Subpart F Income

When a US person owns shares in a Foreign Corporation you must ask two questions: 1/ Is the Foreign Corporation a CFC? 2/ If so, did the Corporation earn Subpart F income?

Last week we reviewed the test to establish whether a Foreign Corporation is a CFC. This week we will focus on the second question: Did the Foreign Corporation earn Subpart F income?

Subpart F income is income that was probably shifted offshore strictly for tax purposes. If there is a legitimate business purpose for earning income offshore, it is usually not characterized as Subpart F income.

Subpart F income includes several different categories of income, we will focus on Foreign Base Holding Company Income (FBHC) and Foreign Base Company Sales Income (FBC Sales Income).

Foreign Base Holding Company Income

FBHCI is investment income that is moved offshore. Remember the first example in Lecture 6 where a US person transferred the ownership of his international portfolio to a Foreign Corporation. This is the type of transaction that typically creates FBHCI. Generally, whenever a CFC earns dividends, interest, royalties or rent or capital gain from the sale of investment income producing property, such income is FBHCI. This is because this type of income is easy to move offshore and there is no reason for it to be earned offshore as opposed to in the US. There are some exceptions:

Rents and Royalties from an Active Trade/Business and received from a Non-Related Party

When the CFC has active rental or licensing income from an unrelated party there is more evidence that the offshore company is located there for legitimate business reasons rather than tax reasons alone.

Regular Dealer or Active Banking Business Exception

When the CFC is conducting an active banking business or when the CFC is a regular dealer in investment properties (e.g. stock brokerage business) there is more evidence that the offshore company is located there for legitimate business reasons rather than tax reasons alone.

Same Country and from a Related Party Exception

When a CFC receives investment income from a related party from the country in which the CFC is incorporated, there is a legitimate business reason for the existence of the CFC. For instance, assume that Ted, a US shareholder, owns 100% of a Dutch holding company (HoldCo). The Dutch holding company owns shares in other companies throughout Europe including a company in the Netherlands (DutchCo). Also assume that DutchCo only earns non-Subpart F income (see Scenario B in the attachment). Dividend payments from DutchCo to HoldCo would normally be considered FBHCI since they are dividends received by a CFC. However, since the dividend was from a related party in the same country (both HoldCo and DutchCo are Dutch), an exception applies and the income is not Subpart F income. The legislators saw no reason to tax US shareholders on dividends received by a CFC (HoldCo) from a related party in the same country where the US shareholder would not have been taxed if he had owned the stock of the related party (DutchCo) directly (in Scenario A, the dividend payment would not exist). The conclusion is that there must be a legitimate business reason for creating HoldCo since the taxpayer could have avoided the dividend income altogether by not creating HoldCo in the first place.

There is an exception to this exception (and this is where it gets tricky). Assume the same facts as above, a Dutch company (HoldCo) owning 100% of another Dutch company (DutchCo). However, this time assume that DutchCo earns $500 of Subpart F income and $500 of non-Subpart F income. DutchCo received a loan from HoldCo and makes interest payments of $1000 (see Scenario C). Both HoldCo and DutchCo are CFCs so we need to determine if either one has Subpart F income that Ted needs to include currently in his gross income.

DutchCo had $500 of Subpart F income and $500 of non-Subpart F income, however it made an interest payment of $1000, so DutchCo’s net income is $0 and there is no income for Ted to include in his gross income.

HoldCo had $1000 of interest income which would normally be Subpart F income. However, since it was received from a related party in the same country the exception applies. As a result Ted does not include this amount in his gross income either.

You will note that Ted does not include anything in his gross income even though DutchCo had $500 of Subpart F income. This income was reduced to $0 as a result of the interest payment from DutchCo to HoldCo. Since $500 of the interest payment from DutchCo to HoldCo served to reduce Ted’s Subpart F inclusion, the exception will not apply to that amount. As a result of the exception to the exception HoldCo is deemed to have $500 of Subpart F income since the payment from DuthCo to HoldCo served to reduce Ted’s overall Subpart F income inclusion by $500.

