What is Subpart F Income?

Introduction

U.S. taxpayers who own foreign corporations often find themselves in a complex web of international tax regulations when doing business abroad. One of the most significant issues is that of Subpart F income. But what exactly is Subpart F, and what purpose does it serve? In this article, we will discuss the Subpart F rules, components of Subpart F Income, and how it is taxed.

Purpose of Subpart F Income Rules

Imagine a typical situation where a successful U.S. company sets up a subsidiary in a country with low or no taxes. This allows the company to put off paying U.S. taxes on the subsidiary’s foreign profits. Although the above strategy to avoid taxes may appear to be a smart move, the Internal Revenue Service (“IRS”) recognized it could be misused.

Subpart F rules under the Internal Revenue Code (IRC §§951–965) was created to stop this kind of tax deferral. Its main goal is to prevent U.S. taxpayers from shifting income to foreign companies in tax havens or jurisdictions with special tax breaks. This prevents them from avoiding paying U.S. taxes on such income.

In short, Subpart F requires that certain income earned by a controlled foreign corporation (CFC) be taxed to the U.S. shareholder immediately. This happens even if the income is not actually paid out to the shareholder. Basically, Subpart F acts as if a U.S. shareholder actually received their share of certain types of the CFC’s current earnings and profits (E&P). This means taxpayers may not use foreign companies to defer paying U.S. tax on certain types of Subpart F income.

This rule helps ensure the U.S. government receives income tax that might otherwise remain overseas.

In the next section, we will explain Subpart F income.

What Subpart F Income Rules Mean in Practice

Subpart F Income Rules apply to a U.S. person who owns an interest in a foreign corporation if they meet certain requirements.

The following are the three requirements:

1. The U.S. Person should be a U.S. Shareholder as defined under IRC 951(b).
2. The foreign corporation should be a Controlled Foreign Corporation (CFC).
3. The Controlled Foreign Corporation (CFC) should have Subpart F income.

Let’s understand these requirements one by one:

1.  The U.S. Person should be a U.S. Shareholder as defined under IRC 951(b).

First of all, a U.S. citizen should be considered a U.S. shareholder. Section  §951(b) defines what is meant by a U.S. Shareholder. In order to be a U.S. shareholder, the U.S. person should directly, indirectly, or constructively own at least 10 percent of the total voting power or 10 percent of the value of the shares in the foreign corporation. This ownership requirement means that Subpart F applies only to persons or organizations that have significant influence over, or an economic interest in, the foreign corporation.

So, if a U.S. person owns less than 10% of a foreign corporation, then that person doesn’t qualify as a U.S. shareholder. And that U.S. person will be exempt from Subpart F rules.

Example 1: Suppose ABC Ltd. is a foreign corporation established in Ireland.

The company is owned by several shareholders, including U.S. shareholders. The distribution of the company’s ownership is as stated below:

• John is a U.S. citizen and owns 30% of the company.
• Another person, Sarah, is a U.S. citizen and holds 25% of the shares.
• A third U.S. Citizen, David, owns 10% of the company.
• A fourth U.S. Citizen, Maria, owns 5% of the company.
• The remaining 30% is owned by a foreign investor who is not a U.S. person.

In the above example, each of the following U.S. Citizens, John, Sarah, and David, holds more than 10% of ABC Ltd. In that case, they may qualify as U.S. Shareholders for Subpart F Income purposes.

However, the fourth U.S. Citizen, Maria, holds 5% of ABC Ltd., which is less than 10%. In that case, Maria may not qualify as a U.S. Shareholder for Subpart F Income purposes.

Next, let’s take a look at the second requirement for application of the Subpart F income rule : The foreign corporation should be a Controlled Foreign Corporation (CFC).

2. The Foreign Corporation should be a Controlled Foreign Corporation (“CFC”)

A foreign corporation is eligible as a Controlled Foreign Corporation (“CFC”) when U.S. shareholders hold more than 50% of the stock of the foreign corporation. Here, each U.S. shareholder should own at least 10% of the stock.

