US CFC Rules: What Income Is Included?

The CFC rules regarding income inclusion have to thread a very small needle.  On one hand, they need to prevent US taxpayers from moving offshore, thereby taking advantage of a technical reading of the US tax code that prevents taxation of non-US (foreign) corporations (see discussion here).  On the other hand, they can't be so restrictive they prevent US corporations from  expanding internationally, thereby hindering legitimate business development.  In effect, the rules need to exclude income derived from "legitimate" business expansion but include evasion.

Before moving forward, be advised: below is a general summation of the CFC income inclusion rules: there are many nuanced ins and outs to these rules that are far beyond the scope of a blog post.  

So -- if a corporation is a CFC, what income do we include in the US taxpayer's income for the taxable year?  Under section 951(a)(1)(A)(i) we include the taxpayers "pro rate share of sub-part F income" which is more completely defined in section 954 and the accompanying treasury regulations.  The code defines Subpart F income as being  "foreign base company income" which is further broken down "foreign personal holding company income," "foreign base company sales income" and "foreign base company services income."  Let's look at each one of these sub-sections as defined in the treasury regulations.

Foreign personal holding company income is designed to include the income from offshore investment accounts.  As such it includes dividends, capital gains, interest, commodities and currencies transactions and all other manner of standard investment transactions.  In short, if a US person wants to move his investment account to the Cayman's and place it into a corporation, this provision would include all the trading income from the account in his income for the taxable year. 

Foreign base company sales income "consist of gross income (whether in the form of profits, commissions, fees or otherwise) derived in connection with the purchase of personal property from a related person and its sale to any person, the sale of personal property to any person on behalf of a related person, the purchase of personal property from any person and its sale to a related person, or the purchase of personal property from any person on behalf of a related person."  

In general, here's what the rules are trying to prevent: using an offshore entity to act as a sales agent for a US company and then structuring transactions with that sales company to effectively transfer income to this low-tax entity.  

There are two very important exclusions to this rules which are:

Foreign base company sales income does not include income derived in connection with the purchase and sale of personal property .... if the property is manufactured, produced, constructed, grown, or extracted in the country under the laws of which the controlled foreign corporation which purchases and sells the property (or acts on behalf of a related person) is created or organized.

AND

Foreign base company sales income does not include income derived in connection with the purchase and sale of personal property .... if the property is sold for use, consumption, or disposition in the country under the laws of which the controlled foreign corporation which purchases and sells the property (or sells on behalf of a related person) is created or organized or (b), where the property is purchased by the controlled foreign corporation on behalf of a related person, 

So -- the definitions exclude income if the company is not simply forming an offshore sales agent but instead is looking to actually develop a market in the company of incorporation.

And finally, we exclude "foreign base company services income", which is 

... income of a controlled foreign corporation, whether in the form of compensation, commissions, fees, or otherwise, derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services which—

(1) Are performed for, or on behalf of a related person, and

(2) Are performed outside the country under the laws of which the controlled foreign corporation is created or organized.

Put more generally, a company can't transfer it's human capital offshore and then trap the profits earned by the human capital offshore.

Remember that the above rules generally summarize the big points of the CFC income inclusion rules; there are many nuanced points contained in the treasury regulations that go far beyond the confines a blog post.  But, the above inclusions do provide a good start for outlining the broad strokes of the law.

  

US CFC Rules: What Is A US Shareholder?

Like most subparts in the US tax code (the CFC rules are a sub-part to sub-chapter N in the code), the CFC rules have specific concepts and definitions that apply only to this particular sub-part.  The most important definition is that of a "US shareholder."  In addition, like most sections in the code, the CFC rules require us to reference multiple sections to get a complete definition.

Let's start with section 957, which states:

For purposes of this subpart, the term “controlled foreign corporation” means any foreign corporation if more than 50 percent of—

 

     (1) the total combined voting power of all classes of stock of such corporation entitled to      vote, or

 

     (2) the total value of the stock of such corporation,

 

is owned (within the meaning of section 958 (a)), or is considered as owned by applying the rules of ownership of section 958 (b), by United States shareholders on any day during the taxable year of such foreign corporation.

