Controlled Foreign Corporation
Tax Guide for U.S. Shareholders
By Vernon K. Jacobs, CPA and
J. Richard Duke, JD, LLM
Copyright, 2006,
Offshore Press, Inc.
 This presentation is a summary of the
topics included in “The Controlled
Foreign Corporation Tax Guide” by
Vernon Jacobs and Richard Duke
 It is published and copyrighted by
Offshore Press, Inc.
 http://www.offshorepress.com/cfcibc-tax.htm
Circular 230 Notice


This report is not a reliance opinion or a marketed opinion. This
report and its contents were not intended or written by the authors
to be used, and cannot be used, by anyone for the purpose of (i)
avoiding U.S. tax penalties, or (ii) promoting, marketing or
recommending to another party any transaction or matter
addressed or stated herein. This report and its contents are not
treated as a marketed opinion because (a) the advice was not
intended or written to be used, and it cannot be used by any
taxpayer, for the purpose of avoiding penalties that may be
imposed on the taxpayer; (b) the advice was not written to
support the promotion or marketing of the transaction(s) or
matter(s) addressed herein; and (c) the taxpayer should seek
advice based on the taxpayer's particular circumstances from an
independent tax advisor. [31 C.F.R. sections 10.35(b)(4)(ii);
10.35(b)(5)(i); and (b)(5)(ii)(a), (b) and (c).]
For an explanation of the Circular 230 requirements to which tax
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Introduction to the
CFC Tax Guide
 An offshore corporation is not subject
to the taxing jurisdiction of the U.S.
 But the U.S. shareholders are subject
to the taxing jurisdiction of the U.S.
 In 1962, the law was changed to deter
the use of foreign corporations to
avoid taxes. (IRC 951-964)
 Generally, foreign investment income
and certain kinds of foreign source
business income are subject to current
taxation by U.S. shareholders.
Definition of a Foreign
Corporation
 A foreign corporation is one that is not formed
or organized in the USA or under the law of any
state or possession. [IRC 7701(a)(5)]
 However, if a foreign corporation has U.S.
shareholders, those shareholders are subject to
the jurisdiction of the U.S. and to the taxing
jurisdiction of the U.S.
 If a foreign corporation has income that is
"effectively connected" with a trade or business
(or has other U.S. source income) in the U.S.,
then it is subject to the taxing jurisdiction of the
U.S.
 There are many exceptions to the general rules
relating to the taxation of foreign corporations
Definition of a Controlled
Foreign Corporation
 A controlled foreign corporation is a foreign
corporation that is controlled more than 50% by
"U.S. shareholders".
 A "U.S. shareholder" is a U.S. person who owns, or
is considered to own, at least 10% of the stock
 IRC Section 7701(a)(30) defines a U.S. person
very broadly to include individuals, partnerships,
corporations, trusts and estates.
 In determining the 10% or more ownership, the
attribution rules of both IRC Section 958(a) and
IRC Section 958(b) apply.
 If U.S. shareholders own more than 50%, by vote
or value, in the foreign corporation, it is classified
as a controlled foreign corporation (CFC).
A Summary Explanation of
"Subpart F Income"
 U.S. shareholders of a CFC are subject
to current taxation on certain kinds of
income of a CFC set forth in "Subpart
F" of the tax code. Hence, these forms
of income are referred to as "subpart F
income".
 If the foreign corporation has subpart
F income, then, to the extent of the
earnings and profits of the corporation,
those earnings are taxable each year
(whether distributed or not) to the
10% or more shareholders
Five Categories of
Subpart F Income
 (1)
insurance income as defined at
IRC Section 953;
 (2)
foreign base company income as
defined at IRC Section 954;
 (3)
income from countries subject to
international boycotts [IRC Section 999];
 (4)
illegal bribes, kickbacks and
similar payments [IRC Section 162(c];
and
 (5)
income from countries where the
U.S. has severed diplomatic relations [IRC
Section 901(j)].
