Foreign Business Lawyers | CFC & Subpart F Tax – International Tax Compliance
- 1 CFC
- 2 Why does the U.S. Accelerate CFC Income?
- 3 International Business Planning
- 4 Foreign Business & Investment Tax Law Summary
- 5 Tax Treaties
- 6 Tax Structure of the Foreign Country
- 7 Permanent Establishment
- 8 Controlled Foreign Corporation (CFC)
- 9 Transferring Assets to a Foreign Corporation
Foreign Entity and CFC/Subpart F Rules: 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.
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.
A CFC is a Controlled Foreign Corporation. In accordance with U.S. ownership rules, if U.S. persons own more than 50% of the foreign corporation and each U.S. shareholder owns at least 10% of the business, the business is considered a CFC.
While this can get confusing, and there are ways around falling into the CFC trap — for the typical small business in the United States which wants to expand overseas, it is hard to get around the rule. For example, if four people each own 25% of the foreign business and they are all US persons, then the business will be considered a Controlled Foreign Corporation.
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.
International Business Planning
Beyond just CFC and Subpart F income rules, the various issues that a US business overseas has to contend with. A summary is provided below:
- FTC (Foreign Tax Credit)
- Income Tax Treaties
- International Tax Law Forms
- FIRPTA (U.S. & Foreign Real Estate Investments)
- International 1031 Exchanges
- Inbound Transactions
- Outbound Transactions
- EB-5 Investor Visas
- Foreign Retirement Plans
Foreign Business & Investment Tax Law Summary
Generally, a business is going to be taxed on its global earnings. If the business is based in the United States, then the owners of the business will generally pay U.S. Tax on the foreign earnings under CFC and PFIC rules, as well as foreign tax (depending on each foreign country’s residence requirements and if the U.S. entered into a treaty with the particular(s) foreign country).
The U.S. and foreign countries understand that issues involving double taxation and differences in global tax regimes can bring unnecessary complications and deter international trade, which is why the U.S. has entered into tax treaties with nearly 60 countries (estate tax treaties with around 16 countries)
When it comes to international sales some basic tax issues that must be considered are for example:
- Does the Foreign Country have an international tax treaty with the United States?
- Whether the US business is operating overseas as a subsidiary or branch office?
- Are there ways to avoid immediate tax liability on foreign income which is not distributed?
- What are the withholding requirements for payments to foreign persons?
- What are the disclosure and reporting requirements US business conducting overseas (FBAR, FATCA, PFIC, CFC, etc.)
The United States has entered into tax treaties with nearly 60 foreign countries. The main idea behind tax treaties is that the United States does not want taxpayers who operate in “U.S. friendly countries” to have to worry about double taxation. Moreover, the United States generally enters into tax treaties with countries that it likes, and therefore provides additional tax benefits to these particular countries such as reduced passive income tax rates as well as the elimination of certain foreign taxes.
Many times the tax treaty will include a reduction in taxes for certain types of income such as FDAP (Fixed, Determinable, Annual and Periodical). FDAP is generally income earned from investments or “passive income.”
Even without a tax treaty, “portfolio interest” is a common example of passive income which is income earned overseas or from a foreign institution and may not be taxable in the United States (or taxed at a reduced rate). This may significantly impact a PFIC (Passive Foreign Investment Company) that is in the business of lending money.
In addition, foreign interest received from a bank is also usually exempted. While FDAP is passive income, there are also a different set of laws that apply to ECI (Effectively Connected Income, which is usually “active” income) that goes beyond the scope of this article.
It is important that a business reviews the tax treaty before determining which country the business is going to operate in. Unless there is a specific reason why the business must operate in a particular foreign country, it would usually be in the best interest of the business to operate in foreign countries which have signed a U.S. Tax Treaty.
By reviewing the tax treaty beforehand, the business can also gain guidance as to how certain items taxed, such as rents, royalties, dividends, and other income will be taxed.
Tax Structure of the Foreign Country
When a US company is deciding which country it wants to expand into, another issue to consider is how the tax structure is set up in the particular foreign country. Not only can this assist with integrating tax reduction strategies, but will also include an overall enhancement in the company’s tax organization and compliance.
In most countries, there are two general laws in determining how the country is going to tax the business. It will all depend on whether the country taxes businesses as a resident and/or nonresident. Not all countries define the term resident and nonresident same – especially when it comes to taxation of business profits.
If the business is going to be considered a resident of a foreign country then the business is going to either be taxed by that country on its worldwide Income or only on the income earned in the particular country (this will vary depending on the residence of the business owners, the structure of the company, and which country the company was formed in).
Thus, if the business decides it wants to develop a company in Austria and the business is considered to be a resident of Austria (generally means Austria will be the main focus of management operations) then the company is going to be taxed on all of its income. When a business is a resident business of that foreign country than that foreign country would typically have the right to tax that business on its worldwide sourced income.
