Introduction
Many U.S. citizens or residents, as well as U.S. corporations, own shares in a foreign corporation. If you own part of a foreign corporation and wish to sell those shares, you may need to check certain requirements under U.S. Tax law.
Let’s say the foreign company where you own shares is considered a “Controlled Foreign Corporation” (CFC) under U.S. tax law. There are special rules that apply when you decide to sell or otherwise dispose of your ownership in it. These rules may significantly affect how much tax you owe on any profit you make from the sale.
This article will look into the U.S. tax implications that apply when you sell stock in a CFC.
But first, let’s understand what a CFC is in the next section.
What Is a Controlled Foreign Corporation (CFC)?
A Controlled Foreign Corporation (CFC) is simply a foreign company in which U.S. owners, also called “U.S. shareholders,” together own more than 50% of the foreign company’s stock. A U.S. shareholder is generally anyone who owns at least 10% of the company’s voting power or value in a CFC.
While you own the CFC, you may already pay U.S. tax on certain types of its income each year under Subpart F and GILTI. For a more detailed overview of how CFC income is taxed, please refer to our following article.
When you finally sell your shares in a CFC, there may be tax consequences. But first, let’s understand why the sale of shares in a CFC triggers special tax rules, as explained in the next section.
Why Does the Sale of Stock of a CFC Trigger Special Tax Rules?
When you sell the stock, you normally calculate your gain the usual way: sale price minus your adjusted basis in the shares. Without special rules, that gain would usually be taxed as a capital gain, which is often taxed at a lower rate for individuals or at the standard 21% corporate rate. Here, the lower rate for individuals implies that capital gains are taxed at 0-15%, compared with ordinary income rates that may go as high as 37%.
However, part of that profit may actually come from earnings the foreign company has made over the years that haven’t yet been taxed in the U.S. To prevent people from turning those untaxed earnings into a lower-taxed capital gain, the law uses Section 1248. This section recharacterizes part of your gain as ordinary dividend income instead of capital gain.
In simple terms, if this profit represents the foreign company’s accumulated earnings, the IRS will likely tax it as a dividend rather than as a profit from a stock sale.
Next, let’s understand when Section 1248 applies.
When Does Section 1248 Apply?
Section 1248 kicks in if the following three basic conditions are met:
- You (the seller) are a U.S. person or U.S. company.
- During the five years before the sale, you owned at least 10% of the foreign company’s voting power at some point.
- During that same five-year period, the foreign company was a CFC while you owned that 10% stake.
If these tests are satisfied, then the profit from the sale is treated as a dividend up to the amount of the company’s accumulated earnings and profits (E&P) that belong to your shares. Any profit beyond that amount is treated as a regular capital gain.
Please note that the above rule may apply even if the company is no longer a CFC on the exact day you sell it. The five-year look-back period makes it harder for U.S. Shareholders in corporations whose CFC status had recently changed to avoid taxation under Section 1248.
Next, let’s understand how much of the gains derived from selling these shares qualify as dividend income.
How Much of the Gain from CFC Stock Sale Becomes a “Dividend”?
When a U.S. shareholder sells stock in a CFC, the gain is recharacterized as a dividend under IRC § 1248(a). The amount treated as a dividend is the CFC’s undistributed earnings and profits (E&P) attributable to the shares sold. Such earnings were accumulated while the corporation was a CFC during the shareholder’s holding period. This means the portion of the CFC’s untaxed earnings and profits that can be traced back to the shares you sold.
Calculating the exact amount of earnings and profits may be complicated, especially if the CFC owns other foreign companies. You need good records. If you are unable to clearly show how much untaxed earnings belong to your shares, the IRS may treat the entire gain as a dividend.
Next, let’s understand how the gains are taxed for individuals and for companies.
How are the Gains from the sale of CFC Stock Taxed for Individuals vs. Companies?
You may sell shares in a CFC as an individual or as a company. However, the tax implications may differ between the two. Let’s understand the key differences in the next section.
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For Individual Owners
If you are selling the shares of a CFC as an individual, then the following could be the tax implications.
This § 1248 dividend is generally eligible for taxation at preferential qualified dividend income (QDI) rates (0%, 15%, or 20%, plus the 3.8% Net Investment Income Tax if applicable), provided the CFC qualifies as a “qualified foreign corporation.” This typically requires that the CFC be either incorporated in a U.S. possession or resident in a country with a comprehensive U.S. income tax treaty that includes an adequate exchange-of-information provision.
If the CFC does not qualify as a qualified foreign corporation, the § 1248 dividend is taxed at ordinary income tax rates (up to 37% + 3.8% NIIT).