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Foreign Base Sales Income

Sales income earned by a CFC is Subpart F income when the buyer or seller are related parties. If a CFC buys goods from unrelated parties and then sells them to unrelated parties, there is no Subpart F income.

There are two exceptions to FBC Sales Income:

Same Country Exception

If the goods that are being sold were manufactured in the CFC’s country or if they were sold in the CFC’s country, the income is not Subpart F income.

Example 1: A US shareholder owns 100% of the shares of a CFC in Hong Kong (HKCo) and 100% of the shares of a US corporation (USCo). HKCo buys goods from USCo and sells them to retailers in Hong Kong. The income received is not Subpart F income even though the seller is a related party because the goods were sold in the CFC’s country.

Example 2: Same as above except instead of selling the goods to retailers in Hong Kong, HKCo sells the goods to a distributor in Hong Kong that resells them to retailers throughout Asia (outside Hong Kong). If HKCo knows, or has reason to know, that the end user of the goods is outside of the CFC’s country of incorporation (Hong Kong), then the exception does not apply and the income is Subpart F income.

Manufacturing Exception

If the goods sold by the CFC were manufactured by the CFC, the income is not Subpart F income. Manufacturing is defined as Substantial Transformation of the product. So merely packaging or labeling will not qualify as a product. Assembly may qualify as manufacturing if an entirely different product results after the assembly occurs. Note that the manufacturing does not need to occur in the CFC’s country of incorporation for this to apply.

Example 1: A US shareholder owns 100% of the shares of a CFC in the Netherlands (DutchCo). DutchCo owns a manufacturing operation in Ireland (since the operation is not independently incorporated it is a branch of DutchCo). DutchCo sells the goods manufactured by the Irish branch throughout Europe. The income received is not Subpart F income because the goods were manufactured by the CFC (in its Irish branch).

Example 2: A US shareholder owns 100% of the shares of a CFC in the Netherlands (DutchCo). DutchCo enters into an agreement with an unrelated third party (MfgCo) to perform manufacturing on its behalf. Under the agreement, DutchCo retains all risk of loss and owns the raw materials used in the manufacturing. MfGCo performs the manufacturing services for a cost plus mark-up fee. DutchCo sells the goods manufactured by the contract manufacturer throughout Europe. The income received is not Subpart F income because the goods are deemed to be manufactured by the CFC. Even though the CFC does not manufacture the goods itself, if it enters into a contract manufacturing agreement with a third party manufacturer it is deemed to have performed the manufacturing.

Note: Even though Rev. Rul. 97-48 appears to invalidate this position, tax planners have successfully relied on general agency law to argue that manufacturing performed by a contract manufacturer may be deemed to be performed by a CFC.

Relief Provisions

High-Tax Exception

If the CFC’s income is subject to an effective tax rate that is greater than 90% of the maximum US corporate tax rate, none of the Subpart F income is included in the taxpayer’s gross income. If the maximum US corporate tax rate is 35%, then the CFC’s Subpart F income will not be included in the taxpayer’s gross income if its income is subject to a rate of 32% since this is higher than 31.5% (90% of 35%).

The theory is that the CFC was not set up for tax avoidance purposes if its income is subject to a rate of tax that is about as high, or higher, than the US tax rate.

DeMinimis Exception

If the proportion of Subpart F income to total income (Subpart F and non-Subpart F) falls below a certain threshold, then NONE of the income is Subpart F income. The threshold is the lesser of $1,000,000 or 5% of the CFC’s gross income.

If the CFC had $900,000 of Subpart F income and $19,000,000 of non-Subpart F income, the $900,000 of Subpart F income would not be included in the taxpayer’s gross income since it is less than 5% of the CFC’s gross income. ($900,000 is 4.5% of $19,900,000).

If a CFC had $700,000 of Subpart F income and $10,000,000 of non-Subpart F income, the $700,000 of Subpart F income would be included in the taxpayer’s gross income since it is greater than 5% of the CFC’s gross income ($700,000 is 6.5% of $10,700,000).

If the CFC had $2,000,000 of Subpart F income and $45,000,000 of non-Subpart F income, the $2,000,000 of Subpart F income would be included in the taxpayer’s gross income since it is more than $1,000,000 (even though it is less than 2,350,000 – 5% of $47M).

