Tax Treatment on the Sale of CFC Stock

The sale of stock in a foreign corporation by a United States person can introduce complex tax considerations, particularly when the foreign entity is a Controlled Foreign Corporation (CFC). The transaction is not a straightforward calculation of capital gains. Instead, a specific set of rules governs the tax outcome, potentially changing the character of the income received from the sale.

Understanding the tax implications is a multi-step process that involves determining the nature of the foreign entity, calculating the gain on the sale, and applying special recharacterization rules. The tax treatment hinges on the earnings generated by the foreign corporation during the U.S. person’s ownership period. This framework ensures that income accumulated offshore is appropriately taxed when a U.S. shareholder realizes that value by selling their ownership stake.

Core Tax Treatment of the Sale

The tax outcome of selling foreign stock fundamentally changes if the entity is a Controlled Foreign Corporation (CFC). A foreign corporation is designated a CFC if “U.S. Shareholders” collectively own more than 50 percent of its stock, measured by either voting power or value. A U.S. Shareholder is a U.S. person, such as a citizen, resident, or domestic corporation, who owns at least 10 percent of the foreign corporation’s voting power or stock value.

When a U.S. Shareholder sells stock in a CFC that they have held for more than one year, Internal Revenue Code Section 1248 comes into play. This rule recharacterizes some or all of the gain from the sale from what would typically be treated as a capital gain into dividend income. The amount recharacterized as a dividend is based on the earnings and profits of the CFC that have not yet been taxed in the U.S.

The policy behind this recharacterization is to prevent the indefinite deferral of U.S. tax on foreign earnings. Without this rule, a U.S. Shareholder could allow earnings to accumulate within the foreign corporation, paying no U.S. tax on that income. They could then sell their stock, realizing the value of those accumulated earnings as a capital gain, which is often taxed at a preferential rate for individuals.

If the sale of CFC stock results in a loss, Section 1248 does not apply. The loss is generally treated as a capital loss, subject to the standard rules and limitations governing capital losses. The provision also requires that the U.S. Shareholder held the stock for a continuous five-year period ending on the date of the sale during which the corporation was a CFC.

Calculating the Dividend Amount

The process of determining the portion of gain treated as a dividend involves a specific calculation. The dividend amount under Section 1248 is limited to the U.S. Shareholder’s proportional share of the CFC’s “earnings and profits” (E&P) accumulated in taxable years after December 31, 1962. This calculation is restricted to the period the shareholder actually held the stock while the company qualified as a CFC. E&P is a tax-specific measure of a corporation’s economic income available for distribution.

Calculating a company’s historical E&P can be a complex undertaking, requiring access to the CFC’s financial and tax records. The calculation starts with the corporation’s taxable income and then makes numerous adjustments for items treated differently for tax purposes than for financial accounting. The burden of proof for establishing the correct E&P amount rests on the taxpayer, and failure to do so can result in the entire gain being treated as a dividend.

To illustrate the mechanics, consider a U.S. Shareholder with a tax basis of $200,000 in their CFC stock who sells it for $1,000,000. The total gain on the sale is $800,000. The next step is to determine the shareholder’s pro-rata share of the CFC’s relevant post-1962 E&P. Assume that this amount is calculated to be $500,000.

The amount of gain recharacterized as a dividend is the lesser of the total gain on the sale or the attributable E&P. In this example, the shareholder must treat $500,000 of the gain as dividend income. The remaining portion of the gain, $300,000, is treated as a capital gain. If the shareholder’s share of E&P had been $900,000, the entire $800,000 gain would have been treated as a dividend.

Impact of Previously Taxed Income and Foreign Tax Credits

The calculation of the dividend amount is further refined by Previously Taxed Income (PTI). PTI consists of a CFC’s earnings and profits that have already been included in the gross income of a U.S. Shareholder under other anti-deferral regimes, such as Subpart F or Global Intangible Low-Taxed Income (GILTI). These rules require U.S. Shareholders to pay U.S. tax on certain foreign income annually, even if they do not receive a cash distribution.

To prevent double taxation, the E&P figure used in the Section 1248 calculation must be reduced by any PTI. When income is included under Subpart F or GILTI, the shareholder increases their tax basis in the CFC stock by the amount of the inclusion. When the stock is later sold, these PTI amounts are excluded from the E&P pool available to be recharacterized as a dividend.

Another consequence of the dividend recharacterization is the potential to claim foreign tax credits. The dividend income created by Section 1248 is treated as if it were an actual dividend distribution from the CFC. This allows the U.S. Shareholder to be “deemed” to have paid a portion of the foreign income taxes that the CFC paid on the underlying earnings.

The ability to claim these deemed-paid foreign tax credits can substantially reduce the U.S. tax liability on the Section 1248 dividend. The rules for calculating these credits differ for individual and corporate shareholders. Corporate shareholders, for instance, may be able to claim a 100 percent dividends received deduction for the foreign-source portion of the dividend under Section 245A.

Filing and Reporting Requirements

A U.S. Shareholder’s disposition of CFC stock triggers specific reporting obligations to the IRS. The primary vehicle for this reporting is Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” The sale of stock that affects a U.S. person’s proportional interest in a foreign corporation is a reportable event that necessitates filing this form for the year of the sale.

Taxpayers are also generally required to attach a separate statement to their tax return that provides a detailed breakdown of the Section 1248 calculation. This statement should clearly demonstrate how the gain was computed and how the CFC’s E&P was determined. The results of the sale must then be reported on the shareholder’s main income tax return.

Key forms and actions for reporting the sale include:

• Filing Form 5471, which includes Schedule I for the Section 1248 dividend, Schedule J for accumulated E&P, and Schedule P for Previously Taxed E&P.
• Attaching a statement to the tax return that breaks down the Section 1248 calculation.
• Reporting the dividend portion of the gain on Schedule B of Form 1040 for individuals, or on Form 1120 for corporations.
• Reporting the capital gain portion on Schedule D for individuals, or on Form 1120 for corporations.
• Claiming any associated foreign tax credits on Form 1116 for individuals or Form 1118 for corporations.