Subpart F Income & CFC

Subpart F Income

Subpart F Income & Controlled Foreign Corporations (CFC): The IRS Rules for Subpart F Income, CFC, and U.S. Shareholder Foreign Earnings are very complicated. Essentially, Subpart F Income involves CFCs (Controlled Foreign Corporations) that accumulate certain specific types of income (primarily passive income). When a CFC has Subpart F income under IRC Section 952, that means the U.S. shareholders may have to pay tax on the earnings. The kicker is that the ratable share of Subpart F income may be attributable to the U.S. shareholder, even if the income is never distributed to the shareholder.

Fair, right?

*Subpart F Income overlaps with various other related issues, such as Form 5471, GILTI, and PFIC. And, with the Internal Revenue Service taking an aggressive position on issues involving Foreign Accounts Compliance and Unreported Foreign Income — compliance is important to avoid offshore penalties.

Definition of Subpart F Income

We will summarize the basics of Subpart F Income and interaction with CFC rules.

What is Subpart F Income?

Subpart F income is codified under 26 U.S.C. 952.

As provided by the IRS

• • • A foreign corporation is a CFC for a particular year if on any day during such year U.S. shareholders own

      • (1) more than 50% of the total combined voting power of all classes of the corporation’s stock entitled to vote (voting test), or

      • (2) more than 50% of the total value of all classes of the corporation’s stock (value test). I.R.C. § 957

        • A U.S. shareholder is a U.S. person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation.

        • I.R.C. § 957(c) defines the term “U.S. person” for purposes of Subpart F by referencing the definition in I.R.C. § 7701(a)(30), which defines a U.S. person as any of the following: U.S. citizen/resident, domestic partnership, domestic corporation, or any estate/trust that is not a foreign estate/trust as defined in I.R.C. § 7701(a)(31).

What are the Different Types of Subpart F Income?

There are various different types of Subpart F Income:

FBCSI (Foreign Base Company Sales Income)

One of the abuses that Subpart F is intended to prevent is U.S. shareholders using their CFCs to shift sales income from the U.S. to foreign jurisdictions to avoid U.S. tax. The FBCSI rules of Subpart F address this abuse. When a CFC buys/sells tangible personal property (1) from/to (or on behalf of) a related person and the property is (2) manufactured, produced, constructed, grown, or extracted outside the CFC’s country of incorporation and the property is purchased/sold (3) for use, consumption or disposition outside the CFC’s country of incorporation, the income from the sale of the property by the CFC is FBCSI, a type of Subpart F income. § 954(d). The U.S. shareholder(s) of the CFC may have a subpart F inclusion.

FBC Services Income (Foreign Based Company Services Income)

Another area of abuse is where a service corporation is separated from the activities of a related corporation and organized in another country primarily to obtain a lower rate of tax for the service income. Subpart F addresses this abuse by requiring the U.S. shareholder to include its pro-rata share of the CFC’s FBC Services. FBC Services Income consists of income derived by a CFC in connection with the performance outside the CFC’s country of incorporation of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services for or on behalf of any related person. § 954(e)

FPHCI (Foreign Personal Holding Company Income)

When Congress enacted Subpart F, it recognized the need for U.S. businesses with active business operations abroad to be on equal competitive footing from a tax standpoint with other operating businesses in the same countries. However, where a CFC has portfolio types of investments, or where the CFC is merely passively receiving investment income, there is no competitive justification to defer the tax until the income is repatriated. As such, the provisions of Subpart F require a U.S. shareholder to include its pro-rata share of the CFC’s FPHCI in income currently. FPHCI generally includes a CFC’s income from dividends, interest, annuities, rents, royalties, net gains on dispositions of property, and many more.

