Income derived by a foreign corporation—including a foreign corporation owned by US shareholders—from conducting operations outside the United States has not generally been subject to US taxation. Under Subpart F, however, certain types of income and investments of earnings of a foreign corporation controlled by US shareholders (controlled foreign corporation, or CFC) are deemed distributed to the US shareholders and subject to current taxation. The recent tax reform legislation (Public Law No. 115-97, or the Tax Act) increased the amount of CFC income currently taxable to US shareholders, and expanded the CFC ownership rules, which means more foreign corporations are treated as CFCs.
Subpart F Income
US shareholders of a CFC must include in income on a current basis the net Subpart F income of the CFC. The Tax Act did not modify the existing definitions of Subpart F income, except that it removed the Subpart F income category for oil related income. For a C corporation, Subpart F income is subject to a maximum tax rate of 21 percent, and for individuals and pass-through entities the maximum income tax rate is 37 percent (regulations also apply the 3.8 percent net investment income tax under certain circumstances to income of, and distributions from, CFCs, but that tax is not addressed further herein).
Subpart F income taxable to the US shareholders includes insurance income, foreign base company sales income, foreign base company services income, and foreign personal holding company income. The last category includes dividends, interest, rents, royalties, certain passive gains and certain foreign currency gains not related to the CFC’s business. In determining the amount of Subpart F income included in the income of the US shareholders, any gross Subpart F income is reduced by expenses (including taxes) properly allocated to the income.
The various business exceptions to the above categories of Subpart F income remain, such as the exceptions for income from sales of products manufactured by the CFC, active rents and royalties received from unrelated persons, active financing income, and income from services performed for unrelated persons. Dividends, interest, rents and royalties received from a related CFC continue to qualify for a temporary exception provided the expense does not reduce the payor’s Subpart F income. Also, payments that are disregarded pursuant to entity classification elections continue to not be recognized for most US tax purposes.
A taxpayer may elect to exclude an item of Subpart F income if it qualifies for a high-tax exception. This election is available if the item of income was taxed in the foreign country at a rate higher than 90 percent of the highest US corporate tax rate. Because the Tax Act reduced the US corporate tax rate from 35 percent to 21 percent, the threshold rate of foreign income tax needed to qualify for the high-tax exception decreased from 31.5 percent to 18.9 percent (this rate is the same for corporations and individuals).
US corporate shareholders are eligible for a foreign tax credit for foreign income taxes paid on Subpart F income (the amount of Subpart F income is grossed-up for the amount of the deemed paid taxes). Unlike prior law, the associated taxes will no longer be computed on a multi-year pool basis, but instead based on some determination of actual taxes paid on the income included as Subpart F income. Any excess foreign tax credits can be carried back one year and carried forward ten years. No similar credit is allowed to US shareholders who are not C corporations (and there also is no gross up).
For example, assume a CFC earns $100 of Subpart F income before taxes, and pays a 10 percent foreign income tax rate on the income. A US shareholder that is a corporation would include $100 in income ($90 + $10), and have a US tax liability of $21, which generally can be reduced to $11 with foreign tax credits. On the other hand, a US shareholder who is an individual will pay $33.3 of US income taxes ($90 x .37) on the Subpart F income.
An individual US shareholder may make an election under section 962 to be subject to tax on Subpart F income as if it were a domestic corporation. This would include the lower corporate tax rate and the ability to claim foreign tax credits. With such election, an individual US shareholder would pay $11 of income tax on the Subpart F income (rather than $33.3). A portion of the Subpart F earnings will be again subject to taxation when distributed.
Global Intangible Low-Taxed Income
The Tax Act added new section 951A, which requires US shareholders of a CFC to include in gross income their global intangible low-taxed income (GILTI). Only 50 percent of GILTI is included in the taxable income of US shareholders that are corporations, but 100 percent is included in the income of US shareholders who are individuals.
A number of steps are required to determine a US shareholder’s GILTI inclusion. The calculation is performed at the US shareholder level.
