As mentioned in the previous blog, So You Own a CFC, What Now?, we introduced the fact that controlled foreign corporations must pay U.S. tax on their Subpart F Income. Subpart F (of part III of subchapter N of chapter 1 of subtitle A) of the Code limits deferral on certain types of income. The Subpart mandates that a U.S. Shareholder of a CFC include their pro rata share of the CFC’s Subpart F Income in their gross income; this is regardless of whether the U.S. Shareholder actually receives any distributions from the CFC.
So, what exactly is Subpart F Income? Well, it is typically comprised of income that is relatively movable between taxing jurisdictions and is generally known to be subject to low tax rates in foreign jurisdictions. Subpart F Income, however is limited to the CFC’s earnings and profits for that taxable year, with earnings and profits being the measure of a corporation’s ability to pay its shareholders dividends. This means that a CFC shareholder will typically have Subpart F Income when the shareholder receives a dividend.
The Code excludes “any item of income from sources within the U.S. which is effectively connected with the conduct by such corporation of a trade or business within the U.S. unless such item is exempt from taxation to (or is subject to a reduced rate of tax) pursuant to a treaty obligation of the U.S.” from Subpart F Income.
This exclusion makes sense, because if a CFC has effectively connected income with a U.S. trade or business (ECI) then the ECI will be taxed as ordinary income instead of as Subpart F Income. We previously discussed ECI and the parameters around a U.S. trade or business in our blogs titled, Surprise! Even Nonresidents may be Taxable on their U.S.-Sourced Income, The Code fails to define a “U.S. Trade or Business,” even though You’re on the Hook for Paying Taxes on it, and Is a Nonresident Alien’s Sale of a Partnership Interest a U.S. Trade or Business?, all available for reference at AsenaAdvisors.com
It is important for CFC shareholders to accurately determine whether they have Subpart F Income, so they can comply with their U.S. tax reporting obligations. Shareholders should seek proper advice to not only ensure their compliance, but to also avoid overpaying or reporting. If you, or your client, has global operations or interests in foreign corporations (either directly, indirectly or constructively), then feel free to reach us at AsenaAdvisors.com. We specialize in helping global executives, companies, and family offices protect their assets worldwide through tax and estate planning.