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Controlled Foreign Corporation Tax Guide for U.S. Shareholders By Vernon K. Jacobs, CPA and J. Richard Duke, JD, LLM.

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Presentation on theme: "Controlled Foreign Corporation Tax Guide for U.S. Shareholders By Vernon K. Jacobs, CPA and J. Richard Duke, JD, LLM."— Presentation transcript:

1 Controlled Foreign Corporation Tax Guide for U.S. Shareholders By Vernon K. Jacobs, CPA and J. Richard Duke, JD, LLM

2 Copyright, 2006, Offshore Press, Inc. This presentation is a summary of the topics included in The Controlled Foreign Corporation Tax Guide by Vernon Jacobs and Richard Duke It is published and copyrighted by Offshore Press, Inc. http://www.offshorepress.com/cfc- ibc-tax.htm http://www.offshorepress.com/cfc- ibc-tax.htm

3 Circular 230 Notice This report is not a reliance opinion or a marketed opinion. This report and its contents were not intended or written by the authors to be used, and cannot be used, by anyone for the purpose of (i) avoiding U.S. tax penalties, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed or stated herein. This report and its contents are not treated as a marketed opinion because (a) the advice was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer; (b) the advice was not written to support the promotion or marketing of the transaction(s) or matter(s) addressed herein; and (c) the taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor. [31 C.F.R. sections 10.35(b)(4)(ii); 10.35(b)(5)(i); and (b)(5)(ii)(a), (b) and (c).] For an explanation of the Circular 230 requirements to which tax advisors are subject, see http://www.offshorepress.com/vkjcpa/disclosurerules.htm http://www.offshorepress.com/vkjcpa/disclosurerules.htm

4 Introduction to the CFC Tax Guide An offshore corporation is not subject to the taxing jurisdiction of the U.S. But the U.S. shareholders are subject to the taxing jurisdiction of the U.S. In 1962, the law was changed to deter the use of foreign corporations to avoid taxes. (IRC 951-964) Generally, foreign investment income and certain kinds of foreign source business income are subject to current taxation by U.S. shareholders.

5 Definition of a Foreign Corporation A foreign corporation is one that is not formed or organized in the USA or under the law of any state or possession. [IRC 7701(a)(5)] However, if a foreign corporation has U.S. shareholders, those shareholders are subject to the jurisdiction of the U.S. and to the taxing jurisdiction of the U.S. If a foreign corporation has income that is "effectively connected" with a trade or business (or has other U.S. source income) in the U.S., then it is subject to the taxing jurisdiction of the U.S. There are many exceptions to the general rules relating to the taxation of foreign corporations

6 Definition of a Controlled Foreign Corporation A controlled foreign corporation is a foreign corporation that is controlled more than 50% by "U.S. shareholders". A "U.S. shareholder" is a U.S. person who owns, or is considered to own, at least 10% of the stock IRC Section 7701(a)(30) defines a U.S. person very broadly to include individuals, partnerships, corporations, trusts and estates. In determining the 10% or more ownership, the attribution rules of both IRC Section 958(a) and IRC Section 958(b) apply. If U.S. shareholders own more than 50%, by vote or value, in the foreign corporation, it is classified as a controlled foreign corporation (CFC).

7 A Summary Explanation of "Subpart F Income" U.S. shareholders of a CFC are subject to current taxation on certain kinds of income of a CFC set forth in "Subpart F" of the tax code. Hence, these forms of income are referred to as "subpart F income". If the foreign corporation has subpart F income, then, to the extent of the earnings and profits of the corporation, those earnings are taxable each year (whether distributed or not) to the 10% or more shareholders

8 Five Categories of Subpart F Income (1)insurance income as defined at IRC Section 953; (2)foreign base company income as defined at IRC Section 954; (3)income from countries subject to international boycotts [IRC Section 999]; (4)illegal bribes, kickbacks and similar payments [IRC Section 162(c]; and (5)income from countries where the U.S. has severed diplomatic relations [IRC Section 901(j)].

9 Foreign Base Company Income - I (1)foreign personal holding company income [IRC Section 954(c)]; (2)foreign base company sales income [IRC Section 954(d)]; (3)foreign base company services income [IRC Section 954(e)]; (4)foreign base company shipping income [IRC Section 954(f)]; and (5)foreign base company oil related income [IRC Section 954(g)].