Alternatively, if the business is considered a nonresident business (the business does not conduct its main operations from the particular foreign country), then that foreign country generally only has the authority to tax the company on its foreign source income in that particular country. So taking the Austria example, if a company formed a branch or subsidiary in Austria then as a nonresident company, Austria can only tax the company on profits earned in sales or other income sourced in Austria.
*As you can imagine, when it comes time for international companies to file US tax returns, it is important determine how much has been paid in foreign tax, to determine what type of tax credit from community intends
Not all countries follow the resident versus nonresidents tax analysis. For example, Hong Kong utilizes a “territorial” system, which means that in Hong Kong it does not matter whether you are a resident Corporation or nonresident Corporation. If you earn profits outside of Hong Kong, then Hong Kong does not generally tax you on those earnings; if you have earnings inside of Hong Kong, then you are taxed.
Before a business decides whether or not it is going to set up operations in a foreign country, one of the main reasons why it must determine if there is a tax treaty with the United States is to determine whether the “permanent establishment” is an issue.
Most, if not all of the tax treaties a foreign country has with the United States makes reference to a permanent establishment. The analysis for a personal establishment can become somewhat complicated and involves different prongs and factors to determine whether a permanent establishment has been made.
For the most part, if a business from country A conducts business in foreign country B, then unless that business sets up a permanent establishment in country B, country B will not tax the company. In other words, Country B will only tax the earnings on profits earned from the business if there is a permanent establishment in country B.
In order to determine whether a permanent establishment exists, there is a two prong analysis:
- Whether the corporation has a fixed place of business within the target country, as defined under the language of a specific treaty
- Whether the corporation operates in the target country through a dependent agent that habitually exercises the authority to conclude contracts on behalf of the corporation in the target country
The analysis of permanent establishment should be conducted before a business decides to conduct business in any particular foreign country.
Controlled Foreign Corporation (CFC)
A controlled foreign corporation is a complex concept which was introduced in order to combat company’s attempts to avoid immediate taxation on profits.
For example, let’s say a person is a U.S. Taxpayer (usually a US citizen or legal permanent resident). Let’s also say that the person decided to purchase interest in a foreign company. Before the introduction CFCs, what many people would do would be to try to suspend the earnings overseas to avoid tax consequences.
In other words, if the US taxpayer earned a half-million dollars in foreign income, instead of having that money distributed to the US taxpayer, the taxpayer would have that money remain overseas and develop creative ways to keep that money offshore without having to disclose it (this is also before the days of FATCA).
Then, the US taxpayer would either not report the earnings (technically they had not been distributed to shareholders) and/or would simply have the foreign company provide loans to the shareholders instead of dividends – in which the company would then forgive the loan. Depending on which country the business operated in it may not have had to report loan forgiveness; moreover, since the US taxpayer received a “loan” and not income there is nothing to report in terms of income.
As a result, taxpayers saved billions of dollars in tax payments.
The United States, along with several other countries, did not look kindly upon this practice and therefore introduced the concept of controlled foreign corporations and subpart F income.
The definition of a controlled foreign corporation (for US tax purposes) is as follows:
- Controlled Foreign Corporation Defined . A controlled foreign corporation is any foreign corporation in which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned directly, indirectly, or constructively by U.S. shareholders on any day during the taxable year of such foreign corporation or more than 50% of the total value of the stock is owned directly, indirectly or constructively by U.S. shareholders on any day during the taxable year of the corporation.
- U. S. Shareholder Defined . A U.S. shareholder is a U.S person (defined in IRC section 957(c)) who owns directly, indirectly, or constructively 10 percent or more of the total combined voting power of all classes of stock entitled to vote in a foreign corporation.
The general rule of thumb is that if a total of 50% of the voting power or value of the foreign corporation’s stock is owned by US shareholders, then subpart F income rules coming to play. US Shareholders own at least 10% of voting stock.
There are ways to work around these numbers, such as if the company is owned 50% by US persons, and each US person owns less than 10% of the value of combined voting power of the classes of stock – but this generally defeats the purpose for small businesses and entrepreneurs who own the company as only a few shareholders and do not want to bring in additional U.S. or Foreign Investors.
These are just some of the many different factors that must be taken into consideration before determining whether the company should operate in the particular foreign country. There are other common issues such as Thin Capitalization, Transfer Pricing, and VAT registration which must also be considered before determining which foreign country to operate in.
Transferring Assets to a Foreign Corporation
Due to the concern that individuals and corporations might attempt to shift income overseas by transferring property with built-in gains to foreign corporations, the United States does not provide the same nontaxable event protection when properties are transferred into a foreign corporation.
As a result, Internal Revenue Code section 367(a) essentially treats the transfer of property, which can also include stock, by a US person to a foreign Corporation as a taxable event unless the transfer qualifies for an exception. Click Here to read a recent article we authored.