U.S. persons who are direct or indirect shareholders of a “controlled foreign corporation” (CFC) are subject to unique taxation rules that differ from those applicable to traditional corporations.
Typically, shareholders of traditional corporations are taxed only when dividends are distributed or when they sell their shares. In contrast, shareholders of CFCs may be required to include the foreign corporation’s profits on their personal U.S. tax return in the year the income is earned, regardless of whether they have received any distributions. This regulation is designed to prevent shareholders from deferring taxes by keeping profits offshore.
Let’s delve into the details of CFCs.:
A Controlled Foreign Corporation is a type of foreign corporation in which U.S. shareholders—those owning at least 10% of the corporation’s voting power or value—together hold more than 50% of the total voting power or value of the corporation’s stock.
For more details about CFC, please refer to the following article.
Now, let us understand the different ways a U.S. shareholder can own a CFC through various methods in the next section.
The U.S. shareholders can own a CFC through various methods. Let’s discuss these methods as follows:
Direct Ownership
Direct ownership occurs when U.S. shareholders hold more than 50 percent of the voting power or value of a foreign corporation. Under this method, the U.S. shareholder maintains immediate control and ownership interest in the foreign entity without any intermediary structures.
Indirect Ownership
Indirect ownership arises when a U.S. shareholder owns an interest in one foreign entity, which in turn holds an interest in another foreign entity. The U.S. shareholder’s indirect ownership percentage is calculated based on their proportional interest through the ownership chain.
Constructive Ownership
Constructive ownership attributes stock ownership based on specific relationships and legal structures, even when direct ownership does not exist:
A U.S. shareholder is defined as any U.S. person, including a domestic partnership, who holds a voting interest of 10% or more in a controlled foreign corporation. In that case, such a U.S person or company qualifies as a U.S. Shareholder only for CFC purposes.
However, U.S. persons or companies having less than 10% voting interest will not qualify as a U.S. shareholder for CFC purposes. They will be considered shareholders for other purposes.
Under the pre-2018 worldwide system, U.S. multinationals could indefinitely defer U.S. tax on profits earned through foreign subsidiaries until those profits were actually distributed as dividends, resulting in large pools of untaxed accumulated earnings remaining offshore. The transition tax (IRC §965) ended this deferral by treating all post-1986 accumulated foreign E&P as if it were repatriated in 2017, even if no dividend was declared—creating a “deemed dividend” inclusion. Even though these profits were never actually distributed as dividends, they were treated as untaxed earnings because they represented real profits that had accumulated in foreign subsidiaries but had never been subject to U.S. tax under the old deferral system.
The transition tax required those earnings to be included in U.S. taxable income immediately, but at special reduced rates—15.5% on cash and cash-like assets, and 8% on non-cash assets like property or equipment—with an option to pay the liability in installments. This way, all pre-TCJA foreign profits were brought into the U.S. tax net so that none could escape taxation permanently.
The Transition Tax under Section 965 imposes a one-time tax on U.S. shareholders to pay a transition tax on the untaxed earnings of specified foreign corporations.
The untaxed earnings refer to the amount of profit made by a foreign business that has not yet been repatriated. Section 965 was enacted to tax the accumulated and previously untaxed earnings of specific foreign corporations owned by US shareholders.
Transition tax applies to U.S. persons who owned at least 10 percent or more of the voting power or value of any specified foreign corporation (SFC) on the final day of the SFC’s tax year that began before January 1, 2018. This ownership can be direct, indirect, or constructive, and these individuals are referred to as U.S. shareholders.
For these purposes, a Special Foreign Corporation (SFC) refers to any foreign corporation that is classified as a controlled foreign corporation, or any other foreign corporation with at least one U.S. shareholder who is a corporation, provided that the foreign corporation is not classified as a passive foreign investment company.
U.S. shareholders can utilize several strategies to minimize the impact of the transition tax. Let’s understand some of these strategies as follows:
Foreign tax credits are available to offset the transition tax liability on a dollar-for-dollar basis, subject to limitations on foreign tax credits. However, excess credits generated from Section 965 inclusions could not be carried forward to future tax years.
The Section 962 election is a necessary tax provision available to individual shareholders of Controlled Foreign Corporations (CFCs). It allows these shareholders to be taxed at corporate rates (21%) instead of higher individual rates (which can go up to 37%).
By opting for the Section 962 election, individual shareholders benefit from being taxed at lower corporate rates rather than higher individual rates.
Individual shareholders can also gain access to corporate-level foreign tax credit advantages
Typically, individual shareholders cannot claim deemed paid foreign tax credits for taxes paid by foreign corporations. As a result, without the Section 962 election, individuals would face higher individual tax rates without the benefit of offsetting foreign tax credits. This situation could lead to double taxation, with foreign earnings being taxed both by foreign corporate tax and U.S. individual tax. Therefore, the Section 962 election is essential for individual CFC shareholders to avoid this tax disadvantage.
