By Anthony Diosdi
In order to provide the Internal Revenue Service (“IRS”) with the information necessary to ensure compliance with the subpart F rules and global intangible low-taxed income (
“GILTI”) provisions, each year certain U.S. persons with interests in foreign corporations must file an IRS Form 5471 otherwise known as “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” This is the first of a series of articles designed to provide a basic overview of the Form 5471 and the tax law anyone completing a Form should understand.
The Form 5471 begins with a question on Page 1 Box B by asking you to select one or more categories of being a filer. The classification selected will determine the appropriate schedules of the Form 5471 that needs to be completed. You can characterize yourself as being a Category 1, Category 2, Category 3, Category 4, or Category 5 filer. You are not limited to one category. These categories are defined as follows:
A. (Category 1) U.S. persons who are officers, directors to ten percent or greater shareholders in a foreign holding company. This category was repealed not relevant for years. That all changed with the passage of the 2017 Tax Cuts and Jobs Act. Now category 1 is once again relevant.
B. (Category 2) U.S. persons who are officers or directors of a foreign corporation in which, since the last Form 5471 was filed, a U.S. person has acquired a ten percent or greater ownership or acquired an additional ten percent or greater ownership.
C. (Category 3) a U.S. person who (a) has acquired a cumulative ten percent or greater ownership in the outstanding stock of the foreign corporation, (b) since the last filing of Form 5471 has acquired an additional ten percent or greater ownership in such stock, (c) owns ten percent or greater of the value of the outstanding stock of the foreign corporation when it is reorganized, or (d) disposes of sufficient stock in the foreign corporation to reduce the value of his ownership of stock in that corporation to less than ten percent, or who becomes a U.S. person while owning ten percent or greater in value of the outstanding stock of the foreign corporation.
D. (Category 4) A U.S. person who had “control” of a foreign corporation for an uninterrupted period of at least 30 days during the foreign corporation’s annual accounting period. Control is defined as more than 50 percent of voting power or value, with Internal Revenue Code Section 958 attribution rules applying. Section 958(a)(1) provides the direct ownership rules for determining stock ownership for such purposes. Internal Revenue Code Section 958(a)(2) provides indirect ownership rules to determine beneficial ownership of shares when a foreign corporation is interposed between a U.S. person and foreign corporation.
E. (Category 5) A U.S. person who is a ten percent or greater shareholder in a corporation that was a controlled foreign corporation for an uninterrupted period of thirty days during its annual accounting period and who owned stock in the controlled foreign corporation on its last day of its annual accounting period.
Determining which category filer you are is no easy task. For example, Category D asks if a U.S. person had “control” of 50 percent of voting power or value of the foreign corporation. In order to determine which category of filer you are and to understand the rest of the Form 5471, you must have an understanding of Internal Revenue Code Section 958 as well as the definition of a “controlled foreign corporation (“CFC”).”
The CFC and attribution rules of Internal Revenue Code Section 958 have been in place since 1961. These rules have long been used in the planning of outbound internal tax transaction to avoid U.S. taxation of foreign corporations. Wealthy U.S. taxpayers such as former Massachusetts Governor Willard Romney has been criticized for utilizing these rules to avoid or defer paying taxes on offshore income.
In any event, in its original form, Internal Revenue Code Section 957(a) defined a CFC as a foreign corporation of which more than 50 percent of the total combined voting power of all classes of stock entitled to vote was owned, directly, indirectly, or constructively under Internal Revenue Code Section 958 ownership rules. Internal Revenue Code 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 or more of the total combined voting power of all classes of stock of a foreign corporation. Under these rules, only U.S. shareholders owning 10 percent or more of the voting power of a foreign corporation were to be taken into account in determining whether a foreign corporation is 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. shareholder.
Congress became concerned that the original definition of CFC based solely on ownership of the corporation’s voting power was being manipulated. To prevent manipulation of the CFC rules, Congress broadened the definition of a CFC 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 owned by U.S. shareholders. See IRC Section 957(a). The test of CFC status is applied on a year-by-year basis.
Below, see Illustration 1 and Illustration 2 which demonstrates how the CFC rules operate.
Illustration 1.
Company A, a domestic corporation owns 50 percent of the stock of F1, a foreign corporation. Unrelated foreign persons own the remaining 50 percent of F1. Company A also owns 10 percent of the stock of F2, a foreign corporation. F1 owns 51 percent of F2, and an unrelated foreign persons own the remaining 30 percent. F1 is not a CFC because Company A, F1’s only U.S. shareholder, does not own more than 50 percent of the stock. Company A also is a U.S. shareholder of F2 because it owns more than 10 percent of F2 directly. Under the constructive ownership rules, F1 is treated as constructively owning 100 percent of F2 because F1 owns more than 50 percent of F2. Thus, Company A is treated as owning 60 percent of F2, 10 percent directly and 50 percent through F1. As a consequence, F2 is a CFC.
Illustration 2.
One hundred different U.S. citizens each own 1 percent of a foreign corporation. Although the foreign corporation is 100 percent owned by U.S. persons, none of the U.S. persons own 10 percent of the foreign corporation. Since each of the U.S. citizens owns less than 10 percent interest in the foreign corporation, it is not a CFC.
In theory, it is possible to avoid CFC status by spreading ownership of the foreign corporation among 11 U.S. persons, each owning only 9.09 percent of the company. However, because indirect and constructive ownership are considered in applying the 10 percent test, the 11 persons would have to be unrelated to one another, by family and business connections, in order to avoid U.S. shareholder status. Therefore, planning designated to take advantage of the CFC rules requires a careful analysis of these rules.
If a foreign corporation is a CFC during a taxable year, the U.S. shareholder is generally required to include in gross income for U.S. tax purposes its pro rata share of only certain types of undistributed income of the CFC (collectively called “subpart F income”). In addition to requiring that the U.S. shareholder include in income a pro rata share of the CFC’s subpart F income, the U.S. shareholder will need to include in his or her income certain favored investments such as investments in U.S. property.
After carefully reviewing the CFC rules and attribution rules of Internal Revenue Code Section 958, you may be ready to determine your proper filer classification. The above discussed rules are not only important to determine your Form 5471 filing category characterization, you will need to know the CFC and attribution rules of Section 958 to complete Schedule B of Form 5471. Schedule B of the Form 5471 asks the filer to list the name, address, and identify the number of shares in the foreign corporation. Schedule B asks you to name the U.S. shareholders of the foreign corporation and the percentage of shares owned by each U.S. shareholder. In essence, Schedule B asks you to tattle on the other U.S. shareholders of the foreign corporation to the IRS. Part 1 Section E of Schedule B, also asks you to utilize the CFC allocation rules to determine your “pro rata share of subpart F income.” You will need to use the above discussed CFC and attribution rules of Internal Revenue Code Section 958 to determine your percentage of subpart F income from the foreign corporation.
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 international tax matters throughout the United States. 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.