Controlled Foreign Corporations
Now we are going to switch focus from the tax consequences for non-US persons to the tax consequences for US persons. As we discussed at the beginning of the course, US persons are taxed on their worldwide income. Their ultimate tax liability may be reduced by a foreign tax credit but all income, US source and foreign source, is included in the US taxpayer’s gross income. We will discuss the application of the Foreign Tax Credit in more detail in 2 weeks. First we will look at Anti-Deferral Legislation.
Purpose of the Controlled Foreign Corporation / Subpart F Rules
Consider the following two scenarios:
Ted, a US individual, has a portfolio of foreign stocks that pay annual dividend payments of $100,000. Although the income is foreign source income (since a foreign corporation is making the distributions) Ted must include the full amount in his US gross income. If no foreign tax was imposed on the dividend income, Ted would not be entitled to a foreign tax credit.
Ted creates a newly formed corporation in Bermuda, BerCo, and transfers his portfolio of foreign stocks to BerCo. Now the only asset that Ted owns is stock in BerCo. When BerCo earns the $100,000 dividend payments, it will not be subject to US tax because BerCo is a non-US person (it is incorporated outside the US) and non-US persons with no US trade/business are not subject to US tax on foreign source income. Meanwhile, Ted is also not subject to US tax since he did not receive any payments. Only when BerCo makes a dividend payment to Ted will he be subject to tax. Hence, Ted was able to defer US tax on the foreign stock dividends indefinitely. Meanwhile, BerCo can reinvest the dividend proceeds and grow the portfolio offshore without being affected by US tax.
You should note how easily it was for Ted to make the switch from Scenario 1 to Scenario 2. All he had to do was file some paperwork (incorporate BerCo and transfer his shares to BerCo) and his tax consequences were drastically altered.
Consider another similar strategy for abuse:
USCo has an export business in which it purchases baseball caps in the US for $500,000 and sells them to retailers in Japan for $600,000, resulting in a gain of $100,000. USCo also has a branch in Japan that negotiates and concludes the sales. Title transfers in Japan making the gain from the sales foreign source. Nonetheless, USCo is subject to US tax on the $100,000 even though it’s foreign source income because USCo is a US person.
USCo creates a newly formed corporation in Bermuda, BerCo, and sells the baseball caps to BerCo for a small but reasonable mark-up of $40,000. BerCo resells the baseball caps to the Japanese retailers for $600,000. In this scenario, USCo only has $40,000 of gain and the remaining $60,000 of gain is earned by BerCo. Since BerCo is not a US person the $60,000 would not be subject to US tax until it is distributed to USCo as a dividend. USCo was able to defer US tax on the income indefinitely while BerCo reinvests the sales proceeds offshore without being affected by US tax.
As in the earlier example, the shift from Scenario 1 to Scenario 2 merely requires some paperwork: incorporating BerCo and drafting sales agreements between USCo and BerCo and another agreement between BerCo and the Japanese retailers. Other than the documentation no real changes have occurred. USCo may still ship the baseball caps directly to Japan and all sales activities continue to be performed in Japan. The employment contracts of the sales force in Japan may be redrafted so that BerCo is their employer instead of USCo. Basically, the form of the transaction has been changed but the underlying substance of the transaction remains unchanged.
The Controlled Foreign Corporation (CFC) and Subpart F legislation was enacted in order to control these abuses. The intent of the legislation is to prevent US persons from accumulating wealth in low-tax jurisdictions. However, they also did not want to cause US corporations to be less competitive abroad. So when you have a foreign corporation with US shareholders you must ask two questions: 1) Is the foreign corporation controlled by US shareholders (is it a CFC)?; and, if so 2) Is the income earned by Foreign Corporation tainted income (does it earn Subpart F income)? Tainted income (commonly referred to as Subpart F income) is income that was shifted to the Foreign Corporation strictly for tax reasons and not really for business reasons.
Consequences of a CFC with Subpart F Income
Assume you have a Foreign Corporation that is a CFC (which we will define later) and that CFC earns $1000 of Subpart F income (which we will define next week) and $2000 of non-Subpart F income. The consequence is that the US shareholders of the CFC must include the $1000 of Subpart F income in their Gross Income in the year it was earned by the Foreign Corporation. The $2000 of non-Subpart F income does not need to be included in the US shareholder’s Gross Income until such time that the Foreign Corporation distributes the income. Basically, if a CFC earns Subpart F income you treat it as if the CFC distributed that income to the US shareholder in the year it was earned by the CFC.
