U.S. Income Tax Return of a Foreign Corporation

Additional Information Required

Be sure to complete all items at the bottom of page 2 of Form 1120-F that apply to the corporation.

Item M - Personal Holding Company

See the instructions for line 4 on page 8.

Item O - Personal Service Corporation

A personal service corporation is a corporation whose principal activity (defined below) for the testing period for the tax year is the performance of personal services. The services must be substantially performed by employee-owners. Employee-owners must own more than 10% of the fair market value of the corporation's outstanding stock on the last day of the testing period.

Testing period. Generally, the testing period for a tax year is the prior tax year. The testing period for a new corporation starts with the first day of its first tax year and ends on the earlier of:

• The last day of its first tax year or
• The last day of the calendar year in which the first tax year began.

Principal activity. The principal activity of a corporation is considered to be the performance of personal services if, during the testing period, the corporation's compensation costs for the performance of personal services, are more than 50% of its total compensation costs.

Performance of personal services. Personal services are those performed in the health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting fields (as defined in Temporary Regulations section 1.448-1T(e)). The term performance of personal services includes any activity involving the performance of personal services in these fields.

Substantial performance by employee-owners. Personal services are substantially performed by employee-owners if, for the testing period, more than 20% of the corporation's compensation costs for the performance of personal services are for services performed by employee-owners.

Employee-owner. A person is considered to be an employee-owner if the person:

• Is an employee of the corporation on any day of the testing period and
• Owns any outstanding stock of the corporation on any day of the testing period.

Stock ownership is determined under the attribution rules of section 318, except that any is substituted for 50% in section 318(a)(2)(C).

Accounting period. A personal service corporation must use a calendar tax year unless:

• It can establish a business purpose for a different tax year (see Rev. Proc. 87-32, 1987-2 C.B. 396, and Rev. Rul 87-57, 1987-2 C.B. 117) or
• It elects under section 444 to have a tax year other than a calendar year. To make the election, see Form 8716, Election To Have a Tax Year Other Than a Required Tax Year.

Personal service corporations that want to change their tax year must also file Form 1128.

If a corporation makes the section 444 election, its deduction for certain amounts paid to employee-owners may be limited. See Schedule H (Form 1120), Section 280H Limitations for a Personal Service Corporation (PSC), to figure the maximum deduction.

If a section 444 election is terminated and the termination results in a short tax year, type or print at the top of the first page of Form 1120-F for the short tax year, SECTION 444 ELECTION TERMINATED. See Temporary Regulations section 1.444-1T(a)(5) for more information.

For more information about personal service corporations, see Temporary Regulations section 1.441-4T.

Other rules. For other rules that apply to personal service corporations, see Passive activity limitations on page 11 and Contributions of property other than cash on page 13.

Item P

Show any tax-exempt interest received or accrued. Include any exempt-interest dividends received as a shareholder in a mutual fund or other RIC.

Item R

Check this box if the corporation elects under section 172(b)(3) to forego the carryback period for a net operating loss (NOL). To be valid, the election must be made by the due date (including extensions) for filing Form 1120-F. If the corporation checks this box, do not attach the statement described in Temporary Regulations section 301.9100-12T(d).

Item S

Enter the amount of the NOL carryover to the tax year from prior years, even if some of the loss is used to offset income on this return. The amount to enter is the total of all NOLs generated in prior years but not used to offset income (either as a carryback or carryover) to a tax year prior to 2001. Do not reduce the amount by any NOL deduction reported on page 3, Section II, line 30a.

Item T

Check the Yes box if the corporation is a subsidiary in a parent-subsidiary controlled group. This applies even if the corporation is a subsidiary member of one group and the parent corporation of another.

Note: If the corporation is an excluded member of a controlled group (see section 1563(b)(2)), it is still considered a member of a controlled group for this purpose.

A parent-subsidiary controlled group is one or more chains of corporations connected through stock ownership (section 1563(a)(1)). Both of the following requirements must be met.

1. At least 80% of the total combined voting power of all classes of voting stock or at least 80% of the total value of all classes of stock of each corporation in the group (except the parent) must be owned by one or more of the other corporations in the group and
2. The common parent must own at least 80% of the total combined voting power of all classes of voting stock or at least 80% of the total value of all classes of stock of at least one of the other corporations in the group. Stock owned directly by other members of the group is not counted when computing the voting power or value.

