Subpart F Income: An OverviewMarch 17, 2023 - Phil HodgenForm 5471, Minimultinationals
We have default assumptions about everything. “Unless proven otherwise, X is true.”
For U.S. taxpayers who own stock of controlled foreign corporations, the default assumptions for how CFCs behaved shifted abruptly in late 2017. This was a geomagnetic reversal, the tax equivalent of the magnetic North Pole and magnetic South Pole flipping places.
The old way of thinking (about international tax) was simple: a U.S. shareholder would expect deferral of U.S. income tax on a controlled foreign corporation’s earnings and profits unless:
- You fought the law and the law won. The controlled foreign corporation’s income was Subpart F income (as defined by Internal Revenue Code Section 952); or
- You shot yourself in the foot. The controlled foreign corporation paid you dividend (you controlled the corporation and voted for the dividend!) or the controlled foreign corporation invested in U.S. assets (IRC §956, and you controlled the corporation and made the investment happen).
In other words, deferral was the default state of nature, and taxpayers spent a great deal of effort to make a controlled foreign corporation’s income not be Subpart F income.
Starting in late 2017, the default state of nature (for international tax, anyway) changed. What changed? We were blessed with the execrably acronymed Global Intangible Low-Taxed Income–new Internal Revenue Code Section 951A.
Now there were two ways the law fought tax deferral (and won):
- Subpart F income, as always; and
- Global Intangible Low-Taxed Income, of which there shall be much discussion later.
Between those two anti-deferral rules, there are now perishingly few opportunities for a U.S. shareholder to defer recognition of income from a controlled foreign corporation’s earnings and profits.
And, of course, a U.S. shareholder continues to this day to hold the same two footguns (dividends received and investment in U.S. assets) that will cause income recognition from a CFC, even though with the advent of IRC §951A and Global Intangible Low-Taxed Income these are now considerably less lethal.
This bonus episode of The Form 5471 Series is a quick overview of these four ways in which a U.S. shareholder of a controlled foreign corporation will see gross income magically appear on his/her/its U.S. income tax return:
- Subpart F income;
- Global Intangible Low-Taxed Income;
- Distributions from CFCs to U.S. shareholders; and
- The CFC’s investment in U.S. assets.
Subpart F Income: Generally
Subpart F income is the classic anti-deferral mechanism and has been with us since 1962. Internal Revenue Code Section 952 defines five different categories of CFC income as “Subpart F income.” If an item of income fits within one of those categories, Section 951(a) pipelines a pro rata share of that income directly through to the U.S. shareholder’s income tax return.
There four small categories of Subpart F income and one big, messy, complicated category. (It’s the Pareto Principle in action! Twenty percent of the Subpart F income categories give you eighty percent of your tax compliance headaches!).
Let’s deal with the big one first. Foreign Base Company Income.
The Big Category of Subpart F Income: Foreign Base Company Income
“Subpart F income” includes “foreign base company income.” IRC §952(a)(2). That’s a totally wordcel way to do things: make up a term of art (“Subpart F income”), and define it by pointing at another term of art that you also made up–in this case, “foreign base company income” as that term is defined in IRC §954.
And when you look at IRC §954 to understand the meaning of “foreign base company income,” you will find out that it, too, is built with three other terms of art:
- Foreign personal holding company income [IRC §954(a)(1)];
- Foreign base company sales income [IRC §954(a)(2)]; and
- Foreign base company services income [IRC §954(a)(3)].
Let’s dive in. There is a bottom to this swimming pool and we are going to touch bottom. Each of the three subcategories of foreign base company income is (more or less) intelligible and understandable.
Foreign Personal Holding Company Income
Look for passive investment income earned by a CFC. You’re likely to find foreign personal holding company income.
Classically, we default to thinking that Subpart F income is investment income, like interest, dividends, capital gains, royalties, etc. This is partly true: this type of income is indeed Subpart F income, and it is defined at length in IRC §954(c).
To be precise (and to stack the definitional turtles on top of each other):
- Interest, dividends, capital gains, etc.
- Are a CFC’s “foreign personal holding company income” [IRC §954(c)],
- And “foreign personal holding company income” is one of three types of “foreign base company income” [IRC §954(a)(1)];
- And in turn “foreign base company income” is one of five different types of “Subpart F income” [IRC §952(a)(2)] that a CFC can have.
- Finally, a U.S. shareholder of a CFC includes a pro rata share of the CFC’s Subpart F income in gross income (and therefore pays U.S. income tax on that income). [IRC §951(a)(1)(A)].
As you might guess, in the old days (pre-2017) U.S. shareholders had many brilliant ideas for how to convert a CFC’s passive income (passed through as Subpart F income and taxed immediately) into income that looked like active business income (and thus would not be classified as Subpart F income and would enjoy tax deferral until eventually paid out as a dividend to the U.S. shareholder.
When you prepare Form 5471, you will do a robust set of calculations in Worksheet A (in the Instructions) and port the foreign personal holding company income amount to Schedule I, line 1e.
Foreign base company sales income
The second type of foreign base company income is called “foreign base company sales income.”
