Instructions for Schedule M-3 (Form 1120) - PDF by jrv19070

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									2004                                                                                             Department of the Treasury
                                                                                                 Internal Revenue Service



Instructions for
Schedule M-3 (Form 1120)
Net Income (Loss) Reconciliation for Corporations With Total Assets of
$10 Million or More
Section references are to the Internal Revenue Code unless otherwise noted.

                                            required or voluntary). A corporation      consolidated Schedule L reported in the
General Instructions                        filing Schedule M-3 must not file          return does not include the assets of
                                            Schedule M-1.                              one or more of the insurance
Purpose of Schedule                              If the parent corporation of a U.S.   companies in the U.S. consolidated tax
                                            consolidated tax group files Form 1120     group, in order to determine if the group
Schedule M-3 Part I asks certain                                                       meets the $10 million threshold test for
questions about the corporation’s           and files Schedule M-3, all members of
                                            the group must file Schedule M-3.          the requirement to file Schedule M-3,
financial statements and reconciles                                                    use the sum of the amount of total
financial statement net income (loss) for   However, if the parent corporation of a
                                            U.S. consolidated tax group files Form     assets reported on the consolidated
the consolidated financial statement                                                   Schedule L plus the amounts of all
group to income (loss) per the income       1120 and any member of the group
                                            files Form 1120-PC, U.S. Property and      assets reported on Forms 1120-PC and
statement for the U.S. consolidated tax                                                1120-L that are included in the
group.                                      Casualty Insurance Company Income
                                            Tax Return, or Form 1120-L, U.S. Life      consolidated return.
   Schedule M-3 Parts II and III            Insurance Company Income Tax                  Schedule M-3 is not required for any
reconcile financial statement net           Return, that member may either (a) fully   taxpayers other than those identified in
income (loss) for the U.S. consolidated     complete Schedule M-3 as if the            the preceding paragraphs including, for
tax group (per Schedule M-3, Part I,        member filed Form 1120; or (b)             example, taxpayers required to file
line 11) to taxable income on Form          complete Schedule M-3 by including         Form 1065, U.S. Return of Partnership
1120, page 1, line 28.                      the sum of all differences between the     Income, Form 1120S, U.S. Income Tax
                                            member’s income statement net              Return for an S Corporation, Form
Who Must File                               income (or loss) and taxable income        1120-REIT, U.S. Income Tax Return for
                                            (differences) (regardless of whether the   Real Estate Investment Trusts, Form
Schedule M-3 is effective for any tax
                                            difference would otherwise be reported     1120-F, U.S. Income Tax Return of a
year ending on or after December 31,
                                            elsewhere on Part II or on Part III) on    Foreign Corporation, Form 1120-H,
2004. For purposes of determining
                                            Part II, line 26, Other income (loss)      U.S. Income Tax Return for
whether a corporation with a
                                            items with differences, and separately     Homeowners Associations, and Form
52-53-week tax year must file Schedule
                                            state and adequately disclose each         1120-SF, U.S. Income Tax Return for
M-3, such corporation’s tax year is
                                            difference in a supporting schedule.       Settlement Funds. In addition,
deemed to end or close on the last day
                                            Any member of the U.S. consolidated        Schedule M-3 is not required for any
of the calendar month nearest to the
                                            tax group that files Form 1120-PC or       member of a U.S. consolidated tax
last day of the 52-53 week tax year.
                                            Form 1120-L and is required to file        group if the parent corporation of the
(For further guidance on 52-53 week
                                            Schedule M-3 (in accordance with the       group files Form 1120-PC or Form
tax years, see Regulations section
                                            preceding sentence) may classify all       1120-L.
1.441-2(c)(1).) Any domestic
corporation (including a U.S.               differences as permanent in column (c)        Example 1. U.S. corporation A
consolidated tax group consisting of a      or identify each difference as temporary   owns U.S. subsidiary B and foreign
U.S. parent corporation and additional      or permanent, as appropriate.              subsidiary F. For its 2004 tax year, A
includible corporations listed on Form           If the parent company of a U.S.       prepares consolidated financial
851, Affiliations Schedule) required to     consolidated tax group files Form 1120     statements with B and F that report
file Form 1120, U.S. Corporation            and any member of the group files          total assets of $12 million. A files a
Income Tax Return, that reports on          Form 1120-PC or Form 1120-L and the        consolidated U.S. federal income tax
Schedule L of Form 1120 total               consolidated Schedule L reported in the    return with B and reports total
consolidated assets at the end of the       return includes the assets of all of the   consolidated assets on Schedule L of
corporation’s tax year that equal or        insurance companies (as well as the        $8 million. A’s U.S. consolidated tax
exceed $10 million must complete and        non-insurance companies in the U.S.        group is not required to file Schedule
file Schedule M-3 in lieu of Schedule       consolidated tax group), in order to       M-3 for the 2004 tax year.
M-1, Reconciliation of Income (Loss)        determine if the group meets the $10          If a corporation was required to file
per Books With Income per Return. A         million threshold test for the             Schedule M-3 for the preceding tax
U.S. corporation filing Form 1120 that is   requirement to file Schedule M-3, use      year but reports on Schedule L of Form
not required to file Schedule M-3 may       the amount of total assets reported on     1120 total consolidated assets at the
voluntarily file Schedule M-3 in place of   Schedule L of the consolidated return.     end of the current tax year of less than
Schedule M-1. A corporation filing          If the parent company of a U.S.            $10 million, the corporation is not
Schedule M-3 must check the box on          consolidated tax group files Form 1120     required to file Schedule M-3 for the
Form 1120, page 1, item A, indicating       and any member of the group files          current tax year. The corporation may
that Schedule M-3 is attached (whether      Form 1120-PC or Form 1120-L and the        either (a) file Schedule M-3, or (b) file

                                                         Cat. No. 38103Y
Schedule M-1, for the current tax year.      books and records. The Schedule L             complete Parts II and III of a separate
However, if the corporation chooses to       balance sheet may show tax-basis              Schedule M-3 for consolidation
file Schedule M-1 for the current tax        balance sheet amounts if the                  eliminations. For example, if a U.S.
year, and for a subsequent tax year the      corporation is allowed to use books and       consolidated tax group consists of four
corporation is required to file Schedule     records for Schedule M-3 and the              includible corporations (the parent and
M-3, the corporation must complete           corporation’s books and records reflect       three subsidiaries), the U.S.
Schedule M-3 in its entirety (Part I and     only tax-basis amounts.                       consolidated tax group must complete
all columns in Parts II and III) for that                                                  six Schedules M-3 as follows: (a) one
subsequent tax year.                         Schedule M-2                                  consolidated Schedule M-3 with Parts I,
                                             The amount shown on Schedule M-2,             II, and III completed to reflect the
    In the case of a U.S. consolidated                                                     activity of the entire U.S. consolidated
tax group, total assets at the end of the    line 2, Net income (loss) per books,
                                             must equal the amount shown on                tax group; (b) Parts II and III of a
tax year must be determined based on                                                       separate Schedule M-3 for each of the
the total year-end assets of all             Schedule M-3, Part I, line 11. Schedule
                                             M-2 must reflect activity only of             four includible corporations to reflect
includible corporations listed on Form                                                     the activity of each includible
851, net of eliminations for                 corporations included in the U.S.
                                             consolidated tax return.                      corporation; and (c) Parts II and III of a
intercompany transactions and                                                              separate Schedule M-3 to eliminate
balances between the includible
corporations. In addition, for purposes      Consolidated Return                           intercompany transactions between
                                             (Form 1120, Page 1)                           includible corporations and to include
of determining for Schedule M-3                                                            limitations on deductions (e.g.,
whether the corporation (or U.S.             Report on Form 1120, page 1, each             charitable contribution limitations and
consolidated tax group) has total assets     item of income, gain, loss, expense, or       capital loss limitations) and carryover
at the end of the current tax year of $10    deduction net of elimination entries for      amounts (e.g., charitable contribution
million or more, the corporation’s total     intercompany transactions between             carryovers and capital loss carryovers).
consolidated assets must be                  includible corporations. The corporation
determined on an overall accrual             must not report as dividends on Form             If an item attributable to an includible
method of accounting unless both of          1120, Schedule C, any amounts                 corporation is not shared by or
the following apply: (a) the tax returns     received from an includible corporation.      allocated to the appropriate member of
of all includible corporations in the U.S.   In general, dividends received from an        the group but is retained in the parent
consolidated tax group are prepared          includible corporation must be                corporation’s financial statements (or
using an overall cash method of              eliminated in consolidation rather than       books and records, if applicable), then
accounting, and (b) no includible            offset by the dividends-received              the item must be reported by the parent
corporation in the U.S. consolidated tax     deduction.                                    corporation on its separate Schedule
group prepares or is included in                                                           M-3. For example, if the parent of a
financial statements prepared on an                                                        U.S. consolidated tax group prepares
accrual basis.
                                             Entity Considerations                         financial statements that include all
                                             for Schedule M-3                              members of the U.S. consolidated tax
Other Form 1120                              For purposes of Schedule M-3,                 group and the parent does not allocate
                                             references to the classification of an        the group’s income tax expense as
Schedules Affected by                        entity (for example, as a corporation, a      reflected in the financial statements
                                             partnership, or a trust) are references to    among the members of the group but
Schedule M-3                                 the treatment of the entity for U.S.          retains it in the parent corporation, the
Requirements                                 federal income tax purposes. An entity        parent corporation must report on its
                                             that generally is disregarded as              separate Schedule M-3 the U.S.
Report on Schedules L, M-2, and Form                                                       consolidated tax group’s income tax
1120, page 1, amounts for the U.S.           separate from its owner for U.S. federal
                                             income tax purposes (disregarded              expense as reflected in the financial
consolidated tax group.                                                                    statements.
                                             entity) must not be separately reported
Schedule L                                   on Schedule M-3. Instead, any item of            Any adjustments made at the
                                             income, gain, loss, deduction, or credit      consolidated group level that are not
Total assets shown on Schedule L, line
                                             of a disregarded entity must be               attributable to any specific member of
15, column (d), must equal the total
                                             reported as an item of its owner.             the U.S. consolidated tax group (e.g.,
assets of the corporation (or, in the
case of a U.S. consolidated tax group,                                                     disallowance of net capital losses,
the total assets of all members of the       Consolidated                                  contribution deduction carryovers, and
group listed on Form 851) as of the last                                                   limitation of contribution deductions)
day of the tax year, and must be the
                                             Schedule M-3 Versus                           must not be reported on the separate
                                                                                           consolidating parent or subsidiary
same total assets reported by the            Consolidating                                 Schedules M-3 but rather on the
corporation (or by each member of the
U.S. consolidated tax group) in the          Schedules M-3                                 consolidated Schedule M-3 and on the
financial statements, if any, used for       A U.S. consolidated tax group must file       consolidating Schedule M-3 for
Schedule M-3. If the corporation             a consolidated Schedule M-3. Parts I,         consolidation eliminations (see the
prepares financial statements,               II, and III of the consolidated Schedule      second preceding paragraph).
Schedule L must equal the sum of the         M-3 must reflect the activity of the             If an includible corporation has no
financial statement total assets for each    entire U.S. consolidated tax group. The       activity for the tax year (e.g., because
corporation listed on Form 851 and           parent corporation also must complete         the corporation is a dormant or inactive
included in the U.S. consolidated tax        Parts II and III of a separate Schedule       corporation), no amount for the
return (includible corporation) net of       M-3 to reflect the parent’s own activity.     corporation was included in Part I, line
eliminations for intercompany                In addition, Parts II and III of a separate   11, and the corporation has no
transactions between includible              Schedule M-3 must be completed by             amounts to report on Part II and Part III
corporations. If the corporation does not    each includible corporation to reflect the    of Schedule M-3 for the tax year, the
prepare financial statements, Schedule       activity of that includible corporation.      parent corporation of the U.S.
