991 / What is Subpart F? What types of income trigger the Subpart F tax in the CFC context?

Once an entity is classified as a CFC, it becomes necessary to determine whether the CFC income is currently taxable to U.S. shareholders. Currently taxable income is generally defined in Subpart F. Under the Subpart F rules, certain types of CFC income must be included in the U.S. shareholder’s gross income in the year the income is earned by the CFC even though it has not yet been distributed to the U.S. shareholder.

The 2017 tax reform legislation (the TCJA) significantly changed the tax treatment of foreign income earned by CFCs. Certain previously deferred earnings were made immediately taxable under the IRC Section 965 transition tax. Further, the TCJA established a new Subpart F tax regime for global intangible low-taxed income (GILTI) and a dividends-received deduction for foreign source dividends. The GILTI rules are extremely complex and are generally beyond the scope of this text.

Under the Subpart F provisions, income realized by certain activities conducted by corporations controlled by U.S. shareholders is deemed to be currently received by certain of those U.S. shareholders.¹ In other words, the income becomes taxable before the individual actually receives dividend distributions from the foreign corporation.²

In summary, these rules provide that if more than 50 percent of (i) the voting power of the foreign corporation or (ii) the value of the stock of the foreign corporation is owned by U.S. persons who own 10 percent or more (whether owned directly, indirectly or constructively) of the total combined voting power of all classes of stock entitled to vote of such foreign corporation or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation, the “deemed income” rules apply to those 10 percent-or-greater owners.³

This concept is known as “downward attribution” from a foreign person to a related U.S. person, where the stock of a foreign corporation owned by a foreign person is attributed to a related U.S. person for purposes of determining whether the related U.S. person is a U.S. shareholder of the foreign corporation.⁴

The pro rata share of a CFC’s Subpart F income that a U.S. shareholder is required to include in gross income, however, continues to be determined based on direct or indirect ownership of the CFC, without application of the downward attribution rule. Consequently, the Subpart F provisions are aimed at significant shareholders of foreign corporations which are closely held and controlled by U.S. taxpayers. Obviously, therefore, these rules would apply to the U.S. shareholder of a wholly owned foreign corporation, but also apply in situations of lesser ownership, assuming some degree of control.

The specific categories of CFC income that may be classified as tax haven-type income and, therefore, deemed currently received by those U.S. shareholders include:

a) foreign personal holding company income (i.e., passive investment-type income, such as dividends, rents, royalties, interest, etc.);

b) foreign base company sales income, (i.e., sales income from property purchased from, or sold to, a related person, if the property is manufactured and sold for use, consumption, or disposition outside the country of incorporation of the base company); and

c) foreign base company services income, (i.e., service income from services performed outside the country of incorporation of the base company, when those services are performed for or on behalf of related persons).

The statute refers to these various types of income as “foreign base company income.” In addition, income derived by a CFC from the insurance of risks outside the country of its organization will be subject to current income inclusion to the shareholders (i.e., it will be treated as Subpart F income).⁵ The foreign base company income and this insurance income are collectively referred to as “Subpart F income.”

The Subpart F rules also provide that earnings (whether or not the earnings are categorized as “Subpart F income”) of CFCs are currently taxable to U.S. shareholders if the earnings are invested in certain U.S. property (thereby treated as effectuating a deemed taxable repatriation of those foreign based profits). These provisions have been evolving over several decades. Some of the provisions which have been repealed can have continuing significance.

For example, until the Tax Reduction Act of 1975,⁶ various exceptions to this current taxation of undistributed tax haven-types of CFC income applied. An exception was available if the foreign corporation properly elected and satisfied a “minimum distribution” requirement.⁷ A second exception was the “less developed country exception” that allowed U.S. income tax deferral if foreign-based profits were reinvested into qualified investments in “less developed countries.”⁸

See Q for a discussion of situations where U.S. taxpayers may be able to prevent current taxation of Subpart F income.