Instructions for Form 1120-F (2006)

Specific Instructions

This is archived information that pertains only to the 2006 Tax Year. If you
are looking for information for the current tax year, go to the Tax Prep Help Area.

Table of Contents

Period Covered

File the 2006 return for calendar year 2006 and fiscal years that begin in 2006 and end in 2007. For a fiscal or short tax year return, fill in the tax year space at the top of the form.

The 2006 Form 1120-F may also be used if:

The corporation has a tax year of less than 12 months that begins and ends in 2007 and
The 2007 Form 1120-F is not available at the time the corporation is required to file its return.

The corporation must show its 2007 tax year on the 2006 Form 1120-F and take into account any tax law changes that are effective for tax years beginning after December 31, 2006.

Address

Include the suite, room, or other unit number after the street address. If the post office does not deliver mail to the street address and the corporation has a P.O. box, show the box number instead.

If the corporation receives its mail in care of a third party (such as an accountant or an attorney), enter on the street address line “C/O” followed by the third party's name and street address or P.O. box.

If a foreign address, enter the information in the following order: city, province or state, and country. Follow the country's practice for entering the postal code. Do not abbreviate the country's name.

Employer Identification Number (EIN)

Enter the corporation's EIN. If the corporation does not have an EIN, it must apply for one. An EIN may be applied for:

Online-Click on the EIN link at www.irs.gov/businesses/small. The EIN is issued immediately once the application information is validated.
By telephone at 1-800-829-4933 from 7:00 a.m. to 10:00 p.m. in the corporation's local time zone.
By mailing or faxing Form SS-4, Application for Employer Identification Number.

If the corporation has not received its EIN by the time the return is due, enter “Applied for” and the date you applied in the space for the EIN. For more details, see the instructions for Form SS-4.

The online application process is not yet available for corporations with addresses in foreign countries or Puerto Rico.

Initial Return, Final Return, Amended Return, Name Change, or Address Change

Check the applicable box(es).

Address change. If the corporation has changed its address since it last filed Form 1120-F (including a change to an “in care of” address), check the box for “Address change.”

If a change in address occurs after the return is filed, use Form 8822, Change of Address, to notify the IRS of the new address.

Computation of Tax Due or Overpayment

Line 5b. Estimated Tax Payments

Enter any estimated tax payments the corporation made for the tax year.

Beneficiaries of trusts. If the corporation is the beneficiary of a trust, and the trust makes a section 643(g) election to credit its estimated tax payments to its beneficiaries, include the corporation's share of the payment in the total for line 5b. Enter “T” and the amount on the dotted line next to the entry space.

Line 5c. Overpaid Estimated Tax

If the corporation overpaid estimated tax, it may be able to get a quick refund by filing Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax. The overpayment must be at least 10% of the corporation's expected income tax liability and at least $500. File Form 4466 after the end of the corporation's tax year, and no later than the 15th day of the third month after the end of the tax year. Form 4466 must be filed before the corporation files its tax return.

Line 5f. Credit for Tax Paid on Undistributed Capital Gains

Credit from Form 2439. Enter any credit from Form 2439, Notice to Shareholder of Undistributed Long-Term Capital Gains, for the corporation's share of the tax paid by a regulated investment company or a real estate investment trust on undistributed long-term capital gains included in the corporation's income. Attach Form 2439 to Form 1120-F.

Line 5g. Credit for Federal Tax on Fuels

Enter the credit from Form 4136, Credit for Federal Tax Paid on Fuels. Attach Form 4136 to Form 1120-F.

Credit for tax on ozone-depleting chemicals. Include on line 5g any credit the corporation is claiming under section 4682(g)(2) for tax on ozone-depleting chemicals. Write “ODC” on the dotted line to the left of the entry space.

Line 5i. Credit for Federal Telephone Excise Tax Paid

If the corporation was billed after February 28, 2003, and before August 1, 2006, for the federal telephone excise tax on long distance or bundled service, the corporation may be able to request a credit for the tax paid. The corporation had bundled service if its local and long distance service was provided under a plan that does not separately state the charge for local service. The corporation may not request the credit if it has already received a credit or refund from its service provider. If the corporation requests the credit, it may not ask its service provider for a credit or refund and must withdraw any request previously submitted to its provider.

The corporation may request the credit by attaching Form 8913, Credit for Federal Telephone Excise Tax Paid, showing the actual amount the corporation paid. The corporation also may be able to request the credit based on an estimate of the amount paid. See Form 8913 for details. In either case, the corporation must keep records to substantiate the amount of the credit requested.

Line 5j. Total Payments

Backup withholding. If the corporation had income tax withheld from any payments it received due to backup withholding, include the amount withheld in the total for line 5j. Do not include these amounts on line 5h. (Include on line 5h only amounts withheld under Chapter 3 of the Code.) Enter the amount withheld and the words “Backup Withholding” in the blank space in the right-hand column between lines 4 and 5j.

Line 6. Estimated Tax Penalty

If Form 2220 is attached, check the box on line 6 of Form 1120-F and enter any penalty on this line.

Line 9. Electronic Deposit of Refund

If the corporation has a refund of $1 million or more and wants it electronically deposited into its checking or savings account at any U.S. bank or other financial institution, complete Form 8302 and attach it to Form 1120-F.

Section I—Income From U.S. Sources Not Effectively Connected With the Conduct of a Trade or Business in the United States

Include in Section I amounts received by the foreign corporation that meet all of the following conditions.

The amount received is fixed or determinable, annual or periodic (FDAP) (see definition below).
The amount received is includible in the gross income of the foreign corporation. Therefore, receipts that are excluded from income (e.g., interest income received on state and local bonds that is excluded under section 103) would not be included as income in Section I.
The amount received is from U.S. sources (see Source of Income Rules on page 7).
The amount received is not effectively connected with the conduct of a U.S. trade or business (see Section II on page 10).
The amount received is not exempt (by Code) from taxation. For example, interest on deposits that are exempted by section 881(d) would not be included as income in Section I.

Amounts fixed or determinable, annual or periodic include:

Interest (other than original issue discount (OID) as defined in section 1273), dividends, rents, royalties, salaries, wages, premiums, annuities, compensation, and other FDAP gains, profits, and income. Certain portfolio interest is not taxable for obligations issued after July 18, 1984. See section 881(c) for more details.
Gains described in section 631(b) or (c), relating to disposal of timber, coal, or domestic iron ore with a retained economic interest.
On a sale or exchange of an OID obligation, the amount of the OID accruing while the obligation was held by the foreign corporation, unless this amount was taken into account on a payment.
On a payment received on an OID obligation, the amount of the OID accruing while the obligation was held by the foreign corporation, if such OID was not previously taken into account and if the tax imposed on the OID does not exceed the payment received less the tax imposed on any interest included in the payment received. This rule applies to payments received for OID obligations issued after March 31, 1972.

Certain OID is not taxable for OID obligations issued after July 18, 1984. See section 881(c) for more details.

For rules that apply to other OID obligations, see Pub. 515.
Gains from the sale or exchange of patents, copyrights, and other intangible property if the gains are from payments that are contingent on the productivity, use, or disposition of the property or interest sold or exchanged.

For more information, see section 881(a) and Regulations section 1.881-2.

For purposes of determining whether its income is taxable under section 881(a), a corporation created or organized in Guam, American Samoa, the Northern Mariana Islands, or the U.S. Virgin Islands will not be treated as a foreign corporation if it meets the rules of section 881(b). For dividends paid after October 22, 2004, a corporation created or organized in Puerto Rico will be taxed under section 881(a) at a rate of 10% with respect to such dividends received during the tax year in the circumstances outlined in section 881(b)(2).

Line 9. Gross Transportation Income

A 4% tax is imposed on a foreign corporation's U.S. source gross transportation income for the tax year. U.S. source gross transportation income generally is any gross income that is transportation income if such income is treated as from U.S. sources.

Transportation income is any income from or connected with:

The use (or hiring or leasing for use) of a vessel or aircraft or
The performance of services directly related to the use of a vessel or aircraft. For this purpose, the term “vessel or aircraft” includes any container used in connection with a vessel or aircraft.

Generally, 50% of all transportation income that is attributable to transportation that either begins or ends in the United States is treated as from U.S. sources. See section 863(c)(2)(B) for a special rule for personal service income.

Exceptions. U.S. source gross transportation income does not include income that is:

Effectively connected with the conduct of a U.S. trade or business or
Taxable in a possession of the United States under the provisions of the Internal Revenue Code as applied to that possession.

Transportation income of the corporation will not be treated as effectively connected income unless:

The corporation has a fixed place of business in the United States involved in the earning of transportation income and
Substantially all of the corporation's U.S. source gross transportation income (determined without regard to the rule that such income does not include effectively connected income) is attributable to regularly scheduled transportation (or, in the case of income from the leasing of a vessel or aircraft, is attributable to a fixed place of business in the United States).

For more information, see section 887.

Enter the foreign corporation's U.S. source gross transportation income on line 9, column (b). Also, attach a statement showing the dates the vessels or aircraft entered or left the United States and the amount of gross income for each trip.

Additional Information Required

Complete all applicable items at the bottom of page 2.

Item M — 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. See Pub. 542 for more details.

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 (defined below) are more than 50% of its total compensation costs.

Performance of personal services. The term “performance of personal services” includes any activity involving the performance of personal services in the field of: health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting (as defined in Temporary Regulations section 1.448-1T(e)).

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

It elects to use a 52-53-week tax year that ends with reference to the calendar year or tax year elected under section 444;
It can establish a business purpose for a different tax year and obtains the approval of the IRS (see Form 1128 and Pub. 538); or
It elects under section 444 to have a tax year other than a calendar year. To make the election, use Form 8716, Election To Have a Tax Year Other Than a Required Tax Year.

