Controlled Foreign Corporations (outline)

by Roger Royse

I. US shareholder of CFC is taxed directly on pro rata share of CFC’s Subpart F income, increase in CFC’s earnings invested in US property, and earnings invested in excess passive assets.

II. CFC DEFINED.

A. Foreign corporation is CFC if more than 50% of its stock, by vote or value, is held by U.S. shareholders at any time during the year. I.R.C. sec. 957(a).

  1. U.S. shareholder is US person owning at least 10% of corporation’s voting stock. I.R.C. sec. 951(b).
    1. Indirect ownership.
      1. Stock held by foreign entity is considered held by entity’s shareholders or partners. I.R.C. sec. 958(a)(2).
      2. Ownership attributed until U.S. person deemed owner.
    2. Constructive ownership. I.R.C. sec. 318.
      1. Rule only applies to treat US person as US shareholder of foreign corporation as CFC (do not attribute ownership away from US person).
      2. Stock owned by nonresident alien is not attributed to US individual under family attribution rule. I.R.C. sec. 958(b)(1).
      3. If entity owns more than 50% (by vote) of foreign corporation, ownership attributed as if entity owned all stock. I.R.C. sec. 958(b)(2).
      4. Stock owned by corporation attributed ratably, but no attribution to shareholder of less than 10% (by value). I.R.C. sec. 958(b)(3).
      5. (5) Stock owned by foreign shareholder not attributed to domestic entity under I.R.C. sec. 318(a)(3).
  2. U.S. person is U.S. citizen, resident, domestic corporations and partnerships, and U.S. estates and trusts. I.R.C. sec. 957(c).
  3. Taxable year of CFC must be same as US shareholder owning more than 50%. I.R.C. sec. 898.

