What Is Foreign Personal Holding Company Income?

Foreign Personal Holding Company Income, or FPHCI, is a classification of passive income earned by certain foreign corporations and is a component of the U.S. tax code’s Subpart F provisions. Normally, the United States does not tax a foreign corporation’s profits until they are distributed to a U.S. owner. The Subpart F rules create an exception to this principle of deferral.

When a foreign corporation controlled by U.S. taxpayers earns FPHCI, the tax on that income can no longer be postponed. The rules require U.S. owners to include their share of this income on their tax returns for the year it was earned by the foreign entity, regardless of whether they received any cash distributions. This framework eliminates the deferral benefit for income that is easily movable to low-tax jurisdictions.

Defining a Controlled Foreign Corporation (CFC)

A foreign corporation is classified as a Controlled Foreign Corporation (CFC) if it meets two ownership tests. First, on any day of its tax year, more than 50% of its stock must be owned by “U.S. Shareholders.” This 50% threshold is met by measuring either the total combined voting power or the total value of the stock.

A “U.S. Shareholder” is a U.S. person—including citizens, residents, domestic corporations, partnerships, and trusts—who owns 10% or more of the foreign corporation’s stock, also measured by either vote or value. For a company to be a CFC, both the 50% aggregate ownership and 10% individual shareholder tests must be met.

Consider a foreign corporation with 100 shares of stock. If four unrelated U.S. citizens each purchase 15 shares, the corporation becomes a CFC. Each citizen is a U.S. Shareholder because they each own more than 10% of the stock. Collectively, these U.S. Shareholders own 60% of the corporation, which surpasses the 50% control threshold.

Conversely, if 11 unrelated U.S. citizens each owned an equal amount of the stock (approximately 9.09% each), the entity would not be a CFC. Even though U.S. persons own 100% of the corporation, no single person meets the 10% U.S. Shareholder definition. These ownership rules, including complex attribution rules, are found in Section 958 of the Internal Revenue Code.

Categories of Foreign Personal Holding Company Income

Foreign Personal Holding Company Income includes several distinct categories of passive income identified in Internal Revenue Code Section 954. The purpose is to identify income not derived from the active conduct of a trade or business that could be easily shifted to a low-tax jurisdiction.

Dividends, Interest, Royalties, Rents, and Annuities

This group represents the most common form of FPHCI. It includes dividends from stock investments, interest earned from loans or bank deposits, royalties received for the use of intangible property like patents or copyrights, and rents from leasing property. For example, if a CFC holds excess cash in an interest-bearing bank account, the interest it earns is FPHCI.

Gains from Certain Property Transactions

This category includes the net gains from the sale or exchange of property that produces other types of FPHCI, such as dividend-paying stocks or interest-bearing bonds. The category also includes gains from the sale of property that does not generate any income, like undeveloped land held for speculation.

Gains from Commodities Transactions

Net gains from transactions involving commodities, including futures and forwards, are classified as FPHCI. For instance, if a CFC speculates in the gold market by buying and selling futures contracts, the net gain from these activities would be FPHCI. An exception applies to gains from qualified active sales or hedging transactions that are a normal part of operations for a CFC actively engaged in a commodities-related business.

Foreign Currency Gains

This category captures net foreign currency gains that arise from transactions denominated in a currency other than the CFC’s functional currency. If a CFC whose functional currency is the Euro makes a loan in U.S. dollars, any gain resulting from fluctuations in the exchange rate when the loan is repaid would be FPHCI. These rules focus on gains attributable to Section 988 transactions.

Income Equivalent to Interest

This is a broad category designed to capture income that is economically equivalent to interest. It includes items like commitment fees paid to the CFC for its agreement to lend money in the future. Income from factoring, where a CFC purchases accounts receivable from another company at a discount, can also fall into this category.

Calculating Net FPHCI and Relevant Exceptions

After identifying the gross FPHCI, certain deductions are subtracted to calculate the net amount. Several exceptions can also reduce or eliminate the FPHCI that is included in a U.S. Shareholder’s income, designed to provide relief when the income is not being used for tax avoidance purposes.

The De Minimis Rule

This rule provides a safe harbor for CFCs with a small amount of passive income. If a CFC’s Subpart F income is less than both 5% of its total gross income and $1 million, then none of its income is treated as Subpart F income for that year. This allows a CFC with substantial active business income to earn a small amount of passive income without triggering immediate U.S. taxation.

The Full Inclusion Rule

This rule applies when a CFC’s income is overwhelmingly passive. If a CFC’s Subpart F income exceeds 70% of its total gross income for a year, then the entire amount of the CFC’s gross income is treated as Subpart F income. This prevents taxpayers from shielding large amounts of passive income with a small amount of active business income.

The High-Tax Exception

This rule, sometimes called the “high-tax kick-out,” allows an item of FPHCI to be excluded if it was subject to a high rate of foreign income tax. The income must have been taxed in the foreign country at an effective rate greater than 90% of the highest U.S. corporate tax rate, which currently means the foreign rate must exceed 18.9%. If income is already taxed at a comparable rate abroad, the goal of deferring U.S. tax is not being achieved.

Active Business Exceptions

The tax code provides specific exceptions for certain rents and royalties. If rents or royalties are derived from the active conduct of a trade or business and are not received from a related person, they can be excluded. For example, income earned by a CFC in the business of leasing automobiles would likely qualify. For royalties to qualify, the CFC must have substantially developed or added value to the intangible property being licensed.

Same-Country Exception

Dividends and interest received by a CFC from a related corporation are not treated as FPHCI if the related corporation is organized under the laws of the same foreign country as the CFC. A further condition is that the paying corporation must have a substantial part of its assets used in a trade or business in that same country. This allows corporate groups to move active earnings between related entities within the same foreign country without triggering an immediate U.S. tax.

Tax Treatment for U.S. Shareholders

Each U.S. Shareholder of a CFC must include their pro-rata share of the corporation’s net FPHCI in their own gross income. This income inclusion is required for the U.S. Shareholder’s tax year in which the CFC’s tax year ends.

This inclusion is often called a “deemed dividend” because the shareholder is taxed on the earnings even though no actual cash has been distributed from the foreign corporation. This prevents the deferral of U.S. tax on these passive earnings and applies to both individual and corporate shareholders.

The income is reported on IRS Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. On this detailed form, the shareholder provides information about the CFC, calculates their pro-rata share of Subpart F income, and attaches it to their annual tax return. Failure to file Form 5471 can lead to penalties starting at $10,000 for each year.