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.

Other rules. For other rules that apply to personal service corporations, see Passive activity limitations on page 13.

Item N

Show any tax-exempt interest received or accrued. Include any exempt-interest dividends received as a shareholder in a mutual fund or other RIC. Also, if required, include the same amount on Schedule M-1, line 7a.

Item P

If the corporation has a net operating loss (NOL) for its 2006 tax year, it may elect to waive the entire carryback period for the NOL and instead carry the NOL forward to future tax years. To do so, check the box in item P and file the tax return by its due date, including extensions. Do not attach the statement described in Temporary Regulations section 301.9100-12T. Once made, the election is irrevocable. See Pub. 542, Corporations, and Form 1139, Corporation Application for Tentative Refund, for more details.

Item Q

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 2006. Do not reduce the amount by any NOL deduction reported on page 3, Section II, line 31a.

Item R

Check the “Yes” box in item R 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. For a definition of a parent-subsidiary controlled group, see the instructions for Schedule O (Form 1120).

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.

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 19) 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;
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; or
Any income or gain that is equivalent to any item of income or gain listed above must be treated in the same manner as such item for purposes of determining whether that income is foreign source effectively connected income.

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) more than 50% 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 that 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 that would have been effectively connected income immediately before such cessation (see section 864(c)(7));
Elect to treat real property income as effectively connected income (see page 11);
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 section 897(i).

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 5h, 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 certain advance payments for goods and long-term contracts, see Regulations section 1.451-5. For permissible methods for reporting advance payments for services and certain goods by an accrual method corporation, see Rev. Proc. 2004-34, 2004-22 I.R.B. 991.

Exclusion from gross income for certain income from ships and aircraft. A foreign corporation engaged in the international operation of ships or aircraft and organized in a qualified foreign country may exclude qualified income from its gross income, provided that the corporation can satisfy certain ownership requirements. See Regulations sections 1.883-1 through 1.883-4 for details, including documentation requirements.

See Notice 2005-65, 2005-39 I.R.B. 607, for a special rule for certain transports of petroleum between September 1, 2005, and September 18, 2005, relating to the temporary operation of ships in the domestic trade as a result of Hurricane Katrina.

Income from qualifying shipping activities. The corporation's gross income does not include income from qualifying shipping activities (as defined in section 1356) if the corporation makes an election under section 1354 to be taxed on its notional shipping income (as defined in section 1353) at the highest corporate tax rate (35%). If the election is made, the corporation generally may not claim any loss, deduction, or credit with respect to qualifying shipping activities. A corporation making this election also may elect to defer gain on certain dispositions of qualifying vessels under section 1359.

Use Form 8902, Alternative Tax on Qualifying Shipping Activities, to figure the tax. Include the alternative tax from Form 8902, line 30, on Schedule J, line 8, and be sure to check the “Form 8902” box on that line.

Installment sales. Generally, the installment method may not be used for dealer dispositions of property. A “dealer disposition” is any disposition of: (a) personal property by a person who regularly sells or otherwise disposes of personal property of the same type on the installment plan or (b) 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). Report this addition to the tax on Schedule J, line 8.

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 corporations are not required to accrue certain amounts to be received from the performance of services that, on the basis of their experience, will not be collected, if:

The services are in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting or
The corporation's average annual gross receipts for the 3 prior tax years does not exceed $5 million.

This provision does not apply to any amount if interest is required to be paid on the amount or if there is any penalty for failure to timely pay the amount. For more information, see section 448(d)(5) and Regulations section 1.448-2.

Corporations that qualify to use the nonaccrual experience method 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.

Line 2. Cost of Goods Sold

See the instructions for Schedule A on page 17.

Line 4. Dividends

See the instructions for Schedule C on
page 18.

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.

Report tax-exempt interest income on Form 1120-F, item N at the bottom of page 2. Also, if required, include the same amount on Schedule M-1, line 7a.

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 Passive activity limitations on page 13.

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), Capital Gains and Losses, 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 included in income from Form 6478, Credit for Alcohol Used as Fuel.
The amount included in income from Form 8864, Biodiesel and Renewable Diesel Fuels Credit.
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.
Any recapture amount under section 179A for certain clean-fuel vehicle property (or clean-fuel vehicle refueling property) that 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 28. Show the partnership's name, address, and EIN on a separate statement attached to Form 1120-F. If the amount entered is from more than one partnership, identify the amount from each partnership.

Section 481(a) adjustment. The corporation may have to make an adjustment under section 481(a) to prevent amounts of income or expense from being duplicated or omitted. The section 481(a) adjustment period is generally 1 year for a net negative adjustment and 4 years for a net positive adjustment. However, a corporation may elect to use a 1-year adjustment period if the net section 481(a) adjustment for the change is less than $25,000. The corporation must complete the appropriate lines of Form 3115 to make the election.

Include any net positive section 481(a) adjustment on page 3, Section II, line 10. If the net section 481(a) adjustment is negative, report it on line 28 of Section II.

Deductions

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 generally require corporations to capitalize, or include in inventory, certain costs incurred in connection with:

The production of real property 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, videotape, book, or similar property.

Corporations subject to the section 263A uniform capitalization rules are required to capitalize:

Direct costs and
An allocable part 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 were $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.
Geological and geophysical costs amortized under section 167(h).
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 17 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 the 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 and Regulations section 1.280G-1.

Business start-up and organizational costs. Business start-up and organizational costs must be capitalized unless an election is made to deduct or amortize them. The corporation may elect to amortize costs paid or incurred before October 23, 2004, over a period of 60 months or more. For costs paid or incurred after October 22, 2004, the following rules apply separately to each category of costs.

The corporation may elect to deduct up to $5,000 of such costs for the year the corporation begins business operations.
The $5,000 deduction is reduced (but not below zero) by the amount the total costs exceed $50,000. If the total costs are $55,000 or more, the deduction is reduced to zero.
If the election is made, any costs that are not deductible must be amortized ratably over a 180-month period beginning with the month the corporation begins business operations.

For more information, see Pub. 535, Business Expenses. For more details on the election for business start-up costs, see section 195. For more details on the election for organizational costs, see section 248.

Attach any statement required by Regulations section 1.195-1(b) or 1.248-1(c). Report the deductible amount of these costs and any amortization on line 28. For amortization that begins during the 2006 tax year, complete and attach Form 4562.

Passive activity limitations. Limitations on passive activity losses and credits under section 469 apply to personal service corporations (for definition, see Item M—Personal Service Corporation on page 9) and closely held corporations (see definition below).

Generally, the two kinds of passive activities are:

Trade or business activities in which the corporation did not materially participate for the tax year and
Rental activities, regardless of its participation.

For exceptions, see Form 8810, Corporate Passive Activity Loss and Credit Limitations.

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), the at-risk rules of section 465, or the tax-exempt use loss rules of section 470, 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. 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 for determining stock ownership, see section 544 (as modified by section 465(a)(3)).

Reducing certain expenses for which credits are allowable. If the corporation claims any of the following credits, it may need to reduce the otherwise allowable deductions for expenses used to figure the credit.

Employment credits. See the instructions for line 13 below.
Research credit.
Orphan drug credit.
Disabled access credit.
Employer credit for social security and Medicare taxes paid on certain employee tips.
Credit for small employer pension plan startup costs.
Credit for employer-provided childcare facilities and services.
Low sulfur diesel fuel production credit.
Mine rescue team training 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. See the instructions for the applicable form used to figure the applicable credit.

Limitations on deductions related to property leased to tax-exempt entities. If a corporation leases property to a governmental or other tax-exempt entity, the corporation may not claim deductions related to the property to the extent that they exceed the corporation's income from the lease payments (tax-exempt use loss). Amounts disallowed may be carried over to the next tax year and treated as a deduction with respect to the property for that tax year. See section 470 for more details and exceptions.

Contributions. See the instructions for line 19 on page 14 for limitations that apply to contributions.

Line 12. Compensation of Officers

Enter deductible officers' compensation on line 12. See Employment credits below for a list of employment credits that may reduce your deduction for officers' compensation. 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.

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. Include only the deductible part of each officer's 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.
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.

Line 13. Salaries and Wages

Enter the total salaries and wages paid for the tax year. Do not include salaries and wages deductible elsewhere on the return, such as amounts included in officers' compensation, 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.

If the corporation provided taxable fringe benefits to its employees, such as personal use of a car, do not deduct as wages the amount allocated for depreciation and other expenses claimed on lines 20 and 28.

Employment credits. If the corporation claims a credit on any of the following forms, it may need to reduce its deduction for officers' compensation and salaries and wages. See the applicable forms for details.

Form 5884, Work Opportunity Credit,
Form 5884-A, Credits for Employers Affected by Hurricane Katrina, Rita, or Wilma,
Form 8844, Empowerment Zone and Renewal Community Employment Credit,
Form 8845, Indian Employment Credit, and
Form 8861, Welfare-to-Work Credit.

Line 14. Repairs and Maintenance

Enter the cost of incidental repairs and maintenance not claimed elsewhere on the return, such as labor and supplies, that do not add to the value of the property or appreciably prolong its life. New buildings, machinery, or permanent improvements that increase the value of the property are not deductible. They must be depreciated or amortized.

Line 15. Bad Debts

Enter the total debts that became worthless in whole or in part during the tax year. A small bank or thrift institution using the reserve method of section 585 should attach a schedule showing how it figured the current year's provision. A cash basis taxpayer may not claim a bad debt deduction unless the amount was previously included in income.