10 Foreign Base Company Income - II "Foreign personal holding company income" is basically income from passive investments such as interest, dividends, certain rents, royalties and capital gains. Foreign base company sales income generally includes income from selling personal property purchased from a related person or sold to a related person. Foreign base company services income" is defined as income derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or like services. Foreign base company shipping income and foreign base company oil related income are clearly intended for these specific industries and will not be discussed further in this presentation

11 Investment Income of Controlled Foreign Corporations There are two primary methods by which the U.S. imposes current taxation on the investment income of foreign corporations with U.S. stockholders. The foreign personal holding company rules of IRC section 954(c) The passive foreign investment company (PFIC) rules of IRC sections 1296 and 1297. (A brief discussion of the PFIC rules is included later in this report.) Any CFC with a significant amount of investment income should consider a detailed review of these definitions for potential exceptions.

12 Related Party Purchases or Sales Foreign base company sales income is defined by IRC Section 954(d) as (1) the purchase of personal property from a related person and its sale to any person, (2) the purchase of personal property from any person and its sale to a related person, (3) the purchase of personal property from any person on behalf of a related person For this purpose, a related person does NOT include an individual who is a non-resident alien even if that individual is related to the U.S. taxpayer. The bottom line is that income from a trade or business conducted entirely outside the U.S. is not subpart F income unless a related party is involved.

13 Related Party Services Income Profits derived from the sale of certain services through a controlled foreign corporation are subject to current taxation to the "U.S. shareholders". Foreign base company services income is defined in IRC 954(e) as income derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial or like services which (A)are performed for or on behalf of any related person and (B)are performed outside the country under the laws of which the controlled foreign corporation is created or organized.

14 Subpart F income also includes Insurance income as defined in IRC 953 International boycott income as defined in section 999 Expenses in the form of illegal bribes, kickbacks or other payments to an official, employee or agent of a foreign government as defined in IRC 162(c) Income derived from countries not recognized by the US as defined in IRC 901(j) Foreign base company shipping income as defined in IRC 954(f) Foreign base company oil related income as defined in IRC 954(g)

15 Exceptions to Subpart F Income - I Most of the exceptions are set forth in IRC 954(b). The "de minimus" rule excludes foreign base company if less than 5% of the gross income or less than $1,000,000 – whichever is less If the foreign base company income exceeds 70% of the gross income all of the income will be treated as subpart F income unless one of the following exceptions applies.

16 Exceptions to Subpart F Income - II The FPHC income is subject to an effective rate of foreign tax greater than 90% of the maximum corporate tax rate FPHC income is reduced by allowable deductions Income derived in the active conduct of banking, financing, (securities) or similar businesses Income derived in the active conduct of an insurance business Income of a foreign corporation that is subject to U.S. corporate income taxes

17 U.S. Source Income of Foreign Corporations A foreign corporation is subject to U.S. tax on U.S. source income that is effectively connected with the conduct of a U.S. trade or business The foreign corporation will file a Form 1120F and pay U.S. corporate income taxes Foreign corporations that have "fixed or determinable annual or periodical income from a U.S. source" (FDAP) are subject to withholding on payments from the U.S. FDAP income includes interest, dividends, gains from the sales of real property, annuities and similar kinds of income.

18 Income from a Trade or Business in the U.S. The foreign corporation has a fixed place of business in the U.S., an employee in the U.S. or an agent in the U.S. who can conclude contracts on behalf of the corporation. General rules as to the source of income. Interest income is generally U.S. source income if paid by a U.S. entity or person Dividends paid by a U.S. corporation are U.S. source income. Compensation for services provided in the U.S. is U.S. source income. Rents or royalties on property located in the U.S. is U.S. source income. Gains from the sale of U.S. realty is U.S. source income.

19 CFC Earnings Invested in U.S. Property Tax code section 956 imposes a tax on the U.S. shareholders for the investment of earnings of a CFC in U.S. property. For this purpose, U.S. property includes Tangible property located in the U.S. Stock of a domestic corporation An obligation of a U.S. person The use in the U.S. of an intangible asset IRC 956(c)(2) describes an assortment of exceptions to the definition of U.S. property.

20 Shareholder Election to be Taxed as a U.S. Corporation Corporate owners of foreign corporations may claim a credit for foreign taxes paid by their foreign subsidiary corporation Individual owners of foreign corporations are not permitted to claim a credit for foreign taxes paid by their foreign corporation. Tax code section 962 permits an individual shareholder of a CFC to be taxed as if the shareholder were a domestic corporation.

21 U.S. Corporations with Foreign Operations There are two basic ways to avoid the CFC reporting rules and the complications of the shareholder tax on the subpart F income of a CFC. Operate an offshore business as an unincorporated branch of a U.S. corporation, a U.S. partnership or even a U.S. proprietorship. Establish a foreign corporation or LLC and file an election to treat the foreign corporation as a disregarded entity.

