Controlled Foreign Corporation Effects on U.S. Expats

When a particular business needs international exposure, one of the best ways to do that is creating a Controlled Foreign Corporation (CFC). A CFC is a business entity, registered and operating in a country different than the residency of the controlling owners. In the case of CFC rules for U.S. citizens, 50% of the voting power or the value of its shares must be owned by U.S. shareholder. To qualify as a shareholder the person has to own at least 10% of the voting power. The CFC rules were originally introduced in 1961 as a measure of dealing with tax evasion by U.S. citizens who set up foreign companies in low or no tax jurisdictions. The set of rules is very complex and sometimes can be hard to comprehend for someone who does not deal with the IRC professionally.
The CFC rules were originally introduced in 1961 as a measure of dealing with tax evasion by U.S. citizens who set up foreign companies in low or no tax jurisdictions. The set of rules is very complex and sometimes can be hard to comprehend for someone who does not deal with the IRC professionally.
U.S. shareholders are required to fill in a disclosure form (Form 5471). The amount and type of the information that would need to be disclosed depends on the category of the taxpayer. Generally, a U.S. shareholder will be required to share information about their basic personal details like name, address, etc., classes and attributes of issued and outstanding stock, balance sheet, income statement and their current earnings and profits. The complication comes from the fact that the U.S. shareholders are taxed on current basis on particular types of income earned by the CFC, called Subpart F income, even when the CFC has not made actual distributions of that income to the shareholders. In addition, the tax rates are the same as those on ordinary income, even if it was treated like capital gains. This is slightly unfair, given the fact that capital gains would usually save a taxpayer money as they should be taxed on a lower rate.

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There are 4 main types of Subpart F income which make up the CFC gross income. Some of these can be deemed as dividend distribution and then must be detailed in the taxpayer’s personal income tax return.
  • Foreign Based Holding Company Income: this consists of royalties, rents, annuities, interests and dividends.
  • Foreign Based Company Sales Income: this includes any income from the sale or purchase of a personal property to or from a related person. The property must have been manufactured and sold outside of the country of incorporation.
  • Foreign Based Company Service Income: this means any income for the delivery of personal service for the CFC for or on behalf of a related person. The service must have been performed outside of the country of incorporation.
  • Insurance Income: this is income, which came as a result of issuing insurances on properties, liability arising out of an activity, or life and health of people. The properties, activities or persons must have been or residing a country different than the country of incorporation.

There’s a rule which allows the second and third components to be excluded from the gross Subpart F income, as well as any insurance income which is up to $1 million or makes up 5% of the gross income (the lesser applies) .

However, here comes another spin. If a foreign company has qualified as CFC for at least 30 consecutive days during the tax year and it has been established that the CFC has Subpart F income, the U.S. shareholder would have to include a deemed distribution in their gross income. In the case where a U.S. shareholder owns some amount of stock in a foreign company in the last day of the tax year in which the company has qualified as CFC, the shareholder is treated as if they are receiving a deemed dividend from the CFC equal to their pro rata share of the Subpart F income. There’s a specific formula used to calculate the pro rata share and it looks like this:
Ax B x C = D, where:
A = % of stock owned at the end of the tax year;
B = Subpart F income;
C = Number of days in which the corporation was a CFC (it could be during the whole year, i.e. 365 days, but no less than 30 days)
D = Pro rata share of the Subpart F income to the U.S. shareholder

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The deemed dividend may be reported as part of the U.S. shareholder’s individual or entity tax return, depending on which applies to the particular case. It must be accompanied by a copy of the disclosure Form 5471, which we already mentioned above.
The effects of Controlled Foreign Corporation rules are far too many and far too complex to be described in just one article. What we have tried doing today, though, is giving you a basic understanding of the general requirements and implications on CFC taxation. It is fair to say that every individual situation will not fit into certain brackets and deeper exploration of the related rules will be needed. If you feel that there are too many questioned left unanswered in relation to CFC or you are not sure how exactly to apply the rules in your particular case, the best thing to do would be to contact an experienced CPA who will go over every single detail of your situation and will give you the best advice on how to derive maximum benefits for yourself and your CFC.

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.

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