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.