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. Dave Kim, the leader of Frazier & Deeter’s International Tax practice, recently 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 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.
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.
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 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 percent 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, 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.
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. Let’s say in year two, it’s tested again. In year two it no longer fails either test but 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. So, in my 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.
Turning to the other rules around PFICs, I’ll largely segregate between distributions and the sale of a PFIC. Regarding distributions, there are two distinct categories of distributions from a PFIC. One is an excess distribution and the second is the traditional non-excess distribution. I’ll start with the non-excess distribution, which is a little simpler.
The non-excess distribution is treated as a distribution, but it’s not treated as a qualified dividend because a PFIC by definition isn’t a qualified foreign corporation. So, any distributions that you receive from a PFIC will be taxed at ordinary income rates and not the preferential capital gains rates.
Now let’s talk about excess distributions. If a distribution exceeds 125 percent of the average distributions in the prior three years, then that distribution will be treated as an excess distribution. The earnings that make up that distribution of the dividend will be prorated through the entire period of the US shareholders holding period of the PFIC, both in the current year and prior PFIC years. The current year, again, will be treated as a dividend taxed at ordinary rates. In the prior years, there will be no tax due, but it is treated as though the earnings were not taxed. In the final year, when the actual distributions are made, there’s an interest charge on the prior years as well as tax due on that distribution. That can get expensive very quickly.
Regarding the second situation, the disposition of shares of a PFIC by US shareholders, the gain on that sale will be treated as though it were an excessive distribution, meaning that there would be an interest charge on that gain that’s prorated over the holding period of that particular US shareholder in the current year as well as prior PFIC years and the tax due would be at ordinary income rates. Very often for our clients, especially our private equity clients, the taxation as an excess distribution will turn the economics of the investment upside down so that it’s not worth the underlying investment for the private equity investors.
Dave, now that you’ve defined PFIC and the rules, why should we care about all this?
DK: First of all, the punitive nature of the US taxation on PFICs is something that US investors should be aware of. One of the rules that I didn’t mention up until now is that there’s some overlap. If a foreign corporation is a CFC and you are a US shareholder of that foreign corporation, i.e., you own 10 percent or more of the shares, then the rules default to the CFC rules and not the PFIC rules. More often than not, the CFC rules are more advantageous to our clients than the PFIC rules.
The other point I want to talk about is planning techniques in the CFC realm, as well as the PFIC realm. If you have a CFC, there’s check the box planning, which is an administrative election made here in the US to treat the foreign corporation as something other than a foreign corporation for US tax purposes. It’s done by filling out a form, so administratively it’s pretty easy to do. That may or may not be advantageous in your particular situation.
The second opportunity is to proactively plan into GILTI income. If you’re a US individual or US flow-through entity that owns a CFC, you may want to consider converting your US flow-through to a C corporation or inserting a US C corporation blocker to hold that CFC. That allows the US shareholder to include GILTI at the US corporation level at 10.5 percent and also potentially utilize foreign tax credits to offset US taxation at 80 percent of foreign taxes paid by the CFC.
With respect to PFICS, a US shareholder may consider making a QEF election to cleanse the PFIC taint of the foreign corporation in the year of the election, so that every year after the election the PFIC rules no longer apply to excess distribution. Also, the PFIC rules on a disposition of shares of the PFIC will no longer apply to that particular US shareholder that makes the QEF election.
Another planning opportunity is what we call a domestication transaction and we’re seeing more and more of this, especially with our UK portfolio companies. 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. A very kind place to do that is Delaware, we’ve done several of these for our clients.
Those are just a few planning opportunities with foreign corporations classified as CFCs or PFICs. If you find yourself in either the CFC or PFIC classification vis-à-vis your ownership in a foreign corporation, Frazier & Deeter can assist with US reporting obligations and planning opportunities.
About Dave Kim
As Frazier & Deeter’s National Practice Leader for International Tax, Dave Kim brings a deep knowledge of global tax planning with more than twenty years of public accounting experience. His areas of expertise include international tax structuring and restructuring, global value chain tax planning, intellectual property migration strategies, and cross-border mergers and acquisitions. Dave has worked with a broad range of clients from U.S. and foreign publicly-traded companies, private equity groups and portfolio companies, to fast-growing start-ups in a variety of industries with a focus in technology, private equity, and manufacturing and distribution. Read More