By Anthony Diosdi
The Controlled Foreign Corporation (“CFC”) rules are embedded in the Internal Revenue Code. The CFC rules are designed to limit artificial deferral of foreign income using foreign entities. The CFC provides that certain classes of taxpayers must include in their U.S. taxable income amounts earned by foreign entities they or related entities/persons control. The 2017 Tax Cuts and Jobs Act made significant changes to these rules.
The Definition of a CFC Before the Enactment of the 2017 Tax Cuts and Jobs Act
Prior to the 2017 Tax Cuts and Jobs Act, Internal Revenue Code Section 951 provides that a United States shareholder of a CFC must include in its income its pro rata share of its “Subpart F income” regardless of whether that income has been distributed to the shareholder. Section 957(a) defined the term “CFC” as any foreign corporation of which more than 50 percent of the total combined voting power of of all classes of stock entitled to vote was owned, directly, indirectly, or constructively under Internal Revenue Code Section 958 ownership rules, by “U.S. shareholders” on any day during the foreign corporation’s tax year. Internal Revenue Section 951(b) defined a “U.S. shareholder” as a U.S. citizen, resident alien, corporation, partnership, trust or estate, owning directly, indirectly or constructively under the ownership rules of Section 958, ten percent of more of the combined voting power of all classes of stock of a foreign corporation. Only those U.S. shareholders owning ten percent or more of the voting power were to be taken into account in determining whether a foreign corporation was a CFC, and a foreign corporation would fall within the definition only if more than 50 percent of the total combined voting power of all classes of its stock were owned directly, indirectly or constructively by such ten-percent U.S. shareholders.
In determining whether a U.S. person met the Section 951(b) definition of a U.S. shareholder and whether a foreign corporation was a CFC, Section 958 applied direct, indirect, and constructive ownership rules to determine stock ownership in the foreign corporation. Internal Revenue Code Section 958(a)(1) provides direct ownership rules for determining stock ownership for such purposes. Section 958(a)(2) provides indirect ownership rules to determine beneficial ownership of shares when a foreign entity is interposed between the US person and the foreign corporation. In particular, stock of a foreign corporation owned, in turn, by another foreign corporation or by a foreign partnership, trust or estate is deemed to be owned proportionately by the owner’s interest. Section 958(b) applies the constructive ownership rules of Section 318(a).
These constructive ownership rules of Section 318(a) require attribution of stock between certain family members and between corporations, partnerships, trusts and estates, on the one hand, and their shareholders, partners or beneficiaries or shareholder-to-corporation attribution, a minimum threshold of stock ownership.
These definitions were intended to ensure that a U.S. taxpayer holding merely a portfolio (less than ten percent) interest in a foreign corporation would not have to pay current U.S. tax on the taxpayer’s pro rata share of the undistributed earnings of the foreign corporation even though the taxpayer lacked the voting power needed to force distribution of those earnings. Congress later became concerned that the definition of controlled foreign corporation based solely on ownership of the corporation’s voting power was being manipulated by taxpayers. To prevent avoidance techniques, the Tax Reform Act of 1986 broadened the definition of controlled foreign corporation to include a foreign corporation if more than 50 percent of either the value of all the outstanding stock or the total combined voting power is owned by U.S. shareholders. See IRC Section 957(a). However, the definition of a U.S. shareholder based on ownership of at least ten percent of the foreign corporation’s voting power was not changed by the 1986 Act.
The Changes to the CFC 10 Percent Rule
As discussed above, a foreign corporation is a CFC if more than 50 percent of the total combined voting power of all classes of stock of such corporation entitled to vote, or of the total value of the stock of such corporation, is owned (within the meaning of Section 958(a)) or is considered as owned (by attribution of ownership under Section 958(b)) by “U.S. shareholders” on any day during the taxable year of such foreign foreign corporation. See IRC Section 957(a). Prior to the 2017 Tax Cuts and Jobs Act, for purposes of Subpart F, a “U.S. shareholder” only included a U.S. person who owns or is considered as owning 10 percent or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation, with the above attribution rules applying. The 2017 Tax Cuts and Jobs Act expanded the definition of U.S. shareholders to include U.S. persons who own 10 percent or more of the total value of shares of all classes of stock of the foreign corporation. See IRC Section 951(b).
