Table of Contents
This page describes US Tax rules that apply to Controlled Foreign Corporations (CFCs)
Definition of CFC
Controlled Foreign Corporation (CFC): If more than 50% of a foreign corporation is owned by US Shareholders (as defined below), that foreign corporation is a CFC, which triggers not only increased disclosure on Form 5471, but also potential liability to the US Shareholder for US tax on undistributed income of the CFC.
US Shareholder: A US person (any US taxpayer – citizen, resident, corporation, partnership, etc.) that owns 10% or more (by either value or voting power) of a foreign corporation is a US Shareholder of that foreign corporation and is required to disclose their ownership on Form 5471 (the extent of disclosure will depend on how much is owned and whether the foreign corporation is a CFC). There are attribution rules to keep shareholders from splitting ownership between related parties to stay below the ownership threshold.
Entity Classification Rules
Foreign entities rarely fit exactly into the definitions in the US tax code. Some entities are per se corporations - that is they must be reported as a corporation on a US tax return. Other entities qualify for an election to be classified as either a corporation or a disregarded entity.
- more detail including code references and form numbers are needed for this section
- more detail and/or links needed
Subpart F Income
When Congress enacted the CFC rules in 1962, the idea was to ensure that easily mobile passive income wasn't stashed in foreign corporations in order to avoid US tax. The subpart F rules require a US Shareholder of a CFC to include passive income and personal holding company income in their current US taxable income regardless of whether the income was distributed to the US shareholder. Generally, US tax on any active business income could be deferred until the CFC distributed the income to the US Shareholder, but passive income was taxable immediately. TCJA did not materially change the subpart F rules; instead it added the §965 transition tax and §951A GILTI as a parallel tax regime, included in US taxable income as if they were subpart F inclusions.
§965 Transition Tax
The 2017 tax reform bill added section 965 to the Internal Revenue Code. This section was written overly broadly, and affects the local corporations of US expats, not just the intended targets of Apple, Google and Microsoft.
- IRS Issues Guidance on Transition Tax on Foreign Earnings 27 December 2017 (Notice 2018-07)
- IRS Issues Additional Guidance on Transition Tax on Foreign Earnings 19 January 2018 (Notice 2018-13)
- IRS Issues Guidance on Changes in Accounting Periods Related to the Transition Tax 13 February 2018 (Rev. Proc. 2018-17)
- IRS Issues Additional Guidance on Transition Tax on Foreign Earnings 2 April 2018 (Notice 2018-26)
This section serves as a technical appendix to the blog post Explaining GILTI - Measurement.
GILTI is found in §951A of the Internal Revenue Code. Note that the description below is general in nature. It ignores many of the problems that occur when a US taxpayer owns multiple CFCs or has to allocate expenses between tested income and income taxed under other provisions.
GILTI = Net CFC Tested Income - Net Deemed Tangible Income Return
It is computed at the US Shareholder level, aggregated across all CFCs in which the taxpayer is a US Shareholder.
Tested Income is defined as gross income less:
- US-source business income (effectively connected income)
- Subpart F income
- Any income that would have been subpart F income, but was excluded because the effective foreign tax rate was greater than 90% of the US tax rate
- Dividends received from related parties
- Foreign oil and gas extraction income
- Deductions allocable to any remaining gross income
This essentially boils down to the net income of the CFC that has not already been subject to US tax. There is some controversy over what Congress intended by the high-tax exclusion (third bullet point above). This is the point argued on behalf of the Israeli Ministry of Finance in a public comment on the proposed regulations (see blog post).
Deemed Tangible Income Return (DTIR)
DTIR = (10% of QBAI) - Interest Expense
QBAI is Qualified Business Asset Investment. To compute QBAI, first compute cost less depreciation (computed using US tax rules) of all depreciable assets used in the production of income. This computation is done on a quarterly basis over the year and QBAI is the average of these quarterly numbers. So, if the company’s tangible assets are old, the net value will be small. Leased assets don’t count, and neither do non-depreciable tangible assets such as inventory or land.
Base Scenario (all numbers in USD):
US Shareholder has one wholly owned CFC with the following
- Fixed Assets (QBAI) = 500
- Net Income before any taxes = 1000
- Local (foreign) effective tax rate = 25%
- Interest expense = 0
- Local tax rate on dividends = 15%
Assume that the CFC has no US source income and no subpart F income (all active business income). Also assume that only one CFC is owned and that the corporate shareholder has no domestic expenses that must be allocated to foreign source income under the FTC rules.
