Subpart F Income: IRS Tax Rules for CFC

Subpart F Income

Subpart F Income Overview

Subpart F Income: The IRS rules for overseas earnings such as Subpart F income are complex. It relates to certain U.S. shareholders who have an ownership or interest in foreign corporations that are controlled (aka CFC). The U.S. government developed Subpart F to avoid deferral of certain foreign income from CFCs.  A CFC is a Controlled Foreign Corporation, and not all foreign corporations are CFCs. Under Subpart F rules and IRC 952,  U.S. shareholders of a CFC may be taxed on certain foreign corporation income, even if it has not been distributed. The income attributed to them is based on their ratable share.  There are other requirements, such as required current year earnings and profit (E&P) and other rules, which we will summarize.

How is Subpart F Defined?

Subpart F refers to foreign income, and Subpart F income is codified in Internal Revenue Code section 952

I.R.C. § 952

• • • (a) In general

      • For purposes of this subpart, the term “subpart F income” means, in the case of any controlled foreign corporation, the sum of —

        • (1) insurance income (as defined under section 953),

        • (2) the foreign base company income (as determined under section 954),

        • (3) an amount equal to the product of—

          • (A) the income of such corporation other than income which—

            • (i) is attributable to earnings and profits of the foreign corporation included in the gross income of a United States person under section 951 (other than by reason of this paragraph), or

              • (ii) is described in subsection (b), multiplied by (B)the international boycott factor (as determined under section 999),

Categories of Subpart F Income

There are different categories of Subpart F income.

As provided by the IRS:

• • • FPHCI: FPHCI generally includes a CFC’s income from dividends, interest, annuities, rents, royalties, and net gains on dispositions of property producing any of the foregoing types of income (as well as several other types of income not covered in this Concept Unit – see separate Practice Unit on FPHCI). § 954(c)

    • FBC Services Income: FBC Services Income consists of income derived by a CFC in connection with the performance outside 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. § 954(e)

    • FBCSI: When a CFC buys/sells tangible personal property (1) from/to (or on behalf of) a related person and the property is (2) manufactured, produced, constructed, grown, or extracted outside the CFC’s country of incorporation and the property is purchased/sold (3) for use, consumption or disposition outside the CFC’s country of incorporation, the income from the sale of the property by the CFC is FBCSI, a type of Subpart F income. § 954(d). The U.S. shareholder(s) of the CFC may have a subpart F inclusion.

What is Earnings and Profit (E&P)?

For Subpart F to apply, a company must have earnings and profit (E&P).  Earnings and Profit (E&P) is complicated. There is no straight, bright-line test to determine E&P.  (Please refer to 26 CFR sec. 1.312-6 for a summary of how to calculate E&P.)

What is a CFC?

Subpart F Income and CFC go hand-in-hand.

A CFC is a Controlled Foreign Corporation (Legal Term) and a Foreign Corporation is categorized as a CFC when:

• • • More than 50% of the corporation is owned by a US person

    • Each US person owns at least 10% of the corporation.

Unfortunately, attribution rules apply — so it is important to determine whether family members also on shares of stock, because family ownership of the stock may also be “attributed” to you.

Common CFC structures include:

• • • A Sociedad Anonima, in which the U.S. Person usually owns 90% of the Foreign Corporation, with a local resident owning 10%

    • A Wholly Owned Foreign Corporation such as Hong Kong Ltd., BVI, or Australia PTY Ltd.

    • A Foreign Corporation (Even if established just as a Foreign Trust), but is considered a Per Se Corporation under IRC§ 301.7701-2

Example of Subpart F Income & U.S. Tax

Here is a common Subpart F Income example: David is a U.S. person. He is a shareholder in a foreign BVI holding company. The BVI is a CFC, because it is owned 75% by U.S. persons, who each own at least 10% (individually or through attribution). The company’s purpose is to hold passive investments. In the current year, the company has E&P (Earnings and Profit).  Even though the dividends generated from the investments are not distributed, the ratable ownership attributed to David (and other U.S. shareholders) may be taxable in the current year — before the income is ever distributed.

Common Subpart F Income Questions & Answers 

To best understand the concept of subpart F Income, it is important to understand these two main ideas about who is being taxed and what income is being taxed:

IRS is Not Directly Taxing the Foreign Corporations

Is important to note, that the IRS does not have the authority to tax a foreign corporation unless certain rules apply such as US source income, which is not otherwise exempt by under the Tax Treaty. Rather it is the Subpart F Income being attributed to the U.S. Person that is being taxed.

