Understanding the Tax Laws of a Controlled Foreign Corporation – Subpart F & Foreign Passive Income
- 1 Controlled Foreign Corporation
- 2 What is a Controlled Foreign Corporation?
- 3 Controlled Foreign Corporation – What is Subpart F Income?
- 4 Controlled Foreign Corporation – Form 5471
- 5 Controlled Foreign Corporation – Ordinary Income Reporting
- 6 Controlled Foreign Corporation – Attribution Rules
- 7 Golding & Golding – Limited to IRS Voluntary Disclosure
Corporate tax law is very tough and the Controlled Foreign Corporation is a very complicated area of Tax Law.
Controlled Foreign Corporation
When it comes to corporations and U.S. Tax Law, even the slightest change in facts or circumstances may result in two wildly divergent tax results. And, when it comes to international tax and business, one of the most important issues to understand is the basics of a Controlled Foreign Corporation.
A Controlled Foreign Corporation is a very common issue for both U.S. based residents and foreign residents who are considered U.S. persons (U.S. Citizens, Legal Permanent Residents, and Foreign Nationals Subject to U.S. tax under the Substantial Presence Test).
We are going to provide you with a relatively brief (For Tax Purposes) summary of the main issues that you must consider when you find that your business is going to be deemed a Controlled Foreign Corporation by the U.S. Government.
There are six main questions to consider when dealing with a Controlled Foreign Corporation. We will list and summarize each consideration below.
- What is a Controlled Foreign Corporation?
- Controlled Foreign Corporation – What is Subpart F Income
- Controlled Foreign Corporation – Form 5471
- Controlled Foreign Corporation – Ordinary Income Reporting
- Controlled Foreign Corporation – IRS 5471 Penalties
- Controlled Foreign Corporation – Attribution Rules
What is a Controlled Foreign Corporation?
A Controlled Foreign Corporation is a corporation which is “Foreign” (aka incorporated under a foreign country’s rules and meets certain U.S. ownership requirements). The following is a summary of the threshold requirements for being deemed a Controlled Foreign Corporation (ownership attribution rules apply, see below).
More than 50% Ownership
The basic requirements are relatively simple: the first requirement is that the business is more than 50% owned by U.S. persons. Recalling back to our Master’s in Tax program, our professor made it clear that unfortunately, many individuals receive bad legal advice and believe they are the owner of a Controlled Foreign Corporation, when in fact they are not. Remember, you must be more than 50%.
For example: if a US person and a non-US person each own 50% of a foreign corporation, it is not a Controlled Foreign Corporation. Why? Because a U.S. person does not own more 50% of the corporation.
To complicate ownership rules further, there are attribution rules which apply – which means if you happen to own a subsidiary which owns a foreign corporation, the ownership can be attributed back to you so that no matter how sneaky you believe you are. Attribution rules also apply to family relationships (children, spouses, grandparents, etc.), and if ownership is ultimately “attributed” to you, then you will be deemed the de facto owner of the foreign corporation – even if your name is nowhere to be found on title.
At Least 10% Ownership
The next issue is the level of ownership, and again attribution rules. For example, assuming that U.S. persons own more than 50% of the foreign corporation, the next issue is to determine whether each U.S. Person owner meets the threshold requirements.
In order to meet the basic minimum requirements, a U.S. owner must have at least a 10% ownership of the Corporation. For example, if a foreign corporation was owned entirely by U.S. persons but each person owned less than 10% of the foreign corporation, then none of the owners would be considered to meet the threshold requirement and thus the business would not be a Controlled Foreign Corporation.
**Important to note, that even if your business can successfully sidestepped CFC status, you may still be considered PFIC (Passive Foreign Investment Company), and are still subject to reporting under Internal Revenue Code section 1291 et seq. which is reported on IRS form 8621.
Controlled Foreign Corporation – What is Subpart F Income?
Subpart F income is not your friend. Rather, Subpart F income is one of the worst aspects of owning a Controlled Foreign Corporation. Here’s why: the mere fact that someone is an owner of a Controlled Foreign Corporation in and of itself does not require the booking of income that the corporation earned but didn’t distribute — that requirement is reserved for Subpart F income. In other words, if it is a regular foreign corporation that is functioning as an active company, that is not overrun by passive income or assets, then the mere fact that your company is deemed a Controlled Foreign Corporation is of little consequence.
If you have a foreign corporation but do not earn Subpart F income, you can operate normally — without the fear of booking non-distributed income. As such, corporate items such as retained earning’s, salary, expenses etc., and the corporation will report annually on a form 5471 and there is no major issues to contend with (not because it is a controlled foreign corporation, but because any US person with more than 10% ownership of a foreign corporation has to file a form 5471, although under some circumstances only one form needs to be filed per company).
If the company generated Subpart F income and current E&P, the rules are different. Subpart F income is generally considered a type of passive income and it can be broken down into various different categories, but for introductory purposes just consider it as passive income.
And, as you may or may not be aware, the United States government hates foreign passive income – with a passion. Merely owning a foreign mutual fund in which you receive an excess distribution (which does not need to be much in the way of “excess”) can lead you down a dark tax highway and towards a 100% tax liability – click here to learn more about the basics of a PFIC Calculation.
When do I report Subpart F income?
