What Is a Controlled Foreign Corporation (CFC)?
A Controlled Foreign Corporation (CFC) is a foreign corporation in which US shareholders, who each own at least 10% voting power or value, collectively own more than 50% of the total voting power or value of the corporation’s stock. CFC rules were designed to prevent US citizens from deferring US taxes by holding profits in foreign entities located in low-tax jurisdictions.
Key Takeaways
- In the US, a corporation is considered a CFC if American shareholders, each owning at least a 10% share, collectively own more than 50% of either the stock value or voting shares of a foreign corporation. Shareholders owning less than 10% of the shares are generally not included when determining if the 50% ownership level is exceeded.
- Normally, shareholders are taxed when income is distributed or when selling shares, regardless of whether the corporation earned any profits during the year. However, CFC shareholders can be taxed when the corporation has income, regardless of whether distributions are made.
- All 10% or more CFC shareholders must file Form 5471 and Form 8992.
- Depending on how the CFC’s income is earned, non-distributed income is taxed under Subpart F or Global Intangible Low-Taxed Income (GILTI) rules.
- For US expats, drawing a reasonable salary from the CFC will mitigate any of the corporation’s profits that may be taxable to the shareholder. This salary may qualify for the Foreign Earned Income Exclusion. Learn how here.
Who Needs to File?
CFC filing requirements can be complex and depend on a little more than just your ownership stake. Here are the main categories of those required to file:
- More than 50% owners: If you collectively own more than 50% of a foreign corporation, you must file annually.
- 10% or more owners: If you own at least 10% of the shares in a CFC, you may need to file every year or only in certain years.
- US citizens who are officers or directors of a CFC: Even if you don’t own any shares, you may have to periodically file as an officer or director.
- Unexpected situations that may result in a reporting requirement:
- When a non-resident alien (NRA) owns a foreign corporation and later becomes a US taxpayer.
- Indirect ownership: Other companies you hold stakes in may mean you are “considered” to own shares you don’t directly own,
- Constructive ownership: Family members owning shares may mean you are “considered” to own shares you don’t directly own.
Failure to file Form 5471 when required can lead to significant penalties.
How Is a CFC Taxed?
A Controlled Foreign Corporation (CFC) is subject to unique taxation rules that differ from how regular corporations are taxed. For traditional corporations, shareholders are taxed only when dividends are distributed, or shares are sold. However, CFC shareholders may be required to include the foreign corporation’s profits on their personal US tax return in the year the income is earned—whether or not they’ve actually received any distribution. This is to prevent shareholders from deferring taxes by holding profits offshore. Two main provisions govern this taxation:
1. Subpart F Income
Established in 1962, the Subpart F Income provisions were introduced to target passive income and transactions between related parties that could be used to artificially shift profits to low-tax jurisdictions. Related party transactions in this context typically involve setting up two or more 100% owned companies to buy and sell between each company. The goal of using related party transactions is to report income in a way that is most beneficial to the company for tax purposes, often by using shell companies. These are the main categories of Subpart F income:
- Passive income such as interest, dividends, rents, royalties, and gains from the sale of property.
- Foreign base company sales income: Income derived from the purchase or sale of goods involving a related party, especially if the goods do not physically pass through the CFC’s country of incorporation.
- Foreign base company services income: Fees from services performed outside the CFC’s country of incorporation for related parties.
Under Subpart F, income is taxed to US shareholders immediately, even if the profits remain within the CFC and no dividends are distributed. The idea behind this rule is to discourage companies from setting up offshore shell companies simply to delay paying taxes to the IRS,
2. Global Intangible Low-Taxed Income (GILTI)
Global Intangible Low-Taxed Income (GILTI) is a special way of calculating CFC income. It was intended to target intellectual property and other “intangibles,” but in practice, it captures any income that isn’t explicitly exempted or taxed in another way.
The GILTI provision was introduced by the 2017 Tax Cuts and Jobs Act (TCJA) to capture income that multinational corporations might shift into low-tax foreign countries. While initially aimed at targeting intangible assets like patents, it broadly affects most undistributed income held in a CFC.
GILTI applies to a CFC’s income exceeding 10% of its tangible assets (Qualified Business Asset Investment or QBAI). The GILTI income is included in the shareholder’s gross income, and corporate shareholders may be eligible for a 50% deduction on GILTI. In contrast, an individual may opt to file a Section 962 election to be taxed as a corporation and benefit from a similar deduction.
While Subpart F focuses on specific types of income like passive income or related party income, GILTI targets the remainder of the CFC’s earnings that might not be taxed under Subpart F. GILTI was specifically designed to capture income that was not taxed by Subpart F due to various loopholes in the law.