This definition is a government countermeasure to taxpayers’ attempts to recognize profits in, for instance, inventory sales, in an offshore corporation with zero or low income tax. The game, in the Bad Old Days was:
A U.S. manufacturer of widgets would create a foreign sales subsidiary in a low-tax jurisdiction. The manufacturer would sell widget inventory to its foreign subsidiary, and the foreign subsidiary would resell the widgets to end users all over the world, with no or next-to-no value added work on the widget.
This would mean the U.S. manufacturer would report taxable income based on the profit made on selling widgets to its subsidiary.
But the foreign subsidiary’s profit, earned when the foreign subsidiary sold widgets to end users, would not be subject to U.S. income tax–because the income nominally is a real, active business selling widgets to real customer, earned in a foreign country, and subject to that country’s low or nonexistent income tax.
That led Congress to add “foreign base company sales income” as a category of controlled foreign corporation income that would be passed through to a U.S. shareholder. The foreign subsidiary’s profit would be classified as:
- Foreign base company sales income [IRC §954(d)] of a controlled foreign corporation,
- Which is a sub-category of the CFC’s foreign base company income [IRC §954(a)(2)],
- And foreign base company income is one of the five categories of a CFC’s Subpart F income [IRC §952(a)(2)],
- So the U.S. shareholder would take its pro rata share of that Subpart F income into its gross income for income tax purposes [IRC §951(a)(1)(A)].
A lot of the work in this category–foreign base company sales income–revolves around the place of organization of the CFC and the place where the economic activity occurs. Generally speaking, when a CFC’s economic activity happens with related parties with little or no contact to the CFC’s place of incorporation, you should be wary for the presence of foreign base company sales income.
If you wonder whether you might have a foreign base company sales income problem, look at your tax return for inventory, related party transactions, cross-border transactions, and the faint stench of a gratuitously complex business structure.
Foreign base company services income
The third category of foreign base company income deals with services rendered in the normal course of business. This is the services counterpart for sales of inventory. If a controlled foreign corporation’s presence in a services business creates artificial recognition of income at the CFC level, we have “foreign base company services income.”
Here is a simple example of foreign base company services income.
U.S. manufacturer sells widgets to customers all over the world. These are complicated widgets requiring factory service. The U.S. manufacturer sets up a foreign subsidiary in a low-taxed jurisdiction and hires engineers and service technicians to provide service to customers with broken widgets.
The income earned by the foreign subsidiary is foreign base company services income.
My example is the distilled essence of the zen you will find in Reg. §1.954-4(b)(3) Ex. 1.
If the foreign subsidiary’s income were not defined as foreign base company services income, the CFC’s profits would have been (in the olden times before Global Intangible Low-Taxed Income) tax-deferred. The U.S. shareholder would not have paid U.S. income tax on the service income generated by its technicians.
The government wanted to discourage income-shifting using services. This is why foreign base company services income exists as a sub-sub category of Subpart F income.
Foreign Base Company Income and Planning Opportunities
Passive income streams (“foreign personal holding company income” are fairly easy to identify in a CFC’s general ledger. Yes, you might be trying to argue that these are not passive income streams but the profits of an active business–much like a taxpayer might argue that he is a day-trader rather than a mere stock market investor in order to gain a tax benefit. This is hard work and rarely fruitful.
Related party transactions in inventory or services involve more work. Here, you are attempting to exploit imperfect rules to classify profit as something other than foreign base company sales income or foreign base company services income.
First, you must spot the income streams in the CFC’s general ledger, then go through a complicated thicket of rules, exceptions, and exceptions to the exceptions to see if the income items fall within the definitions of foreign base company sales income or foreign base company services income.
In the olden times (before Global Intangible Low-Taxed Income) these efforts had a high payoff. If your anti-anti-deferral tax strategy was successful, the CFC’s earnings and profits enjoyed tax deferral. The profits were not classified as Subpart F income, therefore the U.S. shareholder was not immediately taxed on the CFC’s earnings and profits.
The upside of successful tax planning, in other words, was the present value of the difference between “pay tax today” and “pay tax decades from now at the time of your choice.”
Now, if you are successful in classifying your CFC’s income away from foreign base company sales income or foreign base company services income, you do not achieve deferral. Instead, you jump from the Subpart F income frying pan into the Global Intangible Low-Taxed Income fire. That income item avoids one anti-deferral mechanism (Subpart F income) by becoming trapped by another anti-deferral mechanism (Global Intangible Low-Taxed Income).
We will talk more about the interplay between these two anti-deferral methods in the chapter about Global Intangible Low-Taxed Income. But if you want a simple way to see how they work hand-in-glove, look at Form 5471, Schedule I-1, lines 1-4. Basically, a CFC’s gross income minus its Subpart F income equals the gross income attributable to Global Intangible Low-Taxed Income.
There are some instances where you can reduce income tax by flagging a dollar of CFC profit as Subpart F income or Global Intangible Low-Taxed Income. These are marginal tax savings that may amount to real dollars at scale, but for regular people running regular businesses, it’s rarely worth the effort to play these games. The cost/benefit just isn’t there.
The Other Four Categories of Subpart F Income
Foreign base company income, as a category of Subpart F income, will probably take most of your time. This is where real companies doing real things generate transactions and tax compliance headaches.
The other four categories of Subpart F income are infrequently seen (at least in my experience) and should probably be studied on an as/when needed basis. Still, let’s give a quick overview of these income categories and a quick explanation of what they entail, so you can recognize one when you see it.