What’s the Definition of a Controlled Foreign Corporation?
Controlled Foreign Corporation (CFC): The controlled foreign corporation (CFC) rules are very complicated. In general, a Controlled Foreign Corporation (CFC) is a type of foreign corporation in which U.S. Persons own more than 50% of the foreign corporation and U.S. shareholders each own at least 10% — attribution rules apply. The IRS has developed a very comprehensive body of law regarding CFCs. The concept of a controlled foreign corporation is not unique to the United States. But, with the recent enactment of TCJA, the introduction of GILTI, and the aggressive position the IRS is taking towards foreign accounts compliance it is important to understand if you have a controlled foreign corporation. A shareholder of a CFC may have a Form 5471 reporting requirement, along with possible FBAR & FATCA reporting. If the taxpayer is already out of compliance for prior years, they may consider various amnesty programs such as the streamlined program or offshore disclosure.
How is a CFC Defined?
A controlled foreign corporation is when a foreign corporation is owned more than 50% by U.S. persons who each own at least 10%. In addition, attribution and constructive ownership rules apply. In other words, while a shareholder may not own a direct share of the controlled foreign corporation, if one spouse owns 15%, of the foreign corporation, the other spouse may then be attributed 15% ownership as well through attribution.
Controlled Foreign Corporation Definition
For those of you who prefer the more technical definition, please refer to the Internal Revenue Code section 952, which is reproduced below.
IRC Section 957
For purposes of this title, the term “controlled foreign corporation” means any foreign corporation if more than 50 percent of —
(1) The total combined voting power of all classes of stock of such corporation entitled to vote, or
(2) The total value of the stock of such corporation, is owned (within the meaning of section 958(a)), or is considered as owned by applying the rules of ownership of section 958(b), by United States shareholders on any day during the taxable year of such foreign corporation.
Purpose of a CFC
The purpose of a CFC is for the Internal Revenue Service to be able to exert some control over income generated by a foreign Corporation that does not necessarily have any U.S.-sourced income. Under the CFC rules, it is important to note that the IRS is not exerting any tax authority over the foreign corporation per se. Rather, the Internal Revenue Service is exerting tax authority over the U.S. shareholders of the controlled foreign corporation. This is most prevalent when a foreign corporation has subpart F income. Subpart F income is highly complex. Once you have completed the basics of a controlled foreign corporation, you should continue on to our other article on subpart F income.
3 (Common) Controlled Foreign Corporation Examples
CFC Examples help explain how the process works. We will keep this relatively simple because there is no need to make it complicated.
David is a U.S. person who owns 100% of a Sociedad Anonima in Portugal. This is a controlled foreign corporation, because David owns more than 50% and at least 10% of the shares.
Michelle is a U.S. person and owns 58% of a Hong Kong Pvt. Limited. This would also be a controlled foreign corporation, because Michelle owns more than 50%, and at least 10% of the shares
Scott’s wife Daniella is a U.S. person who owns 19% of a foreign corporation in Australia (PVT Ltd.), in which three other U.S. persons each own 12%. This is a controlled foreign corporation because the total ownership of the U.S. shareholders exceed 50%. In addition, Scott may also be considered an indirect owner by way of attribution.
These are three common situations in which a foreign corporation may be considered a controlled foreign corporation. As you can imagine, it gets infinitely more complex when there are sister and brother corporations, parent and sibling corporations, and everything in between.
The purpose of the three above examples is just to show you how individual filers may easily be considered owners of a controlled foreign corporation, without ever intending to do so.
Taxation of a CFC
The CFC taxation rules are complex.
When income is distributed, it is generally going to be taxed, unless an exception or exclusion applies.
But, even if the income was not distributed if there are current year earnings and profits (E&P), the U.S. shareholder may still be taxed on their ratable share of Subpart F income, even if that income was not distributed and may never be distributed – see subpart F income and GILTI Rules.
Reporting of a CFC
The most common form used to report a controlled foreign corporation (and other foreign corporations) owned by a U.S. shareholder is Form 5471. There are other forms that may need to be filed as well, but Form 5471 is highly complicated. The IRS estimates it takes about 30 hours to complete the form, which presumes the person has some background in accounting, assets, equities, liabilities, etc..
In addition to filing this form, if the foreign corporation also has foreign bank accounts, the shareholder may also have to file an annual FBAR.
Controlled Foreign Corporation Penalties for Not Reporting
The penalties for not properly reporting these forms can be brutal. But, the Internal Revenue Service has developed various offshore voluntary disclosure programs such as the Streamlined Program, delinquency procedures, and Post-OVDP to assist you.
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