Controlled Foreign Corporation Cfc Definition Rules Examples

Controlled Foreign Corporation (CFC) Definition

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Jurisdictions use a range of factors to determine control. For example, some jurisdictions state that a foreign corporation is a CFC if it conducts its operations in a low-tax jurisdiction. Some jurisdictions base CFC designation on a taxation test, while some consider resident taxpayers‘ voting rights or shareholder value.

Key Takeaways

Controlled Foreign Corporations are those in which the United States shareholders own more than 50% of the stock’s total value or the combined voting power of all classes of stock, directly, indirectly, or constructively on any day during the foreign corporation’s tax year.Jurisdictions use a range of factors to determine control of CFCs.Different jurisdictions have different definitions of CFC income, with some exclusively enforcing passive income while others enforce CFC restrictions on all forms of income.Subpart F of the Internal revenue code has covered the taxation of CFC earnings under U.S. law.

Controlled Foreign Corporation (CFC) Explained

A Controlled Foreign Corporation is a foreign business directly or indirectly under the control of a resident taxpayer. Any foreign corporation directly or indirectly under the ownership of the United States (U.S. shareholders) on any day during the foreign corporation’s tax year is a CFC.

This applies to any foreign corporation with more than 50% of its total combined voting power across all classes of stock that carry voting power or whose total stock value is owned. Meanwhile, a U.S. shareholder is only a United States citizen who owns 10% or more of the total voting power or market value of all classes of a corporation’s shares.

In addition to the various factors considered for determining control, different jurisdictions have different controlled foreign corporation rules for income. For example, while some exclusively enforce passive income, others enforce CFC restrictions on all forms of income (i.e., income from sources such as interest, dividends, rental property, royalties, or capital gains). Furthermore, the usage of substantial activity tests varies across jurisdictions.

Rules

The early stages of examining CFCs typically involve determining the applicability of subpart F of the Internal Revenue Code and exclusions to the taxpayer. The following information is necessary to understand the scope and mode of taxpayer operations:

Consolidated financial statements, including operating results of all related foreign entities.Certified (or other) statements and corporate books (including minutes of meetings) of the individual foreign entities (including translations wherever applicable).Copies of all international tax returns submitted by affiliated foreign entities where the taxpayer holds U.S. shareholder status.A statement from the taxpayer outlining how each associated overseas entity operates.If such returns were filed for any linked foreign entity, the original Form 1120 or Form 1120-F (or copies thereof).Organizational charts displaying the connections between all domestic and international entities (including respective stock ownership percentages).Information on modifications to accounting methods made to comply with IRC 951 requirements.Copies of existing corporate documents (publications, manuals, instructions, or correspondence) outline the steps for reporting foreign revenue.If returns were submitted, the original Forms 5471 or copies of those forms.

Taxation

The taxation of CFC earnings under U.S. law is present in Subpart F of the Internal Revenue Code. Following its provisions, some forms of CFC income undistributed must be included in the U.S. shareholder’s gross income in the year the CFC earns the income. A new taxation subpart F regime for global intangible low-taxed income (GILTI) came into existence in 2017.

Before the tax reform, a U.S. citizen was taxed only on income received as a foreign corporation dividend. Shareholders with 10% ownership of controlled foreign corporations should report their share of the overseas revenue on their tax filings. Certain previously deferred profits also became taxable under the IRC 965 transition tax. The taxation part is complex and vast. However, a few highlights are as follows:

There are two sets of CFC inclusion regulations in the U.S.

Regulation 1

A U.S. shareholder must report their portion of a CFC’s subpart F income, typically passive or mobile revenue, as income. The de minimis rule of subpart F states that revenue that would otherwise be subject to the subpart F rules will not be part of the subpart F income category if it is less than the lesser 5% of the CFC’s gross income or $1,000,000. However, if a CFC’s subpart F income and insurance income surpass 70% of its gross income, then all of the CFC’s income will be subpart F income.

The controlled foreign corporation rules governing subpart F income also include a high tax exception, about subpart F income subject to an effective income tax rate imposed by a foreign nation greater than 90% of the highest corporate tax rate in the United States (currently greater than 18.9%).

Regulation 2

Under the second set of regulations (introduced in 2017), U.S. shareholder must include their GILTI (global intangible low-taxed income) in their income. First, a 10% return on the tangible assets of the CFCs from the GILTI amount is deducted. After this, the GILTI regulations apply a formulaic approach that often involves an income inclusion by the U.S. stockholder based on their portion of the income of their CFCs.

The term ‘such income’ excludes income effectively connected to a trade or business carried on in the United States (taxed separately). Related-party dividend revenue and foreign oil and gas extraction income are also exempt. The same goes for the income that would be subpart F but is exempt from taxation due to high tax rates.

Some of the taxable subpart F income under IRC 952 includes insurance income defined in IRC 953 and foreign base company income defined in IRC 954. It also includes income as determined under IRC 952(a)(3) (amounts applicable under IRC 999’s international boycott rules) and any foreign country revenue where IRC 901(j) applies. In addition, income from foreign-based corporations, as defined by IRC 954, consists of the following:

Income from foreign personal holding companies (FPHCI)Sales revenue from the foreign-based companyForeign-based company services revenue

Examples

Let’s take a look at some controlled foreign corporation examples to get a better idea of the topic:

Example #1

Alex is an entrepreneur and owns 75% of a company that sells kitchen utensils in the U.K. Alex is a U.S. resident taxpayer. Since Alex owns 75% of the company, it is a controlled foreign corporation.

Example #2

Class I and Class II stock includes 70 and 30 shares outstanding for the foreign corporation “Atlas.” For all purposes, each share of each class of stock has one vote. Susan, a citizen of the United States, holds fifty-one shares of Class I stock. Corporation’ Atlas” is, therefore, a controlled foreign corporation.