Subpart F Income of Controlled Foreign Corporations
Because income from a controlled foreign corporation (CFC) is not taxed by the United States until it is repatriated, corporations have an incentive to try to source income in so-called tax haven countries to reduce taxes. For instance, suppose a United States (US) corporation forms a controlled foreign subsidiary in the Cayman Islands, which assesses no income tax on corporate profits. The US corporation manufactures widgets to sell in Europe. To avoid tax, the corporation can sell the widgets at cost to its subsidiary in the Cayman Islands. Since the widgets are sold to the Cayman subsidiary for cost, the corporation earns no profit. Then the CFC sells the widgets to its European subsidiary at the market price, so that when the European subsidiary sells it, it earns no profits. Only the Cayman subsidiary earns a profit, but pays no tax on it. To avoid this type of scenario, the U.S. enacted, in 1962, Subpart F - Controlled Foreign Corporations, which stipulates that any Subpart F income — which is income with little or no economic relation to the CFC's country of incorporation — earned by a CFC that is not distributed or otherwise taxed for the tax year in which it was earned is considered constructively repatriated, and therefore, US persons — including citizens, residents, domestic corporations, partnerships, estates, and trusts of the US — must include the pro rata share of their CFC Subpart F income in their gross income. IRC §951
Any actual distributions are excluded if they have already been accounted for by the shareholder, and only include income for the portion of the year that the corporation qualifies as a CFC. To prevent double taxation, Subpart F income increases the shareholders' basis in the stock and any distributions decreases the basis.
A CFC is considered any foreign corporation where US persons own more than 50% of the total voting power or value of the corporate stock and who individually also own at least 10% of the CFC voting stock. This rule is to prevent public corporations owned by many shareholders from being affected by the rule. So if 20 shareholders have an equal interest in a CFC, then it is not subjected to Subpart F rules.
- CFC Shareholder
- A US shareholder who must report Subpart F income is defined as a US person, who owns 10% or more of the combined voting power of the foreign corporation, either directly, indirectly, or constructively on the last day of the CFC's tax year and who has held the stock for a continuous period of 30 days or more during the CFC tax year.
A US shareholder of a CFC must file Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations furnishing information about the entity and its subsidiaries (IRC §6038). Failure to file Form 5471 may result in penalties and a reduced foreign tax credit. Information must also be provided about acquisitions, reorganizations, and dispositions of CFC ownership interests during the tax year (IRC §6046). A domestic corporation shareholder is permitted to claim a foreign tax credit for any foreign taxes paid by the CFC on any income that is either distributed or attributed to the US shareholder.
Example: Calculating the Constructive Dividend for a US Corporation from a Dividend Received from its CFC
- A US corporation owns 60% of the stock of a CFC.
- The CFC's income for the year is $100,000.
- Therefore, the US corporation must recognize a constructive dividend of $60,000.
- The basis of the stock was $400,000 before the constructive dividend; afterwards, it is increased by the amount of the constructive dividend, totaling $460,000.
Indirect ownership is the ownership of a CFC through a foreign entity, whether it be a corporation, partnership, or trust. Constructive ownership rules also generally apply, in that the share percentages of related taxpayers are added together. So if Alice owns 30% of the foreign corporation and her son George owns 5%, then Alice must recognize a constructive dividend of 30% of the CFC's income while George must recognize 5%. Bill, on the other hand, also owns 5% of the CFC, but since he is unrelated to any of the other shareholders, he does not have to recognize a constructive dividend since he does not constructively own at least 10% of the stock.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, the top corporate tax rate is reduced from 35% to 21%. Unlike the changes for regular taxpayers, most of which expire in 2025, most of the tax changes for businesses have been made permanent.
This new law has changed some of the rules for Subpart F income taxation. Before, taxpayers were taxed on their worldwide income, but for shareholders of a CFC, non-Subpart F income earned in the foreign country was not taxed until it was repatriated. Under the new law, there is a one-time transition tax of 15.5% on cash or cash equivalents and 8% on illiquid assets, such as factories, which can be paid over an 8-year period. These assets earned under the old tax system are "deemed repatriated," and therefore subject to the tax transition tax.
Because the new law has changed the tax system to a territorial system, where only the money earned within the United States will be taxed by the United States, the tax on repatriated future income will no longer be a consideration. A primary purpose of these changes was to encourage the repatriation of trillions of dollars earned by US corporations in other countries that was subject to US tax under the old system. Since the law has passed, the repatriation of cash or cash equivalents has increased greatly, but it is not likely that much of the non-cash assets will be repatriated, since much of it is in the form of fixed assets, such as factories.