Line 16. Rents

If the corporation rented or leased a vehicle, enter the total annual rent or lease expense paid or incurred during the year. Also complete Part V of Form 4562, Depreciation and Amortization. If the corporation leased a vehicle for a term of 30 days or more, the deduction for vehicle lease expense may have to be reduced by an amount called the inclusion amount. The corporation may have an inclusion amount if:

The lease term began:	And the vehicle's FMV on the first day of the lease exceeded:
After 12/31/04 but before 1/1/07		$15,200
After 12/31/03 but before 1/1/05		$17,500
After 12/31/02 but before 1/1/04		$18,000
After 12/31/98 but before 1/1/03		$15,500
If the lease term began before January 1, 1999, see Pub. 463, Travel, Entertainment, Gift, and Car Expenses, to find out if the corporation has an inclusion amount. The inclusion amount for lease terms beginning in 2007 will be published in the Internal Revenue Bulletin in early 2007.

See Pub. 463 for instructions on figuring the inclusion amount.

Line 17. Taxes and Licenses

Enter taxes paid or accrued during the tax year, but do not include the following:

Federal income taxes.
Foreign or U.S. possession income taxes if a foreign tax credit is claimed.
Taxes not imposed on the corporation.
Taxes, including state or local sales taxes, that are paid or incurred in connection with an acquisition or disposition of property (these taxes must be treated as a part of the cost of the acquired property or, in the case of a disposition, as a reduction in the amount realized on the disposition).
Taxes assessed against local benefits that increase the value of the property assessed (such as for paving, etc.).
Taxes deducted elsewhere on the return, such as those reflected in cost of goods sold.

See section 164(d) for apportionment of taxes on real property between seller and purchaser.

See section 906(b)(1) for rules concerning certain foreign taxes imposed on income from U.S. sources that may not be deducted or credited.

Line 18. Interest

Any provision that disallows, defers, or capitalizes interest expense applies after determining the amount of interest expense allocated to effectively connected income under the rules outlined below under Allocation of interest. For example, in determining the amount of interest expense disallowed under section 265 or 163(j), deferred under section 163(e) or 267(a)(3), or capitalized under section 263A from a U.S. trade or business, take into account only the amount of interest expense allocable to effectively connected income under the rules outlined below.

Note. Do not offset interest income against interest expense.

Allocation of interest. All foreign corporations (including corporations that are residents of countries with which the U.S. has an income tax treaty) must use the 3-step process described in Regulations section 1.882-5 to allocate interest. In addition, all corporations must attach a schedule showing how the deduction was determined, using the exclusive rules outlined in the regulations.

If the foreign corporation is a bank, see Notice 2005-53, 2005-32 I.R.B. 263, for additional information.

The interest expense allocable to effectively connected income is the sum of:

The interest paid or accrued by the foreign corporation on its liabilities booked in the U.S., adjusted under the 3-step process described in Regulations section 1.882-5 and
Any interest directly allocated to income from an asset (see Regulations section 1.882-5(a)(1)(ii)).

In determining the amount of interest expense allocable to effectively connected income (Step 3 of the process), the corporation may use either:

The adjusted U.S. booked liabilities method (Regulations section 1.882-5(d)) or
The separate currency pools method (Regulations section 1.882-5(e)).

Generally, once a method is elected, it must be used for a consecutive 5-year period. Indicate the method used.

If the separate currency pool method is used, attach a schedule showing the following:

The currency denomination of each currency pool in which U.S. assets are denominated;
The amount of U.S.-connected liabilities in each currency pool; and
The average rate of interest paid on liabilities by all branches and offices of the foreign corporation worldwide in each currency pool. The corporation may convert any currency pool in which it holds less than 3% of its U.S. assets for the year in U.S. dollars, and apply the U.S. dollar interest rate. See Regulations section 1.882-5(e).

Line 19. Charitable Contributions

This deduction is allowed for all contributions, whether or not connected with income that is effectively connected with the conduct of a trade or business in the United States. See section 882(c)(1)(B).

Enter contributions or gifts actually paid within the tax year to or for the use of charitable and governmental organizations described in section 170(c) and any unused contributions carried over from prior years. Special rules and limits apply to contributions to organizations conducting lobbying activities. See section 170(f)(9).

Corporations reporting taxable income on the accrual method may elect to treat as paid during the tax year any contributions paid by the 15th day of the 3rd month after the end of the tax year if the contributions were authorized by the board of directors during the tax year. Attach a declaration to the return stating that the resolution authorizing the contributions was adopted by the board of directors during the tax year. The declaration must include the date the resolution was adopted. See Regulations section 1.170A-11.

Limitation on deduction. The total amount claimed may not exceed 10% of taxable income (line 32) computed without regard to the following:

Any deduction for contributions.
The special deductions on line 31b.
The deduction allowed under section 249.
The domestic production activities deduction under section 199.
Any net operating loss (NOL) carryback to the tax year under section 172.
Any capital loss carryback to the tax year under section 1212(a)(1).

Suspension of 10% limitation for farmers and ranchers. For tax years beginning in 2006, a corporation that is a qualified farmer or rancher (as defined in section 170(b)(1)(E)), and that does not have publicly traded stock, may deduct contributions of qualified conservation property without regard to the general 10% limit. The total amount of the contribution claimed for the qualified conservation property may not exceed 100% of the excess of the corporation's taxable income (as computed above substituting “100%” for “10%” ) over all other allowable charitable contributions. Any excess qualified conservation contributions may be carried over to the next 15 years subject to the 100% limitation. See section 170(b)(2)(B).

For contributions made after August 17, 2006, contributed conservation property that is used in agriculture or livestock production must remain available for such production.

Carryover. Charitable contributions over the 10% limitation may not be deducted for the tax year but may be carried over to the next 5 tax years.

Special rules apply if the corporation has an NOL carryover to the tax year. In figuring the charitable contributions deduction for the current tax year, the 10% limit is applied using the corporation's taxable income after taking into account any deduction for the NOL.

To figure the amount of any remaining NOL carryover to later years, taxable income must be modified (see section 172(b)). To the extent that contributions are used to reduce taxable income for this purpose and increase an NOL carryover, a contributions carryover is not allowed. See section 170(d)(2)(B).

Substantiation requirements. Generally, no deduction is allowed for any contribution of $250 or more unless the corporation gets a written acknowledgment from the donee organization that shows the amount of cash contributed, describes any property contributed, and either gives a description and a good faith estimate of the value of any goods or services provided in return for the contribution or states that no goods or services were provided in return for the contribution. The acknowledgment must be obtained by the due date (including extensions) of the corporation's return, or if earlier, the date the return is filed. Do not attach the acknowledgment to the tax return, but keep it with the corporation's records.

For contributions of cash, check, or other monetary gifts (regardless of the amount) made in tax years beginning after August 17, 2006, the corporation must maintain a bank record, or a receipt, letter, or other written communication from the donee organization indicating the name of the organization, the date of the contribution, and the amount of the contribution.

Contributions of property other than cash. If a corporation (other than a closely held or personal service corporation) contributes property other than cash and claims a deduction of more than $500 for the property, it must attach a schedule to the return describing the kind of property contributed and the method used to determine its fair market value (FMV). Closely held corporations and personal service corporations must complete Form 8283, Noncash Charitable Contributions, and attach it to their returns. All other corporations generally must complete and attach Form 8283 to their returns for contributions of property (other than money) if the total claimed deduction for all property contributed was more than $5,000. Special rules apply to the contribution of certain property. See the instructions for Form 8283.

Special rules for contributions of certain easements in registered historic districts. The following rules apply to certain contributions of real property interests located in a registered historic district.

For contributions made after July 25, 2006, a deduction is allowed for the qualified real property interest, if the exterior of the building (including the front, side, rear, and space above the building) is preserved and no portion of the exterior is changed in a manner that is inconsistent with its historical character. For more details, see section 170(h)(4)(B).
For contributions made after August 17, 2006, a deduction is allowed on the building only (no deduction is allowed for a structure or land) if located in a registered historic district. However, if listed in the National Register, a deduction is also allowed for structures or land areas. For more information, see section 170(h)(4)(C).
For contributions made in tax years beginning after August 17, 2006, the corporation must also include the following information with the tax return.
1. A qualified appraisal (as defined in section 170(f)(11)(E)) of the qualified property interest.
2. Photographs of the entire exterior of the building, and
3. A description of all restrictions on the development of the building. See section 170(h)(4)(B)(iii).
The corporation's deduction may be reduced if rehabilitation credits were claimed on the building. See section 170(f)(14).
A $500 filing fee may apply to certain deductions over $10,000. See section 170(f)(13).

Other special rules. The corporation must reduce its deduction for contributions of certain capital gain property. See sections 170(e)(1) and 170(e)(5).

A larger deduction is allowed for certain contributions of:

Inventory and other property to certain organizations for use in the care of the ill, needy, or infants (section 170(e)(3)), including contributions of “apparently wholesome food” (section 170(e)(3)(C)) and contributions of qualified book inventory to public schools (section 170(e)(3)(D)), and
Scientific equipment used for research to institutions of higher learning or to certain scientific research organizations (other than by personal holding companies and service organizations (section 170(e)(4)).
Computer technology and equipment for educational purposes (section 170(e)(6)).

For more information on charitable contributions, including substantiation and recordkeeping requirements, see section 170 and the related regulations and Pub. 526, Charitable Contributions. For special rules that apply to corporations, see Pub. 542.

Line 20. Depreciation

Include on line 20, depreciation and the part of the cost of certain property that the corporation elected to expense under section 179. See Form 4562 and its instructions.

Line 23. Depletion

See sections 613 and 613A for percentage depletion rates applicable to natural deposits. Also, see section 291 for the limitation on the depletion deduction for iron ore and coal (including lignite).

Attach Form T (Timber), Forest Activities Schedule, if a deduction for depletion of timber is claimed.