L must be based on the corporation’s         Lastly, it generally will be necessary to     consolidated tax group may attach to
                                                                -2-                     Instructions for Schedule M-3 (Form 1120)
the consolidated Schedule M-3 a             the case of a U.S. consolidated tax            Line 2. Questions Regarding
statement that provides the name and        group, for the U.S. parent corporation’s
EIN of the includible corporation in lieu   consolidated group) filing Form 1120,
                                                                                           Income Statement Period
of filing a blank Part II and Part III of   the U.S. corporation (or the U.S. parent       and Restatements
Schedule M-3 for such entity.               corporation of a U.S. consolidated tax         Enter the beginning and ending dates
                                            group) must enter “No” on questions            on line 2a for the corporation’s income
Completion of                               1a, 1b, and 1c, skip Part I, lines 2           statement period ending with or within
                                            through 10, and enter the net income           this tax year. Answer “Yes” on lines 2b
Schedule M-3                                (loss) per the books and records of the        and/or 2c if the corporation’s income
A corporation (or any member of a U.S.                                                     statement has been restated for any
                                            U.S. corporation (or U.S. consolidated
consolidated tax group) required to file                                                   reason, and attach an explanation for
Schedule M-3 must complete the form         tax group) on Part I, line 11, Net             each restatement, the original amount
in its entirety. At the time the Form       income (loss) per income statement of          of each income statement item
1120 is filed, all applicable questions     includible corporations.                       restated, and the restated amount of
must be answered on Part I (except                                                         each income statement item restated.
that in the case of a U.S. consolidated        If a non-publicly traded U.S. parent
tax group, Part I need only be              corporation of a U.S. consolidated tax         Line 3. Questions Regarding
completed once, on the consolidated         group prepares financial statements            Publicly Traded Voting
Schedule M-3, by the parent                 and that group includes a publicly             Common Stock
corporation), all columns must be           traded subsidiary that files financial
completed on Parts II and III, and all                                                     The primary U.S. publicly traded voting
                                            statements with the Securities and             common stock class is the most widely
numerical data required by Schedule         Exchange Commission (SEC), the
M-3 must be provided at the time the                                                       held or most heavily traded within the
                                            consolidated financial statements of the       U.S. as determined by the corporation.
Form 1120 is filed. Any schedule
                                            parent corporation are the appropriate         If the corporation has more than one
required to support a line item on
Schedule M-3 must be attached at the        financial statements for purposes of           class of publicly traded voting common
time Schedule M-3 is filed and must         completing Part I. Do not use any              stock, attach a list of the classes of
provide the information required for that   separate company financial statements          publicly traded voting common stock,
line item.                                  that might be prepared for publicly            the trading symbol of each class, the
                                            traded subsidiaries.                           nine-digit CUSIP number of each class,
                                                                                           and the name and EIN of the
                                                 If a corporation (a) is included in the   corporation issuing the stock.
Specific Instructions                       consolidated financial statements of a         Line 4. Worldwide
for Part I                                  group (consolidated financial statement
                                            group) with a U.S. parent corporation
                                                                                           Consolidated Net Income
                                            filing a Form 1120 and Schedule M-3,           (Loss) per Income Statement
Part I. Financial                           (b) is not included in the Form 1120 of        In completing Schedule M-3, the
Information and Net                         the parent corporation of the                  corporation must use financial
                                                                                           statement amounts from the financial
                                            consolidated financial statement group,
Income (Loss)                               (c) does not have a separate financial         statement type checked “Yes” on Part I,
                                                                                           line 1. If Part I, line 1a, is checked
Reconciliation                              statement (certified or otherwise) of its
                                                                                           “Yes,” report on Part I, line 4, the net
                                            own, and (d) files its own Form 1120
                                            (separate or consolidated), the                income amount reported in the income
When To Complete Part I                                                                    statement presented to the SEC on the
                                            corporation must answer questions 1a,          corporation’s Form 10-K (the Form
Part I must be completed for any tax
year for which the corporation files        1b, and 1c of Part I as appropriate for        10-K for the security identified on Part I,
Schedule M-3.                               its own Form 1120 and must report on           line 3b, if applicable).
                                            Part I, line 4 or 11, as appropriate, the
                                                                                              If a corporation prepares financial
Line 1. Questions Regarding                 amount for the corporation’s net income
                                                                                           statements, the amount on line 4 must
the Type of Income                          (loss) that is equal to the amount             equal the financial statement net
                                            included in the income statement of the
Statement Prepared                          consolidated financial statement group
                                                                                           income (loss) for the income statement
For Schedule M-3, Part I, lines 1                                                          period ending with or within the tax year
                                            and removed in Schedule M-3, Part I of         as indicated on line 2a.
through 11, use only the financial          that group’s U.S. federal income tax
statements of the U.S. corporation filing                                                     If the corporation prepares financial
                                            return. However, if in the circumstances       statements and the income statement
the U.S. federal income tax return (the
                                            described immediately above, the               period differs from the corporation’s tax
consolidated financial statements for
the U.S. parent corporation of a U.S.       corporation does have separate                 year, the income statement period
consolidated tax group). If the U.S.        financial statements (certified or             indicated on line 2a applies for
corporation filing a U.S. federal income    otherwise) of its own, independent of          purposes of Part I, lines 4 through 8.
tax return (or the U.S. parent              the amount of the corporation’s net               If the corporation does not prepare
corporation of a U.S. consolidated tax      income included in its parent                  financial statements, skip lines 2a
group) is controlled by another             company’s consolidated financial               through 10 and enter the net income
corporation (U.S. or foreign), the U.S.     statements, the corporation must               (loss) per the books and records of the
corporation (or the U.S. parent             answer questions 1a, 1b, and 1c of Part        U.S. corporation or the U.S.
corporation of a U.S. consolidated tax      I, as appropriate, for its own Form            consolidated tax group on Part I, line
group) must not use the financial           1120, based on its own separate                11, Net income (loss) per income
statements of the controlling               income statement, and must report on           statement of includible corporations.
corporation for its Schedule M-3, Part I.   Part I, line 4, the net income amounts            If line 4 includes net income (loss)
   If no financial statements are           shown on its separate income                   for a corporation that files Form
prepared for the U.S. corporation (or, in   statement.                                     1120-PC or Form 1120-L, see the
Instructions for Schedule M-3 (Form 1120)                       -3-
instructions for Part I, line 10, for            Attach a supporting schedule that          applicable) of each corporation to which
adjustments that may be necessary to          provides the name, EIN (if applicable),       the adjustment relates, the net
reconcile financial statement income to       and financial statement net income            adjustment included on line 10 for each
statutory income.                             (loss) included on this line 7 for each       corporation, and an explanation of each
                                              other includible corporation.                 net adjustment.
Line 5. Net Income (Loss) of
Nonincludible Foreign                         Line 8. Adjustment to                         Line 11. Net Income (Loss)
Entities                                      Eliminations of Transactions                  per Income Statement of
Remove the financial statement net            Between Includible                            Includible Corporations
income (line 5a) or loss (line 5b) of         Corporations and                              Report on line 11 the consolidated
each foreign entity that is included in       Nonincludible Entities                        income statement net income (loss) of
the consolidated financial statement                                                        all corporations included in the U.S.
group and is not an includible                Include on line 8 any adjustments for         consolidated tax return for the tax year
corporation in the U.S. consolidated tax      minority interest, intercompany               and listed on the Form 851. If the
group (nonincludible foreign entity). In      dividends, and eliminations of                corporation does not prepare financial
addition, on Part I, line 8, adjust for       intercompany transactions associated          statements, enter on line 11 the net
consolidation eliminations and correct        with amounts included on Part I, line 4,      income (loss) per the books and
for minority interest and intercompany        amounts removed on Part I, line 5 or 6,       records of the U.S. consolidated tax
dividends for any nonincludible foreign       or amounts included on Part I, line 7, so     group.
entity. Do not remove in Part I the           that the adjusted consolidation entries
financial statement net income (loss) of      and intercompany eliminations are only           Example 2. U.S. corporation P is
any nonincludible foreign entity              those applicable to the income (loss) of      publicly traded and files Form 10-K with
accounted for in the financial                includible corporations for the financial     the SEC. P owns 80% or more of the
statements on the equity method.              statement period. Adjustments on Part         stock of U.S. corporations DS1-DS75,
                                              I, line 8, for consolidation entries are      between 51% and 79% of the stock of
   Attach a supporting schedule that          necessary to ensure that transactions         U.S. corporations DS76-DS100, and
provides the name, EIN (if applicable),       between includible corporations and           100% of the stock of foreign
and financial statement net income            either nonincludible foreign entities or      subsidiaries FS1-FS50. P eliminates all
(loss) included on line 4 that is removed     nonincludible U.S. entities are not           dividend income from DS1-DS100 and
on this line 5 for each nonincludible         eliminated. Additionally, adjustments on      FS1-FS50 in financial statement
foreign entity.                               Part I, line 8, for consolidation entries     consolidation entries. Furthermore, P
                                              are necessary to ensure that                  eliminates the minority interest
Line 6. Net Income (Loss) of                  transactions between includible               ownership of DS1-DS100 in financial
Nonincludible U.S. Entities                   corporations that are in the                  statement consolidation entries. P’s
Remove the financial statement net            consolidated financial statement group        SEC Form 10-K includes P,
income (line 6a) or loss (line 6b) of         and other includible corporations that        DS1-DS100 and FS1-FS50 on a fully
each U.S. entity that is included in the      are not in the consolidated financial         consolidated basis. P files a U.S.
consolidated financial statement group        statement group are eliminated.               consolidated tax return with DS1-DS75.
and is not an includible corporation in
                                              Line 9. Adjustment to                            P must check “Yes” on Part I, line
the U.S. consolidated tax group
                                                                                            1a. On Part I, line 4, P must report the
(nonincludible U.S. entity). In addition,     Reconcile Income Statement                    consolidated net income from the SEC
on Part I, line 8, adjust for consolidation
eliminations and correct for minority         Period to Tax Year                            Form 10-K for the consolidated financial
                                              Include on line 9 any adjustments             statement group of P, DS1-DS100, and
interest and intercompany dividends for
                                              necessary to the income (loss) of             FS1-FS50. P must remove the net
any nonincludible U.S. entity. Do not
                                              includible corporations to reconcile          income (loss) of FS1-FS50 on Part I,
remove in Part I the financial statement
                                              differences between the corporation’s         lines 5a or 5b, as applicable. P must
net income (loss) of any nonincludible
                                              income statement period reported on           remove the net income (loss) before
U.S. entity accounted for in the financial
                                              line 2a and the corporation’s tax year.       minority interests of DS76-DS100 on
statements on the equity method.
                                                                                            Part I, lines 6a or 6b, as applicable. P
   Attach a supporting schedule that          Line 10. Other Adjustments                    must reverse on Part I, line 8, the
provides the name, EIN (if applicable),                                                     elimination of any transactions between
and financial statement net income            Required To Reconcile to                      the includible corporations (P and
(loss) included on line 4 that is removed     Amount on Line 11                             DS1-DS75) and the nonincludible
on this line 6 for each nonincludible         Include on line 10 any other                  entities (DS76-DS100 and FS1-FS50),
U.S. entity.                                  adjustments to reconcile net income           including dividends received from
                                              (loss) on Part I, line 4, with net income     DS76-DS100 and FS1-FS50 and the
Line 7. Net Income (Loss) of                  (loss) of includible corporations             minority interest’s share of the net
Other Includible                              reported on Part I, line 11. If the net       income (loss) of DS1-DS100.