First, each CFC’s gross income is determined and then reduced by certain items of income, including Subpart F income (even if the high-tax exception is elected), dividends received from related corporations, and income that is effectively connected with a US trade or business. This amount is reduced by deductions (including taxes) properly allocable to such income, yielding “tested income.” If this calculation results in a loss for a CFC, it is a “tested loss.”
These amounts are attributed to a US shareholder on a pro rata basis. All amounts are aggregated, with losses offsetting income, and the result is the US shareholder’s “net CFC tested income.”
Second, with respect to each CFC for which a US shareholder has tested income (but not a tested loss), a determination is made of the amount of such CFC’s tangible property that is used in a trade or business, subject to an allowance for depreciation, and used in the production of tested income. The amount is the aggregate adjusted basis of such property, calculated using quarterly averages and straight line depreciation. The portion of the amount of such property used in the production of tested income is a CFC’s “qualified business asset investment” and is attributed to the CFC’s US shareholders on a pro rata basis.
Third, the US shareholder’s aggregate net CFC tested income is reduced by 10 percent of the US shareholder’s aggregate qualified business asset investment. This amount of the qualified business asset investment is reduced by a CFC’s interest expense that was taken into account in calculating tested income but that was not included in the US shareholder’s net CFC tested income (generally any interest not paid to a related CFC). The result of this calculation is GILTI. Apparently GILTI is calculated separately for each domestic corporation within a consolidated group, and thus a taxpayer may consider combining ownership of its CFCs under a single domestic holding company.
US shareholders that are corporations deduct 50 percent of their GILTI. On the other hand, individuals and pass-through entities are required to include 100 percent of GILTI in their taxable incomes.
In addition, US shareholders that are corporations are entitled to claim a tax credit for 80 percent of the foreign income taxes associated with GILTI. The amount of foreign income taxes associated with GILTI is calculated as the percentage of GILTI relative to all tested income, multiplied by the foreign income taxes properly attributable to the tested income taken into account by the US shareholder. If a credit is claimed, 100 percent of the foreign income taxes associated with GILTI are added to income (and then a deduction is allowed for 50 percent of this gross up). The foreign tax credit limitation is calculated separately for GILTI, and any excess foreign tax credits may not be carried forward or back.
Assume the facts in the above example, where a CFC earns $100 and pays $10 of foreign taxes, but now the income is not Subpart F income. Further assume the CFC has a $40 basis in depreciable tangible property used in generating non-Subpart F income and has no interest expense. For a US shareholder that is a corporation, it would have $90 of tested income ($100 - $10), which would be reduced by $4 (10 percent of $40 qualified business asset investment). The amount of GILTI would be $86. The US corporate shareholder would have gross income of $96 ($86 + $10), and then deduct 50 percent of that amount, or $48. The US corporate shareholder would then be subject to tax of $10.08 ($48 x .21), which could be reduced by $8 of foreign tax credits ($10 x .8), for a net tax of $2.08, subject to the application of the Section 904 limitation.
A US shareholder who is an individual would also have $86 of GILTI ($90 - $4) and would be liable for $31.82 of US income taxes ($86 x .37). The individual would not receive a foreign tax credit for the foreign taxes paid by the CFC. As an alternative, an individual can elect under section 962 to be taxed on the income as a domestic corporation, although apparently the individual still would not be entitled to deduct 50 percent of the GILTI. Under this election, the individual would be subject to taxes of $20.16 ($96 x .21) less a tax credit of $8, or current taxes of $12.16. A portion of the CFC’s earnings subject to taxation as GILTI will be again subject to taxation when distributed.
Prior to the Tax Act, amounts included in the income of US shareholders under Subpart F generally were excluded from income when distributed to the US shareholders. This rule was retained, and now also applies to the amount of tested income taken into account by a US shareholder in calculating the amount of its GILTI inclusion.
In addition, for US shareholders that are corporations, a 100 percent deduction is now provided for distributions by CFCs of foreign earnings that were not subject to taxation under Subpart F. This rule requires a one-year ownership period of the stock and does not apply to dividends that are deductible by the CFC in calculating its foreign income taxes.