Remember that under the tax code's definitions section (section 7701), a "foreign" corporation is one not formed in the US.  So, according to the CFC definition, a non-US company that is owned by a "US shareholder" is a CFC.  This, of course, leads us to define a "US shareholder" which is defined in section 951(b):

For purposes of this subpart, the term “United States shareholder” means, with respect to any foreign corporation, a United States person (as defined in section 957 (c)) who owns (within the meaning of section 958 (a)), or is considered as owning by applying the rules of ownership of section 958 (b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation.

And finally, attribution rules from section 318 apply under section 358, preventing a US resident from diversifying his ownership over several companies and or family members to theoretically prevent technical ownership while still actually remaining in control.

 

Putting these two sections together, we arrive at the following definition:  if more than 50% of the combined voting power of a foreign (non-US company) is owned by a "US shareholder(s) (individuals who each own at least 10% of the stock)" we have a controlled  foreign corporation, thereby requiring us to include certain types of income from that company in each shareholder's gross income on a pro-rata basis. 

It's very important to note that we have two ownership thresholds to meet in this definition.  First, we have to establish majority control by "US shareholders."  This means that if the foreign corporation is majority owned by foreigners (non-US individuals), a CFC does not exist.  In addition, we only have to include certain types of income in the personal gross income of US residents who own more than 10% of the company. 

Next, we'll start to look at what types of income we need to include.

The US Controlled Foreign Corporation (CFC Rules): An Introduction

     Commentators and practitioners often refer to the US controlled foreign corporation statute (or "CFC") as extremely complex and Byzantine in their construction and application.  I would agree with this assessment to a point; if someone is simply trying to learn the pure mechanics of the statute then, yes, it is very difficult to fathom.  However, when one looks at the rules after understanding the underlying policy for their implementation and overall effect, the statutory scheme becomes easier to comprehend.  So, let's begin with an explanation of why the US (and other developed, OECD countries) put these types of rules into place.

     To begin we will need to know a few definitions from section 7701.   A domestic corporation is one "created or organized in the United States or under the law of the United States or of any State" while a foreign corporation is "one that is "is not domestic."  Moving one step further, a foreign corporation is taxed by the US on income that is either connected with a "United States business" or is derived from sources within the United States.  Putting all of these definitions together into a workable (and far more user friendly) statement, the US taxes a foreign corporation when that corporation either formally engages in a trade or business within US borders or derives some type of profit from an activity within the US.  While this all may seem a bit obvious, knowledge of these definitions is key to understanding why the US implemented CFC rules.

     Next, it's important to remember the US taxes US corporations and individuals on world wide income (income from "whatever source derived").  But given the above definitions, it would be possible for a US person to transfer his assets to a foreign company thereby removing the income from the US taxation, as that company would have no taxing nexus with the US -- they were not conducting a trade or business within the US or engaging in any non-business related transaction.  And as the entity was not a partnership, the income would not pass through to the individual. And this is exactly what was happening to a larger extent in the 1950s -- US corporations and individuals would form foreign corporations outside the US' taxing jurisdiction while still living and residing in the US.  This creates a "free rider" problem: people or companies who live/reside in the US receive all the benefits of taxpayer funded programs (the interstate system, public education, a judiciary to name a few) without funding them through taxes.  And it is that behavior which the CFC rules were designed to prevent.

     In general, the CFC rules attribute offshore corporate income to US shareholders when the perceived purpose of the offshore corporation is not to engage in legitimate foreign business (such as opening a "bricks and mortar" branch to sell products) but instead to divert income to a low-tax jurisdiction with the sole intent of removing it from the US tax base.  As we move forward into a general overview of the CFC mechanics, keep this concept in mind as it helps to clarify the underlying CFC policy and makes the overall rules that much easier to understand.