|No election||§962 Election||Old Rules|
|Net Income before Tax||1,000||1,000||1,000||1,000|
|Local tax @ 25.00%||250||250||250||250|
|Net Income = Tested Income||750||750||750||750|
|Deemed Tangible Income Return||50||50||50|
|Foreign Tax Paid on GILTI||233||233|
|80% FTC limitation||187||187|
|Plus Foreign Tax Paid (§78)||233||233|
|Gross GILTI Inclusion||933||700||933|
|Net GILTI increase to taxable income||467||700||933|
|Tax (21% for corporation, 37% indiv)||98||259||196|
|FTC (smaller of Tax or 80% FTC limitation)||98||0||187|
|Net Increase to Tax||0||259||9||0|
|Increase in PTEP||700||700||9||0|
Line by line explanations:
- Deemed Tangible Income Return is 10% of QBAI
- Foreign Tax Paid on GILTI is (700/750)*250 or (GILTI/Tested Income)*(tax on tested income) - this is used for the deemed paid FTC credit for a corporation or an individual making a §962 election
- 80% FTC limitation is 80% of 233, which is the FTC allowable against US tax on GILTI
- GILTI is Tested Income less Deemed Tangible Income Return or 750 - 50 = 700
- Foreign Tax Paid (§78) represents the “gross-up” required under §78 for foreign taxes paid. The idea is that the US taxes income before foreign tax, then allows a credit for the foreign tax. This is computed as (700/750)*250=233
- Gross GILTI Inclusion is the gross amount taxable under the GILTI - including the §78 where applicable
- §250 deduction is a deduction of 50% of GILTI allowable ONLY to corporate US Shareholders by §250
- Net GILTI increase to taxable income is the gross GILTI inclusion less the §250 deduction where applicable
- Tax is computed at 21% for corporations and individuals making a §962 election, and at 37% for individuals not making a §962 election. Technically, the FTC limitation is computed by allocating total US tax based on US source and foreign source income under separate rules that apply only to computing the FTC limitation. These rules could end up allocating more or less income to the GILTI basket than the net amount of GILTI included in taxable income. These rules are beyond the scope of this simple example.
- FTC is the lower of Tax on GILTI or the 80% FTC limitation (zero for individuals not making a §962 election)
- Net Increase to Tax is US tax paid in addition to foreign tax. Note that the foreign tax rate exceeds the US corporate tax rate of 21%, but an individual not making a §962 election will still pay an additional $259 in tax to the US over the $250 already paid by the CFC.
- Increase in PTEP is the increase to “Previously Taxed Earnings and Profits”, which is relevant because subsequent distributions out of PTEP are not taxed by the US. For individuals who make a §962 election, PTEP is increased by only the amount of tax paid to the US (after FTC).
Of course, the initial taxation of GILTI is not the whole picture. At some point the US Shareholder will need to get the income out of the CFC, often by making a dividend distribution. The next table shows how the original taxation of GILTI affects the taxation of that subsequent distribution. The treatment of individual US Shareholders under previous law is included for comparison.
This example has been re-written to account for the proposed regulations on foreign tax credits. Much of the proposed regulations cover the detail of allocating expenses in affiliated groups - which will not apply to this simple example. However, the simple example had to be re-worked to account for the separate FTC baskets. TCJA added a GILTI FTC basket with no carryover or carryback of associated foreign tax paid or accrued. To the extent that PTEP is allocated to GILTI (that is, the portion of earnings previously taxed as GILTI and now distributed), the allocable foreign tax is placed in the GILTI FTC basket and can only offset current year US tax on GILTI. In addition, the PTEP ordering rules in Notice 2019-01 state that if there is any PTEP that is allocated to a previous §965 inclusion, then distributions are allocated to that PTEP first (with a haircut based on the §965(c) deduction). The end result is that Individual US shareholders who have NOT made a §962 election may have difficulty getting any benefit from foreign taxes paid on subsequent dividends. The following numbers assume that there is NO previous year PTEP, so all PTEP is from the table above. The example further assumes that the distribution is made in a year with NO GILTI inclusion - this is the worst case, as the foreign tax allocated to the GILTI basket is lost.
Yeah, it's confusing. Here's the Cliff Notes version of how to compute FTC:
- All items of gross income in your US tax return are put into baskets - the relevant baskets for most individuals would be: US Source, General Foreign Source Income, Passive Foreign Source Income, GILTI.1)
- The deductions in your return are allocated (if related to a specific type or types of income) or apportioned (if not related to any specific type of income) between the baskets.
- The net difference in each basket is your US Taxable Income for that basket (US Source Taxable Income, General Foreign Source Taxable Income, etc.).
- Total US tax is apportioned among the baskets proportional to US taxable income in each basket. For the Foreign Source baskets (including GILTI), this is the MAXIMUM foreign tax credit allowed for each basket.
- Next you add up all creditable foreign taxes paid or accrued. This needs to be allocated between the foreign source baskets.
- Foreign taxes are allocated to the various baskets as a proportion of foreign taxable income. For income other than CFC dividends, allocating foreign taxable income is fairly straight forward. Salary would go into the general basket, dividends and interest would go into the passive basket.
- For CFC dividends you look through to the earnings and profits (E&P - essentially retained earnings computed under US tax rules) of the CFC. E&P that was generated by active business income and has not been previously taxed by the US would normally go into the general basket. But, if some of the E&P of the CFC has already been taxed by the US, you need to follow the ordering rules in Notice 2019-01.
