While the U.S. tax system appears to be federal in nature, the U.S. uses the Internal Revenue Code to cast a wide web and bring international persons and entities under its taxing power. Not only does this web capture foreign persons physically present in the U.S. but it also captures foreign companies statutorily deemed as being controlled by U.S. Shareholders; in the tax world, these companies are called controlled foreign companies, or CFCs. The Code focuses a few highly complex provisions on tax laws applicable only to CFCs and their shareholders, and failure to comply with them is likely to result in high punishments, both civil and criminal. Thus, it is critical that you, whether you own a foreign company or have a client who owns a foreign company (either directly, indirectly, or constructively), understand if that company will be classified as a CFC under the Code.
A company will be a CFC if it meets the following requirements:
- The company is a foreign company;
- The company has at least one U.S. Shareholder; and
- The U.S Shareholder(s) own, on any day during the foreign corporation’s tax year, 50% of either:
- the company’s total value, or
- The company’s total voting stock.
Under the first requirement, a company may only be a CFC if it is foreign. Under the Code a corporation will not be foreign if it is “domestic,” meaning that it will not be foreign if the company was created or organized in the United States or under the law of any State within the United States. Thus, if you have a company that was created under Delaware law, then it will be a domestic company and the CFC rules will be inapplicable.
If the company is foreign, then it needs to have at least one U.S. Shareholder. With respect to a foreign corporation, a U.S. Shareholder is a U.S. person who owns at least 10% of the company’s total value or voting stock. Accordingly, a U.S. partnership that owns 12% of a foreign company’s voting shares will be a U.S. Shareholder, even where the partnership only owns 3% of the foreign company’s total value, and vice versa.
Lastly, a company will only be a CFC if its U.S Shareholders own at least 50% of the company’s total value or voting stock, on any day during the foreign corporation’s tax year. Accordingly, if a foreign company has six foreign shareholders who combined own 30% of the company’s total value, and two U.S. Shareholders who own 70% of the company’s total value, then the company will be classified as a CFC for U.S. tax purposes.
The key thing to note here is that ownership may be through direct, indirect, or constructive means. In our next few posts, we will discuss these ownership types as it has large consequences for both foreign and domestic persons and entities alike. Moreover, please look for our post illustrating the significance of a CFC classification and how it materially alters the reporting and tax obligation of the CFC and its shareholders.
In the meantime, if you have questions regarding the classification of a company as a CFC, please refer to our Whitepaper, The Expansion of “United States” Taxpayers: How the TCJA Drags Unassuming Foreign Companies and Individuals under its Scope, as it provides an in-depth discussion on the ptax provisions relating to CFCs. Additionally, please refer to our website AsenaAdvisors.com as we continue to post resources on tax provisions relevant to the global individuals, cross-border entities, and family offices.