Corporations                                  income (loss) of an includible                    P reports on Part I, line 11, the
Include the financial statement net           corporation that files Form 1120-PC or        consolidated financial statement net
income (line 7a) or loss (line 7b) of         Form 1120-L is included on Part I, lines      income (loss) attributable to the
each corporation includible in the U.S.       4, 7, 8, or 9, and is computed on a           includible corporations. Intercompany
consolidated tax group that is not            basis other than statutory accounting,        transactions between the includible
included in the consolidated financial        include on line 10 the adjustments            corporations that had been eliminated
statement group (other includible             necessary such that Part I, line 11,          in the net income amount on line 4
corporation). In addition, on Part I, line    includes net income (loss) for such           remain eliminated in the net income
8, adjust for consolidation eliminations      corporation on a statutory accounting         amount on line 11. Transactions
and correct for minority interest and         basis.                                        between the includible corporations and
intercompany dividends for any other             Attach a supporting schedule that          the nonincludible entities that are
includible corporation.                       provides the name and EIN (if                 eliminated in the net income amount on
                                                                 -4-                      Instructions for Schedule M-3 (Form 1120)
line 4 are included in the net income        before minority interest and interest             4. Report on Part II, line 30, column
amount on line 11.                           expense to P, less the minority interest       (d), the sum of Part II, line 30, columns
    Example 3. Foreign corporation F         of $20 in the net income of DS1, and           (a), (b), and (c).
owns 100% of the stock of U.S.               the entire net income of P of $1,000
corporation P. P owns 100% of the            measured before recognition of the             Note. Part II, line 30, column (d), must
stock of DS1, 60% of the stock of DS2,       intercompany interest from DS1 and the         equal the amount on Form 1120, page
and 100% of the stock of FS1. F              consolidation of DS1 operations.               1, line 28.
prepares certified audited financial                                                        When To Complete
statements. P does not prepare any                                                          Columns (b) and (c)
financial statements. P files a U.S.
consolidated tax return with DS1.            Specific Instructions for                      Columns (b) and (c) of Parts II and III
                                                                                            must be completed for any tax year for
    P must check “No” on Part I, lines       Parts II and III                               which the corporation files Schedule
1a, 1b, and 1c, skip lines 2a through 10     For U.S. consolidated tax returns, file        M-3.
of Part I, and enter net income (loss)       supporting schedules for each
per the books and records of the                                                                For any item of income, gain, loss,
                                             includible corporation. See
includible corporations (P and DS1) on                                                      expense, or deduction for which there
                                             Consolidated returns on page 4 of the
Part I, line 11, net of eliminations for                                                    is a difference between columns (a)
                                             Form 1120 instructions.
transactions between P and DS1.                                                             and (d), the portion of the difference
                                                                                            that is temporary must be entered in
    Example 4. U.S. corporation C            General Format of                              column (b) and the portion of the
owns 60% of the capital and profits          Parts II and III                               difference that is permanent must be
interests in U.S. LLC N. N has net
                                             For each line item in Parts II and III,        entered in column (c).
income of $100 (before minority
interests) and makes no distributions        report in column (a) the amount of net             If financial statements are prepared
during the year. C treats N as a             income (loss) included in Part I, line 11,     by the corporation in accordance with
corporation for financial statement          and report in column (d) the amount            generally accepted accounting
purposes and as a partnership for U.S.       included in taxable income.                    principles (GAAP), differences that are
federal income tax purposes. In its                                                         treated as temporary for GAAP must be
financial statements, C consolidates N       When To Complete                               reported in column (b) and differences
and includes $60 of net income ($100         Columns (a) and (d)                            that are permanent (that is, not
less the minority interest of $40) on        A corporation is not required to               temporary for GAAP) must be reported
Part I, line 4.                              complete columns (a) and (d) of Parts II       in column (c). Generally, pursuant to
    C must remove the $100 net income        and III for the first tax year the             GAAP, a temporary difference affects
of N on Part I, line 6a. C must reverse      corporation is required to file Schedule       (creates, increases, or decreases) a
on Part I, line 8, the elimination of the    M-3. The corporation must complete             deferred tax asset or liability.
$40 minority interest net income of N.       columns (a) and (d) of Parts II and III            If the corporation does not prepare
The result is that C includes no income      for all tax years subsequent to the first      financial statements, or the financial
for N on Part I, line 11. C’s taxable        tax year the corporation is required to        statements are not prepared in
income from N must be reported by C          file Schedule M-3.                             accordance with GAAP, report in
on Part II, line 9, Income (loss) from          If, for any tax year (or tax years)         column (b) any difference that the
U.S. partnerships.                           prior to the first tax year a corporation is   corporation believes will reverse in a
    Example 5. U.S. corporation P            required to file Schedule M-3, a               future tax year (that is, have an
owns 80% of the stock of corporation         corporation voluntarily files Schedule         opposite effect on taxable income in a
DS1. DS1 is included in P’s U.S.             M-3 in lieu of Schedule M-1, then in           future tax year (or years) due to the
consolidated federal income tax return,      those voluntary filing years the               difference in timing of recognition for
even though DS1 is not included in P’s       corporation is not required to complete        financial accounting and U.S. federal
consolidated financial statements. DS1       columns (a) and (d) of Parts II and III.       income tax purposes) or is the reversal
has current year net income of $100          In addition, in the first tax year the         of such a difference that arose in a prior
after it pays interest of $40 to P. P has    corporation is required to file Schedule       tax year. Report in column (c) any
net income of $1,040 after recognition       M-3 the corporation is not required to         difference that the corporation believes
of the interest income from DS1. In its      complete columns (a) and (d) of Parts II       will not reverse in a future tax year (and
financial statements, P reports the $40      and III.                                       is not the reversal of such a difference
interest as part of its net income of                                                       that arose in a prior tax year).
$1,040 on Part I, line 4. P is required to      If a corporation chooses not to                 If the corporation is unable to
include the $100 net income of DS1 on        complete columns (a) and (d) of Parts II       determine whether a difference
Part I, line 7, and the operations of DS1    and III in the first tax year the              between column (a) and column (d) for
must be included in P’s return on a fully    corporation is required to file Schedule       an item will reverse in a future tax year
consolidated basis. P must remove on         M-3 (or in any year in which the               or is the reversal of a difference that
Part I, line 8, the $40 of interest income   corporation voluntarily files Schedule         arose in a prior tax year, report the
received from DS1 included by P on           M-3), then Part II, line 30, is reconciled     difference for that item in column (c).
line 4 and the $40 of interest expense       by the corporation (or, in the case of a
of DS1 included in line 7 for a net          U.S. consolidated tax group, by the                Example 6. For the 2004, 2005, and
change of zero on line 8. On line 8, P       group’s parent corporation on Part II,         2006 tax years, corporation A has total
must also remove the $20 minority            line 30, of the group’s consolidated           consolidated assets on the last day of
interest in the net income of DS1 (DS1       Schedule M-3) in the following manner:         the tax year as reported on Schedule L,
net income of $100 × 20% minority                1. Report the amount from Part I,          line 15, column (d), of $8 million, $11
interest). On Part 1, line 11, P reports     line 11, on Part II, line 30, column (a);      million, and $12 million, respectively. A
$1,120, $1,040 from line 4, $100 from            2. Leave blank Part II, lines 1            is required to file Schedule M-3 for its
line 7, and ($20) from line 8. The result    through 29, columns (a) and (d);               2005 and 2006 tax years.
is that P includes on Part I, line 11, the       3. Leave blank Part III, columns (a)           For its 2004 tax year, A voluntarily
entire net income of DS1 of $140             and (d); and                                   files Schedule M-3 in lieu of Schedule
Instructions for Schedule M-3 (Form 1120)                        -5-
M-1 and does not complete columns (a)       that reportable transaction must be                Furthermore, in applying the two
and (d) of Parts II and III.                reported on Part II, line 12.                  preceding paragraphs, a corporation is
                                                                                           required to report in column (a) of Parts
     For A’s 2005 tax year, the first tax       A corporation is required to report in     II and III the amount of any item
year that A is required to file Schedule    column (a) of Parts II and III the amount      specifically listed on Schedule M-3 that
M-3, A is only required to complete Part    of any item specifically listed on             is included in the corporation’s financial
I and columns (b) and (c) of Parts II and   Schedule M-3 that is in any manner             statements or exists in the corporation’s
III.                                        included in the corporation’s current          books and records, regardless of the
   For A’s 2006 tax year, A is required     year financial statement net income            nomenclature associated with that item
to complete Schedule M-3 in its             (loss) or in an income or expense              in the financial statements or books and
entirety.                                   account maintained in the corporation’s        records. Accurate completion of
                                            books and records, even if there is no         Schedule M-3 requires reporting
    Example 7. Corporation B is a U.S.      difference between that amount and the         amounts according to the substantive
publicly traded corporation that files a    amount included in taxable income              nature of the specific line items
U.S. consolidated tax return and            unless (a) otherwise provided in these         included in Schedule M-3 and
prepares consolidated GAAP financial        instructions or (b) the amount is              consistent reporting of all transactions
statements. In prior years, B acquired      attributable to a reportable transaction       of like substantive nature that occurred
intellectual property (IP) and goodwill     described in Regulations section               during the tax year. For example, all
through several corporate acquisitions.     1.6011-4(b) other than a transaction           expense amounts that are included in
The IP is amortizable for both U.S.         described in Regulations section               the financial statements or exist in the
federal income tax and financial            1.6011-(4)(b)(6) (relating to significant      books and records that represent some
statement purposes. In the current          book-tax differences) and is therefore         form of “Bad debt expense,” must be
year, B’s annual amortization expense       reported on Part II, line 12. For              reported on Part III, line 32, in column
for IP is $9,000 for U.S. federal income    example, with the exception of interest        (a), regardless of whether the amounts
tax purposes and $6,000 for financial       income reflected on a Schedule K-1             are recorded or stated under different
statement purposes. In its financial        received by a corporation as a result of       nomenclature in the financial
statements, B treats the difference in IP   the corporation’s investment in a              statements or the books and records
amortization as a temporary difference.     partnership or other pass-through              such as: “Provision for doubtful
The goodwill is not amortizable for U.S.    entity, all interest income, whether from      accounts”; “Expense for uncollectible
federal income tax purposes and is          unconsolidated affiliated companies,           notes receivable”; or “Impairment of
subject to impairment for financial         third parties, banks, or other entities,       trade accounts receivable.” Likewise,
statement purposes. In the current          whether imputed interest or not,               as stated in the preceding paragraph,
year, B records an impairment charge        whether from foreign or domestic               all fines and penalties must be included
on the goodwill of $5,000. In its           sources, whether taxable or exempt             on Part III, line 12, column (a),
financial statements, B treats the          from tax and regardless of how or              regardless of the terminology or
goodwill impairment as a permanent          where the income is classified in the          nomenclature attached to them by the
difference. B must report the               corporation’s financial statements, must       corporation in its books and records or
amortization attributable to the IP on      be included on Part II, line 13, column        financial statements.
Part III, line 28, Other amortization or    (a). Likewise, all fines and penalties
impairment write-offs, and report           paid to a government or other authority            With limited exceptions, Part II
$6,000 in column (a), a temporary           for the violation of any law for which         includes lines for specific items of
difference of $3,000 in column (b), and     fines or penalties are assessed must be        income, gain, or loss (income items).
$9,000 in column (d). B must report the     included on Part III, line 12, column (a),     (See Part II, lines 1 through 25.) If an
goodwill impairment on Part III, line 26,   regardless of the government authority         income item is described in Part II, lines
Amortization/impairment of goodwill,        that imposed the fines or penalties,           1 through 25, report the amount of the
and report $5,000 in column (a), a          regardless of whether the fines or             item on the applicable line, regardless
permanent difference of ($5,000) in         penalties are civil or criminal,               of whether there is a difference for the
column (c), and $0 in column (d).           regardless of the classification,              item. If there is a difference for the
                                            nomenclature, or terminology attached          income item, or only a portion of the
Reporting Requirements                      to the fines or penalties by the imposing      income item has a difference and a
                                            authority in its actions or documents,         portion of the item does not have a
for Parts II and III                        and regardless of how or where the             difference, and the item is not
                                            fines or penalties are classified in the       described in Part II, lines 1 through 25,
General Reporting                           corporation’s financial income                 report and describe the entire amount
Requirements                                statement or the income and expense            of the item on Part II, line 26, Other
                                            accounts maintained in the                     income (loss) items with differences.
If an amount is attributable to a           corporation’s books and records.
reportable transaction described in                                                            With limited exceptions, Part III
Regulations section 1.6011-4(b) (other          If a corporation would be required to      includes lines for specific items of
than a transaction described in             report in column (a) of Parts II and III       expense or deduction (expense items).