See section 1563(d)(1) for the definition of stock for purposes of determining the stock ownership above.

Section II - Income Effectively Connected With the Conduct of a Trade or Business in the United States

Foreign Corporations Engaged in a U.S. Trade or Business

These corporations are taxed on their effectively connected income using the same graduated tax rate schedule (see page 17) that applies to domestic corporations. Effectively connected income can be U.S. source or foreign source as explained below.

U.S. Source Effectively Connected Income

Fixed or determinable, annual or periodic (FDAP) items are generally effectively connected income (and are therefore includible in Section II) if the asset-use test, the business-activities test, or both tests (explained below) are met.

If neither test is met, FDAP items are generally not effectively connected income (and are therefore includible in Section I instead of Section II). For more information, see section 864(c)(2) and Regulations section 1.864-4(c).

U.S. source income other than FDAP items is effectively connected income.

Asset-use test. The FDAP items are from assets used in, or held for use in, the conduct of U.S. trade or business. For example, the following items are effectively connected income:

• Income earned on a trade or note receivable acquired in the conduct of the U.S. trade or business and
• Interest income earned from the temporary investment of funds needed in the foreign corporation's U.S. trade or business.

Business-activities test. The activities of the U.S. trade or business were a material factor in the realization of the FDAP items.

Foreign Source Effectively Connected Income

Foreign source income is generally not effectively connected income. However, if the foreign corporation has an office or other fixed place of business in the United States, the following types of foreign source income it receives from that U.S. office are effectively connected income:

• Rents or royalties received for the use outside the United States of intangible personal property described in section 862(a)(4) if from the active conduct of a U.S. trade or business;
• Dividends or interest from foreign sources if from the active conduct of a U.S. banking, financing, or similar business or if the principal business of the foreign corporation is trading in stocks or securities for its own account; or
• Income from the sale or exchange of inventory outside the United States through the U.S. office, unless the property is sold or exchanged for use, consumption, or disposition outside the United States and an office of the foreign corporation in a foreign country materially participated in the sale.

See section 864(c)(5)(A) and Regulations section 1.864-7 for the definition of office or other fixed place of business in the United States. See sections 864(c)(5)(B) and (C) and Regulations section 1.864-6 for special rules for determining when foreign source income received by a foreign corporation is from an office or other fixed place of business in the United States.

Foreign insurance companies. Foreign source income of a foreign insurance company that is attributable to its U.S. trade or business is effectively connected income.

Excluded foreign source income. Foreign source income that would otherwise be effectively connected income under any of the above rules for foreign source income is excluded if:

• It is foreign source dividends, interest, or royalties paid by a foreign corporation in which the taxpayer owns or is considered to own (within the meaning of section 958) 50% or more of the total combined voting power of all classes of stock entitled to vote or
• The taxpayer is a controlled foreign corporation (as defined in section 957) and the foreign source income is subpart F income (as defined in section 952).

For more information, see section 864(c)(4) and Regulations section 1.864-5.

Foreign Corporations Not Engaged in a U.S. Trade or Business

Report income in Section II only if these corporations:

• Had current year income or gain from a sale or exchange of property or from performing services (or any other transaction) in any other tax year and would have been effectively connected income in that other tax year (see section 864(c)(6));
• Had current year income or gain from a disposition of property that is no longer used or held for use in conducting a U.S. trade or business within the 10-year period before the disposition and would have been effectively connected income immediately before such cessation (see section 864(c)(7));
• Elected to treat real property income as effectively connected income (see below);
• Were created or organized and are conducting a banking business in a U.S. possession, and receive interest on U.S. obligations that is not portfolio interest (see section 882(e)); or
• Had gain or loss from disposing of a U.S. real property interest (see below).

Election To Treat Real Property Income as Effectively Connected Income

A foreign corporation that receives, during the tax year, any income from real property located in the United States, or from any interest in such real property, may elect, for the tax year, to treat all such income as effectively connected income. Income to which this election applies includes:

• Gains from the sale or exchange of real property or an interest therein,
• Rents or royalties from mines, wells, or other natural deposits, and
• Gain described in sections 631(b) or (c).

The election may be made whether or not the corporation is engaged in a U.S. trade or business during the tax year for which the election is made or whether or not the corporation has income from real property that, for the tax year, is effectively connected with the conduct of a U.S. trade or business.