Foreign intangible drilling costs and foreign exploration and development costs must either be added to the corporation's basis for cost depletion purposes or be deducted ratably over a 10-year period. See sections 263(i), 616, and 617 for details.

See Pub. 535, Business Expenses, for more information on depletion.

Line 25. Pension, Profit-sharing, etc., Plans

Enter the deduction for contributions to qualified pension, profit-sharing, or other funded deferred compensation plans. Employers who maintain such a plan generally must file one of the forms listed below, even if the plan is not a qualified plan under the Internal Revenue Code. The filing requirement applies even if the corporation does not claim a deduction for the current tax year. There are penalties for failure to file these forms on time and for overstating the pension plan deduction. For more information, see sections 6652(e) and 6662(f).

Form 5500, Annual Return/Report of Employee Benefit Plan. File this form for a plan that is not a one-participant plan (see below).

Form 5500-EZ, Annual Return of One-Participant (Owners and Their Spouses) Retirement Plan. File this form for a plan that only covers the owner (or the owner and his or her spouse) but only if the owner (or the owner and his or her spouse) owns the entire business.

Line 26. Employee Benefit Programs

Enter contributions to employee benefit programs not claimed elsewhere on the return (e.g., insurance, health, and welfare programs, etc.) that are not an incidental part of a pension, profit-sharing, etc., plan included on line 25.

Line 28. Other Deductions

Attach a schedule, listing by type and amount, all allowable deductions that are not deductible elsewhere on Form 1120-F.

Examples of other deductions include the following. See Pub. 535 for details on other deductions that may apply to corporations.

Amortization (see Form 4562).
Certain costs of qualified film or television productions. See section 181 for details.
Certain business start-up and organizational costs the corporation elects to deduct. See page 12.
Reforestation costs. The corporation may elect to deduct up to $10,000 of qualifying reforestation expenses for each qualified timber property. The corporation may elect to amortize over 84 months any amount not deducted. See Pub. 535. In certain instances, this limit may be increased. See Pub. 4492, Information for Taxpayers Affected by Hurricanes Katrina, Rita, and Wilma, for additional information.
Insurance premiums.
Legal and professional fees.
Supplies used and consumed in the business.
Travel and entertainment expenses. Special rules apply (discussed below).
Utilities.
Ordinary losses from trade or business activities of a partnership (from Schedule K-1 (Form 1065 or 1065-B)). Do not offset ordinary income against ordinary losses. Instead, include the income on line 10. Show the partnership's name, address, and EIN on a separate statement attached to this return. If the amount is from more than one partnership, identify the amount from each partnership.
Any negative net section 481(a) adjustment. See the instructions for line 10 on page 11.
Deduction for certain energy efficient commercial building property. See section 179D and Notice 2006-52, 2006-26 I.R.B. 1175.
GO Zone clean-up cost. The corporation may elect to deduct certain costs paid or incurred during the tax year for the removal of debris from, or the demolition of structures on certain real property located in the GO Zone. See section 1400N(f).
Dividends paid in cash on stock held by an employee stock ownership plan. However, a deduction may only be taken for such dividends if, according to the plan, the dividends are:
1. Paid in cash directly to the plan participants or beneficiaries;
2. Paid to the plan, which distributes them in cash to the plan participants or their beneficiaries no later than 90 days after the end of the plan year in which the dividends are paid;
3. At the election of such participants or their beneficiaries (a) payable as provided under 1 or 2 above or (b) paid to the plan and reinvested in qualifying employer securities; or
4. Used to make payments on a loan described in section 404(a)(9).

See section 404(k) for more details and the limitation on certain dividends.

Do not deduct:

Fines or penalties paid to a government for violating any law.
Any amount that is allocable to a class of exempt income. See section 265(b) for exceptions.
Lobbying expenses. However, see exceptions (discussed below).

Special rules apply to the following expenses.

Travel, meals, and entertainment. Subject to limitations and restrictions discussed below, a corporation may deduct ordinary and necessary travel, meals, and entertainment expenses paid or incurred in its trade or business. Also, special rules apply to deductions for gifts, skybox rentals, luxury water travel, convention expenses, and entertainment tickets. See section 274 and Pub. 463 for more details.

Travel. The corporation may not deduct travel expenses of any individual accompanying a corporate officer or employee, including a spouse or dependent of the officer or employee, unless:

That individual is an employee of the corporation and
His or her travel is for a bona fide business purpose and would otherwise be deductible by that individual.

Meals and entertainment. Generally, the corporation may deduct only 50% of the amount otherwise allowable for meals and entertainment expenses paid or incurred in its trade or business. In addition (subject to exceptions under section 274(k)(2)):

Meals must not be lavish or extravagant;
A bona fide business discussion must occur during, immediately before, or immediately after the meal; and
An employee of the corporation must be present at the meal.

See section 274(n)(3) for a special rule that applies to expenses for meals consumed by individuals subject to the hours of service limits of the Department of Transportation.

Membership dues. The corporation may deduct amounts paid or incurred for membership dues in civic or public service organizations, professional organizations (such as bar and medical associations), business leagues, trade associations, chambers of commerce, boards of trade, and real estate boards. However, no deduction is allowed if a principal purpose of the organization is to entertain, or provide entertainment facilities for, members or their guests. In addition, corporations may not deduct membership dues in any club organized for business, pleasure, recreation, or other social purpose. This includes country clubs, golf and athletic clubs, airline and hotel clubs, and clubs operated to provide meals under conditions favorable to business discussion.

Entertainment facilities. The corporation may not deduct an expense paid or incurred for a facility (such as a yacht or hunting lodge) used for an activity usually considered amusement, entertainment, or recreation.

Amounts treated as compensation. Generally, the corporation may be able to deduct otherwise nondeductible entertainment, amusement, or recreation expenses if the amounts are treated as compensation to the recipient and reported on Form W-2 for an employee or on Form 1099-MISC for an independent contractor.

However, if the recipient is an officer, director, or beneficial owner (directly or indirectly) of more than 10% of any class of stock, the deductible expense is limited. See section 274(e)(2) and Notice 2005-45, 2005-24 I.R.B. 1228.

Lobbying expenses. Generally, lobbying expenses are not deductible. These expenses include:

Amounts paid or incurred in connection with influencing federal or state legislation (but not local legislation) or
Amounts paid or incurred in connection with any communication with certain federal executive branch officials in an attempt to influence the official actions or positions of the officials. See Regulations section 1.162-29 for the definition of “influencing legislation.”

Dues and other similar amounts paid to certain tax-exempt organizations may not be deductible. See section 162(e)(3). If certain in-house lobbying expenditures do not exceed $2,000, they are deductible.

Line 30. Taxable Income Before NOL Deduction and Special Deductions

At-risk rules. Generally, special at-risk rules under section 465 apply to closely held corporations (see Passive activity limitations on page 13) engaged in any activity as a trade or business or for the production of income. These corporations may have to adjust the amount on line 30.

The at-risk rules do not apply to:

Holding real property placed in service by the taxpayer before 1987;
Equipment leasing under sections 465(c)(4), (5), and (6); or
Any qualifying business of a qualified corporation described in section 465(c)(7).

However, the at-risk rules do apply to the holding of mineral property.

If the at-risk rules apply, adjust the amount on line 30 for any section 465(d) losses. These losses are limited to the amount for which the corporation is at risk for each separate activity at the close of the tax year. If the corporation is involved in one or more activities, any of which incurs a loss for the year, report the loss for each activity separately. Attach Form 6198, At-Risk Limitations, showing the amount at risk and gross income and deductions for the activities with the losses.

If the corporation sells or otherwise disposes of an asset or its interest (either total or partial) in an activity to which the at-risk rules apply, determine the net profit or loss from the activity by combining the gain or loss on the sale or disposition with the profit or loss from the activity. If the corporation has a net loss, it may be limited because of the at-risk rules.

Treat any loss from an activity not allowed for the tax year as a deduction allocable to the activity in the next tax year.

Line 31a. Net Operating Loss Deduction

A corporation may use the NOL incurred in one tax year to reduce its taxable income in another tax year. Enter on line 31a the total NOL carryovers from other tax years, but do not enter more than the corporation's taxable income (after special deductions). Attach a schedule showing the computation of the NOL deduction. Also complete Item Q at the bottom of page 2 of the form.

The following special rules apply.

A personal service corporation may not carry back an NOL to or from any tax year to which an election under section 444 (to have a tax year other than a required tax year) applies.
A corporate equity reduction interest loss may not be carried back to a tax year preceding the year of the equity reduction transaction (see section 172(b)(1)(E)).
If an ownership change occurs, the amount of the taxable income of a loss corporation that may be offset by the pre-change NOL carryovers may be limited. See section 382 and the related regulations. A loss corporation must include the information statement as provided in Temporary Regulations section 1.382-11T(a) with its income tax return for each tax year that certain ownership shifts described in Temporary Regulations section 1.382-2T(a)(2)(ii) occur. If the corporation makes the closing-of-the-books election, see Regulations section 1.382-6(b).
If a corporation acquires control of another corporation (or acquires its assets in a reorganization), the amount of pre-acquisition losses that may offset recognized built-in gain may be limited (see section 384).
If a corporation elects the alternative tax on qualifying shipping activities under section 1354, no deduction is allowed for an NOL attributable to the qualifying shipping activities to the extent that the loss is carried forward from a tax year preceding the first tax year for which the alternative tax election was made. See section 1358(b)(2).
Certain qualified GO Zone losses are eligible for a special 5-year carryback period. See section 1400N(k).
A corporation may elect to treat any GO Zone public utility casualty loss as a specified liability loss to which the 10-year carryback period applies. See the Instructions for Form 1139.

