How CFC & PFIC Become Domestic for Trust Income Taxation

How CFC & PFIC Become Domestic for Trust Income Taxation

CFC & PFIC Become Domestic for Trust Income Taxation

When it comes to international tax, two of the most complicated components of taxation involve Controlled Foreign Corporations (CFCs) and Passive Foreign Investment Companies (PFICs). Making the analysis infinitely more complicated is when there are trusts involved with these entities. In general, the trust taxation rules for foreign trusts are very complex. While on the one hand the general grantor and non-grantor tax provisions apply, the foreign component — along with factors such as the throwback rule; modification of the DNI definition, and loss of character for certain UNI can make it even more (unnecessarily) difficult. Confounding the analysis even further is what happens in the situation in which a CFC or PFIC has ownership of a trust?

CFC or PFIC Trust Ownership Domestic Tax Rules

With a Controlled Foreign Corporation (Subpart F Income) or Passive Foreign Investment Company, a US Person ends up being taxed significantly on various types of foreign income, even if that income has not been repatriated to the United States.  With a trust, the concern with a CFC or PFIC owner would be if the entity claims ownership as a “foreign company” and deems the trust as “foreign” — so that the owner of the Trust would not be subject to US Tax except on US-Sourced trust income (since a foreign grantor would then own the trust) — and thus the IRS would not be able to exert tax on the income. In other words, in general, with a foreign grantor trust situation — if a trust has a foreign owner and there is no US income, then the US cannot typically exert tax liabilities against a foreign nonresident alien owner of a foreign grantor trust — on income generated outside of the United States. To avoid this situation in which the CFC/PFIC owner of a grantor trust would claim that it is foreign-owned because it is owned by a CFC or PFIC — the IRS has specific rules identifying trust income generated and HCFC or PFIC as domestic income.

26 USC 672 (f)(3)

(3) Special rules

Except as otherwise provided in regulations prescribed by the Secretary—

      • (A) A controlled foreign corporation (as defined in section 957) shall be treated as a domestic corporation for purposes of paragraph (1), and

      • (B) paragraph (1) shall not apply for purposes of applying section 1297.

Treas. Reg. 1.672(f)-2(a)

(f)-2 Certain foreign corporations.

      • Application of general rule in this section.

      • Subject to the provisions of paragraph (b) of this section, if the owner of any portion of a trust upon application of the grantor trust rules without regard to section 672(f) is a controlled foreign corporation or a passive foreign investment company (as defined in section 1297), the corporation is treated as a domestic corporation for purposes of applying the rules of § 1.672(f)-1.

      • For purposes of this section, a controlled foreign corporation has the meaning provided in section 957, determined without applying section 318(a)(3)(A), (B), and (C) so as to consider a United States person as owning stock which is owned by a person who is not a United States person

Special Rule for CFCs and PFICs Trusts owned by (CFCs) and (PFICs)

As provided by the IRS:

      • If the owner of any portion of a trust is a CFC or PFIC, then the CFC or PFIC will be treated as a domestic corporation for purposes of the grantor trust rules.

How Does the IRS Evaluate it?

As further provided by the IRS: 

    • Determine if the trust meets one of the exceptions under the Code to be considered a grantor trust with a foreign grantor (or if owned by a CFC or PFIC it will be treated as having a U.S. grantor).

    • If you do have a foreign person treated as the owner of the trust, the foreign owner is taxed as any non-resident for U.S. tax purposes. If you have a CFC or a PFIC treated as the grantor then the income will be taken into account directly or through the CFC or PFIC.

    • Although, a U.S. beneficiary of the foreign grantor trust would not be taxed on any distributions from the trust, the U.S. beneficiary would nevertheless be required to file information returns (i.e., Form 3520) with respect to any distributions from the foreign trust (or the uncompensated use of foreign trust property) –

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