How Section 957 Defines a Controlled Foreign Corporation

In United States international tax law, classifying a foreign corporation as a Controlled Foreign Corporation (CFC) is a foundational concept. This designation carries significant consequences for any U.S. person with an ownership stake, as it determines when a foreign entity’s U.S. connection warrants Internal Revenue Service (IRS) attention.

Understanding if a foreign entity is a CFC is a primary step for U.S. individuals and businesses with global operations. The classification triggers specific tax and reporting duties, and failing to correctly identify a CFC can lead to compliance oversights and financial penalties.

Defining a Controlled Foreign Corporation

A foreign corporation’s classification as a CFC begins with identifying its U.S. shareholders. The Internal Revenue Code (IRC) defines a “U.S. shareholder” as a U.S. person—an individual, corporation, partnership, trust, or estate—who owns 10% or more of the foreign corporation’s stock. This 10% threshold can be met by owning either 10% of the total combined voting power or 10% of the total value of all stock classes.

Once U.S. shareholders are identified, the main test for CFC status is applied. A foreign corporation is designated a CFC if, on any day of its tax year, its U.S. shareholders collectively own more than 50% of the company’s stock. This control is measured by two criteria: the “vote test” and the “value test,” meaning the 50% threshold applies to either total voting power or total stock value.

The vote test focuses on the ability to govern corporate policy, while the value test looks at the economic ownership of the company. This dual approach prevents taxpayers from using complex share structures, such as creating non-voting stock classes, to avoid CFC status. For example, a foreign corporation could be a CFC if U.S. shareholders own 40% of the vote but 60% of the total value.

Understanding Stock Ownership and Attribution Rules

Determining if the 50% control threshold is met requires analyzing stock ownership beyond shares held in a person’s name. The rules aggregate holdings among related parties to reflect economic reality. Ownership is categorized into three types: direct, indirect, and constructive.

Direct Ownership

Direct ownership is the most straightforward type, referring to stock a U.S. person holds in their own name. For example, a U.S. citizen who purchases and holds shares of a foreign corporation is a direct owner.

Indirect Ownership

Indirect ownership involves owning stock through a foreign entity, such as a corporation, partnership, or trust. A person is considered to own their proportionate share of stock held by that foreign entity. For instance, if a U.S. individual owns 50% of a foreign holding company that in turn owns 80% of a foreign operating company, the individual indirectly owns 40% of the operating company.

Constructive Ownership

Constructive ownership rules attribute stock ownership between related parties. A person is treated as owning stock that is actually held by family members or controlled entities. For example, an individual is considered to own stock held by their spouse, children, grandchildren, and parents.

Another constructive ownership rule involves “downward attribution,” which was expanded by the Tax Cuts and Jobs Act of 2017 (TCJA). Under this rule, stock owned by a foreign person can be attributed downward to a related U.S. entity. For example, if a foreign parent owns both a U.S. subsidiary and a foreign subsidiary, the U.S. subsidiary may be treated as owning the foreign subsidiary’s stock. This change expanded the number of entities classified as CFCs.

Tax Implications of CFC Status

CFC status has direct U.S. tax consequences for its U.S. shareholders, primarily by eliminating the tax deferral on certain foreign income. U.S. shareholders must include their pro-rata share of specific CFC earnings in their taxable income for the year, even if the money is not distributed as a dividend. This income is taxed currently in the U.S. and is generally not taxed again when later distributed.

This anti-deferral system is enforced through two income inclusion regimes: Subpart F income and Global Intangible Low-Taxed Income (GILTI). These systems capture different types of a CFC’s earnings to ensure they are subject to U.S. taxation.

Subpart F Income

The Subpart F regime targets income that is passive or easily shifted to low-tax jurisdictions. This includes earnings from sources like dividends, interest, rents, and royalties, as well as certain sales and services income from related-party transactions. The goal is to prevent taxpayers from using a foreign entity to hold passive investments or route sales solely to avoid U.S. tax. Exceptions exist for small amounts of Subpart F income and for income already subject to a high foreign tax rate.

Global Intangible Low-Taxed Income (GILTI)

Introduced by the TCJA in 2017, the GILTI regime is a broad anti-deferral provision that acts as a backstop to Subpart F. GILTI is designed to tax the active business income of a CFC that exceeds a presumed return on its tangible assets. The calculation is complex, but the result is an amount of GILTI that is included in the U.S. shareholder’s income. For corporate U.S. shareholders, the GILTI tax rate is effectively reduced, and they can claim a credit for a portion of the foreign taxes paid by the CFC.

Reporting and Compliance Obligations

Ownership in a CFC triggers information reporting requirements to give the IRS a clear view of the entity’s finances and ownership. The primary document is Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. Filing this form often requires detailed financial statements, including a balance sheet and income statement prepared under U.S. accounting principles.

The obligation to file Form 5471 falls on U.S. persons meeting specific ownership or control criteria. For example, a U.S. shareholder of a CFC may be required to file if they own stock for at least 30 consecutive days during the year and on the last day of the year. The form is an attachment to the U.S. person’s annual income tax return, with a separate form required for each foreign corporation.

The IRS imposes penalties for failing to file Form 5471 on time or for filing an incomplete form. The base penalty is $10,000 for each annual accounting period of each foreign corporation. If the failure continues for more than 90 days after an IRS notice, an additional penalty of $10,000 is charged for each 30-day period, up to a maximum of $50,000. Timely and accurate compliance is necessary to avoid these penalties.