Example 2:

In Example 1 above, the three U.S. individual shareholders collectively own 65% of ABC Ltd. So, they hold more than 50% of the company’s total voting power. Also, each of these three U.S. shareholders owns more than 10% of ABC Ltd.

As ABC Ltd. is owned more than 50% by U.S. shareholders (each holding more than 10% of the equity), it qualifies as a Controlled Foreign Corporation (CFC).

Next, let’s take a look at the third requirement for application of Subpart F income rule : The Controlled Foreign Corporation (CFC) should have Subpart F income.

3. The CFC should have Subpart F income

Subpart F rules apply only if the CFC earns specific types of income. In that case, such income is taxable to the CFC’s U.S. shareholders in the year earned, even if not actually distributed.

Next, let us understand what constitutes Subpart F Income.

What Constitutes Subpart F Income?

The following are the categories of Subpart F Income:

1. Foreign Base Company Income (FBCI)
2. Insurance Income
3. International Boycott Factor Income
4. Illegal Bribes, Kickbacks, or Other Unlawful Payments
5. Income from Countries Under U.S. Sanction.

Let’s discuss these categories in the next section.

Foreign Base Company Income (FBCI)

Foreign Base Company Income (FBCI) is the largest category and includes several subcategories, which are as follows: 

Foreign Personal Holding Company Income (FPHCI) IRC §954(c)(1).

This income includes rents, dividends, interest, royalties, and annuities that may not arise out of the active conduct of a trade or business. It also includes net gains from the disposition of property.

Example: Suppose a U.S.-based Global Tech Inc. has a CFC, a holding company, Asian Electronics Ltd. in Singapore. They earn $500,000 in interest from their excess cash holdings in a Singaporean bank. This interest income may be classified as FPHCI and thus Subpart F income, immediately taxable to Global Tech Inc. in the U.S.

Foreign Base Company Sales Income, IRC §954(d)(1).

Here, Subpart F rules apply to foreign base company sales income when a controlled foreign corporation (CFC) sells property to a related party.

Generally, the rules apply when the following conditions are met:

• CFC Involvement: The transaction is carried out by a Controlled Foreign Corporation (CFC).
• Related Party: The property is purchased or sold to a related person. Generally, a person is considered related to the CFC if the person controls, is controlled by, or is under common control with the CFC. Generally, a person is considered related to the CFC if the person is under common control with the CFC. This can include a U.S. shareholder, another corporation, or another entity that has the required ownership or control relationship with the CFC.
• Property Manufactured Outside the CFC’s Country: The property is purchased from a person who is related to the CFC and is manufactured or produced outside the country where the CFC is incorporated or organized.
• Property Sold Outside the CFC’s Country: The property is sold for consumption, use, or disposition outside the country where the CFC is incorporated or organized.

When these conditions are satisfied, the CFC’s income from the transaction may be treated as Subpart F income and potentially taxed currently to its U.S. shareholders, even if the CFC does not distribute the income.

Example:

A U.S. company owns an Irish subsidiary, which is also a CFC of the U.S. company. A Related Chinese Company of the Irish subsidiary sells a product to the Irish Subsidiary. The Irish subsidiary ultimately resells these products in Canada. Here, the Irish subsidiary generated sales income.

However, the sales revenue was generated by the subsidiary in Ireland, a different country from where the products were made (China) or sold (Canada). This means the products were made and sold outside the CFC’s country, which is in Ireland. Hence, by virtue of the Foreign Base Company Sales Income Rules, the U.S. company may be taxed on the subsidiary’s sales income, even if the income isn’t distributed as dividends.

Foreign Base Company Services Income, IRC §954(e)(1)

This category covers income earned by a CFC from performing services for or on behalf of a related party. Such services are required to be conducted outside the CFC’s country of incorporation.

