Blocked income is foreign income that, because of restrictions in a foreign country, is not readily convertible into US dollars or into other money or property that is readily convertible into US dollars, and the IRS calls the same amount “blocked” or “deferrable” income (IRS Publication 54). The label changes when the income has to be reported, not whether it is taxable.
Three separate parts of US tax law answer that same underlying fact, and they answer it differently. An individual abroad chooses between reporting now and postponing. A controlled group whose payments are stopped by a foreign legal restriction may elect a deferred income method under the transfer pricing rules. A controlled foreign corporation’s restricted earnings drop out of certain earnings and profits computations altogether.
The Test Is Convertibility, Not Where the Money Sits
The starting obligation is the ordinary one. A taxpayer must generally report foreign income in terms of US dollars and, with one exception for Fulbright grants, must pay the taxes due on it in US dollars (IRS Publication 54).
Income becomes blocked only when a foreign country’s restrictions defeat that. The published test has two limbs, and both are about convertibility: the income is not readily convertible into US dollars, or it is not readily convertible into other money or property that is itself readily convertible into US dollars (IRS Publication 54).
A Taxpayer With Blocked Income Has Two Choices
The first is to report the income and pay the federal income tax on it with US dollars held in the United States or in some other country. The second is to postpone the reporting of the income until it becomes unblocked (IRS Publication 54).
Postponement is not silent. A taxpayer who postpones must file an information return with the tax return, and the form named for that purpose is another Form 1040 or Form 1040-SR labeled “Report of Deferrable Foreign Income, pursuant to Rev. Rul. 74-351” (IRS Publication 54). The vehicle is the ordinary individual return covered under Form 1040, submitted a second time under that label.
Two declarations have to appear on that information return, not one. The taxpayer must declare that the deferrable income will be included in taxable income for the year it becomes unblocked, and must also state that any right to claim the deferrable income was includible in income for an earlier year is waived (IRS Publication 54).
Two mechanical rules ride with it. The income is reported on the information return in the foreign currency in which it was received, and blocked income from more than one foreign country needs a separate information return for each country (IRS Publication 54).
Income Becomes Unblocked Three Ways
Two of them are about the money itself. Income becomes unblocked and reportable for tax purposes when it becomes convertible, or when it is converted, into US dollars or into other money or property that is convertible into US currency (IRS Publication 54).
The third is a deemed unblocking, and it is the one that catches people. A taxpayer who uses blocked income for personal expenses, or disposes of it by gift, bequest or devise, must treat it as unblocked and reportable (IRS Publication 54).
There is a standing duty to look. A taxpayer holding blocked income on which tax has not been paid should check whether that income is still blocked, and if it is not, should take immediate steps to pay tax on it, file a declaration or amended declaration of estimated tax, and include the income on the return for the year in which it became unblocked (IRS Publication 54).
Changing Method Needs IRS Permission in Both Directions
Both switches are accounting method changes and both go on Form 3115. A taxpayer who chose to postpone reporting and later wants to begin including the income in gross income while it is still blocked must obtain the permission of the IRS, and a taxpayer who has not chosen to defer in the past but now wants to begin reporting under the deferred method must request permission on the same form (IRS Publication 54).
The Fulbright Grant Is the One Place Tax Is Paid in Blocked Currency
Where at least 70 percent of a Fulbright grant has been paid in nonconvertible foreign currency, the grantee can use the currency of the host country to pay the part of the US tax that is based on that blocked income (IRS Publication 54). It covers only the part of the tax attributable to the blocked income, not the whole liability.
The route is documented rather than elected. Qualifying for it means preparing a statement showing that the grantee was a Fulbright grantee paid in nonconvertible foreign currency, the total grant received during the year and the amount received in nonconvertible foreign currency, and that at least 70 percent of the grant was paid in nonconvertible foreign currency, and that statement must be certified by the US educational foundation or commission paying the grant or another person having control of the grant payments (IRS Publication 54).
