Specific Instructions for Parts II and III

General Reporting information A schedule or statement may be attached to any line even if none is required.

For each line item in Parts II and III, report in column (a) the amount of net income (loss) included in Part I, line 11, and report in column (d) the amount included in total income (loss) on Form 1120-S, Schedule K, line 18.

Part II, line 26, column (a) must

TIP equal Part I, line 11, and column

(d) must equal the amount on Form 1120-S, Schedule K, line 18.

For any item of income, gain, loss, expense, or deduction for which there is a difference between columns (a) and (d), the portion of the difference that is temporary must be entered in column (b) and the portion of the difference that is permanent must be entered in column (c).

If financial statements are prepared by the corporation under with generally accepted accounting principles (GAAP), differences that are treated as temporary under GAAP must be reported in column (b) and differences that are permanent (that is, not temporary) for GAAP must be reported in column (c). Generally, under to GAAP, a temporary difference affects (creates, increases, or decreases) a deferred tax asset or liability.

If the corporation doesn't prepare financial statements, or the financial statements aren't prepared under GAAP, report in column (b) any difference that the corporation believes will reverse in a future tax year (that is, have an opposite effect on total income (loss) in a future tax year (or years) due to the difference in timing of recognition for financial accounting and U.S. income tax purposes) or is the reversal of such a difference that arose in a prior tax year. Report in column (c) any difference that the corporation believes won't reverse in a future tax year (and isn't the reversal of such a difference that arose in a prior tax year).

If the corporation is unable to determine whether a difference between column (a) and column (d) for an item will reverse in a future tax year or is the reversal of a difference that arose in a prior tax year, report the difference for that item in column (c).

DS1 has net income of $100 (before minority interests) and pays dividends of $50, of which P receives $30. The dividend reduces P's investment in DS1 for equity method reporting on P's separate general ledger where P includes its 60% equity share of DS1 income, which is $60. In its financial statements, P eliminates the DS1 equity method income of $60 and consolidates DS1, including $60 of net income ($100 less the minority interest of $40) on Part I, line 4a.

P must remove the $100 net income of DS1 on Part I, line 6a. P must reverse on Part I, line 8, the elimination of the $40 minority interest net income of DS1 and the elimination of the $60 of DS1 equity income. The net result is that P includes the $60 of equity method income from DS1 at Part I, line 11, and on Part II, line 5, column (a). P's dividend income included on the tax return from its investment in DS1 must be reported on Part II, line 6, column (d).

4. U.S. corporation C owns 60% of the capital and profits interests in U.S. LLC N. C accounts for N in C's separate general ledger on the equity method. N has net income of $100 (before minority interests) and makes no distributions during the tax year. C treats N as a corporation for financial statement purposes and as a partnership for U.S. income tax purposes. For equity method reporting on C's separate general ledger, C includes its 60% equity share of N income, which is $60. In its financial statements, C eliminates the $60 of N net income ($100 less the minority interest of $40) on Part I, line 4a.

C must remove the $100 net income of N on Part I, line 6a. C must reverse on Part I, line 8, the elimination of the $40 minority interest net income of N and the elimination of the $60 of N equity method income. The result is that C includes the $60 of equity method income for N on Part I, line 11, and on Part II, line 7, column (a). C's taxable income from N must be reported by C on Part II, line 7, column (d).

Example 4. U.S. corporation P owns 100% of the stock of QSub corporation DS1. DS1 is included in P's federal income tax return, even though DS1 isn't included in P's consolidated financial statements on either a consolidated basis or on the equity method. DS1 has current year net income of $100 after taking into account its $40 interest payment to P. P has net income of $1,040 after recognition of the interest income from DS1. Because

DS1 is a QSub, 100% of the net income of both P and DS1 must be reported on Form 1120-S of P's U.S. income tax return, and the intercompany interest income and expense must be removed by consolidation elimination entries.

P must report its financial statement net income of $1,040 on Part I, line 4a, and reports DS1's net income of $100 on Part I, line 7c. Then, in order to reflect the full consolidation of the financial accounting net income of P and DS1 at Part I, line 11, the following consolidation and elimination entries are reported on Part I, line 8: offsetting entries to remove the $40 of interest income received from DS1 included by P on line 4a, and to remove the $40 of interest expense of DS1 included in line 7c for a net change of zero. The result is that Part I, line 11, reports $1,140: $1,040 from line 4a, and $100 from line 7c. Stated another way, Part I, line 11, includes the entire $1,000 net income of P, measured before recognition of the intercompany interest income from DS1 and the consolidation of DS1 operations, plus the entire $140 net income of DS1, measured before interest expense to P. P's U.S. income tax group isn't required to include on the attached supporting statement for Part I, line 8, the offsetting adjustment to the intercompany elimination of interest income and interest expense (though it is permitted to do so).

