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 subject to taxes in the USA 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 second of a series of articles on Subpart F deals with the branch rule that requires CFC shareholders to include income from sales branches of CFCs.
Shareholders of CFCs that buy and sell goods must include in their income their shares of the CFC’s income if the goods are bought from or sold to a related party and both made and for use outside the CFC’s country. A high tax exception prevents this if the foreign income tax exceeds 31.5% on the income. This normally does not apply to shareholders of a CFC that makes and sells goods, even if it is not subject to foreign tax. Under the branch rule, though, part of the income of a CFC that makes and sells goods may be subject to Subpart F inclusion by the U.S. shareholders.
Where the branch rule applies, the sales and manufacturing branches are treated as different, separate CFCs. The effect of this is to treat the sales branch as if it purchased goods from a related party and resold them. The sales branch is treated as incorporated in the home office CFC’s country of incorporation. Thus, sales of goods for use outside that country are treated as Subpart F income.
The branch rule applies only if both of two tests are met: foreign tax reduction, and home-country tax deferral. The first test is met if the total foreign income taxes imposed on the CFC are reduced by at least 5 percentage points as a result of the use of branches. The second test is met if the effect of a branch is to defer income tax in the CFC’s country of incorporation until the earnings of the branch are remitted.
The branch rule does not result in Subpart F income if the earnings of the branch are still subject to foreign income tax in excess of 31.5%. It also does not apply with respect to a branch in the USA.
Example: Mech AG is a Swiss corporation owned by a Bob, U.S. citizen. Mech AG makes and sells machines. The machines are made by an Ireland branch, subject to 12.5% Irish income tax on the income of the branch only. The Ireland branch transfers the machines to an office of Mech AG in Switzerland. The transfer price results in a profit in Ireland. The Swiss office sells the machines to customers for use around the world. Under Swiss tax law, the Ireland profits are not taxed until remitted. The profits of the sales branch (treating the transfer from Ireland as if it were a purchase) are subject to 22% Swiss Federal and cantonal income tax. As a result of the Swiss tax law rules, the Ireland profits are taxed at 9.5 percentage points less than the other profits, and not taxed (deferred) until remitted. The branch rule tests are met. The sales branch profits are considered Subpart F income, and Bob must pay taxes in the USA on the sales income as if it were distributed.
Note that Subpart F inclusions are not qualified dividends. Thus, for individuals who own CFCs, a Subpart F inclusion may be not only an acceleration of tax, but a permanent increase. Bob’s tax is up to 35% on the Subpart F income, rather than the 15% that would apply to a dividend from a Swiss corporation. For regular corporations who own 10% or more of a CFC, the Subpart F inclusion is only a temporary difference, since all a regular corporation’s income is taxed at the same rate.
Summary: U.S. owners of foreign corporations may be required to include in their income their share of income of a CFC from making and selling goods if the CFC has separate manufacturing and sales branches.
International tax planning can be complex, especially such provisions as Subpart F. Call Steve Fox to help make sure you are not paying more tax than necessary.