Introduction

The most common type of Subpart F income is referred to as Foreign Base Company Income. This category includes 4 subcategories in the Internal Revenue Code:

  1. Foreign personal holding company income;
  2. Foreign Base company sales income;
  3. Foreign base company service income;
  4. Foreign base company oil-related income.

When a foreign company (or subsidiaries) has taxpayers who are United States shareholders, it’s a Controlled Foreign Corporation (CFC) for US tax purposes. Even if a CFC is operated abroad, some types of income will be taxed in the US for the United Stated shareholder as earned. The most common category of taxable income in a CFC is Foreign Base Company Income and is includable in the gross income of the shareholder. 

A company (or subsidiaries) with Foreign Base Company Income (or foreign personal holding company income) has United States shareholders if resident taxpayers, green card holders, or citizens of the United States own more than 50% of the company. US persons also include domestic partnerships, domestic corporations, and certain estates and trusts (Internal revenue code § 951).

For purposes of determining who are United States shareholders and CFC status, stock owned directly, indirectly, and constructively is taken into account (purposes of section IRC § 957). These are called the “look through” rules and prevent United States shareholders from avoiding CFC status by giving shares to their families or putting them in offshore structures and trusts.

The purpose of the personal holding company income rules is to prevent US persons from the opportunity of deferral of tax on passive income on portfolio-type investments. Deferral is possible if an active business can defer foreign source income, but an individual can’t typically structure their passive investments offshore and receive the same benefit of passive income.

Under certain circumstances, the classification of income earned by a CFC as FBC services income or Foreign base company sales income may be unclear

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Definition

The purpose of section Subpart F is that income (foreign base company service income) from a foreign country is an item of income defined in the IRC as income derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services that are performed for, or on behalf of, a related person, and are performed outside the country under the laws of which the CFC is incorporated in a taxable year.

In terms of this definition, income earned by a CFC in a foreign country in a taxable year will constitute foreign base company services income and be included in gross income only if it satisfies all three of the following tests:

  1. The item of income is derived in connection with the performance by the CFC of certain specified services;
  2. The services are performed by the CFC for, or on behalf of, a related individual or company; and
  3. The services are performed outside of the country in which the CFC is organized

Therefore, if a CFC performs services in a taxable year for a related party through a branch established outside of its country of incorporation, it may incur foreign base company services income for United States Shareholders.

Exception

The IRC provides several exceptions to the general definition of FBC services income Two exceptions are available for services income related to property manufactured, produced, grown, or extracted by the CFC. 

Prior to its repeal, income derived by a CFC that fell within the Foreign base company shipping income category of former §954(f) (2004) was expressly excluded from the definition of FBC services income. In general, however, if the item of income-qualified for an exception to the Foreign base company shipping income, it was still tested to see if it met the definition of FBC services income under §954(e). Despite this general twice-tested rule, if the item of income-qualified for the same-country exception to FBC shipping income, it was entirely excluded from FBCI. 

The purpose of section IRC §954(e)(2) is that the FBC services income rules do not apply to income derived in a taxable year in connection with the performance of services that are directly related to the sale or exchange by the CFC of property the CFC has manufactured, produced, grown, or extracted and which are performed before the time of the sale or exchange, or income derived in connection with the performance of services that are directly related to an offer or effort to sell or exchange such property. 

The 2017 tax act, commonly referred to as the Tax Cuts and Jobs Act (TCJA) repealed the Foreign base company oil-related income category of FBCI.

For years beginning before January 1, 2018, the income of a CFC that qualified as Foreign base company oil-related income was expressly excluded from the definition of FBC services income. However, if the item qualified for an exception to the Foreign base company oil-related income category, it would be tested according to §954(e) for possible inclusion as FBC services income. Now, with the Foreign base company oil-related income category repealed, such items of income will be directly tested under §954 for inclusion in another category of FBCI. 

Exceptions are also provided to FBC services income for securities dealers and services income derived in the conduct of an active banking, financing, securities, or gross insurance income in a taxable year. 

Items Included in Foreign Base Company Services Income

The purpose of this paragraph (subchapter) is to stipulate that income earned by a CFC in a taxable year will constitute FBC services income only if it satisfies the following three conjunctive requirements:

  • The income is derived in connection with the performance of certain services by the CFC;
  • The services are performed by the CFC for, or on behalf of, a §954(d)(3) person that is related; and
  • The services are performed outside of the country in which the CFC is organized.

The purpose of this paragraph (subchapter) is to emphasize that this category does not include income from all CFC services, but only that income derived in a taxable year by a CFC from services performed for, or on behalf of, a person that is related (within the meaning of §954(d)(3)) in situations where the CFC’s services are also performed outside of the CFC’s country of organization. Income from services performed anywhere by a CFC for an unrelated individual with no involvement or performed for any person within the CFC’s country of organization, in a taxable year does not constitute FBC services income. Certain services income derived in the active conduct of a banking, financing, securities, or gross insurance income by insurance business in a taxable year is also expressly excluded from this category of FBCI

Services Performed in Foreign Base Company Services Income

The examples contained in the treasury regulations identify the following types of activities as those which may be treated as services for purposes of the FBC services income rules in a taxable year:

  • The installation and/or maintenance of machines; 
  • Equipment warranty and maintenance services; 
  • Contract oil well drilling; 
  • Construction of a dam; and
  • Construction of a superhighway. 

