By Anthony Diosdi
U.S. taxpayers that have an interest in a “controlled foreign corporation” (“CFC”) that are “U.S. shareholders” must file an Internal Revenue Service (“IRS”) Form 5471. Completing a Form 5471 is no easy task and there are serious penalties associated with not accurately filing this form. In addition, the federal tax consequences associated with filing a Form 5471 may be significant. Consequently, anyone with an interest in a foreign business organization must determine if that entity can be classified as a CFC and the U.S. tax consequences of the foreign entity being classified as a CFC.
A foreign corporation is a CFC if more than 50 percent of the total combined voting power of all classes 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 corporation. See IRC Section 957(a). A “U.S. shareholder” includes 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 discussed attribution rules applying or U.S. persons who own 10 percent or more of the total value of shares of all classes of stock of the foreign corporation. It should be noted that foreign partnerships or other entities can be classified as a foreign corporation for U.S. tax purposes.
If a foreign corporation is a CFC, each U.S. shareholder of the corporation (as defined in Section 951(b)), must include in their gross income a pro rata share of the corporation’s GILTI or subpart F income. In determining whether a U.S. person meets the Section 951(b) definition of a U.S. shareholder and whether a foreign corporation meets the definition of a CFC. Section 958 applies direct, indirect, and constructive ownership rules to determine stock ownership in the foreign corporation. Stock ownership under all three types of rules counts for purposes of determining whether a shareholder is a “U.S. shareholder” and whether a foreign corporation is a CFC.
Section 958(a)(1) provides the direct ownership rules for determining stock ownership 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 U.S. person and the foreign corporation. Specifically, 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 latter’s shareholders, partners, or beneficiaries.
Section 958(b) applies the constructive ownership rules of Section 318(a). Section 318 is one of several sets of constructive ownership rules in the Internal Revenue Code and applies only when it is expressly made applicable by another provision of the Internal Revenue Code.The attribution rules in Section 318 fall into the following four categories.
1. Family Attribution. An individual is considered as owning stock owned by his spouse, children, grandchildren and parents. See IRC Section 318(a)(1).
2. Entity to Beneficiary Attribution. Stock owned by or for a partnership or estate is considered as owned by partners or beneficiaries in proportion to their beneficial interest. See IRC Section 318(a)(2)(A). Stock owned by a trust (other than a qualified employee trust) is considered as owned by the beneficiaries in proportion to their actuarial interests in the trust. In the case of grantor trusts, stock is considered owned by the grantor or other person who is taxable on the trust income. See IRC Section 318(a)(2)(B).
3. Beneficiary to Entity Attribution. Stock owned by partners or beneficiaries of an estate is considered as owned by the partnership or estate. See IRC Section 318(a))(A). All stock owned by a trust beneficiary is attributable to the trust except where the beneficiary’s interest is “remote” and “contingent.” Grantor trusts are considered to own stock owned by the grantor or other person taxable on the income of the trust. All the stock owned by a 50 percent or more shareholder of a corporation is attributable to the corporation.
4. Option Attribution. A person holding an option to acquire stock is considered as owning that stock. See IRC Section 318(a)(4).
Section 958(b) makes the following four modifications to Section 318(a) constructive ownership rules:
1. In applying the family constructive ownership rules in Section 318(a)(1), Section 958(b)(1) provides that stock owned by a nonresident alien individual shareholder will not be attributed to a U.S. citizen or resident alien.
2. In applying the entity-to-entity constructive ownership rules in Section 318(a)(2), Section 958(b)(2) provides that if a partnership, estate, trust or corporation owns more than 50 percent of the combined voting power of a corporation, it will be treated as owning all of the voting stock of the corporation.
3. Section 318(a)(2)(C) treats stock owned by a corporation as owned proportionately by its shareholders, but only if the shareholders have a minimum threshold of stock ownership in the corporation.
4. Section 318(a)(3)(C) requires attribution of stock owned by a partner of a partnership, a beneficiary of a trust or estate or 50 percent or more shareholder of a corporation to the partnership, trust, estate or corporation.
For purposes of any one determination, in applying the direct, indirect, and constructive ownership rules in Section 958(a) and (b), the same stock cannot be counted twice (i.e., the same stock cannot be attributed twice to the same person under different indirect ownership or attribution rules or to two different persons under the same or different indirect ownership or attribution rules). However, stock which may be owned by a person under more than one of these rules, or by more than one person, is treated as “owned under that attribution rule which imputes to the person, or persons, concerned the largest total percentage of such stock. See Treas. Reg. Section 1.958-2(f)(2).
In certain cases, determining whether or not a foreign corporation is a CFC for U.S. compliance and tax purposes may be a difficult exercise. If you have an interest in a foreign corporation, you should consult with an attorney well versed in international tax planning and compliance. We provide international compliance assistance and international tax planning services to domestic corporations. We also assist other tax professionals who need guidance regarding international tax compliance matters.
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: firstname.lastname@example.org.
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.