Regulations section 1.6011-(4)(b)(6)        the amount of any item specifically            (See Part III, lines 1 through 34.) If an
relating to significant book-tax            listed on Schedule M-3 in accordance           expense item is described on Part III,
differences), the amount must be            with the preceding paragraph, except           lines 1 through 34, report the amount of
reported in columns (a), (b), (c), and      that the corporation has capitalized the       the item on the applicable line,
(d), as applicable, of Part II, line 12,    item of income or expense and reports          regardless of whether there is a
Items relating to reportable                the amount in its financial statement          difference for the item. If there is a
transactions, regardless of whether the     balance sheet or in asset and liability        difference for the expense item, or only
amount would otherwise be reported on       accounts maintained in the                     a portion of the expense item has a
Part II or Part III of Schedule M-3.        corporation’s books and records, the           difference and a portion of the item
Thus, if a taxpayer files Form 8886,        corporation must report the proper tax         does not have a difference and the item
Reportable Transaction Disclosure           treatment of the item in columns (b),          is not described in Part III, lines 1
Statement, the amounts attributable to      (c), and (d), as applicable.                   through 34, report and describe the
                                                               -6-                       Instructions for Schedule M-3 (Form 1120)
entire amount of the item on Part III,        required to file Schedule M-3 for its       Schedule M-3 for its 2005 tax year. On
line 35, Other expense/deduction items        2005 tax year. C’s total depreciation       January 2, 2005, E establishes an
with differences.                             expense for its 2005 tax year for five of   allowance for uncollectible accounts
     If there is no difference between the    the assets is $50,000 for income            receivable (bad debt reserve) of
financial accounting amount and the           statement purposes and $70,000 for          $100,000. During 2005, E increased
taxable amount of an entire item of           U.S. federal income tax purposes. C’s       the reserve by $250,000 for additional
income, loss, expense, or deduction           total annual depreciation expense for its   accounts receivable that may become
and the item is not described or              2005 tax year for the other five assets     uncollectible. Additionally, during 2005
included in Part II, lines 1 through 26,      is $40,000 for income statement             E decreases the reserve by $75,000 for
or Part III, lines 1 through 35, report the   purposes and $30,000 for U.S. federal       accounts receivable that were
entire amount of the item in column (a)       income tax purposes. In its financial       discharged in bankruptcy during 2005.
and (d) of Part II, line 29, Other income     statements, C treats the differences        The balance in the reserve account on
(loss) and expense/deduction items            between financial statement and U.S.        December 31, 2005, is $275,000. The
with no differences.                          federal income tax depreciation             $100,000 amount to establish the
Separately stated and adequately              expense as giving rise to temporary         reserve account and the $250,000 to
disclosed. Each difference reported in        differences that will reverse in future     increase the reserve account are
Parts II and III must be separately           years. C must combine all of its            expenses on E’s 2005 financial
stated and adequately disclosed. In           depreciation adjustments. Accordingly,      statements but are not deductible for
general, a difference is adequately           C must report on Part III, line 31,         U.S. federal income tax purposes in
disclosed if the difference is labeled in     Depreciation, for its 2005 tax year         2005. However, the $75,000 decrease
a manner that clearly identifies the item     income statement depreciation expense       to the reserve is deductible for U.S.
or transaction from which the difference      of $90,000 in column (a), a temporary       federal income tax purposes in 2005. In
arises. For further guidance about            difference of $10,000 in column (b),        its financial statements, E treats the
adequate disclosure, see Regulations          and U.S. federal income tax                 reserve account as giving rise to a
section 1.6662-4(f). If a specific item of    depreciation expense of $100,000 in         temporary difference that will reverse in
income, gain, loss, expense, or               column (d).                                 future tax years. E must report on Part
deduction is described on Part II, lines           Example 9. Corporation D is a          III, line 32, Bad debt expense, for its
9 through 25, or Part III, lines 1 through    calendar year taxpayer that was             2005 tax year income statement bad
34, and the line does not indicate to         required to file Schedule M-3 for its       debt expense of $350,000 in column
“attach schedule” or “attach details,”        2004 tax year and is required to file       (a), a temporary difference of
and the specific instructions for the line    Schedule M-3 for its 2005 tax year. On      ($275,000) in column (b), and U.S.
do not call for an attachment of a            December 31, 2005, D establishes            federal income tax bad debt expense of
schedule or statement, then the item is       three reserve accounts in the amount of     $75,000 in column (d).
considered separately stated and              $100,000 for each account. One                  Example 11. Corporation F is a
adequately disclosed if the item is           reserve account is an allowance for         calendar year taxpayer that was
reported on the applicable line and the       accounts receivable that are estimated      required to file Schedule M-3 for its
amount(s) of the item(s) are reported in      to be uncollectible. The second reserve     2004 tax year and is required to file
the applicable columns of the                 is an estimate of a settlement D may        Schedule M-3 for its 2005 tax year.
applicable line. See the instructions         have to pay as a result of pending          During 2005, F incurs $200 of meals
beginning on page 8 for specific              litigation. The third reserve is an         and entertainment expenses that F
additional information required to be         estimate of future warranty expenses.       deducts in computing net income per
provided for amounts reported on Part         In its financial statements, D treats the   the income statement. $50 of the $200
II, lines 1 through 8.                        three reserve accounts as giving rise to    is subject to the $50% limitation under
     Except as otherwise provided,            temporary differences that will reverse     section 274(n). In its financial
differences for the same item must be         in future years. The three reserves are     statements, F treats the limitation on
combined or netted together and               expenses in D’s 2005 financial              deductions for meals and entertainment
reported as one amount on the                 statements but are not deductions for       as a permanent difference. Because
applicable line of Schedule M-3.              U.S. federal income tax purposes in         meals and entertainment expenses are
However, differences for separate items       2005. D must not combine the                specifically described in Part III, line 11,
must not be combined or netted                Schedule M-3 differences for the three      Meals and entertainment, F must report
together and each item (and                   reserve accounts. D must report the         all of its meals and entertainment
corresponding amount attributable to          amounts attributable to the allowance       expenses on this line, regardless of
that item) must be separately stated          for uncollectible accounts receivable on    whether there is a difference.
and adequately disclosed on the               Part III, line 32, Bad debt expense, and    Accordingly, F must report $200 in
applicable line of Schedule M-3. In           must separately state and adequately        column (a), $25 in column (c), and
addition, every item of difference must       disclose the amounts attributable to        $175 in column (d). F must not report
be separately stated and adequately           each of the two reserves for pending        the $150 of meals and entertainment
disclosed. Differences for dissimilar         litigation and the warranty costs on a      expenses that are deducted in F’s
items cannot be combined even if the          required, attached schedule that            financial statement net income and are
amounts are below a certain dollar            supports the amounts at Part III, line      fully deductible for U.S. federal income
amount.                                       35, Other expense/deduction items with      tax purposes on Part II, line 29, Other
     Example 8. Corporation C is a            differences.                                income (loss) and expense/deduction
calendar year taxpayer that placed in            Example 10. Corporation E is a           items with no differences, and the $50
service ten depreciable fixed assets in       calendar year taxpayer that was             subject to the limitation under section
2000. C was required to file Schedule         required to file Schedule M-3 for its       274(n) on Part III, line 11, Meals and
M-3 for its 2004 tax year and is              2004 tax year and is required to file       entertainment.




Instructions for Schedule M-3 (Form 1120)                        -7-
Part II. Reconciliation of                     Line 3. Subpart F, QEF, and                    Line 7. U.S. Dividends Not
                                               Similar Income Inclusions                      Eliminated in Tax
Net Income (Loss) per                          Report on line 3, column (d), the              Consolidation
Income Statement of                            amount included in taxable income              Report on line 7, column (a), the
                                               under section 951 (relating to Subpart         amount of dividends received from any
Includible Corporations                        F), gains or other income inclusions           U.S. corporation included in Part I, line
With Taxable Income per                        resulting from elections under sections        11. Report on line 7, column (d), the
                                               1291(d)(2) and 1298(b)(1), and any             amount of any U.S. dividends included
Return                                         amount included in taxable income              in taxable income on Form 1120, page
                                               pursuant to section 1293 (relating to          1, line 28 (that is, taxable dividends
Lines 1 Through 8.                             qualified electing funds). The amount of       received from any U.S. corporation that
Additional Information for                     Subpart F income corresponds to the            is not included in the U.S. consolidated
                                               total of the amounts reported by the           tax group and required to be listed on
Each Corporation                                                                              Form 851).
                                               corporation on line 6, Schedule I, of all
For any item reported on Part II, lines 1,
3 through 6, or 8, attach a supporting         Forms 5471, Information Return of U.S.              For any dividends reported on Part
schedule that provides the name of the         Persons With Respect to Certain                II, line 7, that are received on classes of
entity for which the item is reported, the     Foreign Corporations. The amount of            voting stock in which the corporation
type of entity (corporation, partnership,      qualified electing fund income                 directly or indirectly owned 10% or
etc.), the entity’s EIN (if applicable), and   corresponds to the total of the amounts        more of the outstanding shares of that
the item amounts for columns (a)               reported by the corporation on line 3(a),      class at any time during the tax year,
through (d). See the instructions for          Part II, of all Forms 8621, Return by a        report on an attached supporting
Part II, lines 2 and 7, for the specific       Shareholder of a Passive Foreign               schedule for Part II, line 7, the name of
information required for those particular      Investment Company or Qualified                the dividend payer, the class of voting
lines.                                         Electing Fund.                                 stock on which the dividend was paid,
                                                                                              the payer’s EIN (if applicable), and the
Line 1. Income (Loss) From                                                                    item amounts for columns (a) through
                                                 Also include on line 3 PFIC
                                                                                              (d).
Equity Method Foreign                          mark-to-market gains and losses under
Corporations                                   section 1296. Do not report such gains         Line 8. Minority Interest for
                                               and losses on Part II, line 16,
Report on line 1, column (a), the              Mark-to-market income (loss).                  Includible Corporations
income statement income (loss)                                                                Report on line 8, column (a), the
included in Part I, line 11, for any                                                          minority interest in the income (loss)
foreign corporation accounted for on           Line 4. Section 78 Gross-Up                    included in the income statement
the equity method and remove such              Report on line 4, column (d), the              income (loss) on Part I, line 11, for any
amount in column (b) or (c), as                amount of any section 78 gross-up. The         member of the U.S. consolidated tax
applicable. Report the amount of               section 78 gross-up amount must                group that is less than 100% owned.
dividends received and other taxable           correspond to the total section 78
amounts received or includible from                                                              Example 12. Corporation G is a
                                               gross-up amounts reported by the               calendar year taxpayer that was
foreign corporations on Part II, lines 2
through 5, as applicable.                      corporation on all Forms 1118, Foreign         required to file Schedule M-3 for its
                                               Tax Credit – Corporations.                     2004 tax year and is required to file
                                                                                              Schedule M-3 for its 2005 tax year. G
Line 2. Gross Foreign                                                                         owns 90% of the stock of U.S.
Dividends Not Previously                       Line 5. Gross Foreign                          corporation DS1. G files a U.S.
Taxed                                          Distributions Previously                       consolidated tax return with DS1. G
Report on line 2, column (d), the              Taxed                                          prepares certified GAAP financial
amount (before any withholding tax) of                                                        statements for the consolidated
                                               Report on line 5 any distributions             financial statement group consisting of
any foreign dividends included in              received from foreign corporations that
current year taxable income on Form                                                           G and DS1. G has no net income of its
                                               were included in Part I, line 11, and that     own, and G does not report its equity
1120, page 1, line 28. Report on line 2,       were previously taxed. For example,
column (a), the amount of dividends                                                           interest in the income of DS1 on its
                                               include amounts that are excluded from         separate financial statements. DS1 has
from any foreign corporation included in
                                               income under sections 959 and                  financial statement net income (before
Part I, line 11. Do not report any
amounts that are reported on Part II,          1293(c). Report the full amount of the         minority interests) and taxable income
lines 3 or 4, or dividends that were           distribution before any withholding tax.       of $1,000 ($2,500 of revenue less
previously taxed (see the instructions                                                        $1,500 cost of goods sold). On Part I,
for line 5 on this page).                                                                     line 11, Net income (loss) per income
                                               Line 6. Income (Loss) From                     statement of includible corporations, of
     For any dividends reported on Part        Equity Method U.S.                             the consolidated Schedule M-3, the
II, line 2, that are received on a class of    Corporations                                   U.S. consolidated tax group must report
voting stock of which the corporation                                                         $900 of financial statement income
directly or indirectly owned 10% or            Report on line 6, column (a), the              ($1,000 net income less $100 minority
more of the outstanding shares of that         income statement income (loss)                 interest). On Part II, line 8, Minority
class at any time during the tax year,         included in Part I, line 11, for any U.S.      interest for includible corporations, of
report on an attached supporting               corporation accounted for on the equity        the consolidated Schedule M-3, the
schedule the name of the dividend              method and remove such amount in               U.S. consolidated tax group reports
payer, the class of voting stock on            column (b) or (c), as applicable. Report       ($100) in column (a), $100 in column
which the dividend was paid, the               on Part II, line 7, dividends received         (c), and $0 in column (d). On Part II,
payer’s EIN (if applicable), and the item      from any U.S. corporation accounted            line 29, Other income (loss) and
amounts for columns (a) through (d).           for on the equity method.                      expense/deduction items with no
                                                                  -8-                       Instructions for Schedule M-3 (Form 1120)
differences, of the consolidated              and the amount reported in column (a),           For each pass-through entity
Schedule M-3, the U.S. consolidated           (b), (c), or (d) of lines 9 or 10, as         reported on line 11, attach a supporting
tax group reports $1,000 in both              applicable.                                   schedule that provides that entity’s
columns (a) and (d). As a result,                 Example 13. U.S. corporation H is a       name, EIN (if applicable), the
financial statement net income on Part        calendar year taxpayer that was               corporation’s end of year profit-sharing
II, line 30, column (a), will total $900,     required to file Schedule M-3 for its         percentage (if applicable), the
net permanent differences on Part II,         2004 tax year and is required to file         corporation’s end of year loss-sharing
line 30, column (c), will total $100, and     Schedule M-3 for its 2005 tax year. H         percentage (if applicable), and the
taxable income on line 30, column (d),        has an investment in a U.S. partnership       amounts reported by the corporation in
will total $1,000. G must prepare three       USP. H prepares financial statements          column (a), (b), (c), or (d) of line 11, as
consolidating Schedules M-3, each with        in accordance with GAAP. In its               applicable.