However, there is a special “ceiling” rule that often limits how much extra tax you actually pay. Section 1248(b) imposes a tax ceiling if the stock is a capital asset held more than one year. In such a case, the tax on the recharacterized dividend should not exceed:
- The hypothetical U.S. corporate tax the CFC would have paid on the E&P had it been treated as a domestic corporation (after foreign tax credits), plus
- The incremental tax that would arise if the remaining portion of the gain were taxed as a long-term capital gain. Here, the remaining portion of the gains refers to the excess of the Section 1248 dividend over the amount described in point 1.
This ceiling is designed so that your total tax on the sale is usually somewhere between the top ordinary income tax rate of 37% and the preferential long-term capital gains rates of 0%, 15%, or 20%, depending on the taxpayer’s income level.
Tax treaties between the U.S. and the CFC’s country may also help you qualify for these lower qualified dividend rates. If a treaty applies, it may reduce or eliminate foreign withholding tax on dividends paid by the CFC to a U.S. shareholder.
Treaties can also help the foreign corporation qualify as an eligible entity under Internal Revenue Code Section 1(h)(11) for qualified dividend tax treatment. If other requirements are met, then such dividends may be taxed at lower capital gains rates rather than higher ordinary-income rates.
This can significantly lower the overall tax burden for U.S. shareholders receiving income from foreign corporations.
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For U.S. Corporate Owners
If you are selling through a U.S. corporation, the rules are often much more favorable. The dividend portion may qualify for a 100% dividends-received deduction (DRD) under Section 245A if the holding period and other requirements are met.
As per these requirements, the domestic corporation should have held the stock for more than 45 days during the 91-day period beginning 45 days before the ex-dividend date, as required under Section 246(c), and all other statutory requirements are satisfied.
Corporate sellers may be able to claim indirect foreign tax credits for foreign taxes paid to foreign governments on the CFC’s earnings and profits. These credits may allow a U.S. company to reduce its U.S. tax bill dollar-for-dollar by the amount of foreign taxes paid on earnings treated as a dividend.
After applying the 100% DRD, any remaining U.S. tax is usually fully offset by these credits. In many cases, this may mean that the corporate owner ends up paying little or no additional U.S. tax on the whole sale.
Next, let’s understand the impact of the Tax Cuts and Jobs Act on Section 1248.
Impact of the Tax Cuts and Jobs Act on Section 1248
Over the past several years, new laws, including the 2017 Tax Cuts and Jobs Act (TCJA), have reduced the impact of Section 1248 for U.S. shareholders.
Before the TCJA, U.S. shareholders were able to defer taxation on CFC earnings for years by simply leaving profits offshore. However, they would face a steep tax bill at the point of sale. This is because Section 1248 recharacterized what would have been capital gains into ordinary dividend income from large pools of accumulated earnings.
The TCJA shifted this significantly by requiring the current taxation of CFC earnings through GILTI and Subpart F. Those earnings are placed in a Previously Taxed Earnings & Profits (PTEP) account and cannot be taxed again. This eventually reduces the amount subject to recharacterization when the stock is eventually sold. For corporate sellers, the §245A participation exemption adds a further layer of relief, allowing a 100% deduction on any gain recharacterized as a dividend. This combination makes selling a CFC considerably less painful today than it once was.
Next, let’s understand the reporting requirements for selling CFC Shares.
Reporting Requirements
You should report the sale of your CFC shares on Form 8949 (Sales and Other Dispositions of Capital Assets). Thereafter, summarize the gain or loss on Schedule D of your Form 1040 (for individuals). These forms handle the capital gain or loss and any portion recharacterized as a dividend under Section 1248.
You will also likely need to file Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations). This form may be needed to provide detailed information about the CFC, including the sale transaction.
Failing to file or incorrectly filing these forms may lead to substantial penalties.
Final Thoughts
Section 1248 is the IRS’s way of making sure that profits earned inside a foreign company you control don’t escape proper taxation. This may happen when you sell the stock instead of taking the money out as a dividend. While tax changes such as the TCJA have made the rules more taxpayer-friendly—especially for corporations—the rules still require careful attention and good record-keeping.
If you own or are thinking of selling an interest in a foreign corporation, these rules may have a real impact on your after-tax proceeds. It’s always wise to work with an experienced international tax advisor who can look at your specific facts and help you plan the best approach.
Are you looking for personalized advice on how to evaluate your CFC exit strategy in the United States? Contact the International Tax Attorney at Arora Law P.C. today at (201) 620-1482 for an international tax consultation.
Disclaimer: The information provided in this article is for general informational purposes only and does not include legal advice. This article does not comprise an attorney-client relationship between the reader and Arora Law P.C. or its attorneys. If you have specific questions regarding your individual situation, please consult with a licensed attorney.
The information in this article is current as of the publication date. U.S. Tax laws and regulations change frequently, and readers should confirm whether any updates have occurred since.