Working with US investors can help fuel growth, but it can also be tricky in terms of understanding US tax regulations. It is therefore important for companies based outside the US to have an awareness of the rules and involve a specialist where required. Dave Kim, the leader of Frazier & Deeter’s International Tax practice, sat down to explain some of the key terms and their tax implications when US investors are involved.

Dave, could you tell us in general terms what a CFC is?

Dave Kim (DK):
A CFC is a foreign corporation that meets a specified ownership test. The ownership test is that the foreign corporation needs to be owned greater than 50 percent, by vote or value, by US shareholders. US shareholders are defined as US persons that own 10 percent or more of the foreign corporation. It's a very clear-cut ownership test.

For example, if you have 11 US persons who equally own a foreign corporation, you don't have a CFC. Each of them would own approximately 9.1 percent of that corporation, so no one would be a US shareholder, and you don't have a CFC because no individual US person owns more than 10 percent of that foreign corporation.

There are also indirect and constructive ownership rules that you have to be careful about. I'll give you an example of constructive ownership rules. Let’s say I own nine percent of the corporation and my daughter owns one percent of the foreign corporation. In combination, we own 10 percent, and the constructive ownership rules will, in fact, attribute 10 percent ownership to both myself and my daughter. The tax consequences of being a US shareholder of the CFC remain with my 9 percent ownership and my daughter's one percent ownership, but in terms of meeting that definition of a US shareholder and a CFC, the constructive ownership rules aggregate our ownership.

So, what are the rules to be aware of regarding CFCs?

DK:
The rules around CFCs are quite detailed, and I'll try to keep this at a very high level. Once a foreign corporation is classified as a CFC, certain rules apply, and the two major ones are Subpart F income and GILTI income.

Certain income that is earned by a CFC is going to be subject to what we call anti-deferral rules, or Subpart F rules. Subpart F income is mostly passive but also includes other types of income. The mechanism for taxing that income to US shareholders is that the income earned in the current year by the foreign corporation will be taxed as a deemed distribution of that income or of those earnings, even though no actual distribution has occurred in that current year.

Individuals who own foreign corporations, either directly or through a US flow-through vehicle, need to understand that the Subpart F income, i.e., the deemed dividend that you include in your current year tax return, will not qualify for the preferential rates, i.e., the capital gains rates. So, that's something to watch out for.

Beyond Subpart F, the Tax Cuts & Jobs Act also introduced a whole new type of income called GILTI income. GILTI is Global Intangible Low Tax Income, and this is the income that most US taxpayers who own foreign corporations really need to watch out for. Backing up, GILTI income is taxed very much the same way as Subpart F – it is taxed as a deemed dividend in the current year, irrespective of whether an actual distribution was made by the CFC.

The GILTI mechanism gets complicated quickly, but at a high level, the rules will allow a US shareholder to take a 10 percent return on their Qualified Business Assets Investments (QBAI), and that's tangible depreciable assets that are used in the trade of business of the foreign corporation. Anything above that 10 percent QBAI comes back as a GILTI in the form of a deemed dividend to the US shareholders.

The majority of income earned by CFCs post-2017 is coming back as GILTI income. On the foreign tax credit side, there is a 20 percent haircut with GILTI, and it is computed year to year (use it or lose it), whereas with Subpart F income, you get a full 100 percent foreign tax credit and you can carry forward the credit to future years. So those are two important distinctions on Subpart F and GILTI income.

Why Should People Care About CFCs?

DK:
Once a corporation is classified as a CFC, there are rules that can be advantageous or disadvantageous to US shareholders. For example, if a US shareholder is a US C corporation, then the GILTI income that I discussed previously will come back into the US at 10.5 percent versus the current headline rate for corporations at 21 percent. It does come back with that foreign tax credit that I mentioned previously. Now, the foreign tax credit has a 20 percent haircut, but 80 percent of the foreign taxes that the foreign corporation pays in its home country should be creditable against other income in that GILTI basket for foreign tax credit purposes. That Subpart F income comes back at the 21 percent tax rate and has a full foreign tax credit without a haircut.