Foreign Base Company
Income - I
 (1)
foreign personal holding
company income [IRC Section 954(c)];
 (2)
foreign base company sales
income [IRC Section 954(d)];
 (3)
foreign base company services
income [IRC Section 954(e)];
 (4)
foreign base company shipping
income [IRC Section 954(f)]; and
 (5)
foreign base company oil
related income [IRC Section 954(g)].
Foreign Base Company
Income - II




"Foreign personal holding company income" is
basically income from passive investments such as
interest, dividends, certain rents, royalties and
capital gains.
“Foreign base company sales income” generally
includes income from selling personal property
purchased from a related person or sold to a related
person.
“Foreign base company services income" is defined
as “income” derived in connection with the
performance of technical, managerial, engineering,
architectural, scientific, skilled, industrial,
commercial or like services.
Foreign base company shipping income and foreign
base company oil related income are clearly intended
for these specific industries and will not be discussed
further in this presentation
Investment Income of
Controlled Foreign Corporations
 There are two primary methods by which the
U.S. imposes current taxation on the investment
income of foreign corporations with U.S.
stockholders.
 The foreign personal holding company rules of
IRC section 954(c)
 The passive foreign investment company (PFIC)
rules of IRC sections 1296 and 1297. (A brief
discussion of the PFIC rules is included later in
this report.)
 Any CFC with a significant amount of investment
income should consider a detailed review of
these definitions for potential exceptions.
Related Party
Purchases or Sales
“Foreign base company sales income” is defined
by IRC Section 954(d) as
 (1) the purchase of personal property from a
related person and its sale to any person, (2) the
purchase of personal property from any person
and its sale to a related person, (3) the purchase
of personal property from any person on behalf of
a related person
 For this purpose, a “related person” does NOT
include an individual who is a non-resident alien—
even if that individual is related to the U.S.
taxpayer.
 The “bottom line” is that income from a trade or
business conducted entirely outside the U.S. is not
subpart F income unless a “related” party is
involved.

Related Party
Services Income
 Profits derived from the sale of certain services
through a controlled foreign corporation are
subject to current taxation to the "U.S.
shareholders".
 Foreign base company services income is
defined in IRC 954(e) as income” derived in
connection with the performance of technical,
managerial, engineering, architectural,
scientific, skilled, industrial, commercial or like
services which
 (A)
are performed for or on behalf of any
related person and
 (B)
are performed outside the country
under the laws of which the controlled foreign
corporation is created or organized.”
Subpart F income
also includes
 Insurance income as defined in IRC 953
 International boycott income as defined in
section 999
 Expenses in the form of illegal bribes, kickbacks
or other payments to an official, employee or
agent of a foreign government as defined in IRC
162(c)
 Income derived from countries not recognized
by the US as defined in IRC 901(j)
 Foreign base company shipping income as
defined in IRC 954(f)
 Foreign base company oil related income as
defined in IRC 954(g)
Exceptions to
Subpart F Income - I
 Most of the exceptions are set forth in
IRC 954(b).
 The "de minimus" rule excludes
foreign base company if less than 5%
of the gross income or less than
$1,000,000 – whichever is less
 If the foreign base company income
exceeds 70% of the gross income all of
the income will be treated as subpart F
income unless one of the following
exceptions applies.
Exceptions to
Subpart F Income - II
 The FPHC income is subject to an effective
rate of foreign tax greater than 90% of
the maximum corporate tax rate
 FPHC income is reduced by allowable
deductions
 Income derived in the active conduct of
banking, financing, (securities) or similar
businesses
 Income derived in the active conduct of an
insurance business
 Income of a foreign corporation that is
subject to U.S. corporate income taxes
U.S. Source Income of
Foreign Corporations
 A foreign corporation is subject to U.S. tax on
U.S. source income that is effectively
connected with the conduct of a U.S. trade or
business
 The foreign corporation will file a Form 1120F
and pay U.S. corporate income taxes
 Foreign corporations that have "fixed or
determinable annual or periodical income from
a U.S. source" (FDAP) are subject to
withholding on payments from the U.S.
 FDAP income includes interest, dividends, gains
from the sales of real property, annuities and
similar kinds of income.
