The Internal Revenue Code limits tax-deferral on foreign-based income realized by U.S. shareholders of foreign corporations. Undistributed foreign corporation income is taxed either annually, or upon investment sale.
There are two primary anti-tax deferral regimes: Controlled Foreign Corporation (“CFC”) and Passive Foreign Investment Company (“PFIC”)
(I) Controlled Foreign Corporation (“CFC”) Annual Tax
U.S. shareholder pays annual income tax on pro-rata share of CFC’s income, and files IRS Form 5471.
A U.S. shareholder of a foreign corporation, that is a “controlled foreign corporation” (CFC) for an uninterrupted period of 30 days or more during the tax year, and is a shareholder on the last day of the CFC’s tax year, must include in gross income its proportionate share of the CFC’s “Subpart F income” (whether distributed or not) (IRC Sec. 951).
A CFC’s Subpart F income is limited for any tax year to its total earnings and profits for that year. The income is treated as a deemed dividend.
A foreign corporation is a CFC if more than 50 percent of its total voting power or value is owned by U.S. shareholders (IRC Sec. 957). A “U.S. shareholder” is any U.S. person (citizen, resident, domestic corporation, partnership, estate or trust) that owns 10 percent or more of the total combined voting power of the foreign corporation. Ownership may be direct, indirect, or constructive with certain exceptions (IRC Sec. 958).
The U.S. shareholders of a CFC are taxed on earnings, which are undistributed, if the CFC earns “tainted income”, (i.e., Subpart F Foreign Base Company Income). CFC Subpart F income is the sum of the corporation’s insurance income, foreign base company income, boycott income, illegal payments and income from countries not diplomatically recognized by the U.S. government (IRC Sec. 952).
CFC income does not include income from sources within the U.S. that is effectively connected with the conduct of a trade or business by the corporation in the United States, unless that income is exempt from tax or taxed at a reduced rate pursuant to a treaty.
Subpart F income is limited to the CFC’s total earnings and profits for that year, and may be reduced in certain circumstances to accumulated deficits of earnings and profits.
Foreign Base income of a CFC is made up of income from foreign personal holding company (FPHC) and foreign base company sales, services and oil-related income (IRC Sec. 954).
FPHC income is the major component of foreign base income. FPHC income includes: dividends, interest (including otherwise tax-exempt interest), rents, royalties and annuities.
FPHC income does not include rents and royalties from an active trade or business.
Tainted CFC Income attributed to U.S. shareholders includes:
(1) Foreign Personal Holding Company Income (IRC Sec. 954(c)): dividends, interest, royalties and other types of passive income, including gains from stock and commodity sale.
(2) Foreign Base Company Sales Income: (IRC Sec. 954(d)(3)); i.e. sale of personal property sold for use outside the CFC’s country of incorporation.
(3) Foreign Base Company Services Income: (IRC Sec. 954(c)): income from the performance of technical, managerial, engineering or commercial services performed outside the CFC’s country of incorporation for a related person.
(4) Foreign Base Company Income includes: shipping and oil-related income.
(5) Increase in Earnings Invested in U.S. Property: Excess of CFC earnings invested in U.S. property at year end, over earnings so invested at the beginning of the year (IRC Sec. 956).
Regarding FHPC Income, the sale of a partnership interest by a CFC is treated as a sale of the proportionate share of partnership assets attributable to that interest (including subpart F income).
U.S. shareholders of a CFC are taxed on their pro-rata share of the CFC’s earnings which are invested in U.S. property during the tax year and which are not distributed or otherwise taxed (IRC Sec. 956). The amount of earnings invested in U.S. property is a “dividend deemed paid” to the corporation’s U.S. shareholder. U.S. property includes: tangible real or personal property located in the U.S., stock of domestic corporations, obligations of U.S. persons, and the right to use a patent, copyright or invention in the U.S.
