Controlled Foreign Corporations (CFCs) are a hot topic for U.S. expats who own or are considering owning a foreign company abroad. Understanding the U.S. tax implications of a CFC is crucial for compliance and optimal tax planning. This article aims to provide a comprehensive overview of what a CFC is, the benefits, and the tax obligations under U.S. law, focusing on the Internal Revenue Code (IRC) sections relevant to CFCs in the United States.
WHAT IS A CONTROLLED FOREIGN CORPORATION?
A Controlled Foreign Corporation is a corporate entity registered and operated in a foreign jurisdiction, where more than 50% of the total combined voting power or value is owned by U.S. shareholders. According to IRC Section 957, U.S. shareholders are defined as U.S. persons who own at least 10% of the foreign entity’s voting shares. This direct ownership is crucial for determining whether a corporation is a CFC under U.S. tax rules.
COMBINED VOTING POWER AND STOCK OWNERSHIP
The term “combined voting power” refers to the total voting rights held by U.S. shareholders in a foreign company. Stock ownership is not just direct but can also be indirect ownership through another entity. Understanding both direct and indirect ownership is crucial for determining CFC status.
FUNCTIONAL CURRENCY AND FINANCIAL STATEMENTS
The functional currency is the primary currency used in the day-to-day operations of the CFC. Financial statements, including balance sheets and income statements, must often be translated into U.S. dollars for reporting purposes.
BENEFITS OF OWNING A CFC
Tax Planning Flexibility: Owning a CFC allows for more strategic tax planning. You can decide how to distribute profits, whether as dividends, salary, or retained earnings, to optimize your taxable income.
Elimination of U.S. Self-Employment Tax: One of the most significant benefits for self-employed U.S. expats is the ability to pay oneself a salary from the CFC, potentially eliminating the U.S. self-employment tax. This is especially advantageous in countries that have not signed a totalization agreement with the United States, as these agreements often require payment of social security taxes to the host country, eliminating the U.S. self-employment tax.
Deferral of U.S. Taxation: Under certain threshold requirements, income earned by a CFC can be deferred from U.S. taxation until it is distributed to U.S. shareholders as dividends. This allows for potential tax savings and the ability to reinvest undistributed earnings in the business before paying U.S. income tax.
Access to Lower Corporate Tax Rates: If the CFC is located in a foreign jurisdiction with a lower corporation tax rate than the U.S., there may be opportunities for tax savings. However, this benefit is somewhat mitigated by the U.S.’s anti-avoidance provisions, such as the Global Intangible Low-Taxed Income (GILTI) tax and Subpart F rules, which aim to prevent profit-shifting to low-tax jurisdictions.
Asset Protection: Owning assets through a CFC can provide an additional layer of legal protection, as the assets are owned by a separate legal entity. This can be beneficial in protecting assets from creditors or legal disputes.
Estate Planning: A CFC can also be an effective tool for estate planning. By placing assets within a CFC, you may be able to more efficiently pass wealth to future generations, although this comes with its own set of complex tax implications that should be carefully considered.
Business Expansion Opportunities: Having a CFC can make it easier to expand your business operations into other countries. The CFC can serve as a hub for international activities, potentially providing access to new markets and customers.
It’s important to note that while owning a CFC can offer several benefits, it also comes with complex reporting requirements and potential tax liabilities, such as the GILTI tax and Subpart F income rules. These special rules are crucial for U.S. expats to understand, especially when it comes to filing their income tax returns.
GILTI VS. SUBPART F: WHAT’S THE DIFFERENCE?
Both GILTI (Global Intangible Low-Taxed Income) and Subpart F income are U.S. tax provisions aimed at preventing U.S. taxpayers from shifting profits to low-tax jurisdictions through Controlled Foreign Corporations (CFCs). However, they target different types of passive income and operate under distinct rules. Here’s a breakdown:
WHAT IS GILTI TAX?