To make the election, attach a statement that includes the information required in Regulations section 1.871-10(d)(1)(ii) to Form 1120-F for the first tax year for which the election is to apply. Use Section II to figure the tax on this income.

Disposition of U.S. Real Property Interest by a Foreign Corporation

A foreign corporation that disposes of a U.S. real property interest (as defined in section 897(c)) must treat the gain or loss from the disposition as effectively connected income, even if the corporation is not engaged in a U.S. trade or business. Figure this gain or loss on Schedule D (Form 1120), Capital Gains and Losses. Carry the result to Section II, line 8, on page 3 of Form 1120-F.

A foreign corporation may elect to be treated as a domestic corporation for purposes of sections 897 and 1445. See sections 897(i) and 882(d).

See Temporary Regulations section 1.897-5T for the applicability of section 897 to reorganizations and liquidations.

If the corporation had income tax withheld on Form 8288-A, include the amount withheld in line 6h, page 1.

Income

Line 1. Gross Receipts

Enter gross income effectively connected with the conduct of a U.S. trade or business (except those income items that must be reported on lines 4 through 10). In general, advance payments are reported in the year of receipt. To report income from long-term contracts, see section 460. For special rules for reporting advance payments for goods and long-term contracts, see Regulations section 1.451-5. For permissible methods for reporting advance payments for services by an accrual method corporation, see Rev. Proc. 71-21, 1971-2 C.B. 549.

Installment sales. Generally, the installment method cannot be used for dealer dispositions of property. A dealer disposition is (a) any disposition of personal property by a person who regularly sells or otherwise disposes of personal property of the same type on the installment plan or (b) any disposition of real property held for sale to customers in the ordinary course of the taxpayer's trade or business.

These restrictions on using the installment method do not apply to dispositions of property used or produced in a farming business or sales of timeshares and residential lots for which the corporation elects to pay interest under section 453(l)(3).

For sales of timeshares and residential lots reported under the installment method, the corporation's income tax is increased by the interest payable under section 453(l)(3). To report this addition to the tax, see the instructions for Schedule J, line 9 on page 18.

Enter on line 1 (and carry to line 3), the gross profit on collections from installment sales for any of the following:

• Dealer dispositions of property before March 1, 1986.
• Dispositions of property used or produced in the trade or business of farming.
• Certain dispositions of timeshares and residential lots reported under the installment method.

Attach a schedule showing the following information for the current and the 3 preceding years: (a) gross sales, (b) cost of goods sold, (c) gross profits, (d) percentage of gross profits to gross sales, (e) amount collected, and
(f) gross profit on the amount collected.

Nonaccrual experience method. Accrual method taxpayers do not need to accrue certain amounts to be received from the performance of services that, on the basis of their experience, will not be collected (section 448(d)(5)). This provision does not apply to any amount if interest is required to be paid on that amount or if there is any penalty for failure to timely pay the amount. Corporations that fall under this provision should attach a schedule showing total gross receipts, the amount not accrued as a result of the application of section 448(d)(5), and the net amount accrued. Enter the net amount on line 1a. For more information and guidelines on this nonaccrual experience method, see Temporary Regulations section 1.448-2T.

Line 2. Cost of Goods Sold

See the instructions for Schedule A on page 15.

Line 4. Dividends

See the instructions for Schedule C on page 16.

Line 5. Interest

Enter taxable interest on U.S. obligations and on loans, notes, mortgages, bonds, bank deposits, corporate bonds, tax refunds, etc.

Do not offset interest expense against interest income.

Line 6. Gross Rents

Enter the gross amount received for the rental of property. Deduct expenses such as repairs, interest, taxes, and depreciation on the proper lines for deductions. A rental activity held by a closely held corporation or a personal service corporation may be subject to the passive activity loss rules. See Form 8810 and its instructions.

Line 8. Capital Gain Net Income

Every effectively connected sale or exchange of a capital asset must be reported in detail on Schedule D (Form 1120), even if there is no gain or loss.