- After allocating foreign taxable income into the various FTC baskets, Foreign tax paid or accrued (step 5 above) is allocated to the baskets in proportion to the foreign taxable income in each basket.
- Then, basket by basket, you compare foreign tax paid with the US tax paid (step 4 above) - the smaller of the two numbers is your allowed FTC for that basket.
- Except for the GILTI basket, any excess foreign tax paid can be carried back one year or forward 10 years.
The takeaway from this is that where timing differences mean that GILTI is taxed in the US in a different year than the foreign tax on the distribution of that income, there could be an excess foreign tax credit that will disappear - and the individual shareholder is essentially double taxed on that income. Since GILTI is an ongoing tax - it is possible to offset the US tax on GILTI in year X2 with foreign tax on distributions of GILTI from previous years. But, if distributions are not matched to GILTI every year, there will be double taxation at some point.
Furthermore, the actual computations depend heavily on what other types of income are in both your US return and your foreign return. This example is illustrative, but each individual taxpayer MUST do the computations based on their own personal situation.
|Subsequent Dividend (in a year with zero GILTI):|
|No election||§962 Election||Old Rules|
|Income to distribute||750||750||750||750|
|§245A deduction and/or PTEP||750|
|Tax at 20% (assume qualified dividend)||0||10||148||150|
|Less FTC (see below)||0||8||111||113|
|Total US Tax Payable on Dividend||0||31||66||66|
|Total tax on Dividend||144||179||179|
|Foreign Tax Paid at 15%||113||113||113|
|FTC Allocated to GILTI Basket (Limit=0)||105||2|
|FTC Allowed - GILTI||0||0|
|FTC Allocated to General Basket||8||111||113|
|FTC Allowed - General||8||111||113|
|Total Tax Div + GILTI + Corporate||250||653||437||429|
|Effective Tax Rate (US + Foreign)||25.00%||65.25%||43.74%||42.85%|
|Total Tax if not US taxpayer||363||363||363|
|Cost of CBT||290||75||66|
|Percent of pre-tax corporate income||29.00%||7.50%||6.60%|
Line by line explanations:
- Income to distribute - after paying foreign taxes, the CFC has $750 in retained earnings available to distribute as a dividend.
- PTEP - the portion of the distribution that has already been taxed under US tax rules. We are assuming that ALL of this is due to the GILTI inclusion above.
- §245A deduction and/or PTEP - For a corporate shareholder, the distribution will be allocated between PTEP for GILTI (on which there will be zero US tax) and E&P not previously taxed by the US (which will be eligible for a 100% dividend received deduction under §245A. Net result is zero US tax.
- Net taxable is computed by subtracting PTEP from the income distributed.
- Tax at 20% - it is assumed that the CFC is incorporated in a country with a US tax treaty and therefore the dividend is a “qualified dividend” eligible for the reduced tax rate of 20%
- Less FTC - For corporate shareholders a foreign tax rate of zero is used as this is the rate that applies when an Australian corporation pays dividends to a US resident that owns 80% or more of the corporation (Tax Treaty Article 10(3)). The current US Model Tax Treaty imposes a 5% rate on dividends paid to a corporation in the other country that owns 10% or more of the corporation paying dividends. For Individual US Shareholders, the FTC limitation is computed below.
- Net tax is tax payable to the US before the application of NIIT
- NIIT is Net Investment Income Tax - payable at 3.8% by individuals above certain income thresholds. The tax code states that FTC cannot offset NIIT, but there are those who argue that this violates the double tax provisions of tax treaties.
- Total US Tax Payable on Dividend is Net tax plus NIIT.
- Total tax on Dividend is US tax plus any foreign tax.
- Foreign Tax Paid is assumed to be paid at a flat rate of 15%.
- FTC Allocated to GILTI Basket is computed as (PTEP/Distribution)*Foreign Tax Paid. Note that this is assuming that there is no other PTEP except the GILTI inclusion in the table above.
- FTC Allowed - GILTI is zero because we have assumed that the distribution occurs in a year with zero GILTI inclusion. This is the worst case.
- FTC Allocated to General Basket is computed as ((Distribution-PTEP)/Distribution)*Foreign Tax Paid.
- FTC Allowed - General is the lower of US tax at 20% or FTC allocated to General Basket. In this case, as the US tax rate of 20% exceeds the foreign tax rate of 15%, the amount will be equal to foreign tax allocated to the General Basket.
- Total Tax Div + GILTI + Corporate aggregates all taxes paid on the original $1000 of pre-tax income.
- Effective Tax Rate (US + Foreign) measures the total tax burden as a percentage of the $1000 of pre-tax income.
- Total Tax if not US taxpayer computes the total tax that an individual shareholder would have paid if they were not subject to US taxation.
- Cost of CBT - for nonresident US citizens this measures the additional tax paid solely due to citizenship. Measured as Total tax less Tax if not US Taxpayer.
- Percent of pre-tax corporate income measures the cost of CBT as a percentage of the original $1000 of pre-tax income.