Parts II and III, one for G, one for DS1,     financial statements, H treats the
and one for consolidation eliminations.       difference between financial statement
                                                                                            Line 12. Items Relating to
On the consolidating Schedule M-3 for         net income and taxable income from its        Reportable Transactions
DS1, on Part II, line 29 and line 30, G       investment in USP as a permanent              Any amounts attributable to any
reports for DS1 $1,000 in both columns        difference. For its 2005 tax year, H’s        reportable transactions (as described in
(a) and (d). On the consolidating             financial statement net income includes       Regulations section 1.6011-4) other
Schedule M-3 for G, on Part II, line 30,      $10,000 of income attributable to its         than transactions described in
G reports for itself zero in both columns     share of USP’s net income. H’s                Regulations section 1.6011-4(b)(6)
(a) and (d). On the consolidating             Schedule K-1 from USP reports $5,000          relating to significant book-tax
Schedule M-3 for consolidation                of ordinary income, $7,000 of long-term       differences must be included on Part II,
eliminations, on Part II, line 8 and line     capital gains, $4,000 of charitable           line 12, regardless of whether the
30, G reports the minority interest           contributions, and $200 of section 179        difference, or differences, would
elimination for the U.S. consolidated tax     expense. H must report on Part II, line       otherwise be reported elsewhere in Part
group of ($100) in column (a), $100 in        9, $10,000 in column (a), a permanent         II or Part III. Thus, if a taxpayer files
column (c), and $0 in column (d).             difference of ($2,200) in column (c),         Form 8886 for any reportable
                                              and $7,800 in column (d).                     transaction described in Regulations
Line 9. Income (Loss) From                                                                  section 1.6011-4 and the transaction is
                                                  Example 14. Same facts as
U.S. Partnerships and Line                    Example 13 except that corporation H’s        not described in Regulations section
10. Income (Loss) From                        charitable contribution deduction is          1.6011-4(b)(6) relating to significant
                                                                                            book-tax differences, the amounts
Foreign Partnerships                          wholly attributable to its partnership
                                                                                            attributable to that reportable
For any interest owned by the                 interest in USP and is limited to $90
                                              pursuant to section 170(b)(2) due to          transaction must be reported on Part II,
corporation or a member of the U.S.                                                         line 12. In addition, all income and
consolidated tax group that is treated        other investment losses incurred by H.
                                              In its financial statements, H treated        expense amounts attributable to a
as an investment in a partnership for                                                       reportable transaction must be reported
U.S. federal income tax purposes (other       this limitation as a temporary difference.
                                              H must not report the charitable              on Part II, line 12, columns (a) and (d)
than an interest in a disregarded entity),                                                  even if there is no difference between
report the following on Part II, line 9 or    contribution limitation of $3,910 ($4,000
                                              - $90) on Part II, line 9. H must report      the financial statement amounts and
10, as applicable:                                                                          the taxable amounts.
                                              the limitation on Part III, line 21,
    1. In column (a) the sum of the           Charitable contribution limitation, and           Each difference attributable to a
corporation’s distributive share of           report the disallowed charitable              reportable transaction must be
income or loss from a U.S. or foreign         contributions of ($3,910) in columns (b)      separately stated and adequately
partnership that is included in Part I,       and (d).                                      disclosed. A corporation will be
line 11, Net income (loss) per income                                                       considered to have separately stated
statement of includible corporations;         Line 11. Income (Loss) From                   and adequately disclosed a reportable
    2. In column (b) or (c), as
applicable, the sum of all differences, if
                                              Other Pass-Through Entities                   transaction on line 12 if the corporation
                                              For any interest in a pass-through entity     sequentially numbers each Form 8886
any, attributable to the corporation’s                                                      and lists by identifying number on the
distributive share of income or loss from     (other than an interest in a partnership
                                              reportable on Part II, line 9 or 10, as       supporting schedule for Part II, line 12,
a U.S. or foreign partnership; and                                                          each sequentially numbered reportable
    3. In column (d) the sum of all           applicable) owned by a member of the
                                              U.S. consolidated tax group (other than       transaction and the amounts required
amounts of income, gain, loss, or                                                           for Part II, line 12, columns (a) through
deduction attributable to the                 an interest in a disregarded entity),
                                              report the following on line 11:              (d).
corporation’s distributive share of
income or loss from a U.S. or foreign             1. In column (a) the sum of the               In lieu of the requirements of the
partnership (i.e., the sum of all amounts     corporation’s distributive share of           preceding paragraph, a corporation will
reportable on the corporation’s               income or loss from the pass-through          be considered to have separately
Schedule(s) K-1 received from the             entity that is included in Part I, line 11,   stated and adequately disclosed a
partnership (if applicable)), without         Net income (loss) per income statement        reportable transaction if the corporation
regard to any limitations computed at         of includible corporations;                   attaches a supporting schedule that
the partner level (e.g., limitations on           2. In column (b) or (c), as               provides the following for each
utilization of charitable contributions,      applicable, the sum of all differences, if    reportable transaction:
capital losses, and interest expense).        any, attributable to the pass-through             1. A description of the reportable
                                              entity; and                                   transaction disclosed on Form 8886 for
    For each partnership reported on              3. In column (d) the sum of all           which amounts are reported on Part II,
line 9 or 10, attach a supporting             taxable amounts of income, gain, loss,        line 12;
schedule that provides the name, EIN          or deduction reportable on the                    2. The name and tax shelter
(if applicable), end of year profit-sharing   corporation’s Schedules K-1 received          registration number, if applicable, as
percentage (if applicable), end of year       from the pass-through entity (if              reported on lines 1a and 1b,
loss-sharing percentage (if applicable),      applicable).                                  respectively, of Form 8886; and
Instructions for Schedule M-3 (Form 1120)                        -9-
    3. The type of reportable transaction      reportable transaction described in             financial statement rental income is
(i.e., listed transaction, confidential        Regulations section 1.6011-4(b)(4).             included on page 11 in the instructions
transaction, transaction with contractual      This reportable transaction is the only         for line 18, Sale versus lease (for
protection, etc.) as reported on line 2 of     reportable transaction for K’s 2005 tax         sellers and/or lessors).
Form 8886.                                     year and results in a $7 million capital
                                               loss for both financial statement               Line 14. Total Accrual to
    If a transaction is a listed transaction   purposes and U.S. federal income tax
described in Regulations section               purposes. Although the transaction
                                                                                               Cash Adjustment
1.6011-4(b)(2), the description also           does not result in a difference, K is           This line is completed by a corporation
must include the description provided          required to report on Part II, line 12, the     that prepares financial statements (or
on line 3 of Form 8886. In addition, if        following amounts: ($7 million) in              books and records, if permitted) using
the reportable transaction involves an         column (a), zero in columns (b) and (c),        an overall accrual method of accounting
investment in the transaction through          and ($7 million) in column (d). The             and uses an overall cash method of
another entity such as a partnership,          transaction will be adequately disclosed        accounting for U.S. federal income tax
the description must include the name          if K attaches a supporting schedule for         purposes (or vice-versa). With the
and EIN (if applicable) of that entity as      line 12 that (a) sequentially numbers           exception of amounts required to be
reported on line 5 of Form 8886.               the Form 8886 and refers to the                 reported on Part II, line 12, Items
    Example 15. Corporation J is a             sequentially-numbered Form 8886-X1              relating to reportable transactions, the
calendar year taxpayer that was                and (b) reports the applicable amounts          corporation must report on Part II, line
required to file Schedule M-3 for its          required for line 12, columns (a)               14, a single amount net of all
2004 tax year and is required to file          through (d). Alternatively, the                 adjustments attributable solely to the
Schedule M-3 for its 2005 tax year. J          transaction will be adequately disclosed        use of the different overall methods of
incurred seven different abandonment           if the supporting statement for line 12         accounting (e.g., adjustments related to
losses during its 2005 tax year. One           includes a description of the                   accounts receivable, accounts payable,
loss of $12 million results from a             transaction, the name and tax shelter           compensation, accrued liabilities, etc.),
reportable transaction described in            registration number, if any, and the type       regardless of whether a separate line
Regulations section 1.6011-4(b)(5),            of reportable transaction disclosed on          on Schedule M-3 corresponds to an
another loss of $5 million results from a      Form 8886.                                      item within the accrual to cash
reportable transaction described in                                                            reconciliation. Differences not
Regulations section 1.6011-4(b)(4), and        Line 13. Interest Income                        attributable to the use of the different
the remaining five abandonment losses                                                          overall methods of accounting must be
                                               With the exception of interest income           reported on the appropriate lines of
are not reportable transactions. J             derived from a pass-through entity and
discloses the reportable transactions                                                          Schedule M-3 (e.g., a depreciation
                                               required to be reported on Part II, line        difference must be reported on Part III,
giving rise to the $12 million and $5          9, 10, or 11, as applicable, or interest
million losses on separate Forms 8886                                                          line 31, Depreciation).
                                               from a reportable transaction (as
and sequentially numbers them X1 and           described in Regulations section                    Example 17. Corporation L is a
X2, respectively. J must separately            1.6011-4) other than a transaction              calendar year taxpayer that was
state and adequately disclose the $12          described in Regulations section                required to file Schedule M-3 for its
million and $5 million losses on Part II,      1.6011-4(b)(6) relating to significant          2004 tax year and is required to file
line 12. The $12 million loss and the $5       book-tax differences required to be             Schedule M-3 for its 2005 tax year. L
million loss will be adequately disclosed      reported on Part II, line 12, Items             prepares financial statements in
if J attaches a supporting schedule for        relating to reportable transactions,            accordance with GAAP using an overall
line 12 that lists each of the                 report on Part II, line 13, column (a),         accrual method of accounting. L uses
sequentially numbered forms, Form              the total amount of interest income             an overall cash method of accounting
8886-X1 and Form 8886-X2, and with             included on Part I, line 11, and report         for U.S. federal income tax purposes.
respect to each reportable transaction         on Part II, line 13, column (d), the total      L’s financial statements for the year
reports the appropriate amounts                amount of interest income included on           ending December 31, 2005, report
required for Part II, line 12, columns (a)     Form 1120, page 1, line 28. In columns          accounts receivable of $35,000, an
through (d). Alternatively, J’s                (b) or (c), as applicable, adjust for any       allowance for bad debts of $10,000,
disclosures will be adequate if the            amounts treated for U.S. federal                and accounts payable of $17,000
description provided for each loss on          income tax purposes as imputed                  related to current year acquisition and
the supporting schedule includes the           interest income or other interest income        reorganization legal and accounting
names and tax shelter registration             that are treated as some other form of          fees. In addition, for L’s year ending
numbers, if any, disclosed on the              income in the financial statements. For         December 31, 2005, L reported
applicable Form 8886, identifies the           example, if rental income is reported in        financial statement depreciation
type of reportable transaction for the         the financial income statement or books         expense of $15,000 and depreciation
loss, and reports the appropriate              and records with respect to a                   for U.S. federal income tax purposes of
amounts required for Part II, line 12,         transaction required to be treated for          $25,000. For L’s 2005 tax year using an
columns (a) through (d). J must report         U.S. federal income tax purposes as a           overall cash method of accounting, L
the losses attributable to the other five      sale in exchange for periodic payments          does not recognize the $35,000 of
abandonment losses on Part II, line            of purchase price, part of the “rent”           revenue attributable to the accounts
23e, Abandonment losses, regardless            each year is principal and part is              receivable, cannot deduct the $10,000
of whether a difference exists for any or      interest income for U.S. federal income         allowance for bad debt, and cannot
all of those abandonment losses.               tax purposes. The interest income               deduct the $17,000 of accounts
    Example 16. Corporation K is a             imputed on the transaction each year            payable. In its financial statements, L
calendar year taxpayer that was                must be shown as a difference on Part           treats both the difference in overall
required to file Schedule M-3 for its          II, line 13, columns (b) or (c), as             accounting methods used for financial
2004 tax year and is required to file          applicable, with the taxable interest           statement and U.S. federal income tax
Schedule M-3 for its 2005 tax year. K          amount being included in column (d). A          purposes and the difference in
enters into a transaction with                 description of how to report the                depreciation expense as temporary
contractual protection that is a               difference for the corresponding                differences. L must combine all
                                                                  -10-                       Instructions for Schedule M-3 (Form 1120)
adjustments attributable to the               contracts to which section 1256(a)             on Part II, line 13, Interest income, in
differences related to the overall            applies.                                       column (a) or (d), as applicable.
