Subpart F of the Tax Code covers one of the major sets of anti-deferral rules for investors in the United States who own an interest in a foreign corporation. Once a person has been determined to be a U.S. shareholder of a CFC, it is important to consider two main sets of anti-deferral rules: Subpart F income rules (discussed here) and Global Intangible Low Taxed Income (GILTI) rules (to be discussed in a later blog post). A U.S. shareholder is in fact a defined term in the tax law — not every U.S. person considered is a “U.S. shareholder.”
Under Subpart F rules, a U.S. shareholder of a CFC is treated as if they actually received their proportionate share of certain categories of the CFC’s current earnings and profits (E&P). The U.S. shareholder is required to report this proportionate share of E&P as income currently in the U.S., regardless of whether or not the CFC makes a distribution. The provisions of Subpart F are exceedingly intricate and contain general rules, special rules, definitions, exceptions, exclusions and limitations, all of which require careful consideration. Below is an overview of the basic provisions of Subpart F.
There are three basic requirements that must be met for the applicability of Subpart F rules to a U.S. person who owns an interest in a foreign corporation:
- U.S. person is a U.S. shareholder with respect to the foreign corporation
- The foreign corporation is a CFC
- CFC earns Subpart F income
With respect to the last requirement, the key categories of Subpart F income are the following:
- Foreign personal holding company income (FPHCI)
- Foreign base company sales income (FBCSI)
- Foreign base company services income (FBCSvI)
Note that Subpart F income also includes insurance income, income related to foreign base company oil, international boycott income, certain illegal bribes and kickbacks, income from certain blacklist countries and investment of earnings in U.S. property; however, these types of income are outside the scope of this article.
This blog will examine the key categories of Subpart F income.
FOREIGN PERSONAL HOLDING COMPANY INCOME
Generally, U.S. businesses with active business operations abroad seek to be on equal competitive footing from a tax standpoint with other operating businesses in the same countries. However, as viewed by the U.S. Congress, 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 current income based on the pro-rata share of the CFC’s FPHCI. This generally includes a CFC’s income from dividends, interest, annuities, rents, royalties and net gains on dispositions of property producing any of the types of income that are treated as Subpart F income.
FOREIGN BASE COMPANY SALES INCOME
One of the perceived abuses that Subpart F intended to prevent when enacted, was U.S. shareholders using their CFCs to shift sales income from the U.S. to low-tax or no-tax foreign jurisdictions to avoid U.S. tax.
The FBCSI rules of Subpart F were intended to address this perceived abuse by focusing on the sale of property by a CFC.
The income from the sale of property by a CFC is considered FBCSI when a CFC meets all three of the following requirements:
- CFC buys and/or sells tangible personal property from, to or on behalf of a related person
- Property is manufactured, produced, constructed, grown or extracted outside the CFC’s country of incorporation
- Property is purchased/sold for use, consumption or disposition outside the CFC’s country of incorporation
If a transaction meets all three of these criteria, the U.S. shareholder(s) of the CFC may have Subpart F inclusion.
FOREIGN BASE COMPANY SERVICES INCOME
Another area of perceived abuse by U.S. shareholders occurs when a service corporation is separated from the activities of a related corporation and organized in another country primarily to obtain a lower tax rate for the service income.
Subpart F is meant to address this perceived abuse by requiring the U.S. shareholder to include their pro-rata share of the CFC’s FBCSvI in income currently.
FBCSvI consists of income derived by a CFC in connection with the performance outside of 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.
NOTABLE EXCEPTIONS AND EXCLUSIONS
Below are some common exceptions/exclusions to Subpart F income:
- Inclusion is limited to current-year E&P: The amount included in a U.S. shareholder’s taxable income is limited to the CFC’s undistributed E&P (just as an actual distribution would be a dividend only to the extent of the CFC’s undistributed E&P).
- De minimis rule: If the amount of Subpart F income is less than the lesser of 5 percent of gross income or $1 million, none of the CFC’s income is considered Subpart F income.
- High tax exception: An item of income taxed at more than 90 percent of the highest U.S. rate (e.g., 21 percent X 90 percent = 18.9 percent) is not Subpart F income.
- Same country manufacturing exception from FBCSI: Income from property manufactured in the CFC’s country of incorporation is not treated as FBCSI.
- Same country sales/use exception from FBCSI: Income from property sold for use, consumption or disposition within the CFC’s country of incorporation is not treated as FBCSI.
- CFC manufacturing exception from FBCSI: Income from the sale of property that the CFC itself manufactures is not treated as FBCSI.
- Active financing exception from FPHCI: Qualified income derived by a CFC that is predominantly engaged in the active conduct of banking, financing or similar business is not treated as FPHCI.
- Look-through exception from FPHCI: Certain income received from a related CFC and allocable or attributable to income that is neither Subpart F nor effectively connected income (ECI) is not treated as FPHCI.
- Same country exception from FPHCI: Certain income received from a related CFC incorporated in the same country that uses a substantial part of its assets in a trade or business in that country is not treated as FPHCI.
A note of caution: These exceptions/exclusions involve a variety of complex requirements and are summarized very briefly here for informational purposes only.
Please contact GHJ’s International Tax team for a more comprehensive discussion of the tax implications of ownership and income from CFCs as well as various tax planning considerations.