Line 12. Total Assets and Liabilities of Entities Included or Removed on Part I, Lines 4, 5, 6, and 7 Line 12 must be completed by all corporations that file Schedule M-3. Report on lines 12a, 12b, 12c, and 12d the total amount (not just the corporation's share) of assets and liabilities of entities included or removed on Part I, lines 4, 5, 6, and 7. All assets and liabilities reported on lines 12a through 12d must be reported as positive amounts.

On line 12a, enter the worldwide consolidated total assets and total liabilities of all of the entities included in computing Part I, line 4a. On line 12b, enter the total assets and total liabilities of the entities removed in completing Part I, line 5. On line 12c, enter the total assets and total liabilities removed in completing Part I, line 6. On line 12d, enter total assets and total liabilities included in completing Part I, line 7.

Instructions for Schedule M-3 (Form 1120-S) -7-

Furthermore, in applying the two preceding paragraphs, a corporation is required to report in column (a) of Parts II and III the amount of any item specifically listed on Schedule M-3 that is included in the corporation's financial statements or exists in the corporation's books and records, regardless of the nomenclature associated with that item in the financial statements or books and records. Accurate completion of Schedule M-3 requires reporting amounts according to the substantive nature of the specific line items included in Schedule M-3 and consistent reporting of all transactions of like substantive nature that occurred during the tax year. For example, all expense amounts that are included in the financial statements or exist in the books and records that represent some form of “Bad debt expense,” must be reported on Part III, line 25, in column (a), regardless of whether the amounts are recorded or stated under different nomenclature in the financial statements or the books and records such as: “Provision for doubtful accounts”; “Expense for uncollectible notes receivable”; or “Impairment of trade accounts receivable.” Likewise, as stated in the preceding paragraph, all fines and penalties must be included on Part III, line 9, column (a), regardless of the terminology or nomenclature attached to them by the corporation in its books and records or financial statements.

With limited exceptions, Part II includes lines for specific items of income, gain, or loss (income items). (See Part II, lines 1 through 21.) If an income item is described in Part II, lines 1 through 21, report the amount of the item on the applicable line, regardless of whether there is a difference for the item. If there is a difference for the income item, or only a portion of the income item has a difference and a portion of the item doesn't have a difference, and the item isn't described in Part II, lines 1 through 21, report and describe the entire amount of the item on Part II, line 22.

With limited exceptions, Part III includes lines for specific items of expense or deduction (expense items). (See Part III, lines 1 through 28.) If an expense item is described on Part III, lines 1 through 28, report the amount of the item on the applicable line, regardless of whether there is a difference for the item. If there is a difference for the expense item, or only a portion of the expense item has a difference and a portion of the item

Example 5. At the end of Corporation A's first tax year, it wasn't required to file Schedule M-3 for any reason.

A may elect to file Schedule M-3 instead of completing Schedule M-1.

If A elects to file schedule M-3, it must either (i) complete Schedule M-3 entirely or (ii) complete Schedule M-3 through Part I and complete Schedule M-1 instead of completing Parts II and III of Schedule M-3.

If A elects to complete Schedule M-3 entirely, it must complete all columns of Parts II and III.

If A completes Schedule M-3 through Part I and completes Schedule M-1 instead of completing Parts II and III of Schedule M-3, line 11 of Part I of Schedule M-3 must equal line 1 of Schedule M-1.

Example 6. Corporation B is a U.S. corporation that files a U.S. tax return and prepares GAAP financial statements. In prior years, B acquired intellectual property (IP) and goodwill. The IP is amortizable for both U.S. income tax and financial statement purposes. In the current year, B's annual amortization expense for IP is $9,000 for U.S. income tax purposes and $6,000 for financial statement purposes. In its financial statements, B treats the difference in IP amortization as a temporary difference. The goodwill isn't amortizable for U.S. income tax purposes and is subject to impairment for financial statement purposes. In the current year, B records an impairment charge on the goodwill of $5,000. In its financial statements, B treats the goodwill impairment as a permanent difference. B must report the amortization attributable to the IP on Part III, line 21, and report $6,000 in column (a), a temporary difference of $3,000 in column (b), and $9,000 in column (d). B must report the goodwill impairment on Part III, line 19, and report $5,000 in column (a), a permanent difference of ($5,000) in column (c), and $0 in column (d).