For more details on the NOL deduction, see section 172, the Instructions for Form 1139, and Pub. 542.

Line 31b. Special Deductions

See the instructions for Schedule C on page 18.

Line 32. Taxable Income or (Loss)

Net operating loss (NOL). If line 32 is zero or less, the corporation may have an NOL that may be carried back or forward as a deduction to other tax years. Generally, a corporation first carries back an NOL 2 tax years. However, the corporation may elect to waive the carryback period and instead carry the NOL forward to future tax years. To make the election, see the instructions for Item P on page 10.

See Form 1139 for details, including other elections that may be available, which must be made no later than 6 months after the due date (excluding extensions) of the corporation's tax return.

Schedule A—Cost of Goods Sold

Generally, inventories are required at the beginning and end of each tax year if the production, purchase, or sale of merchandise is an income-producing factor. See Regulations section 1.471-1.

However, if the corporation is a qualifying taxpayer or a qualifying small business taxpayer, it may adopt or change its accounting method to account for inventoriable items in the same manner as materials and supplies that are not incidental (unless its business is a tax shelter (as defined in section 448(d)(3))).

A qualifying taxpayer is a taxpayer that, for each prior tax year ending after December 16, 1998, has average annual gross receipts of $1 million or less for the 3 prior tax years.

A qualifying small business taxpayer is a taxpayer (a) that, for each prior tax year ending on or after December 31, 2000, has average annual gross receipts of $10 million or less for the 3 prior tax years, and (b) whose principal business activity is not an ineligible activity.

Under this accounting method, inventory costs for raw materials purchased for use in producing finished goods and merchandise purchased for resale are deductible in the year the finished goods or merchandise are sold (but not before the year the corporation paid for the raw materials or merchandise, if it is also using the cash method). For additional guidance on this method of accounting for inventoriable items, see Pub. 538 and the instructions for Form 3115.

Enter amounts paid for all raw materials and merchandise during the tax year on line 2. The amount the corporation may deduct for the tax year is figured on line 8.

All filers not using the cash method of accounting should see Section 263A uniform capitalization rules on page 12 before completing Schedule A.

Line 1. Inventory at beginning of year. If the corporation is changing its method of accounting for the current tax year, it must refigure last year's closing inventory using its new method of accounting and enter the result on line 1. If there is a difference between last year's closing inventory and the refigured amount, attach an explanation and take it into account when figuring the corporation's section 481(a) adjustment (explained on page 12).

Line 4. Additional section 263A costs. An entry is required on this line only for corporations that have elected a simplified method of accounting.

For corporations that have elected the simplified production method, additional section 263A costs are generally those costs, other than interest, that were not capitalized under the corporation's method of accounting immediately prior to the effective date of section 263A but are now required to be capitalized under section 263A. For details, see Regulations section 1.263A-2(b).

For corporations that have elected the simplified resale method, additional section 263A costs are generally those costs incurred with respect to the following categories.

Off-site storage or warehousing.
Purchasing.
Handling, such as processing, assembling, repackaging, and transporting.
General and administrative costs (mixed service costs).

For details, see Regulations section 1.263A-3(d).

Enter on line 4 the balance of section 263A costs paid or incurred during the tax year not includible on lines 2, 3, and 5.

Line 5. Other costs. Enter on line 5 any costs paid or incurred during the tax year not entered on lines 2 through 4.

Line 7. Inventory at end of year. See Regulations sections 1.263A-1 through 1.263A-3 for details on figuring the amount of additional section 263A costs to be included in ending inventory. If the corporation accounts for inventoriable items in the same manner as materials and supplies that are not incidental, enter on line 7 the portion of its raw materials and merchandise purchased for resale that is included on line 6 and was not sold during the year.

Line 9a. Inventory valuation methods. Inventories may be valued at:

Cost;
Cost or market value (whichever is lower); or
Any other method approved by the IRS that conforms to the requirements of the applicable regulations cited on page 18.

However, if the corporation is using the cash method of accounting, it is required to use cost.

Corporations that account for inventoriable items in the same manner as materials and supplies that are not incidental may currently deduct expenditures for direct labor and all indirect costs that would otherwise be included in inventory costs.

The average cost (rolling average) method of valuing inventories generally does not conform to the requirements of the regulations. See Rev. Rul. 71-234, 1971-1 C.B. 148.

Corporations that use erroneous valuation methods must change to a method permitted for federal income tax purposes. Use Form 3115 to make this change.

On line 9a, check the method(s) used for valuing inventories. Under lower of cost or market, the term “market” (for normal goods) means the current bid price prevailing on the inventory valuation date for the particular merchandise in the volume usually purchased by the taxpayer. For a manufacturer, market applies to the basic elements of cost—raw materials, labor, and burden. If section 263A applies to the taxpayer, the basic elements of cost must reflect the current bid price of all direct costs and all indirect costs properly allocable to goods on hand at the inventory date.

Inventory may be valued below cost when the merchandise is unsalable at normal prices or unusable in the normal way because the goods are subnormal due to damage, imperfections, shopwear, etc., within the meaning of Regulations section 1.471-2(c). The goods may be valued at the current bona fide selling price, minus direct cost of disposition (but not less than scrap value) if such a price can be established.

If this is the first year the Last-in, First-out (LIFO) inventory method was either adopted or extended to inventory goods not previously valued under the LIFO method provided in section 472, attach Form 970, Application To Use LIFO Inventory Method, or a statement with the information required by Form 970. Also check the LIFO box on line 9c. On line 9d, enter the amount or the percent of total closing inventories covered under section 472. Estimates are acceptable.

If the corporation changed or extended its inventory method to LIFO and had to write up the opening inventory to cost in the year of election, report the effect of the write-up as other income (Section II, line 10, on page 3) proportionately over a 3-year period that begins with the year of the LIFO election (section 472(d)).

For more information on inventory valuation methods, see Pub. 538.

Schedule C—Dividends and Special Deductions

For purposes of the 20% ownership test on lines 1 through 7, the percentage of stock owned by the corporation is based on voting power and value of the stock.

Line 1, Column (a)

Enter dividends (except those received on debt-financed stock acquired after July 18, 1984-see section 246A) that:

Are received from less-than-20%-owned domestic corporations subject to income tax and
Qualify for the 70% deduction under section 243(a)(1).

Also include on line 1:

Taxable distributions from an IC-DISC or former DISC that are designated as eligible for the 70% deduction and certain dividends of Federal Home Loan Banks. See section 246(a)(2).
Dividends (except those received on debt-financed stock acquired after July 18, 1984) from a regulated investment company (RIC). The amount of dividends eligible for the dividends-received deduction under section 243 is limited by section 854(b). The corporation should receive a notice from the RIC specifying the amount of dividends that qualify for the deduction.

Report so-called dividends or earnings received from mutual savings banks, etc., as interest. Do not treat them as dividends.

Line 2, Column (a)

Enter on line 2:

Dividends (except those received on debt-financed stock acquired after July 18, 1984) that are received from 20%-or-more-owned domestic corporations subject to income tax and that are subject to the 80% deduction under section 243(c) and
Taxable distributions from an IC-DISC or former DISC that are considered eligible for the 80% deduction.

Line 3, Column (a)

Enter dividends that are:

Received on debt-financed stock acquired after July 18, 1984, from domestic and foreign corporations subject to income tax that would otherwise be subject to the dividends-received deduction under section 243(a)(1), 243(c), or 245(a). Generally, debt-financed stock is stock that the corporation acquired by incurring a debt (e.g., it borrowed money to buy the stock).
Received from a RIC on debt-financed stock. The amount of dividends eligible for the dividends-received deduction is limited by section 854(b). The corporation should receive a notice from the RIC specifying the amount of dividends that qualify for the deduction.

Line 3, Columns (b) and (c)

Dividends received on debt-financed stock acquired after July 18, 1984, are not entitled to the full 70% or 80% dividends-received deduction. The 70% or 80% deduction is reduced by a percentage that is related to the amount of debt incurred to acquire the stock. See section 246A. Also, see section 245(a) before making this computation for an additional limitation that applies to dividends received from foreign corporations. Attach a schedule that shows how the amount on line 3, column (c), was figured.

Line 4, Column (a)

Enter dividends received on the preferred stock of a less-than-20%-owned public utility that is subject to income tax and is allowed the deduction provided in section 247 for dividends paid.

Line 5, Column (a)

Enter dividends received on preferred stock of a 20%-or-more-owned public utility that is subject to income tax and is allowed the deduction provided in section 247 for dividends paid.

Line 6, Column (a)

Enter the U.S.-source portion of dividends that:

Are received from less-than-20%-owned foreign corporations and
Qualify for the 70% deduction under section 245(a). To qualify for the 70% deduction, the corporation must own at least 10% of the stock of the foreign corporation by vote and value.

Line 7, Column (a)

Enter the U.S.-source portion of dividends that are received from 20%-or-more-owned foreign corporations and that qualify for the 80% deduction under section 245(a).

Line 8, Column (c)

Limitation on dividends-received deduction. Generally, line 8, column (c), may not exceed the amount from the worksheet on page 19. However, in a year in which an NOL occurs, this limitation does not apply even if the loss is created by the dividends-received deduction. See sections 172(d) and 246(b).

