Controlled Foreign Corporation - Explained
What is a Controlled Foreign Corporation?
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Table of ContentsWhat is a Controlled Foreign Corporation?How Does a Controlled Foreign Corporation Work?Do Other Countries Have CFCs?How is CFC income Taxed?Global Intangible Low-Taxed Income (GILTI)Mandatory Repatriation TaxAcademic Research for Controlled Foreign Corporation
What is a Controlled Foreign Corporation?
In the United States, a CFC is a foreign corporation in which US Shareholders own more than 50% of its value. The shareholders are required to report the foreign income earned, which is subject to US taxation.
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How Does a Controlled Foreign Corporation Work?
The CFC status is also called a Subpart F regulation since it was set up under Subpart F of the Internal Revenue Code. This category of the CFC was formed with the purpose of getting information on the income realized from the foreign corporations under US citizens' control and collect the tax associated with that income. Therefore, the management and shareholders of the CFCs are required to report the income from their earnings. According to IRS, a foreign corporation is controlled if: "more than 50% of the total combined voting power of all stock classes of such corporation entitled to vote, or more than 50 percent of the value of all its outstanding stock, is owned (directly, indirectly, or constructively) by U.S. shareholders on any day during the foreign corporation's tax year." Furthermore, the IRS defines a US shareholder on a foreign corporation as US citizen owning 10% or more of the total voting power of the foreign corporation. This means that a foreign corporation is determined by the amount of its stock owned by US shareholders. Occasionally, the IRS publishes information to auditors on the criteria that it looks at regarding CFC's. Such information includes:
- Whether a person owns shares in a foreign corporation
- Whether the shareholder is a citizen of the US for the CFC designation. In regards to this, the shareholder's citizenship and percentage of ownership are considered.
- Whether the business is a CFC. It must be a foreign business only treated as a corporation for tax reasons.
Under the Subpart F, the IRS treats the shareholder as if he received the proportionate share of specific categories of the current earnings of the CFC. All the US shareholders having a controlling interest in a foreign corporation are required to report their share of income from the CFC and their share of profits and earnings of the CFC that are invested in property in the US. This corporation is required to file an annual report on IRS Form 5471. This form is completed and then attached to the corporation's income tax return. It is submitted for a tax year by the company, and it requires information on:
- Individuals who are U.S. citizens: officers, shareholders, and directors
- A list of the total US shareholders and the stock which they hold.
- The classes of stock in the corporation and the shares outstanding.
- The income statement and the balance sheet of the corporation for the tax year.
In addition to this, a separate form is also required for any shareholder, officer and director meeting the 50% and above criterion. This form is used to list the individual's income from the foreign company in terms of dividends, other incomes and investments. This form or report is called a Summary of the Shareholders Income from the Foreign Corporation and is given to the person expected to include the income on his tax return. The income that is received by the individuals and the tax charged on this income is distinct from the corporate tax paid by the company. The preparation of such a report requires the expertise of a tax preparer who is knowledgeable about foreign corporations and taxes.
Do Other Countries Have CFCs?
Several other countries including the UK and Germany have foreign corporation designation although each country determines the CFC status and identifies the individuals differently to require them to report and pay taxes on foreign income.
How is CFC income Taxed?
The previously described summary report is included in the person's individual income tax return. The section of this return where the information is included depends on the type of income. If the income is dividends, for example, it might be included on Schedule B-Interest and Ordinary Dividends. The income is taxed depending on the type of income. Dividend income is usually taxed depending on the type of dividend and for how long it is held. Since the CFC status is complicated, it is difficult to know if one must report his income as a shareholder in a CFC. A US shareholder must include as gross income his pro rata share of the foreign entity's Subpart F income for the year if the Foreign Company is a CFC. The Foreign Personal Holding Company Income is the most common type of Subpart F, and it comprises mainly of passive investments like dividends, rents and capital gains from the sale of various assets. The Tax Code allows certain exceptions; for rents and royalties which are received from unrelated parties as the company conducts its business, the income earned from a payer who is incorporated in the same country as the recipient etc.
Global Intangible Low-Taxed Income (GILTI)
A new requirement was introduced for the US shareholders of CFCs by the Tax Cuts and Jobs Act to include their GILTI in their gross income. GILTI is seen as the excess of the shareholder's net CFC tested income for the year and the shareholder's net that is regarded as the substantial income for the year. GILTI, when included in gross income, is treated as Subpart F for various purposes. The corporate taxpayers are required to include 50% of GILTI in their taxable income so that their liability can be reduced by 80% of the foreign tax credits on the CFC's income. However, individual taxpayers and pass-through entities are required to include 100% of GILTI although they can elect to be taxed as corporations to enjoy the benefits accorded to such bodies. After repatriation, no further tax is imposed on the individuals who included GILTI in its income.
