Controlled Foreign Corporation (CFC) Rules – A Tax Guide

Can a US person who owns shares in a foreign corporation be subject to current taxation on the undistributed earnings and profits of that foreign corporation?

The short answer is yes, it is possible – but as with most US tax matters, the answer depends on the specific facts and circumstances of each case.

What is a Controlled Foreign Corporation (CFC)?

Under general US tax rules, foreign corporations are subject to US tax only if they earn income that is effectively connected with a US trade or business, or if they have US-source income. As a result, a foreign corporation that earns only foreign income is generally not taxed in the United States.

Likewise, US shareholders of a foreign corporation are typically not taxed on the corporation’s earnings until those earnings are distributed as dividends.

However, the Controlled Foreign Corporation (CFC) rules are an important exception. These rules require certain US shareholders to include in their taxable income specific types of undistributed earnings of a foreign corporation – even if no cash distribution has been made.

The CFC Rules Explained

The CFC regime modifies the usual “deferral” of taxation on foreign corporate income. Three threshold requirements must be met before undistributed earnings can be taxed currently:

1. The foreign corporation must be a CFC – generally, a foreign corporation in which US shareholders own more than 50% of either (a) the total combined voting power of all classes of stock entitled to vote, or (b) the total value of the stock, at any time during the taxable year.
2. The shareholder must be a US shareholder – a “US shareholder” is defined as any US person (including corporations, partnerships, trusts, estates, or individuals) who owns at least 10% of the total combined voting power or value of the foreign corporation’s stock.
3. The CFC must have certain types of income or investments – such as Subpart F income, investments in US property, or GILTI.

Ownership can be direct, indirect, or constructive, meaning stock may be attributed through entities, family members, or option holdings. Importantly, stock owned by non-US individuals (other than certain foreign trusts or estates) is not attributed to US individuals.

What are the CFC Requirements and Regulations?

The Tax Cuts and Jobs Act of 2017 (TCJA) significantly affected CFC rules by repealing the limitation on “downward attribution.” This change means that foreign corporations previously not considered CFCs – and US persons previously not considered US shareholders – may now fall within the CFC regime.

What is CFC Income?

US shareholders of a CFC are required to include in current taxable income their pro rata share of certain categories of income or investment, specifically:

• Subpart F income
• Investments in US property (known as a Section 956 inclusion)
• Global Intangible Low-Taxed Income (GILTI)

Subpart F Income Explained

Subpart F income is designed to prevent US taxpayers from sheltering passive or mobile income in foreign corporations. It primarily includes:

• Dividends, interest, rents, and royalties
• Certain foreign currency or commodity gains
• Gains from the sale of property that produces passive income

There are important exceptions:

• The “de minimis” rule allows a CFC to have a small amount of Subpart F income ( reduced by the lesser of 5% of gross income or $1 million) without triggering inclusion.
• Certain income between related CFCs may also be excluded if earned within the same country or where the lower-tier CFC is engaged in an active business.

Subpart F income is taxed at ordinary income tax rates for individuals (i.e., as non-qualified dividends).

Investment in US Property

Another way US shareholders may be taxed currently is if the CFC invests in US property. Examples include:

1. Loans by the CFC to a US shareholder
2. Purchase of stock in a related US corporation
3. Establishment of a US branch using foreign earnings
4. Use or license of intangible property in the US

After TCJA, most corporate US shareholders no longer have Section 956 inclusions, but individual US shareholders may still have to include these amounts.

Example: If a CFC loans money to its US individual shareholder, that loan may be treated as a taxable dividend to the extent of the CFC’s earnings and profits.

Understanding GILTI

Global Intangible Low-Taxed Income (GILTI) is another anti-deferral regime introduced by the TCJA.

• GILTI is the excess of a US shareholder’s net CFC tested income over the net deemed tangible income return (10% of the shareholder’s share of the CFC’s qualified business asset investment, or QBAI).
• QBAI generally includes depreciable tangible property used in the CFC’s trade or business.
• Tested income is the CFC’s gross income minus allocable deductions (including foreign income taxes).

Taxation of Previously Taxed Income (PTI)

Amounts already taxed under Subpart F or GILTI rules become Previously Taxed Income (PTI). When PTI is later distributed, it is not subject to additional US taxation.

Foreign Tax Credits for CFCs

US corporate shareholders can claim a deemed paid foreign tax credit for taxes paid by the CFC on amounts included in US taxable income.

Individual US shareholders may elect to be taxed as a corporation for purposes of Subpart F and GILTI income, allowing them to benefit from corporate tax rates and claim deemed foreign tax credits.

Key Takeaways

The CFC rules are complex and can result in current US taxation of foreign earnings even when no dividends have been distributed. Whether these rules apply depends on the share ownership structure, type of income, and other facts.

If you own shares in a foreign corporation and are unsure whether CFC rules apply to you, professional tax advice is essential.

Need help navigating the CFC rules?

Our experienced international tax team can guide you through CFC analysis, GILTI calculations, and foreign tax credit planning. Contact us today for tailored advice.

Article written by Bradley Albin