What is Subpart F Income?
It relates to international tax and is income earned within a Controlled Foreign Corporation (CFC) that will be taxed to the U.S. person taxpayers, irrespective of being distributed to the U.S. person taxpayers.
What are the Different Types of Income For Subpart F Purposes?
FBCSI (Foreign Base Company Sales Income)
The FBCSI rules help to prevent U.S. shareholders from avoiding U.S. taxation by using a foreign corporation they own to shift or divert U.S. income (sales income usually) to a foreign jurisdiction with a low tax rate.
When a CFC either buys or sells tangible personal property
- from/to (or on behalf of) a related person, and the property is
- manufactured, produced, constructed, or extracted outside the country where the CFC is incorporated,
- and the property is purchased/sold for consumption or disposition outside the country where the CFC is incorporated,
Such income will be regarded as FBCSI.
FBC Services Income (Foreign Based Company Services Income)
Foreign Base Company Services Income prevents services-based companies from being separated and moved from a related corporation to different jurisdictions with a lower tax rate to reduce its taxes on services income.
FBC Services Income prevents this profit-shifting scheme by placing an obligation on the U.S. Shareholders to include their share (pro-rata) of the CFC’s FBC Services Income in its current income.
FBC Services Income focuses explicitly on types of services that are technical, industry-specific, engineering or technical, and other similar services. The anti-abuse provision applies when the CFC derives this income by rendering services to a related person or on behalf of a related person rendered or performed outside the CFC’s country of incorporation.
FPHCI (Foreign Personal Holding Company Income)
Subpart F inclusion generally includes a Controlled Foreign Corporation’s income from dividends, interest, annuities, rents, and royalties, though this is not an exhaustive list.
Any insurance income taxed in subchapter L of the IRC if a domestic insurance company derived the income provided that such income is not “exempt insurance income.”
Example of Subpart F Income & U.S. Tax
Addie is a U.S. person who holds 60% of the shares and voting power in Addie and Sons Fisheries Inc, a foreign company (CFC) incorporated in the Isle of Man (IOM). This CFC’s only asset is a passive investment that generates annual interest and dividend income. Since the company is regarded as a CFC, the income earned will be attributable to Addie irrespective of her receiving any distributions / income from the company and income tax will be payable on Addie’s pro rata share.
Categories of Subpart F Income
What is Earnings and Profit (E&P)?
For Subpart F rules to apply, a company must have earnings and profit (E&P).
Earnings and profits (E&P) is essentially an economic concept of a corporation’s ability to pay dividends without distributing any capital contributed by its shareholders or creditors.
Exceptions, Exclusions, and Limitations to Subpart F
“Some of the common exceptions are:
- Inclusion Limited To Current E&P
- The amount included in a U.S. shareholder’s taxable income is limited to the undistributed E&P.
- De Minimis Rule
- If the Subpart F income (certain categories) of the CFC is less than $1,000,000 or 5% of the CFC’s gross income, that income category will be disregarded for purposes of Subpart F.
- High Tax Exception
- An item of income taxed at more than 90% of the highest U.S. rate
- Same Country Manufacturing Exception From FBCSI
- Manufacturing income generated in the CFC’s country of incorporation will not be regarded as FBCSI.
- Same Country Sales/Use Exception From FBCSI
- Sales or consumption Income generated from the sale or disposition of property in the same country as that of the CFC will not be regarded as FBCSI.
- CFC Manufacturing Exception
- Income from the sale of property that the CFC itself manufactures (anywhere) is not FBCSI.
- Active Financing Exception
- Income (that is qualified) generated by a CFC engaged in active banking, or similar service will not be regarded as F.P. Holding Company income.
- Look Through Exceptions From FPHCI
- Income that a CFC generates from providing services to a related CFC, which is neither regarded as Subpart F income nor Effectively Connected Income (ECI), will not be considered FPHCI.
- Same Country Exception From FPHCI
- A CFC that generates income from a related CFC in the same country and uses a substantial portion of its assets in day-to-day trade will not be regarded as FPHCI.
- Inclusion Limited To Current E&P
Calculating Subpart F Income (IRM 4.61.7)
18.104.22.168 (10-08-2019): Limitation as to Earnings and Profits
If the CFC’s E&P for a financial year is less than the U.S. shareholders’ includable portion for purposes of his gross income, it will be limited to the CFC’s E&P for the year.