Mandatory Repatriation Tax
The earnings of a foreign company are not taxed in the US unless they are repatriated. Because of this rule, many US multinationals are taking advantage and maintaining the foreign earned income abroad to avoid US taxation. An estimated $1.6 to $2.1 trillion in foreign profits have escaped US taxes. A mandatory repatriation tax was put in place by the Tax Cuts and Job Acts on the accumulated foreign earnings and profits of a CFC and those foreign corporations owned by more than 10% US shareholders. This repatriation imposes a reduced 15.5% tax rate for the earnings held in cash or ash equivalent and 8% for others. It is a one-time repatriation tax that can be paid via installments for over eight years. A CFC can bring about tax consequences which are unfavorable for the US taxpayers more so if they are not prepared. US citizens expanding overseas need to be aware of the rules as well as resident aliens and foreign investors staying in the US and satisfy the Substantial Presence Test and own companies in their home country.
- Taxes and the division of foreign operating income among royalties, interest, dividends and retained earnings, Grubert, H. (1998). Journal of Public economics, 68(2), 269-290. Unlike previous work that focused mostly on dividend repatriation behavior, this paper analyses comprehensively the disposition of the foreign subsidiary operating income to show that taxes have a large and significant effect on the composition of payments.
- Fiscal paradise: Foreign tax havens and American business, Hines Jr, J. R., & Rice, E. M. (1994). The Quarterly Journal of Economics, 109(1), 149-182. This article discusses how the tax haven affiliates of American Corporations represent more than 20% of foreign direct investment and almost a third of the foreign profits of the US firms.
- Do taxes influence where US corporations invest?, Grubert, H., & Mutti, J. (2000). National Tax Journal, 825-839. This paper identifies the role of host countries tax rates in determining the capital that is invested in 60 possible locations by utilizing data which is aggregated from tax returns of more than 500 US multinational corporations.
- A Comparative Perspective on the US Controlled Foreign Corporation Rules, Arnold, B. J. (2011). Tax L. Rev., 65, 473. This article attempts to provide a comparative perspective on the US Subpart F rules through the examination of the CFC rules of selected countries.
- International tax as international law, Avi-Yonah, R. S. (2003). Tax L. Rev., 57, 483. This primary objective of this paper is to introduce to the international lawyer the different set of categories that are used by the international tax lawyers and then explain the causes of some of the differences.
- The taxation of passive foreign investment: lessons from German experience, Ruf, M., & Weichenrieder, A. J. (2012). Canadian Journal of Economics/Revue canadienne d'conomique, 45(4), 1504-1528. This paper investigates how the German CFC rules work in restricting the use of foreign subsidiaries located in low-tax countries to shelter the passive investment income from home taxation.
- The effects of US tax policy on the income repatriation patterns of US multinational corporations, Altshuler, R., & Newlon, T. S. (1991). (No. w3925). National Bureau of Economic Research. This study uses data from the 1986 corporate tax returns to examine the incentives which are created by the US tax system for the legal avoidance of taxes on foreign source income. It also investigates the extent to which the US corporations manage to structure and coordinate the remittances of income from their foreign subsidiaries to decrease their US and foreign tax liabilities.
- Coming home to America: Dividend repatriations by US multinationals, Hines Jr, J. R., & Hubbard, R. G. (1990). In Taxation in the global economy (pp. 161-208). University of Chicago Press. This paper analyses the financial flows emanating from the foreign subsidiaries of American multinational corporations to their parent corporations located in the United States.
- Has US investment abroad become more sensitive to tax rates?, Altshuler, R., Grubert, H., & Newlon, T. S. (2000). (pp. 9-38). University of Chicago Press. This paper utilizes data that is derived from the US Treasury corporate tax files from 1984 and 1992 to answer two questions which are related and are concerned about the investment decisions of the US multinational corporations.
- The impact of controlled foreign company legislation on real investments abroad: A two-dimensional regression discontinuity design, Egger, P. H., & Wamser, G. (2011). This study quantifies the impacts of CFC rules on foreign investments through the use of a regression discontinuity design and the universe of German foreign investments which are notified to Deutsche Bundesbank.
- Controlled Foreign Corporations, 1988, Latzy, J., & Miller, Y. (1992). This paper describes how the largest foreign corporations that were controlled by large multinational firms held around $958 billion in assets and then managed to generate $823 billion in business receipts. It further states that these amounts had increased from those of 1986 by 29% and 40% respectively.