligation or financial instrument held by the controlled foreign corporation that gives rise to income included in the gross tested income of the controlled foreign corporation for the CFC inclusion year that is excluded from foreign personal holding company income (as defined in section 954(c)(1)) by reason of section 954(c)(2)(C)(ii) or section 954(h) or (i).
Your tax money paid for prose like that. Here. Let me help. A qualified asset is a receivable of some kind where the CFC is the creditor. The receivable generates income. And the income is not:
- A “related party receivable” (that is the meaning of the exception at the beginning, referring to Reg. §1.951A-4(b)(1)(iii)(B)(2); and it is not
- A receivable that generates income which would be treated as foreign personal holding company income (because then the income generated on the receivable would be Subpart F income).
Back to the example.
The CFC paid $1,000 of interest, and that interest expense is allocated and apportioned to gross tested income. (Form 5471, Schedule I-1, line 9a).
The CFC’s “qualified assets” will be zero, because the CFC does not hold any obligations that generate income of any kind.
Therefore the formula for calculating “qualified interest expense” is:
$1,000 * ($0 / $10,000) = zero.
In words carefully enhanced with dollar values, the formula for calculating “qualified interest expense” is:
Interest expense incurred (and reflected on Form 5471, Schedule I-1, line 5) multiplied by (qualified assets = $0 divided by total assets = $10,000) equals zero.
The fraction will be zero because the numerator is zero. Put a zero on Form 5471, Schedule I-1, line 9b.
Line 9c. Tested Loss QBAI Amount
Remember how I said that “net deemed tangible investment return” is “qualified business asset investment” reduced by “tested interest expense”?
Actually, “net deemed tangible investment return” equals “qualified business asset investment” reduced by TWO things:
- tested interest expense; and
- Tested loss QBAI amount.
“Tested loss QBAI amount” is defined in Regs. §1.951A-4(b)(1)(iv). You will have a number here if the CFC operates at a loss for the tax year. You will not have a number here if the CFC is profitable for the tax year.
In order to keep this blog post mercifully brief, I am going to ignore this item.
Line 9d. Tested Interest Expense
Tested interest expense (Form 5471, Schedule I-1, line 9d) is then a simple subtraction exercise. Put $1,000 on line 9d: the amount of interest expense actually incurred, reduced by zero.
This is the third and final number we need to take over to Form 8992.
Line 10a – Line 10c. Let’s Ignore These
Are you sensing a pattern? Anything out of bounds or remotely complicated, I ignore it.
Now that you have your “tested interest expense” item, let’s figure out the shareholder’s gross income inclusion under IRC §951A(a).
The computations happen on Form 8992 and its attached Schedule A.
Schedule A is an organizing tool. Form 8992 itself is where the magic happens. On Form 8992, you will see the two essential numbers calculated that you will need to compute the global intangible low-taxed income:
- Net CFC tested income (Form 8992, Part I, line 3); and
- Net Deemed Tangible Investment Return (Form 8992, Part II, line 4).
Form 8992 is organized the way it is because it assumes that a taxpayer is a United States shareholder in dozens and dozens of CFCs. Some of the CFCs operate at a loss, some at a profit. Form 8992 (and Schedule A) carefully distill the operating results from all of those CFCs in order to end up with the magic number:
- Global Intangible Low-Taxed Income (Form 8992, Part II, line 5).
My example is for normal life: one American human owns all of the stock of one CFC.
Form 8992, Schedule A
Here is where the numbers come from for Form 8992, Schedule A:
|From Form 5471, Schedule I-1 (line)||To Form 8992, Schedule A (column)||Comment|
|e||Multiply (c) by the shareholder’s stock ownership|
|8||g||Enter the shareholder’s pro rata share directly|
|9d||j||Enter the shareholder’s pro rata share directly|
Form 8992, Part I. Net Tested Income
Part I is how you combine the operating results for all of the CFCs that generated profits (line 1) with the operating results for all of the CFCs that generated losses (line 2).
Line 3 is your bottom line. You can never have negative global intangible low-taxed income, so if the sum of line 1 and line 2 is zero or less, put a zero here.
In my example, the CFC had tested income of $17,000. That goes on line 1, and by assumption there are no CFCs owned by the taxpayer that generated losses (line 2).
Therefore, net CFC tested income (line 3) is $17,000.
Form 8992, Part II. Global Intangible Low-Taxed Income
Line 1 simply carries net CFC tested income down from Part I, line 3.
Interesting stuff happens on lines 2 through 4. This is where we calculate the amount by which we reduce CFC tested income and thereby reduce the amount of global intangible low-taxed income that drops onto the U.S. shareholder’s Federal income tax return.
Line 2 asks you to take the shareholder’s pro rata share of Qualified Business Asset Investment and multiply it by 10%. IRC §951A(b)(2)(A). This is the theoretical maximum amount by which we would reduce net CFC tested income in order to compute global intangible low-taxed income.
The shareholder’s pro rata share of Qualified Business Asset Investment comes from Form 8992, Schedule A, column (g), line 1.
The example has $18,000 of Qualified Business Asset Investment on Schedule A. Multiply that by 10% and we enter $1,800 on line 2.
Line 3a is the add-back. The $1,800 potential reduction in net CFC tested income is reduced by the $1,000 tested interest expense that we calculated on Form 5471, Schedule I-1, then transferred to Form 8992, Schedule A, column (j).
Line 3b is not applicable in this example.
Line 3c is “Specified Interest Expense” and this is the actual reduction that applies to Deemed Tangible Investment Return. It is the net of line 3a and line 3b. Since in this example line 3b is zero, the total on line 3c equals the amount on line 3a.
Line 4 is a subtraction. This is where the Deemed Tangible Investment Return of $1,800 (which would reduce net CFC tested income, thereby reducing global intangible low-taxed income) is itself reduced by the $1,000 tested interest expense (reducing the reduction in net CFC tested income, thereby increasing global intangible low-taxed income).
The number here is $800. Line 2 ($1,800) minus line 3c ($1,000) equals $800.
Line 5 is the gross income inclusion amount required by IRC §951A(a). Line 1 ($17,000) minus line 4 ($800) equals $16,200. This is the amount that drops onto the U.S. shareholder’s Federal income tax return.
The new tax law in 2017 added complexity. As the saying goes, “over any considerable period of time, it gets worse, never better.” That’s my experience in watching the Internal Revenue Code since 1982.
This little example has just highlighted just one of the complexities: the interaction of interest expense deductions with the calculation of the IRC §951A(a) gross income inclusion. And it’s not even a terribly complicated example.
This blog post was created as supporting material for my August 14, 2020 International Tax Lunch: “A Guide to Global Intangible Low-Taxed Income (Section 951A)”.
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