While a U.S. corporation is subject to tax on its earnings and then its shareholders on their dividends, the U.S. has no taxing jurisdiction on a foreign corporation that neither receives U.S.-source income nor has income effectively connected with the conduct of a U.S. trade or business. However, any dividends earned by U.S. shareholders from foreign corporations are taxable. Without anti-deferral rules in place, U.S. individuals could make investments through foreign entities and indefinitely defer taxation in the U.S. by not issuing dividends. In addition to PFIC rules, Subpart F provisions are powerful anti-deferral mechanisms to prevent this deferral of foreign earned income. Subpart F rules, discussed below, apply to CFCs.
Controlled Foreign Corporations (CFCs)
A foreign corporation is a controlled foreign corporation (CFC) for a particular year if, on any day during such year, U.S. Shareholders own more than 50% of the:
- total combined voting power of all classes of stock, or
- total value of the stock
A taxpayer may meet the threshold through a direct, indirect, or constructive ownership of shares in a foreign corporation. The foreign entity must be a corporation for U.S. tax purposes. Certain foreign entities are always (“per se”) corporations. Other foreign entities are eligible to be treated as corporations or not as corporations, either by default or by making a check-the-box election. See Form 8832, Entity Classification Election. This election must be timely made.
A U.S. Shareholder is subject to the current inclusion rules of Subpart F only if the foreign corporation was a CFC for an uninterrupted period of 30 days or more during the taxable year and the U.S. Shareholder owned stock in the foreign corporation on the last day of such taxable year.
Subpart F Income
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”). The Subpart F inclusion will generally bring an indirect foreign tax credit with it under I.R.C. § 960. Note that the Subpart F inclusion is not a dividend and consequently does not qualify for the lower rate of tax under I.R.C. § 1(h)(11).
There are many categories of Subpart F income. In general, it consists of movable income. For example, a major category of Subpart F income is Foreign Base Company Income (FBCI), as defined under I.R.C. § 954(a), which includes foreign personal holding company income, or FPHCI, which consists of investment income such as dividends, interest, rents and royalties.
3 U.S. investors/shareholders form an offshore entity in the British Virgin Islands (BVI Company) to hold rental income earned from properties held abroad. The shareholders are related and each has constructive ownership per Treas. Reg. 1.958-1(b). The foreign entity has net earnings of $1,000,000 from rents. If the company is not actively engaged in producing the rental income, the foreign rental income is considered foreign personal holding company income and is subject to Subpart F. Under Subpart F, each U.S. shareholder of the CFC is treated as having received a pro rata share of company’s earning and profits that are attributed to the Subpart F income regardless of whether an actual distribution was made. Each shareholder will have received a deemed distribution of $333,333, whether or not dividends were actually paid. Of course any taxable dividends will be reduced by the deemed distribution to avoid double tax.
Foreign corporations generally have no requirement to file a U.S. tax return (unless they conduct trade or business in the U.S.); however, U.S. shareholders who directly, indirectly, or constructively own greater than a 10% share in foreign corporations are required to file an FBAR (for personal and corporate foreign financial accounts) and report a number of international tax forms (e.g., 8938, 5471) on their income tax returns and declare their foreign income. While penalties for failure to report foreign income and assets can be enormous, there are opportunities to correct previous non-compliance through streamlined filing compliance procedures.