What Is a Subpart F Inclusion for US Shareholders?

The U.S. tax system generally allows for the deferral of tax on income earned by foreign corporations until that income is distributed to its U.S. owners. However, specific rules known as Subpart F were enacted in 1962 to prevent the indefinite deferral of U.S. tax on certain types of mobile or passive income. The purpose of the Subpart F regime is to eliminate this deferral advantage by taxing certain U.S. owners on their share of this specific foreign income in the year it is earned, regardless of whether they actually receive a cash distribution from the foreign company.

This system operates by treating specific categories of a foreign corporation’s income as if it were distributed to the U.S. owners, creating a “deemed dividend.” This amount is then included in the U.S. owner’s gross income for the year. The rules are designed to be a targeted anti-abuse measure, focusing on income that lacks a substantial economic connection to the foreign corporation’s country of operation.

Determining Applicability

The Subpart F rules are triggered only when two ownership definitions are met. The first is that the foreign corporation must be classified as a Controlled Foreign Corporation (CFC). A foreign corporation meets this definition if, on any day of its tax year, U.S. Shareholders collectively own more than 50 percent of its stock, measured by either voting power or total value. The Subpart F inclusion, however, only applies to U.S. Shareholders who own stock on the last day of the year that the corporation is a CFC.

The second definition is that of a “U.S. Shareholder.” This is a U.S. person—an individual, corporation, partnership, or trust—that owns 10 percent or more of the foreign corporation’s stock by either vote or value. It is only the stock owned by these 10-percent-or-greater U.S. Shareholders that counts toward the “more than 50 percent” CFC test.

To illustrate, consider a foreign corporation owned 8% by a U.S. individual, 12% by a U.S. corporation, and 45% by another U.S. corporation. Only the two U.S. corporations are U.S. Shareholders because they each meet the 10% threshold. Their combined ownership is 57%, classifying the entity as a CFC, but the individual owning 8% is not a U.S. Shareholder and is not subject to the Subpart F inclusion rules.

Identifying Subpart F Income

Once a company is identified as a CFC, the next step is to determine if it has earned any Subpart F income. This income, outlined in Internal Revenue Code Section 952, is what triggers a potential tax liability. The largest category of Subpart F income is Foreign Base Company Income (FBCI), which is a collection of income types that are generally passive or can be easily shifted between jurisdictions.

• Foreign Personal Holding Company Income: This includes classic passive income streams such as dividends, interest, royalties, rents, and annuities. For example, if a CFC holds a portfolio of stocks and bonds, the dividends and interest it receives would generally be this type of income. The purpose is to prevent U.S. taxpayers from parking investment assets in an offshore corporation to defer tax on the earnings.
• Foreign Base Company Sales Income: This income is generated from the sale of personal property where a related party is involved and the property’s origin and destination are both outside the CFC’s country of incorporation. For instance, a U.S. parent sells goods to its Swiss CFC, which then sells the goods to a customer in France.
• Foreign Base Company Services Income: This is income from technical or managerial services performed by the CFC for a related person, where the services are performed outside the country in which the CFC is organized. An example is a U.S. company paying its Irish CFC to provide consulting services to clients in Germany.
• Insurance Income: This category targets situations where a CFC earns premiums for insuring risks on property or activities located within the United States. This stops U.S. companies from setting up offshore insurance companies to insure their own U.S.-based operations.

Calculating the Inclusion Amount

After identifying Subpart F income, the U.S. Shareholder must calculate their pro-rata share of that income. This share is generally determined based on the percentage of the corporation’s stock the shareholder owns and the portion of the year during which the corporation was a CFC.

A limitation on the inclusion amount is the CFC’s current year earnings and profits (E&P), an accounting measure of a corporation’s economic ability to pay dividends. The total Subpart F inclusion for all U.S. Shareholders cannot exceed the CFC’s current E&P. If a CFC has $1 million of Subpart F income but only $600,000 of current E&P, the total inclusion is limited to $600,000.

This E&P limitation ensures that shareholders are not taxed on phantom income. Any Subpart F income that exceeds the current E&P limit is not immediately taxed but can be subject to inclusion in future years if the CFC generates sufficient E&P. Furthermore, qualified deficits in E&P from prior years may be used to reduce the amount of Subpart F income subject to the E&P limitation.

Key Exceptions and Relief Provisions

Under the high-tax exception, a U.S. Shareholder can elect to exclude an item of Subpart F income if that income was subject to a high rate of foreign income tax. The threshold for “high tax” is met if the foreign income tax paid is greater than 90 percent of the maximum U.S. corporate tax rate (currently 18.9%). This election prevents U.S. taxation on income that has already been substantially taxed by another country.

Another relief measure is the de minimis rule, which allows CFCs with only a small amount of Subpart F income to avoid the regime for the year. If the CFC’s gross FBCI and insurance income is less than both $1 million and 5 percent of its total gross income, then none of its income is treated as Subpart F income for that year.

Conversely, a full inclusion rule applies when Subpart F income makes up a vast majority of the CFC’s earnings. If the sum of the CFC’s FBCI and insurance income exceeds 70 percent of its total gross income, then the CFC’s entire gross income for the year is generally treated as Subpart F income.

Reporting and Tax Consequences

A U.S. Shareholder has a compliance obligation to report a Subpart F inclusion on Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. This detailed form is filed as an attachment to the shareholder’s annual U.S. income tax return. On its various schedules, the shareholder reports the CFC’s financial data and calculates their pro-rata share of Subpart F income.

Completing Form 5471 requires obtaining the foreign corporation’s income statement and balance sheet and converting them to conform with U.S. accounting principles. This includes the calculation of the CFC’s earnings and profits (E&P). Failure to file Form 5471 can result in significant penalties, even if no tax is ultimately due.

The first tax consequence is that the shareholder may be able to claim a foreign tax credit for the foreign income taxes paid by the CFC on the included income. This “deemed-paid” credit, available to corporate U.S. Shareholders under Section 960, prevents double taxation on the same earnings.

Second, the Subpart F inclusion creates what is known as Previously Taxed Income (PTI). The amount included in the shareholder’s income increases their basis in the CFC stock and is tracked in a PTI account. When the CFC later makes an actual cash distribution of these earnings, that distribution is treated as a non-taxable return of PTI, ensuring the same earnings are not taxed twice.