Controlled Foreign Corporation Fundamentals
Controlled Foreign Corporation (CFC): International tax law is complicated. In order to avoid U.S. shareholders from hiding money overseas in foreign businesses, the IRS developed the CFC regime. 26 U.S.C section 957 defines the rules, and who may be subject to tax.
It is important to note, that the U.S. Government is not necessarily exerting tax jurisdiction over the foreign corporation. Rather, the IRS is exerting tax requirements for U.S. Shareholders of CFCs.
With a CFC, the shareholders (not necessarily the corporation) are taxed on Subpart F income and GILTI (Global Intangible Low-Taxed Income).
The failure to properly pay tax on income, and report the corporation on Form 5471, FBAR and FATCA (if applicable) may result in significant offshore fines and penalties — which can be reduced or avoided with voluntary disclosure.
How is it Defined
The controlled foreign corporation definition is found in IRC 952.
In general, the purpose of the CFC is to reduce and eliminate the deferral of certain CFC income.
With a controlled foreign corporation, the IRS has authority over U.S. shareholders. The IRS wants to avoid the shareholders from deferring tax. Therefore, the U.S. government developed the Subpart F rules under IRC section 952.
IRS tax law defines a CFC as a foreign corporation owned by more than 50% by U.S persons, who each own at least 10% (Attribution Rules apply). If you have a CFC, the IRS tax and reporting rules becomes infinitely more complicated.
The two primary elements of determining if you have a Controlled Foreign Corporation is when the foreign corporation is:
- Owned more than 50% by U.S. Persons (aka U.S. Shareholder); and
- Each U.S. Person owns at least 10% (attribution riles apply).
Once a foreign corporation is classified as a CFC, the tax rules changes, as well as certain reporting requirements in accordance with Form 5471.
The IRS methods for taxing U.S. shareholders of foreign corporations changed significantly in 1962. At this time, Subpart F rules were introduced into the IRC (Internal Revenue Code). The goal of the Subpart F and CFC law was to reduce offshore tax havens, by expanding the U.S. tax anti-deferral regime. As a result of Subpart F, some categories of foreign corporation income is taxable — even if the income has not been distributed.
TCJA (Tax Cuts & Jobs Act )
The rules were modified by the TCJA (Tax Cuts and Jobs Act), which introduced GILTI (Global Intangible Low-Taxed Income) and IRC 965 transition tax, the general guidelines remain the same.
Who is a U.S. Shareholder?
As provided by the IRS:
“A U.S. shareholder is a U.S. person (defined in IRC 957(c)) who owns directly, indirectly, or constructively 10 percent or more of the total combined voting power of stock entitled to vote or 10 percent or more of the total value of all classes of stock entitled to vote in a foreign corporation. IRC 958(a) provides rules for determining direct and indirect stock ownership of a corporation.
IRC 958(b) provides that the constructive ownership rules of IRC 318(a) apply to the extent that the effect is to treat a U.S. person as a U.S. shareholder or a foreign corporation as a CFC. For tax years ending on or before December 31, 2017 IRC 958(b)(4) turned off “downward attribution” which prevented a U.S. person from being treated as owning stock that is owned by a Non-U.S. person. In December, 2017 IRC 958(b)(4) was repealed.
As a result, for tax years beginning on or after January 1, 2018 the “downward attribution” under IRC 318(a)(3) does apply to treat U.S. persons as owning the stock of Non-U.S. persons which will have the effect of creating U.S. shareholders and, in turn, CFCs that were not treated as such in prior years.
*Note there are special rules for determining whether a foreign corporation is a specified foreign corporation (SFC) for purposes of IRC 965, which increases the subpart F income of a deferred foreign income corporation (DFIC), a type of SFC, for its last taxable year beginning before January 1, 2018 by the greater of certain of its post-1986 earnings and profits as of November 2, 2017 or December 31, 2017. Under these rules, SFCs include all CFCs and certain other foreign corporations.
What is Attribution and Constructive Ownership
There are constructive ownership rules for the ownership of a CFC. This leads indirect shareholders to be attributed ownership of a Controlled Foreign Corporation, even if they do not directly own the shares.
Controlled Foreign Corporation Examples
We have developed our own set of controlled foreign corporation examples. While these types of entities come in many shapes and sizes, there a a few common CFCs we work with at Golding & Golding, in which having U.S. shareholders is the norm. 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 Wholly Owned Foreign Corporation such as Hong Kong Ltd., BVI, or Australia PTY Ltd.
– A Foreign Corporation (Even if established just as a Foreign Trust), but is considered a Per Se Corporation under IRC§ 301.7701-2
How is a CFC Taxed?
The CFC tax rules in accordance with Subpart F allow the IRS to tax certain income of the CFC, even though the corporation is foreign, and the U.S. would have not direct authority over the foreign corporation. As long as there is current year earnings & profit, a U.S. shareholder may be subject tax on the shareholders ratable share of income — even if it was not distributed.
The tax rules involving a CFC can be very complicated in light of the Subpart F income rules. This is especially true after the introduction of the TCJA. The new Tax Cuts and Jobs Act introduced new international tax rules referred to as GILTI (Global Intangible Low-Taxed Income)
And, while GILTI is not the same as Subpart F income, it is equally complex. If you are concerned about potential CFC income, you may want to speak with an experienced offshore tax lawyer.
How are CFCs Reported?
Controlled Foreign Corporation Reporting involves the reporting of information and disclosure to the IRS. If a person’s ownership interest meets the Form 5471 reporting requirements.