Transfer Pricing Treats a Foreign Restriction as Evidence, Not as an Excuse
The transfer pricing rules start from what the restriction did to real bargaining. The district director will take into account the effect of a foreign legal restriction to the extent that the restriction affects the results of transactions at arm’s length, and so a foreign legal restriction is taken into account only to the extent it is shown that the restriction affected an uncontrolled taxpayer under comparable circumstances for a comparable period of time (26 CFR 1.482-1(h)(2)(i)). Where there is no evidence of the restriction’s effect on uncontrolled taxpayers, it is taken into account only to the extent the deferred income method allows (26 CFR 1.482-1(h)(2)(i)). The arm’s length standard those results are measured against is the one covered under intercompany.
Four conditions gate the whole paragraph. Foreign legal restrictions, whether temporary or permanent, are taken into account for purposes of that paragraph only if, and so long as, all four are met (26 CFR 1.482-1(h)(2)(ii)). The restrictions must be publicly promulgated, generally applicable to all similarly situated persons both controlled and uncontrolled, and not imposed as part of a commercial transaction between the taxpayer and the foreign sovereign. The taxpayer, or another member of the controlled group the restrictions apply to, must have exhausted all remedies prescribed by foreign law or practice for obtaining a waiver, other than remedies that would have a negligible prospect of success if pursued. The restrictions must have expressly prevented the payment or receipt, in any form, of part or all of the arm’s length amount that would otherwise be required under section 482, and the regulation gives its own example of what falls outside that: a restriction that applies only to the deductibility of an expense for tax purposes is not a restriction on payment or receipt for this purpose. And the related parties subject to the restriction must not have engaged in any arrangement with controlled or uncontrolled parties that had the effect of circumventing the restriction, and must not have otherwise violated it in any material respect.
Electing the deferred income method then takes two more things. The controlled taxpayer must establish to the district director’s satisfaction that the payment or receipt of the arm’s length amount was prevented by a foreign legal restriction and the circumstances above, and the controlled taxpayer whose US tax liability may be affected must elect the method on a written statement attached to a timely return or an amended return filed before the IRS first contacts any member of the controlled group about an examination of the return for the taxable year the restriction applies to (26 CFR 1.482-1(h)(2)(iii)). That statement has to identify the affected transactions, the parties to them, and the applicable foreign legal restrictions.
A Controlled Foreign Corporation’s Blocked Earnings Follow a Third Rule
Here the amount leaves the computation rather than being deferred by the taxpayer. Where it is established to the satisfaction of the district director, in accordance with paragraph (d) of that section, that an amount of a controlled foreign corporation’s earnings and profits for the taxable year was subject to a currency or other restriction or limitation imposed under the laws of any foreign country on its distribution to United States shareholders who own stock of the corporation, that amount is not included in earnings and profits for purposes of sections 952, 955 and 956 for that taxable year (26 CFR 1.964-2(a)).
The timing test is unusually precise, and it straddles the year end. The amount is excluded only if it is subject to the restriction or limitation throughout the 150-day period beginning 90 days before the close of the taxable year and ending 60 days after the close of that year (26 CFR 1.964-2(b)(1)). A restriction that lifts inside that window breaks the requirement that it hold throughout, on either side of the fiscal year end.
What counts as a restriction is decided on all the facts and circumstances in each case, and generally the restriction must prevent at least one of two things (26 CFR 1.964-2(b)(2)). Either it prevents the ready conversion, directly or indirectly, of the currency into US dollars or into property of a type normally owned by the corporation in the operation of its business or other money readily convertible into US dollars, or it prevents the distribution of dividends by the corporation to its United States shareholders.
Questions Firms Ask
No. Blocking changes the year of reporting, not the character of the income. The published choice is between reporting it now and paying with dollars held elsewhere, or postponing the reporting until it becomes unblocked and filing an information return in the meantime (IRS Publication 54).
The information return itself is the mechanism, and it carries the two required declarations about the later inclusion and the waiver of any earlier year (IRS Publication 54). Changing to or from that treatment later is what needs IRS permission on Form 3115.
Because they answer different questions. One asks when an individual reports income already earned, one asks what price a controlled group should be charged with when a payment was legally impossible, and one asks whether a foreign subsidiary’s earnings enter a shareholder-level computation at all.
Accountably places trained offshore accountants inside US CPA and EA firms, and a firm carrying international clients whose foreign currency positions keep landing on a partner’s desk can grade a real block of that preparation work through a trial task before it touches a live client file.
