Freeman Law frequently advises international business ventures. International operations often give rise to unique (and sometime unanticipated) compliance obligations and complex reporting requirements. Recent tax reform rules and regulations have imposed a number of new requirements. This post focuses on, and provides a short introduction to, the Controlled Foreign Corporation (“CFC”) rules under Subpart F of the Code.
Historically, U.S. taxpayers were not subject to tax on the income derived by a foreign subsidiary from operations outside the United States. This concept—deferring the income of the foreign subsidiary until it is repatriated in the form of a dividend or otherwise—is known as deferral. The Subpart F provisions were a congressional attempt to eliminate deferral for certain types of categories of foreign income.
The Subpart F rules were first enacted in 1962 as part of the Revenue Act of 1962 (the ‘‘1962 Act’’), Pub. L. 87–834. Subpart F was specifically intended to curtail the use of low-tax jurisdictions for indefinite deferral of U.S. tax on certain earnings that would otherwise be subject to U.S. federal income tax. H.R. Rep. No. 1447 at 57 (1962). Congress expressly sought to target taxpayers who had ‘‘taken advantage of the multiplicity of foreign tax systems to avoid taxation by the United States on what could ordinarily be expected to be U.S. source income.’’ Id. at 58.
Before the 1962 Act, United States shareholders of CFCs were not subject to U.S. tax on the earnings of foreign subsidiaries unless and until earnings of the foreign corporations were distributed to the shareholders as a dividend. S. Rep. No. 1881 at 78 (1962). The subpart F regime eliminated deferral for certain earnings of CFCs—subjecting those earnings to immediate U.S. taxation regardless of whether there was an actual distribution.
In effect, the Subpart F rules treat a U.S. shareholder of a controlled foreign corporation (“CFC”) as though it received its pro rata share of certain categories of the CFC’s current earnings and profits (“E&P”). The U.S. shareholder is obligated to include this income (known as “subpart F” income) currently whether or not the foreign subsidiary actually distributes the income.
In other words, the Subpart F tax is on the U.S. shareholder, not the CFC. Under section 951(a), a U.S. shareholder is required to include its pro rata share of the CFC’s Subpart F income. Those shareholders are treated as though they actually received the Subpart F income from the CFC, even when they did not. This, of course, raises the question of just what constitutes Subpart F income?
Subpart F Income
As a general matter, Subpart F income is generally passive or highly mobileincome. One major category of Subpart F income is Foreign Base Company Income (FBCI). FBCI includes:
- foreign personal holding company income (“FPHCI”), which consists of investment income such as dividends, interest, rents and royalties;
- foreign base company sales income (“FBCSI”), which is income received by a CFC from the purchase or sale of personal property involving a related person;
- foreign base company services income (“FBC Services Income”), which is income from the performance of services by or on behalf of a related person; and
- foreign base company oil-related income (this category was removed under the Tax Cuts and Jobs Act of 2017)
Other categories of Subpart F income include:
- insurance income under section 953;
- international boycott income; and
- illegal bribes, kickbacks, or certain other income
Taxpayers must also consider the taxability of investments of earnings in U.S. property under section 956.
Controlled Foreign Corporations—CFCs
A foreign corporation is a CFC if during the year “U.S. shareholders” own more than 50 percent of the total voting power or value of all classes of its stock. That is, section 957 defines a Controlled Foreign Corporation as a foreign corporation that is more than 50% owned (directly, indirectly or constructively) by U.S. persons who are U.S. shareholders.
As this indicates, attribution rules apply in this context. Section 958(b) provides that, with certain exceptions and modifications, the section 318(a) constructive ownership rules apply to determine whether a foreign corporation is a CFC and whether a U.S. person is a “U.S. shareholder” under section 951(b). Notably, under the TCJA, section 958(b)(4) was repealed in order to allow attribution of stock from a non-U.S. person to a U.S. person. This amendment—which represents a major change—was made effective retroactively, effective the first day of the last tax year that began before January 1, 2018.