When it comes to reporting a CFC, one common international reporting form is form 5471. oftentimes, a U.S. shareholder reports ownership share on Form 5471.
Reporting a controlled foreign corporation on Form 5471 can be complex, and is not limited to just CFCs. We have prepared two separate summaries to assist you:
Common Controlled Foreign Corporation FAQs
Common questions we receive about controlled foreign corporations, include:
What is IRC Section 957?
IRC section 957 is the code section in the Internal Revenue Code which details Controlled Foreign Corporations (CFC).
What is CFC IRS?
CFC IRS is just a
Foreign Corporation Tax Reform
In 2018 the tax rules have changed. With the introduction of TCJA, GILTI, and updated Form 5471 reporting requirements, the landscape for reporting Controlled Foreign Corporations has intensified.
Dividends are generally taxed in the year they are received. In addition, there may be some Subpart F income for the controlled foreign corporation — even in years when no income was distributed.
More Than 50% U.S. Ownership
In order for a Foreign Corporation to be considered a Controlled Foreign Corporation, it must be owned more than 50% by U.S. Persons. It is important to note that if the Foreign Corporation is owned 50% by U.S. Person (one U.S. Person and One Non-U.S. Person each owning 50% of the corporation), it is not considered a Controlled Foreign Corporation, because it is not being ‘controlled’ in the legal sense of the word.
Beyond the Foreign Corporation being owned more than 50% by U.S. Persons, it must be also be that each of the shareholders within that +50% each own at least a 10% share. In other words, if 6 unrelated U.S. Persons own at least 9% share each, they would technically own 54% of the corporation, but because none of them each own at least 10%, it is not considered to be a Controlled Foreign Corporation (unless attribution rules applied)
What is Attribution IRC (958)?
Attribution is the idea that one person considered to constructively own stock that another person owns only due to the relationship between the two individuals. The main purpose of attribution is to avoid artificially low tax reductions strategies by making sales or transfers between “related” parties. More information can be found in Internal Revenue Code section 958. As provided by the IRS :
Constructive ownership rules apply for determining whether the U.S. person is a U.S. Shareholder and whether a foreign corporation is a CFC, but are not considered in determining the amount of a U.S. Shareholder’s Subpart F inclusion.
– A corporation, partnership, trust or estate that owns more than 50% of the voting stock of a corporation is considered to own 100% of the voting stock of that corporation.
– Stock owned by a non-resident alien individual is not treated as owned by a U.S. person.
– More than one family member can be attributed the same stock. For example, stock owned by a child can be attributed to both a parent and a grandparent.
What is Subpart F Income (IRC 951)
Subpart F income is income that is earned within a Controlled Foreign Corporation that is going to be taxed to the U.S. person — whether or not any money was distributed to the U.S. persons. One of the main purposes behind this law is that in days past,Controlled Foreign Corporations would stockpile money and neither distribute nor issue it as income, dividends, interest, capital gains, etc.. Thereafter, the Controlled Foreign Corporation would issue loans to shareholders (which is not income) and then when it’s time to repay the loan, the company would simply forgive loan (no major detriment to the corporation).
Therefore, the IRS developed subpart F income, which can be very detailed.
The main information is found in code section IRC 951:
In general: If a foreign corporation is a controlled foreign corporation for an uninterrupted period of 30 days or more during any taxable year, every person who is a United States shareholder (as defined in subsection (b)) of such corporation and who owns (within the meaning of section 958(a)) stock in such corporation on the last day, in such year, on which such corporation is a controlled foreign corporation shall include in his gross income, for his taxable year in which or with which such taxable year of the corporation ends—
(A)the sum of—
(i) his pro rata share (determined under paragraph (2)) of the corporation’s subpart F income for such year,
(ii) his pro rata share (determined under section 955(a)(3) as in effect before the enactment of the Tax Reduction Act of 1975) of the corporation’s previously excluded subpart F income withdrawn from investment in less developed countries for such year, and
(iii) his pro rata share (determined under section 955(a)(3)) of the corporation’s previously excluded subpart F income withdrawn from foreign base company shipping operations for such year; and
(B) the amount determined under section 956 with respect to such shareholder for such year (but only to the extent not excluded from gross income under section 959(a)(2)).
But I Did Not Receive any Subpart F Income Distribution
It is immaterial whether the US shareholder of controlled foreign corporation actually received any of the money. That is why the phraseology used by the Internal Revenue Service code is “pro rata share” and “amount determined” vs. “received.” There are certain other factors that are important regarding subpart F income such as whether there is any current earnings and profits (E&P), whether taxes have been paid, and whether dividends have also been issued (these will all impact the complex ordering rules of Subpart F Income)
What is Form 8938
Under current U.S. Tax law, the IRS and U.S. Government have made Foreign Financial Reporting a key enforcement priority.
Form 8938 (Statement of Specified Foreign Financial Assets) is an IRS Form associated with FATCA (Foreign Account Tax Compliance Act). It is similar to the FBAR, but more detailed in scope as to what has to be filed (Stock Ownership and Actual Income Earned for example). The failure to file this FATCA Form can lead to extensive Fines and Penalties.
CFC Penalties Will Flow Through 8938
There are many penalties a person may be subject to if they have a controlled foreign corporation but did not file properly. These include penalties for not filing of an FBAR or 8938. They also include started properly report Subpart F Income, or filing a form 5471 form 8621 (depending on the nature of a controlled foreign entity/partnership).
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.
Contact our firm today for assistance.