This is usually income earned from the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or other services.

Income earned by a CFC is considered foreign base company service income only if it meets all three of the following criteria:

  1. The income is earned in connection with the performance by the CFC of certain specified services;
  2. The services are performed by the CFC for, or on behalf of, a related person; and
  3. The services are performed outside of the country in which the CFC is incorporated.
  4. This all means that, when a CFC performs services for a related party through a branch established outside of its country of incorporation, it may incur “foreign base company services income” that may be currently included in its US shareholder’s gross income under Section 951.

Services will be considered performed wherever the worker performs their duties. If you’re a consultant flying from country to country performing a technical task, you probably have foreign base company service income.

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Special Rules

Guaranty of Performance

This paragraph and subchapter (Subparagraph (1)(ii)) is written to stipulate that it shall not apply for services performed by a CFC pursuant to a contract the performance of which is guaranteed by a related person, if 

    • the related person’s sole obligation with respect to the contract is to guarantee the performance of such services;
    • the CFC is fully obligated to perform the services under the contract, and
    • the related person does not in fact: 
      • pay for the performance of, or perform, any of such services the performance of which is so guaranteed or 
      • pay for the performance of, or perform, any significant services related to such services. 
Application of Substantial Assistance Test

Within this section, the treaty states that the assistance furnished by a related person or persons to the CFC shall include, but shall not be limited to, direction, supervision, services, know-how, financial assistance (other than contributions to capital), and equipment, material, or supplies.

Special Rule Applicable to Distributive Share of Partnership Income

A CFC’s distributive share of partnership’s services income will be deemed to be derived from services performed for or on behalf of a related person, within the meaning of IRC section 954(e)(1)(A), if the partnership is a related person with respect to the cfc, under IRC section 954(d)(3), and, in connection with the services performed by the partnership, the cfc, or a person that is a related person with respect to the cfc, provided assistance that would have constituted substantial assistance contributing to the performance of such services, under paragraph (b)(2)(ii) of this section, if furnished to the controlled foreign corporation by a related person. 

The Place Where Services Are Performed

The place where services will be considered to have been performed for purposes of paragraph (a)(2) of this section will depend on the facts and circumstances of each case. As a general rule, services will be considered performed where the persons performing services for the CFC which derives income in connection with the performance of technical, managerial, architectural, engineering, scientific, skilled, industrial, commercial, or like services are physically located when they perform their duties in the execution of the service activity resulting in such income. 

Items Excluded

Foreign base company services income does not include –

Such income derived in connection with the performance of services by a CFC if:

    • The services directly relate to the sale or exchange of personal property by the cfc,
    • The property sold or exchanged was manufactured, produced, grown, or extracted by such controlled foreign corporation, and
    • The services were performed before the sale or exchange of such property by the controlled foreign corporation;
    • The services, performed in a taxable year, directly relate to an offer or effort to sell or exchange personal property which was, or would have been, manufactured, produced, grown, or extracted by such CFC whether or not a sale or exchange of such property was consummated; or
    • For taxable years beginning after December 31, 1975, foreign base company shipping income

How to Eliminate Subpart F Foreign Base Company Service Income

To avoid Subpart F base company service item of income issues is to ensure that the services are performed where your offshore business is incorporated. The substance is therefore important for IRS purposes. Your main aim should therefore not be based on a low tax rate. 

If your employees are providing a service from India, and the business operates through a Costa Rican corporation, you’re opening yourself up to the item of income being regarded as Subpart F foreign base company service income.

Another way to avoid Subpart F income (item of income services) issues is for the offshore corporation to contract directly with the customer and pay the foreign company directly. This could also help with paying tax at a lower tax rate. 

FAQs

  • What is foreign base company income?
    • Foreign base company income (FBCI) is an item of income and type of subpart F income that U.S. shareholders of a controlled foreign corporation (CFC) must include in their gross income even though the income would not otherwise be currently taxed to the U.S. shareholders.
  • What is a foreign base company?
    • This is a corporation classified by the IRS as a corporation that is not a US tax resident.  
  • What is excluded from foreign personal holding company income?
    • The principal exceptions of foreign personal holding company income   categories item of income include:
      • Dividends, interest, rents, and royalties received from a related person with a connection to the CFC’s country of the organization;
      • Rents and royalties received from unrelated persons in the active conduct of a trade or business;
      • Gains from the sale of property used in an active trade or business and from the sale of inventory;
      • Foreign currency and commodities gains related to a CFC’s business; 
      • Income derived by dealers; 
      • Income from the active conduct of a banking, financing, insurance or securities business; and
      • Dividends, interest, rents, and royalties received or accrued by one CFC from a related CFC to the extent attributable or properly allocable to non-subpart F income of the related CFC.
For more information on Foreign Base Company Services Income, please contact one of our specialists at Asena Advisors. We make sure that your specific needs are catered for.

Shaun Eastman

Peter Harper