GILTI is a provision introduced by the Tax Cuts and Jobs Act of 2017. It aims to tax U.S. shareholders on investment income earned by their CFCs that exceeds a 10% return on tangible assets. Essentially, it’s designed to target income that is presumed to be “intangible” like royalties, rather than income generated from physical assets like factories.
How It’s Taxed: GILTI is taxed at the U.S. shareholder’s marginal tax rate, and it’s calculated on a global basis, meaning it aggregates the income and assets of all CFCs owned by the U.S. shareholder. However, a 50% deduction is available for corporate U.S. shareholders, effectively reducing the tax rate to 10.5%. Foreign tax credits may also be available to offset the U.S. tax liability.
Related: Avoiding GILTI Tax on CCPCs for US Expats
WHAT IS SUBPART F INCOME?
Subpart F income rules have been around since the 1960s and are designed to prevent U.S. shareholders from deferring U.S. tax by keeping certain types of easily movable income in foreign subsidiaries. This includes income like dividends, interest, rents, and royalties.
How It’s Taxed: Subpart F income is taxed immediately in the year it is earned, regardless of whether it is distributed to the U.S. shareholder. The tax rate is the U.S. shareholder’s marginal tax rate. Unlike GILTI, Subpart F income is calculated on a per-entity basis, meaning each CFC is considered separately for Subpart F purposes.
Type of Income: GILTI targets “intangible” income that exceeds a 10% return on tangible assets, while Subpart F targets specific types of easily movable income.
Calculation Basis: GILTI is calculated on a global basis, aggregating all CFCs, while Subpart F is calculated on a per-entity basis.
Tax Rate: Corporate U.S. shareholders can get a 50% deduction on GILTI, effectively reducing the tax rate to 10.5%. Subpart F income doesn’t offer this deduction.
Foreign Tax Credits: Both allow for foreign tax credits, but the rules are more restrictive for GILTI.
Deferral: Subpart F income is immediately taxable, while GILTI allows for some deferral opportunities based on the 10% return on tangible assets.
HOW ATTRIBUTION RULES CAN AFFECT U.S. EXPATS AND THEIR FILING OBLIGATION?
Attribution rules are a set of IRS regulations that determine who is considered the “constructive owner” of a corporation for tax purposes. These rules are particularly relevant for U.S. expats who may think they can avoid U.S. tax obligations by setting up a foreign corporation in the name of a non-U.S. spouse or other family members. However, under attribution rules, shares owned by a spouse, parents, children, or grandchildren can be “attributed” to the U.S. expat, making them the constructive owner. This means that even if the corporation is technically in someone else’s name, the U.S. expat could still be subject to U.S. tax filing requirements, including Form 5471 for Controlled Foreign Corporations (CFCs). Ignorance of these rules can lead to unexpected tax liabilities and penalties, making it crucial for U.S. expats to understand how attribution rules apply to their specific situations.
In summary, navigating the intricate landscape of owning a Controlled Foreign Corporation (CFC) is a task that shouldn’t be taken lightly, especially for U.S. expats. Understanding the nuances of GILTI tax, Subpart F income, and attribution rules is crucial for ensuring compliance and optimal tax planning. Proper planning can help you avoid the pitfalls of double taxation, unexpected tax liabilities, and costly penalties.
Given the complexities involved, particularly with Form 5471, we strongly recommend consulting a tax professional. At 1040 Abroad, we charge $500 specifically for this form due to its intricate nature. We also offer free tax consultations via email to help you better understand your obligations and options.
If you have any questions or need further clarification, please don’t hesitate to contact us. We are committed to bringing tax knowledge to the world, empowering you to make informed decisions about your financial future.
Olivier Wagner, 1040 Abroad
A tax preparer who is both an Enrolled Agent and a CPA (New Hampshire) very well aware of the tax situation of US citizens living abroad. He runs the tax practice 1040Abroad.
USA: (833) 397-2829 (toll free)
320 Bay St. Suite 101
Toronto, ON M5H 4A6
1632 1st Ave #29692
New York, NY 10028
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