Global Intangible Low-Taxed Income (GILTI) refers to a tax on the foreign earnings of Controlled Foreign Corporations (CFCs). It is a U.S. tax provision brought under the Tax Cuts and Jobs Act (TCJA) in 2017.
GILTI was introduced as a measure to ensure that U.S. corporations pay taxes on income derived from intangible assets held by their controlled foreign corporations (CFCs). Here, intangible assets include Patents, copyrights, and trademarks.
The primary objective behind GILTI is to discourage U.S. corporations from shifting their profits to low-tax jurisdictions by exploiting these intangible assets. Let’s understand some of the key features of GILTI:
GILTI applies when a CFC’s income exceeds 10% of its tangible assets (Qualified Business Asset Investment or QBAI).
Tangible assets refer to physical items utilized in a company’s operations. Examples include machinery used in manufacturing, buildings that house operational activities, and land owned by the corporation.
Example:
A U.S. corporation owns a CFC in Bermuda, a low-tax jurisdiction. The CFC has had a successful year, earning $1 million.
$300,000 is attributed to tangible assets, such as machinery and real estate.
Tax Calculation:
GILTI is calculated by the following formula
GILTI = Total CFC Income – 10% of Tangible Assets
GILTI = $1,000,000 – ($300,000 * 10%)
GILTI = $1,000,000 – $30,000
GILTI = $970,000
Here, the CFC would need to include $970,000 as GILTI in its U.S. taxable income.
GILTI income is taxed at ordinary corporate tax rates for U.S. Corporate shareholders. For U.S. individuals, it is taxed at their ordinary income tax rates. This income is included in the U.S. shareholder’s gross income.
However, corporate shareholders are potentially eligible for a 50% deduction on GILTI.
Conversely, individuals can opt for a Section 962 election to be taxed similarly to corporations and benefit from comparable deductions.
Subpart F income is a specific type of foreign income that is immediately taxable in the U.S., even if it hasn’t been distributed to shareholders. This rule, part of the IRC’s Subpart F provisions, aims to prevent U.S. taxpayers from deferring taxes by keeping specific income within CFCs.
The Subpart F rules apply to U.S. persons who own at least 10% or more of the voting stock in a controlled foreign corporation, either directly or indirectly, and who control the corporation. Under these rules, it is assumed that shareholders receive a proportionate share of specific categories of current earnings and profits from the controlled foreign corporation (CFC).
U.S. shareholders must report Subpart F income in the United States, even if the CFC does not distribute it.
U.S. shareholders of CFCs encounter important tax implications related to Subpart F income. This income is subject to U.S. taxation at ordinary income tax rates, even if it has not been distributed as a dividend. This is in contrast to the generally lower tax rate applied to qualified dividends.
U.S. shareholders cannot defer taxes on passive income from CFCs due to Subpart F provisions. Consequently, shareholders must pay taxes on this income in the year it is earned, regardless of whether they receive any distributions.
The income types defined under Subpart F are referred to as “Subpart F income,” in accordance with IRC section 952. The primary categories of Subpart F income include:
Foreign Base Company Income (FBCI) – §954
This is the largest category of Subpart F income earned by a CFC, which consists of several subcategories, as follows:
This includes passive income, such as:
This includes income from buying or selling goods, which is derived via the following:
This includes income from services, which is derived via the following:
This includes income related to oil exploration, drilling, or mineral extraction, with specific definitions and exceptions.
Exceptions to Subpart F rules permit the exclusion of certain types of income from being classified as Subpart F income. This allows U.S. shareholders to avoid being taxed on that income.
Understanding these exceptions is essential for U.S. shareholders with interests in foreign corporations to manage their tax liabilities effectively.
Let’s discuss some of these exceptions, which are as follows:
U.S. Code Section 956 requires U.S. taxpayers to include certain investments made by a controlled foreign corporation (CFC) in U.S. property as part of their income. If not managed properly, Section 956 can lead to unfavourable tax consequences for U.S. taxpayers.
The main principle of Section 956 is that shareholders must account for a Controlled Foreign Corporation’s (CFC) investments in U.S. property, particularly if these investments exceed any Subpart F income that has already been reported. Suppose the CFC invests in U.S. property beyond the current Subpart F income and previously taxed earnings and profits. In that case, the shareholder will experience a “deemed income inclusion” and must report that excess.
For this purpose, the term “United States property” refers to any property (if obtained after December 31, 1962) that includes physical real estate or personal assets situated within the United States, shares of an American company, a debt or financial obligation owed by a U.S. individual or entity, or the legal right to utilize a patent, copyright, invention, confidential formula, or comparable intellectual property within the U.S. territory if such property was obtained or created by the CFC specifically for that usage. Not included in this definition are, among other items, bank account deposits, U.S. government bonds and currency, specific debts that emerge during normal business operations from selling or handling property, particular assets used for transporting people or goods in international trade, and an amount equivalent to certain earnings and profits from before 1963.
The following are some of the income types subject to Section 956 inclusions: