CFC Rules: Controlled Foreign Corporations and Taxes
Contents
- What Makes it a Controlled Foreign Corporation: Ownership and Control Criteria
- Types of Income Affected
- Subpart F Income
- Global Intangible Low-Taxed Income (GILTI)
- Passive Foreign Investment Company (PFIC) Income
- CFC Rules in Other Countries
- Americans Can't Move to Avoid CFC Rules
- Can't You Indefinitely Defer Tax on a Foreign Corporation’s Profits?
- How to Actually Avoid CFC Rules
- The Right Way to Plan Around Controlled Foreign Corporation Rules
Controlled Foreign Corporations (CFCs) are foreign companies owned and/or controlled by US shareholders. The foreign company may be organized as a corporation, limited liability company, or other business entity.
It’s a foreign company where one or more US shareholders own more than 50% of voting power or value.
The rules make sure US taxes are paid on certain types of foreign income, mainly passive income like dividends and interest, but also active business income booked overseas.
US shareholders must report and pay taxes on this income, even if they don’t actually bring it back into the US.
If you’re thinking about an offshore company, it’s important to understand these rules and how they can fit into your plan.
What Makes it a Controlled Foreign Corporation: Ownership and Control Criteria
Unfortunately, the rules around these things are complex. Uncle Sam wants his due from every American taxpayer. Over the years, people have come up with creative ways to try and avoid these taxes, leading to the idea that if you either own it, or control it in any way, you have to pay tax on it.
This is called the Ownership and Control Criteria and includes:
Direct Ownership: You own more than 50% of the voting power or value of the foreign corporation.
Indirect Ownership: You own the CFC through other entities, such as subsidiaries or partnerships.
Attribution of Ownership: Shares of the company are owned by family members, trusts, estates, or partnerships over which you have influence or control.
Constructive Ownership: Shares of the company are owned by related entities over which you have significant influence.
Voting Power: You control over more than 50% of the voting power through various means.
The CFC rules apply to foreign corporations where more than 50% of the total combined voting power or value is owned by US shareholders.
A US shareholder is any US person owning at least 10% of the foreign corporation’s voting stock.
Now, I realize that all of this can be mind-numbing. But it shouldn’t put you off.
Rather, it emphasizes the need to have someone help you figure these things out.
Types of Income Affected
When the CFC rules were first introduced in the 1960s, they were fairly limited in the types of assets they taxed. Over the years, however, that income has expanded greatly. It now includes…
Subpart F Income
This includes various passive earnings such as dividends, interest, rents, royalties, and gains from certain property sales, as well as certain services-related income and income from insurance involving US risks.
Global Intangible Low-Taxed Income (GILTI)
GILTI is foreign income a CFC earns on intangible assets, such as patents, copyrights, and trademarks. You must pay GILTI if you own at least 10% of a CFC, and if your company is a CFC.
Passive Foreign Investment Company (PFIC) Income
This applies to US shareholders of foreign corporations primarily earning passive income (e.g., from investments like stocks and bonds).
If a foreign corporation meets the PFIC criteria, its US shareholders must report and pay taxes on the income, often leading to higher tax rates and interest charges on deferrals.
The PFIC rules aim to prevent US taxpayers from deferring tax on passive income held in foreign investment vehicles like foreign mutual funds.
PFIC related income is probably the most common pitfall we see with US clients who invest internationally.
Basically, if you put money into any sort of international fund, you will be earning PFIC income. It’s beyond the scope of this article to address how to deal with that. But it comes with extra forms and potentially a higher tax bill.
There is one way around this, however. If you hold your offshore investments within a retirement account like an IRA, it will be taxed the same way it would if you held a US asset.
Be sure to have a qualified advisor help with this.
CFC Rules in Other Countries
The US has stringent CFC rules to prevent tax avoidance. These rules require US shareholders to report and pay taxes on certain types of foreign income, even if you leave all profits to build up in the company.
Canada, the UK, and Australia all have a similar framework. However, not all do. In fact, there are a number of countries that don’t, including:
Switzerland: Switzerland does not have CFC rules, allowing income accrued in offshore companies controlled by Swiss residents to be free of Swiss taxes. This makes Switzerland a great location for managing a tax-free network of companies.
Panama: As a territorial tax country, Panama does not tax income earned outside its borders. Residents of Panama can manage foreign corporations without facing local taxes.
Costa Rica: Similar to Panama, Costa Rica operates on a territorial tax system. Foreign-earned income is not subject to local taxes, no matter in what form it’s earned.
Monaco: Although Monaco taxes profits made outside its borders for Monaco companies, it has no CFC rules. Residents can use offshore companies without incurring Monégasque tax on undistributed income.
Liechtenstein: Liechtenstein does not impose CFC rules, making it a tax-friendly place to manage overseas companies and foundations.
