One type of entity through which foreign operations may be conducted is a foreign corporation. A major tax advantage of using a foreign corporation to conduct foreign operations is income tax deferral. Generally, US tax on the income of a foreign corporation is deferred until the income is distributed as a dividend or otherwise repatriated by the foreign corporation to its US shareholders. Tax deferral is a major motivator to work abroad, but subpart F was enacted by Congress to limit the deferral of U.S. taxation of certain income (subpart F income) earned outside the United States by controlled foreign corporations (“CFC”).
Under Subpart F, certain types of income earned by a CFC are taxable to the CFC’s U.S. shareholders in the year earned even if the CFC does not distribute the income to its shareholders in that year. Subpart F operates by treating the shareholders as if they had actually received the income from the CFC. The income of a CFC that is currently taxable to its U.S. shareholders under the Subpart F rules is referred to as “Subpart F income.” Under I.R.C. § 951(a), a U.S. shareholder is required to include in income currently its pro rata share of the CFC’s Subpart F income (“Subpart F inclusion”).
Prior to the enactment of Subpart F, many US taxpayers achieved deferral of US tax on certain types of movable income, such as dividends, interest, rents and royalties, by earning such income through foreign corporations. In addition, by placing these corporations in low to no tax jurisdictions, US taxpayers were able to ensure the income was taxed at a very low rate (until it was repatriated back to the US) thereby significantly reducing their overall tax liability.
Congress determined that this type of deferral was inappropriate and reacted by enacting Subpart F. Thus, one of primary purposes of reporting Subpart F income is to prevent CFCs from structuring transactions in a way that are designed to manipulate the inconsistencies between foreign and U.S. tax systems to inappropriately generate low or non-taxed income on which U.S. tax may be permanently deferred.
It provides that certain types of income of CFCs, though undistributed, must be included in the gross income of the U.S. shareholder in the year the income is earned by the CFC.
What Is A CFC
A foreign corporation is a CFC for a particular year if on any day during such year U.S. shareholders own (1) more than 50% of the total combined voting power of all classes of the corporation’s stock entitled to vote (voting test), or (2) more than 50% of the total value of all classes of the corporation’s stock (value test).
Who Is A US Shareholder
A U.S. shareholder is a U.S. person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation. I.R.C. § 957(c) defines the term “U.S. person” for purposes of Subpart F by referencing the definition in I.R.C. § 7701(a)(30), which defines a U.S. person as any of the following: U.S. citizen/resident, domestic partnership, domestic corporation, or any estate/trust that is not a foreign estate/trust as defined in I.R.C. § 7701(a)(31).
What is Subpart F Income?
The Subpart F income provisions eliminate deferral of US tax on some categories of foreign income by taxing certain US 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 it neither receives U.S.-source income nor engages in U.S.-based activities. However, the U.S. generally does tax all income, wherever derived, of U.S. persons. The Subpart F rules operate by treating a U.S. shareholder of a foreign corporation as if the shareholder 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 foreign corporation actually makes a distribution.
Subpart F does not tax the foreign corporation directly. 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.
In general, certain classes of taxpayers must include in their income certain amounts earned by foreign entities they or related persons control. Subpart F income is one of the important issues to be aware of when completing Form 5471, but it is also very difficult to determine. The provisions of Subpart F contain many general rules, special rules, definitions, exceptions, exclusions, and limitations that require careful consideration.
There are many categories of Subpart F income. In general, it consists of movable income. For example, one major category of Subpart F income – foreign personal holding company income, or FPHCI – consists of investment income such as dividends, interest, rents and royalties. Other types of Subpart F income include income received by a CFC from the purchase or sale of personal property involving a related person (i.e., foreign base company sales income) and from the performance of services by or on behalf of a related person (i.e., foreign base company services income).
These categories of rules define the type of owners and entities affected and the types of income or investments subject to current inclusion. These categories are listed below along with the I.R.C. section where you can find the applicable definition of the category:
(1) Insurance income (IRC Section 953),
(2) Foreign base company income (IRC Section 954),
(3) Income as determined under IRC section 952(a)(3) (amounts subject to the International Boycott rules of IRC section 999),
(4) Illegal bribes, kickbacks, or other payments unlawful under the Foreign corrupt Practices Act of 1977,
(5) Income derived from any foreign country when IRC section 901(j) applies to such country.
Foreign Base Company Income
We will focus on the second category, foreign base company income, as it is the category most often applicable to foreign companies. Foreign base company income includes:
(1) Foreign Personal Holding Company Income (FPHCI) which consists of the following items:
- Dividends, interest, rents royalties, and annuities
- Net gains from the sale and exchange of certain properties; including gains from the sale or other disposition of any interest in a partnership or trust
- Net gains from commodities transactions
- Net currency gains from non-functional transactions
- Income equivalent to interest
- Income from notional principal contracts
- Payments in lieu of dividends
When Congress enacted Subpart F, it recognized the need for U.S. businesses with active business operations abroad to be on equal competitive footing from a tax standpoint with other operating businesses in the same countries. However, where a CFC has portfolio types of investments, or where the CFC is merely passively receiving investment income, there is no competitive justification to defer the tax until the income is repatriated. As such, the provisions of Subpart F require a U.S. shareholder to include its pro-rata share of the CFC’s FPHCI in income currently.
FPHCI generally includes a CFC’s income from dividends, interest, annuities, rents, royalties, and net gains on dispositions of property producing any of the foregoing types of income.
