U.S. Taxation of a Controlled Foreign Corporation

For U.S. expats who own foreign businesses, learning how the U.S. taxes those profits is essential—especially when those businesses qualify as controlled foreign corporations (CFCs) under IRC §957, a section of the Internal Revenue Code that applies to foreign corporations with U.S. shareholders meeting specific ownership thresholds.

This article will break down the complex CFC rules, the default taxation framework, and the options expats can use to significantly reduce their exposure to Subpart F and GILTI income.

Key Takeaways:

U.S. expats with foreign corporations face a layered tax regime:

• Subpart F income is always included, but §962 softens the blow

• GILTI can be brutal without planning — taxed even if income isn’t distributed

• §250 and §962 provide relief, but still involve complexity

• GILTI High-Tax Exclusion is the cleanest outcome — if you qualify and elect

What Is a Controlled Foreign Corporation?

A controlled foreign corporation is a foreign corporation (i.e., corporation organized under foreign law) in which U.S. shareholders—defined as United States persons owning 10% or more of the total combined voting power or total value of shares—collectively own more than 50% of the company. These rules also apply to foreign corporations beginning operations or ownership changes during a tax year.

Ownership is measured using constructive ownership rules, which can attribute stock entitled to vote indirectly held via relatives or entities.

If you own more than 50% of a foreign company, or you participate in one where a group of such shareholders does, you’re likely dealing with a controlled foreign corporation—a corporation treated as subject to specific anti-avoidance measures in the Internal Revenue Code.

This brings two main CFC rules into play:

1. Subpart F Income (IRC §951)

• Typically passive income: interest, dividends, royalties, rents, and insurance income from insurance or annuity contracts

• Taxed immediately, even if not distributed

• Taxed at individual rates unless a §962 election is made

• Applies even if such corporation reinvests profits abroad

2. GILTI Income (IRC §951A)

• Active business income that exceeds a 10% return on Qualified Business Asset Investment (QBAI)

• Also included annually, even if undistributed

• Designed to discourage profit shifting to low tax jurisdictions and tax havens

These provisions are applied annually for taxable years beginning after ownership thresholds are met.

What’s the Default Method of Taxation for CFCs?

The default method of taxation for a CFC is the straightforward inclusion of all Subpart F and GILTI income directly into the individual’s taxable income. Specifically:

• Subpart F income and GILTI are taxed annually, irrespective of whether the profits are actually distributed

• Income is taxed at the individual’s ordinary income tax rates, which can reach as high as 37%

• There is no Section 250 deduction available to individuals by default

• Individuals are generally ineligible for foreign tax credits on GILTI unless they make a specific election (like §962)

This treatment reflects the broader intent of the CFC legislation to deter U.S. shareholders from deferring U.S. tax on income derived from foreign entities and corporations created offshore.

Why the Default Method Is Problematic:

• High tax rates: Individuals face significantly higher U.S. tax exposure without beneficial deductions or credits

• Double taxation risk: Without FTCs, foreign taxes paid on already taxed gross income can be taxed again in the U.S.

• Complex compliance: Higher administrative complexity without any tax relief benefit

Thus, the default method often results in the highest possible income tax obligation, making it generally the least favorable approach for U.S. expats owning foreign corporations—especially those operating in such a possession or such other possession subject to U.S. jurisdiction.

U.S. Taxpayer Options — Planning Tools and Elections

U.S. expats owning foreign corporations have three primary strategies to reduce the tax burden associated with Subpart F and GILTI income:

OPTION 1: §962 Election — Be Treated Like a Corporation

This is a lifesaver for individuals.

§962 Election allows individuals to be taxed as if they were a domestic corporation only for Subpart F and GILTI income.

Benefits:

• You get the §250 deduction on GILTI (cuts inclusion by 50%)

• You can claim foreign tax credits (FTCs) on GILTI (limited to 80%)

• Your GILTI is taxed at 21% × 50% = 10.5%

• Access to corporate treatment like a corporation entitled to deductions

Drawbacks:

• If your CFC later issues dividends paid, you may be taxed again (possibly at 15–20%)

• You must track earnings & profits (E&P), property acquired, and basis carefully

• §962 must be elected each year and only affects Subpart F and GILTI

When It Makes Sense:

• You don’t qualify for the GILTI High-Tax Exclusion

• Your CFC’s foreign tax rate is moderate (10–20%)

• You want to use FTCs to offset U.S. tax

• Your foreign subsidiaries are located in foreign country jurisdictions with mid-level taxes

OPTION 2: GILTI High-Tax Exclusion (HTE)

The GILTI High-Tax Exclusion completely excludes the foreign income from GILTI if it’s taxed abroad at a rate higher than 18.9%.