Additionally, Subpart F rules were modified to include more US shareholders of foreign corporations into the Subpart F deemed inclusion rules, expanding the definition of a US shareholder to include US persons who own at least 10% of either the voting power or the value of the CFC rather than just 10% of the voting power under the previous law.
There is also a Global Intangible Low Taxed Income (GILTI) provision to dissuade US taxpayers from off-shoring their intangible property to earn higher after-tax income in low-income-tax countries, such as Ireland. Because of the difficulty of quantifying a company's specific income derived from IP assets, the GILTI provision assigns a 10% return on the fixed assets of the CFC, so that any income exceeding this 10% return is deemed intangible, and therefore deemed repatriated in the year earned.
Types of Subpart F Income
Subpart F income is not just any income, but is characterized as income with little or no economic relation with the CFC's country of incorporation. Subpart F income includes: insurance income, foreign base company income, international boycott factor income, illegal bribes, and income derived from a §901(j) foreign country, which are countries that sponsor terrorism or are otherwise not recognized by the US, such as Iran and North Korea.
Insurance income is the income earned from insuring risk outside of the country of incorporation of the CFC.
Foreign base company income (FBCI) is the broadest type of income in that it includes any income earned that has no economic connection to its country of organization, and includes 5 specific types of FBCI:
- foreign personal holding company income,
- foreign base company (FBC) sales income,
- FBC services income,
- FBC shipping income,
- FBC oil-related income.
Foreign personal holding company income (FPHC) includes:
- dividends, interest, royalties, rents, and annuities;
- excess gains over losses from property sales or exchanges;
- net foreign currency gains, unless it was specifically related to CFC business needs;
- income earned from notional principal contracts;
- certain payments in lieu of dividends.
FBC sales income is earned from sales where the CFC is unnecessary in generating the income. So if a US corporation sells inventory to a CFC in Europe, who then sells the inventory to Asia, then that will be considered FBC sales income, since there was no added value by sending it to the European CFC. If, on the other hand, the CFC adds significant value to the inventory, then it would not be considered FBC sales income.
Likewise, FBC services income is income earned for the performance of services for or on behalf of a related person that is performed outside of the CFC country.
Subpart F Income Exceptions
If the total FBCI plus gross insurance income for the tax year is less than the lesser of 5% of gross income or $1 million, then a de minimis exception treats FBCI as 0. On the other hand, if FBCI plus gross insurance income exceeds 70% of total gross income, then all the gross income is treated as Subpart F income, unless the foreign country imposes a tax rate exceeding 90% of the maximum US corporate tax rate under IRC §11. Since the current maximum rate is 35%, then FBCI and insurance income will not be considered Subpart F income if the foreign country assesses at least a 31.5% tax on that income.
Investment of Earnings
US shareholders are taxed on their pro rata share of undistributed, untaxed CFC earnings that are invested in United States property. The US investment is considered a dividend deemed to have been paid to the US shareholders. US property includes tangible real or personal property in the United States, obligations of US persons, stock of domestic corporations, and the right to use a patent, copyright, invention, or other intellectual property in the United States.
So if you, a US citizen, own 50% of the CFC that lends you $10,000, then you must recognize a constructive dividend of $5000, since the CFC increased its US investment by buying a US note receivable.
Distributions of CFC Income
An indirect foreign tax credit is also available for US shareholders who own at least 10% of the voting stock of the CFC and who have included Subpart F constructive dividend income in their returns. An indirect foreign tax credit may also be available for Subpart F income attributable to certain lower tier foreign corporations. IRC §902
An indirect foreign tax credit can be claimed for foreign taxes paid by up to 6 lower tiers of foreign corporations:
|Indirect FTC||=||Actual or Constructive Dividend |
|×||Paid Foreign Taxes|
Example: Indirect Foreign Tax Credit
A US corporation owns 60% of a foreign corporation, from which it receives a dividend of $300,000. The foreign corporation paid $400,000 of taxes on its $1,000,000 income. Therefore, the US company can claim a foreign tax credit equal to the following:
|Indirect FTC||=||$300,000 |
The FTC must be used to offset the deemed-paid foreign taxes, which are added to the gross income of the US corporation:
|Deemed-Paid Foreign Taxes||$120,000||= $300,000 / $1,000,000 × $400,000|
|Add to Gross Income of US Company||$420,000|
Thus, the FTC is applied to the deemed-paid foreign taxes that was grossed up in the income of the US company, with the result that the $300,000 dividend is not taxed by the United States.