III. TAXATION OF US SHAREHOLDERS.

A. Subpart F Income.

  1. Insurance income from contract covering risks outside country in which CFC is organized. I.R.C. sec. 953(a).
  2. US shareholders taxed on pro rata shares of all related person insurance income. I.R.C. sec. 953(c).
    1. Related person insurance income is income from insuring US persons owning stock in foreign insurer.
    2. US shareholders include all US persons who own any stock (and US policyholders of mutual insurance company) and corporation is CFC for this purpose if US shareholders own more than 25%, by value or vote. I.R.C. sec. 953(c)(3).
    3. Exceptions if less than 20% by vote and value is held by insured US persons, if related person insurance income is less than 20% of insurance income.
  3. Foreign Personal Holding Company Income.
    1. Dividends, Interest and Annuities.
      1. Related person factoring income treated as interest.
      2. Export financing interest derived in active conduct of trade or business excluded from FPHC income. I.R.C. sec. 954(c)(2)(B).
      3. Exclusion for dividends or interest received from a related person organized under the laws of the same country if a substantial part of the payor’s assets are used in that country. I.R.C. sec. 954(c)(3(A)(i).
    2. Rents and royalties.
      1. Exclusion for rents and royalties derived in the active conduct of a trade or business received from a person who is not a related person. I.R.C. sec. 954(c)(2)(A).
      2. Rents and royalties from a related person excluded if paid for the use of property in the country in which the CFC is organized. I.R.C. sec. 954(c)(3)(A)(ii).
    3. Gains on sales of investment property are FPHC income. I.R.C. sec. 954(c)(1)(B).
      1. Property that produces FPHC income.
      2. Interest in trust or partnership.
      3. Property that generates no income.
    4. Commodity transaction gains. 954(c)(1)(C).
      1. Exception for bonafide hedging transaction.
      2. Exception for active business gains from sale of commodities.
    5. Foreign currency gains. I.R.C. sec. 954(c)(1)(D).
  4. Foreign Base Company Sales Income.
    1. Income from sales if related person is seller or buyer.
      1. Related person is any person that controls the CFC, and entity controlled by the CFC, and any person controlled by persons who control the CFC. I.R.C. sec. 954(d)(3).
      2. Control is more than 50% ownership, by vote or value, applying constructive ownership and attribution.
    2. Exceptions.
      1. Income from sales of goods produced in country in which CFC is organized or sold for use, consumption or disposition in that country. I.R.C. sec. 954(d)(1).
      2. Income from sales of goods manufactured or produced by the CFC. Treas. Reg. sec. 1.954-3(a).
        1. Goods substantially transformed prior to sale. I.R.C. sec. 1.954-3(a)(4)(ii).
        2. Apportionment required if assembly not manufacturing. Treas. Reg. sec. 1.954-3(a)(5).
      3. Transaction in agricultural products grown outside the U.S. I.R.C. sec. 954(d)(1).
    3. Branch Rule.
      1. Manufacturing exclusion may not be available if sales made through branch if country of incorporation and country of operation treat branch as subsidiary corporation.
      2. Sales and purchasing branches treated as separate corporations if located outside the country of incorporation, and the effective rate of tax on branch income is less than the lesser of (i) 90% of rate of country of incorporation, or (ii) a rate 5 percentage points below country of incorporation rate.
      3. Manufacturing branches treated as separate corporations if located outside the country of incorporation, and the effective rate of tax on non-branch income is less than the lesser of (i) 90% of rate of country of manufacturing, or (ii) a rate 5 percentage points below country of manufacture rate.
  5. Foreign Base Company Services Income.
    1. Income from service transactions involving related persons. I.R.C. sec. 954(a)(3).
    2. CFC’s services are performed on behalf of related person if:
      1. compensation is received from related persons;
      2. a related person is obligated to perform the services performed by the CFC;
      3. the CFC’s performance of services is a condition or material term of a sale by a related party;
      4. the related person provides substantial assistance contributing to the performance of the services. Treas. Reg. sec. 1.954-4(b)(1).
    3. FBC services income excluded if the services are performed in the country of organization. I.R.C. sec. 954(e)(1)(B).
  6. Foreign Base Company Shipping Income is foreign base company income.
    1. Income from the use of aircraft or vessel in foreign commerce.
    2. Income from activity conducted in space, on or under ocean, and in Antarctica. I.R.C. sec. 954(f).
  7. Foreign Base Company Oil Related Income.
    1. Income from oil and gas activities in foreign countries other than country of extraction. I.R.C. sec. 954(g)(1).
    2. Exclusion for CFC that are not “large oil producers”. I.R.C. sec. 954(g)(2)(A).
  8. Foreign Base Company Income.
    1. Aggregate of CFC’s FPHC income, and FBC sales, services, shipping and oil related income. I.R.C. sec. 954(a).
    2. De Minimis Rule – FBC income is 0 if all FBC income and gross insurance income is less than $1 million and 5% of all gross income. I.R.C. sec. 954(b)(3)(A).
    3. Full inclusion rule – all CFC’s income is FBC income if gross FBC income and insurance income exceeds 70% of all gross income.
    4. Deductions allocated to FBC income under 904(d) principles. Treas. Reg. sec. 1.954-1T(c).
    5. FBC income adjusted by removing any item subject to an income tax imposed by a foreign country at an effective rate exceeding 90% of the highest rate under section 11.
  9. Subpart F Income.
    1. Foreign base company income plus insurance income, income from certain countries, illegal payments, international boycott income. I.R.C. sec. 952(a).
    2. Effectively connected U.S. source income excluded from subpart F income. I.R.C. sec. 952(b).
    3. Subpart F income limited by earnings and profits. I.R.C. sec. 952(c)(1)(A).
      1. Excess of Subpart F income over E&P is carried forward and later E&P recharacterized as Subpart F income. I.R.C. sec. 952(c)(2).
      2. Qualified prior year deficits reduce later year Subpart F income.
        1. Corporation was CFC in year deficit incurred. I.R.C. sec. 952(c)(1)(B)(ii).
        2. May be offset against current inclusion only to the extent that it arises from same activity in which deficit was incurred. I.R.C. sec. 952(c)(1)(B)(ii).
        3. Offset against inclusion is shareholder’s pro rata share of deficit carried forward. I.R.C. sec. 952(c)(1)(B)(iv).

