My earlier blog post introduced readers to the concepts of so-called CFCs and PFICs and some of the downsides of owning a “foreign” corporation. It analogized to quicksand simply because it is very easy to be swallowed up in harsh tax results and onerous reporting obligations if planning is not undertaken beforehand.
I will remind readers on a point that is often overlooked: any entity that is not created under US law is treated as “foreign” for purposes of the US tax rules. This remains so even if it is an entity created in the country where you may reside or run your business, or of which you may also be a citizen. Today’s post provides further detail on these topics.
What is a “Controlled Foreign Corporation” (CFC)?
A foreign corporation is a CFC when more than 50 percent of the voting power or value of its shares is owned by “U.S. shareholders”. A “United States shareholder” is generally a US person owning 10% or more of the voting power of the corporation. US shareholders of a CFC are taxed on a current basis on certain types of income (generally referred to as “Subpart F” income) earned by the CFC even though the CFC has not made an actual distribution to the shareholder. Furthermore, this income is taxed at ordinary income rates even if it would have been treated as capital gain (possibly taxed at lower tax rates) had it been earned directly by the shareholder.
It is very common to see a CFC earning Subpart F income when the corporation is primarily engaged in passive investment activities and earning investment and capital gain income. In this case, the US shareholders of the CFC will be required to pay tax on the Subpart F income in the tax year it is earned by the corporation even if no distribution is made to the shareholder by the company. Certain related-party transactions can also give rise to Subpart F income, for example, when sales income is earned on sales that are made for or on behalf of parties related to the CFC or when service fees earned by the corporation are due to related party services.
What is a “Passive Foreign Investment Company” (PFIC)?
A foreign corporation will be classified as a PFIC if it satisfies the requirements of either the income test or the asset test:
The “Income Test” is met if 75 percent or more of a foreign corporation’s gross income for a particular taxable year is treated as “passive”. The “Asset Test” is met if 50 percent or more of the average value of a foreign corporation’s assets either produce or are held for the production of “passive income”. Under a published IRS Notice, the asset test is applied on a gross basis, without taking into account any liabilities, even those that are secured or traceable to assets.
For both tests, “passive income” is defined under the tax laws by reference to a certain category of Subpart F income delineated under the CFC rules. Passive income generally includes:
Dividends, interest, royalties, rents and annuities;
- Excess of gains over losses from the sale / exchange of property in certain cases;
- Excess of gains over losses from transactions in any commodities;
- Excess of foreign currency gains over foreign currency losses;
- Interest income & amounts equivalent to interest;
- So-called personal service contract income (this can often apply to the small foreign corporation that is owned by a single employee-owner that contracts with its customers to supply his expertise).
Once a corporation qualifies as a PFIC, adverse tax consequences can result to its US person shareholders upon either of two events: when they dispose of their stock in the PFIC or when they receive a so-called “excess distribution” from the PFIC. The onerous tax consequences are imposition of a special tax and an interest charge (compounded daily) upon any of the two events. The combination of these charges can be astronomical and wipe out an investment.
Generally, from a US tax perspective, it is far worse if a taxpayer holds shares in a PFIC than in a CFC. Importantly, the CFC regime will take precedence over the PFIC regime in cases of overlap of the two sets of rules. CFC rules prevail if the corporation qualifies as a CFC and while it is so qualified, the US person also qualifies as a so-called “US shareholder” of the CFC (generally a shareholder owning 10% or more of the CFC’s stock).
Sometimes taxpayers think they can circumvent the CFC or PFIC rules by having shares held in other entities or by other family members. These types of arrangements will generally fail. Both the PFIC and CFC rules examine not only the direct ownership of shares of the foreign corporation owned outright by the US person, but under special extremely complex rules, ownership by certain family members and entities is also attributed to the US person. For example, under “family attribution rules” that apply to CFCs, an individual is generally deemed to “constructively” own shares that are owned directly or indirectly by or for that person’s spouse, children, grandchildren and parents. In applying these family attribution rules, however, stock owned by a nonresident alien individual is not considered as being owned by the US person.
Another Big Downside – Tax-Related Reporting and Record-Keeping Rules
There are significant record-keeping and reporting burdens imposed on US owners of CFC or PFIC shares. Form 5471 is one reporting form that involves significant disclosure depending on the “Category of Filer” status that the person meets.
For example, each US person that controls a foreign corporation and each 10% “U.S. shareholder” of a CFC is required to annually file this form to report its interest in the corporation and to report certain transactions with the entity. Each US person that acquires a 10% or larger interest in a foreign corporation (or disposes of sufficient interest to go below 10%) must file the Form 5471 to report the acquisition or disposition of the foreign corporation’s stock. With regard to a PFIC, US shareholders of a PFIC must file Form 8621 annually; itrequires significant disclosure. The Form can be accessed here.
In addition, depending on the circumstances, additional filing requirements may arise. See for example, Form 926, “Return of a US Transferor of Property to a Foreign Corporation,” to report transfers of property to a foreign corporation, including certain transfers of cash; Form 5713 must be completed for a US shareholder in a corporation that has operations in a so-called “boycotting country” (including for example, the UAE, or Saudi Arabia). Form 5713 can be accessed here.
Posted November 5, 2018
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