Learn about the interplay between foreign corporations and eligibility for lower tax rates available only for “qualified dividends”. It’s a complicated topic and all of the posts in the series should be read in order to understand the ramifications. Access links here Part I, Part II (which appears below) and Part III. Unsurprisingly, many US owners of corporations that are foreign (i.e., not incorporated in the USA) get the short end of the stick when it comes to US tax.
Reproduced below is my post as it appeared (May 5, 2014) on my former blog “Let’s Talk About US Tax” hosted by AngloInfo. (As updated on May 6, 2021)
As detailed in my last blog posting, “qualified dividend income” is taxed at beneficial lower tax rates and can be received from both domestic (US) corporations and certain “qualified” foreign (non-US) corporations. A “qualified foreign corporation” excludes a so-called “Passive Foreign Investment Company” or, PFIC. Subject to this limitation, the term “qualified foreign corporation” means any foreign corporation that is incorporated in a possession of the United States or that is eligible for the benefits of a comprehensive US income tax treaty which the IRS has determined is satisfactory for qualified dividend purposes. In addition, a foreign corporation will be treated as a “qualified’ with respect to any dividend paid by the corporation on stock which is readily tradable on an established securities market in the United States. The Internal Revenue Code does not exclude a so-called “controlled foreign corporation” (CFC) from the definition of a “qualified foreign corporation”.
Can “Controlled Foreign Corporations” (CFC) Distribute “Qualified Dividend Income”?
Special rules apply to distributions from CFCs. Before detailing these rules, a bit of background about CFCs will be helpful.
Since a foreign corporation is not a US taxpayer, income earned by a foreign corporation from its foreign operations generally is subject to US tax only when that income is distributed to its US shareholder. As such, a US person that is a shareholder in a foreign corporation is generally not taxed on the income earned by the foreign corporation until that income is distributed to the shareholder as a dividend. The US tax law, however, contains a variety of “anti-deferral” tax regimes. If the CFC tax regime applies, it can subject the US shareholder to US tax on income earned by the foreign corporation even if that income is not actually distributed to the shareholder. These rules prevent US taxpayers from otherwise deferring payment of tax by keeping profits within a foreign corporation that is itself, not subject to the reach of the US taxman.
What is a CFC? How do the CFC Rules Work?
The Tax Cuts and Jobs Act (TCJA) changed certain definitions such that more foreign corporations will likely be characterized as CFCs. A CFC is a foreign corporation which is more than 50% owned by so-called “United States shareholders,” by vote or by value. A “United States shareholder” is any US person who owns 10 percent or more of the total value of shares of all classes of stock of the foreign corporation or who owns 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation. The new definition is effective for taxable years of foreign corporations beginning after December 31, 2017, and for taxable years of United States shareholders in which or within which those taxable years of foreign corporations end. See IRC Section 951(b).
United States shareholders of CFCs are required to include in their gross income, on a current basis, their proportionate share of certain income earned by the CFC. This is a special type of income and is referred to as “Subpart F income”. The US shareholder’s proportionate share of this Subpart F income is taxed to the shareholder currently on his US tax return, regardless of whether that income was actually distributed by the CFC to its shareholders in the year the income was earned. There are numerous different categories of Subpart F income, and the rules are exceedingly complex. One type of Subpart F income is “foreign personal holding company income “( e.g., dividends, interest, annuities and other types of specified passive income); other types include so-called “foreign base company sales income”, “foreign base company services income”, and certain insurance income.
The amounts included on a current basis in a US shareholder’s income are limited to the shareholder’s pro rata share of the current earnings and profits of the CFC (in other words, it is taxed as if it were a dividend distribution from the corporation). When income of a CFC has been included in the gross income of its United States shareholder under the anti-deferral regime, a special Code section ensures that it is not again included in his gross income when it is actually distributed at a later time.
If all or any part of the CFC’s income is not Subpart F income, this “untainted” income is not subject to the anti-deferral regime (however it can be taxed under TCJA’s “GILTI” tax regime). Any income of a CFC that is not included in the gross income of its United States shareholders under the anti-deferral/GILTI regime is not subject to US tax as income of the United States shareholder until it is actually paid out to the shareholder as a dividend.
In addition to these rules, under Code section 1248, a United States shareholder of a CFC that sells stock in the CFC is generally required to report any recognized gain from the sale of the stock as a dividend to the extent of the untaxed undistributed earnings and profits of the CFC.
Whether any Supbart F current inclusions, dividends and gain on the sale of CFC stocks is eligible for the beneficial US tax treatment as “qualified dividend income” will be detailed in the next blog posting.
Posted October 4, 2018
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