With the increase of globalization, many US businesses are expanding their operations overseas through foreign subsidiaries. Besides understanding the taxation of each country where they operate, US shareholders of foreign companies should be aware of the US tax implications of operating a business abroad.
What is a Controlled Foreign Corporation?
The United States does not have jurisdiction over companies established abroad that do not operate within its territory. Unless the foreign entity repatriates its earnings by paying dividends to its US parent or US individual shareholder, the profits of the foreign company are not taxed in the US.
The Internal Revenue Code (“IRC”) provides a set of rules to prevent US taxpayers from escaping taxation by establishing companies overseas. Section 957(a) defines a Controlled Foreign Corporation (“CFC”) as any foreign corporation in which more than 50% of the total combined voting power of all classes of stock entitled to vote or total value of the stock is owned directly, indirectly, or constructively by U.S. shareholders on any day during the taxable year of such foreign corporation.
A U.S. shareholder is a U.S person (US citizen, permanent resident or resident by the substantial presence test) who owns directly, indirectly, or constructively 10% or more of the total combined voting power or total value of shares of all classes of stock entitled to vote in a foreign corporation.
I have a CFC, now what?
If the foreign company is a CFC, then the US shareholder must include as gross income his pro rata share of the foreign entity’s Subpart F income for the year.
Subpart F income is defined by Section 954(a) of the IRC. The most common type of Subpart F income is the so called “Foreign Personal Holding Company Income,” which comprises primarily of passive investments, such as dividends, rents, interest, royalties, annuities and capital gains from the sale of certain assets. The Tax Code provides certain exceptions for rents and royalties received from unrelated parties in the conduct of the company’s trade or business, income received from a payor incorporated in the same country as the recipient, among others.
Other types of Subpart F income include insurance income and income from sales, services, and other transactions between related parties or affiliated companies.
GILTI – Global Intangible Low-Taxed Income
The Tax Cuts and Jobs Act introduced a new requirement for US shareholders of CFCs to include their global intangible low-taxed income (GILTI) in their gross income. GILTI is the excess of i) the shareholder’s net CFC tested income for the year over ii) the shareholder’s net deemed tangible income for the year. GILTI included in gross income is treated as Subpart F income for certain purposes.
Corporate taxpayers must include 50% of GILTI in their taxable income and their liability can be reduced by 80% of the foreign tax credits on the CFC’s income. On the other hand, individual taxpayers and pass-through entities must include 100% of GILTI, but they can elect to be taxed as corporations to enjoy the same benefits available to those entities.
Upon repatriation, no further tax will be imposed on the US shareholder who included GILTI in its income.
Mandatory Repatriation Tax
As seen above, the earnings of a foreign company are not taxed in the US unless they are repatriated. Many US multinationals have taken advantage of this rule by maintaining foreign earned income abroad to avoid US taxation. It has been estimated that around U$1.6 to $2.1 trillion of foreign profits have escaped US taxes.
The Tax Cuts and Jobs Act set forth a mandatory repatriation tax on accumulated foreign earnings and profits of a CFC and foreign corporations owned by more than 10% US shareholders. This deemed repatriation imposes a reduced 15.5% tax rate for earnings held in cash or cash equivalent and 8% for other types of earnings.
This one-time repatriation tax can be paid in installments over 8 years.
Having a CFC can bring unfavorable tax consequences for US taxpayers, specially those who are not prepared. Not only US citizens expanding overseas must be aware of the rules, but also resident aliens and foreign investors residing in the US who satisfy the Substantial Presence Test and own companies in their home country. Having the guidance and advice of a law firm specialized in international tax law, such as Brunoro Law, allows for peace of mind that the right strategy is in place to minimize your and/or your company’s worldwide tax exposure.
 Introduced by the Tax Cuts and Jobs Act.
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