Benefits:

• Fully eliminates GILTI-related U.S. tax on qualifying high-taxed income

• Reduces complexity: no FTCs, §250 deductions, or §78 gross-up required

• Works well for expats in foreign countries with high statutory rates

Downside:
Only applicable when income derived from such foreign corporation is already highly taxed

OPTION 3: Restructuring or Strategic Tax Planning

What it does:
Includes changing the foreign entity structure, the nature of account income, the type of active conduct, or strategically timing income and dividends paid. Example, if you pay yourself wages, the income can be excluded using the FEIE.

Benefits:

• Can significantly reduce exposure to Subpart F or GILTI rules

• Tailored long-term solution aligning with individual goals

• Potential to avoid status as a CFC if percent of the total ownership drops below 50% through direct ownership or reallocation

Downside:
Often complex, requiring compliance with regulations prescribed under the IRC and possibly involving certain exceptions, transitional rule relief, or such amendments

All Options Compared – One Scenario

You’re a U.S. expat in Germany and own 100% of a German GmbH (a CFC):

• Net tested gross income = $1,000,000

• German foreign taxes paid = $300,000 (30%)

• QBAI = $0 (to simplify)

A. No Election

• You include $1M GILTI at full U.S. individual rate (say, 37%) → $370,000 tax

• No FTCs or deductions
  Result: Maximum taxable income, no relief — a poor outcome

B. §962 Election

• GILTI inclusion = $1,000,000

• §250 deduction = $500,000

• Tax @ 21% = $105,000

• FTC = 80% of $300,000 = $240,000 → offsets all tax
  ✅ U.S. tax = $0 (with careful coordination)

C. HTE Election

• German tax rate = 30% > 18.9% → qualifies

• Income excluded from GILTI
  ✅ U.S. tax = $0
  ✅ Cleanest and most elegant strategy for such individual

Decision Tree for U.S. Expats with CFCs

Ask yourself:

• Is your CFC income Subpart F?
  → Yes → Must include (consider §962 to lower rate)

• Is it GILTI income?
  → Yes → Continue below

• Is the foreign tax rate > 18.9%?
  → Yes → Consider HTE
  → No → Consider §962

• Do you want to use FTCs?
  → Yes → §962 needed

• Are you okay with future tax on dividends received?
  → Yes → §962 might still be better than nothing

Recommended Strategy Based on Foreign Tax Rate

The best approach for minimizing U.S. tax on CFC income depends heavily on the foreign tax rate paid by the foreign corporation:

• If the foreign tax rate is high (above 18.9%), the GILTI High-Tax Exclusion is usually the most effective strategy. It can eliminate GILTI entirely without the need for credits, deductions, or additional elections.

• For moderate foreign tax rates (between 10% and 18.9%), a §962 election often makes the most sense. This allows the individual to be taxed like a U.S. corporation, unlocking the §250 deduction and enabling use of foreign tax credits to offset U.S. tax.

• When the foreign tax rate is low (below 10%), the most effective strategy may involve a combination of §962, restructuring, or broader strategic tax planning. These scenarios typically require a more tailored approach to reduce or defer exposure to Subpart F and GILTI.

Smart Planning Can Eliminate Unnecessary Tax

The U.S. tax system imposes detailed rules and burdens on U.S. shareholders of controlled foreign corporations. While these rules under the Internal Revenue Code are aimed at reducing united states risks tied to offshore activity and profit shifting, they can unfairly penalize U.S. expats.

With proper planning—using §962, the §250 deduction, or the GILTI High-Tax Exclusion—you can reduce or even eliminate U.S. tax on foreign income, whether from passive foreign investment companies, passive income, or operational business income.

Need help? Contact the cross-border experts at 1040 Abroad to optimize your compliance and minimize your U.S. tax exposure.