Can a US person who owns shares in a foreign corporation be subject to current taxation on the undistributed earnings and profits of that foreign corporation? The short answer to that question is that it is possible but as with everything US tax related, the answer depends on the facts and circ*mstances of each case.
Under the general rules of the Internal Revenue Code (Code), foreign corporations are subject to US taxation only to the extent they earn income from a trade or business in the United States, or otherwise have US source income. Thus, a foreign corporation that earns only foreign income generally would not be subject to US taxation. Furthermore, under the general US federal income tax rules, US shareholders of a foreign corporation are not subject to taxation on income earned by the foreign corporation until the income is actually distributed to them.
The rules applicable to the Controlled Foreign Corporations (CFCs) regime do not change the general US income tax rules regarding the taxation of foreign corporations. Instead, the CFC provisions change the general rules of taxation of US persons who are shareholders in certain foreign corporations. Specifically, a US person who is subject to the CFC provisions may be required to include in income certain undistributed earnings of the foreign corporation as if such earnings had been distributed currently.
The basic rules for taxing undistributed income earned by certain foreign corporations to US persons who own stock in the foreign corporation provides that if a foreign corporation is a controlled foreign corporation (CFC) at any time during any taxable year every person — (1) who is a “US shareholder” of such corporation and (2) who owns (or treated as owning) stock in such corporation on the last day (in such year) on which such corporation was a CFC — will include the shareholder’s pro rata share of certain income, withdrawn investments and investments of earnings of the CFC in its gross income for the shareholder’s taxable year during which the CFC’s taxable year ends.
This rule sets forth three threshold requirements for the taxation of undistributed earnings and profits to apply:
- The foreign corporation must be a CFC
- The shareholder must be a US shareholder
- The CFC must derive certain types of income, have withdrawn certain investments or have invested its earnings in certain assets
The CFC provisions apply only to US shareholders of a foreign corporation that meets the definition of a “controlled foreign corporation.” In general, a CFC is defined as any foreign corporation if more than 50% of (1) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation, is owned by US shareholders at any time during the foreign corporation’s taxable year.
A “US shareholder”, for these purposes, is a US person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10% or more of the total value of shares of all classes of stock of the foreign corporation. A US person is defined generally as any domestic corporation, domestic partnership, domestic trust or estate, or US individual citizen or resident.
Ownership in the foreign corporation can either be direct, indirect (i.e. through another entity) or constructive (i.e. rules that attribute the ownership of stock to certain family members, between certain entities and their owners, and to holders of options to acquire stock). Note that for CFC purposes, stock owned by a non-US individual (other than a foreign trust or estate) shall not be considered as owned by a US individual (either citizen or resident alien).
Finally, the Tax Cuts and Jobs Act of 2017 (TCJA) repealed the prevention of downward attribution of stock ownership from foreign persons to US person; therefore, US persons that previously were not treated as US shareholders and foreign corporations that were not treated as CFCs may be treated as a CFC.
US shareholders are subject to current taxation on their pro rata share of only certain types of income, and investments of the CFC. Specifically, these include:
- Subpart F income
- The amount of the CFC’s earnings invested in US property, sometimes referred to as the “Section 956 inclusion” amount
- The US shareholder’s global intangible low-taxed income (GILTI) for the taxable year
Subpart F income, for these purposes, includes primarily passive income i.e. dividends, interests, rents, royalties, currency and commodities gains, and gains from the sale of property. Generally, the inclusion of subpart F income is limited by the company’s current earnings and profits. Subpart F income is taxed as other income which means that for US individual shareholders, the distributions will be treated like nonqualified dividends and taxed at ordinary income rates.
Furthermore, there are exceptions to the general rule – for example, a CFC can have aminimal amount of Subpart F income (if the amount of subpart F income is less than the lesser of 5 percent of gross income or $1 million, none of the CFC’s income will be Subpart F income). Certain interest income and dividend income may also not be Subpart F income if earned by one CFC from another CFC if both CFCs are in the same country or if the lower CFC is an active trading business and the upper CFC owns 25% or more of that lower CFC.
Categories of Investment in US Property include the following: (1) certain loans made by the CFC to a US shareholder; (2) purchase by the CFC of stock in a related US company; (3) formation of a US branch by the CFC in which the CFC uses its earnings realized from foreign operations to acquire tangible real or personal property in the US; or (4) the use in the US by a CFC of intangible property that it has purchased or developed or the license of such intangible property to a US parent or related US company for use in the US.
With the passing of the TCJA, Section 956 inclusions are no longer an issue for most corporate US shareholders. However, individual US shareholders may still have to pick up undistributed earnings and profits with respect to any Investments in US Property. For example, if a CFC loans money to its US individual shareholder and the CFC has sufficient earnings and profits to pay a dividend, some or all of the money loaned may be current income to the US shareholder as the loan would be an Investment in US Property. As with Subpart F income, Section 956 Inclusions are taxed at ordinary income tax rates instead of a potential preferential rate for qualified dividends.
GILTI means the excess (if any) of that shareholder’s “net CFC tested income” for the taxable year over the “net deemed tangible income return” for the taxable year.
- Net CFC tested income reduced by tested loss of the CFC
- Tested income of a CFC is the excess of gross income over deductions (including taxes) properly allocable to such income, and tested loss of a CFC is the excess of allocable deductions over gross income
- Net deemed tangible income return means the excess of 10% of the aggregate of the US shareholder’s pro rata share of the “qualified business asset investment” (QBAI) of each CFC over a certain amount of interest expense
- QBAI is defined as tangible, depreciable property used in a trade or business that produces tested income
Subpart F income and GILTI previously taxed under the above rules that is subsequently distributed is referred to as “previously taxed income” (PTI) and is not subject to further US income tax.
A US corporate shareholder can claim a deemed paid foreign tax credit for taxes paid by the CFC with respect to amounts taxed to US shareholders under the above rules.
Individuals who are US shareholders can make an election to be taxed as a corporation on income taxable under the subpart F and GILTI rules, and, therefore, apply the corporate tax rates and claim a deemed paid foreign tax credit with respect to the foreign tax paid on such income.
Article written by Bradley Albin
