DEFERRING US TAXES
ON FOREIGN BUSINESS INCOME
INTERNAL REVENUE CODE SUBPART “F”
I.
INTRODUCTION
A US Company seeking to expand its operations overseas should consider establishing a
foreign corporate subsidiary for a number of reasons. For example, doing business
through a foreign corporate subsidiary, (often a form of limited company, depending on
the country involved), can shield the US parent from liabilities incurred by the subsidiary.
Otherwise, the US Company could be liable for the liabilities of the overseas “branch”.
Furthermore, the US Company would likely be “doing business” in the foreign country
and therefore subject to foreign judicial process.
Another reason to consider a corporate or limited subsidiary, and the subject of this
article, is to defer US taxes on foreign earned profits until the profits are “repatriated”
back to the US parent. This admirable goal, however, is not so easily accomplished.
Commencing in 1962, Congress enacted the Subpart F provisions of the Internal Revenue
Code, for the express purpose of preventing US companies from deferring taxes on
foreign earnings through the use of tax havens or low-tax jurisdictions.1 Congress was
convinced that untaxed foreign earnings were being reinvested overseas, to ultimately
produce capital gain treatment on sale of the foreign subsidiary’s stock. The foreign
earnings were often directed to outside investments, again to convert ordinary income to
capital gain.
Prior to enactment of the Subpart F Rules, a US Corporation, could, for example,
establish a subsidiary corporation in a non-tax or low-tax jurisdiction, for the purpose of
selling into or operating in a country with higher taxes. A number of techniques might be
utilized to minimize taxes on profits earned in the high-tax country. The end result was
no or low-tax on the foreign subsidiary’s profits, and no US tax until the profits were
“repatriated”. These pre-tax profits might be reinvested in the business or in outside
investments, and ultimately “repatriated”, if ever, at capital gains rates.
The Subpart F provisions have been substantially expanded over the years, including the
Taxpayer Relief Act of 1997. The result of piecemeal evolution of rules and regulations
has produced one of the most complex and convoluted areas of the US Tax Code.
Nevertheless, the well-advised company may still have opportunities to defer US tax on
foreign profits.
1
H.R. 10650, 87th Cong., 2d Sess. (1962).
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II.
Overview of Subpart F
The Subpart F Rules impose current US tax on the undistributed earnings of a “controlled
foreign corporation”, referred to as a “CFC”.2 The Code defines a CFC as a foreign
corporation of which more than 50% of the voting power or of the total value is owned
directly or indirectly by one or more US shareholders. A “United States shareholder” is
further defined as a US resident, citizen or corporation owning directly or indirectly 10%
or more of the voting stock of the foreign corporation. Rules of constructive stock
ownership apply.3 Therefore, a US Corporation owning 50% or less of a foreign entity
may not be subject to the Subpart F Rules.
To avoid CFC status, a US Company might give the majority of voting stock to a foreign
“partner”, while keeping all the common stock entitled to the profits. Alas, the IRS
adopted regulations to the effect that US shareholders who can exert “effective control”
will be deemed to own a majority interest, i.e. the subsidiary will be a CFC. “Effective
control” includes, for example, the power to elect the majority of Directors, or the power
to break deadlocks. Furthermore, the IRS can determine that foreign shareholders
holding the majority interest have no “compelling economic interest” to exercise their
voting power, if, for example, their financial return or remuneration is predetermined,
i.e., the majority interest has no real incentive to exercise its voting majority. The
minority US interest will be deemed “in control”.4
The Subpart F Rules are generally drafted to prevent tax deferral on profits earned (1)
“for or on behalf of a related person”, and (2) outside the country of incorporation. For
example, profits earned by a US subsidiary incorporated in the tax-free British Virgin
Islands (BVI) from sales or services to Germany, would be Subpart F income, and subject
to current US tax, for two reasons: (1) the income is produced for or on behalf of a
“related person”, the US parent, and (2) the income is from sales outside the country in
which the subsidiary is incorporated.
On the other hand, if the BVI subsidiary was actually manufacturing a product for sale in
Germany, the profits might not be Subpart F income. Profits earned from products
manufactured, grown or extracted in the subsidiary’s country of incorporation may be
entitled to US tax deferral. However, treasury regulations attempt to define
“manufactured” as a “substantial transformation” of the product. Minor improvement,
assembly or packaging activity will not constitute “manufacturing”5, and profits would be
Subpart F income subject to US tax.
2
IRC Sec. 952 et seq; Regs. Section 1.952-1(a)(2).
IRC Sec. 957(a).
4
Treas. Reg. 1.957-1(b).
5
Treas. Reg. 1.954-3(a)(4); see e.g. Bausch & Lomb v. Comm’r. 71 C.M. 2031 (1996)
3
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Subpart F income must be included in the US parent’s gross income, using the parent’s
fiscal year.6
The Code defines nine (9) classes of Subpart F income.7 However, only three classes
typically impact the foreign subsidiary of a US parent. The definitions use the term
“foreign base company”, which is a controlled foreign corporation (CFC).
