It is often the case that a U.S. shareholder of a foreign corporation jointly owns the entity with other family members. The constructive ownership rules under IRC 958 can be confusing. These rules were meant to eliminate abusive tax-deferral by large multi-national corporations. Unfortunately the same rules apply to small, closely-held foreign corporations which must also navigate through these complex rules.
What is a controlled foreign corporation?
A foreign corporation is a controlled foreign corporation (CFC) for a particular year if, on any day during such year, U.S. Shareholders own more than 50% of the:
– total combined voting power of all classes of stock, or
– total value of the stock
In general, a foreign corporation is a CFC if more than 50 percent of its voting power or value is owned by U.S. Shareholders. A U.S.
Shareholder of a foreign corporation is a U.S. person who owns 10 percent or more of the total voting power of that foreign corporation.
Is there constructive ownership?
Under IRC 958(b), an individual shall be considered as owning the stock owned, directly or indirectly, by:
(i) His spouse; and
(ii) His children, grandchildren, and parents.
Example 1: A, B, C, and D are U.S. persons. A and B are married and each own 25% of foreign Corporation X. Additionally, C, their daughter, and D, C’s daughter, each own 25% of Corporation X. A and B are each considered to own 100% of Corporation X because they are attributed each other’s stock, as well as the stock owned by C (their daughter) and D (their granddaughter).
Example 2: C also constructively owns 100% of Corporation X, because she is attributed her parents’ and daughter’s stock. D constructively owns 50% (only her own and her mother’s stock).
But the constructive ownership rules do not apply where the person is a non-resident:
Example 3: If in example 2 D was a non resident alien, A, B, and C would only constructively own 75% of Corporation X because stock of a nonresident alien is not considered to be owned by a U.S. person.
Why does this matter?
Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, is required to be filed by every U.S. shareholder (as defined in IRC § 951) of a foreign corporation. The form is filed annually with Form 1040, U.S. Individual Income Tax Return. U.S. shareholders of CFCs are category 4 and 5 filers and must provide much more detailed company financial information.
A U.S. individual shareholder of a non-CFC only reports income from dividend distributions. The undistributed income is tax deferred. However, U.S. taxpayers with ownership in a CFC are subject to special reporting requirements called Subpart F. The Subpart F provisions eliminate deferral of U.S. tax for some categories of income earned by controlled foreign corporations. The Subpart F rules operate by treating a U.S. Shareholder of a CFC as if it actually received its proportionate share of certain categories of the CFC’s current earnings. The U.S. shareholder is required to report this income (“Subpart F inclusion”) currently in the United States whether or not the CFC actually makes a distribution to the U.S. Shareholder. With the passing of the Tax Cuts and Jobs Act, the Subpart F inclusion has been broadly expanded to include all accumulated post-’86 deferred foreign income.
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