accounting methods on Part II, line 14.          Report hedging gains and losses             Depreciation expense for such
As a result, L must report on Part II, line   computed under the mark-to-market              transactions must be reported on Part
14, $8,000 in column (a) ($35,000 -           method of accounting on Part II, line          III, line 31, Depreciation, in column (a)
$10,000 - $17,000), ($8,000) in column        15, Hedging transactions, and not on           or (d), as applicable. Use columns (b)
(b), and zero in column (d). L must not       line 16.                                       and (c) of Part II, lines 13 and 18, and
report the accrual to cash adjustment                                                        Part III, line 31, as applicable to report
attributable to the legal and accounting      Line 17. Inventory Valuation                   the differences between column (a) and
fees on Part III, line 24, Current year       Adjustments                                    (d).
acquisition or reorganization legal and
accounting fees. Because the                  Report on line 17 any amounts                      Example 18. Corporation M sells
difference in depreciation expense does       deducted as part of cost of goods sold         and leases property to customers. M is
not relate to the use of the cash or          during the tax year, including any             a calendar year taxpayer that was
accrual method of accounting, L must          amounts attributable to inventory              required to file Schedule M-3 for its
report the depreciation difference on         valuation, for example, amounts                2004 tax year and is required to file
Part III, line 31, Depreciation, and          attributable to cost-flow assumptions,         Schedule M-3 for its 2005 tax year. For
report $15,000 in column (a), $10,000         additional costs required to be                financial accounting purposes, M
in column (b), and $25,000 in column          capitalized to ending inventory                accounts for each transaction as a sale.
(d).                                          (including depreciation) such as section       For U.S. federal income tax purposes,
                                              263A costs, inventory shrinkage                each of M’s transactions must be
Line 15. Hedging                              accruals, inventory obsolescence               treated as a lease. In its financial
                                              reserves, and lower of cost or market          statements, M treats the difference in
Transactions                                  write-downs. Report section 481(a)             the financial accounting and the U.S.
Report on line 15, column (a), the net        adjustments related to cost of goods           federal income tax treatment of these
gain or loss from hedging transactions        sold or inventory valuation on Part II,        transactions as temporary. During
included in net income per the income         line 19, Section 481(a) adjustments,           2005, M reports in its financial
statement. Report in column (d) the           and not on this line 17.                       statements $1,000 of sales and $700 of
amount of taxable income from hedging              Report any gain or loss from              cost of goods sold with respect to 2005
transactions. Use columns (b) and (c)         inventory hedging transactions on Part         lease transactions. M receives periodic
to report all differences caused by           II, line 15, Hedging transactions, and         payments of $500 in 2005 with respect
treating hedging transactions differently     not on this line 17.
for financial accounting purposes and                                                        to these 2005 transactions and similar
for U.S. federal income tax purposes.              Report mark-to-market income or           transactions from prior years and treats
For example, if a portion of a hedge is       (loss) associated with the inventories of      $400 as principal and $100 as interest
considered ineffective under GAAP but         dealers in securities under section 475        income. For financial income purposes,
still is a valid hedge under section          on Part II, line 16, Mark-to-market            M reports gross profit of $300 ($1,000 -
1221(b)(2), the difference must be            income (loss), and not on this line 17.        $700) and interest income of $100 from
reported on line 15. The hedge of a                                                          these transactions. For U.S. federal
capital asset, which is not a valid hedge     Line 18. Sale Versus Lease                     income tax purposes, M reports $500 of
for U.S. federal income tax purposes          (for Sellers and/or Lessors)                   gross rental income (the periodic
but may be considered a hedge for                                                            payments) and (based on other facts)
                                              (Also see the instructions at Part III, line
GAAP purposes, must also be reported                                                         $200 of depreciation deduction on the
                                              34, on page 15, for purchasers and/or
here.                                                                                        property. On its 2005 Schedule M-3, M
                                              lessees.)
                                                                                             must report on Part II, line 13, Interest
   Report hedging gains and losses               Asset transfer transactions with            income, $100 in column (a), ($100) in
computed under the mark-to-market             periodic payments characterized for            column (b), and zero in column (d). In
method of accounting on line 15 and           financial accounting purposes as either        addition, M must report on Part II, line
not on Part II, line 16, Mark-to-market       a sale or a lease may, under some              18, $300 of gross profit in column (a),
income (loss).                                circumstances, be characterized as the         $200 in column (b), and $500 of gross
                                              opposite for tax purposes. If the              rental income in column (d). Lastly, M
   Report any gain or loss from               transaction is treated as a lease, the
inventory hedging transactions on line                                                       must report on Part III, line 31,
                                              seller/lessor reports the periodic             Depreciation, $200 in column (b) and
15 and not on Part II, line 17, Inventory     payments as gross rental income and
valuation adjustments.                                                                       (d).
                                              also reports depreciation expense or
                                              deduction. If the transaction is treated
Line 16. Mark-to-Market                       as a sale, the seller/lessor reports gross     Line 19. Section 481(a)
Income (Loss)                                 profit (sale price less cost of goods          Adjustments
Report on line 16 any amount                  sold) from the sale of assets and              With the exception of a section 481(a)
representing the mark-to-market               reports the periodic payments as               adjustment that is required to be
income or loss for any securities held        payments of principal and interest             reported on Part II, line 12, Items
by a dealer in securities, a dealer in        income.                                        relating to reportable transactions, any
commodities having made a valid                  On Part II, line 18, column (a), report     difference between an income or
election under section 475(e), or a           the gross profit or gross rental income        expense item attributable to an
trader in securities or commodities           for financial income purposes for all          authorized (or unauthorized) change in
having made a valid election under            sale or lease transactions that must be        method of accounting made for U.S.
section 475(f). “Securities” for these        given the opposite characterization for        federal income tax purposes that
purposes are securities described in          tax purposes. On Part II, line 18,             results in a section 481(a) adjustment
section 475(c)(2) and section 475(e)(2).      column (d), report the gross profit or         must be reported on Part II, line 19,
“Securities” do not include any items         gross rental income for federal income         regardless of whether a separate line
specifically excluded from sections           tax purposes. Interest income amounts          for that income or expense item exists
475(c)(2) and 475(e)(2), such as              for such transactions must be reported         in Part II or Part III.
Instructions for Schedule M-3 (Form 1120)                        -11-
   Example 19. Corporation N is a                3. Amounts treated as interest or          Line 23d. Net Gain/Loss
calendar year taxpayer that was               OID under the stripped bond rules
required to file Schedule M-3 for its         under section 1286; and                       Reported on Form 4797, Line
2004 tax year and is required to file            4. Amounts treated as OID under            17, Excluding Amounts From
Schedule M-3 for its 2005 tax year. N         the below-market interest rate rules          Flow-Through Entities,
was depreciating certain fixed assets         under section 7872.
over an erroneous recovery period and,                                                      Abandonment Losses, and
effective for its 2005 tax year, N                                                          Worthless Stock Losses
receives IRS consent to change its            Line 23a. Income Statement                    Report on line 23d the net gain or loss
method of accounting for the
depreciable fixed assets and begins
                                              Gain/Loss on Sale,                            reported on line 17 of Form 4797, Sales
                                              Exchange, Abandonment,                        of Business Property, excluding
using the proper recovery period. The                                                       amounts from (a) flow-through entities,
change in method of accounting results        Worthlessness, or Other                       which must be reported on Part II, lines
in a positive section 481(a) adjustment
of $100,000 that is required to be
                                              Disposition of Assets Other                   9, 10, or 11, as applicable; (b)
spread over four tax years, beginning         Than Inventory and                            abandonment losses, which must be
with the 2005 tax year. In its financial                                                    reported on Part II, line 23e; and (c)
                                              Flow-Through Entities                         worthless stock losses, which must be
statements, N treats the section 481(a)       Report on line 23a, column (a), all
adjustment as a temporary difference.                                                       reported on Part II, line 23f.
                                              gains and losses on the disposition of
N must report on Part II, line 19,
                                              assets except for (a) gains and losses
$25,000 in columns (b) and (d) for its
                                              on the disposition of inventory, and (b)      Line 23e. Abandonment
2005 tax year and each of the                                                               Losses
subsequent three tax years (unless N is       gains and losses allocated to the
otherwise required to recognize the           corporation from a flow-through entity        Report on line 23e any abandonment
remainder of the 481(a) adjustment            (e.g., on Schedule K-1) that are              losses, regardless of whether the loss
earlier). N must not report the section       included in the net income (loss) per         is characterized as an ordinary loss or
481(a) adjustment on Part III, line 31,       income statement of includible                a capital loss.
Depreciation.                                 corporations reported on Part I, line 11.
                                              Reverse the amount reported in column         Line 23f. Worthless Stock
Line 20. Unearned/Deferred                    (a) in column (b) or (c), as applicable.
                                              The corresponding gains and losses for        Losses
Revenue                                       U.S. federal income tax purposes are          Report on line 23f any worthless stock
With the exception of income                  reported on Part II, lines 23b through        loss, regardless of whether the loss is
recognized from long-term contacts that       23g, as applicable.                           characterized as an ordinary loss or a
is reported on line 21, Income                                                              capital loss. Attach a schedule that
recognition from long-term contracts,                                                       separately states and adequately
report on line 20 any revenue amounts         Line 23b. Gross Capital
                                                                                            discloses each transaction that gives
that are attributable to revenue that is,     Gains From Schedule D,                        rise to a worthless stock loss and the
or was, unearned or deferred for              Excluding Amounts From                        amount of each loss.
financial statement purposes (or books
and records, if applicable) or U.S.           Flow-Through Entities
federal income tax purposes.                  Report on line 23b, gross capital gains       Line 23g. Other Gain/Loss on
                                              reported on Schedule D, excluding             Disposition of Assets Other
Line 21. Income Recognition                   capital gains from flow-through entities,     Than Inventory
From Long-Term Contracts                      which must be reported on Part II, lines
                                              9, 10, or 11, as applicable.                  Report on line 23g any gains or losses
Report on line 21 the amount of net                                                         from the sale or exchange of property
income or loss for financial statement                                                      other than inventory and that are not
purposes (or books and records, if            Line 23c. Gross Capital                       reported on lines 23b through 23f.
applicable) or U.S. federal income tax        Losses From Schedule D,
purposes for any contract accounted for       Excluding Amounts From
under a long-term contract method of                                                        Line 24. Disallowed Capital
accounting.                                   Flow-Through Entities,                        Loss in Excess of Capital
                                              Abandonment Losses, and                       Gains
Line 22. Original Issue                       Worthless Stock Losses                        Report as a positive amount on line 24,
Discount and Other Imputed                    Report on line 23c, gross capital losses      columns (b) or (c), as applicable, and
Interest                                      reported on Schedule D, excluding             (d), the excess of the net capital losses
Report on line 22 any amounts of              capital losses from (a) flow-through          over the net capital gains reported on
original issue discount (OID) and             entities, which must be reported on Part      Schedule D, Capital Gains and Losses,
imputed interest. The term ‘‘original         II, lines 9, 10, or 11, as applicable; (b)    by the corporation. For a U.S.
issue discount and other imputed              abandonment losses, which must be             consolidated tax group, the Schedule
interest’’ includes, but is not limited to:   reported on Part II, line 23e; and (c)        M-3 adjustment for the amount of the
    1. The difference between issue           worthless stock losses, which must be         consolidated net capital loss that is
price and the stated redemption price at      reported on Part II, line 23f. Do not         disallowed should not be made on the
maturity of a debt instrument, which          report on line 23c capital losses carried     separate consolidating Schedules M-3
may be wholly or partially realized on        over from a prior tax year and utilized in    of the includible corporations, but on
the disposition of a debt instrument          the current tax year. See the                 the separate Schedule M-3 for
under section 1273;                           instructions for Part II, line 25,            consolidation eliminations as described
    2. Amounts that are imputed               regarding the reporting requirements for      in Consolidated Schedule M-3 Versus
interest on a deferred sales contract         capital loss carryovers utilized in the       Consolidating Schedules M-3, on page
under section 483;                            current tax year.                             2.