For
purposes of this article, (and oversimplified), the terms “CFC”, and “foreign base
company” or “FBC”, are used interchangeably.
The three relevant classes of Subpart F income are:
(1)
(2)
(3)
Foreign base company sales income,
Foreign base company service income,
Foreign personal holding company income.
The various exclusions and special rules for banking activities, insurance, shipping, air
transportation and other activities are not discussed here.
III.
Foreign Base Company (FBC) Services Income
FBC services income includes compensation, commissions, fees, and other forms of
remuneration.8 Profits from services provided through the foreign subsidiary will be
Subpart F income if performed “for or on behalf of a related person” and outside the
country of incorporation. Therefore, compensation for services rendered inside the
country of incorporation, even for a “related person”, is generally excluded. For
example, compensation to a UK subsidiary for services rendered in the UK would not be
Subpart F income. The UK will, of course, impose a substantial tax on those profits (up
to 30%), and the US parent will normally be allowed a credit for foreign taxes. The US
Company may prefer to minimize UK taxes, and accumulate tax-deferred profits in a tax
haven jurisdiction, which might be possible with proper planning.
The term “related person” is broadly defined, and includes a parent or “sister”
corporation, or even a branch of a CFC located in a country other than the CFC’s country
of incorporation.9 Generally, a “related person” with respect to a CFC includes an
individual, corporation, trust or estate which controls, or is controlled by, the CFC, or if
such person or entity controls both the parent and the foreign subsidiary.
Regulations attempt to define when services are rendered “for or on behalf of a related
person”:
6
IRC Sec.898
IRC Sec. 952(a), 959(a)
8
IRC Sec. 954(e).
9
Treas. Reg. 1.954-4(b)
7
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1. If the CFC receives a substantial financial benefit from the related person for
performance of the services;
2. If the CFC performs services which the related person is obligated to perform;
3. If the CFC performs services related to property sold by the related person and
such services as a material condition of the sale;
4. If the related person provides substantial assistance to the CFC in connection
with its services.10
Treasury Regulation 1.954-4(b) gives a number of examples to illustrate “related person”
activities, which result in Subpart F income. As a general rule, the US parent must limit
its involvement with the foreign subsidiary, and it should avoid becoming directly
responsible for the subsidiary’s business and financial obligations.
Obviously, complex business arrangements are not clearly within any of the defined
categories. Consider, for instance, the situation in which a CFC is paid for services in its
country of incorporation, in connection with the sale of goods in another country by its
US parent, a “related person”. If the income is classified as income from services in the
country of incorporation, it is excluded from Subpart F. On the other hand, if the income
is classified as from sales in another country, it is Subpart F income.
As explained above, sales income from goods, which qualify as “manufactured” or grown
in the CFC’s country of incorporation, can be excluded from Subpart F.11
IV.
Foreign Base Company Sales Income
The “related party” definitions apply to this category of income, and FBC sales income
includes:
10
11
1.
Purchase of personal property from a related person and sale to any
person,
2.
Sale of personal property on behalf of a related person (a commission
agent, for example),
3.
Purchase of personal property from any person for sale to a related party,
4.
Purchase of personal property “on behalf of a related person”.
Treas. Reg. 1.954-4(a)(1)
IRC Sec. 954(e)
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As in FBC service income, FBC sales income results from sales outside the country of
incorporation or organization, for a related person.
As an example, a US parent might establish a Cayman Islands subsidiary, to purchase the
US parent’s goods for resale in Europe. The subsidiary’s profits are clearly Subpart F
income, which the US parent must take into current income. This could be the case even
if the Cayman Company set up its own service or sales subsidiaries in various other
countries. On the other hand, a UK subsidiary’s income from sales in the UK would not
be Subpart F income.
V.
Foreign Personal Holding Company (FPHC)
An FPHC is one in which 50% or more of the voting power is held by five or fewer US
persons, and at least 50% (after the first year) of its profits are from “passive” sources,
such as dividends, stock and securities transactions, and personal service contracts.
There are exceptions, such as computer software royalties to a US Company actively
engaged in the software business.12
Shareholders of an FPHC are required to pay US tax on undistributed FPHC income.
Furthermore, a CFC can be an FPHC even if it has no Subpart F income, usually by
reinvesting its profits in assets which produce passive income, unrelated to the CFC’s
business. In such cases the CFC rules govern.13
VI.
Planning Opportunities
The Subpart F Rules, while daunting, do not eliminate the opportunity for US tax deferral
on foreign income. First, there is a “de minimus” rule which provides that income
otherwise subject to Subpart F is excluded if the income is the lesser of (a) 5% of the
CFC gross income, or (b) $1 million US.14 Also, Subpart F income does not include
income subject to an effective foreign tax rate greater than 90% of the US rate.15
Subpart F income is reduced by deductions properly allocated to such income, by
accumulated deficits, and by blocked currency accounts.16
12
IRC sec.553
IRC Sec. 951 (d)
14
IRC sec. 954(b)(3)(A)
15
IRC ibid
16
IRC 952; Treas. Reg 1.964-2(b)(2).
