CFC and Subpart F Income (2018) – How Does The IRS Tax You?
CFC and Subpart F Income (2018) – How Does The IRS Tax You?
CFC and Subpart F Income are very complex areas of International Tax Law. Specifically, because if someone is attributed Subpart F Income from a CFC, in a year the CFC has current year E&P, then the the person may be subject to U.S. Tax on the income — even if it is not distributed to the Person.
Sounds fair, right?
CFC – A Global World Economy
With the globalization of the U.S. economy, many U.S. businesses are seeking to expand their operations into foreign territories. There are various methods and ways for performing business overseas, and which option the entrepreneur/business selects will result in various tax ramifications that should be addressed before commencing business overseas.
For some businesses, it is simply expanding their current operations overseas and there is no distinction between a U.S. company in a foreign entity aside from forming a “Foreign Branch” of the U.S. company. For other businesses, they may want to form a foreign entity in order to try to shield income from the United States by using only the foreign entity to perform work outside of the United States. Each country as its own distinct types of entities – although more and more, foreign countries are actively seeking to U.S. and foreign businesses for investment by developing LLC or similar type of Limited Liability businesses.
U.S. Person Investors – Beware
When a U.S. person decides they want to form a foreign entity in order to conduct business overseas, there are various rules they have to be aware of, as well as reporting requirements for the foreign accounts in accordance with FATCA and FBAR Reporting.
Beyond just reporting requirements, one of the main issues the U.S. person will have to contend with are CFC Rules (Controlled Foreign Corporations) and the resulting Subpart F income. In accordance with CFC and Subpart F rules, the United States will accelerate foreign income – even if it has not been distributed – to the U.S. Owners of a CFC. The resulting imputing of non-distributed Subpart F income requires a US person to pay tax on their ratable share of the earnings, even though they have not actually received the money yet.
*Not all foreign companies with U.S. investors qualify as a CFC, and not all CFC income is considered Subpart F Income.
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.
Why does the U.S. Accelerate CFC Income?
The reason the US accelerates CFC income can be explained with the following example:
-U.S. Citizens David, Michelle, and Peter formed Corporation X. Corporation X is a foreign entity that is formed in country X. Country X, like many foreign countries have corporate rules which provide that if the owners of the business are not residents of Country X, then the country does not tax Country X on its earnings that are earned outside of Country X.
-Therefore, Corporation X is formed in country X but only operates in Country Y and Z. In Countries Y and Z there is a very low tax rate, much lower than the United States. Thus, as a result of forming this foreign corporation, the US taxpayers will be earning overseas income, but paying very minimal tax.
-Furthermore, instead of having the corporation pay dividends to the US citizen owners, the corporation makes loans to the US citizens; thus, the US citizens have no “income” to report in the United States. Back in the day, after the loan was made and in accordance with foreign lending rules in the particular jurisdiction that was selected by the US citizens, the company could then forgive the loan without any penalty. As a result, no taxes were being paid by the US citizens but they were receiving loans – which really amounted to earnings.
-Under current CFC rules, since the owners of Corporation X are US citizens and Corporation X is a CFC earning Subpart F income, the U.S. owners are required to pay U.S. tax on their worldwide income in the United States. The U.S. wants to make sure that it receives the tax money it should be receiving (by taxing the U.S. Investors’ worldwide income) aside from any creative foreign business planning.
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)
Me & My 12 Family Members 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.
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.
When Do I Need to Use Voluntary Disclosure?
Voluntary Disclosure is for individuals, estates, and businesses who are out of compliance with the IRS and the Department of Treasury. What does that mean? It means that if you are required to file a U.S. tax return and you don’t do so timely, then you are out of compliance.
If the IRS discovers that you are out of compliance, you may become subject to extensive fines and penalties – ranging from a warning letter all the way up to tax liens, tax levies, seizures, and criminal investigations. To combat this, you can take the proactive approach and submit to Voluntary Disclosure.
Golding & Golding – Offshore Disclosure
At Golding & Golding, we limit our entire practice to offshore disclosure (IRS Voluntary Disclosure of Foreign and U.S. Assets). The term offshore disclosure is a bit of a misnomer, because the term “offshore” generally connotes visions of hiding money in secret places such as the Cayman Islands, Bahamas, Malta, or any other well-known tax haven jurisdiction – but that is not the case.
In fact, any money that is outside of the United States is considered to be offshore; the term offshore is not a bad word. In other words, merely because a person has money offshore (a.k.a. overseas or in a foreign country) does not mean that money is the result of ill-gotten gains or that the money is being “hidden.”
It just means it is not in the United States. Many of our clients have assets and bank accounts in their homeland countries and these are considered offshore assets and offshore bank accounts. Nevertheless, the IRS still wants to penalize you on the unreported accounts, assets, investments, etc.
Contact us today, we can help you.