1.	Refigure Section II, line 30, without any domestic production activities deduction, without any adjustment under section 1059, and without any capital loss carryback to the tax year under section 1212(a)(1)	1.
2.	Multiply line 1 by 80%	2.
3.	Add lines 2, 5, and 7, column (c), and the part of the deduction on line 3, column (c), that is attributable to dividends from 20%-or-more-owned corporations	3.
4.	Enter the smaller of line 2 or 3. If line 3 is greater than line 2, stop here; enter the amount from line 4 on line 8, column (c), and do not complete the rest of this worksheet	4.
5.	Enter the total amount of dividends from 20%-or-more-owned corporations that are included on lines 2, 3, 5, and 7, column (a)	5.
6.	Subtract line 5 from line 1	6.
7.	Multiply line 6 by 70%	7.
8.	Subtract line 3 above from line 8, column (c)	8.
9.	Enter the smaller of line 7 or line 8	9.
10.	Dividends-received deduction after limitation (sec. 246(b)). Add lines 4 and 9. Enter the result here and on line 8, column (c)	10.

Line 10, Column (a)

If the corporation claims the foreign tax credit, enter the tax that is deemed paid under sections 902 and 960. See sections 78 and 906(b)(4).

Line 11, Column (a)

Enter taxable distributions from an IC-DISC or former DISC that are designated as not eligible for a dividends-received deduction.

No deduction is allowed under section 243 for a dividend from an IC-DISC or former DISC (as defined in section 992(a)) to the extent the dividend:

Is paid out of the corporation's accumulated IC-DISC income or previously taxed income or
Is a deemed distribution under section 995(b)(1).

Line 12, Column (a)

Include the following:

Dividends (other than capital gain distributions reported on Schedule D (Form 1120) and exempt-interest dividends) that are received from RICs and that are not subject to the 70% deduction.
Dividends from tax-exempt organizations.
Dividends (other than capital gain distributions) received from a REIT that qualifies, for the tax year of the trust in which the dividends are paid, under sections 856 through 860.
Dividends not eligible for a dividends-
received deduction, which include the following.
1. Dividends received on any share of stock held for less than 46 days during the 91-day period beginning 45 days before the ex-dividend date. When counting the number of days the corporation held the stock, you may not count certain days during which the corporation's risk of loss was diminished. See section 246(c)(4) and Regulations section 1.246-5 for more details.
2. Dividends attributable to periods totaling more than 366 days that the corporation received on any share of preferred stock held for less than 91 days during the 181-day period that began 90 days before the ex-dividend date. When counting the number of days the corporation held the stock, you may not count certain days during which the corporation's risk of loss was diminished. See section 246(c)(4) and Regulations section 1.246-5 for more details. Preferred dividends attributable to periods totaling less than 367 days are subject to the 46-day holding period rule above.
3. Dividends on any share of stock to the extent the corporation is under an obligation (including a short sale) to make related payments with respect to positions in substantially similar or related property.
Any other taxable dividend income not properly reported elsewhere on Schedule C.

If patronage dividends or per-unit retain allocations are included on line 12, identify the total of these amounts in a schedule and attach it to Form 1120-F.

Line 13, Column (c)

Section 247 allows public utilities a deduction of 40% of the smaller of:

Dividends paid on their preferred stock during the tax year or
Taxable income computed without regard to this deduction.

In a year in which an NOL occurs, compute the deduction without regard to section 247(a)(1)(B). See section 172(d).

Schedule J—Tax Computation

Line 1

If the corporation is a member of a controlled group, as defined in section 1563, it must check the box on line 1 and complete and attach Schedule O (Form 1120). Members of a controlled group must use Schedule O (Form 1120) to figure the tax for the group. See Schedule O (Form 1120) and its instructions for more information.

Line 2. Income Tax

Most corporations should figure their tax using the Tax Rate Schedule below. Qualified personal service corporations should see the instructions below.

Tax Rate Schedule

If taxable income (Section II, line 32) is:
Over—	But not over—	Tax is:	Of the amount over—
$0	$50,000	15%	$0
50,000	75,000	$ 7,500 + 25%	50,000
75,000	100,000	13,750 + 34%	75,000
100,000	335,000	22,250 + 39%	100,000
335,000	10,000,000	113,900 + 34%	335,000
10,000,000	15,000,000	3,400,000 + 35%	10,000,000
15,000,000	18,333,333	5,150,000 + 38%	15,000,000
18,333,333	- - - - -	35%	0

Qualified personal service corporation. A qualified personal service corporation is taxed at a flat rate of 35% on its taxable income. If the corporation is a qualified personal service corporation, check the box on line 2, even if the corporation has no tax liability.

A corporation is a qualified personal service corporation if it meets both of the following tests:

Substantially all of the corporation's activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting and
At least 95% of the corporation's stock, by value, is owned, directly or indirectly, by (a) employees performing the services, (b) retired employees who had performed the services listed above, (c) any estate of an employee or retiree described above, or (d) any person who acquired the stock of the corporation as a result of the death of an employee or retiree (but only for the 2-year period beginning on the date of the employee or retiree's death).

Additional tax under section 197(f). A corporation that elects to pay tax on the gain from the sale of an intangible under the related person exception to the anti-churning rules should include any additional tax due under section 197(f)(9)(B) in the total for line 2. On the dotted line next to line 2, write “Section 197” and the amount.

Line 3. Alternative Minimum Tax (AMT)

A corporation that is not a small corporation exempt from the AMT may be required to file Form 4626 if it claims certain credits, even though it does not owe any AMT. See Form 4626 for details.

Unless the corporation is treated as a small corporation exempt from the AMT, it may owe the AMT if it has any of the adjustments and tax preference items listed on Form 4626, Alternative Minimum Tax-Corporations. The corporation must file Form 4626 if its taxable income (or loss) before the NOL deduction, combined with these adjustments and tax preference items, is more than the smaller of $40,000 or the corporation's allowable exemption amount (from Form 4626). For this purpose, taxable income does not include the NOL deduction.

See Form 4626 for definitions and details on how to figure the tax.

Line 5a. Foreign Tax Credit

A foreign corporation engaged in a U.S. trade or business during the tax year may take a credit for income, war profits, and excess profits taxes paid, accrued, or deemed paid to any foreign country or U.S. possession for income effectively connected with the conduct of a trade or business in the United States. See section 906 and Form 1118, Foreign Tax Credit—Corporations.

Line 5b. Qualified Electric Vehicle (QEV) Credit.

Use Form 8834, Qualified Electric Vehicle Credit, if the corporation may claim a credit for a qualified electric vehicle placed in service in 2006.

Line 5c. General Business Credit

Enter on line 5c the corporation's total general business credit.

The corporation is required to file Form 3800, General Business Credit, to claim certain business credits. For a list of allowable credits, see Form 3800. Check the “Form 3800” box and include the allowable credit from Part II, line 19, of Form 3800 on 5c of Form 1120-F. Also, see the applicable credit form and its instructions.

However, if the corporation is filing any of the following forms, check the applicable box, and include the allowable credit on line 5c:

Form 6478, Credit for Alcohol Used as Fuel,
Form 8835, Renewable Electricity, Refined Coal, and Indian Coal Production Credit, with a credit from Section B; or
Form 8844, Empowerment Zone and Renewable Community Employment Credit.

See the instructions of the applicable form.

Line 5d. Credit for Prior Year Minimum Tax

To figure the minimum tax credit and any carryforward of the credit, use Form 8827, Credit for Prior Year Minimum Tax—Corporations. Also, see Form 8827 if any of the corporation's 2005 nonconventional source fuel credit or qualified electric vehicle credit was disallowed solely because of the tentative minimum tax limitation. See section 53(d).

Line 5e. Bond credits from Forms 8860 and 8912

Enter the amount of any credit from Form 8860, Qualified Zone Academy Bond Credit, and/or from Form 8912, Credit for Clean Renewable Energy and Gulf Tax Credit Bonds. Check the applicable box(es) and include the amount of the credit in the total for line 5e.

Line 8. Other Taxes

Include any of the following taxes and interest in the total on line 8. Check the appropriate box(es) for the form, if any, used to compute the total.

Recapture of investment credit. If the corporation disposed of investment credit property or changed its use before the end of its useful life or recovery period, it may owe a tax. See Form 4255, Recapture of Investment Credit, for details.

Recapture of low-income housing credit. If the corporation disposed of property (or there was a reduction in the qualified basis of the property) for which it took the low-income housing credit, it may owe a tax. See Form 8611, Recapture of Low-Income Housing Credit.

Interest due under the look-back methods. If the corporation used the look-back method for certain long-term contracts, see Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts, for information on figuring the interest the corporation may have to include.

The corporation may also have to include interest due under the look-back method for property depreciated under the income forecast method. See Form 8866.

Alternative tax on qualifying shipping activities. Enter any alternative tax on qualifying shipping activities from Form 8902, line 30. Check the box for Form 8902.

Other. Additional taxes and interest amounts may be included in the total entered on line 8. Check the box for “Other” if the corporation includes any additional taxes and interest such as the items discussed below. See How to report below for details on reporting these amounts on an attached schedule.

Recapture of qualified electric vehicle (QEV) credit. The corporation must recapture part of the QEV credit it claimed in a prior year if, within 3 years of the date the vehicle was placed in service, it ceases to qualify for the credit. See Regulations section 1.30-1 for details on how to figure the recapture.
Recapture of Indian employment credit. Generally, if an employer terminates the employment of a qualified employee less than 1 year after the date of initial employment, any Indian employment credit allowed for a prior tax year because of wages paid or incurred to that employee must be recaptured. For details, see Form 8845 and section 45A.
Recapture of new markets credit (see Form 8874).
Recapture of employer-provided childcare facilities and services credit (see Form 8882).
Interest on deferred tax attributable to
(a) installment sales of certain timeshares and residential lots (section 453(l)(3)) and
(b) certain nondealer installment obligations (section 453A(c)).
Interest due on deferred gain (section 1260(b)).

How to report. If the corporation checked the “Other” box, attach a schedule showing the computation of each item included in the total for line 8 and identify the applicable section and the type of tax or interest.

