Working with US investors can help fuel growth, but it can also be tricky in terms of understanding US tax regulations. Companies based outside the US will often be asked to make representations about their PFIC or CFC status when they are looking to take on a US investor. They could also be asked to provide specific financial information on a regular basis to enable their US investors to comply with the PFIC or CFC annual reporting rules. It is therefore important to have an awareness of the rules and involve a specialist where required.
What is a CFC?
A Controlled Foreign Corporation (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%, by vote or value, by US shareholders. US shareholders are defined as US persons who own 10% or more of the foreign corporation.
For example, if you have eleven US persons who equally own a foreign corporation, you don’t have a CFC. Each of them would own approximately 9.1% of that corporation; no one would be a US shareholder, and you don’t have a CFC because no individual US person owns more than 10% of that foreign corporation.
There are also indirect and constructive ownership rules to consider. For example, an individual owns 9% of a foreign corporation, and his daughter owns 1% of the same foreign corporation. In combination, they own 10%. The constructive ownership rules will attribute 10% ownership to both parties. The tax consequences of being a US shareholder of the CFC remains with the man’s 9% and his daughter’s 1% ownership, but in terms of meeting that definition of a US shareholder and a CFC, the constructive ownership rules aggregate their ownership.
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 remains 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.
Rules Regarding CFCs
The rules around CFCs are quite detailed. At a 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.
Subpart F
Certain income that is earned by a CFC is going to be subject to anti-deferral rules, also known as 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, though no actual distribution has occurred in that year.
Notably, 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 included in a current year tax return) will not qualify for preferential rates (i.e., the capital gains rates).
GILTI
The Tax Cuts & Jobs Act (TCJA) introduced a new type of income called Global Intangible Low Tax Income (GILTI). GILTI is taxed much the same way as Subpart F – as a deemed dividend in the current year, irrespective of whether an actual distribution was made by the CFC. GILTI is the income that most US taxpayers who own foreign corporations need to monitor closely.
The GILTI mechanism gets complicated quickly, but at a high level, the rules will allow a US shareholder to take a 10% return on Qualified Business Assets Investments (QBAI), which are tangible, depreciable assets that are used in the trade of business of the foreign corporation. Anything above that 10% QBAI comes back as a GILTI in the form of a deemed dividend to the US shareholders.
Distinctions Between Subpart F and GILTI
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% 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% foreign tax credit, and you can carry forward the credit to future years.
A significant tax advantage is that if a US shareholder is a US C corporation, the GILTI income will be taxed at a reduced rate of 10.5%, compared to the current corporate tax rate of 21%. It does come back with the foreign tax credit. While the foreign tax credit has a 20% haircut, 80% of the foreign taxes that the corporation pays in its home country should be creditable against other income in that GILTI basket. That Subpart F income comes back at the 21% tax rate and has a full foreign tax credit without a haircut.
For US individuals who hold CFCs through US flow-through vehicles (such as S corporations, U.S. LLCs or U.S. partnerships), the rules are fairly difficult for GILTI income. It is taxed at ordinary income rates, which can be as high as 37%. An important distinction between holding your investment in this format versus a C corporation is that you do not receive foreign tax credits, meaning any foreign taxes paid in the home country of the CFC cannot be credited against US tax obligations. As a result, GILTI income is subject to double taxation—once in the foreign jurisdiction and once in the US—which can create a substantial tax burden.
What is a PFIC?
A Passive Foreign Investment Company (PFIC) is 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 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. One is an income test, if 75% or more of the gross income of the foreign corporation is passive, then it will be treated as a PFIC. The other test is an asset test, where if 50% 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.
Rules Regarding PFICs
Once a PFIC, Always a PFIC
The rules around PFICs can get very complicated very quickly, but one of the most critical to understand is the “Once a PFIC, Always a PFIC” rule. If a foreign corporation meets the PFIC criteria in year one, failing either the income test or the asset test, it retains PFIC status for US tax purposes for any shareholders from that year, even if it passes the tests in subsequent years.