A U.S. shareholder is a U.S. person who owns 10 percent or more of the total combined voting power or value of the foreign corporation’s stock. A U.S. person for these purposes is defined by reference to Code section 7701(a)(3), which defines a U.S. person as a 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).
Before the TCJA, section 951(b) defined a U.S. shareholder of a foreign corporation as a U.S. person that holds at least 10 percent of the total combined voting power of all classes of stock entitled to vote in a foreign corporation. The definition was determined exclusively by looking to voting power.
The TCJA amended and expanded this definition, however, to also include a U.S. person that holds at least 10 percent of the total value of shares of all classes of stock of the foreign corporation. The amendment also eliminated the requirement that a foreign corporation be a CFC for an uninterrupted period of 30 days or more in order to give rise to an inclusion under section 951(a)(1) (the “30-day requirement”).
Thus, Section 951(b) defines a U.S. shareholder as a U.S. person who owns (directly, indirectly, or constructively) 10% of the voting stock or (as added under the TCJA) 10% of the total value of shares of a foreign corporation. This expanded definition is effective for tax years of foreign corporations beginning after December 31, 2017.
The “Expansion” of Subpart F income
The TCJA requires that a U.S. shareholder of any CFC must include its share of GILTI in its gross income. For many purposes, a GILTI inclusion is treated similarly to a section 951(a)(1)(A) inclusion of a CFC’s Subpart F income. Thus, in a sense, by latching on to the existing subpart F infrastructure, the TCJA expanded the scope of the Subpart F provisions.
The TCJA also repealed section 958(b)(4). That section previously prevented downward attribution from a foreign parent. Its repeal allows for attribution of stock from a non-U.S. person to a U.S. person. This repeal—which represents a major change—was made effective retroactively, effective the first day of the last tax year that began before January 1, 2018. The repeal is a trap for the unwary, and greatly expands the scope of Subpart F and the definition of a CFC.
Common Exclusions to Subpart F income
Subpart F is a notoriously complex regime. There are a number of exclusions that may come into play that, where applicable, exclude income from the scope of subpart F income. While those exceptions are not exhaustively set forth or addressed here, the following are exceptions that tax professionals should consider:
- Inclusion limited to current E&P – the amount included in a U.S. shareholder’s taxable income under subpart F is limited to the CFC’s undistributed E&P. § 952(c)(1)(A)
- De minimis rule – if the sum of FBCIand insurance income is less than the lesser of 5% of gross income or $1M, none of the CFC’s income is FBCI or insurance income. § 954(b)(3)(A)
- High-tax exception – an item of income taxed at more than 90% of the highest US rate is not FBCI or insurance income. § 954(b)(4)
- Same-country manufacturing exception from FBCSI – income from property manufactured in the CFC’s country of incorporation is not FBCSI. § 954(d)(1)(A)
- Same-country sales/use exception from FBCSI – income from property sold for use, consumption or disposition within the CFC’s country of incorporation is not FBCSI. § 954(d)(1)(B)
- CFC manufacturing exception from FBCSI – income from sale of property that the CFC itself manufactures (anywhere) is not FBCSI. Treas. Reg. § 1.954-3(a)(4)
- Active-financing exception from FPHCI – qualified income derived by a CFC that is predominantly engaged in the active conduct of a banking, financing or similar business is not FPHCI. § 954(h)
- Look-through exception from FPHCI – certain income received from a related CFC and allocable or attributable to income that is neither Subpart F nor Effectively Connected Income (ECI), as defined under § 864(c), is not FPHCI. § 954(c)(6)
- Same-country exception from FPHCI – certain income received from a related CFC incorporated in the same country that uses a substantial part of its assets in a trade or business in that country is not FPHCI. § 954(c)(3)
For more international tax Insights, try Advising International Business Ventures: Tax Reform and a Quasi-Territorial Tax System.