Subpart F Income: The IRS Rules for Subpart F Income, CFC, and U.S. Shareholder Foreign Earnings analysis is very complicated. Essentially, Subpart F Income is involves CFC (Controlled Foreign Corporations) that accumulate certain, specific types of income (primarily passive income).
When a CFC has Subpart F income under IRC Section, that means the U.S. shareholders may have to pay tax on the earnings. The kicker is that the ratable share of Subpart F income may be attributable to the U.S. shareholder, even if the income is never distributed to the shareholder.
*Subpart F Income overlaps with various other related issues, such as Form 5471, GILTI, and PFIC. And, with the Internal Revenue Service taking an aggressive position on issues involving Foreign Accounts Compliance and Unreported Foreign Income — compliance is important to avoid offshore penalties.
Subpart F Income
We will summarize the basics of Subpart F Income and interaction with CFC rules.
What is Subpart F Income?
Subpart F income is codified under 26 U.S.C. 952.
As provided by the IRS
A foreign corporation is a CFC for a particular year if on any day during such year U.S. shareholders own
(1) more than 50% of the total combined voting power of all classes of the corporation’s stock entitled to vote (voting test), or
(2) more than 50% of the total value of all classes of the corporation’s stock (value test). I.R.C. § 957
A U.S. shareholder is a U.S. person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation.
I.R.C. § 957(c) defines the term “U.S. person” for purposes of Subpart F by referencing the definition in I.R.C. § 7701(a)(30), which defines a U.S. person as any of the following: U.S. citizen/resident, domestic partnership, domestic corporation, or any estate/trust that is not a foreign estate/trust as defined in I.R.C. § 7701(a)(31).
What are the Different Types of Subpart F Income?
There are various different types of Subpart F Income:
FBCSI (Foreign Base Company Sales Income)
One of the abuses that Subpart F is intended to prevent is U.S. shareholders using their CFCs to shift sales income from the U.S. to foreign jurisdictions to avoid U.S. tax.
The FBCSI rules of Subpart F address this abuse.
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.
FBC Services Income (Foreign Based Company Services Income)
Another area of abuse is where a service corporation is separated from the activities of a related corporation and organized in another country primarily to obtain a lower rate of tax for the service income.
Subpart F addresses this abuse by requiring the U.S. shareholder to include its pro-rata share of the CFC’s FBC Services Income in income currently
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)
FPHCI (Foreign Personal Holding Company Income)
When Congress enacted Subpart F, it recognized the need for U.S. businesses with active business operations abroad to be on equal competitive footing from a tax standpoint with other operating businesses in the same countries.
However, 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 its pro-rata share of the CFC’s FPHCI in income currently.
FPHCI generally includes a CFC’s income from dividends, interest, annuities, rents, royalties, and net gains on dispositions of property, and many more.
IRM 4.61.7: How is Subpart F Income Calculated?
The IRM (Internal Revenue Manual) provides how Subpart F is evaluated and calculated. Some of the key paragraphs, include:
22.214.171.124.2 (10-08-2019): Limitation as to Earnings and Profits
- Subpart F income includible in gross income by a U.S. shareholder for any taxable year may not exceed the CFC’s earning and profits for the taxable year. IRC 962(c)(1)(A) and IRC 951A(c)(2)(B)(ii).
- In the computation of earnings and profits determine that earnings and profits are reported according to U.S. standards. See IRC 964(a) and the regulations thereunder. However, for purposes of IRC 952(c), earnings and profits will be determined without regard to IRC 312(n)(4), IRC 312(n)(5), and IRC 312(n)(6) (the preceding clause will not apply to the extent it would increase earnings and profits by an amount which was previously distributed by the CFC).
- The limitation described in IRM 126.96.36.199(1) does not apply to amounts of post-1986 earnings and profits included in subpart F income with respect to a DFIC. For purposes of IRC 965, an SFC’s post-1986 earnings and profits are earnings and profits accumulated in taxable years beginning after December 31, 1986, but only taking into account periods during which the foreign corporation was an SFC and without diminution by reason of dividends distributed during the inclusion year other than dividends distributed to another SFC.
188.8.131.52 (10-08-2019): Certain Prior Year Deficit
The amount of subpart F income included in the U.S. shareholder’s gross income may be reduced by his pro rata share of the CFC’s prior year qualified deficits. IRC 952(c)(1)(B).
- A qualified deficit is post-1986 deficit in earnings and profits that is attributable to the same qualified activity as the activity giving rise to the income to be offset and which has not previously been taken into account. See IRC 952(c)(1)(B)(ii).
- A qualified activity is any activity giving rise to 1) foreign base company sales income, 2) foreign base company services income, 3) in the case of a qualified insurance company, insurance income or foreign personal holding company income or 4) in the case of a qualified financial institution, foreign personal holding company income. See IRC 952(c)(1)(B)(iii).
For purposes of IRC 965, an EPDFC is, with respect to any taxpayer, a SFC with respect to which the taxpayer is a U.S. shareholder, if, as of November 2, 2017, the SFC has a deficit in post-1986 earnings and profits. For purposes of determining whether a SFC is an EPDFC, all post-1986 earnings and profits must be taken into account.
Attribution and Constructive Ownership
Attribution and Constrictive Ownership Rules are very complicated. When a person (or other company) is deemed to have constructive ownership, it means that while the person may no directly own the stock, they are deemed to own the stock by way of constructive ownership
In accordance with IRC 958
(b) Constructive ownership
For purposes of sections 951(b), 954(d)(3), 956(c)(2), and 957, section 318(a) (relating to constructive ownership of stock) shall apply to the extent that the effect is to treat any United States person as a United States shareholder within the meaning of section 951(b), to treat a person as a related person within the meaning of section 954(d)(3), to treat the stock of a domestic corporation as owned by a United States shareholder of the controlled foreign corporation for purposes of section 956(c)(2), or to treat a foreign corporation as a controlled foreign corporation under section 957, except that—
(1) In applying paragraph (1)(A) of section 318(a), stock owned by a nonresident alien individual (other than a foreign trust or foreign estate) shall not be considered as owned by a citizen or by a resident alien individual.
(2) In applying subparagraphs (A), (B), and (C) of section 318(a)(2), if a partnership, estate, trust, or corporation owns, directly or indirectly, more than 50 percent of the total combined voting power of all classes of stock entitled to vote of a corporation, it shall be considered as owning all the stock entitled to vote.
(3) In applying subparagraph (C) of section 318(a)(2), the phrase “10 percent” shall be substituted for the phrase “50 percent” used in subparagraph (C). Paragraph (1) shall not apply for purposes of section 956(c)(2) to treat stock of a domestic corporation as not owned by a United States shareholder.
CFC vs. PFIC Rules
There are some overlap rules with CFC and PFIC. A PFIC is Passive Foreign Investment Company. The income of a PFIC may be considered similar to Subpart F, but the CFC (Controlled Foreign Corporation) rules are not required.
GILTI vs. Subpart F Income
GILTI is not the same as Subpart F income, but some of the categories of GILTI (Global Low-Taxed Intangible Income) are similar to Subpart F Income. There are rules and regulations still being considered to make sure U.S. persons are not overtaxed.
Form 5471 is used to report certain foreign corporations. A foreign corporation does not need to be “Controlled,” for reporting purposes. The 5471 Form is very complex, and has various different schedules to be filed, depending on what category the filer qualifies as. A person may qualify for various different categories, which would result in many different schedules being filed – including schedules that detail Subpart F income.
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