Line 10. Other Income

Enter any other taxable income not reported on lines 1 through 9. List the type and amount of income on an attached schedule. If the corporation has only one item of other income, describe it in parentheses on line 10. Examples of other income to report on line 10 are:

• Recoveries of bad debts deducted in prior years under the specific charge-off method.
• The amount of credit for alcohol used as fuel (determined without regard to the limitation based on tax) that was entered on Form 6478, Credit for Alcohol Used as Fuel.
• Refunds of taxes deducted in prior years to the extent they reduced income subject to tax in the year deducted (see section 111). Do not offset current year taxes against tax refunds.
• The amount of any deduction previously taken under section 179A that is subject to recapture. The corporation must recapture the benefit of any allowable deduction for clean-fuel vehicle property (or clean-fuel vehicle refueling property), if the property later ceases to qualify. See Regulations section 1.179A-1 for details.
• Ordinary income from trade or business activities of a partnership (from Schedule K-1 (Form 1065 or 1065-B)). Do not offset ordinary losses against ordinary income. Instead, include the losses on line 27. Show the partnership's name, address, and EIN on a separate statement attached to this return. If the amount entered is from more than one partnership, identify the amount from each partnership.

Deductions

Important. In computing the taxable income of a foreign corporation engaged in a U.S. trade or business, deductions are allowed only if they are connected with income effectively connected with the conduct of a trade or business in the United States. Charitable contributions, however, may be deducted whether or not they are so connected. See section 882(c) and Regulations section 1.882-4(b) for more information.

Apportionment of Expenses

Expenses that are directly related to a class of gross income (including tax-exempt income) must be allocated to that class of gross income. Expenses not directly related to a class of gross income should be allocated to all classes of income based on the ratio of gross income in each class of income to total gross income, or some other ratio that clearly relates to the classes of income. See Regulations section 1.861-8 and Temporary Regulations section 1.861-8T for more information.

Attach a schedule showing each class of gross income, and the expenses directly allocable to each class. For expenses that are not directly allocable to a class of gross income, show the computation of the expense allocated to each class.

Limitations on Deductions

Section 263A uniform capitalization rules. The uniform capitalization rules of section 263A require corporations to capitalize, or include in inventory, certain costs incurred in connection with:

• The production of real and tangible personal property held in inventory or held for sale in the ordinary course of business.
• Real property or personal property (tangible and intangible) acquired for resale.
• The production of real property and tangible personal property by a corporation for use in its trade or business or in an activity engaged in for profit.

Tangible personal property produced by a corporation includes a film, sound recording, video tape, book, or similar property.

Corporations subject to these rules are required to capitalize:

1. Direct costs and
2. An allocable portion of most indirect costs (including taxes) that (a) benefit the assets produced or acquired for resale or
   (b) are incurred by reason of the performance of production or resale activities.

For inventory, some of the indirect expenses that must be capitalized are:

• Administration expenses.
• Taxes.
• Depreciation.
• Insurance.
• Compensation paid to officers attributable to services.
• Rework labor.
• Contributions to pension, stock bonus, and certain profit-sharing, annuity, or deferred compensation plans.

Regulations section 1.263A-1(e)(3) specifies other indirect costs that relate to production or resale activities that must be capitalized and those that may be currently deductible.

Interest expense paid or incurred during the production period of designated property must be capitalized and is governed by special rules. For more details, see Regulations sections 1.263A-8 through 1.263A-15.

The costs required to be capitalized under section 263A are not deductible until the property (to which the costs relate) is sold, used, or otherwise disposed of by the corporation.

Exceptions. Section 263A does not apply to:

• Personal property acquired for resale if the corporation's annual average gross receipts for the 3 prior tax years are $10 million or less.
• Timber.
• Most property produced under a long-term contract.
• Certain property produced in a farming business.
• Research and experimental costs under section 174.
• Intangible drilling costs for oil, gas, and geothermal property.
• Mining exploration and developmental costs.
• Inventoriable items accounted for in the same manner as materials and supplies that are not incidental. See Schedule A - Cost of Goods Sold on page 15 for details.

For more details on the uniform capitalization rules, see Regulations sections 1.263A-1 through 1.263A-3. See Regulations section 1.263-4 for rules for property produced in a farming business.

Transactions between related taxpayers. Generally, an accrual basis taxpayer may only deduct business expenses and interest owed to a related party in the year the payment is included in the income of the related party. See sections 163(e)(3), 163(j), and 267 for limitations on deductions for unpaid interest and expenses.

Section 291 limitations. Corporations may be required to adjust deductions for depletion of iron ore and coal, intangible drilling and exploration and development costs, certain deductions for financial institutions, and the amortizable basis of pollution control facilities. See section 291 to determine the amount of adjustment. Also see section 43.