If a U.S. shareholder sells CFC stock, recognized gain will be included in taxpayer’s gross income as an ordinary dividend to the extent of the foreign corporation’s earnings and profits allocable to the stock (IRC Sec. 1248). Any gain exceeding the CFC’s earnings and profits is treated as capital gain. The shareholder may claim a foreign tax credit for the taxes the CFC paid on the income.
Every U.S. person (i.e. taxpayer) who is a U.S. shareholder of a CFC must file an annual Form 5471 (IRC Sec. 6038) or be subject to penalties and a reduced foreign tax credit.
CFC investments in U.S. property include: tangible property, stock of a domestic corporation an obligation of a U.S. person.
Investments not included: U.S. bonds, U.S. bank deposits, debts arising in the ordinary course of business from the sale of property.
“Repatriated” earnings of offshore corporation will be deemed taxable subpart F income.
To prevent double taxation, the basis of the U.S. shareholder’s CFC stock, (and basis in property the shareholder is considered owning through the CFC), is increased by the amount of subpart F income required to be included in income and decreased by any distribution that is excluded from income (IRC Sec. 961).
A U.S. shareholder of a CFC that is a domestic corporation is allowed a foreign tax credit for any foreign taxes paid (or deemed paid) by the CFC for income that is attributed or distributed to it as a U.S. shareholder (IRC Sec. 960).
Effective for tax years beginning after December 31, 2010, the credit is limited to taxes that would have been deemed paid if the foreign corporation had made an actual distribution to the domestic corporation.
A “deemed-paid’ credit is available to any individual U.S. shareholder who elects to be taxed at domestic corporate rates on amounts included in gross income (IRC Sec. 962).
(II) Passive Foreign Investment Company (“PFIC”)
U.S. shareholder of a PFIC pays income tax plus interest (based on value of tax deferral):
(a) Upon sale of PFIC investment
(b) Upon receipt of PFIC “excess distribution” (i.e. distribution which is greater than 125% of the average distribution received by the shareholder during the preceding 3 tax years).
A PFIC is any foreign corporation who has:
(c) At least 75% of its gross income from passive investments or
(d) At least 50% of its assets produce passive income (IRC Sec. 1297)
A Special tax regime applies when a U.S. shareholder receives a PFIC distribution (unlike the normal rules of U.S. federal corporation income taxation, a PFIC’s earnings and profits are not relevant to the taxation of a PFIC distribution).
PFIC distributions fall into 2 categories: “excess” and “non-excess” distributions. An excess distribution is the PFIC distribution that exceeds 125% of the average distributions made to the shareholder with respect to the shareholder’s shares within the 3 preceding years or if held for less than 3 years the shareholders holding period. (IRC§1291(b)(2)(A)).
A non-excess distribution is a PFIC distribution that is not an excess distribution (i.e. does not exceed 125% of the average PFIC distributions). A non-excess distribution is taxed to the U.S. shareholder under the rules of U.S. corporate income taxation, which is taxed as a dividend (Prop. Treas. Reg. §1.291-2(e)(1)). A PFIC non-excess distribution will not qualify for the 15% tax rate on qualified foreign dividends because a PFIC is not a “qualified foreign corporation” (IRC§1(h)(11)(C)(iii)).
A PFIC excess distribution is subject to a special tax regime. The taxpayer must first allocate the distribution pro rata to each day in the shareholder’s holding period for the shares (IRC§1291(a)(1)(A)). Whether the PFIC had earnings and profits in those years is irrelevant. The portion of the excess distribution allocated to the current year and the pre-PFIC years (prior 3 years) is included in the taxpayer’s income for the year of receipt as ordinary income (IRC§1291(a)(1)(B)(i)(ii)). These PFIC excess distributions are not qualified foreign dividends subject to the 15% tax rate.
The portion of the excess distribution allocated to the other years in the taxpayers holding period (the “PFIC years”) is not included in the taxpayer’s current income. Rather, this portion is subject to a special “deferred tax” that the taxpayer must add to his tax that is otherwise due (IRC§1291(c)).
