Defining Foreign Base Company Income Under Section 954

The United States international tax system allows U.S. companies to defer paying U.S. tax on the profits of their foreign subsidiaries until those earnings are repatriated. This created opportunities for companies to shift mobile income, like interest or royalties, to corporations in low-tax jurisdictions. To combat this, Congress enacted anti-deferral rules, including the Subpart F regime in 1962. The Subpart F provisions identify specific income types earned by foreign subsidiaries that are subject to immediate U.S. taxation. U.S. owners are taxed on their share of this income in the year it is earned, eliminating the deferral benefit by treating it as a dividend.

Defining a Controlled Foreign Corporation

The Subpart F rules apply only to entities defined as Controlled Foreign Corporations (CFCs). A foreign corporation is classified as a CFC if more than 50% of its stock is owned by U.S. Shareholders on any day of its tax year. This ownership test considers either the total combined voting power or the total value of the stock.

A U.S. Shareholder is a U.S. person, such as a citizen, resident, or domestic corporation, that owns at least 10% of the foreign corporation’s stock by vote or value. To determine if an entity is a CFC, the ownership percentages of all its U.S. Shareholders are added together. If their combined ownership exceeds 50%, the entity is a CFC.

Categories of Foreign Base Company Income

The core of the Subpart F regime is identifying Foreign Base Company Income (FBCI), which is income easily shifted between jurisdictions to minimize taxes. FBCI is composed of several categories that target passive earnings and certain related-party transactions. The primary types are Foreign Personal Holding Company Income, Foreign Base Company Sales Income, and Foreign Base Company Services Income.

Foreign Personal Holding Company Income

Foreign Personal Holding Company Income (FPHCI) captures passive income not derived from an active trade or business, such as dividends, interest, royalties, rents, and annuities. For example, if a CFC earns interest from a bank account or receives dividends from stock it owns, that income is FPHCI. The purpose of this rule is to prevent U.S. taxpayers from holding passive, income-generating assets in a low-tax foreign corporation to defer U.S. tax.

Foreign Base Company Sales Income

Foreign Base Company Sales Income (FBCSI) prevents using a foreign subsidiary as a sales intermediary to avoid taxes. FBCSI arises from the purchase or sale of personal property if the transaction involves a related person, and the property is manufactured and sold for use outside the CFC’s country of incorporation. A related person can be a parent, subsidiary, or commonly controlled entity.

For example, a U.S. parent manufactures a product and sells it to its Swiss CFC subsidiary. The Swiss CFC then sells the product to a customer in France. The income the Swiss CFC earns is FBCSI because the property was purchased from a related person and was manufactured and sold for use outside of Switzerland.

Foreign Base Company Services Income

Foreign Base Company Services Income (FBCSvcI) targets income from services a CFC performs for a related person outside the country where the CFC is organized. This rule prevents routing services income through a subsidiary in a low-tax jurisdiction when the services have no connection to that location. For example, a U.S. parent company contracts to provide consulting services to a customer in Germany. The U.S. parent has its Bermuda CFC subsidiary perform the work. The income earned by the Bermuda CFC is FBCSvcI because the services were for a related person and performed outside Bermuda.

Key Exceptions and Special Rules

After identifying the gross amount of Foreign Base Company Income, a series of rules and exceptions can modify or eliminate the amount subject to current U.S. taxation. These rules provide relief where the potential for tax avoidance is low. The primary exceptions are the de minimis rule, the full inclusion rule, and the high-tax exception.

The De Minimis Rule

The de minimis rule provides a safe harbor for CFCs with a small amount of FBCI. None of a CFC’s income is treated as FBCI if its gross FBCI for a tax year is less than the lesser of two amounts: 5% of the CFC’s total gross income or $1 million. For example, if a CFC has $10 million in gross income and its FBCI is $400,000, it meets the rule. The $400,000 is not treated as FBCI because it is less than both $500,000 (5%) and $1 million.

The Full Inclusion Rule

The full inclusion rule applies to CFCs with a high concentration of FBCI. If a CFC’s gross FBCI exceeds 70% of its total gross income for the year, then the CFC’s entire gross income is treated as FBCI. For instance, if a CFC has $2 million in gross income and $1.5 million is FBCI, the 70% threshold ($1.4 million) is exceeded. As a result, the entire $2 million of gross income is reclassified as FBCI.

The High-Tax Exception

The high-tax exception prevents the Subpart F rules from applying to income already taxed at a high rate in a foreign country. An item of income is excluded from FBCI if it was subject to a foreign income tax rate greater than 90% of the maximum U.S. corporate tax rate (currently 21%). This means the foreign tax rate must exceed 18.9%. For example, interest income taxed at 20% in a foreign country would qualify for this exception.

Taxation and Reporting of Subpart F Income

The Deemed Dividend

A U.S. Shareholder of a CFC must include their pro-rata share of the corporation’s Subpart F income in their tax return for the year. This inclusion is required even if the CFC does not actually distribute any cash or property to its shareholders.

Reporting Requirements

The primary tool for administering these rules is IRS Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. U.S. Shareholders of CFCs must file this form annually with their income tax returns. Form 5471 is a detailed report that discloses the CFC’s financial information, such as its balance sheet and income statement. The form is used to calculate the U.S. Shareholder’s pro-rata share of any Subpart F income.