Golden parachute payments. A portion of the payments made by a corporation to key personnel that exceeds their usual compensation may not be deductible. This occurs when the corporation has an agreement (golden parachute) with these key employees to pay them these excess amounts if control of the corporation changes. See section 280G.

Business startup expenses. Business startup expenses must be capitalized unless an election is made to amortize them over a period of 60 months. See section 195 and Regulations section 1.195-1.

Passive activity limitations. Limitations on passive activity losses and credits under section 469 apply to personal service corporations as defined in Temporary Regulations section 1.441-4T (see Item O - Personal Service Corporation on page 9, and Closely held corporations on page 12.

Generally, two kinds of passive activities are:

• Trade or business activities in which the corporation did not materially participate for the tax year (see Temporary Regulations section 1.469-1T(g)(3)) and
• Rental activities regardless of its participation.

For exceptions, see Form 8810.

An activity is a trade or business activity if the activity is not a rental activity, and

• The activity involves the conduct of a trade or business (i.e., deductions from the activity would be allowable under section 162 if other limitations, such as the passive loss rules, did not apply) or
• The activity involves research and experimental costs that are deductible under section 174 (or would be deductible if the corporation chose to deduct rather than capitalize them).

Corporations subject to the passive activity limitations must complete Form 8810 to compute their allowable passive activity loss and credit. Before completing Form 8810, see Temporary Regulations section 1.163-8T, which provides rules for allocating interest expense among activities. If a passive activity is also subject to the earnings stripping rules of section 163(j) or the at-risk rules of section 465, those rules apply before the passive loss rules. For more information, see section 469, the related regulations, and Pub. 925, Passive Activity and At-Risk Rules.

Closely held corporations. For this purpose, a corporation is a closely held corporation if:

• At any time during the last half of the tax year more than 50% in value of its outstanding stock is owned, directly or indirectly, by or for not more than five individuals and
• The corporation is not a personal service corporation.

Certain organizations are treated as individuals for purposes of this test. See section 542(a)(2). For rules of determining stock ownership, see section 544 (as modified by section 465(a)(3)).

Reducing certain expenses for which credits are allowable. For each credit listed below, the corporation must reduce the otherwise allowable deductions for expenses used to figure the credit by the amount of the current year credit.

• Work opportunity credit.
• Research credit.
• Enhanced oil recovery credit.
• Disabled access credit.
• Empowerment zone employment credit.
• Indian employment credit.
• Employer credit for social security and Medicare taxes paid on certain employee tips.
• Orphan drug credit.
• Welfare-to-work credit.

If the corporation has any of these credits, figure each current year credit before figuring the deduction for expenses on which the credit is based.

Line 12. Compensation of Officers

Complete Schedule E if total receipts (line 1a, plus lines 4 through 10, on page 3 of Form 1120-F) are $500,000 or more. Do not include compensation deductible elsewhere on the return, such as amounts included in cost of goods sold, elective contributions to a section 401(k) cash or deferred arrangement, or amounts contributed under a salary reduction SEP agreement or a SIMPLE IRA plan.

Include only the deductible part of each officers' compensation on Schedule E. (See Disallowance of deduction for employee compensation in excess of $1 million below.) Complete Schedule E, line 1, columns (a) through (f), for all officers. The corporation determines who is an officer under the laws where it is incorporated.

Disallowance of deduction for employee compensation in excess of $1 million. Publicly held corporations may not deduct compensation to a covered employee to the extent that the compensation exceeds $1 million. Generally, a covered employee is:

• The chief executive officer of the corporation (or an individual acting in that capacity) as of the end of the tax year or
• An employee whose total compensation must be reported to shareholders under the Securities Exchange Act of 1934 because the employee is among the four highest compensated officers for that tax year (other than the chief executive officer).

For this purpose, compensation does not include the following:

• Income from certain employee trusts, annuity plans, or pensions and
• Any benefit paid to an employee that is excluded from the employee's income.

The deduction limit does not apply to:

• Commissions based on individual performance,
• Qualified performance-based compensation, and
• Income payable under a written, binding contract in effect on February 17, 1993.

The $1-million limit is reduced by amounts disallowed as excess parachute payments under section 280G.

For details, see section 162(m) and Regulations section 1.162-27.

2001 Instructions Index | 2001 Tax Forms Main | IRS-Forms Main | Home