What type of Controlled Foreign Corporation (CFC) income is taxed in the U.S.?

Introduction

A Controlled Foreign Corporation refers to a foreign corporation where U.S. shareholders own at least 10% of the corporation’s voting power or value. These U.S. shareholders collectively hold more than 50% of the total voting power or value of the corporation’s stock. To learn more about CFCs, please refer to the following article.

According to the Internal Revenue Code, U.S. shareholders of a CFC are required to pay taxes on the following main types of CFC income: 

• Subpart F income and
• Global Intangible Low-Taxed Income (GILTI).

These two categories are designed as anti-deferral measures, ensuring that the undistributed earnings of foreign corporations are subject to immediate U.S. taxation.

First, let’s understand the first type of CFC income: Subpart F Income.

Subpart F Income

Subpart F income refers to specific types of foreign earnings that are immediately taxable in the United States. This happens even if they haven’t been distributed to shareholders.

Subpart F income rule, under IRC’s Subpart F provisions, is meant to prevent U.S. taxpayers from deferring taxes by keeping specific income within CFCs in foreign jurisdictions.

Categories of Subpart F income generally include:

Foreign Base Company Income (FBCI) – §954

Foreign Base Company Income (FBCI) is a major category of Subpart F income under IRC §954.

FBCI is divided into several subcategories, which are as follows:

• Foreign Personal Holding Company Income
• Foreign Base Company Sales Income
• Foreign Base Company Services Income

First, let’s discuss the first category of FBCI, which is Foreign Personal Holding Company Income.

Foreign Personal Holding Company Income

Foreign Personal Holding Company Income constitutes passive income. The following are some of the examples of passive income which are as follows:

• Dividends.
• Interest.
• Rents and royalties (with some exceptions).
• Capital gains from property producing such income.

Next, let’s discuss the second category of FBCI, which is Foreign Base Company Sales Income.

Foreign Base Company Sales Income

Foreign Base Company Sales Income generally means income earned by a CFC from buying and selling personal property when:

• The property is bought from, or sold to, a related party; and
• The property is made, produced, grown, or extracted outside the CFC’s country of organization, and is sold for use outside that country.

Let’s understand Foreign Base Company Sales Income through a simple example.

Example:

A U.S. company manufactures widgets in the United States and sells them to its CFC in Bermuda. In this example, the U.S. Company is a related party with the CFC. Bermuda CFC then sells the widgets to unrelated customers in Europe.

Bermuda CFC’s resale profit may be Foreign Base Company Sales Income because:

• The widgets were purchased from a related party (the U.S. parent);
• The widgets were manufactured outside the CFC’s country of organization (Bermuda); and
• The widgets were sold for use outside the CFC’s country of organization (Bermuda).

Next, let’s discuss the third category of FBCI, which is Foreign Base Company Services Income.

Foreign Base Company Services Income

Foreign Base Company Services Income generally constitutes income a CFC earns from providing services when:

• The services are performed for a related person or on behalf of a related person; and
• These services are performed outside the country under whose laws the CFC was created or organized.

The services can include technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or similar services.

Let’s understand Foreign Base Company Services Income through a simple example.

Example:

A U.S. parent company owns a CFC organized in India. The Indian CFC provides management and consulting services to its U.S. parent. Although the CFC is organized in India, the employees performing these services are physically located in Italy while performing their duties.

Here, the services are performed for a related person and outside India, the country where the CFC was created or organized. Therefore, the income earned by the CFC may qualify as Foreign Base Company Services Income.

Next, let’s discuss another category of Subpart F income, which is Insurance income.

Insurance Income – §953

Generally, insurance income, as defined in section 953(a), is treated as Subpart F income by a foreign insurance company that qualifies as a CFC.

Under Section 957(b), foreign insurance companies may be considered CFCs when the following conditions are met:

• S. shareholders hold more than 25% of the company; and

• More than 75% of the total premium income of the U.S. company comes from either reinsurance or from providing insurance or annuity contracts. These contracts that do not count as exempt contracts within section 953(e)(2).

Section 953(a) defines “insurance income” as any income produced by a Controlled Foreign Corporation (CFC) that arises from issuing or reinsuring insurance or annuity contracts.

This income would be taxable under Subchapter L if it were earned by a domestic insurance company.

Next, let’s understand another category of Subpart F income, which is International Boycott Factor Income.

International Boycott Factor Income – §999

An international boycott generally means agreeing to participate in or support a boycott of a country, its businesses, or its citizens. This usually happens when doing business with another country, government, company, or person requires participation in the boycott.

For example, a company may be required, as a condition of doing business in a foreign country, to agree not to do business with companies from a particular country.

Under IRC § 999, participation in an international boycott can include agreeing to:

• Not do business with a country that is the target of the boycott;
• Not do business with U.S. persons doing business in that country;
• Avoid companies because of the nationality, race, or religion of their owners or managers; or
• Not employ individuals of a particular nationality or religion.

For a CFC, income connected with participation in an international boycott may constitute Subpart F income.

The amount is generally determined by applying the international boycott factor to the CFC’s income. The factor is based on the CFC’s operations in or related to countries associated with the boycott, compared with its worldwide operations.

Next, let’s understand another category of Subpart F income, namely illegal bribes, kickbacks, and other unlawful payments.

Illegal Bribes, Kickbacks, or Other Unlawful Payments – §952(a)(4)

Any bribes, kickbacks, or illicit payments made to an employee or official of a foreign government in violation of U.S. laws such as the Foreign Corrupt Practices Act (FCPA).

Normally, an illegal payment is not deductible for U.S. tax purposes under IRC § 162(c). In addition, § 952(a)(4) specifically includes the amount of these unlawful payments in the CFC’s Subpart F income.

In other words, the CFC generally cannot reduce its taxable income by treating an illegal bribe or kickback as a deductible business expense. Instead, the amount can be included in Subpart F income and may result in additional U.S. taxation to the CFC’s U.S. shareholders.

Next, let’s understand another category of Subpart F income: income from countries under U.S. sanctions.

Income from Countries Under U.S. Sanctions – §952(a)(5)

Income from doing business in countries that the U.S. government has identified as supporting terrorism or being otherwise restricted (formerly known as “Section 901(j)” countries).

Now that we have understood the different types of Subpart F income, let’s next examine the Subpart F income tax implications for U.S. Shareholders.

This income is taxed at ordinary corporate tax rates for U.S. Corporate shareholders. For U.S. individuals, income is taxed at their ordinary income tax rates.

Clarify Your CFC Income Tax Obligations with Expert Guidance

If you are unsure about your Controlled Foreign Corporation (CFC) tax responsibilities, we will conduct a detailed review of your CFC to identify any risks and opportunities for savings associated with Subpart F and GILTI. For a full tax consultation today, please contact Arora Law P.C. at (551) 800-0777 to make sure that you are in compliance with the most recent CFC regulations.