The Changes to the CFC Attribution Rules
To prevent avoidance of the stock ownership rules by dividing ownership among related parties, Internal Revenue Code Section 958 provides detailed ownership rules and attribution rules. Under Internal Revenue Code Section 958(a), stock owned directly or indirectly by or for a foreign corporation, foreign partnership, foreign trust, or beneficiaries. Stock considered as directly owned is treated as actually owned for purposes of applying the direct and indirect ownership rules. Internal Revenue Code Section 958(b) provides for the rules of Internal Revenue Code Section 318(a) to apply for the purpose of treating a U.S. person as a U.S. shareholder under the ten percent test of Internal Revenue Code Section 951(b), for classifying a foreign corporation as a CFC under Internal Revenue Code Section 957, and for certain other related purposes. For example, under Internal Revenue Code Section 318(a)(2), stock owned directly or indirectly by a foreign trust is treated as considered as owned by its beneficiaries in proportion to the actuarial interests of such beneficiaries. Internal Revenue Code Section 958(b) also provides special rules of application for the constructive ownership rules of Section 318, the most important of which is that in applying the family attribution rules, stock owned by a nonresident alien individual, other than a foreign trust or foreign estate, is not to be attributed to a U.S. citizen or resident alien.
An important difference between the direct and indirect ownership rules of Internal Revenue Code Section 958(a) and the constructive ownership rules of Section 958(b) is the constructive ownership rules apply only for purposes of categorization whereas the direct/indirect ownership rules will apply in determining taxation of a CFC’s income to U.S. Shareholders as well as for purposes of categorization. See IRC Section 951(a)(1).
Effective for the last tax year of foreign corporations beginning before January 1, 2018, and each subsequent year of such foreign corporations, and for tax years of U.S. shareholders in which or with which such tax years of foreign corporations end, the 2017 Tax Cuts and Job Act repeals former Internal Revenue Code Section 958(b)(4).
Due to the repeal of Internal Revenue Code Section 958(b)(4), stock of a foreign corporation owned by a foreign person can be attributed to a U.S. person under Section 318(a)(3) for purposes of determining whether such U.S. person is a U.S. shareholder of the foreign corporation and, therefore, whether the foreign corporation is a CFC. As a result of the repeal of former Internal Revenue Code Section 958(b)(4), Internal Revenue Code Section 958(b) now provides for “downward attribution” from a foreign person to a U.S. person in circumstances in which pre-2017 Tax Cuts and Jobs Act Section 958(b) did not otherwise provide and foreign corporations that were not previously treated as CFCs for purposes of the Internal Revenue Code may now be treated as CFCs.
Potential 965 Inclusions as the Result of the New Attribution Rules
The constructive attribution rules may cause a foreign corporation to be a “deferred foreign income corporation” for purposes of Internal Revenue Code Section 965 based on the other assets of its shareholders and related parties. Internal Revenue Code Section 965 imposes a one-time transition tax on a U.S. shareholder’s share of deferred foreign income of certain foreign corporations.
Internal Revenue Code Section 965 accomplishes the transition tax by increasing the Subpart F income of each specified foreign corporation (“SFC”) in its last taxable year that began before January 1, 2018 by the greater of the SFC’s accumulated deferred foreign income (“ADFI”). As of the 2018 tax year, Internal Revenue Code Section 965 effectively taxes a corporate U.S. shareholder’s share of the SFCs’ ADFI at 15.5 percent and an individual at 17.54 percent to the extent the U.S. shareholder held ADFI in cash, cash equivalents, or certain short-term assets. For individual shareholders with a fiscal year SFC, the tax rate increases to 27.31 percent on cash and cash equivalents and 14.1 percent on non-cash.
The transition tax in Internal Revenue Code Section 965 applies to U.S. shareholders of SFCs. An SFC is a foreign corporation that is either a CFC or has at least one U.S. shareholder that is a corporation. For Section 965 purposes, the term SFC includes not only CFCs, but also entities which have at least one U.S. shareholder, but which are not CFCs because U.S. shareholders do not own more than 50 percent by vote or value.
The aforementioned rules may result in a very unwelcome surprise for the unwary. For example, suppose an individual shareholder, whether foreign or a U.S. citizen, owns 50 percent of a domestic C corporation’s stock and 10 percent of a foreign corporation’s stock. In this case, Internal Revenue Code Section 318(a)(3)(C) treats a C corporation as constructively owning any stock held by a 50-percent or greater shareholder, consequently, the domestic C corporation constructively owns 10 percent of the foreign corporation’s stock. Because the foreign corporation has a constructive 10 percent corporate U.S. shareholder, it is a SFC, which causes Section 965 inclusions to apply to its individual U.S. shareholders.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.