22 Tax Deferral of Non CFC Income -I If a foreign corporation is not a CFC, the U.S. owners/stockholders are not subject to tax on the business income of the foreign corporation The foreign corporation is treated the same as a non resident alien for U.S. tax purposes Investment income of the foreign corporation is not subject to U.S. tax unless it exceeds 25% of the total income or meets the asset test

23 Tax Deferral of Non CFC Income -II The subpart F rules relating to purchases from or sales to related persons will not apply. The U.S. stockholders will be able to treat any gain as a capital gain There will be a step-up-in-basis of the stock at the death of the taxpayer

24 Tax Treatment of U.S. Stockholders in CFC - I Any gain on the subsequent sale of controlled foreign corporation stock is treated as dividend income to any U.S. shareholder who owns 10% or more of the stock Gains from the sale of stock by shareholders who do not directly or indirectly own 10% of the company are eligible to be treated as a long- term capital gain Although U.S. shareholders of a CFC may be subject to current tax on the subpart F income of the CFC, losses are not passed through as deductions to the shareholders.

25 Tax Treatment of U.S. Stockholders in CFC - II If a U.S. person forms a CFC to invest in a foreign security, no loss is available if the security becomes worthless because the security is owned by the corporation instead of by the shareholder. There is no step-up in basis at the death of the U.S. shareholder of a CFC not engaged in a trade or business (i.e. - the IBC owns passive investment assets).

26 Special Rules for Passive Foreign Investment Co. – I Most U.S. mutual funds make declarations of "deemed distributions" each year to avoid double taxation The U.S. mutual fund industry therefore lobbies the Congress to level the playing field with foreign funds U.S. shareholders of a passive foreign investment company (PFIC) have three methods for reporting tax at the shareholder level for a particular taxable year.

27 Special Rules for Passive Foreign Investment Co. – II One is a qualified electing fund (QEF) election to have the shareholders share of PFIC earnings taxed on a yearly basis. A second method is referred to as the "mark-to-market" method. The third method defers the tax until distributions are received or when shares are sold but at the cost of an interest charge and a punitive method of taxation.

28 Special Rules for Passive Foreign Investment Co. – III Only gross gains are subject to the 1291 tax. Losses are ignored Any share disposition is treated as a sale or exchange - including gifts or bequests Gain is allocated to each day of ownership back to 1986 & taxed at the top tax rate Interest is compounded daily at the underpayment rates Distributions are taxed the same way except to the extent of 125% of the average distributions for the previous three years

29 Election to Treat a CFC as a Disregarded Entity - I Many foreign brokers (banks) wont sell directly to a U.S. person U.S. investors must first form a foreign corporation or LLC This can become a tax disaster because the foreign corporation is a CFC - and a PFIC if it is an investment company To avoid this, the U.S. owner can elect to be taxed as a disregarded entity

30 Election to Treat a CFC as a Disregarded Entity - II Treasury Regs may classify the foreign corporation as a disregarded entity (one owner) or a partnership (two or more owners) if an election is made No election can be made for an IBC that is not on the per se corporation list [Reg. Sec. 301.7701-2(b)(8)] Some of the jurisdictions that are not on the per se list include: The Bahamas, Bermuda, Cayman Islands, Isle of Man, Jersey, Nevis, St. Vincent and the Grenadines, and Turks and Caicos.

31 Attribution and Constructive Ownership Rules The foreign corporation rules relating to constructive ownership and attribution of ownership are extremely convoluted. The phrase, attribution of ownership is usually applied with respect to entities in which the taxpayer has some control or beneficial interest. The phrase constructive ownership means that one taxpayer is deemed to own the shares of certain other related taxpayers - such as a spouse, child or parent The primary definition of constructive ownership and attribution of ownership is provided in IRC Section 318

32 Deemed Royalty on Intangibles IRC 367 – Tax on deemed royalty from intangibles Intangible property" as defined in IRC Section 936(h)(3)(B) means any Patent, invention, formula, process, design, pattern or knowledge Copyright, literary, musical or artistic composition Trademark, trade name or brand name Franchise, license or contract Method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list or technical data, or Any similar item which has substantial value independent of the services of any individual

33 Foreign Tax Credits - I U.S. persons who have paid foreign income taxes may either deduct those taxes or elect to claim a foreign income tax credit A domestic corporation may claim indirect credit for foreign taxes paid by a subsidiary Individuals may not claim an indirect credit unless they elect to be treated as a domestic corporation If a foreign government imposes a tax that is not a tax on income, that tax may only be available as a business expense deduction to the U.S. taxpayer The foreign tax credit is limited to the tax that would be imposed on the same income at the same rate as in the U.S.