Section III—Branch Profits Tax and Tax on Excess Interest

Part I—Branch Profits Tax

Section 884(a) imposes a 30% branch profits tax on the after-tax earnings of a foreign corporation's U.S. trade or business (i.e., effectively connected earnings and profits (ECEP)) that are not reinvested in a U.S. trade or business by the close of the tax year, or are disinvested in a later tax year. Changes in the value of the equity of the foreign corporation's U.S. trade or business (i.e., U.S. net equity) are used as a measure of whether earnings have been reinvested in, or disinvested from, a U.S. trade or business. An increase in U.S. net equity during the tax year is generally treated as a reinvestment of earnings for the current tax year. A decrease in U.S. net equity is generally treated as a disinvestment of prior year's earnings that have not previously been subject to the branch profits tax.

The amount subject to the branch profits tax for the tax year is the dividend equivalent amount. See Regulations section 1.884-1(b).

Exempt corporations. A foreign corporation is exempt from the branch profits tax on its dividend equivalent amount if:

It is a qualified resident of a country with which the United States has an income tax treaty in effect for the year in which the dividend equivalent arises and
The income tax treaty with that country has not been modified on or after January 1, 1987.

See Item V on page 22 for the definition of qualified resident.

If the foreign corporation is exempt from the branch profits tax, do not complete Part I. However, be sure to complete Items U and V at the bottom of page 5.

Other entities subject to the branch profits tax.

A foreign corporate partner of a partnership engaged in a U.S. trade or business is subject to the branch profits tax on its ECEP attributable to its distributive share of effectively connected income.
A foreign government is subject to both the branch profits tax and the branch-level interest taxes. However, no branch profits tax or branch-level interest tax will be imposed on ECEP and interest accrued prior to September 11, 1992. See Regulations section 1.884-0.

Line 2

Attach a schedule showing the following adjustments (based on the principles of section 312) to the corporation's line 1 effectively connected taxable income (ECTI) (before the NOL deduction and special deductions) to get ECEP:

Positive adjustments for certain effectively connected income items that are excluded from ECTI but that must be included in computing ECEP (such as tax-exempt interest income).
Positive adjustments for certain items deducted in computing ECTI but that may not be deducted in computing ECEP. Include adjustments for certain deductions claimed in computing ECTI, such as:
1. Excess of percentage depletion over cost depletion,
2. Excess of accelerated depreciation over straight line depreciation (but only if 20% or more of the foreign corporation's gross income from all sources is U.S. source), and
3. Capital loss carrybacks and carryovers.
Negative adjustments for certain deductible items (that are allocable to effectively connected income) that may not be deducted in computing ECTI but that must be deducted in computing ECEP (e.g., federal income taxes, capital losses in excess of capital gains, and interest and expenses that are not deductible under section 265).

Do not reduce ECEP by any dividends or other distributions made by the foreign corporation to its shareholders during the year.

See Temporary Regulations section 1.884-2T for any adjustments to ECEP due to a reorganization, liquidation, or incorporation.

Exceptions. Do not include the following types of income when computing ECEP:

Income from the operation of ships or aircraft exempt from taxation under section 883(a)(1) or (2).
FSC income and distributions treated as effectively connected income under section 921(d) or section 926(b) that are not otherwise effectively connected income.
Gain on the disposition of an interest in a domestic corporation that is a U.S. real property interest under section 897(c)(1)(A)(ii) if the gain is not otherwise effectively connected income.
Related person insurance company income that a taxpayer elects to treat as effectively connected income under section 953(c)(3)(C) if the income is not otherwise effectively connected income.
Income that is exempt from tax under section 892.
Interest income derived by a possession bank from U.S. obligations if the interest is treated as effectively connected income under section 882(e) and is not otherwise effectively connected income.

Deductions and other adjustments attributable (under the principles of Regulations section 1.861-8) to the types of income not includible in ECEP listed above do not reduce ECEP.

Lines 4a and 4b. U.S. Net Equity

U.S. net equity is U.S. assets reduced by U.S. liabilities. U.S. net equity may be less than zero. See Temporary Regulations section 1.884-2T for specific rules regarding the computation of the foreign corporation's U.S. net equity due to a reorganization, liquidation, or incorporation.

U.S. assets. In general, property is a U.S. asset if all income from its use and all gain from its disposition (if used or sold on the last day of the tax year) are or would be effectively connected income. The amount of property taken into account as a U.S. asset is the adjusted basis (for purposes of computing earnings and profits) of the property. Special rules exist for specific types of property, such as depreciable property, inventory, and installment obligations. Special rules also exist to determine the amount of a partnership interest that is treated as a U.S. asset. See Regulations section 1.884-1(d).

U.S. liabilities. In general, U.S. liabilities are U.S.-connected liabilities of a foreign corporation (determined under Regulations section 1.882-5), computed as of the end of the tax year, rather than as an average, as required under Regulations section 1.882-5. Special rules may apply to foreign insurance companies. For more details, see Regulations section 1.884-1(e).

If the corporation is electing to reduce liabilities under Regulations section 1.884-1(e)(3), attach a statement that it is making the election and indicate the amount of the reduction of U.S. liabilities and the corresponding reduction in interest expense.

Reporting requirements. In the schedules required for lines 4a and 4b, report U.S. assets according to the categories of U.S. assets in Regulations section 1.884-1(d). For U.S. liabilities, show the formula used to calculate the U.S. liabilities figure.

Line 6. Branch Profits Tax

Qualification for treaty benefits. In general, a foreign corporation must be a qualified resident (see Item V on page 22 for definition) in the tax year in which it has a dividend equivalent amount to obtain treaty benefits for the branch profits tax. It must also meet the requirements of any limitation on benefits article in the treaty. However, a foreign corporation is not required to be a qualified resident if it meets the requirements of a limitation on benefits article that entered into force after December 31, 1986. Treaties other than income tax treaties do not exempt a foreign corporation from the branch profits tax.

If a foreign corporation claims to be a qualified resident based on the two-part stock ownership and base erosion test, a special rule governs the period during which it must be a qualified resident. (See the instructions for Item V on page 22.)

Rate of tax. If treaty benefits apply, the rate of tax is the rate on branch profits specified in the treaty. If the treaty does not specify a rate for branch profits, the rate of tax is the rate specified in the treaty for dividends paid by a wholly owned domestic corporation to the foreign corporation. See Regulations section 1.884-1(g) for applicable rates of tax. Benefits other than a rate reduction may be available under certain treaties, such as the Canadian income tax treaty.

Effect of complete termination. If the foreign corporation has completely terminated its U.S. trade or business (within the meaning of Temporary Regulations section 1.884-2T(a)) during the tax year, enter zero on line 6, and complete Item T at the bottom of page 5.

In general, a foreign corporation has terminated its U.S. trade or business if it no longer has any U.S. assets, except those retained to pay off liabilities. The foreign corporation (or a related corporation) may not use assets from the terminated U.S. trade or business or the proceeds from their sale in a U.S. trade or business within 3 years after the complete termination.

Coordination with withholding tax. If a foreign corporation is subject to the branch profits tax in a tax year, it will not be subject to withholding at source (sections 871(a), 881(a), 1441, or 1442) on dividends paid out of earnings and profits for the tax year.

Part II—Tax on Excess Interest

If a foreign corporation is engaged in a U.S. trade or business, has effectively connected gross income, or has U.S. assets for purposes of Regulations section 1.882-5, it is subject to the tax on excess interest.

Excess interest is the interest apportioned to effectively connected income of the foreign corporation (including capitalized and nondeductible interest) under Regulations section 1.882-5, less branch interest. Branch interest is the interest paid by the U.S. trade or business of the foreign corporation (including capitalized and other nondeductible interest).

See the instructions for line 10 on page 22 to determine if the foreign corporation is exempt from the tax on excess interest. If it is exempt from the tax, and not simply subject to a reduced rate of tax, do not complete Part II of Section III. However, be sure to complete Items U and V on page 5.

Line 8. Branch Interest

Foreign banks. In general, branch interest of a foreign bank is limited to:

Interest paid for branch liabilities that are reported to bank regulatory authorities;
Interest paid for offshore shell branches, if the U.S. branch performs substantially all of the activities required to incur the liability; and
Interest on liabilities that are secured predominantly by U.S. assets or that cause certain nondeductible interest (such as capitalized interest) related to U.S. assets.

All other foreign corporations. In general, branch interest of foreign corporations (other than banks) includes:

Interest on liabilities shown on the books and records of the U.S. trade or business for purposes of Regulations section 1.882-5;
Interest on liabilities that are secured predominantly by U.S. assets or that cause certain nondeductible interest (such as capitalized interest) related to U.S. assets; and
Interest on liabilities identified as liabilities of the U.S. trade or business on or before the earlier of the date on which the first interest payment is made or the due date (including extensions) of the foreign corporation's income tax return for the tax year.

However, a liability may not be identified under 3 above if the liability is incurred in the ordinary course of the foreign corporation's trade or business, or if the liability is secured predominantly by assets that are not U.S. assets. The interest on liabilities identified in 3 above that will be treated as interest paid by the U.S. trade or business is capped at 85% of the interest of the foreign corporation that would be excess interest before considering interest on liabilities identified in 3 above. See Regulations section 1.884-4.

Interbranch interest. Any interest paid for interbranch liabilities is disregarded in computing branch interest of any corporation.

Eighty-percent rule. If 80% or more of a foreign corporation's assets are U.S. assets, the foreign corporation's branch interest will generally equal the interest reported on line 7c. However, any interest included on line 7c that has accrued but has not been paid will not be treated as branch interest on line 8 unless an election is made under Regulations section 1.884-4(c)(1) to treat such interest as paid in that year for all purposes of the Code.