2017/2018 Tax Reform 

With the introduction of the TCJA (Tax Cuts and Jobs Act (TCJA), the government modified the way foreign income is taxed. One major change was GILTI (Global Intangible Low-Taxed Income). GILTI  and Subpart F are similar (but different) and the interrelation between the two concepts severely impacts Subpart F tax and reporting. In addition, Subpart F income may also be impacted by FDII (Foreign Dividend Intangible Income).

Exceptions, Exclusions, and Limitations to Subpart F

Whenever there is a complex law such as subpart F income, there are always exceptions and exclusions — so it is very important to determine if you qualify for any of these exceptions, exclusions, or limitations before submitting any payment or informational returns to the IRS.

Here are some common exceptions:

Inclusion is limited to current E&P

The amount included in a USSH’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). § 952(c)(1)(A)

De minimis rule

If the sum of FCSI and insurance income is less than the lesser of 5% of gross income or $1M, none of the CFC’s income is FBCI or insurance income. § 954(b)(3)(A)

High Tax Exception

An item of income taxed at more than 90% of the highest US rate (i.e. 35% X 90% = 31.5%) is not FBCI or insurance income. § 954(b)(4)

Same country manufacturing exception from FBCSI

Income from property manufactured (by anyone) in the CFC’s country of incorporation is not FBCSI. § 954(d)(1)(A)

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 FBCSI. § 954(d)(1)(B)

CFC manufacturing exception from FBCSI

Income from the sale of property that the CFC itself manufactures (anywhere) is not FBCSI. Treas. Reg. § 1.954-3(a)(4)

Active financing exception from FPHCI

Qualified income derived by a CFC which is predominantly engaged in the active conduct of a banking, financing or similar business is not FPHCI. § 954(h)

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), as defined under § 864(c), is not FPHCI. § 954(c)(6)

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 FPHCI. § 954(c)(3)

International Information Reporting Requirements

Each year, US taxpayers who have foreign investments, accounts, pension plans, and life insurance policies may be required to report the values of their overseas assets — along with any income generated from them — to the Internal Revenue Service. When a taxpayer misses an international information reporting return deadline, it may lead the IRS to issue fines and penalties. Oftentimes these international penalties can be avoided or abated through one of the offshore voluntary disclosure programs — or other IRS amnesty procedures. It is important to note that not all foreign account filing forms have the same deadlines and due dates — and the process for seeking an extension will vary depending on the type of form. Let’s look at six important facts about foreign account filing deadlines.

FBAR Due Date and Extension

The FBAR is used to report foreign bank and financial accounts to the US Government. The Form is due on April 15, but is currently on automatic extension. Therefore, if you did not file the FBAR (FinCEN Form 114) by April 15, you still have until October to file it. And, you do not have to file an extension form such as Form 4868 or 7004 to obtain the FBAR extension — because the extension is automatically granted.

Form 8938 Due Date and Extension

Form 8938 is used to report foreign assets to the IRS in accordance with FATCA (Foreign Account Tax Compliance Act). It is similar (but not identical) to the FBAR. Form 8938 is filed with your tax return and is due when your tax return is due. If you are an individual filing a Form 1040, then the form 8938 would be due in April along with your 1040 tax return — but if you extend the time to file your tax return, then your Form 8938 will go on extension as well.

Form 3520 Due Date and Extension

Form 3520 is used to report foreign gifts and foreign trust information. The due date for Form 3520 is generally April 15, but taxpayers can obtain an extension to file Form 3520 by filing an extension to file their tax return for that year. Similar to Form 8938, there is no specific Form 3520 extension form required beyond requesting an extension of the underlying tax return.

Form 3520-A Due Date and Extension

Form 3520-A is used to report US ownership of a Foreign Trust. Unlike Form 3520, Form 3520–A is usually due in March and not April. In addition, the rules for filing an extension for Form 3520-A are different as well (subject to the substitute filing rules). In order to extend the due date to file Form 3520-A, the taxpayer must file a separate Form 7004 extension form.

Form 5471 Due Date and Extension

Form 5471 is used to report the ownership of certain foreign corporations. The filing date is the same as when a person’s tax return is due — and if the taxpayer files an extension for the underlying tax return, Form 5471 will go on extension as well. In recent years, Form 5471 has become infinitely more complex — so taxpayers should be cognizant of the different filing requirements and plan accordingly.

Missed Prior Year’s Foreign Account Reporting Deadlines?

If a taxpayer has not properly reported their foreign accounts, assets, or investments in prior years, they may want to wait before filing these documents for the current year. That is because Taxpayers should try to avoid making a quiet disclosure (which may result in significant fines and penalties). To do that, Taxpayers should submit to one of the offshore disclosure programs. Taxpayers may also want to consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in international tax matters before submitting to the IRS to get an understanding of the different requirements.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure. 

Contact our firm today for assistance.