For U.S. taxpayers with foreign businesses, understanding Subpart F income is essential. Enacted to prevent tax deferral through Controlled Foreign Corporations (CFCs), Subpart F income rules ensure that certain types of foreign earnings are taxed in the U.S. regardless of whether they’re distributed. This article provides a comprehensive explanation of Subpart F income’s impact on U.S. tax obligations, along with changes introduced by the Tax Cuts and Jobs Act (TCJA), including the new GILTI provisions.
What is Subpart F Income?
Subpart F income, defined under IRC Section 952, includes designated types of foreign income earned by a CFC, which must be reported in the U.S. taxpayer’s gross income in the year earned—even without distribution. The provision aims to counteract tax deferral strategies where U.S. taxpayers could previously delay paying U.S. taxes on foreign income until repatriation. Congress created Subpart F in 1962 to address these tax deferral opportunities, mandating current taxation on specific types of “movable” income, like dividends, interest, rents, and royalties, particularly from jurisdictions with low or no tax rates.
By taxing U.S. shareholders on their pro-rata share of Subpart F income annually, the IRS curbs tax avoidance by treating certain income types as immediately taxable. The TCJA added further measures to capture overseas profits through Global Intangible Low-Taxed Income (GILTI), expanding tax requirements on foreign earnings to include broader income types and requiring U.S. taxpayers to report and pay taxes on these foreign earnings annually.
KEY TAKEAWAYS:
For Subpart F rules to apply, three basic requirements must be met:
- The individual must be a U.S. shareholder.
- The foreign corporation must be classified as a CFC.
- The CFC must have Subpart F income.
**Important:** A Controlled Foreign Corporation (CFC) is defined as a foreign corporation in which U.S. shareholders own more than 50% of the total combined voting power or value of the stock. To qualify as a CFC, each U.S. shareholder must also own at least 10% of the corporation’s voting stock.
What Qualifies as Subpart F Income?
Subpart F income includes various types of passive and mobile income generated by CFCs, which are subject to current taxation for U.S. shareholders. Here are the main categories that qualify as Subpart F income:
Foreign Personal Holding Company Income (FPHCI)
It includes specific passive income earned by a CFC, such as dividends, interest, rents, royalties, and capital gains from certain asset sales. Since FPHCI is passive and generally involves investment income or asset sales, it’s treated as immediately taxable for U.S. shareholders of the CFC, even if it’s not distributed.
This means U.S. shareholders must report their pro-rata share of FPHCI on their tax returns in the year it’s earned by the CFC, preventing tax deferral benefits.
Foreign Base Company Sales Income (FBCSI)
Income from the sale of personal property to related persons, where the property is manufactured or produced outside the CFC’s country of incorporation and sold for use outside that country.
This provision aims to prevent U.S. taxpayers from avoiding taxes by setting up foreign subsidiaries that handle international sales transactions, creating an artificial tax advantage in low-tax regions. If the CFC is primarily engaged in buying or selling for related entities, FBCSI includes those earnings in U.S. taxable income, bypassing deferral. FBCSI includes income from the sale of tangible personal property.
Foreign Base Company Services Income (FBCSvI):
FBC Services Income applies to service-based income from technical, managerial, engineering, or similar services performed for or on behalf of a related person outside the CFC’s country of incorporation.
This provision prevents tax avoidance through “service-shifting,” where a CFC provides services for related U.S. persons or entities in a low-tax country. The U.S. tax law treats this income as Subpart F income to curb the tax advantage of performing such services outside the CFC’s resident country, ensuring immediate U.S. tax inclusion.
Insurance Income:
Income derived from insuring U.S. risks, as defined under Internal Revenue Code Section 953.
How to Calculate Subpart F Income?
Calculating Subpart F income involves navigating a complex set of rules and regulations outlined by the Internal Revenue Service (IRS). The process requires a thorough understanding of the foreign corporation’s earnings and profits (E&P) and the specific types of income that qualify as Subpart F income. Here’s a step-by-step guide to help you understand the calculation:
- Determine the Foreign Corporation’s E&P:
- Start by calculating the foreign corporation’s earnings and profits (E&P) for the taxable year. This figure represents the corporation’s net income after accounting for expenses, taxes, and other deductions.
- Identify Subpart F Income Types:
- Next, identify the types of income that are considered Subpart F income. This includes foreign base company income (FBCI), insurance income, and certain types of services income. These categories are specifically targeted to prevent tax deferral strategies.
- Attribution to U.S. Shareholders:
- Calculate the amount of Subpart F income attributable to each U.S. shareholder based on their ownership percentage in the foreign corporation. This ensures that each shareholder reports their fair share of the income on their U.S. tax return.
- Apply Exceptions and Exclusions:
- Finally, apply any applicable exceptions, exclusions, or limitations to the calculation. For instance, the de minimis rule or the high-tax exception can significantly impact the final amount of Subpart F income that needs to be reported.
Given the complexity of these calculations, it’s often advisable to seek the assistance of an experienced offshore tax attorney. They can help navigate the intricate rules and ensure compliance with all applicable tax laws, ultimately helping to eliminate international reporting penalties.
How Is Subpart F Income Reported?
To report Subpart F income, U.S. shareholders must include their pro rata share of a Controlled Foreign Corporation’s (CFC) Subpart F income in their gross income for the year it’s earned, even if no distribution is made. This is primarily done through Form 5471, which provides details on the CFC’s earnings, profits, and shareholder information. Form 5471 is required to report the ownership and financial details of certain foreign corporations, underscoring the complexity of tracking income and earnings for U.S. tax compliance. Schedule G within Form 5471 further calculates the pro rata share for each shareholder.
