FOREIGN COMPANIES – A TAX OVERVIEW
U.S. expats are subject to certain anti-deferral regimes that are designed to prevent U.S. taxpayers from deferring payment of U.S. tax through the use of foreign companies.
It is important to keep in mind in this regard that the classification of companies under the tax law of your country may not agree with the classification for U.S. tax purposes. For instance, entities that are not considered corporations under foreign law may be considered corporations for U.S. tax purposes and thus may fall within the U.S. tax rules related to foreign corporations (e.g., Australian unit trusts).
The Internal Revenue Code contains two principal anti-deferral regimes that may impose tax on a U.S. taxpayer on a current basis when its foreign subsidiaries generate income. The two regimes are:
- Controlled Foreign Corporation (“CFC”) regime; and
- Passive Foreign Investment Company (“PFIC”) regime
The CFC Regime
What is a CFC?
Under U.S. tax law, if a foreign corporation is a “Controlled Foreign Corporation” (“CFC”) for an uninterrupted period of 30 days or more during any taxable year, every person who is a “United States Shareholder” of such corporation and who owns stock in such corporation on the last day, in such year, on which such corporation is a CFC, is required to include in its gross income for its taxable year certain “deemed” income, primarily – such person’s pro-rata share of the corporation’s “Subpart F” income for such year.
For expats, this means that if your corporation has earnings and is classified as a CFC, you may have to automatically include those earnings in your personal income for the taxable year.
Additionally, other code provisions are relevant under the CFC regime, including Section 956, relating to investments in U.S. property (which include, importantly, loans to U.S. shareholders) by CFCs that can trigger a current inclusion in a U.S. Shareholder’s gross income.
A CFC is defined as any foreign (i.e., non-U.S.) corporation, if more than 50% of (i) the total combined voting power of all classes of stock of such corporation entitled to vote; or (ii) the total value of the stock of such corporation, is owned in the aggregate, or is considered as owned by applying certain attribution rules, by United States Shareholders on any day during the taxable year of such foreign corporation. A “United States Shareholder” is any U.S. person who owns, or is considered as owning, by applying certain attribution rules, 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation.
The Subpart F Rules
As discussed above, the Subpart F rules attempt to prevent deflection of income from the United States into another jurisdiction, particularly one which has a preferential tax regime. Thus, these rules generally target types of income that are easily deflected to another jurisdiction or that are earned in certain transactions between related parties that can easily direct the flow of income between entities in different jurisdictions. These types generally include passive income and income that is split off from the activities that produced the value in the goods or services generating the income.
Subpart F income inclusion has several limitations. For instance, Subpart F income of any CFC for any taxable year is generally limited by the amount of such corporation’s earnings and profits (“E&P”) for such taxable year, but is subject to recapture as Subpart F income in future years to the extent that Subpart F income exceeds current E&P. Furthermore, it does not include income of a CFC subject to an effective rate of income tax imposed by a foreign country that is more than 90 percent of the maximum U.S. corporate income tax rate (the “high tax exception”).
CFC Reporting Rules
Certain U.S. individuals who own more than 10% of stock in a foreign corporation must include Form 5471 with their federal tax return.
There are also several other similar categories of filers that must file this form. Special attribution rules (which include attribution between spouses) may apply to expand the scope of taxpayers that fall within these categories. It is important for U.S. individuals who own shares in a foreign corporation to determine if they fall into any of such categories.
In general, Form 5471 assists the IRS with gaging the scope of a U.S. taxpayer’s foreign holdings that may facilitate U.S. tax deferral. The form is useful for keeping track of the earnings and profits of U.S.-owned foreign corporations, determining whether a foreign entity is a CFC generating Subpart F income, and tracking possible IRC Section 956 inclusions.
The following penalties, among others, may apply for failure to accurately file Form 5471:
- Civil penalty of $10,000 for each year’s failure. If the information is not filed within 90 days after the IRS has mailed a notice of the failure to the U.S. person, an additional $10,000 penalty (per foreign corporation) is charged for each 30-day period, or fraction thereof, during which the failure continues after the 90-day period has expired. The additional penalty is limited to a maximum of $50,000 for each failure.
- 10% reduction in any foreign tax credits claimed from the relevant foreign corporation.
- Failure to file keeps the audit statute of limitations open indefinitely when information is required to be reported
- Criminal penalties may also apply in certain circumstances.
The PFIC Regime
What is a PFIC?
Technically, a PFIC is a foreign corporation that has one of the following attributes: (i) At least 75% of its income is considered “passive” (e.g., interest, dividends, royalties), or (ii) At least 50% of its assets are passive-income producing assets. A U.S. person that holds any interest in a PFIC, directly or indirectly, is subject to the PFIC rules.
Unbeknownst to many expats, most foreign mutual funds fall within the definition of a PFIC. This can be the case even if such funds are held through a tax-deferred savings account (e.g., U.K. individual savings accounts (“ISAs”) and Canadian tax-free savings accounts (“TFSAs”)) or a non-qualified pension and retirement account (as is the case with most foreign pensions).
PFIC Punitive Tax Rates
PFIC investment income resulting from a distribution from a PFIC or a sale of a PFIC interest is generally subject to highly punitive U.S. federal tax rates, namely the highest marginal tax rate that can be imposed on an individual taxpayer (regardless of whether capital gains tax rates would normally apply). A non-deductible penalty interest charge can also compound regularly while holding an interest in a PFIC. Losses in PFICs generally cannot be used to offset gains in non-PFIC investments.
Several elections are available to mitigate the more onerous aspects of PFIC taxation (e.g., a so-called “QEF election” or “mark-to-market” election). Special rules apply if such elections are not made for the first year of PFIC stock ownership.
When a shareholder makes a QEF election, he will be required to include each year in gross income the pro rata share of earnings of the QEF and include as long-term capital gain the pro rata share of net capital gain of the QEF.
Under the mark-to-market election, shareholders must include each year as ordinary income, the excess of the fair market value of the PFIC stock as of the close of the tax year over its adjusted basis in the shareholder´s books. If the stock has declined in value, an ordinary loss deduction is allowed, but it is limited to the amount of gain previously included in income.
PFIC Reporting Rules
Aside from the high taxation rates associated with PFICs, there are specific reporting rules associated with PFICs. There is a specific form, Form 8621 for reporting your PFIC ownership interests. A separate Form 8621 must generally be filed for each PFIC in which stock is held directly or indirectly.
Internal Revenue Code Section 1298(f) provides the basic reporting requirement that all shareholders of a PFIC must file the Form 8621 each year.
Good recordkeeping is essential for properly reporting PFIC information on the Form 8621. Performing PFIC computations for corporations and shareholders that have not been collecting the required information from the beginning can be very challenging, if not impossible, depending on the information available.
Unlike other information returns, Form 8621 does not carry a penalty for not filing the form. However, failing to file the form does leave open the statute of limitations on all tax matters for that tax year indefinitely. Also, with FATCA, the IRS is receiving masses of information from the foreign financial institutions about the investments of U.S. persons, which could include information about your foreign mutual fund. A mismatch between reports can lead to an IRS audit of your entire return.