To compute the deferred tax, the shareholder first multiply the distribution allocated to each PFIC year by the top marginal tax rate in effect for that year (IRC§1291(C)(1)). The shareholder then aggregates all “unpaid tax amount” for the PFIC years (IRC§1291(c)(2).
The shareholder must then compute interest on those increased tax amounts as if the shareholder had not paid the tax for the PFIC years when due using the applicable federal tax underpayment rate (IRC§1291(c)(3)). The taxpayer includes the deferred tax and interest as separate line items on their Form 1040 individual tax returns (IRC§1291(a)(1)(C)).
A U.S. taxpayer’s sale of PFIC shares is an “excess PFIC distribution” to the extent the sole proceeds exceed the seller’s basis in the PFIC shares (IRC§1291(a)(2)).
The gain is treated as ordinary income realized rationally over the seller’s holding period with deferred tax and interest on the amount allocated to prior years.
Passive Income (under the gross income test) includes: dividends, interest, royalties and other types of passive income.
There are no U.S. shareholder ownership requirements for the entity to be considered a PFIC.
If “Qualified Election Fund” status is elected, the shareholder is taxed currently on undistributed earnings. If the election is made, the shareholder must include in gross income each year as ordinary income its pro rata share of earnings of the corporation, and as long-term capital gain, its pro rata share of the net capital gain of the corporation. (IRC Sec. 1293 and Sec. 1295).
The inclusions are made for the stockholder’s tax year in which the QEF’s tax year ends. Once made, the QEF election is revocable only with the IRS’s consent and is effective for the current tax year and all subsequent tax years. The U.S. shareholder can elect to defer payment of the tax on any undistributed earnings of the QEF (IRC Sec. 1294).
A U.S. shareholder of a PFIC who receives an “excess distribution” with respect to its stock, and disposes of its PFIC stock during the tax year, must allocate the income or gain ratably to each day they held the stock unless the shareholder elects to treat the PFIC as a “Qualifying Electing Fund” (QEF) or makes a mark-to-market election (IRC Sec. 1291).
Under the default method, the amount allocated to the current tax year, and to any prior tax year during the shareholder’s holding period in which the corporation was not a PFIC, is taxed as ordinary income. The amount allocated to any other year in the shareholder’s holding period is taxed at the highest rate applicable for that year, plus interest from the due date for the taxpayer’s return for that year.
An excess distribution is any part of a distribution received from the PFIC which is greater than 125% of the average distribution received by the shareholder during the three preceding tax years, or, if shorter, during the period the shareholder held the stock.
Each U.S. shareholder of a PFIC must file an annual report on Form 8621, effective March 18, 2010. The requirement to file a report may also meet the requirements for disclosing information for specified foreign financial assets (Form 8938).
A U.S. shareholder of a PFIC may avoid the additional tax, or the deferral of income by making a mark-to-market election on their PFIC stock, and annually including in gross income, as ordinary income, an amount equal to the excess of the fair market value of the PFIC stock, as of the close of the tax year, over its adjusted basis. If the stock declines in value, an ordinary loss deduction is allowed, limited to the net amount of gain previously included in income.
The PFIC rules do not apply to a U.S. taxpayer who is also a 10% shareholder of a controlled foreign corporation IRC§1297(e); PLR200943004. Since the shareholder is currently taxable on their share of the CFC’s subpart F income it is unnecessary to tax them under the PFIC tax regime. The CFC rules accomplish the anti-deferral tax objective.
Earnings of a foreign subsidiary of a US-based business are generally not subject to US Federal Income Tax until they are distributed, US tax deferral, on foreign subsidiary income, is limited by the CFC/PFIC rules. Even if share ownership can be structured to avoid CFC status, the foreign corporation may still be a PFIC subject to an interest charge on the tax attributable to PFIC gains or distributions, which eliminates the tax deferral benefits.