61.7.8 (10-08-2019): Certain Prior Year Deficit
The income included in the U.S. shareholder’s gross income for the taxable year may be reduced by their pro-rata share of the CFC’s prior year qualified deficits.
CFC vs. PFIC Rules
There is some overlap in CFC and PFIC rules. A PFIC is a Passive Foreign Investment Company. The main difference is that the income of a PFIC is not conditional on the company being defined as a CFC. So PFIC applies irrespective of the foreign company’s CFC status.
With the introduction of the TCJA (Tax Cuts and Jobs Act (TCJA), the government revised the manner in which foreign income is taxed by the codification of the Global Intangible Low-Taxed Income regime.
Distributions of CFC Income
Section 959(a)(1) contains a rule for distributions that prevents double taxation of the CFC’s U.S. shareholders on the same earnings of the CFC by not attributing or including in a U.S. shareholder’s gross income actual distributions made by the CFC. A Foreign Tax Credit may also be available.
Investment of Earnings
“Undistributed, untaxed CFC income from U.S. property investments is regarded as a deemed dividend for the U.S. shareholder and is taxed on their pro-rata share of that U.S. property investment. U.S. property investments include tangible real or personal property in the U.S.
Certain Prior Year Deficit
Prior year deficits of a CFC may be used to reduce the U.S. shareholder’s gross income for the current year.
Attribution and Constructive Ownership
Constructive ownership refers to deemed ownership by a person that is not a company. In summary, if the person does not own stock directly, he could be considered to own the stock by way of constructive ownership.
- Generally, an individual shall be considered as owning stock, directly or indirectly, for his spouse; and (ii) his children, grandchildren, and parents.
- Effect of adoption. A legally adopted child of an individual will be treated the same as their biological child.
- Stock owned by a non-resident alien individual. An exception to the constructive ownership rules is if an individual regarded as a non-resident alien owns the stock.
GILTI vs. Subpart F Income
Defining Subpart F and GILTI
The main difference between the definitions is that the income for purposes of Subpart F is defined initially by what it includes, while GILTI is determined initially by what it excludes.
Subpart F and GILTI: A Brief Comparative History
Before the CFC rules, foreign-sourced income generated by a CFC was not attributable or included in a U.S. shareholder’s gross income if the shareholder didn’t receive a distribution from the CFC.
The IRC’s campaign against overseas tax deferral dates back to the 1960s with the enactment of the Revenue Act of 1962. This enactment added Subpart F to the IRC.
More recently, the TCJA added a new layer to the taxation of certain CFC income, which was done by codifying the GILTI regime.
Applying Subpart F and GILTI: The Case of Distributions of Appreciated Property
The difference in the definitions could have severe implications in the case of distributing appreciated property.
GILTI’s definition is sufficient to clarify how this should be applied. Due to GILTI first and foremost including all gross income, the gain should initially fall within the definition of GILTI. There are rules and regulations (reg) still being considered to make sure U.S. persons are not overtaxed.
Common Subpart F Income Questions & Answers
- What is income for purposes of Subpart F?
- It is income earned within a Controlled Foreign Corporation that is going to be taxed to the U.S. person, irrespective of being distributed to the U.S. person.
- Do I still get taxed even if I did Not Receive any Distribution?
- Does the IRS tax the Foreign Corporations directly?
- What is Attribution?
- Attribution is an artificial term where a person is deemed to have received income that is a taxable event though he never actually received anything directly.
- What is included in Subpart F income?
- Insurance income, foreign base company income (fbci), illegal bribes, and the income derived from a certain foreign country or countries as stipulated in IRC §901(j).
- How do you calculate Subpart F?
- A CFC calculates it by adding its adjusted net foreign base company income to its adjusted net income. The two main components are adjusted net foreign base company income and adjusted net insurance income, which are determined under specific rules and a multi-step process. Amounts resulting from bad acts are also added to a CFC’s income for subpart F purposes.
- What does Subpart F mean?
- It refers to the part of the Internal Revenue Code (IRC). Subpart F of subtitle A, chapter 1, subchapter N, part III of the IRC (subpart F) (§951–§965) provides comprehensive rules for taxing U.S. shareholders of controlled foreign corporations (CFCs). The fundamental operative feature of these rules is U.S. taxation of certain undistributed amounts earned by the CFC. The amounts subject to U.S. tax fall within three main groups.
- Can subpart F income be a loss?