- 1 Subpart F Income
- 2 CFC & Subpart F Income
- 3 Subpart F Overview
- 4 Subpart F Income Requirements
- 5 U.S. Person with Overseas Foreign Corporation
- 6 CFC Definition
- 7 CFC Examples
- 8 Form a Business Around CFC Rules?
- 9 15 Relatives Each Own Less than 10% Each
- 10 It Does NOT Need to be Distributed to You
- 11 What Type of Income Does it Include?
- 12 E&P (Earnings & Profit)
- 13 Subpart F – Technically
- 14 Important Takeaways From the IRS Summary
- 15 Out of Compliance – IRS Offshore Disclosure
- 16 Which Foreign Accounts Needs to be Reported?
- 17 Interested in the Offshore Tax Amnesty?
Subpart F Income – Overview of IRS International Tax & CFC
Subpart F Income: The concept of Subpart F Income goes hand-in-hand with IRS CFC laws. When a CFC has current-year E&P, U.S. shareholders are subject to IRS Subpart F income rules under I.R.C. § 951(a).
Subpart F Income
With Subpart F Income, U.S. shareholder pay U.S. income tax on their ratable share of CFC Subpart F income — even if the CFC has not distributed the income.
CFC & Subpart F Income
The concept of Subpart F income involves IRS anti-deferral rules for certain CFC income. Subpart F Income of a CFC (controlled foreign corporation) may require a U.S. shareholder to pay U.S. tax on their ratable share subpart F income.
The analysis for determining who has Subpart F income, and who has to pay tax on the income can be very complicated.
As provided by the IRS:
“Under Subpart F, certain types of income earned by a CFC are taxable to the CFC’s U.S. shareholders in the year earned even if the CFC does not distribute the income to its shareholders in that year.
Subpart F operates by treating the shareholders as if they had actually received the income from the CFC.
The income of a CFC that is currently taxable to its U.S. shareholders under the Subpart F rules is referred to as “Subpart F income.”
Under I.R.C. § 951(a), a U.S. shareholder is required to include in income currently its pro rata share of the CFC’s Subpart F income (“Subpart F inclusion”).
The Subpart F inclusion will generally bring an indirect foreign tax credit with it under I.R.C. § 960. Note that the Subpart F inclusion is not a dividend and consequently does not qualify for the lower rate of tax under I.R.C. § 1(h)(11).
Subpart F Overview
Subpart F income generally (but not always) involves passive income, and even if the U.S. has no authority over the foreign corporation, since the foreign corporation is a CFC — the IRS can exert tax authority over the U.S. person owner (if not the full corporation).
The IRS rules involving Subpart F involve complicated tax analyses on certain foreign income generated by a .
Key issues involving Subpart F income, include:
- Attribution Rules
- Earnings & Profit (E&P)
- Current Year E&P
Subpart F Income Requirements
In order for income to be taxed in the U.S. as subpart F income:
- There must be a controlled foreign corporation
- Specific types of foreign income
- Current year Earnings & Profit
U.S. Person with Overseas Foreign Corporation
Millions of individuals in the U.S. have foreign income investments. The confusion often lies in the fact that most foreign corporations do not have a foreign tax or reporting requirement. Thus, the foreign corporation does not provide any documentation (1099) to the U.S. Person regarding IRS Tax Compliance.
Moreover, oftentimes, the U.S. individual is unaware (rightfully so) that even though they have a foreign investment, it is still subject to U.S. Tax.
As if that is not bad enough — and due to lack of information and clarity provided by the IRS, the person is also unaware that they also have other issues to contend with.
One of the most important takeaways from the idea of subpart F income is that it does not involve all foreign investments. Rather, it is primarily limited to CFCs. And, not all foreign corporations involving U.S. persons are considered CFCs.
Rather, a CFC is a Controlled Foreign Corporation (Legal Term) and a Foreign Corporation is categorized as a CFC when:
- More than 50% of the corporation is owned by a US person
- Each US person owns at least 10% of the corporation.
Unfortunately, attribution rules apply — so it is important to determine whether family members also on shares of stock, because family ownership of the stock may also be “attributed” to you.
While Controlled Foreign Corporations come in many shapes and sizes, there a few common we work with at Golding & Golding. They include:
– A Sociedad Anonima, in which the U.S. Person usually owns 90% of the Foreign Corporation, with a local resident owning 10%
– A Foreign Corporation (Even if established just as a Foreign Trust), but is considered a Per Se Corporation under IRC§ 301.7701-2
Form a Business Around CFC Rules?
Yes, but it comes at a risk. In reality, if you are going to open a relatively small (Under $10M) foreign corporation such as a holding corporation as a BVI, Hong Kong Pvt. Limited, or Sociedad Anonima, you are going to want to be the majority owner of the business – especially when it is overseas.
Most astute US persons investing significant time and money into a foreign corporation (unless it’s a major conglomerate) are not going to let go of the reins so much so as to allow someone they do not know to maintain majority ownership and control over a foreign corporation, just to avoid U.S. Tax and Reporting.
In a typical situation, the US person will own (either individually or through an investment group) around 75 to 90% of the foreign corporation, with 10 to 25% being owned by locals (usually required by local law)
15 Relatives Each Own Less than 10% Each
Very smart, but there’s something to keep in mind – attribution. Therefore, if you and your siblings form a foreign corporation and each own about 8%, technically nobody owns at least 10% and therefore you would qualify as a non-CFC, right?