When you have subpart F income and current earnings and profit (E&P), you will have to report as income your ratable share of the subpart F income. So for example, your foreign corporation earned $100,000 in subpart F passive income and you are a 50% owner of the company. You will be required to report your share of the subpart F income in your contact.
And, you will have to pay current U.S. tax on that income even though it was not distributed to you (some exceptions/exclusions may apply). Keep in mind, that down the line when the income is distributed to you, you will receive a tax credit.
Why the Harsh Tax Treatment? A few bad apples ruin the bunch — and the same thing goes for subpart F income. In years past, foreign corporations would simply hoard the passive earnings, never distribute the earning as income but rather issue the money as loans to the owners of the company — and then cancel the loan. Thus, the foreign corporation would have a loss to funnel through the business, and the individual would have no income, because technically a loan is it a debt.
Controlled Foreign Corporation – Form 5471
A Form 5471 is a very comprehensive and potentially complex IRS tax form. It is required to be filed by U.S. persons who have a stake in a foreign corporation (a similar form 8854 is used for foreign partnerships). Hypothetically, if 12 people owned a foreign corporation and none of them owned at least 10% of the business, then they may be able to sidestep filing this form. But for the majority of U.S. persons who either have a stake in, or ownership of a foreign corporation of at least 10%, you will have to file this form annually. (At least one 5471 must be filed per Corporation).
The form is designed to elicit significant amounts of information regarding the foreign business and thus, is very comprehensive. It requires you to report the balance sheet, income, equity, liabilities as well as a host of different addendum schedule forms depending on the type of ownership, whether there is subpart F income, and whether the company has retained earnings, etc.
It is important to make sure that if you own at least 10% of a foreign corporation, that you file this form annually, unless you are otherwise exempt. The failure to file this form can carry significant fines and penalties upwards of $10,000 plus per year, per violation. Therefore, even if you do not have control or much interest in the foreign company, but meet the threshold filing requirements — you should speaking with an international tax lawyer to discuss the reporting requirements.
Controlled Foreign Corporation – Ordinary Income Reporting
When it comes to a Controlled Foreign Corporation, many CFCs are legitimate businesses (read: non-offshore tax shelters). For example, maybe you have family in another country, or a consulting company overseas – or are originally from another country and have investments in active corporations. It i not inconceivable to believe that many individuals would own 10% stake in a foreign business, entrepreneurial enterprise, family business or similar business
If you have earned regular income from a foreign corporation, then you have to report the income on your tax return.
Why? Because under U.S. tax laws you have to report your worldwide Income. That means that whether the income was earned while you resided in the United States or lived in a different country, you have to report the income. Moreover it does not matter whether the income was sourced from the United States or elsewhere – you still have to pay U.S. tax on the money. If you already paid foreign tax on the earnings, then you do not have to pay double tax. Rather, you would obtain a foreign tax credit against the taxes you already paid in the foreign country.
Foreign Tax Credit
If you paid more in tax to the foreign country than you would have paid in the United States, then the IRS is not provide you any refund, but you are entitled usually to carry that credit forward 10 years. If you paid less in the foreign country then you pay in the United States then you have to pay the difference in the United States. And, if you paid the identical amount of money in the foreign country, you would not owe and U.S. tax on the money —but you still must report the income on the tax return as well as the credit (read: you cannot just exclude the income from your tax return because you “already paid tax in a foreign country”)
Controlled Foreign Corporation – Attribution Rules
Attribution rules are designed to prevent the sneaky individuals who want to obtain ownership, but do not want the ownership titled under their name. For example, you may want to own a foreign investment — and you want the income that is generated from the investment — but you do not want your title or name on the ownership documents.
There are many reasons why this is preferred. For example, the Foreign Corporation may publish the names of the owners (and you do not want your information in public). Alternatively, you may be hiding the investment from your spouse, you may be running from creditors, or any other reason that results in you shying away from direct ownership.
Welcome to the world of IRS Attribution Rules. The IRS does not really care whether you want your name on title or now, because under Attribution rules you are the owner. Attribution rules can get very technical and complex. For example, let’s say you own 75% of a wholly owned subsidiary that owns 100% of another subsidiary that then owns 100% of a foreign corporation. Depending on the attribution rules, you may be considered to own 75% of the underlying foreign corporation.
There also attribution rules with family members and for some odd reason they make little to no sense as to who is included versus who is not included in the attribution (read: spouses, aunts, uncles, grandparents, step parents, etc.)
If you believe that under attribution rules you may be subject to US tax, you should speak with an experienced international tax lawyer.
Golding & Golding – Limited to IRS Voluntary Disclosure
At Golding & Golding, we focus our entire law practice on offshore disclosure. In other words, once you have had ownership or interest in a foreign company but never reported the company, income, investments, or assets (aka you are “out of compliance) and want to get into compliance, that is the area of law we practice.
We are not tax planning lawyers. If you are thinking about starting a Controlled Foreign Corporation or evaluating which foreign entity may be best for you in preparing to set up a foreign company, we are not the attorneys to call.
We cannot provide an initial consultation on foreign company formation because it is simply not we do – and we are sure there are plenty of experienced and effective attorneys who can help you in this arena.
If on the other hand, your issue is that you are already out of compliance, then feel free to contact us to discuss.