USA will only tax foreign business earnings if it repatriates it to USA through dividends. This policy is known as “deferral”.
Deferral creates an opportunity for avoiding U.S taxes on passive investment income, inventory trading profits and other income that can be easily shifted to a foreign base company.
Every person who is a U.S shareholder of a controlled foreign corporation during taxable year and holds its stock on the last day of the controlled foreign corporation’s taxable year must include in gross income on pro rata basis of:
Subpart F income
Investments of earnings in U.S property
Example:
USAco is a domestic corporation.
FORco is a foreign corporation.
USAco owns 100% of the stock of FORco.
During the taxable year:
FORco derives $10 million of sub part F income in the form of passive interest income.
Income taxes paid in foreign country = $100,000 at the rate of 10%.
FORco does not distribute any dividends.
Conclusion:
Even though FORco did not distribute any dividends, USAco is not allowed to defer the residual U.S tax due on FORco’s earnings. USAco will recognize a sub part F income of $9 million and pay residual USA taxes on this income.
What is a controlled foreign corporation?
Sub part F applies only to foreign corporation that qualifies as a controlled foreign corporation (CFC).
A foreign corporation is a CFC, on any day during the foreign corporation’s taxable year when U.S shareholders own more than 50% of the combined voting power of all classes of stock or more than 50% of the total value of the foreign corporation.
A U.S shareholder is any U.S person who owns at least 10% of the total combined voting power of all classes of voting stock of the foreign corporation.
All forms of ownership, including direct ownership, indirect or beneficial ownership through intervening foreign entities, and constructive ownership, are taken in account in applying both the 10% ownership test for U.S shareholder status and the more than 50% ownership test for CFC status.
What is included in Subpart F income?
Sub part F income includesfollowing:
Insurance income.
Foreign based company income.
A portion of international boycott income.
The sum of any illegal bribes or kickbacks paid by or on behalf of the CFC to a government employee or official.
Income derived from certain disfavored countries.
What is insurance income?
Any income attributable to issuing or reinsuring any insurance or annuity contract in connection with a risk located outside the CFC’s country of incorporation. The location of a risk is determined by where the insured property or activity is located or by whre the insured individual resides.
Income from insuring risks located within the CFC’s country of incorporation also qualifies as sub part F income if, as a result of an arrangement, another corporation receives a substantially equal amount of premiums for insuring risks located outside the CFC’s country of incorporation.
The taxable amount of insurance income equals the gross amount of such income, less any deductions properly allocable to such income.
What is foreign base company income?
Foreign base company income includes following:
Foreign personal holding company income.
Inclusions:
Dividends, interest, royalties, rent and annuities.
Net gains from the disposition of property that produces dividends, interest, rent and royalty income except for net gains from certain dealer sales and inventory sales.
Net gains from commodity and foreign currency transactions excluding net gains from active business and hedging transactions.
Exclusions:
Rents and royalties derived from the active conduct of a trade or business and received from an unrelated person.
Export financing interest derived in the active conduct of a banking business.
Dividends and interest received from related parties incorporated in the same country as CFC.
Rents and royalties received from related parties for the use of property in the CFC’s country of incorporation.
Income derived from the active conduct of a banking, financing, insurance or similar business.
Dividends, interest, rents, and royalties received from a related CFC, provided the payments are attributable to income of the related CFC which is neither sub part F income nor income that is effectively connected with a U.S trade or business. Under this exception, cross-border payments between related CFCs do not constitute sub part F income as long as the payments are attributable to active foreign business income.
Personal services income received by a CFC whose U.S owner performs the services.
Foreign base company sales income.
It includes any gross profit, commissions, fees or other income derived from the sale of personal property which meets the following requirements:
The CFC purchases the property from or sells the property to related person.
The property is manufactured, produced, grown, or extracted outside the CFC’s country of incorporation by someone other than the CFC.
The property is sold for use, consumption, or disposition outside the CFC’s country of incorporation.
Foreign base company services income.
It includes any compensation, commissions, fees, or other income derived from the performance of technical, managerial, engineering, architectural, scientific, industrial, commercial, and like services, where the CFC performs the services for or on behalf of a related person and the services are performed outside the CFC’s country of incorporation.
Foreign base company oil related income.