See, that is what attribution rules come to play. Thus, if you’re considering forming a foreign corporation and using US persons in order to try to circumvent and navigate CFC formation rules, be sure to speak with an experienced international tax lawyer.
Subpart F income comes in all shapes and sizes, but the purposes of this article – and the most important idea to keep in mind for most individual investors — is that subpart F income usually include passive income. In other words, if you have a foreign corporation that is only earning money through passive means, with current year E&P, than most likely is going to be considered subpart F income.
It Does NOT Need to be Distributed to You
This is where it starts to get complex.
Let’s assume that you and your two partners own 100% of the foreign corporation. You are all US persons and thus it is a CFC. Moreover, let’s say you earn sufficient income so that you have $300,000 of current earnings and profit at the end of the year.
At its most basic function, since it is considered subpart F income, in a year where there is current E&P, the individuals will each be required to book $100,000 of income as a result of subpart F income being generated in the controlled foreign corporation in a year in which there is current earnings and profit.
To add insult to injury, it is not as if this money has to even be distributed to any of the US persons. Rather, the mere fact that a CFC has subpart F income vis-à-vis earnings and profit, makes it enough that these individuals will have to book the income.
What Type of Income Does it Include?
While there many different types of subpart F income, one of the main categories which impacts US persons is Foreign Base Company Income (FBCI), as defined under I.R.C. § 954(a):
As Provided by the IRS: “Subpart F income is Foreign Base Company Income (FBCI), as defined under I.R.C. § 954(a), which includes foreign personal holding company income, or FPHCI, which consists of investment income such as dividends, interest, rents and royalties.”
E&P (Earnings & Profit)
Earnings and profit is a very complex analysis. It would be nice if it was just as simple as these two words would make it seem, but there’s a lot that goes into E & P. therefore, and therefore it is important to evaluate controlled foreign corporation financials before determining whether the actual earnings or income result in E & P.
Subpart F – Technically
As provided by the IRS:
“The Subpart F provisions eliminate deferral of U.S. tax on some categories of foreign income by taxing certain U.S. persons currently on their pro rata share of such income earned by their controlled foreign corporations (CFCs). This approach is based on the principles underlying the United States’ taxing jurisdiction. In general, the United States does not tax a foreign corporation if the foreign corporation neither receives U.S.-source income nor engages in U.S.-based activities.
However, the U.S. does generally tax all income, wherever derived, of U.S. persons. The Subpart F rules operate by treating a U.S. shareholder of a CFC as if it actually received its proportionate share of certain categories of the corporation’s current earnings and profits (E&P). The U.S. shareholder is required to report this income currently in the United States whether or not the CFC actually makes a distribution (I.R.C. § 951(a)).
Subpart F, therefore, does not purport to tax the CFC. Rather, its rules apply only to a U.S. person who owns, directly or indirectly, 10% or more of the voting stock of a foreign corporation that is controlled by U.S. shareholders. The provisions of Subpart F are exceedingly intricate and contain numerous general rules, special rules, definitions, exceptions, exclusions and limitations, which
Important Takeaways From the IRS Summary
IRS is Not Directly Taxing the Foreign Corporation
Is important to note, that the IrRS does not have the authority to tax a foreign corporation unless certain rules apply such as US source income, which is not otherwise exempt by way of a Tax Treaty. Rather it is the Subpart F Income being attributed to the U.S. Person that is being taxed.
IRS Taxes on Worldwide Income
When someone is considered a US person, then the IRS taxes them on their worldwide income. When it involves a CFC, there are a few key issues at play. First, is a foreign corporation so it is not subject to US tax law (exceptions apply). Moreover, if the US person is not actually receiving income, then there is nothing to be taxed by the IRS (presuming cash basis).
With that said, if a person is a US person, a controlled foreign corporation has current year earning profits, and there is subpart F income attributed to the U.S. Person – then a special rule applies which allows the IRS to tax the non-distributed subpart F income that is attributed to the US person (even if it is not distributed)
Exceptions, Exclusions, and Limitations
Whenever there is a complex law such as subpart F income, there are always exceptions and exclusion – so it is very important to determine if you qualify for any of these exceptions, exclusions or limitations before submitting any payment or informational returns to the IRS on his.
Out of Compliance – IRS Offshore Disclosure
If you have on reported subpart F income, the chances are you may also have undisclosed foreign accounts, foreign investments, foreign corporation form 5471 reporting responsibilities, etc..
At Golding & Golding, where one of the only international tax law firms worldwide that focuses exclusively on offshore voluntary disclosure in situations such as these.
In additional to Subpart F Income issues, you may also have offshore/foreign reporting requirements.
Which Foreign Accounts Needs to be Reported?
Essentially, if you have ownership, interest, or signature authority over any foreign accounts, assets, investments, or other foreign money that meet the threshold for filing the requisite international informational return (or associated 1040 schedule) you typically will have a reporting requirement.
The most common reporting requirement is the FBAR (FinCEN 114) and that is because it is very encompassing, and has the lowest threshold.
Even if you already filed the FBAR, you may have many other forms you have to file as well (even if it duplicates the same information).
Interested in the Offshore Tax Amnesty?
No matter where in the world you reside, our international tax team can get you IRS offshore compliant.
Golding & Golding specializes in IRS offshore tax amnesty. Contact our firm today for assistance with getting compliant.
Sean holds a Master's in Tax Law from one of the top Tax LL.M. programs in the country at the University of Denver. He has also earned the prestigious IRS Enrolled Agent credential. Mr. Golding's articles have been referenced in such publications as the Washington Post, Forbes, Nolo, and various Law Journals nationwide.
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