Income from a Trade or
Business in the U.S.
 The foreign corporation has a fixed place of
business in the U.S., an employee in the U.S. or
an agent in the U.S. who can conclude contracts
on behalf of the corporation.
 General rules as to the source of income.
 Interest income is generally U.S. source income
if paid by a U.S. entity or person
 Dividends paid by a U.S. corporation are U.S.
source income.
 Compensation for services provided in the U.S.
is U.S. source income.
 Rents or royalties on property located in the
U.S. is U.S. source income.
 Gains from the sale of U.S. realty is U.S. source
income.
CFC Earnings Invested
in U.S. Property
 Tax code section 956 imposes a tax on the
U.S. shareholders for the investment of
earnings of a CFC in U.S. property.
 For this purpose, U.S. property includes
 Tangible property located in the U.S.
 Stock of a domestic corporation
 An obligation of a U.S. person
 The use in the U.S. of an intangible asset
 IRC 956(c)(2) describes an assortment of
exceptions to the definition of U.S.
property.
Shareholder Election to be
Taxed as a U.S. Corporation
 Corporate owners of foreign
corporations may claim a credit for
foreign taxes paid by their foreign
subsidiary corporation
 Individual owners of foreign
corporations are not permitted to claim
a credit for foreign taxes paid by their
foreign corporation.
 Tax code section 962 permits an
individual shareholder of a CFC to be
taxed as if the shareholder were a
domestic corporation.
U.S. Corporations with
Foreign Operations
 There are two basic ways to avoid the CFC
reporting rules and the complications of
the shareholder tax on the subpart F
income of a CFC.
 Operate an offshore business as an
unincorporated branch of a U.S.
corporation, a U.S. partnership or even a
U.S. proprietorship.
 Establish a foreign corporation or LLC and
file an election to treat the foreign
corporation as a disregarded entity.
Tax Deferral of
Non CFC Income -I
 If a foreign corporation is not a CFC,
the U.S. owners/stockholders are not
subject to tax on the business income
of the foreign corporation
 The foreign corporation is treated the
same as a non resident alien for U.S.
tax purposes
 Investment income of the foreign
corporation is not subject to U.S. tax
unless it exceeds 25% of the total
income or meets the asset test
Tax Deferral of
Non CFC Income -II
 The subpart F rules relating to
purchases from or sales to related
persons will not apply.
 The U.S. stockholders will be able
to treat any gain as a capital gain
 There will be a step-up-in-basis of
the stock at the death of the
taxpayer
Tax Treatment of U.S.
Stockholders in CFC - I
 Any gain on the subsequent sale of controlled
foreign corporation stock is treated as dividend
income to any U.S. shareholder who owns 10%
or more of the stock
 Gains from the sale of stock by shareholders
who do not directly or indirectly own 10% of the
company are eligible to be treated as a longterm capital gain
 Although U.S. shareholders of a CFC may be
subject to current tax on the subpart F income
of the CFC, losses are not passed through as
deductions to the shareholders.
Tax Treatment of U.S.
Stockholders in CFC - II
 If a U.S. person forms a CFC to invest
in a foreign security, no loss is
available if the security becomes
worthless because the security is
owned by the corporation instead of by
the shareholder.
 There is no step-up in basis at the
death of the U.S. shareholder of a CFC
not engaged in a trade or business (i.e.
- the IBC owns passive investment
assets).
Special Rules for Passive
Foreign Investment Co. – I
 Most U.S. mutual funds make
declarations of "deemed distributions"
each year to avoid double taxation
 The U.S. mutual fund industry
therefore lobbies the Congress to level
the playing field with foreign funds
 U.S. shareholders of a passive foreign
investment company (PFIC) have three
methods for reporting tax at the
shareholder level for a particular
taxable year.
Special Rules for Passive
Foreign Investment Co. – II
 One is a “qualified electing fund (QEF)
election to have the shareholder’s
share of PFIC earnings taxed on a
yearly basis.
 A second method is referred to as the
"mark-to-market" method.
