Section 954(b)(4): The High-Tax Income Exception

U.S. tax rules are designed to address income earned by foreign corporations owned by U.S. persons. These provisions prevent the indefinite deferral of U.S. tax on certain mobile or passive income earned abroad. When U.S. persons control a foreign entity, the IRS can tax some of that foreign income currently, even if the money is not brought back to the United States. However, a relief provision exists for income that is already subject to a significant foreign tax. This exception allows U.S. owners to exclude certain foreign earnings from their U.S. taxable income if the income has been taxed abroad at a high rate.

Foundational Concepts for the High-Tax Exception

Controlled Foreign Corporation (CFC)

A Controlled Foreign Corporation (CFC) is a foreign corporation where U.S. shareholders, who each own at least 10% of the voting stock, collectively own more than 50% of the corporation’s stock. This 50% threshold is tested by either voting power or total stock value. The ownership rules include direct, indirect, and constructive ownership, where stock is attributed from related persons.

Once a foreign corporation is classified as a CFC, its U.S. shareholders become subject to rules that can require them to include certain types of the CFC’s income in their own U.S. taxable income. This inclusion occurs regardless of whether the foreign corporation makes a distribution to them. The purpose of the CFC rules is to limit the ability of U.S. taxpayers to shift income to low-tax foreign jurisdictions to avoid U.S. taxation.

Subpart F Income

Subpart F income is a category of a CFC’s earnings that U.S. shareholders must include in their gross income currently. These rules target income that is passive or easily shifted between countries to avoid tax. The main category is “foreign base company income,” which includes foreign personal holding company income (dividends, interest, rents, and royalties), foreign base company sales income, and foreign base company services income.

These provisions target transactions that lack economic substance, such as when a CFC in a low-tax country buys goods from a related party and sells them to another. The Subpart F rules treat this income as if it were distributed to the U.S. shareholders, subjecting it to immediate U.S. tax.

Global Intangible Low-Taxed Income (GILTI)

The Tax Cuts and Jobs Act of 2017 introduced Global Intangible Low-Taxed Income (GILTI), a category of foreign income subject to current U.S. taxation. The GILTI regime is broader than Subpart F and acts as a minimum tax on the foreign earnings of CFCs. It is designed to discourage shifting profits from intangible assets, like patents and trademarks, to low-tax jurisdictions.

Unlike Subpart F, which targets specific types of income, GILTI is calculated using a formulaic approach. The calculation starts with the CFC’s total income and subtracts certain items, including Subpart F income and income subject to the high-tax exception. The U.S. shareholder is then allowed a deemed return on the CFCs’ tangible assets, and any income above this return is classified as GILTI and subject to current U.S. tax.

Qualifying for the High-Tax Exception

The high-tax exception can apply to both Subpart F income and GILTI tested income. The provision prevents the administrative burden and potential for excessive taxation that would occur if the same income were subject to a high foreign tax rate and then again to a full U.S. tax rate. If income qualifies, it is excluded from the shareholder’s U.S. taxable income.

To qualify, the foreign income must be subject to an effective foreign tax rate that is greater than 90% of the maximum U.S. corporate tax rate. With the current U.S. rate at 21%, the foreign effective tax rate must be greater than 18.9%. This threshold ensures the exception is only available for income that has faced a substantial tax burden abroad.

The effective foreign tax rate is calculated by dividing the U.S. dollar amount of foreign income taxes paid or accrued by the net income. This net income must be computed under U.S. tax principles. This may require adjustments to the income reported on foreign financial statements to conform to U.S. rules.

A single, unified high-tax election applies to both Subpart F and GILTI income. The calculation is performed on a “tested unit” basis, which can be the CFC itself or one of its foreign branches. All income attributable to a single tested unit is grouped together to determine one effective foreign tax rate. If a CFC has multiple tested units that are tax residents in the same foreign country, their incomes are also combined. This mandatory grouping prevents taxpayers from selectively applying the exclusion to only high-taxed streams of income within the same jurisdiction.

Information and Documentation for the Election

Making a high-tax election requires gathering detailed financial and tax information. The primary documents are the CFC’s financial statements, prepared under U.S. GAAP or IFRS. Taxpayers must also maintain records that break down the CFC’s income into U.S. tax categories and have complete records of all foreign income taxes paid or accrued.

The central tax form for reporting this information is Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. U.S. shareholders use this form to satisfy their reporting obligations and provide the IRS with the data needed to verify compliance.

Several schedules on Form 5471 are relevant for the high-tax exception. Schedule J tracks the Accumulated Earnings & Profits (E&P) of the CFC. Schedule I-1 is used to calculate a shareholder’s GILTI inclusion and reflects any income excluded under the rule. Schedule Q is where the detailed allocation of income and taxes occurs, requiring a careful mapping of the CFC’s accounting records to the form.

Making the High-Tax Election

The high-tax election is made by the controlling U.S. shareholders of the CFC. These are the shareholders who collectively own more than 50% of the CFC’s voting stock and agree to act on its behalf. If no group holds a majority, then all U.S. shareholders owning at least 10% of the stock are considered the controlling shareholders. An election by this group is binding on all other U.S. shareholders.

To make the election, the controlling U.S. shareholder must attach a formal statement to their income tax return for the relevant year. This statement must identify the CFCs for which the election is being made. The effects of the election are then reported on the appropriate schedules of Form 5471.

Once filed, the qualifying income is excluded from the shareholder’s Subpart F or GILTI inclusion, directly reducing their U.S. taxable income. The election is made annually, providing flexibility to respond to changing foreign tax rates or business circumstances.

The election can also be made or revoked by filing an amended tax return, though specific rules and timeframes apply. A retroactive election may require all U.S. shareholders of the CFC to file amended returns consistently. The controlling shareholders must also provide notice of the election or its revocation to any non-controlling U.S. shareholders.