                                                                -12-                      Instructions for Schedule M-3 (Form 1120)
Line 25. Utilization of Capital                  of the item on line 29. Instead, report       consolidated tax group (income tax
                                                 the entire amount of the item (i.e., both     expense) is allocated among the
Loss Carryforward                                the portion with a difference and the         members of the U.S. consolidated tax
If the corporation utilizes a capital loss       portion without a difference) on the          group in the group’s financial
carryforward on Schedule D in the                applicable line of Part II, lines 1 through   statements (or its books and records, if
current tax year, report the carryforward        26, or Part III, lines 1 through 35. See      applicable), then each member must
utilized as a negative amount on Part II,        Example 11 on page 7.                         report its allocated income tax expense
line 25, columns (b) or (c), as                                                                on Part III, lines 1 through 6, of that
applicable, and column (d). For a U.S.           Line 30. Reconciliation                       member’s separate Schedule M-3.
consolidated tax group, the Schedule             Totals                                        However, if the income tax expense is
M-3 adjustment for the amount of the                                                           not shared or allocated among
consolidated capital loss carryforward           Combine all the amounts on lines 27
                                                                                               members of the U.S. consolidated tax
should not be made on the separate               through 29 and enter the totals in
                                                                                               group but is retained in the parent
consolidating Schedules M-3 of the               columns (a), (b), (c), and (d).
                                                                                               corporation’s financial statements (or
includible corporations, but on the              Note. Line 30, column (a), must equal         books and records, if applicable), then
separate Schedule M-3 for                        the amount on Part I, line 11, and line       amounts are reported only on Part III,
consolidation eliminations as described          30, column (d), must equal Form 1120,         lines 1 through 6, of the parent’s
in Consolidated Schedule M-3 Versus              page 1, line 28.                              separate Schedule M-3.
Consolidating Schedules M-3, on page                If a corporation chooses not to
2.                                               complete columns (a) and (d) of Parts II      Line 7. Foreign Withholding
Line 26. Other Income (Loss)                     and III in the first tax year the             Taxes
                                                 corporation is required to file Schedule      Report on line 7, column (a), the
Items With Differences                           M-3 (or for any year in which the             amount of foreign withholding taxes
Separately state and adequately                  corporation voluntarily files Schedule        included in financial accounting net
disclose on Part II, line 26, all items of       M-3), Part II, line 30, is reconciled by      income on Part I, line 11. If the
income (loss) with differences that are          the corporation (or, in the case of a         corporation is deducting foreign tax,
not otherwise listed on Part II, lines 1         U.S. consolidated tax group, on the           use column (b) or (c), as applicable, to
through 25. Attach a schedule that               group’s consolidated Schedule M-3) in         correct for any difference between
itemizes the type of income (loss) and           the following manner:                         foreign withholding tax included in
the amount of each item.                             1. Report the amount from Part I,         financial accounting net income and the
    If any “comprehensive income” as             line 11, on Part II, line 30, column (a);     amount of foreign withholding taxes
defined by Statement of Financial                    2. Leave blank Part II, lines 1           being deducted in the return. If the
Accounting Standards (SFAS) No. 130              through 29, columns (a) and (d);              corporation is crediting foreign
is reported on this line, describe the               3. Leave blank Part III, columns (a)      withholding taxes against the U.S.
item(s) in detail. Examples of                   and (d); and                                  income tax liability, use column (b) or
sufficiently detailed descriptions include           4. Report on Part II, line 30, column     (c), as applicable, to negate the amount
“Foreign currency translation                    (d), the sum of Part II, line 30, columns     reported in column (a).
adjustments” and “gains and losses on            (a), (b), and (c).
available-for-sale securities.”                                                                Line 8. Incentive Stock
                                                                                               Options
Line 28. Total Expense/                          Part III. Reconciliation of                   Do not report any amount on line 8,
Deduction Items                                  Net Income (Loss) per                         column (a). Instead, include any
Report on Part II, line 28, columns (a)                                                        amount expensed per the income
through (d), as applicable, the negative         Income Statement of                           statement for incentive stock options as
of the amounts reported on Part III, line                                                      part of the amount on Part III, line 9,
36, columns (a) through (d). For
                                                 Includible Corporations                       column (a). Report on line 8, columns
example, if Part III, line 36, column (a),       With Taxable Income per                       (b), (c), and (d), as applicable, any
reflects an amount of $1 million then                                                          deductible amounts attributable to the
report on Part II, line 28, column (a),          Return — Expense/                             disposition of shares delivered pursuant
($1 million). Similarly, if Part III, line 36,                                                 to the exercise of incentive stock
column (b), reflects an amount of
                                                 Deduction Items                               options.
($50,000), then report on Part II, line
28, column (b), $50,000.                         Lines 1 Through 6. Income                     Line 9. Nonqualified Stock
                                                 Tax Expense                                   Options
Line 29. Other Income/Loss                       If the corporation does not distinguish       Report on line 9, column (a), any
and Expense/Deduction                            between current and deferred income           amounts expensed per the income
Items With No Differences                        tax expense in its financial statements       statement attributable to all stock
If there is no difference between the            (or its books and records, if applicable),    options. Report on line 9, column (d),
financial accounting amount and the              report income tax expense as current          any deductible amounts attributable to
taxable amount of an entire item of              income tax expense using lines 1, 3,          the exercise of payments made
income, gain, loss, expense, or                  and 5, as applicable.                         pursuant to nonqualified stock options
deduction and the item is not described             A U.S. consolidated tax group must         (i.e., stock options not qualified under
or included in Part II, lines 1 through          complete lines 1 through 6 in                 section 422 or 423).
26, or Part III, lines 1 through 35, report      accordance with the allocation of tax         Line 10. Other Equity-Based
the entire amount of the item in                 expense among the members of the
columns (a) and (d) of line 29. If a             U.S. consolidated tax group in the            Compensation
portion of an item of income, loss,              financial statements (or its books and        Report on line 10 any amounts for
expense, or deduction has a difference           records, if applicable). If the current and   equity-based compensation or
and a portion of the item does not have          deferred U.S., state, and foreign             consideration that are reflected as
a difference, do not report any portion          income tax expense for the U.S.               expense in the financial statements
Instructions for Schedule M-3 (Form 1120)                           -13-
(column (a)) or deducted in the U.S.         attributable to an estimate of future          tax year that is not otherwise reportable
federal income tax return (column (d))       anticipated payments or actual                 elsewhere on Schedule M-3, including
other than amounts reportable                payments. Report in column (b) or (c),         any compensation deductions deferred
elsewhere on Schedule M-3, Parts II          as applicable, the deductible or               in a prior tax year.
and III (e.g., on Part III, lines 8 and 9,   nondeductible punitive damages.
for incentive stock options and              Report in column (d) the amount of             Line 20. Charitable
nonqualified stock options,                  punitive damages deductible for U.S.           Contribution of Intangible
respectively). Examples of amounts           federal income tax purposes.
reportable on line 10 include payments                                                      Property
attributable to employee stock purchase      Line 14. Parachute Payments                    Report on line 20 any charitable
plans (ESPPs), phantom stock options,        Report on line 14, column (a), the total       contribution of intangible property, for
phantom stock units, stock warrants,         expense included in financial                  example, contributions of:
stock appreciation rights, and restricted    accounting net income on Part I, line          • Intellectual property, patents
stock, regardless of whether such            11, that is subject to section 280G.           (including any amounts of additional
payments are made to employees or            Report in column (b) or (c), as                contributions allowable by virtue of
nonemployees, or as payment for              applicable, the amount of nondeductible        income earned by donees subsequent
property or compensation for services.       parachute payments pursuant to                 to the year of donation), copyrights,
                                             section 280G, and report in column (d)         trademarks;
Line 11. Meals and                           the deductible amount of compensation          • Securities (including stocks and their
Entertainment                                after any excess parachute payment             derivatives, stock options, and bonds);
Report on line 11, column (a), any           limitations under section 280G. If a           • Conservation easements (including
amounts paid or accrued by the               payment is subject to limitation under         scenic easements or air rights);
corporation during the tax year for          both sections 162(m) and 280G, report          • Railroad rights of way;
meals, beverages, and entertainment          the total payment on this line 14.             • Mineral rights; and
that are accounted for in financial
                                             Line 15. Compensation With                     • Other intangible property.
accounting income, regardless of the
classification, nomenclature, or             Section 162(m) Limitation
terminology used for such amounts,
                                                                                            Line 21. Charitable
                                             Report on line 15, column (a), the total       Contribution Limitation
and regardless of how or where such          amount of non-performance-based
amounts are classified in the                current compensation expense for the           Report as a negative amount on line
corporation’s financial income               corporate officers to whom section             21, columns (b), (c), and (d) as
statement or the income and expense          162(m) applies. Report the                     applicable, the excess of charitable
accounts maintained in the                   nondeductible amount of current                contributions made during the tax year
corporation’s books and records.             compensation in excess of $1 million in        over the amount of the charitable
Report only amounts not otherwise            column (b) or (c), as applicable, and the      contribution limitation amount. When a
reportable elsewhere on Schedule M-3,        deductible compensation in column (d).         U.S. consolidated federal income tax
Parts II and III (e.g., Part II, line 17,    If a payment is subject to limitation          return is being filed, the Schedule M-3
Inventory valuation adjustments).            under both sections 162(m) and 280G,           adjustment for the amount of
                                             report the total payment on Part III, line     contributions in excess of the limitation
Line 12. Fines and Penalties                                                                should not be made on the separate
                                             14, Parachute payments. See
Report on line 12 any fines or similar       Regulations section 1.162-27(g) for the        consolidating Schedules M-3 of the
penalties paid to a government or other      interaction between sections 162(m)            includible corporations, but on the
authority for the violation of any law for   and 280G.                                      separate consolidating Schedule M-3
which fines or penalties are assessed.                                                      for consolidation eliminations as
All fines and penalties expensed in          Line 16. Pension and                           described in Consolidated Schedule
financial accounting income (paid or                                                        M-3 Versus Consolidating Schedules
accrued) must be included on this line       Profit-Sharing                                 M-3, on page 2.
12, column (a), regardless of the            Report on line 16 any amounts
government or other authority that           attributable to the corporation’s pension      Line 22. Charitable
imposed the fines or penalties,              plans, profit-sharing plans, and any
regardless of whether the fines and          other retirement plans.
                                                                                            Contribution Carryforward
penalties are civil or criminal,                                                            Used
regardless of the classification,            Line 17. Other                                 If the corporation utilizes a contribution
nomenclature, or terminology used for        Post-Retirement Benefits                       carryforward in the current tax year,
the fines or penalties by the imposing                                                      report the carryforward utilized as a
                                             Report on line 17 any amounts
authority in its actions or documents,                                                      positive amount on Part III, line 22,
                                             attributable to other post-retirement
and regardless of how or where the                                                          columns (b), (c), and (d), as applicable.
                                             benefits not otherwise includible on Part
fines or penalties are classified in the                                                    When a U.S. consolidated federal
                                             III, line 16, for example, retiree health
corporation’s financial income                                                              income tax return is being filed, the
                                             and life insurance coverage, dental
statement or the income and expense                                                         Schedule M-3 adjustment for the
                                             coverage, etc.
accounts maintained in the                                                                  amount of charitable contribution
corporation’s books and records. See                                                        carryforward used should not be made
sections 162(f) and 162(g) for additional
                                             Line 18. Deferred                              on the separate consolidating
guidance.                                    Compensation                                   Schedules M-3 of the includible
                                             Report on line 18, column (a), any             corporations, but on the separate
Line 13. Punitive Damages                    compensation expense included in the           consolidating Schedule M-3 for
Include on line 13, column (a), any          net income amount reported in the              consolidation eliminations and
amount included in net income per the        income statement that was not reported         adjustments as described in
income statement attributable to             elsewhere on Schedule M-3, column              Consolidated Schedule M-3 Versus
punitive damages, regardless of              (a). Report on line 18, column (d), any        Consolidating Schedules M-3, on page
whether the amount deducted was              compensation deductible in the current         2.
                                                               -14-                       Instructions for Schedule M-3 (Form 1120)
Line 23. Current Year                        a subsidiary, or an initial public stock       Line 34. Purchase Versus
                                             offering.