13
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A US Company may find that a Foreign Sales Corporation (FSC) affords a significant tax
savings (up to15%) on qualified overseas sales.17 (The World Trade Organization has
come out against FSCs, but the US has not yet responded.)
More sophisticated planning could include consideration of a “hybrid entity”. This
concept derives from the new “check the box” regulations, adopted in 1997, which
enables a US corporation to elect to treat a foreign subsidiary as a “branch”, or a nonentity for US tax purposes. For example, a US corporation might establish a foreign
subsidiary corporation in a low or non-tax jurisdiction, e.g. Ireland (a 10% tax rate for an
International Financial Services Center). The Irish subsidiary would, in turn, establish its
subsidiary in, e.g. the UK. The Irish Company could loan funds to its UK subsidiary,
which would deduct the interest payments, thereby reducing its taxable UK income. The
interest income to the Irish Company would be Subpart F income, except for the fact that
the US parent would elect to treat the Irish Company as a “branch”, i.e. the Irish
Company is ignored for US tax purposes, but not for UK purposes. Since the Irish
Company is a “branch” and not a subsidiary, its interest income is ignored, and
technically considered as “earned” in the UK subsidiary from UK activities, and therefore
excluded from Subpart F.
The hybrid approach affords some complex and quite advantageous planning
opportunities.18 However, the IRS has adopted regulations directed at curtailing the
“hybrid branch” approach, but implementation of these regulations is postponed at least
until July 1, 2005, pending further comment and study. Planning opportunities are open
at least until that date. Nevertheless, the IRS confirms that it intends to defend its
restrictive approach with Congress, which is considering the Subpart F Rules.19
Another approach might be to avoid CFC status by having the US corporation own 50%
or less of the foreign subsidiary. Joint venture arrangements with foreign partners often
dictate such an approach, as foreign partners will not want to be subject to US tax or US
jurisdiction. Absent “effective control”, the subsidiary would not be a CFC, and profits
could be US tax deferred until repatriated.
If the US Company must own more than a 50% interest, the venture’s profit
arrangements might, for example, require that profits be left in the foreign entity until
certain financial or business benchmarks are achieved, thereby effectively deferring US
tax on the “unearned” profits. However, the contract and profit sharing arrangement
must be carefully documented, as the IRS could, as noted above, determine that the US
Company is in “control” even though it owns 50% or less of the foreign entity. 20
Furthermore, the IRS always has the right to reallocate income to conform to an arm’s
length standard, and an “anti-abuse” rule is part of the Subpart F Regulations.21
See “Foreign Sales Corporations and IRA Ownership”, Stephen A. Malley, Esq.,
Journal of Asset Protection Vol. 5, #5.
18
See, e.g., a definitive article by Lowell D. Yoder, esq: “Proposed Subpart F Hybrid Entity Regulations:
A Further Retreat But No white Flag:, Tax Management Journal Vol 28, No.11, 11/12/99
19
Notice 98-35,1998-27 I.R.B.35 (7/6/98)
20
Tres. Reg. 1.957-1(b)
21
IRC 482; Tres. Reg 1.954-1(b)(1)(i)
17
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The US Corporation might take advantage of favorable treaty arrangements. Services
might be rendered from, or sales might be “sourced” in a country with a favorable treaty
with the “target” country.
For example, a UK independent contractor might pay
management fees to an Isle of Man subsidiary of a US parent, reducing UK taxable
income in the UK, and taking advantage of the Isle of Man/UK treaty. Even if profits
are subject to current US tax, “treaty shopping” is a legitimate and often highly beneficial
approach to minimizing foreign taxes.
Other planning opportunities could be applicable, depending on the facts and flexibility
of business arrangements.
CAVEAT: The IRS has the right to challenge inter-company pricing and allocations of
sales, profits and losses.22 Close attention must be paid to inter-company transfers and
transactions.
VII.
Summary
US companies doing business overseas are subject to the complex and confusing Subpart
F Regulations, which are designed to prevent US tax deferral of foreign earnings through
the use of tax haven or low-tax countries. Congress is studying whether the Subpart F
Regulations should be revamped, and possibly diminished in scope, since the Rules often
operate to prevent US companies from minimizing foreign taxes. There is a real issue as
to whether US companies should be allowed to take advantage of lower foreign taxes and
deferred US tax on foreign earned income in order to compete in the global
marketplace.23
Pending further developments, US companies seeking to expand overseas, or already in
business overseas, can take advantage of various planning and tax opportunities. Careful
analysis involves competent advice from US professionals and the consultation of
qualified experts in each country involved. As always, business considerations are
paramount, and should not be driven solely by tax planning.
This article is intended to provide only a general overview of the material discussed.
Professional advice should be obtained for any specific situation or business
application. Tax laws and regulations change frequently, often with retroactive
effect.
3/8/16
22
23
IEC Sec. 482 et. Seq.
See, e.g. Altshuler, Dept of Economics, Rutgers Univ., 20 Tax Notes Int’l 1579: “Recent Developments
In The Debate On Deferral”.
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