Full Inclusion Rule

This is the opposite of the DeMinimis Exception. Basically, if most of the CFC’s income is Subpart F income (70% or more), then all of it will have to be currently included in the taxpayer’s gross income. So if a CFC had $800,000 of Subpart F income and $200,000 of non-Subpart F income, the entire $1,000,000 would be currently included in the taxpayer’s gross income because $800,000 is 80% of the CFC’s total income.

Non-Subpart F Income

With regard to non-Subpart F income, the CFC is treated as a regular foreign corporation and the income is not subject to US tax until such time that the income is repatriated to a US person as a dividend.

So if a CFC receives $1,000,000 of non-Subpart F income in Year 1 and the income is not distributed to a US person until Year 4, that $1,000,000 will not be subject to US tax until Year 4 when it will be taxed at US tax rates to the shareholder.

New Law: However, under the Tax Cuts and Jobs Act of 2017 there is an exception to the general rule above for 2017. At the end of 2017, all non-Subpart F income that has been retained by a CFC is deemed to distribute that income to its US shareholders. The tax rate for this undistributed income is 15.5% to the extent that it is attributable to cash and 8% to the extent it is attributable to other assets.

For example, assume that in 2016 a CFC had $400,000 of Subpart F income and $500,000 of non-Subpart F income and in 2017 the CFC has no income. Also assume that of that $500,000, $300,000 is cash and $200,000 is non-cash assets.

In 2016, the US shareholders would be subject to tax on the $400,000 as if it was distributed to them. Because of the new law, in 2017 the CFC will be deemed to have distributed the $500,000 to its US shareholders and they would be taxed at 15.5% on the $300,000 of accumulated cash and 8% on the $200,000 of non-cash assets.

Note that this deemed distribution is a one-time event for the end of 2017. For subsequent years the default law will apply whereby non-Subpart F income is not deemed to be distributed to US shareholder and is therefore not subject to US tax until such time that it is acutally distributed.

A Brief Note on PFICs

PFICs can be complicated but here are the essential issues you should understand:

Once you’ve conducted a thorough CFC/Subpart F analysis and determined that the taxpayer does not have to currently include any of the Foreign Corporation’s income in his gross income, you then need to conduct a PFIC analysis.

Generally, when a US Person owns shares of a Foreign Corporation the PFIC rules could potentially apply. The key distinction between PFICs and CFCs is that CFCs only have consequences for US Shareholders (i.e. 10% or more owners) whereas PFICs have consequences for any US Person who owns shares of a Foreign Corporation (even a US person who owns 1 share of a Foreign Corporation needs to be concerned).

So once we’ve identified a Foreign Corporation that is owned in some part by a US person, we need to determine if that Foreign Corporation is a PFIC. It will be a PFIC if it meets either of the two following tests:

Income Test: If 75% or more of the Foreign Corporation’s income is FPHCI (i.e. passive investment income or investment capital gain), then it is a PFIC.

Asset Test: If 50% or more of the Foreign Corporation’s assets produce FPHCI, then it is a PFIC.

If the Foreign Corporation is a PFIC the US person taxpayer will face one of the following consequences:

1 – Excess Distribution: When the PFIC makes an excess distribution (125% of previous year’s distribution) or when the PFIC stock is sold, the taxpayer is taxed on the income as if it was earned in the year the PFIC earned the income (applying the tax rate of that year and interest due). This is the default rule and will apply unless the taxpayer makes an election otherwise.

2 – QEF Election: If a QEF election is made, the PFIC is treated as if it distributed all its income in the year it was earned (this is a similar treatment that Subpart F income receives in the CFC regime).

3- Mark-to-Market Election: Current inclusion of the difference between the taxpayer’s basis in the PFIC stock and its market value on a public exchange at the end of the year (the PFIC’s stock must be publicly trade for this election to apply).

It is possible that a corporation can be a CFC and a PFIC at the same time. If this is the case, only the CFC regime will apply for US shareholders. The PFIC regime will continue to apply for non-US shareholders who are US persons.

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