Form 5471 exists because Subpart F (IRC §§951-965) exists.
Or to be more precise, Form 5471 exists because Subpart F exists and taxpayers are smarter than the government–but eventually even the government catches on.
Why Subpart F Exists
Subpart F (or to be more precise, United States Code, Title 26, Subtitle A, Chapter 1, Subchapter N, Part III, Subpart F) exists because Subchapter C (IRC §§301-391) exists.
And because people are smarter than bureaucracies. But eventually, even bureaucracies wise up.
Why Subchapter C Exists
I have no idea. Some IYI economist or politician long ago thought it would be “Brilliant, I tell you, Brilliant!” to impose income tax on corporations.
(N.B. Some economists suggest that maybe this is less than brilliant and in fact could introduce economically destructive disincentives. But I digress.)
Subchapter C (or to be more precise, United States Code, Title 26, Subtitle A, Chapter 1, Subchapter C) contains the income taxation rules applicable to corporations.
One of the key features of Subchapter C is that the corporation is a taxpayer separate from its shareholders. The corporation computes its taxable income and pays income tax.
The shareholder’s taxable income is unaffected by what happens inside the corporation. The shareholder has gross income only when the corporation distributes cash or property to the shareholder, or when the shareholder sells or exchanges shares of the corporation’s stock.
How Taxpayers Weaponized Subchapter C
In the good old days (meaning pre-Subpart F) clever taxpayers weaponized Subchapter C to effectively create roll-your-own IRAs.
Here’s how it would work if Subpart F didn’t exist.
The tax haven corporation
Imagine a foreign corporation formed in a zero tax jurisdiction, wholly owned by a U.S. citizen. The U.S. citizen makes a capital contribution of $1,000,000 cash to the foreign corporation.
The corporation promptly invests the cash into publicly traded stock (let’s say a non-U.S. corporation) that pays $50,000/year dividends to the foreign corporation. This is a 5% dividend yield by assumption.
Who pays tax on that $50,000 of dividend income? Nobody.
No U.S. corporate income tax
Subchapter C says that the foreign corporation–not the U.S. citizen shareholder–includes the $50,000 of dividend income in its taxable income.
Oh, wait. The foreign corporation is outside of the reach of the U.S. tax enforcement bureaucracy:
- it is formed in a foreign country and has no physical presence in the United states (no in personam jurisdiction)
- it is not engaged in business in the United States (no U.S. source active business income taxable under IRC §882), and
- it has no U.S.-source passive income (taxable under IRC §881) because the dividend income is paid by a non-U.S. corporation.
The United States cannot impose income tax on the $50,000 dividend income.
No foreign country corporate income tax
The foreign corporation owes no foreign country corporate income tax because it is formed and exists in a country that does not impose income tax.
(Maybe but let’s ignore) Withholding tax on dividend income
Some countries impose a withholding tax on dividends paid by their local corporations to foreign shareholders. The U.S., by default, requires 30% tax to be withheld in such a situation.
Let’s keep this example simple and assume that the $50,000 dividend income paid to the foreign corporation was received without withholding tax being imposed.
No individual U.S. income tax paid by the U.S. shareholder
The U.S. citizen shareholder is taxable on his worldwide income, because he holds Uncle Sam’s Magic Passport.
The U.S. citizen shareholder did not receive the $50,000 dividend payment directly. So it can’t be included in the U.S. citizen shareholder’s taxable income.
The U.S. citizen shareholder would only have taxable income if the foreign corporation (of which he is the 100% shareholder) pays a dividend to its sole shareholder.
Which it doesn’t.
Therefore, the U.S. citizen shareholder of the foreign corporation will have no taxable income.
The cycle of tax-free investment returns continues
The foreign corporation has $1,000,000 of stock and $50,000 of cash on its balance sheet. It takes the cash and buys more shares of stock.
The next year, the foreign corporation earns 5% dividend yield on its $1,050,000 of stock, receiving a cash dividend of $52,500.
Again, the foreign corporation pays no income tax to the United States or to the foreign country where it was incorporated. The foreign corporation does not pay a dividend to the U.S. citizen shareholder, so the foreign corporation keeps the $52,500 cash dividend received.
At the end of the year, the foreign corporation has $1,050,000 of stock and $52,500 of cash on its balance sheet.
Repeat the cycle for as long as you want, and as long as the U.S. shareholder chooses not to receive a dividend from his foreign corporation.
Through the magic of Subchapter C (and the hypothetical absence of Subpart F of the Internal Revenue Code), the foreign corporation has achieved 5% annual compounded growth of its assets, tax-free.