IRM 4.61.7: Calculating Subpart F Income

The IRM (Internal Revenue Manual) provides how Subpart F is evaluated and calculated. Some of the key paragraphs include:

4.61.7.7.2 (10-08-2019): Limitation as to Earnings and Profits

• • • Subpart F income includible in gross income by a U.S. shareholder for any taxable year may not exceed the CFC’s earning and profits for the taxable year. IRC 962(c)(1)(A) and IRC 951A(c)(2)(B)(ii).

    • In the computation of earnings and profits determine that earnings and profits are reported according to U.S. standards. See IRC 964(a) and the regulations thereunder. However, for purposes of IRC 952(c), earnings and profits will be determined without regard to IRC 312(n)(4), IRC 312(n)(5), and IRC 312(n)(6) (the preceding clause will not apply to the extent it would increase earnings and profits by an amount which was previously distributed by the CFC).

    • The limitation described in IRM 4.61.7.9(1) does not apply to amounts of post-1986 earnings and profits included in subpart F income with respect to a DFIC. For purposes of IRC 965, an SFC’s post-1986 earnings and profits are earnings and profits accumulated in taxable years beginning after December 31, 1986, but only taking into account periods during which the foreign corporation was an SFC and without diminution by reason of dividends distributed during the inclusion year other than dividends distributed to another SFC.

4.61.7.8 (10-08-2019): Certain Prior Year Deficit

The amount of subpart F income included in the U.S. shareholder’s gross income may be reduced by his pro rata share of the CFC’s prior year qualified deficits. IRC 952(c)(1)(B).

• • • A qualified deficit is post-1986 deficit in earnings and profits that is attributable to the same qualified activity as the activity giving rise to the income to be offset and which has not previously been taken into account. See IRC 952(c)(1)(B)(ii).

    • A qualified activity is any activity giving rise to 1) foreign base company sales income, 2) foreign base company services income, 3) in the case of a qualified insurance company, insurance income or foreign personal holding company income or 4) in the case of a qualified financial institution, foreign personal holding company income. See IRC 952(c)(1)(B)(iii).

For purposes of IRC 965, an EPDFC is, with respect to any taxpayer, a SFC with respect to which the taxpayer is a U.S. shareholder, if, as of November 2, 2017, the SFC has a deficit in post-1986 earnings and profits. For purposes of determining whether a SFC is an EPDFC, all post-1986 earnings and profits must be taken into account.

Attribution and Constructive Ownership

Attribution and Constrictive Ownership Rules are very complicated. When a person (or other company) is deemed to have constructive ownership, it means that while the person may not directly own the stock, they are deemed to own the stock by way of constructive ownership

In accordance with IRC 958

(b) Constructive ownership

• • • For purposes of sections 951(b), 954(d)(3), 956(c)(2), and 957, section 318(a) (relating to constructive ownership of stock) shall apply to the extent that the effect is to treat any United States person as a United States shareholder within the meaning of section 951(b), to treat a person as a related person within the meaning of section 954(d)(3), to treat the stock of a domestic corporation as owned by a United States shareholder of the controlled foreign corporation for purposes of section 956(c)(2), or to treat a foreign corporation as a controlled foreign corporation under section 957, except that—

    • (1) In applying paragraph (1)(A) of section 318(a), stock owned by a nonresident alien individual (other than a foreign trust or foreign estate) shall not be considered as owned by a citizen or by a resident alien individual.

    • (2) In applying subparagraphs (A), (B), and (C) of section 318(a)(2), if a partnership, estate, trust, or corporation owns, directly or indirectly, more than 50 percent of the total combined voting power of all classes of stock entitled to vote of a corporation, it shall be considered as owning all the stock entitled to vote.

    • (3) In applying subparagraph (C) of section 318(a)(2), the phrase “10 percent” shall be substituted for the phrase “50 percent” used in subparagraph (C). Paragraph (1) shall not apply for purposes of section 956(c)(2) to treat stock of a domestic corporation as not owned by a United States shareholder.