 The third method defers the tax until
distributions are received or when
shares are sold but at the cost of an
interest charge and a punitive method
of taxation.
Special Rules for Passive
Foreign Investment Co. – III
 Only gross gains are subject to the 1291
tax. Losses are ignored
 Any share disposition is treated as a sale
or exchange - including gifts or bequests
 Gain is allocated to each day of ownership
back to 1986 & taxed at the top tax rate
 Interest is compounded daily at the
underpayment rates
 Distributions are taxed the same way
except to the extent of 125% of the
average distributions for the previous
three years
Election to Treat a CFC as a
Disregarded Entity - I
 Many foreign brokers (banks) won’t
sell directly to a U.S. person
 U.S. investors must first form a foreign
corporation or LLC
 This can become a tax disaster because
the foreign corporation is a CFC - and a
PFIC if it is an investment company
 To avoid this, the U.S. owner can elect
to be taxed as a disregarded entity
Election to Treat a CFC as a
Disregarded Entity - II
 Treasury Regs may classify the foreign
corporation as a disregarded entity (one
owner) or a partnership (two or more
owners) if an election is made
 No election can be made for an IBC that is
not on the “per se” corporation list [Reg.
Sec. 301.7701-2(b)(8)]
 Some of the jurisdictions that are not on
the per se list include: The Bahamas,
Bermuda, Cayman Islands, Isle of Man,
Jersey, Nevis, St. Vincent and the
Grenadines, and Turks and Caicos.
Attribution and Constructive
Ownership Rules
 The foreign corporation rules relating to
constructive ownership and attribution of
ownership are extremely convoluted.
 The phrase, “attribution of ownership” is usually
applied with respect to entities in which the
taxpayer has some control or beneficial interest.
 The phrase “constructive ownership” means
that one taxpayer is deemed to own the shares
of certain other related taxpayers - such as a
spouse, child or parent
 The primary definition of constructive ownership
and attribution of ownership is provided in IRC
Section 318
Deemed Royalty
on Intangibles
 IRC 367 – Tax on deemed royalty from intangibles
 “Intangible property" as defined in IRC Section
936(h)(3)(B) means any
 Patent, invention, formula, process, design, pattern
or knowledge
 Copyright, literary, musical or artistic composition
 Trademark, trade name or brand name
 Franchise, license or contract
 Method, program, system, procedure, campaign,
survey, study, forecast, estimate, customer list or
technical data, or
 Any similar item which has substantial value
independent of the services of any individual
Foreign Tax Credits - I
 U.S. persons who have paid foreign income
taxes may either deduct those taxes or elect to
claim a foreign income tax credit
 A domestic corporation may claim indirect credit
for foreign taxes paid by a subsidiary
 Individuals may not claim an indirect credit
unless they elect to be treated as a domestic
corporation
 If a foreign government imposes a tax that is
not a tax on income, that tax may only be
available as a business expense deduction to the
U.S. taxpayer
 The foreign tax credit is limited to the tax that
would be imposed on the same income at the
same rate as in the U.S.
Foreign Tax Credits - II
 The foreign tax credit may not be permitted with
respect to foreign income taxes paid to a
country which the U.S. does not recognize, has
severed diplomatic relations or that has been
identified as a country that harbors international
terrorists.
 Additional complications exist where the foreign
source income is a from a controlled foreign
corporation on which only part of the income is
subject to current U.S. tax
 If the taxpayer is (or might be) subject to the
alternative minimum tax, a very complicated set
of alternative rules for the foreign tax credit
become applicable
U.S. Employees Working
and Living Offshore - I
 There is a legal way to use a tax haven to have
tax free earnings of up to $82,400 a year
(indexed for inflation). A married couple could
have tax free earnings of twice that amount
 The taxpayer must establish tax residency in the
foreign country and (a) must be a resident of a
foreign country for the entire tax year, or (b)
must be physically present in the foreign
country for at least 330 days in a tax year.
 Compensation that is a disguised distribution of
corporate earnings and profits will not qualify
for the foreign earned income exclusion.
