Form 5471 is used by 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 is the reporting for Controlled Foreign Corporation (Category 5).
What is a Controlled Foreign Corporation?
Until the CFC regime, it was possible to create a non-US corporation, place investments inside that corporation and defer the income. 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).
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).
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, so there’s that.
(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, 3 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 the 3 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 a most foreign corporation is the second one: Foreign-base company income.
Foreign-base company income includes:
- Investment income (referred to as “Foreign personal holding company income” (I.R.C. Section 954(c)))
- Income from sales to related parties (referred to as “Foreign-base company sales income” (I.R.C Section 954(d)))
- Income derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or “like services” for or on behalf of any related person outside the country under the laws of which the CFC is created or organized (referred to as “Foreign-base company services income” (I.R.C. Section 954(e)))
- Foreign-base company shipping income (I.R.C Section 954 ((f)); and
- Foreign-base company oil-related income (I.R.C. Section 954 (g))
The last two being specific to these industries.
If a foreign corporation is found to have Subpart F income, then the income from the corporation will be taxable to those shareholders owning at least 10% of the corporation, either directly or indirectly (as found in the attribution rules under IRC Section 958(a) ). Their share of Subpart F income will become taxable income, whether distributed or not.
However, in calculating the amount of Subpart F income included in the gross income of the shareholder for the year, certain losses from previous years can be taken into account and will reduce the amount of the subpart F income by the share of the U.S. shareholder of any deficit. In this case, the term “qualified deficit” refers to any deficit in earnings and profits of the CFC for any preceding taxation year that began after 31/12/1986 for which the CFC was a CFC.
What does that mean to you?
Let’s take the example of a doctor who incorporated his practice in a foreign country in order to defer taxation in the home country (such as a “Canadian-controlled private corporation” (CCPC) in Canada).
What happens if said doctor happens to also be a U.S. person?
Since such U.S. person owns 100% of the foreign corporation, it will be 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. Not only that but wait… 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.
Wow, wow, wait, what? Subpart F income, no, I am just a legitimate family doctor here, I do not have investment income….
Well, the thing is that actually “foreign personal holding company income” under IRC 954(c) – more specifically under IRC 954(c)(H); personal service contracts.
(H) Personal service contracts
(i)Amounts received under a contract under which the corporation is to furnish personal services if
(I)some person other than the corporation has the right to designate (by name or by description) the individual who is to perform the services, or
(II)the individual who is to perform the services is designated (by name or by description) in the contract, and
(ii) amounts received from the sale or other disposition of such a contract.
This subparagraph shall apply with respect to amounts received for services under a particular contract only if at some time during the taxable year 25 percent 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 maybe designated (by name or by description) as the one to perform, such services.
So, here we have a person owning 25 percent 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). Boom.
As stated above, it completely defeats the purpose of tax deferral under Canadian law and might even cause double taxation due to the unavailability of a foreign tax credit.
Learn more about Form 5471 here.