Singapore: Singapore has no CFC rules. Residents are free to earn income within foreign-controlled entities without paying tax back home.
Jersey: Not technically a country, but the British island of Jersey (near the French coast) also has no CFC rules.
Americans Can't Move to Avoid CFC Rules
Most of the world operates on a residency-based tax system: if you live there, you pay tax according to local rules. If you leave, you stop paying tax.
The US tax system is different — you are taxed based on citizenship. If you leave, you still have to file your American taxes every year. No matter how long you’re out of the country.
It’s quite unfair but unfortunately, there’s no legal way around it unless you give up your citizenship. (A process called expatriation.)
Short of that, the best you can do is make sure your planning minimizes the worst of the CFC rules, and gives you the maximum benefit to offset the hassle.
Can't You Indefinitely Defer Tax on a Foreign Corporation’s Profits?
Long-time readers may remember an old strategy where you could form a foreign corporation and indefinitely defer tax on its profits if you followed certain rules. That doesn’t work anymore, thanks to the GILTI rules.
In fact, the latest revisions to the CFC laws, which came into effect in 2018, require foreign corporations to pay tax on all their deferred earnings dating back to 1986.
That hasn’t stopped some tax “experts” from claiming you can still avoid tax on a CFC’s profits by using “tricks” such as:
Non-Resident Nominee Shareholders: Using non-resident individuals or entities to hold shares to obscure actual ownership and control.
Spreading Ownership: Distributing shares among related parties to avoid the ownership thresholds for CFC classification.
Creating Complex Corporate Structures: By setting up multi-layered corporate structures in different countries, people hope to hide the true ownership and control of foreign entities. In principle, it’s possible unless you need to open a bank account. Then you’re stuck as no bank will open an account without tracing the money back to a real, breathing person.
The IRS, of course, is not a fan of such manoeuvres.
How to Actually Avoid CFC Rules
Even for experienced international entrepreneurs, CFC Rules can be a hassle. But can they legitimately be avoided in certain cases.
Option #1:
Formally Giving Up U.S. Citizenship
One way to avoid Controlled Foreign Corporation (CFC) rules is to formally renounce US citizenship. By doing so, you are no longer subject to US tax laws, including CFC rules. But this is a significant and usually irreversible step.
Option #2:
Giving Up Formal Ownership and Control of the Assets
You can also formally give up the assets. This means transferring ownership and control of your foreign assets to an unrelated party as a gift. (Although be aware that there are rules around that as well.)
This can be obviously risky. Because you have no legal right to get that property back, you must hope they are honest. Perhaps that’s why, after 15 years in this business, I’m only aware of one person that actually did it (or so he claimed.)
Option #3:
Limit Ownership to 49% or Less
Limiting your ownership of a foreign company to 49% or less, with the other 51% owned by non-US persons who have no other connection to you, can help avoid CFC classification. That’s because the CFC rules kick in when US shareholders collectively own more than 50% of the corporation.
However, this approach can be risky. Here’s what you need to know:
Other Reporting Requirements: Even if you avoid CFC status, you may still have to file reports like Form 5471 or Form 8938 if certain thresholds are met. So there’s no privacy on the holdings.
PFIC Considerations: If your holding is primarily to earn passive income, the foreign corporation might be classified as a Passive Foreign Investment Company (PFIC). PFICs are a huge hassle from a reporting and tax perspective.
Anti-Avoidance Measures: The IRS has various anti-avoidance measures to prevent abuse of these rules, including when someone structures their equity to avoid CFC rules. The IRS may decide your holding is a CFC after all and come after you for back taxes and interest, issue penalties, and even consider it fraud.
Option #4:
Opt Out of the CFC Rules
You can sometimes choose to have a foreign company that would normally fall under CFC rules taxed in another way.
For instance, some foreign companies are eligible to be taxed as disregarded entities (one owner) or partnerships (more than one owner).
Depending on your circumstances, this option may result in a lower tax bill and simpler IRS compliance.
Our Recommendation:
Don't try to avoid CFC rules if it's a CFC
You’ll find people in our industry that will suggest otherwise. We don’t believe that serves your best interests. Truly ethical planning will be designed to help you get the best of your planning without the risk of poking Uncle Sam in the eye.
The Right Way to Plan Around Controlled Foreign Corporation Rules
As you’ve gathered by now, CFC rules are quite complicated. There’s no practical way to avoid them as a US citizen.
But that’s not to say there aren’t some real benefits to investing and doing business overseas. It’s just a question of having the right guide and partner to help you implement and comply with these regulations.
That’s a service we offer, and perhaps we can help you as well. If you’re interested in exploring this further, please book in a free, no-obligation call with one of our Associates.
About The Author
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We have 40+ years experience helping Americans move, live and invest internationally…
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We have 40+ years experience helping Americans move, live and invest internationally…
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