This week’s question comes from a doctor in Canada who as asking about the implications of his corporate structure and Controlled Foreign Corporation. Based on the advice of his Canadian accountant, he created a Canadian corporation known as a ‘Canadian-Controlled Private Corporation’ (CCPC) through which he operates his medical practice.
Taking a Stroll Down Memory Lane
Once upon a time, Elvis Presley was all the rage and PanAm was offering flights to Cuba for American tourists. At that time, taxpayers had a wonderful opportunity to defer and reduce their US tax bill by creating a non-US corporation, placing investments inside that corporation and deferring the income. Since the income belonged to the corporation, it was not taxed to the taxpayer, and since the corporation was non-US, the corporation was not taxed either. Not only could the income be deferred, but if it was realized by selling the corporation, it would be converted from ordinary income to long-term capital gain (and lower rates).
Then 1962 saw the rise of the Beatles, the creation of the Berlin Wall, Cuba became off limits to Americans and … the first Controlled Foreign Corporation / Subpart F income rules.
What is a Controlled Foreign Corporation?
A CFC is a foreign corporation for which U.S. shareholders own more than 50% of the shares (either value or votes). For this purpose, the term “U.S. shareholder” does not include those owning less than 10% of the shares.
Congress enacted the Subpart F provisions to curb this deferral. One of the goals of the subpart F provisions was to curb such deferral which was very enticing when the income was sourced in a jurisdiction with little to no tax.
Taxable amounts by virtue to Subpart F are only some kind of incomes, which are potentially the result of tax avoidance transactions.
Form 5471 is essentially a corporate tax return for the CFC. Amounts are translated into US dollars and financial statements are prepared in accordance with US GAAP.
Since the CFC itself is not a taxpayer, it does not file an actual corporate tax return. Instead form 5471 is to be attached to the shareholder’s tax return. Likewise, subpart F income is taxed to that taxpayer, similarly to what is the case for a pass-through entity (partnership or grantor trust).
Form 5471 is used by U.S. shareholders of foreign corporations. Several categories are required to report their ownership, starting with an acquisition of a minimum of 10% of the stock of a foreign corporation.
But the most relevant use is the reporting for Controlled Foreign Corporation (Category 5).
The Good News (PFIC)
Because Uncle Sam is always so generous, IRC section 951(c) states that if income is to be included under the Subpart F rules, it is not to be included as under the PFIC rules.
(c) Coordination with passive foreign investment company provisions
If, but for this subsection, an amount would be included in the gross income of a United States shareholder for any taxable year both under subsection (a)(1)(A)(i) and under section 1293 (relating to current taxation of income from certain passive foreign investment companies), such amount shall be included in the gross income of such shareholder only under subsection (a)(1)(A).
Taxation of Deemed Dividends
In order for a shareholder to be taxed under section 951 of the IRC, three conditions have to be met:
- The corporation must have been a Controlled Foreign Corporation (CFC) for an uninterrupted period of at least 30 days.
- The shareholder must be a U.S. shareholder. This means, among other criterions, that he owns at least 10% of the shares of the corporation.
- The U.S. shareholder must still own shares of the corporation on the last day of the tax year.
If these three conditions are met, the shareholder has to include some deemed dividends as part of his taxable income. This is referred to as “section 951 income.”.
According to IRC section 951, there are several categories of Subpart F income:
(1) Insurance income (I.R.C Section 953);
(2) Foreign base company income (I.R.C. Section 954);
(3) Income from countries subject to international boycotts (I.R.C. Section 999);
(4) Illegal bribes, kickbacks, and other similar payments (I.R.C. Section 162 (c)); and
(5) Income from countries where the United States has severed diplomatic relations (I.R.C. Section 901 (j)).
The major category, applicable to most foreign corporations is the second one: foreign base company income.
How This Applies in Real Life
Let’s go back tothe example of a doctor who incorporated his practice in a foreign country in order to defer taxation in the home country.
What happens if this doctor happens to also be an American citizen?
Since he owns 100% of the foreign corporation, it will be considered a Controlled Foreign Corporation. The taxpayer will have to include form 5471 which will 1) act as an informational return with financial statements and other information akin to a corporate tax return and 2) will be used to report Subpart F income.
If the corporation does indeed earn subpart F income, it would not be eligible for deferral for US tax purposes, and would be taxed to the shareholder in the year in which it was earned. It gets worse: since deferral occurred for Canadian tax purposes, a foreign tax credit might not be available to offset the additional tax due. Hence, the US tax due on the Subpart F income could become very real.
Not Just Investment income
“Foreign personal holding company income” under IRC 954(c)(H) includes not just investment income, but also personal service contracts.
This subparagraph applies to amounts received for services under a particular contract only if at some time during the taxable year 25% or more in value of the outstanding stock of the corporation is owned, directly or indirectly, by or for the individual who has performed, is to perform, or may be designated (by name or by description) as the one to perform, such services.
So, here we have a person owning 25% or more of the outstanding stock of the corporation (either directly or indirectly) furnishing personal services, hence it is subpart F income under IRC 954(c)(H).
It completely defeats the purpose of tax deferral under Canadian law and might even cause double taxation due to the unavailability of foreign tax credit.
All this in more is why it is so vital for you to understand your status as an American citizen, and how it affects your actions both locally and abroad.