It includes foreign source income derived from refining, processing, transporting, distributing or selling oil and gas or primary products from oil and gas.
Under the look through rule, foreign base company oil-related income also includes dividends and interest derived from a 10% or more owned foreign corporation to the extent such dividends or interest are attributable to foreign base company out related income.
How to treat a U.S shareholder’s earnings from investment in U.S property?
A U.S share holder must include in gross income the excess of the shareholder’s pro rata share of the CFC’s current year investment in U.S property over investments in U.S property taxed to the U.S shareholder in prior tax years, but only to the extent the CFC has undistributed earnings which have not yet been taxed to U.S shareholders.
What are the principal types of U.S properties?
Debt obligations:
U.S property includes an obligation of a U.S person, such as loan to a U.S shareholder, including any pledge or guarantee by a CFC of a U.S person’s obligations.
Certain Receivables:
U.S property includes trade or service receivables acquired, directly or indirectly, from a related U.S person where the obligor is a U.S person.
Stock:
U.S property includes stock of U.S shareholder or other related domestic corporation, but not stock of unrelated domestic corporations.
Tangible property:
U.S property includes any tangible property located in the United States, such as a U.S manufacturing facility.
Intangibles:
U.S property includes any right to use in the United States a patent, copyright, invention, model, design, secret formula or process, or any similar property right.
How to treat deemed paid foreign tax credit for a CFC’s foreign income?
Consistent with the notion that a subpart F inclusion represents a deemed dividend, a domestic corporation which directly owns 10% or more of a CFC’s voting stock can claim a deemed paid foreign tax credit for the CFC’s foreign income taxes in the same year that the shareholder is taxed on the CFC’s earnings.
The deemed paid credit that is allowed with respect to a Subpart F inclusion generally is identical to the deemed paid credit that is allowed with respect to actual dividend distributions.
How can you prevent double taxation?
Distribution of previously taxed income:
A U.S shareholder can exclude from income distribution of a CFC’s earnings and profits that were previously taxed to U.S shareholders by reason of a Subpart F inclusion.
A U.S shareholder cannot claim a deemed paid credit with respect to a distribution of previously-taxed earnings and profits to the extent a credit was already taken for those taxes in the year of Subpart F inclusion.
CFC stock basis adjustment:
A U.S shareholder increases its basis in the stock of a CFC by the amount of a Subpart F inclusion. This adjustment prevents double taxation of any proceeds from the sale of exchange of a CFC’s stock that are attributable to earnings and profits that were already taxed to the U.S shareholder as a Subpart F inclusion.
Currency translations:
U.S shareholders must report Subpart F inclusions in the U.S dollars.
Earnings and Profits:
One amount of a U.S shareholder’s Subpart F inclusion for Subpart F income is limited to the CFC’s current earnings and profits.
The amount of a U.S shareholder’s Subpart F inclusion for an investment in U.S property is limited to the sum of the CFC’s current and accumulated earnings and profits.
What are the reporting requirements by IRS?
A U.S shareholder who owns more than 50% of the stock, by vote or value, of a foreign corporation must file a form 5471, information return of U.S persons with respect to certain foreign corporations.
U.S persons who acquire a 10% ownership interest, acquire an additional 10% interest, or dispose of stock holdings to reduce their ownership in the foreign corporation to less than 10% and U.S citizens and residents who are officers or directors of a foreign corporation in which a U.S person acquires a 10% ownership interest or an additional 10% interest should also file form 5471.
What is the information reported on form 5471?
Stock ownership, including current year acquisition and disposition.
U.S shareholders.
GAAP income statement and balance sheet.
Foreign income taxes.
Current and accumulated earnings and profits, including any actual dividend distributions during the year.
The U.S shareholder’s pro rata share of Subpart F income and any increase in earnings invested in U.S property.
Transactions between the CFC and shareholders or other related persons.
A form 5471 is filed by attaching it to the U.S person’s regular federal income tax return.
U.S person who fails to furnish the required information may be subject to an annual penalty of $10,000 and a reduction in taxpayer’s foreign tax credit.
Practical Guide to US Taxation of International transactions 9th Edition
Robert J. Misey Jr.
Michael S. Schadewald
Publishers: Wolter Kluwer, CCH Incorporated.
The Accounting and Tax