How the Subpart F High Tax Exception Works

The U.S. tax system includes anti-deferral rules to prevent U.S. shareholders from indefinitely deferring U.S. tax on income earned by their foreign corporations. The primary regulations, Subpart F and the Global Intangible Low-Taxed Income (GILTI) regime, treat certain income earned by a Controlled Foreign Corporation (CFC) as if it were immediately distributed to the corporation’s U.S. owners, triggering a current tax liability. These regimes aim to curb the use of low-tax jurisdictions to shield profits from U.S. taxation.

A relief provision known as the high-tax exception exists within this framework. If a CFC’s income has already been subjected to a high rate of tax in a foreign country, this provision allows U.S. shareholders to elect to exclude that income from their Subpart F or GILTI inclusions. This elective relief ensures that income bearing a foreign tax burden comparable to the U.S. rate is not taxed a second time immediately in the United States.

Determining the Effective Foreign Tax Rate

To use the high-tax exception, one must calculate the effective foreign tax rate on specific income. This process is not based on the foreign country’s statutory tax rate but on a formula that compares the actual foreign income taxes paid to the net income as determined under U.S. tax principles. The formula is the U.S. dollar amount of foreign income taxes attributable to an income item divided by the U.S. dollar amount of that net income item.

The numerator of this fraction, “foreign income taxes,” includes taxes paid or accrued by the Controlled Foreign Corporation (CFC) that would be creditable for U.S. foreign tax credit purposes. This means the levy must be an income tax in the U.S. sense, rather than a tax on capital, revenue, or other non-income measures.

The denominator represents the net income item, which is computed according to U.S. tax law. This begins with the gross amount of a particular type of income, such as foreign base company sales income. From this gross figure, any deductions that are properly allocable and apportioned to that income under U.S. Treasury regulations must be subtracted, including direct expenses and a portion of indirect expenses like general and administrative overhead.

For example, consider a CFC that earns $1,000 of gross interest income and pays $250 in foreign income tax on this interest. In earning this income, the CFC incurred $100 of directly related expenses and is allocated an additional $50 of its general overhead expenses. The net item of income under U.S. principles is $850 ($1,000 gross income – $150 total deductions). The effective foreign tax rate is therefore 29.4% ($250 in foreign taxes / $850 in net income).

Applying the High Tax Threshold

Once the effective foreign tax rate for an item of income has been calculated, it is compared against a specific benchmark. The high-tax exception is available only if this calculated rate is greater than 90% of the maximum U.S. corporate income tax rate. This test ensures the exception is reserved for income that has been subject to a tax burden substantially similar to what it would have faced in the United States.

The U.S. federal corporate income tax rate is 21%, which sets the high-tax threshold at 18.9%. An effective foreign tax rate must exceed this 18.9% figure for the associated income to qualify for the exception. A rate of 18.9% or lower does not qualify.

Grouping Rules for Income

The application of the high-tax test is not performed on a CFC’s aggregate income but requires a more granular approach based on a system of “tested units” and income groups. This framework ensures that income subject to a high rate of tax cannot be blended with low-taxed income to qualify the entire pool for the exception. The regulations require taxpayers to first attribute gross income to the correct tested unit and then to group that income into specific categories for testing.

A tested unit is the level at which the high-tax calculation is performed. The primary tested unit is the CFC itself. However, a CFC may have other tested units, such as an interest it holds in a pass-through entity like a partnership, or a foreign branch. Each of these units is treated as a distinct entity for attributing income and the associated foreign taxes.

Within each tested unit, gross income is further segregated into specific income groups before the high-tax test is applied. The grouping rules differ for Subpart F and GILTI. For Subpart F income, the main categories generally align with the types of income, such as foreign personal holding company income and foreign base company sales income. For GILTI, all of the CFC’s income is generally treated as a single income group for testing.

This multi-layered process prevents the blending of taxes between different types of income. A high tax paid on services income, for instance, cannot be used to shelter low-taxed interest income from the Subpart F regime. The U.S. shareholder must calculate the effective tax rate for the interest income group separately from the services income group.

Making the High Tax Election

The high-tax exception is not automatic; an affirmative election must be made to exclude the income. The responsibility for making the election rests with the CFC’s “controlling domestic shareholders.” These are the U.S. shareholders who, in aggregate, own more than 50% of the total combined voting power of all classes of stock entitled to vote and who undertake to act on the CFC’s behalf.

The election is made by attaching a formal statement to a timely filed tax return for the year of the election. Specifically, the statement is attached to the Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” Filing this form and the accompanying election statement with the shareholder’s income tax return by its due date, including extensions, is the required method for making the choice.

The statement must identify the CFC for which the election is being made, typically by name and taxpayer identification number. The statement must also identify the controlling domestic shareholders making the election and describe the income to which the election applies, providing enough detail to show the amounts and character of the income being excluded.

An election made for a particular CFC is binding for the taxable year for which it is made and applies to all U.S. shareholders of that CFC, not just the controlling shareholders who made it. The election is made on an annual basis, providing flexibility from year to year. Taxpayers can choose to make it or not make it in each subsequent year based on what is most advantageous.