Important: The taxation applies to U.S. persons who own directly or indirectly at least 10% of the voting stock of a CFC.
U.S. expats may also have additional international reporting requirements. Form 8938 is filed to report foreign financial assets if the total value meets specific thresholds, while FBAR (FinCEN Form 114) is required to disclose foreign accounts over $10,000.
What Are The Penalties for Failing to Report Subpart F Income?
Failing to report Subpart F income can lead to significant penalties for U.S. shareholders of CFCs. Here’s a summary of the penalties associated with non-compliance:
1. Failure to File Form 5471
- Initial Penalty: A $10,000 penalty for each year a U.S. shareholder fails to file Form 5471, which is required for reporting interests in foreign corporations.
- Continuation Penalty: If the failure continues for more than 90 days after the IRS mails a notice of the failure, an additional $10,000 penalty applies for each 30-day period (or fraction thereof) that the failure continues, up to a maximum of $50,000 per failure.
2. Reduction of Foreign Tax Credits
- If a taxpayer fails to report Subpart F income accurately, there may be a reduction of up to 10% of the foreign taxes available for credit under sections 901, 902, and 960. This reduction can increase to an additional 5% for each three-month period that the failure continues after the initial notice from the IRS.
3. Criminal Penalties
- Willful failure to comply with reporting requirements can lead to criminal penalties under sections 7203, 7206, and 7207. These can include fines and potential imprisonment.
4. Extended Statute of Limitations
- Failure to report Subpart F income can extend the statute of limitations for IRS assessments from three years to six years if there is a substantial omission of gross income on a taxpayer’s return.
The penalties for failing to report Subpart F income are designed to ensure compliance with U.S. tax laws regarding foreign income. U.S. shareholders must be diligent in meeting theese reporting obligations to avoid significant financial repercussions and potential legal consequences.
What Are The Exceptions to the Subpart F Rules?
Exceptions to Subpart F rules allow certain types of income to be excluded from the Subpart F income classification, thereby preventing U.S. shareholders from being taxed on that income. Here are the primary exceptions:
- De Minimis Rule:
- If a CFC’s Subpart F income is less than the lesser of $1 million or 5% of the CFC’s gross income, none of that income is considered Subpart F income.
- High Tax Exception:
- Income that is taxed at a rate greater than 90% of the U.S. corporate tax rate is not treated as Subpart F income. For example, if the highest U.S. corporate tax rate is 21%, then income taxed at over 18.9% qualifies for this exception.
These exceptions are designed to prevent unnecessary taxation on income that does not reflect the intent to defer taxes or avoid U.S. tax obligations through foreign operations. Understanding these exceptions is crucial for U.S. shareholders with interests in foreign corporations to effectively manage their tax liabilities.
What’s the difference between GILTI vs. Subpart F Income?
The differences between Global Intangible Low-Taxed Income (GILTI) and Subpart F Income are significant, particularly in terms of their definitions, tax implications, and the types of income they encompass. Here’s a detailed comparison:
| Feature | Subpart F Income | GILTI (Global Intangible Low-Taxed Income) |
|---|---|---|
| Definition | Defined by included income types, such as passive Foreign Personal Holding Company Income (FPHCI), and Foreign Base Company Income (FBCI) including sales and services income with related parties. | Defined by exclusions: all gross income of a CFC minus Subpart F income, U.S.-connected income, certain related dividends, and foreign oil/gas extraction income. |
| Tax Rates | Taxed at a corporate rate of 21%. | Taxed at an effective rate of 10.5% to 13.125%, depending on foreign tax credits and other factors. |
| Calculation Method | Based on CFC’s earnings and profits (E&P). U.S. shareholders report their pro rata share in the year earned, regardless of distribution. | Calculated as net CFC tested income minus a deemed 10% return on qualified business asset investment (QBAI): GILTI = Net CFC Tested Income − (10% × QBAI) |
| Purpose | Prevents deferral of U.S. tax on certain types of passive and related-party income by applying current U.S. taxation. | Targets mobile intangible income of CFCs not covered by Subpart F; introduced by the Tax Cuts and Jobs Act (TCJA) in 2017. |
| Interaction with Subpart F | Operates independently but often overlaps with GILTI. Subpart F income is taxed separately from GILTI, ensuring comprehensive coverage of CFC earnings. | While calculated independently, GILTI provisions complement Subpart F to cover income categories left unaddressed, minimizing tax deferral. |
Interaction Between GILTI and Subpart F
GILTI was introduced by the Tax Cuts and Jobs Act (TCJA) to address perceived gaps in tax revenue from U.S. shareholders of foreign subsidiaries. While there is some overlap between GILTI and Subpart F income, the two regimes operate independently with distinct rules.
A U.S. shareholder’s inclusion of GILTI is treated similarly to Subpart F income for certain purposes, but they are calculated separately, and care must be taken to avoid double taxation on the same income.
While both GILTI and Subpart F income apply to U.S. shareholders of CFCs, they differ significantly in their definitions, tax rates, calculation methods, and intended purposes. Understanding these differences is crucial for effective tax planning and compliance for U.S. taxpayers with foreign operations.
Contact Us for a Free Tax Consultation
Complying with these rules is essential for U.S. shareholders with foreign corporations, as these regulations carry specific tax implications. At 1040 Abroad, our team of international tax experts is here to simplify the process for you. Whether you have questions about reporting requirements or need strategic guidance, we offer free tax consultations to help you achieve compliance and peace of mind. Don’t hesitate to contact us today to discuss your tax situation and make the most of our expertise in U.S. expat tax matters.