B. Earnings Invested in US Property. I.R.C. sec. 956.

  1. U.S. Property.
    1. Tangible property located in United States.
    2. CFC treated as owning any obligation of US person that CFC guarantees or secures. I.R.C. sec. 956(c).
    3. Stock and debt of domestic corporation are US property if issuer is US shareholder of CFC or 25% or more voting stock held by US shareholders. I.R.C. sec. 956(b)(2)(F).
    4. Domestic bank deposits are not US property. I.R.C. sec. 956(b)(2)(A).
    5. Accounts receivable from US debtors excluded. I.R.C. sec. 956(b)(2)(C).
    6. Intangibles acquired or developed in U.S. I.R.C. sec. 956(b)(1)(D).
  2. Increase in Earnings Invested in US Property.
    1. Aggregate amount of property (or amount that would be a dividend if distributed) at adjusted basis reduced by liabilities to which property subject. I.R.C. sec. 956(a)(3).
    2. Earnings and Profits included in income in prior years excluded until distributed. Treas. Reg. sec. 1.956-1(b)(3).
    3. Each shareholder includes pro rata share of earnings invested in US property at end of taxable year reduced by share of earnings so invested at end of previous year.
    4. Previously taxed subpart F income not included in increase in earnings invested in US property.
  3. Earnings Invested in Excess Passive Assets. I.R.C. ‘956A.
    1. US shareholder includes in income lesser of:
      1. Excess of pro rata share of CFC’s excess passive assets over amount included in income due to excess passive assets in prior years; or
      2. pro rata share of “applicable earnings” (earnings and profits after September 30, 1993 reduced by distributions and income inclusions under ”956 & 956A).
    2. Excess passive assets.
      1. Passive assets are assets held by CFC that produce passive income. I.R.C. ‘956A(c)(2).
      2. Excess passive assets is excess of average passive assets at close of each quarter over 25% of total assets as of close of each quarter. I.R.C. ‘956A(c)(1).
    3. Taxation of U.S. Shareholders.
      1. Ratable share of CFC’s subpart F income. I.R.C. sec. 951(a)(1).
        1. Applies if corporation is CFC for uninterrupted period during the year of at least 30 days.
        2. Applies to shareholder only if on last day of year when corporation was CFC, the shareholder is a US shareholder and owns stock directly or indirectly.
        3. Pro rata share determined as if CFC made ratable distribution to shareholders. I.R.C. sec. 951(a)(2)(A).
          1. If corporation was CFC for entire year, distribution of all subpart F income deemed made on last day of year.
          2. If CFC for only part of year, hypothetical distribution made on last day of year that corporation was a CFC and equals subpart F income ratably attributable to days during year that corporation was CFC. Treas. Reg. sec. 1.951-1(f).
        4. Pro rata share based on direct and indirect ownership (not constructive ownership).
      2. Ratable share of increase in investment in U.S. property. I.R.C. sec. 951(a)(1).
  4. Previously Taxed Earnings.
    1. Distribution of previously taxed earnings excluded from shareholder’s gross income. I.R.C. sec. 959(a).
    2. Previously taxed earnings of lower tier CFC not included in CFC’s income as FPHCI when distributed up.
    3. Distributions traced first, to E&P invested in US property, Subpart F income, and then other E&P. I.R.C. sec. 959(c).
    4. Income inclusions traced first to subpart F income, then to sec. 956 income.
  5. Basis of U.S. shareholder’s stock.
    1. Increased by income inclusions. I.R.C. sec. 961(a).
    2. Decreased by distributions of previously taxed income. I.R.C. sec. 961(b)(1).

For additional information on legal issues, contact Roger Royse.

Please see www.RroyseLaw.com or contact Royse Law Firm, PC at rroyse@rroyselaw.com for additional information.
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