By Anthony Diosdi
Inclusion of Subpart F income of a controlled foreign corporation or (“CFC”) occurs if a foreign corporation was a CFC at “any time” during the taxable year. Prior to the 2017 Tax Cuts and Jobs Act, a subpart F inclusion for a U.S. Shareholder was required only if the foreign corporation was a CFC for an uninterrupted period of 30 days or more during the relevant tax year. Subpart F income can be broken down to the following categories: Foreign Personal Holding Company Income, Foreign Base Company Sales Income, Foreign Base Company Services Income, and Foreign Base Shipping Income.
Who is Subject to Subpart F Income?
Subpart F income is assessed on a “United States shareholder” of any CFC for any taxable year of such United States shareholder that receives Subpart F income. A CFC is defined as a foreign corporation in which 50 percent of: 1) the total combined voting power of all classes of stock of such corporation entitled to vote, or 2) the total value of the stock of such corporation is owned (within the meaning of Section 958(a), or is considered as owned by applying the rules of ownership of Section 958(b) during any day of the taxable year of such foreign corporation. See IRC Section 957(a).
A “United States shareholder” can be defined as a “U.S. person” (Section 7701(a)(1) of the Internal Revenue Code defines a “U.S. person” to include an individual, trust, estate, partnership, or corporation) who owns (within the meaning of Section 958(a)), or is considered as owning by applying the rules of ownership of Section 958(b), 10 percent or more of the total combined voting stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation. See IRC Section 951(b).
Definition of Foreign Base Company Income
1. Foreign Personal Holding Company Income
The first major category of foreign base company income is “foreign personal holding company income,” defined in Section 954(c) of the Internal Revenue Code. It includes most types of passive income, such as interest, dividends, rents, annuities, royalties and gains from the sale of stock, securities or other property that produces interest, dividends, rents, annuities or royalties. However, foreign personal holding company income does not include rents and royalties received from a person who is not a related person and derived from the active conduct of a trade or business. A “related person” is defined in Section 954(d)(3). For purposes of this definition, an individual, partnership, trust or estate that controls or is controlled by a CFC is a “related person” with respect to the CFC. In addition, a corporation, partnership, trust or estate that is controlled by the same persons or persons that control a CFC is a “related person” with respect to the CFC. See IRC Section 954(d)(3)(B). The definition of control means, in the case of a corporation, direct or indirect ownership of more than 50 percent of the total voting power or value of the stock of the corporation. In the case of a partnership, trust or estate, control means direct or indirect ownership of more than 50 percent (by value) of the beneficial interests in the partnership, trust or estate.
Foreign personal holding company income can also include related person factoring income, income from foreign currency gains, income from commodity transactions, gains from the sale of property producing passive income, income from notional principal contracts, payments in lieu of dividends, and certain personal services contract income.
2. Foreign Base Company Sales Income
The second major category of foreign base company income is “foreign base company sales income.” It is defined as income derived from the purchase and sale of personal property 1) if the property is either purchased from (or on behalf of) a related person or sold to (or on behalf of) a related person and 2) if the property purchased is manufactured, produced, grown or extracted outside of the country where the CFC is organized and the property also is sold for use, consumption or disposition outside that country. See IRC Section 954(d)(1)(A).
S. Rep. No. 1881, 87th Cong., 2nd Sess. 84 (1962, explained the two requirements of foreign base company sales income as follows:
The sales income which Subpart F is primarily concerned with income of a selling subsidiary (whether acting as principal or agent) which has been separated from manufacturing activities of a related corporation merely to obtain a lower rate of tax for the sales income. This accounts for the fact that this provision is restricted to sales of property, to a related person, or to purchase of property from a related person. Moreover, the fact that a lower rate of tax for such a company is likely to be obtained only through purchases and sales outside of the country in which it is incorporated, accounts for the fact that the provision is made inapplicable to the extent the property is manufactured, produced, grown, or extracted in the country where the corporation is organized or where it is sold for use, consumption, or disposition in that country. Mere passage of title or the place of the sale are not relevant in this connection.
It should be noted that this definition does not require any finding of a tax-avoidance purpose for the transaction.
Foreign base company income includes income generated by such trading activity whether the controlled foreign corporation buys and resells the property or merely acts as a sales agent or representative in return for a sales commission. Foreign base company sales income includes only sales income from the purchase and sale of property that is not manufactured, produced or constructed by the CFC. It does not include cases in which significant manufacturing, major assembling or construction activity is carried on with respect to the property by the CFC. For this purpose, the property sold will be treated as having been manufactured, produced or constructed by the CFC if the property is “substantially transferred” by the corporation before its sale. In addition, if the property purchased by the CFC is used as a component part of the property sold, the corporation will be treated as having sold a manufactured product, rather than component parts, but only if the operations conducted by the CFC with respect to the property purchased and sold are “substantial” and are generally considered to constitute the manufacture, production or construction of property. The application of this rule generally depends on the facts and circumstances of each case. However, the regulations contain a safe-harbor rule under which the CFC’s operations with respect to the product will be treated as manufacturing if its conversion costs (direct labor and factory burden) account for 20 percent or more of the total costs of goods sold for the product.