If this 80% rule applies, check the box on line 8.

Branch interest of a foreign corporation is treated as if paid by a domestic corporation. A foreign corporation is thus required to withhold on interest paid by its U.S. trade or business to foreign persons (unless the interest is exempt from withholding under a treaty or the Code) and is required to file Forms 1042 and 1042-S for the payments.

Special treaty shopping rules apply if the recipient of the interest paid by the U.S. trade or business is a foreign corporation.

Line 9b

A foreign bank may treat a percentage of its excess interest as if it were interest on deposits and thus exempt from tax. Multiply the amount on line 9a by the greater of 85% or the ratio of the foreign bank's worldwide interest-bearing deposits to its worldwide interest-bearing liabilities as of the close of the tax year.

Line 10. Tax on Excess Interest

The rate of tax on excess interest is the same rate that would apply to interest paid to the foreign corporation by a wholly owned domestic corporation. The tax on excess interest is not prohibited by any provision in any treaty to which the United States is a party. The corporation may qualify for treaty benefits if it meets certain requirements. See Line 6, Branch Profits Tax, on page 21, and Item V below. The corporation is exempt from the tax on excess interest if the rate of tax that would apply to interest paid to the foreign corporation by a wholly owned domestic corporation is zero and the foreign corporation qualifies for treaty benefits.

Additional Information Required

Complete all applicable items on page 5.

Item V

Qualified resident. A foreign corporation is a qualified resident of a country if it meets one of the three tests explained below. See the regulations under section 884 for details on these tests and certain circumstances in which a foreign corporation that does not meet these tests may obtain a ruling to be treated as a qualified resident.

Two-part ownership and base erosion test. A foreign corporation meets this test if:

More than 50% of its stock (by value) is owned (directly or indirectly) during at least half the number of days in its tax year by qualifying shareholders and
Less than 50% of its income is used (directly or indirectly) to meet liabilities to persons who are not residents of the foreign country and are not U.S. citizens or residents.

For purposes of this test, individuals resident in the foreign country, U.S. citizens and residents, governments of foreign countries, and foreign corporations that meet the publicly traded test (described later) are treated as qualifying shareholders.

In general, stock owned by a corporation, partnership, trust, or estate is treated as proportionately owned by the individual owners of such entities.

In order to satisfy the 50% stock ownership test described above, a foreign corporation must, before filing Form 1120-F for the tax year, obtain certain written documentation from the requisite number of its direct and indirect shareholders to show that it meets the test, including a certificate of residency from each foreign individual resident signed by the Competent Authority of the individual's country of residence. See Regulations sections 1.884-5(a) through (c).

If a foreign corporation is a qualified resident under this test and a portion of its dividend equivalent amount for the tax year is from ECEP earned in prior tax years, the foreign corporation will be entitled to treaty benefits for the entire dividend equivalent amount only if:

The foreign corporation was a qualified resident for all tax years within the 36-month period that includes the tax year of the dividend equivalent amount or
The foreign corporation was a qualified resident for the tax year of the dividend equivalent amount, and for the years in which the ECEP included in the dividend equivalent amount were earned.

If the foreign corporation fails the 36-month test but is a qualified resident for the tax year, the portion of the dividend equivalent amount for ECEP from any prior tax year will not be entitled to treaty benefits if the foreign corporation was not a qualified resident for the tax year in which the ECEP was earned. Thus, in some instances, more than one rate of tax may apply to the dividend equivalent amount reported on line 5, Section III. See Regulations section 1.884-1(g)(2).

Publicly traded test. A foreign corporation meets this test if:

Its stock is primarily and regularly traded on one or more established securities markets in its country of residence or in the United States or
90% or more of its stock is owned (directly or indirectly) by another corporation that meets the requirements of 1 above and is a resident of the same country or is a domestic corporation.

See Regulations section 1.884-5(d).

Active trade or business test. A foreign corporation meets this test if it has a substantial presence in its country of residence and its U.S. trade or business is an integral part of an active trade or business conducted by the foreign corporation in its country of residence. See Regulations section 1.884-5(e).

Item X

If the corporation owned at least a 10% interest, directly or indirectly, in any foreign partnership, attach a statement listing the following information for each foreign partnership. For this purpose, a foreign partnership includes an entity treated as a foreign partnership under Regulations section 301.7701-2 or 301.7701-3.

Name and EIN (if any) of the foreign partnership;
Identify which, if any, of the following forms the foreign partnership filed for its tax year ending with or within the corporation's tax year: Form 1042, 1065 or 1065-B, or 8804;
Name of tax matters partner (if any); and
Beginning and ending dates of the foreign partnership's tax year.

Schedules L, M-1, and M-2

The foreign corporation may limit Schedule L to a minimum balance sheet based on the set or sets of books reflecting assets of the corporation located in the United States and its other assets used in the trade or business conducted in the United States (other than assets giving rise to effectively connected income under section 864(c)(6) or (7)). If the foreign corporation has more than one set of books and records relating to assets located in the United States or assets used in a trade or business conducted in the United States, it must report the combined amounts shown on all such books and records on Schedule L. For example, the books and records of a foreign insurance company required to file Form 1120F include, but are not limited to, amounts reported on statements (e.g., NAIC statements) filed with a domestic state insurance authority.

The foreign corporation must report on line 1 of Schedule M-1 the net income (loss) per the set or sets of books taken into account on Schedule L. The foreign corporation must report on line 1 of Schedule M-2 the balance of unappropriated retained earnings per the set or sets of books taken into account on Schedule L.

Do not complete Schedules M-1 and M-2 if total assets at the end of the tax year (line 15, column (d) of Schedule L) are less than $25,000.

Schedule L—Balance Sheets per Books

The balance sheet should agree with the corporation's books and records. Include certificates of deposit as cash on line 1.

Line 5. Tax-exempt securities. Include:

State and local government obligations, the interest on which is excludable from gross income under section 103(a) and
Stock in a mutual fund or other regulated investment company that distributed exempt-interest dividends during the tax year of the corporation.

Line 26. Adjustments to shareholders' equity. Some examples of adjustments to report on this line include:

Unrealized gains and losses on securities held “available for sale.”
Foreign currency translation adjustments.
The excess of additional pension liability over unrecognized prior service cost.
Guarantees of employee stock (ESOP) debt.
Compensation related to employee stock award plans.

If the total adjustment to be entered on line 26 is a negative amount, enter the amount in parentheses.

Schedule M-1—Reconciliation of Income (Loss) per Books With Income per Return

Line 5c. Travel and entertainment expenses. Include any of the following:

Meal and entertainment expenses not deductible under section 274(n).
Expenses for the use of an entertainment facility.
The part of business gifts over $25.
Expenses of an individual over $2,000 that are allocable to conventions on cruise ships.
Employee achievement awards over $400.
The cost of entertainment tickets over face value (also subject to the 50% limit under section 274(n)).
The cost of skyboxes over the face value of nonluxury box seat tickets.
The part of luxury water travel expenses not deductible under section 274(m).
Expenses for travel as a form of education.
Other nondeductible travel and entertainment expenses.

For more information, see Pub. 542.

Line 7a. Tax-exempt interest. Report any tax-exempt interest received or accrued, including any exempt-interest dividends received as a shareholder in a mutual fund or other regulated investment company. Also report this same amount in item N at the bottom of page 2 of the form.

Specific Instructions

Period Covered

Address

Employer Identification Number (EIN)

Note.

Initial Return, Final Return, Amended Return, Name Change, or Address Change

Note.

Computation of Tax Due or Overpayment

Line 5b. Estimated Tax Payments

Line 5c. Overpaid Estimated Tax

Line 5f. Credit for Tax Paid on Undistributed Capital Gains

Line 5g. Credit for Federal Tax on Fuels

Line 5i. Credit for Federal Telephone Excise Tax Paid

Line 5j. Total Payments

Line 6. Estimated Tax Penalty

Line 9. Electronic Deposit of Refund

Section I—Income From U.S. Sources Not Effectively Connected With the Conduct of a Trade or Business in the United States

Note.

Line 9. Gross Transportation Income

Additional Information Required

Item M — Personal Service Corporation

Item N

Item P

Item Q

Item R

Note.

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

U.S. Source Effectively Connected Income

Foreign Source Effectively Connected Income

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

Election To Treat Real Property Income as Effectively Connected Income

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

Income

Line 1. Gross Receipts

Line 2. Cost of Goods Sold

Line 4. Dividends

Line 5. Interest

Note.

Line 6. Gross Rents

Line 8. Capital Gain Net Income

Line 10. Other Income

Deductions

Important.

Apportionment of Expenses

Limitations on Deductions

Line 12. Compensation of Officers

Line 13. Salaries and Wages

Line 14. Repairs and Maintenance

Line 15. Bad Debts

Line 16. Rents

Line 17. Taxes and Licenses

Line 18. Interest

Important:

Line 19. Charitable Contributions

Note.

Note.

Line 20. Depreciation

Line 23. Depletion

Line 25. Pension, Profit-sharing, etc., Plans

Line 26. Employee Benefit Programs

Line 28. Other Deductions

Line 30. Taxable Income Before NOL Deduction and Special Deductions

Line 31a. Net Operating Loss Deduction

Line 31b. Special Deductions

Line 32. Taxable Income or (Loss)

Schedule A—Cost of Goods Sold

Schedule C—Dividends and Special Deductions

Line 1, Column (a)

Line 2, Column (a)

Line 3, Column (a)

Line 3, Columns (b) and (c)

Line 4, Column (a)

Line 5, Column (a)

Line 6, Column (a)

Line 7, Column (a)

Line 8, Column (c)

(Worksheet for Schedule C, line 8)

Line 10, Column (a)

Line 11, Column (a)