Decades of tax-free compound investment returns, and tax deferral, too
At the end of 20 years or whatever, the foreign corporation pays a dividend to the U.S. citizen shareholder. The foreign corporation has much more money to pay as a dividend because it enjoyed tax-free compounded investment returns for decades. The U.S. citizen shareholder gets more cash.
There is also the non-insignificant effect of deferring the payment of income tax liability for decades. Play the present value/future value game for fun and profit. The present value of a tax liability deferred to 20 years in the future . . . is pretty small.
That’s why I call this a “roll-your-own IRA.” U.S. taxpayers could create a tax-exempt entity to earn tax-free investment returns, and choose the date of distribution to the shareholder (and therefore the moment at which U.S. income tax would be imposed).
How the Government Fought Back
Taxpayers, in other words, weaponized Subchapter C as a tax-deferral device, to the distinct benefit of taxpayers and to the great consternation of our Trusted Servants in Washington D.C.
The government fought back against the strategy I describe above, ineffectively, with the personal holding company rules and the foreign personal holding company rules.
But in 1962, with the enactment of the Subpart F rules, the government stopped the shenanigans described above. Dead, dead, dead.
They did this with the simple expedient of shooting a torpedo through the hull of their very own ship, the S.S. Subchapter C.
As a result, Subchapter C is now porous. All animals are equal, but some animals are more equal than others. All corporations are treated equally by Subchapter C, but some corporations are less corporation-y than others (because of Subpart F).
The Gist of Subpart F (IRC §§951-965)
The important idea to remember, in order to understand Subpart F income and how a U.S. taxpayer gets tagged with a corporation’s taxable income, is simple:
- Subchapter C created rigid tax rules.
- Clever taxpayers exploited the rigid rules.
- Congress, in Subpart F, created artificially-defined income types (and other baroque rules) to shut down the taxpayer exploits that the government didn’t like.
How Subpart F overrides Subchapter C
Subpart F says:
- If the right kind of income (“Subpart F income”)
- Is earned by the right kind of foreign corporation (a “controlled foreign corporation”),
- And the shareholder is the right kind of shareholder (a “United States shareholder”),
- Then include the corporation’s right kind of income in the shareholder’s U.S. gross income, in total disregard for the foundational principle of Subchapter C.
My example: “foreign personal holding company income”
One of these categories of “right kind of income” is exactly the type of income I described in my example above.
Subpart F income includes a made-up category of income called “foreign base company income.” One of the types of income that is included in “foreign base company income” is “foreign base company income” as defined in IRC §954(a)(1).
Or, explained in reverse, foreign personal holding company is a subset of foreign base company income, which is a subset of Subpart F income.
It’s Matryoshka dolls all the way down.
There are other types of Subpart F income, caused by different taxpayer exploits
It’s easy to see how this works with simple passive income (aka foreign personal holding company income), such as in the example I give above.
There are several other categories of Subpart F income. Each category of Subpart F income exists to punish a sin committed by clever taxpayers to defer or eliminate income tax).
The Internal Revenue Code was systematically upgraded over the years to block one taxpayer exploit after another.
The different types of Subpart F income will be analyzed later
Subpart F income (the type of income that is included in the United States shareholder’s gross income by IRC §951(a)) is defined in IRC §952. All of these types of income are included in the shareholder’s gross income through the application of IRC §951(a)(1)(A).
If the foreign corporation invests in U.S. property, the amount of the investment is included in the shareholder’s gross income by the application of IRC §951(a)(1)(B) and IRC §956. Can you see the taxpayer exploit there? Grow assets offshore with tax-free compounding, then lend the money to yourself in the United States. You have your cake (earn tax-free income) and you get to eat it (borrowing money does not create taxable income). Hence, IRC §956 to the rescue. Put the plug in the jug.
In later sections, each of these categories of Subpart F income will be analyzed, in my usual overly hyperbolic fashion.
The Important Thing to Remember
Back to the beginning. This explanation is designed to drill a single principle into you:
Subpart F breaches Subchapter C’s theoretical firewall between corporation and shareholder, causing the shareholder to pay income tax on the corporation’s income.
After that, everything is noise designed to reconcile the unanticipated (who could have known!) second- and third-order effects of the Congressional hubris when piling legislative fiction (forcing income recognition on shareholders) upon legislative fiction (Subchapter C). How do foreign tax credits work? How do we track earnings and profits? What happens when a controlled foreign corporation pays a dividend? What’s the shareholder’s basis in the stock?
All of the maddening aspects of Form 5471 exist because of the government’s attempt to adapt compounded fiction to annoying and evolving reality.