Penalties for Non-Compliance
The penalties for failing to meet CFC filing requirements are severe:
- $10,000 for failure to file Form 5471.
- Continuation penalty for each additional month the form remains unfiled after IRS notice is received that a form 5471 needs to be filed.
- Reduced foreign tax credits for failing to file Form 5471 on time.
- The statute of limitation will remain open indefinitely if a form 5471 is not filed when required.
Common Pitfalls and How to Avoid Them
It’s easy to lose sight of the big picture. CFC rules exist to prevent tax avoidance and evasion by companies shifting income into low-tax countries where they’re not actually doing business. They’re there to prevent dishonesty.
Consider the case of Robert Smith, a private equity CEO who evaded taxes for fifteen years by concealing hundreds of millions of dollars in offshore trusts and related foreign corporations. He was caught, prosecuted, and ordered to pay $139M in damages and back taxes. He intentionally broke the law.
However, for most people, filing taxes in good faith and making every effort to report accurately will keep them out of trouble with the IRS. Honest mistakes can happen, and if you follow the rules, you’ll unlikely face such extreme consequences.
Nevertheless, some common pitfalls to avoid are:
- Trying to avoid being classified as a “US Shareholder” by transferring your ownership to other people and organizations. Since “ownership” is aggregated among your direct family members and legal entities you own or are the beneficiary of, this isn’t a good way to avoid CFC taxes.
- Not filing on time.
- Not filing accurately.
The first is easy enough to avoid. For the second and third, unless you’re an expert accountant or have plenty of time, getting help with filing is probably a good idea.
Tax Strategies for CFC Shareholders
Here are some common strategies to reduce tax liability as a CFC shareholder:
- High-Tax Exception: Income from countries with tax rates close to or higher than the US may qualify for a high-tax exception.
- Asset Purchases: The timing of asset purchases can help optimize the timing of taxation and foreign tax credits.
- Timing of Tax Payments: Aligning tax payments with foreign tax credit eligibility can minimize the impact of double taxation. This is more critical than it seems, as only 80% of foreign taxes can generally be used to offset any US tax liabilities. This 80% must be applied to only one year, which differs from other foreign tax credit rules that may allow foreign taxes paid to be applied over a ten-year period.
- 962 Elections: US shareholders can elect to be taxed like corporations for the year, which provides certain tax benefits. Before making this election, many considerations must be made, including the CFC’s expected income and distributions for several years in the future.
Frequently Asked Questions
1. What does CFC stand for in Tax?
It means “controlled foreign corporation.” CFCs are majority-owned by US shareholders. Under CFC rules, a US person must own at least 10% of the shares of stock to be a “US shareholder.”
2. How do I reduce my CFC tax liability?
There are a few ways. The easiest is to be a resident of the country where your CFC is incorporated, take a reasonable salary, and apply the foreign earned income exclusion. The next would be inviting enough foreign shareholders to own more than half of the company. There are other methods, but they’re quite complicated. Consider consulting with a tax professional.
3. Will I be taxed even if I didn’t receive a distribution?
Yes, it is possible that you will be taxed on the corporation’s profits even if you do not receive a distribution. If this happens and later you receive a distribution, there are rules in place with prevent you from being taxed on that same income twice.
4. Does the IRS tax foreign corporations directly?
No, they tax the US shareholders of those corporations. The IRS only has jurisdiction to tax individuals or companies that have direct connections with the US.
5. Should I transfer my stock ownership to my family to avoid being a Shareholder?
This generally will not work, but there are some exceptions. In general, IRS rules aggregate ownership among family members and legal entities you own or are the beneficiary of. If you and your wife each own 5%, in the eyes of the IRS, “you” own 10% and are considered a shareholder.
Have Additional Questions? Greenback is Here to Help!
The IRS estimates that filing the required CFC forms can take over thirty hours—it’s a complex process. When you’re ready, our expat tax services team is here to help. Greenback Expat Tax Services was founded by US expats for expats, and many of our CPAs are expats themselves, familiar with the unique challenges of living abroad.
Dealing with CFCs is challenging, from understanding tax rules to avoiding penalties. If you’ve missed something or haven’t filed, you may be eligible for an amnesty program or need to file amended returns. With years of experience helping expats navigate these rules, we can ensure your compliance and potentially reduce your tax liability.
Contact us, and one of our customer champions will gladly help. If you need very specific advice on your specific tax situation, you can also click below to get a consultation with one of our expat tax experts.
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