Exceptions to Foreign Personal Holding Company Income §1.954-2

U.S. tax law includes Subpart F provisions designed to prevent the deferral of U.S. tax on certain income earned by foreign corporations controlled by U.S. shareholders. These rules target mobile or passive income that could otherwise be accumulated in low-tax jurisdictions. A primary category of this income is Foreign Personal Holding Company Income (FPHCI), which includes dividends, interest, rents, royalties, and certain gains. U.S. shareholders of a Controlled Foreign Corporation (CFC) must include their share of FPHCI on their tax returns in the year it is earned, regardless of whether the cash is distributed. While the definition of FPHCI is broad, the Internal Revenue Code provides specific exceptions for income that is not generated from passive activities.

The Active Rents and Royalties Exception

The default rule under Subpart F treats rental and royalty income received by a Controlled Foreign Corporation (CFC) as Foreign Personal Holding Company Income (FPHCI). This classification subjects the income to immediate taxation for the CFC’s U.S. shareholders. An exception exists for rents and royalties derived from the active conduct of a trade or business, acknowledging that a CFC can earn this income through legitimate operations rather than passive investment. To qualify, the CFC must meet specific tests outlined in the Treasury Regulations, which provide separate criteria for rental and royalty income.

Exception for Rents

For rental income to be considered active, the CFC must satisfy one of several tests. One path is for the CFC to have manufactured or produced the property it is leasing, making the rental income an extension of its primary production activities.

A second test allows a CFC to qualify if it acquires and adds substantial value to the property it leases. The regulations establish a quantitative threshold, requiring that the costs the CFC incurs to add value are more than 100 percent of the property’s adjusted basis at the time of acquisition.

A third avenue involves the CFC deriving rental income from property that it actively markets and services. This test requires the CFC to maintain and operate an organization in a foreign country that regularly engages in these activities, and this organization must be substantial in relation to the rents derived. A safe harbor exists where active leasing expenses, such as salaries, equal or exceed 25 percent of the adjusted leasing profit.

Exception for Royalties

Similar to the rules for rents, royalty income is FPHCI unless it meets an active business exception. The most direct way is for the CFC to have developed, created, or produced the intangible property (IP) from which the royalties are derived. If the CFC’s own officers and employees create the patent, copyright, or other IP, the resulting royalty stream is considered active business income.

Alternatively, a CFC can acquire IP and qualify for the exception if it adds substantial value to it. This requires the CFC to perform development or marketing activities that enhance the IP’s value. The CFC’s development expenditures must equal or exceed 50 percent of the compensation it paid to acquire the IP rights.

The regulations also provide a marketing-focused test. A CFC can treat royalty income as active if it is derived from IP that the CFC actively markets through a substantial organization. A safe harbor is met if the CFC’s marketing expenses are at least 25 percent of its adjusted royalty profit, which is gross royalty income less amortization and related costs.

The Export Financing Interest Exception

Interest income earned by a Controlled Foreign Corporation (CFC) is presumptively categorized as Foreign Personal Holding Company Income (FPHCI). A narrow exception exists for “export financing interest,” which allows certain income related to financing U.S. exports to be excluded from FPHCI. This provision aligns tax policy with trade policy by encouraging foreign banking subsidiaries to finance the sale of U.S. products abroad.

To qualify, the interest must meet several conditions. First, it must be derived in the active conduct of a banking business by the CFC, ensuring the entity is a legitimate financial institution. Second, the interest must be associated with financing the sale of property for use or consumption outside the United States. Finally, the property being financed must be manufactured, produced, grown, or extracted in the United States by the borrower or a person related to the borrower.

The Dealer Exception

Gains from the sale of property that produces passive income, such as stocks or bonds, are treated as Foreign Personal Holding Company Income (FPHCI). An exception exists for income earned by a regular dealer in such property. To qualify, the Controlled Foreign Corporation (CFC) must be a “dealer,” defined as a person who regularly purchases and holds property with the principal purpose of selling it to customers in the ordinary course of a trade or business.

The dealer exception covers several types of income. This includes not only the gains from the sale of the dealer’s inventory property but also interest, dividends, or equivalent amounts earned on that property before its sale. The CFC must have an established, ongoing business of buying and selling the specific property, complete with inventory and regular customer transactions.

For example, consider a CFC that operates as a securities brokerage firm in a foreign country, holding stocks and bonds in inventory to sell to clients. When the CFC sells these securities at a profit, the gain is not FPHCI because it arises from its ordinary business operations. Any interest or dividends received on these securities while held as inventory are also excluded from FPHCI.