In contrast, US shareholders who are individuals include in their incomes 100 percent of dividends received from CFCs that are not distributed out of previously taxed income, subject to a 37 percent income tax rate. If the foreign corporation qualifies for the benefits of a US income tax treaty, such dividends can qualify for a reduced income tax rate of 20 percent. Under ordering rules, distributions from a CFC are treated as being made first out of the CFC’s current and accumulated previously taxed income.
If an individual shareholder made an election under section 962 with respect to Subpart F income and GILTI inclusions from a CFC for the taxable year, then the amount of previously taxed income of the CFC would be the amount of US taxes paid on the prior inclusion. In the above Subpart F income example, the CFC’s previously taxed income would be $11, and in the above GILTI example the CFC’s previously taxed income would be $12.16. Such amount could be distributed without additional US income tax. A distribution of an amount of the CFC’s earnings in excess of these amounts (up to $79 in the Subpart F income example, and $77.84 in the GILTI example) would be treated as taxable dividends generally subject to the 37 percent income tax rate. If the foreign corporation qualifies for the benefits of a US income tax treaty, such dividends may qualify for a reduced income tax rate of 20 percent.
It should be noted that if a CFC invests its earnings in US property, such investment is treated as a deemed dividend under Subpart F. Investments in US property include tangible property located in the United States, intangible property used in the United States, loans to related US persons and guarantees of obligations of related US persons. The amount of any deemed distribution is reduced by a CFC’s previously taxed income, and only the excess amount is included in the income of the US shareholders. The 100 percent dividends received deduction is not available for such amounts included in the income of corporate US shareholders and US individuals are subject to taxation on the inclusion at a 37 percent tax rate. As a result, it will be important for taxpayers to manage such investments to avoid unnecessary US taxes.
Application of Subpart F Rules to More Shareholders and Corporations
Subpart F only applies to foreign corporations that are CFCs and to US shareholders that own stock in a foreign corporation that is a CFC. The Tax Act expanded the rules for determining the persons that are subject to Subpart F (i.e., US shareholders) and the foreign corporations that meet the definition of a CFC.
A CFC is defined as a foreign corporation that is more than 50 percent owned (by vote or value) by US shareholders. For this purpose, stock owned directly, indirectly and constructively is taken into account.
Under prior law, a US shareholder was defined as a person that owned at least 10 percent of the voting power of a CFC. Under the Tax Act, a US person can be a US shareholder if it owns either 10 percent of the voting power or 10 percent of the value of a CFC. For example, a US person that owns 10 percent of the value of a CFC’s stock, but only 6 percent of the voting power, would now be a US shareholder.
Before the Tax Act, a US person would not be treated under the constructive ownership rules as owning the stock of a foreign corporation owned by a foreign person. Under the new rules, a US person with a foreign parent is treated as owning the foreign parent’s foreign subsidiary, which could potentially cause the foreign subsidiary to be a CFC. Nevertheless, no Subpart F amounts should be subject to US taxation, because no US shareholder owns a direct or indirect interest in such foreign subsidiary (although certain reporting requirements would apply).
One potentially unintended result of the expanded ownership rules is that foreign corporations that are majority owned by foreign persons arguably might become CFCs, even though the legislative history suggests that this is not the intent of the provision. For example, assume a foreign corporation is owned 30 percent by a US shareholder and 70 percent by an unrelated foreign company. The foreign owner also has a US subsidiary, which under the modified constructive ownership rules would be considered as owning its 70 percent interest in the foreign corporation, causing it to technically be a CFC. Guidance and/or technical corrections legislation would be useful to confirm the apparent intent not to subject such foreign corporations to the Subpart F rules.
US taxpayers that own shares in foreign corporations will need to study the new rules expanding Subpart F and determine the consequences under their particular circumstances. A taxpayer may implement certain changes to its foreign operating structures to limit additional tax costs, and individuals also may consider electing to be subject to tax as a domestic corporation under section 962.