When a real distribution of the $1000 of Subpart F income is made to the US Shareholders, you ignore the transaction and there is no need to include it in the US Shareholders’ Gross Income again since it was already included earlier.
What is a CFC?
A CFC is a Foreign Corporation that is controlled by US Shareholders. First we must define a “US shareholder.” There are two criteria that must be met for a taxpayer to be a US shareholder: 1) The taxpayer must be a US person (as defined by the residence rules), and 2) The taxpayer must own 10% or more of the Foreign Corporation. So if you have a Foreign Corporation where no single shareholder owns more than 9.99% of the stock, none of the shareholders would be “US shareholders” and as a result the corporation could not be a CFC.
Under the pre-2017 law you only looked to the percentage of voting shares that the shareholder owned to determine if the 10% threshold was met. Under the post-2017 law you can also be a US shareholder by owning 10% of the value of the corporation regardless of ownership of voting shares.
Once you have identified all the US shareholders of a Foreign Corporation, you must add up all of their shares and determine if together they own MORE than 50% of the Foreign Corporation’s stock. So if you have 5 US persons that each own 10% of the stock of a Foreign Corporation and the remaining 50% is owned by Foreign persons, you do not have a CFC, because only 50% (not more than 50%) is owned by US persons.
Direct Ownership, Indirect Ownership & Constructive Ownership
When we calculate the number of shares that a US shareholder owns there are three forms of ownership that we look at, direct, indirect and constructive ownership.
Direct Ownership is straight forward, if a US shareholder owns shares in her name then she owns those shares directly.
If a US shareholder owns shares in a Foreign Corporation (FC1) that owns shares in a Foreign Subsidiary (FC2), then the US shareholder owns shares in FC2 indirectly. So if T, a US shareholder, owns 20% of FC1 and FC1 owns 50% of FC2, then T owns 20% of FC1 directly and 10% of FC2 indirectly.
Note that indirect ownership can only occur through Foreign Corporations. If FC1 was a US corporation, there would be no indirect ownership of FC2.
Constructive Ownership is ownership through family members or related entities (such as parent corporations and their subsidiaries). Assume that a Foreign Corporation has 100 shares, 9 shares are owned by H, a US person, 9 other shares are owned by W, H’s wife who is also a US person, 33 shares are owned by X, an unrelated US person and the remaining 49 shares are owned by a foreign shareholder. If we just rely on Direct Ownership, W and H are not US shareholders since they both hold less than 10% of the Foreign Corporation. As a result we only have one US shareholder (X) and he owns less than the requisite “more than 50%” threshold. However, spouses are required to attribute their shares to each other. So for purposes of determining whether or not a person is a US shareholder, we include their shares and shares of closely related family members. So H is deemed to own 18% of the shares (making him a US shareholder) and W is deemed to own 18% of the shares (making her a US shareholder). So now we have three US shareholders H, W, X. If we add up their shares (9+9+33 = 51), it exceeds the “more than 50% threshold” and the Foreign Corporation is a CFC.
Note that Constructive ownership is only used to determine whether or not a person is a US shareholder. It is not used to determine how much Subpart F they must include in Gross Income. For instance, assume that the Foreign Corporation in the above example earned $5000 of Subpart F income. H would include $450 (9%) in his Gross Income, not $900 (18%). The same would be true for W. X would include $1,650 (33%).
The close family members that attribute shares to each other are the following:
Spouses attribute shares to each other
Siblings DO NOT attribute shares to each other
Parents attribute their shares to their Children and Children attribute their shares to their Parents
Grandchildren attribute their shares to Grandparents but Grandparents do not attribute their shares to Grandchildren (this is a tricky one)
So if you had the following family that owned the following number of shares, here’s how it would break down:
X Corp. has 100 shares outstanding owned by:
Actual Constructive Total
Ownership Ownership Ownership
Husband 10 40 (Wife and Child) 50
Wife 20 60 (Husband, Child and Father) 80
Child 20 30 (Husband and Wife) 50
Wife’s Father 30 60 (Wife, Wife’s Sister, Child) 90
Wife’s Sister 20 30 (Father) 50
Note that a Non-US person can never attribute shares to a US person. So if a US person is married to a Non-US person, they do not constructively own each other’s shares.
To sum up, in order to identify US shareholders we consider Direct, Indirect and Constructive ownership. However, in order to determine the amount of Subpart F inclusion, we only consider Direct and Indirect ownership.
Now that we’re able to identify whether a Foreign corporation is a CFC or not, next week we will learn to determine if the CFC earns Subpart F income.