For example, a foreign corporation is a PFIC in year one. It fails either the income test or the asset test. It’s tested again in year two and it no longer fails either test. However, because it was determined that it was a PFIC in year one, the “PFIC taint” carries over to all subsequent years of the foreign corporation. For year one and two, the foreign corporation would be treated as a PFIC for US tax purposes for US shareholders.
PFIC Distributions
PFIC distributions fall into two categories: non-excess distributions and excess distributions.
A non-excess distribution is treated as a distribution but not treated as a qualified dividend because a PFIC isn’t a qualified foreign corporation. Any distributions that you receive from a PFIC will be taxed at ordinary income rates and not the preferential capital gains rates.
Excess distributions occur when a current-year distribution exceeds 125% of the average distributions from the prior three years. The earnings that make up that distribution of the dividend will be prorated through the entire holding period of the US shareholders. The current year earnings will be treated as a dividend and taxed at ordinary rates, while the earnings allocated to the prior years will be taxed at ordinary rates and subject to an interest charge on the prior year’s tax due.
When a US shareholder disposes of PFIC shares, any gain is treated as an excess distribution, meaning it is allocated over the holding period, taxed at ordinary income rates and subject to an interest charge. This taxation structure can significantly impact investment decisions, particularly for private equity investors, where the financial burden of PFIC tax rules may outweigh the potential returns.
Planning Strategies for CFCs and PFICs
One important point to be aware of is the overlap between PFIC and CFC rules. When a foreign corporation qualifies as both a PFIC and a CFC, and a US shareholder owns 10% or more of the shares, the rules default to the CFC guidelines rather than the PFIC rules. In many cases, the CFC rules are more advantageous for US investors than the PFIC tax treatment.
For CFCs, one strategy is utilizing “check-the-box” planning. This is an administrative election that allows a foreign corporation to be treated as something other than a foreign corporation for US tax purposes. While the process is relatively simple, whether it’s beneficial depends on the specific circumstances.
Another important strategy for CFCs is planning for GILTI. US shareholders of CFCs may want to consider converting their US flow-through entities to C corporations or inserting a US C corporation blocker to hold the CFC. This structure allows the shareholder to include GILTI at a reduced US corporate tax rate of 10.5% and leverage foreign tax credits to offset US taxes, potentially covering up to 80% of the foreign taxes paid by the CFC.
For those involved with PFICs, one of the key strategies is making a Qualified Electing Fund (QEF) election. This election removes the PFIC classification from a foreign corporation, meaning that future distributions and sales of shares will no longer be subject to PFIC rules. The QEF election must be made in the first year the foreign corporation is considered a PFIC, and it can only be made by the first US shareholder, whether direct or indirect.
Popular among UK portfolio companies, another planning opportunity is a domestication transaction. In a domestication transaction, the PFIC will move and convert to a US domestic corporation, which completely removes the “PFIC taint” because it’s no longer a foreign corporation. This strategy is known as a “Delaware Flip.”
Learn how FD helped a tech startup successfully complete a Delaware flip for a $2.5M seed investment—restructuring ownership, securing tax clearances and optimizing the cap table, all in just 3 weeks. Read more here.
Navigating CFC and PFIC Tax Implications: How FD Can Help
Navigating the complexities of PFIC and CFC regulations is essential for US investors and those involved with foreign corporations. The tax implications of both classifications can be significant, potentially resulting in double taxation or missed opportunities for tax credits. Understanding these rules, especially the interplay between CFC and PFIC statuses, is crucial to making informed investment decisions and minimizing tax liabilities.
If you find yourself dealing with CFC or PFIC classifications or need assistance with US reporting obligations and tax planning, Frazier & Deeter is here to help. Our team of experts can guide you through the intricacies of these regulations and develop strategies tailored to your specific needs. Contact us today to take the next step in optimizing your investment strategy.
Contributors
Dave Kim, Partner and National Practice Leader, International Tax