In 1961 President John F. Kennedy addressed Congress regarding the need to eliminate the tax deferral benefits for all U.S.-owned firms operating through foreign subsidiaries. Congress responded with one of the most complex sections of the Internal Revenue Code, Subpart F of Chapter N (sections 951-964), constituting the rules for controlled foreign corporations (CFC).
A CFC is any foreign corporation in which U.S. shareholders own more than 50% of the total combined voting power of all classes of stock entitled to vote, or 50% of the total value of stock of such corporation. (A U.S. shareholder is any U.S. person who owns or is deemed to own 10% or more of all classes of stock entitled to vote.)
A U.S. taxpayer who is a shareholder in a CFC must file Form 5471. In most cases the form is an information disclosure. The information required to be disclosed depends on the category of the filer. Typical disclosures include information regarding the shareholders, classes and attributes of issued and outstanding stock, income statement, balance sheet, and current earnings and profits. All financial information must be in accordance with U.S. GAAP.
If the CFC’s revenue consists of Subpart F income, a portion of that income may have to be recognized as a deemed dividend distribution on the taxpayer personal income tax return (Form 1040). The four major components of subpart F income may be summarized as follows:
A de minimis rule allows for the exclusion of all gross foreign based company income (items 2 and 3 above) and insurance income less than the lesser of 5% of gross income or $1 million. Conversely, there is a full inclusion of all CFC gross income as gross foreign-based company income and insurance income if 70% of the CFC’s gross income is gross foreign-based company and insurance income.
Expenses directly related to and expenses allocated and apportioned to subpart F income may be deducted against subpart F income. In addition, the U.S. shareholder’s pro rata share of earnings and profits previously included in gross income and current year distributions reduce total subpart F income.
If the foreign corporation is determined to be a CFC for an uninterrupted period of 30 days (determined each year), and it is determined that a CFC has subpart F income, then a U.S. shareholder must include in gross income a deemed distribution. A U.S. shareholder who owns stock in a foreign corporation on the last day of the taxable year during which the corporation is a CFC is treated as receiving a deemed dividend from the CFC equal to the shareholder’s pro rata share of the subpart F income computed as follows (assuming one class of issued stock):
Pro rata share of subpart F income to U.S. shareholder = % of stock owned at year end X Subpart F Income X # of days the corporation was a CFC/Total # of days in the year.
The deemed divided is reported on the U.S. shareholder's individual or entity return as applicable. A copy of the Form 5471 must also be attached to the shareholder’s U.S. tax return.
The above is a general outline of the CFC rules and is by no means comprehensive. We hope this outline is helpful to provide our clients with a general understanding of this complex area of the tax code. We look forward to providing the reader with tax consulting and compliance services with relation to specific facts and circumstances.