U.S. Employees Working
and Living Offshore - II
 The foreign earned income exclusion is
also available to a self-employed person,
but if capital is a material income
producing factor in the business, then
only 30% of the net self employment
profits are excludable as foreign earned
income.
 Self employment earnings outside the U.S.
are subject to the self employment tax.
 U.S. employees of U.S. employers are
subject to the FICA and related Medicare
taxes if working outside the U.S.
U.S. Employees Working
and Living Offshore - III
 Foreign subsidiaries of a U.S. company may elect
whether to withhold FICA taxes for it's U.S.
employees working outside the U.S.
 Foreign corporations are not obligated to
withhold social security taxes for any U.S.
employees.
 The foreign tax credit is not allowed for foreign
taxes attributable to the excluded foreign
earned income.
 Various deductions or credits otherwise
available must be allocated between the taxable
income of the taxpayer and the excluded
earnings. It's possible for a taxpayer to lose
substantial deductions as a result of this income
exclusion
Ownership of CFC by A
Charitable Trust
 A charitable remainder trust (CRT) was the
owner of all the stock of a foreign corporation,
which in turn invested in a U.S. partnership.
 Normally, when a CRT receives unrelated
business taxable income (UBTI), that causes the
CRT to lose its exempt status for that tax year.
 In IRS private letter ruling 199952086, the IRS
held that distributions from a wholly owned
foreign corporation to its parent, a charitable
remainder trust, will not result in unrelated
business taxable income (UBTI) to the trust
even though the foreign corporation will invest
in a partnership that will incur debt-financed
income
Withholding on payments to
Foreign Corporations - I
 If a foreign corporation has any U.S. source
income, that income may be subject to a U.S.
withholding tax of 30%.
 A detailed explanation of the rules for
withholding on payments to foreign persons is
available in IRS publication 515.
 If you are not a substantial owner of the foreign
corporation, follow the rule, "If in doubt,
withhold."
 A foreign corporation should provide you with a
withholding certificate to support a lower
withholding rate or to support non-withholding.
Withholding on payments to
Foreign Corporations - II
 The 30% withholding rate is the nontreaty rate.
 Payments to a foreign corporation that are
effectively connected with a U.S. trade or
business are not subject to withholding.
 A payment is subject to NRA withholding
if it is from sources within the U.S. and it
is "Fixed or determinable annual periodic
income" (FADP)
 FADP income includes personal services,
dividends, interest, rents, royalties,
pensions, alimony and scholarships
Withholding on payments to
Foreign Corporations - III
 FADP Income paid to a foreign corporation that
is effectively connected with a U.S. trade or
business is not subject to withholding.
 Certain kinds of interest on U.S. government
obligations, on U.S. bank deposits, on deposits
in U.S. savings & loans and U.S. insurance
companies are exempt from tax if paid to a non
resident alien and are therefore not subject to
withholding.
 In addition, gains on the sale of U.S. securities
are not taxable to a NRA and are not subject to
withholding.
 There is a 10% withholding rate imposed on the
gross receipts from the sale of U.S. real property
interests sold by a foreign person
Some Foreign Corporation
Tax Scams & Myths
 Myth of the Foreign Corporation
without a Shareholder
 Transfer Gains to Foreign
Corporation with Private Annuity
 Attempting to Avoid the CFC
Rules with a Foreign Trust
 Attempt to Avoid CFC Rules with
Nominee or Bearer Shares
Tax Filing Obligations
 Form 5471 – Return of U.S. Shareholders
of Certain Foreign Corporations
 Form 926 – Report of Transfer of Funds to
a Foreign Corporation
 Form TD F 90-22.1 – Foreign Bank &
Financial Accounts
 Form 8621 – Passive Foreign Investment
Company
 Form 8832 – Check the Box Election
 Form 8858 – Return for Foreign
Disregarded Entities
Copyright, Offshore Press, 2006
 This slide presentation is a summary
of the book, Controlled Foreign
Corporation Tax Guide by Vernon
Jacobs & Richard Duke
 It is published and copyrighted by
Offshore Press, Inc.
 http://www.offshorepress.com/cfcibc-tax.htm