Example:

Global Tech Inc., which is a U.S. company. It has two subsidiaries, which are as follows:

• A subsidiary in Singapore, Asian Electronics Ltd., which is a Controlled Foreign Corporation (CFC).
• A subsidiary in Germany, ABC Tech GmbH.
• Asian Electronics Lt and ABC Tech GmbH are related entities.

Asian Electronics Ltd in Singapore provides IT services to ABC Tech GmbH in Germany, its related entity.

However, assuming these services are performed in Philippines, which is outside the CFC’s country of incorporation.

Therefore, the income earned from those services may qualify as Foreign Base Company Services Income (FBCSI) under the Subpart F rules.

In case the income qualifies as FBCSI, Global Tech Inc. may be required to include its share of that income in its U.S. taxable income. This applies even if Asian Electronics Ltd. does not distribute the income to Global Tech Inc. 

Next, let’s take a look at another category of Subpart F income, which is insurance income.

Insurance Income

Generally, insurance income, as defined in section 953(a), is included in the foreign insurance company’s Subpart F income when the insurance company qualifies as a CFC. 

Here, insurance income included under Subpart F is income generated by a CFC that arises from the issuance of insurance or annuity contracts. This income would be taxable under Subchapter L on Insurance Companies as if a domestic insurance company earned it. 

It should be noted that there are special rules concerning the classification of foreign insurance companies as CFCs. According to Section 957(b), foreign insurance companies are treated as CFCs when:

1. U.S. shareholders hold more than 25% of the foreign insurance company; and
2. The foreign insurance company received more than 75% of its total premium income from reinsurance or from issuing insurance/annuity contracts that don’t qualify as exempt contracts under section 953(e)(2).

Next, let’s take a look at another category of Subpart F income, which is International boycott factor income.

International Boycott Factor Income

International boycott income may arise when a CFC participates in or supports a foreign boycott to do business with a particular country, its government, or its businesses or residents.

In such cases, a portion of the CFC’s income connected with participating in the boycott may be included in Subpart F income. The amount is generally determined using the international boycott factor.

For example, a CFC wants to sell products to a company in Country A. The company in Country A requires the CFC to agree not to do business with companies from Country B as a condition of the transaction. The CFC agrees to this boycott and continues doing business with the company in Country A.

Next, let’s take a look at another category of Subpart F income which is Illegal Bribes, Kickbacks and other unlawful payments.

Illegal Bribes, Kickbacks, or Other Unlawful Payments

Under the Subpart F rules, certain illegal bribes, kickbacks, and other unlawful payments made by or on behalf of a CFC are treated as Subpart F income.

This rule applies to payments made directly or indirectly to an official, employee, or agent of a foreign government, when the payments are described in IRC §162(c).

The amount of qualifying illegal bribes, kickbacks, or other unlawful payments is included in the CFC’s Subpart F income. As a result, the CFC’s U.S. shareholders may be required to include the applicable amount in their U.S. taxable income, even if the CFC does not actually distribute the amount to them.

Next, let’s take a look at another category of Subpart F income which is Income from countries under U.S. Sanction.

Income from Countries Under U.S. Sanction

Income from doing business with countries that the U.S. government has imposed sanctions on, as per Section 901(j). For example, such sanctions may apply to countries identified as supporting terrorism or countries with which the U.S has severed diplomatic relations, etc.

Examples of countries currently identified by the IRS for purposes of §901(j) include:

• Iran
• North Korea
• Sudan
• Syria

Therefore, if a CFC earns income from one of these countries during the sanction period, that income may be treated as Subpart F income and included in the income of its U.S. shareholders.

Next, let’s take a look at some of the exception to Subpart F income.

Exception to Subpart F Income:

Not all income of a Controlled Foreign Corporation (CFC) is automatically Subpart F income. The IRS provides several exceptions as follows:

De Minimis Rule

As per the De Minimis Rule, if the sum of Foreign Base Company Income (FBCI) and gross insurance income is less than the lesser of 5% of gross income or $1,000,000, it is disregarded.

