Anti-Deferral of U.S. Tax Rules on Foreign Income | CFC & Subpart F
- 1 Anti-Deferral of U.S. Tax Rules on Foreign Income
- 2 CFC Subpart F Income
- 3 What is a CFC?
- 4 Can’t I Just Form a Business Around CFC Rules?
- 5 15 Relatives Each Own Less than 10% Each
- 6 Subpart F Income
- 7 It Does NOT Need to be Distributed to You
- 8 What Type of Income Does it Include?
- 9 E&P (Earnings & Profit)
- 10 Subpart F – Technically
- 11 Important Takeaways From the IRS Summary
- 12 Golding & Golding, A PLC
Anti-Deferral of U.S. Tax Rules on Foreign Income | CFC & Subpart F
If you have a corporation overseas that is identified by the U.S. government and IRS as a Controlled Foreign Corporation or CFC, there may be serious tax consequences, including immediate tax liability for non-distributed Subpart F Income.
Anti-Deferral of U.S. Tax Rules on Foreign Income
You may think by performing some sort of CFC avoidance, you can outsmart the IRS – and while maybe you can – often times with tax avoidance, by sidestepping one problem, you will sidestep into a different (and oftentimes worse) problem.
CFC Subpart F Income
When it comes to CFC and Subpart F Income, key issues to keep in mind are the the following:
- Defining a CFC
- Defining Subpart F Income
- 5471 Reporting Requirements
- 8621 Reporting Requirements
- 8938 Reporting Requirement
- FBAR Reporting Requirements
- Current Year E&P
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.
What is a CFC?
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.
Can’t I Just 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 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.
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?
…No. That is what attribution rules come to play. Thus, if you’re considering forming a foreign corporation and using US persons like trying to circumvent and navigate CFC formation rules, be sure to speak with an experienced international tax. Lawyer.
Subpart F Income
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.
Golding & Golding, A PLC
We have successfully represented clients in more than 1,000 streamlined and voluntary disclosure submissions nationwide and in over 70-different countries.
We are the “go-to” firm for other Attorneys, CPAs, Enrolled Agents, Accountants, and Financial Professionals across the globe.
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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