CFC vs. PFIC Rules

There are some overlap rules with CFC and PFIC. A PFIC is a Passive Foreign Investment Company. The income of a PFIC may be considered similar to Subpart F, but the CFC (Controlled Foreign Corporation) rules are not required.

GILTI vs. Subpart F Income

GILTI is not the same as Subpart F income, but some of the categories of GILTI (Global Low-Taxed Intangible Income) are similar to Subpart F Income. There are rules and regulations still being considered to make sure U.S. persons are not overtaxed.

Form 5471

Form 5471 is used to report certain foreign corporations. A foreign corporation does not need to be “Controlled,” in order to meet the IRS reporting requirements. The 5471 Form is very complex and has various different schedules to be filed, depending on what category the filer qualifies as — and a person may qualify for various different categories, which would result in many different schedules being filed – including schedules that detail Subpart F income.

We Specialize in International Tax & Offshore Compliance

Our firm specializes exclusively in international tax, and specifically IRS offshore disclosure and Subpart F income.

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International Information Reporting Requirements

Each year, US taxpayers who have foreign investments, accounts, pension plans, and life insurance policies may be required to report the values of their overseas assets — along with any income generated from them — to the Internal Revenue Service. When a taxpayer misses an international information reporting return deadline, it may lead the IRS to issue fines and penalties. Oftentimes these international penalties can be avoided or abated through one of the offshore voluntary disclosure programs — or other IRS amnesty procedures. It is important to note that not all foreign account filing forms have the same deadlines and due dates — and the process for seeking an extension will vary depending on the type of form. Let’s look at six important facts about foreign account filing deadlines.

FBAR Due Date and Extension

The FBAR is used to report foreign bank and financial accounts to the US Government. The Form is due on April 15, but is currently on automatic extension. Therefore, if you did not file the FBAR (FinCEN Form 114) by April 15, you still have until October to file it. And, you do not have to file an extension form such as Form 4868 or 7004 to obtain the FBAR extension — because the extension is automatically granted.

Form 8938 Due Date and Extension

Form 8938 is used to report foreign assets to the IRS in accordance with FATCA (Foreign Account Tax Compliance Act). It is similar (but not identical) to the FBAR. Form 8938 is filed with your tax return and is due when your tax return is due. If you are an individual filing a Form 1040, then the form 8938 would be due in April along with your 1040 tax return — but if you extend the time to file your tax return, then your Form 8938 will go on extension as well.

Form 3520 Due Date and Extension

Form 3520 is used to report foreign gifts and foreign trust information. The due date for Form 3520 is generally April 15, but taxpayers can obtain an extension to file Form 3520 by filing an extension to file their tax return for that year. Similar to Form 8938, there is no specific Form 3520 extension form required beyond requesting an extension of the underlying tax return.

Form 3520-A Due Date and Extension

Form 3520-A is used to report US ownership of a Foreign Trust. Unlike Form 3520, Form 3520–A is usually due in March and not April. In addition, the rules for filing an extension for Form 3520-A are different as well (subject to the substitute filing rules). In order to extend the due date to file Form 3520-A, the taxpayer must file a separate Form 7004 extension form.

Form 5471 Due Date and Extension

Form 5471 is used to report the ownership of certain foreign corporations. The filing date is the same as when a person’s tax return is due — and if the taxpayer files an extension for the underlying tax return, Form 5471 will go on extension as well. In recent years, Form 5471 has become infinitely more complex — so taxpayers should be cognizant of the different filing requirements and plan accordingly.

Missed Prior Year’s Foreign Account Reporting Deadlines?

If a taxpayer has not properly reported their foreign accounts, assets, or investments in prior years, they may want to wait before filing these documents for the current year. That is because Taxpayers should try to avoid making a quiet disclosure (which may result in significant fines and penalties). To do that, Taxpayers should submit to one of the offshore disclosure programs. Taxpayers may also want to consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in international tax matters before submitting to the IRS to get an understanding of the different requirements.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.