Acquisition or                                                                              Lease (for Purchasers and/or
Reorganization Investment                    Line 26. Amortization/                         Lessees)
Banking Fees                                 Impairment of Goodwill                         (Also see the instructions at Part II, line
Report on line 23 any investment                                                            18, on page 11, for sellers and/or
                                             Report on line 26 amortization of              lessors.)
banking fees paid or incurred in             goodwill or amounts attributable to the
connection with a taxable or tax-free        impairment of goodwill.                            Asset transfer transactions with
acquisition of property (e.g., stock or                                                     periodic payments characterized for
assets) or a tax-free reorganization.                                                       financial accounting purposes as either
Report on this line any investment           Line 27. Amortization of                       a purchase or a lease may, under some
banking fees incurred at any stage of        Acquisition, Reorganization,                   circumstances, be characterized as the
the acquisition or reorganization            and Start-Up Costs                             opposite for tax purposes.
process including, for example, fees                                                            If a transaction is treated as a lease,
paid or incurred to evaluate whether to      Report on line 27 amortization of
                                             acquisition, reorganization, and start-up      the purchaser/lessee reports the
investigate an acquisition, fees to                                                         periodic payments as gross rental
conduct an actual investigation, and         costs. For purposes of column (b), (c),
                                             and (d), include amounts amortizable           expense. If the transaction is treated as
fees to consummate the acquisition.                                                         a purchase, the purchaser/lessee
Also include on this line 23 investment      under section 167, 195, or 248.
                                                                                            reports the periodic payments as
banking fees incurred in connection                                                         payments of principal and interest and
with the liquidation of a subsidiary, a      Line 28. Other Amortization                    also reports depreciation expense or
spin-off of a subsidiary, or an initial      or Impairment Write-Offs                       deduction with respect to the purchased
public stock offering.                       Report on line 28 any amortization or          asset.
                                             impairment write-offs not otherwise                Report on Part III, line 34, column
Line 24. Current Year                        includible on Schedule M-3.                    (a), gross rent expense for a
Acquisition or                                                                              transaction treated as a lease for
Reorganization Legal and                     Line 29. Section 198                           income statement purposes but as a
                                                                                            sale for tax return purposes. Report on
Accounting Fees                              Environmental Remediation                      Part III, line 34, column (d), gross rental
Report on line 24 any legal and              Costs                                          deductions for a transaction treated as
accounting fees paid or incurred in          Report on line 29, column (a), any             a lease for tax purposes but as a
connection with a taxable or tax-free        amounts attributable to environmental          purchase for income statement
acquisition of property (e.g., stock or      remediation costs included in the net          purposes. Report interest expense or
assets) or tax-free reorganization.          income per the income statement.               deduction amounts for such
Report on this line any legal and            Report in columns (b), (c), and (d), as        transactions on Part III, line 35, Other
accounting fees incurred at any stage        applicable, any deductible amounts             expense/deduction items with
of the acquisition or reorganization         attributable to environmental                  differences, in column (a) or (d), as
process including, for example, fees         remediation costs described in section         applicable. Report depreciation
paid or incurred to evaluate whether to      198 that are paid or incurred during the       expense or deductions for such
investigate an acquisition, fees to          current tax year.                              transactions on Part III, line 31,
conduct an actual investigation, and                                                        Depreciation, in column (a) or (d), as
fees to consummate the acquisition.                                                         applicable. Use columns (b) and (c) of
Also include on this line 24 legal and
                                             Line 31. Depreciation                          Part III, lines 31, 34, and 35, as
accounting fees incurred in connection       Report on line 31 any depreciation             applicable, to report the differences
with the liquidation of a subsidiary, a      expense that is not required to be             between column (a) and (d) for such
spin-off of a subsidiary, or an initial      reported elsewhere on Schedule M-3             recharacterized transactions.
public stock offering.                       (e.g., on Part II, lines, 9, 10, 11, or 17).
                                                                                                Example 20. U.S. corporation X
                                                                                            acquired property with a sale price of
Line 25. Current Year                        Line 32. Bad Debt Expense                      $3,000 in a transaction that, for
Acquisition/Reorganization                   Report on line 32, column (a), any             financial accounting purposes, X treats
                                             amounts attributable to an allowance           as a lease. X is a calendar year
Other Costs                                  for uncollectible accounts receivable or       taxpayer that was required to file
Report on line 25 any other fees paid or     actual write-offs of accounts receivable       Schedule M-3 for its 2004 tax year and
incurred in connection with a taxable or     included in net income per the income          is required to file Schedule M-3 for its
tax-free acquisition of property (e.g.,      statement. Report in column (d) the            2005 tax year. For U.S. federal income
stock or assets) or a tax-free               amount of bad debt expense deductible          tax purposes, because of its terms, the
reorganization not otherwise reportable      for federal income tax purposes in             transaction is taxed as a purchase and
on Schedule M-3 (e.g., Part III, line 23     accordance with section 166.                   X must treat the periodic payments it
or 24). Report on this line any fees paid                                                   makes partially as payment of principal
or incurred at any stage of the              Line 33. Corporate Owned                       and partially as payment of interest. In
acquisition or reorganization process                                                       its financial statements, X treats the
including, for example, fees paid or         Life Insurance Premiums                        difference between the financial
incurred to evaluate whether to              Report on line 33 all amounts of               accounting and U.S. federal tax
investigate an acquisition, fees to          insurance premiums attributable to any         treatment of this transaction as
conduct an actual investigation, and         life insurance policy if the corporation is    temporary. During 2005, X reports in its
fees to consummate the acquisition.          directly or indirectly a beneficiary under     financial statements $1,000 of gross
Also include on this line 25 other           the policy or if the policy has a cash         rental expense that, for federal income
acquisition/reorganization costs             value. Report in column (d) the amount         tax purposes, is recharacterized as a
incurred in connection with the              of the premiums that are deductible for        $700 payment of principal and a $300
liquidation of a subsidiary, a spin-off of   federal income tax purposes.                   payment of interest, accompanied by a
Instructions for Schedule M-3 (Form 1120)                        -15-
depreciation deduction of $1,200             workpapers provide details for the               that the $1 million of difference is
(based on other facts). On its 2005          anticipated expenses under more                  attributable to actual product
Schedule M-3, X must report the              explanatory and defined categories               replacement cost in the amount of
following on Part III, line 34: column (a)   such as employee termination costs,              $450,000 and actual personal damages
$1,000, its financial accounting gross       lease cancellation costs, loss on sale of        in the amount of $550,000, that level of
rental expense; column (b), ($1,000);        equipment, etc., a supporting schedule           detail will be sufficient to separately
and column (d), zero. On Part III, line      that lists those categories of expenses          state and adequately disclose the $1
35, X reports $300 in columns (b) and        and their details will satisfy the               million deduction.
(d) for the interest deduction. On Part      requirement to separately state and              Various prepaid expenses. Report on
III, line 31, X reports $1,200 in columns    adequately disclose. In order to                 Part III, line 35, the amortization of
(b) and (d) for the depreciation             separately state and adequately                  various items of prepaid expense, such
deduction.                                   disclose the employee termination                as prepaid subscriptions and license
                                             costs, it is not required that an                fees, prepaid insurance, etc.
Line 35. Other Expense/                      anticipated termination cost amount be               Example 23. Corporation Q is a
Deduction Items With                         listed for each employee, or that each           calendar year taxpayer that was
Differences                                  asset (or category of asset) be listed           required to file Schedule M-3 for its
                                             along with the anticipated loss on               2004 tax year and is required to file
Report on Part III, line 35, all items of    disposition.
expense/deduction that are not                                                                Schedule M-3 for its 2005 tax year. On
otherwise listed on Part III, lines 1             Example 21. Corporation P is a              July 1 of each year, Q has a fixed
through 34.                                  calendar year taxpayer that was                  liability for its annual insurance
                                             required to file Schedule M-3 for its            premiums that provides a 12-month
Comprehensive income. If any                 2004 tax year and is required to file
“comprehensive income” as defined by                                                          coverage period beginning July 1
                                             Schedule M-3 for its 2005 tax year. P            through June 30. In addition, Q
SFAS No. 130 is reported on this line,       has been sued by its customers in a
describe the item(s) in detail as, for                                                        historically prepays 12 months of
                                             class action product liability lawsuit.          advertising expense on July 1. On July
example, “Foreign currency translation       The trial date is in 2006. In its 2005
adjustments” and “Gains and losses on                                                         1, 2005, Q prepays its insurance
                                             financial statements, P establishes a            premium of $500,000 and advertising
available-for-sale securities.”              reserve of $1 million for its potential          expenses of $800,000. For financial
Reserves and contingent liabilities.         liability related to the class action            statement purposes, Q capitalizes and
Report on line 35 each reserve or            lawsuit and reports corresponding                amortizes the prepaid insurance and
contingent liability that is not reported    expenses in the amounts of $400,000              advertising over 12 months. For U.S.
elsewhere in Schedule M-3. Report on         for estimated product replacement and            federal income tax purposes, Q deducts
line 35, column (a), expenses included       $600,000 for estimated personal                  the insurance premium when paid and
in net income reported on Part I, line       damages. For U.S. federal income tax             amortizes the advertising over the
11, that are related to reserves and         purposes, the $1 million is not                  12-month period. In its financial
contingent liabilities. Report on line 35,   deductible in 2005. In its financial             statements, Q treats the differences
column (d), amounts related to liabilities   statements, P treats the difference              attributable to the financial statement
for reserves and contingent liabilities      between the financial statement                  treatment and U.S. federal income tax
that are deductible in the current tax       treatment and the U.S. federal income            treatment of the prepaid insurance and
year for U.S. federal income tax             tax treatment of the reserve for the             advertising as temporary differences. Q
purposes. Examples of items that must        lawsuit as a temporary difference. P             must separately state and adequately
be reported on line 35 include warranty      must report in its 2005 U.S. federal             disclose on Part III, line 35, its prepaid
reserves, restructuring reserves,            income tax return on Part III, line 35, $1       insurance premium and report
reserves for discontinued operations,        million in column (a), ($1 million) in           $250,000 in column (a) ($500,000/12
reserves for legal proceedings, and          column (b), and zero in column (d). If P         months X 6 months), $250,000 in
reserves for acquisitions and                attaches a supporting schedule to Part           column (b), and $500,000 in column
dispositions. Only report on line 35         III, line 35, explaining that the $1 million     (d). Q must also separately state and
items that are not required to be            of difference is attributable to estimated       adequately disclose on Part II, line 29,
reported elsewhere on Schedule M-3,          product replacement cost in the amount           Other income (loss) and expense/
Parts II and III. For example, the           of $400,000 and estimated personal               deduction items with no differences, its
expense for a reserve for inventory          damages in the amount of $600,000,               prepaid advertising and report
obsolescence must be reported on Part        that level of detail will be sufficient to       $400,000 in column (a) and (d).
II, line 17, Inventory valuation             separately state and adequately
adjustments.                                 disclose the $1 million adjustment.              Line 36. Total Expense/
     The schedule of details attached to          Example 22. Same as Example 21              Deduction Items
the return for line 35 must separately       except that in 2006 P pays $1 million to         Report on Part II, line 28, columns (a)
state and adequately disclose the            settle the lawsuit with the settlement           though (d), as applicable, the negative
nature and amount of the expense             documents stipulating that the product           of the amounts reported on Part III, line
related to each reserve and/or               replacement amount is $450,000 and               36, column (a) through (d), as
contingent liability. The appropriate        the damage amount is $550,000. Both              applicable. For example, if Part III, line
level of disclosure depends upon each        the $450,000 and $550,000 settlement             36, column (a), reflects an amount of
taxpayer’s operational activity and the      amounts are deductible for U.S. federal          $1 million, then report on Part II, line
nature of its accounting records. For        income tax purposes in 2006. On its              28, column (a), ($1 million). Similarly, if
example, if a corporation’s net income       2006 Schedule M-3, P must report on              Part III, line 36, column (b), reflects an
amount reported in the income                Part III, line 35, zero in column (a), $1        amount of ($50,000), then report on
statement includes anticipated               million in column (b), and $1 million in         Part II, line 28, column (b), $50,000.
expenses for a discontinued operation        column (d). If P attaches a supporting
as a single amount, and its general          schedule to Part III, line 35, explaining
ledger or other books, records, and



                                                                 -16-
                                                           Printed on recycled paper
                                                                                            Instructions for Schedule M-3 (Form 1120)

								
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