Subpart F Income Overview
Subpart F Income: The IRS rules for overseas earnings such as Subpart F income are complex. It relates to certain U.S. shareholders who have an ownership or interest in foreign corporations which are controlled (aka CFC). The U.S. government developed Subpart F to avoid deferral of certain foreign income from CFCs.
A CFC is a Controlled Foreign Corporation, and not all foreign corporations are CFCs. Under Subpart F rules and IRC 952, U.S. shareholders of a CFC may be taxed on certain foreign corporation income, even if it has not been distributed. The income attributed to them is based on their ratable share.
There are other requirements, such as required current year earnings and profit (E&P) and other rules, which we will summarize.
We will explain the basics of Subpart F Income, and how it is intertwined with CFC.
How is it Defined?
Subpart F refers to foreign income, and Subpart F income is codified in Internal Revenue Code section 952
I.R.C. § 952
(a) In general
For purposes of this subpart, the term “subpart F income” means, in the case of any controlled foreign corporation, the sum of —
(1) insurance income (as defined under section 953),
(2) the foreign base company income (as determined under section 954),
(3) an amount equal to the product of—
(A) the income of such corporation other than income which—
(i) is attributable to earnings and profits of the foreign corporation included in the gross income of a United States person under section 951 (other than by reason of this paragraph), or
(ii) is described in subsection (b), multiplied by (B)the international boycott factor (as determined under section 999),
Categories of Subpart F Income
There are different categories of Subpart F income.
As provided by the IRS:
FPHCI: FPHCI generally includes a CFC’s income from dividends, interest, annuities, rents, royalties, and net gains on dispositions of property producing any of the foregoing types of income (as well as several other types of income not covered in this Concept Unit – see separate Practice Unit on FPHCI). § 954(c)
FBC Services Income: FBC Services Income consists of income derived by a CFC in connection with the performance outside the CFC’s country of incorporation of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or like services for or on behalf of any related person. § 954(e)
FBCSI: When a CFC buys/sells tangible personal property (1) from/to (or on behalf of) a related person and the property is (2) manufactured, produced, constructed, grown, or extracted outside the CFC’s country of incorporation and the property is purchased/sold (3) for use, consumption or disposition outside the CFC’s country of incorporation, the income from the sale of the property by the CFC is FBCSI, a type of Subpart F income. § 954(d). The U.S. shareholder(s) of the CFC may have a subpart F inclusion.
What is Earnings and Profit (E&P)?
In order for Subpart F to apply, a company must have earnings and profit (E&P).
Earnings and Profit (E&P) is complicated. There is no straight, bright-line test to determine E&P.
*Please refer to 26 CFR sec. 1.312-6 for a summary of how to calculate E&P.
What is a CFC?
Subpart F Income and CFC go hand-in-hand.
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.
Common CFC structures 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
Examples are a great way to understand a complex topic. Here is a common Subpart F Income example:
David is a U.S. person. He is a shareholder in a foreign BVI holding company. The BVI is a CFC, because it is owned 75% by U.S. persons, who each own at least 10% (individually or through attribution). The company’s purpose is to hold passive investments. In the current year, the company has E&P (Earnings and Profit).
Even though the dividends generated from the investments are not distributed, the ratable ownership attributed to David (and other U.S. shareholders) may be taxable in the current year — before the income is ever distributed.
Common Subpart F Income Questions & Answers
To best understand the concept of subpart F Income, it is important to understand these two main ideas about who is being tax and what income is being taxed:
IRS is Not Directly Taxing the Foreign Corporation
Is important to note, that the IRS 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)
With the introduction of the TCJA (Tax Cuts and Jobs Act (TCJA), the government modified the way foreign income is taxed. One major change was GILTI (Global Intangible Low-Taxed Income). GILTI and Subpart F are similar (but different) and the interrelation between the two concepts severely impacts Subpart F tax and reporting. In addition, Subpart F income may also be impacted by FDII (Foreign Dividend Intangible Income).
Exceptions, Exclusions, and Limitations to Subpart F
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.
Here are some common exceptions:
Inclusion limited to current E&P
The amount included in a USSH’s taxable income is limited to the CFC’s undistributed E&P (just as an actual distribution would be a dividend only to the extent of the CFC’s undistributed E&P). § 952(c)(1)(A)
De minimis rule
If the sum of FCSI and insurance income is less than the lesser of 5% of gross income or $1M, none of the CFC’s income is FBCI or insurance income. § 954(b)(3)(A)
High tax exception
An item of income taxed at more than 90% of the highest US rate (i.e. 35% X 90% = 31.5%) is not FBCI or insurance income. § 954(b)(4)
Same country manufacturing exception from FBCSI
Income from property manufactured (by anyone) in the CFC’s country of incorporation is not FBCSI. § 954(d)(1)(A)
Same country sales/use exception from FBCSI
income from property sold for use, consumption or disposition within the CFC’s country of incorporation is not FBCSI. § 954(d)(1)(B)
CFC manufacturing exception from FBCSI
income from sale of property that the CFC itself manufactures (anywhere) is not FBCSI. Treas. Reg. § 1.954-3(a)(4)
Active financing exception from FPHCI
Qualified income derived by a CFC that is predominantly engaged in the active conduct of a banking, financing or similar business is not FPHCI. § 954(h)
Look through exception from FPHCI
Certain income received from a related CFC and allocable or attributable to income that is neither Subpart F nor Effectively Connected Income (ECI), as defined under § 864(c), is not FPHCI. § 954(c)(6)
Same country exception from FPHCI
Certain income received from a related CFC incorporated in the same country that uses a substantial part of its assets in a trade or business in that country is not FPHCI. § 954(c)(3)
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