Example: Let’s say CFC generates $10 million in gross income. Out of the gross income, only $400,000 falls under the Subpart F categories (e.g., foreign base company income).

Here, 5% of the $10 million gross income is $500,000. Therefore, the Subpart F income of $400,000 is less than 5% of the gross income ($500,000).

In addition, the Subpart F income of $400,000 is less than $ 1 million.

Since Subpart F income is less than 5% of gross income and less than $1 million, the de minimis rule applies.

Hence, the $400,000 may not be subject to Subpart F taxation.

Next, let’s understand about another Subpart F exception: High Tax Exception.

High Tax Exception

Income from a CFC may be excluded if it is already subject to a high level of taxation in the foreign jurisdiction where it is located. A high level of foreign taxation is present if the tax rate exceeds 90% of the highest U.S. rate.

Example: Let’s suppose a CFC earns income in a country with a 40% corporate tax rate, and the highest U.S. corporate tax rate is 21%.

Here, the first step is to determine 90% of the highest US rate: 90% of 21% is 19%

If the CFC is taxed at a rate higher than 19% in the foreign jurisdiction, then the CFC income will come under the High tax exception. Since the CFC is earning income in a country with a 40% tax rate, it will fall under the high-tax exception.

In that case, the income would not be subject to Subpart F taxation.

Next, let’s understand about another Subpart F exception: Same Country Exceptions.

Same Country Exceptions

Certain transactions between related CFC parties in the same country that use a substantial part of their assets in a trade or business in that country are not Subpart F Income.

Example: CFC X receives certain dividend income from related party Y. Both related entities (X and Y) are situated in Germany. Also, both related entities are subsidiaries of a U.S. Parent company.

Both parties use a substantial portion of their assets in a trade or business in Germany, resulting in dividend income. Accordingly, the same-country exception may apply. This may result in the exclusion of dividend income from Subpart F taxation for the U.S. Parent company.

Next, let’s understand about another Subpart F exception: CFC Manufacturing Exception.

CFC Manufacturing Exception

Income from products manufactured by the CFC itself isn’t foreign base company sales income.

Example: CFC X in Ireland manufactures products and sells them to a related party, Y, in Germany. Here, the CFC manufacturing exception will apply, excluding the income from Subpart F taxation.

Next, let’s understand about another Subpart F exception: Active Financing Exception.

Active Financing Exception

Certain income from active banking, financing, or similar business is excluded.

Example: If a CFC is engaged in active banking or financing activities, such as lending money to unrelated parties. In that case, the active financing exception may apply, excluding the income from Subpart F taxation.

Next, let’s understand about the reporting and tax requirements of Subpart F income.

Reporting and Taxation of Subpart F Income

U.S. shareholders may need to report their pro-rata share of the CFC’s Subpart F income on Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. Subpart F income ought to be reported even if it is not distributed. This income is taxed at the ordinary corporate tax rate for U.S. corporate shareholders. For U.S. individuals, income is taxed at their ordinary income tax rates. 

In general, Subpart F income is taxed under U.S. domestic law and is not treated as income for purposes of applying reduced treaty rates. Therefore, a tax treaty may not reduce the U.S. tax imposed on Subpart F income.

Conclusion

It is essential for U.S. companies or individual shareholders operating globally to understand Subpart F income rules.

By carefully structuring your company to avoid CFC status, you may defer U.S. taxes on foreign income. For instance, you may restructure your international business operations to prevent triggering Subpart F income tax rules. This may enable more efficient tax planning and potentially maximize your company’s overall profitability.

If you stay informed and take the initiative, you will be able to navigate the complexities of Subpart F income and ensure that your international operations remain both profitable and compliant.

Keep in mind that international tax law is complicated and constantly changing; although this article gives a good general account, it’s still advisable to get advice from a qualified tax professional regarding your particular case.

If you’re seeking personalized advice on reducing your Subpart F-related risks, you should contact the tax consultants of Arora Law P.C. at (551) 8000-0777 to arrange a full consultation right away and make sure that you comply with the IRS rules.