What Is a Controlled Foreign Corporation for Tax Purposes?
Explore the complexities of US tax law concerning income held in foreign corporations controlled by US shareholders. Understand compliance.
US tax law includes specific provisions to address situations where US taxpayers own interests in foreign corporations. A key concept in this area is the Controlled Foreign Corporation (CFC). The rules surrounding CFCs are primarily anti-deferral measures, designed to prevent US taxpayers from postponing US taxation on certain types of foreign income by holding it within foreign corporate structures. These regulations ensure that income earned by a foreign entity is taxed currently in the United States, rather than only upon distribution to US shareholders. The CFC framework applies to US persons who hold ownership stakes in these foreign entities.
Defining a Controlled Foreign Corporation
A foreign corporation is classified as a Controlled Foreign Corporation (CFC) if more than 50% of its total combined voting power or the total value of its stock is owned by “US Shareholders” on any day during its taxable year. A “US Shareholder” is defined as a US person—which can be an individual, corporation, partnership, trust, or estate—who owns 10% or more of the total combined voting power of all classes of voting stock, or 10% or more of the total value of the foreign corporation’s stock.
The determination of ownership includes not only direct holdings but also indirect and constructive ownership through attribution rules. These attribution rules ensure that ownership is broadly considered, preventing taxpayers from circumventing CFC status through complex ownership structures. For example, family attribution rules attribute stock owned by one family member to another, and entity attribution rules attribute ownership from partnerships, trusts, or corporations to their partners, beneficiaries, or shareholders. Even if a US person does not directly own 10% of a foreign corporation, they might still be considered a US Shareholder if their attributed ownership reaches the 10% threshold through these rules. If multiple US Shareholders collectively meet the more-than-50% ownership test, the foreign corporation is a CFC, and these US Shareholders become subject to its specific tax rules.
Types of Income Subject to CFC Rules
The US tax system subjects specific categories of income earned by a Controlled Foreign Corporation (CFC) to current taxation for its US shareholders. The primary anti-deferral mechanism for this is Subpart F income. This category includes income that is generally considered mobile and easily shifted to low-tax jurisdictions, with less economic connection to the CFC’s country of incorporation.
One significant component of Subpart F income is Foreign Personal Holding Company Income (FPHCI). This includes passive income streams like dividends, interest, rents, royalties, and annuities. It also includes gains from the sale of property generating passive income or property not producing active business income. For instance, interest from loans to unrelated parties or royalties from intellectual property would generally fall under FPHCI.
Another key category is Foreign Base Company Sales Income (FBCSI). This arises from the purchase and sale of personal property manufactured or produced outside the CFC’s country of incorporation, sold to or on behalf of a related person for use outside that country. For example, if a CFC in Country A buys goods manufactured by its US parent and sells them to customers in Country B, the profit could be FBCSI. Foreign Base Company Services Income (FBCSvI) also falls under Subpart F, including income from services performed for or on behalf of a related person outside the CFC’s country of incorporation. For instance, if a CFC in Country A provides consulting services to its US parent for projects in Country B, the fees could be FBCSvI.
Beyond Subpart F income, Global Intangible Low-Taxed Income (GILTI) is another category of income subject to current taxation for US shareholders of CFCs. Introduced by the Tax Cuts and Jobs Act (TCJA) of 2017, GILTI captures active business income exceeding a routine return on the CFC’s tangible depreciable assets. It aims to tax foreign active income not caught by Subpart F rules, particularly income attributable to intangible assets. This ensures a wider range of a CFC’s undistributed earnings are subject to US tax currently.
Tax Implications for US Shareholders
US shareholders of a Controlled Foreign Corporation (CFC) are currently taxed on certain CFC income, even if not distributed. This is known as the current inclusion principle. US shareholders must include their pro-rata share of the CFC’s Subpart F income and Global Intangible Low-Taxed Income (GILTI) in their gross income for US tax purposes in the year earned. This mechanism prevents the deferral of US tax on specific types of foreign earnings.
To mitigate double taxation on currently included income, the US tax system provides foreign tax credits (FTCs). US shareholders may claim a credit for income taxes paid by the CFC to foreign governments on the included income. Corporate US shareholders can claim an indirect, or “deemed-paid,” foreign tax credit for taxes paid by the CFC. Individual US shareholders may elect to be taxed as a corporation on certain CFC income to utilize these credits.
Income included in a US shareholder’s gross income under CFC rules is designated as Previously Taxed Earnings and Profits (PTEP). PTEP ensures such income is not taxed again when distributed by the CFC to the US shareholder in a later year. Distributions of PTEP are generally tax-free, preventing subsequent taxation of amounts already subjected to US tax. For corporate US shareholders, a dividend received deduction (DRD) may be available for certain GILTI inclusions, further reducing the effective US tax rate. This deduction can significantly lower the US tax burden for eligible corporate shareholders.
Reporting a Controlled Foreign Corporation
Reporting a Controlled Foreign Corporation (CFC) to US tax authorities involves specific forms and detailed information. The primary document for this purpose is Form 5471, “Information Return of U.S. Persons With Respect To Certain Foreign Corporations.” This form is required for US shareholders meeting the 10% ownership threshold or involved in certain control or ownership events, to disclose their interest and the CFC’s financial activities.
Form 5471 requires comprehensive CFC information, including ownership structure, financial statements (balance sheet and income statement), and detailed calculations of Subpart F income and GILTI. It also requires reporting of transactions between the CFC and related parties. This form is filed with the US shareholder’s annual income tax return (Form 1040 for individuals or Form 1120 for corporations).
Other forms may also be relevant beyond Form 5471, depending on specific circumstances. For instance, Form 8992 is used to calculate the GILTI inclusion amount. Additionally, Form 1118 or Form 1116 are used to claim foreign tax credits related to the CFC’s income. Failure to file Form 5471, or filing it inaccurately, can result in significant penalties, underscoring the importance of meticulous compliance.