For US individuals that hold controlled foreign corporations through US flow-through vehicles (i.e., an S corporation, a US LLC, or a US partnership), the rules are pretty onerous for GILTI income. First of all, the GILTI income comes back at the ordinary income rates for a US individual (up to 37 percent). An important distinction between holding your investment in this format versus a C corporation is that you don't get foreign tax credits, so any foreign taxes that are paid in the home country of the CFC are not creditable against your US taxation. In essence, that income is subject to double taxation. So that's a very impactful situation.

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Let’s Switch Gears. What Is a PFIC?

DK:
A PFIC is a Passive Foreign Investment Company. It’s a foreign corporation that mostly has passive income or assets that produce passive income. Unlike the CFC rules, there is no ownership threshold to determine whether a foreign corporation is a PFIC or not. Any amount of ownership in a foreign corporation can subject a US shareholder to the rules.

There are two tests for PFICs:

1. Income Test: If 75 percent or more of the gross income of the foreign corporation is passive, then it will be treated as a PFIC.
2. Asset Test: If 50 percent or more of the assets of the foreign corporation produce passive income, then it will also be treated as a PFIC.

The income and asset tests are disjunctive, meaning failing either one will trigger the PFIC rules.

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So, What Are the Rules Regarding PFICs?

DK:
The rules around PFICs can get very complicated very quickly, so I will try to keep this pretty high level. The first rule that I want to mention is the “Once a PFIC, Always a PFIC” rule.

It is best explained by an example:
Let’s say a foreign corporation is a PFIC in year one. It fails either the income test or the asset test, so it’s a PFIC. In year two, it no longer fails either test, but because it was determined to be a PFIC in year one, the PFIC taint carries over to all subsequent years of the foreign corporation. So, in this example, for both years one and two, the foreign corporation would be treated as a PFIC for US tax purposes, even though in year two, the foreign corporation did not fail either the income or asset test. That's an important rule.

Distributions and the Sale of a PFIC

Regarding distributions, there are two distinct categories of distributions from a PFIC:

1. Non-Excess Distribution:
   This is treated as a distribution but not as a qualified dividend because a PFIC, by definition, isn't a qualified foreign corporation. Any distributions you receive from a PFIC will be taxed at ordinary income rates, not the preferential capital gains rates.

2. Excess Distribution:
   If a distribution exceeds 125 percent of the average distributions in the prior three years, it is treated as an excess distribution. The earnings making up that dividend are prorated through the entire holding period of the US shareholder in the PFIC, and interest charges on prior years apply, along with ordinary income tax rates.

Regarding the disposition of shares of a PFIC by US shareholders, the gain on that sale is treated as an excess distribution, leading to interest charges and tax due at ordinary income rates.

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Why Should We Care About All This?

DK:
First, the punitive nature of US taxation on PFICs is something US investors should be aware of. One key overlap is that if a foreign corporation is both a CFC and a PFIC, the rules default to the CFC rules, which are generally more advantageous for US taxpayers.

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Planning Techniques for CFCs and PFICs

1. CFC Planning:

   • Check-the-Box Planning: This US administrative election treats the foreign corporation as something other than a foreign corporation for US tax purposes.
   • GILTI Income Planning: Converting a US flow-through entity to a C corporation or using a C corporation blocker can allow GILTI income to be taxed at the corporate rate (10.5 percent) and use foreign tax credits.

2. PFIC Planning:

   • QEF Election: Cleanses the PFIC taint of the foreign corporation, so excess distribution rules no longer apply after the election.
   • Domestication Transactions: Converts a PFIC into a US domestic corporation, effectively removing the PFIC classification.

If you find yourself in either the CFC or PFIC classification, Frazier & Deeter can assist with US reporting obligations and planning opportunities.

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About Dave Kim

As Frazier & Deeter’s National Practice Leader for International Tax, Dave Kim brings deep expertise in global tax planning with over 20 years of public accounting experience. His expertise includes international tax structuring, global value chain tax planning, intellectual property migration strategies, and cross-border M&A. Dave has worked with clients across various industries, focusing on technology, private equity, and manufacturing.