Even if the CFC manufactures the products it sells, income generated by sales operations handled through a branch operation outside of the country in which the CFC is incorporated will be treated as foreign base company sales income under certain circumstances. That result will occur if the combined effect of the tax treatment accorded the branch by the country of incorporation of the CFC and the country in which the branch is established is to treat the branch substantially the same as if it were a wholly owned subsidiary corporation of the CFC organized in the country in which it carries on its trade or business. See IRC Section 954(d)(2).
3. Foreign Base Company Services Income
The third major category base company income is “foreign base company services income,” which is defined as income derived from the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or similar services, if such services are performed for (or on behalf of) a related person and if they are performed outside the country in which the CFC is organized. See IRC Section 954(e)(1).
4. Foreign Base Company Shipping Income
The fourth major category includes income derived from the use of an aircraft or vessel in foreign commerce, from the performance of services directly related to such use of an aircraft or vessel or from the sale or exchange of the aircraft or vessel.
De Minimis Exception
Gross income of a CFC that would otherwise fall within the scope of foreign base company income is not treated as foreign base company income for the tax year is the lesser of $1,000,000 or five percent of the gross income of a CFC is foreign base company income. For purposes of applying this de minimis rule, the regulations contain an anti-abuse rule under which the income of two or more CFCs is aggregated and treated as the income of a single corporation if a principal purpose for separately incorporating, acquiring or maintaining the corporations was to prevent income from being treated as foreign base company income under the de minimis rule. See Treas. Reg. Section 1.954-1(b)(4).
Exception for High-Taxed Income
An item of income of a CFC that would otherwise by foreign base company income will not be foreign base company income if it was subject to an effective foreign tax rate greater than 90 percent of the maximum U.S. corporate tax rate specified in Section 11 of the Internal Revenue Code. Thus, under current law, if the item of income of a CFC is subject to a foreign tax of more than 18.9 percent (i.e., 90 percent of 21 percent), it will not be foreign base company income. See IRC SEction 954(b)(4). This exception applies after reducing the income by deductions.
Earnings Invested in U.S. Property
In connection with enacting Subpart F, Congress concluded that if any CFC loaned its accumulated earnings that were not Subpart F income to its U.S. shareholder, effective repatriation of the earnings to the United States had occurred and, consequently, the transaction should be treated as a constructive dividend. This treatment was based on the theory that, because the U.S. shareholder had use of the money loaned to it, it could reasonably be treated as if it had received the funds as a dividend even though it had an unconditional obligation to repay the principal of the loan. Section 956 also provides for constructive dividend treatment of earnings invested in U.S. property. Section 956(c) defines U.S. property to include four basic types of property. First, U.S. property includes tangible property located in the United States. See IRC Section 956(c)(1)(A). Second, U.S. property includes stock of a U.S. corporation. See IRC Section 956(c)(1)(B). Third, U.S. property includes obligations of U.S. persons. See IRC Section 956(c)(1)(C). Fourth, U.S. property includes any right to use patents, knowhow, copyrights or similar property in the United States
There are two more items that are excluded from the definition of “U.S. property” in Section 956(c)(2). First, Section 956(c)(2)(L) provides that securities will not be treated as U.S. property if they are acquired and held by the CFC in the ordinary course of its business as a securities dealer. Second, Section 956(c)(2)(M) provides that an obligation issued by a U.S. person will not be treated as U.S. property provided that 1) the issuer is not a U.S. corporation; 2) the issuer is not a U.S. shareholder of the CFC; and 3) the issuer is not a partnership, estate or trust in which the CFC (or any related person) is a partner, beneficiary or trustee immediately after the CFC’s acquisition of the obligation.
Determination of U.S. Shareholder’s Pro Rata Share
As mentioned earlier, inclusion of the Subpart F income of a CFC in the gross income of its U.S. Shareholders under Section 951(a)(1) if the corporation is a CFC for the taxable year at issue. If this test is met, every person who is a U.S. shareholder of the corporation (as defined in Section 951(b)) and who owns stock on the last day of the tax year on which the foreign corporation is a CFC must include its pro rata share of the corporation’s Subpart F income in gross income for the tax year in which or with which the tax year of the corporation ends.
A U.S. shareholder’s pro rata share is determined by going through a hypothetical dividend distribution of the CFC Subpart F income on the last day of its tax year on which it meets the CFC definition. Specifically, a U.S. shareholder’s pro rata share of Subpart F income is the amount of the distribution that the U.S. shareholder would have received with respect to the stock owned in the CFC if, on the last day of its tax year on which it was a foreign corporation if, on the last day of its tax year on which it was a CFC, the corporation had distributed pro rata to all of its shareholders a dividend in an amount equal to the Subpart F income for the year.
Under the rules for determining a U.S. Shareholder’s pro rata share, Subpart F income of a lower-tier CFC owned only indirectly by the U.S. shareholder may be includible in the shareholder’s income. In this situation, the Subpart F income of the lower-tier CFC is treated as if it were received directly by the U.S. Shareholder rather than as if it flowed up through the intervening entities and was homogenized or blended with their earnings. This method of taxation is often referred to as the “hop-scotch” method because the Subpart F income of the lower-tier CFC hop-scotches over the intervening foreign corporations directly to the U.S. Shareholder.
Conclusion
This article provides a very simple overview as to how Subpart F income is computed. The computation of Subpart F income can be an incredibly difficult exercise and in certain cases the application of Subpart F income can be punitive. If you or your business is receiving foreign source income, you should consult with an international tax attorney.
Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.