While a U.S. corporation is subject to tax on its earnings and then its shareholders on their dividends, the U.S. has no taxing jurisdiction on a foreign corporation that neither receives U.S.-source income nor has income effectively connected with the conduct of a U.S. trade or business. However, any dividends earned by U.S. shareholders from foreign corporations are taxable. Without anti-deferral rules in place, U.S. individuals could make investments through foreign entities and indefinitely defer taxation in the U.S. by not issuing dividends. In addition to PFIC rules, Subpart F provisions are powerful anti-deferral mechanisms to prevent this deferral of foreign earned income. Subpart F rules, discussed below, apply to CFCs.
Controlled Foreign Corporations (CFCs)
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
A taxpayer may meet the threshold through a direct, indirect, or constructive ownership of shares in a foreign corporation. The foreign entity must be a corporation for U.S. tax purposes. Certain foreign entities are always (“per se”) corporations. Other foreign entities are eligible to be treated as corporations or not as corporations, either by default or by making a check-the-box election. See Form 8832, Entity Classification Election. This election must be timely made.
A U.S. Shareholder is subject to the current inclusion rules of Subpart F only if the foreign corporation was a CFC for an uninterrupted period of 30 days or more during the taxable year and the U.S. Shareholder owned stock in the foreign corporation on the last day of such taxable year.
Subpart F Income
Under Subpart F, certain types of income earned by a CFC are taxable to the CFC’s U.S. shareholders in the year earned even if the CFC does not distribute the income to its shareholders in that year. Subpart F operates by treating the shareholders as if they had actually received the income from the CFC. The income of a CFC that is currently taxable to its U.S. shareholders under the Subpart F rules is referred to as “Subpart F income.” Under I.R.C. § 951(a), a U.S. shareholder is required to include in income currently its pro rata share of the CFC’s Subpart F income (“Subpart F inclusion”). The Subpart F inclusion will generally bring an indirect foreign tax credit with it under I.R.C. § 960. Note that the Subpart F inclusion is not a dividend and consequently does not qualify for the lower rate of tax under I.R.C. § 1(h)(11).
There are many categories of Subpart F income. In general, it consists of movable income. For example, a major category of Subpart F income is Foreign Base Company Income (FBCI), as defined under I.R.C. § 954(a), which includes foreign personal holding company income, or FPHCI, which consists of investment income such as dividends, interest, rents and royalties.
What should non-compliant taxpayers do?
If taxpayers are non-compliant with the foreign asset and income reporting requirements, they should consider applying to one of IRS’ voluntary disclosure programs:
- Voluntary disclosure program
- Streamlined domestic offshore program
- Streamlined foreign offshore program
- Delinquent international information return submission procedures
- Delinquent FBAR Submission Procedures
We assist taxpayers who have undisclosed foreign financial assets. Schedule an appointment to see how we can help.