34 Foreign Tax Credits - II The foreign tax credit may not be permitted with respect to foreign income taxes paid to a country which the U.S. does not recognize, has severed diplomatic relations or that has been identified as a country that harbors international terrorists. Additional complications exist where the foreign source income is a from a controlled foreign corporation on which only part of the income is subject to current U.S. tax If the taxpayer is (or might be) subject to the alternative minimum tax, a very complicated set of alternative rules for the foreign tax credit become applicable

35 U.S. Employees Working and Living Offshore - I There is a legal way to use a tax haven to have tax free earnings of up to $82,400 a year (indexed for inflation). A married couple could have tax free earnings of twice that amount The taxpayer must establish tax residency in the foreign country and (a) must be a resident of a foreign country for the entire tax year, or (b) must be physically present in the foreign country for at least 330 days in a tax year. Compensation that is a disguised distribution of corporate earnings and profits will not qualify for the foreign earned income exclusion.

36 U.S. Employees Working and Living Offshore - II The foreign earned income exclusion is also available to a self-employed person, but if capital is a material income producing factor in the business, then only 30% of the net self employment profits are excludable as foreign earned income. Self employment earnings outside the U.S. are subject to the self employment tax. U.S. employees of U.S. employers are subject to the FICA and related Medicare taxes if working outside the U.S.

37 U.S. Employees Working and Living Offshore - III Foreign subsidiaries of a U.S. company may elect whether to withhold FICA taxes for it's U.S. employees working outside the U.S. Foreign corporations are not obligated to withhold social security taxes for any U.S. employees. The foreign tax credit is not allowed for foreign taxes attributable to the excluded foreign earned income. Various deductions or credits otherwise available must be allocated between the taxable income of the taxpayer and the excluded earnings. It's possible for a taxpayer to lose substantial deductions as a result of this income exclusion

38 Ownership of CFC by A Charitable Trust A charitable remainder trust (CRT) was the owner of all the stock of a foreign corporation, which in turn invested in a U.S. partnership. Normally, when a CRT receives unrelated business taxable income (UBTI), that causes the CRT to lose its exempt status for that tax year. In IRS private letter ruling 199952086, the IRS held that distributions from a wholly owned foreign corporation to its parent, a charitable remainder trust, will not result in unrelated business taxable income (UBTI) to the trust even though the foreign corporation will invest in a partnership that will incur debt-financed income

39 Withholding on payments to Foreign Corporations - I If a foreign corporation has any U.S. source income, that income may be subject to a U.S. withholding tax of 30%. A detailed explanation of the rules for withholding on payments to foreign persons is available in IRS publication 515. If you are not a substantial owner of the foreign corporation, follow the rule, "If in doubt, withhold." A foreign corporation should provide you with a withholding certificate to support a lower withholding rate or to support non-withholding.

40 Withholding on payments to Foreign Corporations - II The 30% withholding rate is the non- treaty rate. Payments to a foreign corporation that are effectively connected with a U.S. trade or business are not subject to withholding. A payment is subject to NRA withholding if it is from sources within the U.S. and it is "Fixed or determinable annual periodic income" (FADP) FADP income includes personal services, dividends, interest, rents, royalties, pensions, alimony and scholarships

41 Withholding on payments to Foreign Corporations - III FADP Income paid to a foreign corporation that is effectively connected with a U.S. trade or business is not subject to withholding. Certain kinds of interest on U.S. government obligations, on U.S. bank deposits, on deposits in U.S. savings & loans and U.S. insurance companies are exempt from tax if paid to a non resident alien and are therefore not subject to withholding. In addition, gains on the sale of U.S. securities are not taxable to a NRA and are not subject to withholding. There is a 10% withholding rate imposed on the gross receipts from the sale of U.S. real property interests sold by a foreign person

42 Some Foreign Corporation Tax Scams & Myths Myth of the Foreign Corporation without a Shareholder Transfer Gains to Foreign Corporation with Private Annuity Attempting to Avoid the CFC Rules with a Foreign Trust Attempt to Avoid CFC Rules with Nominee or Bearer Shares

43 Tax Filing Obligations Form 5471 – Return of U.S. Shareholders of Certain Foreign Corporations Form 926 – Report of Transfer of Funds to a Foreign Corporation Form TD F 90-22.1 – Foreign Bank & Financial Accounts Form 8621 – Passive Foreign Investment Company Form 8832 – Check the Box Election Form 8858 – Return for Foreign Disregarded Entities

44 Copyright, Offshore Press, 2006 This slide presentation is a summary of the book, Controlled Foreign Corporation Tax Guide by Vernon Jacobs & Richard Duke It is published and copyrighted by Offshore Press, Inc. http://www.offshorepress.com/cfc- ibc-tax.htm http://www.offshorepress.com/cfc- ibc-tax.htm


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