(2) Foreign Base Company Sales Income (FBCSI) is income derived from the sale or purchase of personal property with a related person where the property which is purchased (or sold) is manufactured outside the country of incorporation and the property is sold for use (or purchased for use) outside such foreign country. (IRC section 954(d)(1)). Foreign base company sales income can arise in the following types of transactions:
- The purchase of personal property from a related person and its sale to any person
- The sale of personal property to any person on behalf of a related person
- The purchase of personal property from any person and its sale to a related person
- The purchase of personal property from any person on behalf of a related person
One of the abuses that Subpart F is intended to prevent is U.S. shareholders using their CFCs to shift sales income from the U.S. to foreign jurisdictions to avoid U.S. tax. The FBCSI rules of Subpart F address this abuse. When a CFC buys/sells tangible personal property (1) from/to (or on behalf of) a related person and the property is (2) manufactured, produced, constructed, grown, or extracted outside the CFC’s country of incorporation and the property is purchased/sold (3) for use, consumption or disposition outside the CFC’s country of incorporation, the income from the sale of the property by the CFC is FBCSI, a type of Subpart F income. The U.S. shareholder(s) of the CFC may have a subpart F inclusion.
(3) Foreign Base Company Services Income includes income derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or “like services” for or on behalf of any related person outside the country under the laws of which the CFC is created or organized.
It also includes services performed by a CFC in a case where substantial assistance contributing to the performance of such services has been furnished by a related person.
Services directly related to the sale or exchange by the CFC of property manufactured, produced, grown, or extracted by it that are performed before the time of the sale or exchange or an offer or effort to sell or exchange such property are excluded.
This area of deferral abuse is where a service corporation is separated from the activities of a related corporation and organized in another country primarily to obtain a lower rate of tax for the service income. Subpart F addresses this abuse by requiring the U.S. shareholder to include its pro-rata share of the CFC’s FBC Services Income in income currently. FBC Services Income consists of income derived by a CFC in connection with the performance outside the CFC’s country of incorporation of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or like services for or on behalf of any related person.
(4) Foreign Base Company Shipping Income is applicable specifically to the shipping industry and is not included here for discussion.
(5) Foreign Base Company Oil Related Income is applicable specifically to the oil industry and is not included here for discussion.
Basic Requirements For Applicability Of Subpart F Income
There are three basic requirements for the applicability of the Subpart F rules to a U.S. person that owns an interest in a foreign corporation:
- The U.S. Person must be a U.S. Shareholder as defined under IRC 951(b).
- The foreign corporation must be a CFC.
- The CFC must have Subpart F income.
If a controlled foreign corporation is determined to have subpart F income, then the earnings and profits of the corporation will be taxable each year to the shareholders owning 10% or more determined by direct ownership (or the attribution rules discussed in I.R.C. Section 958(a)). The earnings and profits are taxed whether or not they are distributed, but subpart F income is limited to the extent of the earnings and profits each year. It is important to note that income passes through only to a U.S. shareholder that owns stock in the CFC on the last day in the taxable year in which the corporation is a CFC.
However, in calculating the amount of subpart F income included in the shareholder’s gross income for the year, certain prior year deficits may be taken into account and will reduce the amount of the amount of subpart F income by the shareholder’s pro rata share of any prior year qualified deficits.
A qualified deficit is post-1986 deficit in earnings and profits that is attributable to the same qualified activity as the activity giving rise to the income to be offset and which has not previously been taken into account.
A qualified activity is any activity giving rise to: 1) foreign base company shipping income, 2) foreign base company oil related income, 3) foreign base company sales income, 4) foreign base company services income, 5) in the case of a qualified insurance company, insurance income or foreign personal holding company income or 6) in the case of a qualified financial institution, foreign personal holding company income.
Another important issue to note is that international business companies (IBC) formed in most tax haven countries are not allowed to conduct business in that country so any services performed on behalf of any person (shareholder) “related” to the corporation would be considered subpart F income.
Subpart F income inclusions are not dividends and thus, are not qualified dividend income for purposes of Section 1(h)(11). Thus they do not qualify for the reduced tax rate on dividend income.
While we won’t go into detail on the several exceptions to the categories of subpart F income discussed above, there is a “de minimus” rule that excludes all gross income from being considered as foreign base company income or insurance income if the sum of the CFC’s gross foreign base company income and gross insurance income is less than the lesser of 5 percent of gross income or $1 million. Under the full inclusion rule of IRC section 954(b)(3)(B) if more than 70 percent of the CFC’s gross income is foreign base company income and insurance income then all of the CFC’s gross income will be treated as foreign base company income or insurance income.
It is readily apparent that subpart F income and reporting of Form 5471 is a very complex issue to tackle. It is important to consult the appropriate tax preparation professional if you think your CFC may have subpart F income!
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Tax Samaritan is a team of Enrolled Agents with over 25 years of experience focusing on the taxation of US taxpayers living abroad. Our services include preparing Information Returns of U.S. Persons With Respect To Certain Foreign Corporations, with Subpart F Income. We maintain this tax blog where all articles are written by Enrolled Agents. Our main objective is to educate Americans abroad on their tax responsibilities, so that they can stay in compliance.
Randall Brody is an enrolled agent, licensed by the US Department of the Treasury to represent taxpayers before the IRS for audits, collections and appeals. To attain the enrolled agent designation, candidates must demonstrate expertise in taxation, fulfill continuing education credits and adhere to a stringent code of ethics.
Every effort has been taken to provide the most accurate and honest analysis of the tax information provided in this blog. Please use your discretion before making any decisions based on the information provided. This blog is not intended to be a substitute for seeking professional tax advice based on your individual needs.