When and How Are Controlled Foreign Corporation (CFC) Earnings Taxed in the U.S.?

When and How Are Controlled Foreign Corporation (CFC) Earnings Taxed in the U.S.?

Generally, the undistributed earnings of a Controlled Foreign Corporation (CFC) are subject to U.S. taxation.

Before explaining when and how CFC earnings are taxed, it is helpful to understand what undistributed earnings are and when a foreign corporation qualifies as a CFC.

What Are Undistributed Earnings?

Undistributed earnings are profits that a corporation has earned but has not distributed to its shareholders as dividends.

For example, suppose a foreign corporation earns $100,000 in profit during the year but retains the entire amount in the business rather than paying it to its shareholders. The $100,000 is generally considered undistributed earnings.

In common practice, shareholders are not taxed on a corporation’s profits simply because the corporation earned them. Tax generally arises when the corporation distributes those profits to the shareholders.

However, in certain circumstances, U.S. shareholders may be taxed on specific categories of CFC income even though the CFC has retained the earnings.

To understand why, we first need to determine how the foreign corporation qualifies as a CFC.

What Is a Controlled Foreign Corporation (CFC)?

A Controlled Foreign Corporation (CFC) is generally a foreign corporation that is more than 50% owned, directly, indirectly, or constructively, by U.S. shareholders.

For this purpose, a U.S. shareholder is generally a U.S. person who owns at least 10% of the foreign corporation’s voting power or value.

Therefore, two requirements are important:

1. The U.S. person must generally own at least 10% of the foreign corporation’s to be a U.S. shareholder; and
2. U.S. shareholders, as a group, must own more than 50% of the foreign corporation to generally qualify as a CFC.

Once a foreign corporation meets these requirements, its U.S. shareholders may become subject to special CFC reporting and taxation rules.

Now, let’s discuss when a CFC’s income is taxed to U.S. shareholders.

When Is a CFC’s Income Taxed to U.S. Shareholders?

Not all income earned by a CFC is automatically taxed immediately to its U.S. shareholders.

Instead, the U.S. tax rules identify certain categories of CFC income that may be subject to current U.S. taxation. One of the most important categories is Subpart F Income.

What Is Subpart F Income?

In general, Subpart F income refers to certain types of CFC income that are taxable to U.S. Shareholders, even if such income is not actually distributed.

To learn more about Subpart F income in detail, please refer to the following article.

Next, to understand how these rules work, it is helpful to understand Earnings and Profits (E&P) and how E&P relates to CFC’s undistributed earnings.

What Are CFCs’ Earnings and Profits (E&P)?

Earnings and Profits (E&P) is a U.S. tax concept used to measure a corporation’s economic earnings and its ability to make distributions to its shareholders.

E&P is important because it helps determine the amount of CFC earnings available for distribution and plays a key role in applying U.S. tax rules to those earnings.

Next, let’s understand how CFC’s earnings and profits are taxed under Subpart F.

How Are CFC’s Earnings and Profits (E&P) Taxed Under Subpart F?

Under the Subpart F rules, certain types of income earned by a CFC may be included in the taxable income of its U.S. shareholders in the year the income is earned.

Importantly, the CFC does not have to actually distribute those earnings for U.S. tax to apply.

In other words, a U.S. shareholder may be required to include its share of certain CFC income in its U.S. taxable income even though the related earnings and profits remain with the CFC. This is known as the “Deemed Received” Concept.

Next. Let’s understand this concept and how it applies to CFC earnings and profits.

How Does the “Deemed Received” Concept Apply to CFC Earnings and Profits (E&P)?

Under Subpart F, a U.S. shareholder may be treated as if it received its proportionate share of certain CFC income, even though the CFC did not actually distribute those earnings. This is known as the “deemed-received” Concept.

The U.S. tax rules therefore allow certain CFC earnings to be taxed currently to U.S. shareholders rather than waiting until the CFC actually distributes the earnings.

This rule is intended to prevent U.S. shareholders from avoiding or indefinitely delaying U.S. taxation on certain types of income by keeping earnings within a foreign corporation.

Next, let’s understand the key requirements for taxing a CFC’s undistributed earnings.

What Are the Requirements for Taxing a CFC’s Undistributed Earnings?

To subject a CFC’s undistributed earnings to U.S. taxation, three threshold requirements have to be met, as per I.R.C. § 951(a) :

The foreign corporation has to be classified as a CFC.

Before the Subpart F rules can apply, the foreign corporation should first qualify as a Controlled Foreign Corporation (CFC). In simple terms, the foreign company should meet the ownership requirements under U.S. tax law to be treated as a CFC.

As mentioned earlier, the ownership requirements are as follows:

• Foreign corporation’s U.S. shareholders own at least 10% of the corporation’s voting power or value and
• These U.S. shareholders collectively hold more than 50% of the total voting power or value of the corporation’s stock.

Let’s say TechGlobal Ltd is a holding company based in Singapore. This company has two U.S. Shareholders Sarah and John. Sarah owns 30% and John owns 40% of the company. Here both the U.S. shareholders own 70% of the voting power collectively, with each of them owning more than 10% of the company. This means that TechGlobal Ltd qualifies as a CFC, as it is owned by U.S. shareholders.

The shareholder has to qualify as a U.S. shareholder.

A U.S. shareholder within a CFC is defined as a person or entity that owns at least 10% of the total voting power of a foreign corporation’s stock. A U.S. shareholder may be required to include certain CFC income in their U.S. taxable income even when the CFC has not distributed the income.

In the above example, John and Sarah, as U.S. citizens, own more than 10% of the voting stock of TechGlobal Ltd. Therefore, both qualify as U.S. shareholders for CFC purposes.

The CFC should have Subpart F income.

Subpart F rules apply only if the CFC earns specific types of income. There are several categories of Subpart F Income. For more information about Subpart F income, please refer to the following article.

Let’s say TechGlobal Ltd. earned significant passive income. These types of income will be immediately taxable to U.S. shareholders, even if the profits are not distributed. 

International tax rules like Subpart F and GILTI are complex—but you don’t have to navigate them alone. Contact  Arora Law P.C. today at (551) 800-0777 for a comprehensive tax consultation today and ensure you are compliant with the CFC regulations.