By Anthony Diosdi
The Revenue Act of 1962 enacted Subpart F of the Internal Revenue Code. The 1962 Revenue Act adopted the mechanism of taxing U.S. shareholder on their pro rata shares of the controlled foreign corporation’s (“CFC”) undistributed income as if those shares of income had been distributed as dividends. In general, the purpose of subpart F is to discourage U.S. taxpayers from using foreign corporations to defer U.S. taxes by accumulating certain types of income in foreign “base” companies located in low-tax jurisdictions. Subpart F is primarily directed at two types of income: passive investment income and income derived from dealings with related corporations (i.e., using a base company to shift income away from related parties).
The basic operation of the subpart F provisions is straightforward: certain U.S. taxpayers are taxed directly (as if the foreign corporation were a pass-through entity) on certain income earned by certain CFCs.
In order for subpart F to be triggered, there must be a CFC. A corporation that is not a CFC is treated for tax purposes as a separate entity and is governed by the traditional tax rules. A foreign corporation is a CFC if U.S. shareholders own more than 50 percent of the total combined voting power of its stock or more than 50 percent of the stock’s total value. A U.S. shareholder is defined as a U.S. person owning at least 10 percent or more of the total voting power of the corporate stock. In testing whether a foreign corporation is a CFC, the Internal Revenue Code looks to direct and indirect ownership and to constructive ownership.
The definition of “subpart F income” has five components. The most important component is “foreign base company income.” The other four components are: 1) income from certain insurance activities; 2) certain international boycott-related income; 3) certain illegal bribes, kickbacks or other payments to government officials, employees or agents, and 4) income from certain ostracized foreign countries to which Internal Revenue Code Section 901(j) applies.
The “foreign base company income” component of subpart F income, in turn, has three components: 1) “foreign personal holding company income; 2) “foreign base company sales income,” 3) “foreign base company services income.”
Exception for High-Taxed Income
An item of income of a CFC that would otherwise be tainted foreign base company income will not be included in any “item of income” of a CFC that the taxpayer establishes has been subject to an effective rate of income tax of at least 90 percent of the maximum U.S. corporate tax rate (i.e., 18.9 percent for years beginning after January 1, 2018). The regulations require the U.S. shareholders of a CFC to make an election in order for this high-taxed income exception to apply. See Treas. Reg. Section 1.954-1(d)(1)(i).
This high-taxed income exception applies after the de minimis rule in Section 954(b)(3)(A). Under the de minimis rule, if less than the lesser of $1,000,000 or five percent of the gross income of a CFC is foreign base company income (determined without deductions), none of the gross income is treated as foreign base company income for that year. See IRC Section 954(b)(3)(A).
Items of foreign base company income qualify for this exception generally are treated as foreign base company income for purposes of applying the full-exclusion rule and can cause non-foreign base company income to be treated as foreign base company income under the full-inclusion rule. The regulations, however, contain a special rule that applies if the high-taxed election is made and more than 90 percent of the CFC’s gross foreign base company income and gross insurance income is attributable to income items qualifying for the high-taxed income exception. If this special rule applies, the CFC’s non-foreign base company income that would be treated as foreign base company income only by reason of the full-inclusion rule will be excluded from subpart F income. See Treas. Reg. Section 1.954-1(d)(6).
Below, please find an illustration regarding the high-tax exemption for purposes of the subpart F rules.
FC, a CFC, has $10,000 of portfolio dividend income and $145,000 of interest income that are foreign personal holding company income. FC also has $45,000 of manufacturing income that is not foreign base company income. Under the full-inclusion rule of Section 954(b)(3)(B), because FC’s gross foreign base company income of $155,000 exceeds 70 percent of FC’s total gross income of $200,000, all of its gross income, including the $45,000 of non-foreign base company income, would normally be treated as foreign base company income.
If, however, FC’s interest income is subject to an effective foreign tax rate 20 percent, the $145,000 of interest income will qualify for the high-taxed income exception in Section 954(b)(4) and FC’s income qualifying for the high-taxed income exception will constitute more than 90 percent of its gross foreign base company income of $155,000. Therefore, if FC has the high-taxed income election in effect, the $45,000 of manufacturing income will be excluded from subpart F income treatment. The $145,000 of interest income is excluded from foreign base company income under the high-taxed exception in Section 954(b)(4). The portfolio dividend income is foreign personal holding company income under Section 954(c) and will not be excluded from foreign base company income under the de minimis rule in Section 954(b)(3)(A) because the de minimis rule applies before the high-taxed income exception.
The high-tax exception is limited to a CFC’s current E&P. To the extent that the current E&P limitation reduces a subpart F inclusion in one year, a recapture account is established under Internal Revenue Code Section 952(c)(2). This recapture account may result in the reclassification of non-subpart F income to subpart F income in a later year when the E&P of the CFC exceeds its subpart F income.
As seen from this brief discussion of the high-taxed exception, the high-taxed exception is one of the few remaining avenues to defer U.S. taxation on foreign source income.
The rules discussed above are extraordinarily complex. Any U.S. shareholder of a CFC should consult with a qualified international tax professional should they have any questions regarding their U.S. tax compliance requirements.
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 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.