Subpart F rules limit deferral of foreign income by owners of foreign corporations. Earnings of a foreign corporation owned by U.S. taxpayer(s) are generally not taxable in the U.S. until remitted. This general rule is subject to several anti-deferral regimes, including Subpart F. U.S. shareholders (generally U.S. persons owning 10% or more of the vote) of a controlled foreign corporation (CFC) must include in their income currently certain types of income earned by the CFC, under the provisions of Subpart F. These inclusions are accompanied by a deemed-paid credit for corporate shareholders that operates identically to the deemed-paid credit for dividends. A Subpart F inclusion, however, is not a qualified dividend eligible for the reduced 15% tax rate.
This first of a series of articles on Subpart F deals with the basic rules. The next article in the series will discuss foreign base company sales income and manufacturing.
A CFC is a foreign corporation more than 50% owned (by vote or value) by U.S. persons who own more than 10% of the vote of the foreign corporation. The 50% and 10% are determined with attribution rules, so for example father and son are counted together, and parent corporation and subsidiary are counted together. U.S. persons include U.S. citizens, U.S. resident individuals, U.S. corporations, U.S. LLCs, and partnerships organized under the laws of any of the 50 states or DC.
A 10% or more shareholder of a CFC must include in his/her/its taxable income each year his/her/its pro rata share of:
· Net Subpart F income, and
· The CFC’s investment in U.S. property (up to its total earnings and profits).
Subpart F income includes 3 key types of income for most groups:
· Interest, dividends, rents, and royalties, and gains on property that produce such income (called FPHCI or foreign personal holding company income), with several exceptions,
· Income from purchase of goods from a related party and sale to anyone or purchase of goods from anyone and sale to a related party, where the goods are both produced and for use outside the CFC’s country of incorporation (FBC Sales Income), and
· Income from performing services for, on behalf of, or with substantial assistance from a related party, where the services are performed outside the CFC’s country of incorporation (FBC Services Income).
If Subpart F gross income (total receipts less cost of goods sold) is both less than $1 million and less than 5% of the CFC’s gross income, it is ignored. If it is more than 70%, then all of the CFC’s income is considered Subpart F income.
Example: Fred, a U.S. citizen, owns 51% of Buy-Lo Ltd., a UK company. Buy-Lo purchases nuts and bolts from an Indonesian company of which Fred owns 51%. Buy-Lo makes a pre-tax profit of £2 million in 2011 selling the nuts and bolts throughout Europe, with only minor sales in the UK. Buy-Lo pays £500,000 of UK tax. Fred must include in his 2011 taxable income his share of the Buy-Lo after tax net, in dollars. If the pound is $2=£1, then Fred’s taxable Subpart F inclusion is $1,530,000. That is £2,000,000 profit less £500,000 tax = £1,500,000 times FX rate of 2:1 times 51% ownership.
Net Subpart F income is Subpart F gross income less all expenses and deductions related to that gross income. Subpart F income is after reducing income for allocable income taxes. Subpart F inclusions are limited to the earnings and profits (E&P) of the CFC. Where an amount would be includible under Subpart F but for this E&P limit, future amounts of earnings are recharacterized as Subpart F. In addition, if the earnings of the CFC are subject to foreign income tax of over 31.5%, then the income is permanently excluded from Subpart F. This high tax test is determined under U.S., not foreign, principles.
Several exceptions apply. FPHCI does not include rent or royalty income from an active business of renting or licensing property, with several significant conditions. Example: Paris Rent-All Srl (PRA) rents construction equipment through its locations in France and Switzerland. All rentals are short term, including hourly. PRA’s employees clean, inspect, and repair the equipment after each rental. PRA’s income qualifies for the active rental exception and is not Subpart F income.
FPHCI also does not include interest or dividends received from a related party organized in the same country, or rents or royalties for property used in the same country. For 2006-2012, it does not include dividends, interest, rents, or royalties received from any related party unless the item is attributable to Subpart F income of the payor.
FBC Sales Income includes income from buying and selling, not making and selling. Where components are purchased from related parties, issues may arise as to whether the CFC manufactured the goods. Manufacturing includes substantially transforming the goods, as well as processes generally considered manufacturing.
A special branch rule applies for FBC Sales Income. If one branch of a CFC makes goods and a branch in a different country sells the goods, the profits of the sales branch are Subpart F income if a tax reduction test is met. The branch rule treats a low tax branch as if it were a separate entity, causing a deemed sale between branches, followed by a sale to customers of goods purchased from a related party. Example: Swiss Co. makes machines in Germany and sells them throughout Europe from the Swiss sales office. The branch rule treats the machines as if they were sold by a German CFC to a Swiss CFC, who then sold them to customers. Thus, the sales portion of the profits are Subpart F income.
CFCs earning FBC Services Income may be providing services to customers or to related parties. If a related party subcontracts services to a CFC, and the CFC performs those services outside its country of incorporation, the U.S. shareholder must include the net income in his/her/its taxable income as the CFC earns the income.
A U.S. shareholder must also include in income the amount of the CFC’s E&P invested in U.S. property. For this purpose, U.S. property is narrowly defined. It includes physical assets in the U.S. and amounts owed to the CFC by related U.S. parties. Thus, a loan of earnings back to the U.S. shareholder of a CFC results in an income inclusion for that U.S. shareholder almost as if a dividend had been paid. There are exceptions to the definition of U.S. property for trade payables of U.S. persons not outstanding longer than normal trade terms. A guarantee by a CFC of debts of a related U.S. party is considered an investment in U.S. property, as is a pledge of CFC shares by a U.S. shareholder.
No double tax. Subpart F also contains a mechanism to ensure that a shareholder is not taxed on distribution of E&P by the CFC. Any distribution is considered to come first from previously taxed amounts and is not included again in the distributee’s income.
Conclusion: U.S. shareholders of controlled foreign corporations must include in their income each year their shares of certain of the income of the CFC, even if undistributed. They must also include in income any loans or advances to U.S. related parties. Careful planning is needed to reduce the effects of Subpart F.