What is IRS Subpart F? How has Tax Reform changed it?
by: Anthony Parent
When the IRS introduced Subpart F, it completely changed the the rules of international tax planning. Things have never been the same. Yet Congress was not done. The Tax Cuts and Jobs act of 2017, aka Tax Reform, change Subpart F and not for the best. So what are the Subpart F rules? Why are they so awful? What can be done to avoid Subpart F? This article answers these questions.
Enacted in 1962, the Subpart F rules incorporate most of the features of Controlled Foreign Company (CFC) rules used in other countries. The entire purpose of Subpart F is to prevent U.S. citizens, resident individuals, and corporations from deferring the recognition of otherwise taxable income through the use of foreign entities.
Answering the basics: what is tax deferral?
Subpart F Expanded by Tax Reform
We were promised a simpelr tax code. However, with regarded to outbound US investment overseas, things got much more complicated and much more consequential, including the imposition of a Transistion Tax.
Tax Reform expanded the application of Subpart F, and made CFC ownership rules more complex. As a result, private companies and individuals with investments aroudn the globe need to do a comprehensive analysis of their offshore ownership structures to determine the impact this repeal has on their Subpart F status.
In this video below, we explain how Tax Reform created GILTI income, which must be now included in Subpart F.
What are Subpart F triggers?
If a foreign corporation is classified as a CFC for during any taxable year (Tax Reform removed the 30-day exclusion), every US shareholder who owns stock in that corporation on the last day in said tax year must include in his gross income:
His pro rata share of the corporation’s Subpart F income for the year, and
The amount determined under IRC § 956 with respect to the shareholder for the year.
Only certain types of income to which Subpart F rules apply flow-through to US shareholders personal 1040 obligation, but losses do not .
Subpart F Income is taxed at ordinary tax rates (not at the lower dividend or capital gain rate). Subpart F income includes, subject to certain limitations:
certain insurance income under § 953
foreign base company income under § 954
international boycott income
illegal bribes, kickbacks, or other illegal payments made by the CFC
or income derived from certain disfavored countries.
Additionally, US owners of a CFC may have an informational return obligation, either a Form 5471 or Form 5472, depending on the type of entity,or face a $10,000 per year penalty in addition to any FBAR penalties, if applicable.
The somewhat-helpful Foreign Base Company Income exceptions
Foreign base company income (FBCI) allows U.S. multinationals to compete on equal footing with territorial regimes, but does not allow deferral on passive investments or artificial structures that are used to shift income outside of the United States. FBCI includes:
foreign personal holding company income (FBHCI)
foreign base company sales income
foreign base company services income
foreign base company oil-related income.
Foreign Personal Holding Company Income
Foreign personal holding company income (FPHCI) includes dividends, interest, rents, royalties, and annuities. It also includes gains from commodities transactions and gains from certain property transactions, but gain from the sale of property used or held for use in the CFC’s trade or business is not FPHCI. Foreign currency gains, net income from NPCs (nonparticipating corporations), and payments in lieu are also FPHCI. There is an exception for income from related parties, and COD income is generally not Subpart F income.
Foreign Base Company Sales Income
Foreign base company sales income is profit from the sale of goods that were purchased from or sold as “related party”, except for goods manufactured or produced in the CFC’s country of incorporation, goods sold for use or consumption in the CFC’s country of incorporation, or goods manufactured by the CFC. Generally, property sold or leased by a person is manufactured or produced if: the property is substantially transformed into goods prior to its sale by the taxpayer; the operations conducted by the taxpayer are substantial in nature and generally considered to constitute the manufacture or production or property; or substantial value is added to the property (ex. Direct costs and overhead account for 20% or more of COGS).
Foreign Base Company Services Income
Foreign base company services income includes a CFC’s income from services performed by the CFC, outside of the CFC’s country of incorporation, which is determined by the physical location of the service provider, and for, or on behalf of, a related person.
Full Inclusion Rule
All gross income is treated as FBCI or insurance income if the FBCI or gross insurance income exceeds 70% of the gross income of the CFC.
The “§ 956 amount” is the excess, if any, of the shareholder’s pro rata share of the average of the amount of U.S. property held, directly or indirectly, by the CFC as of the close of each quarter of such taxable year, over the amount of earnings and profits described in § 959(c)(1)(A) with respect to such shareholder. The § 956 amount may not exceed a shareholder’s pro rata share of the earnings and profits of the CFC.
Subpart F rules: How to avoid issues
Under U.S. tax rules, a foreign entity may be classified for U.S. tax purposes as a corporation or a flow-through entity somewhat independently of its classification for foreign purposes. Under these "check-the-box" rules, that is by filing a Form 8832 with the IRS, shareholders may be able to elect to treat their shares income, deductions, and taxes of a foreign corporation as earned and paid by themselves. This is at least partially helpful in allowing U.S. individuals to obtain credits for foreign taxes paid by entities they own, which credits might otherwise not be available.
We help US taxpayers around the nation and around the globe.
Parent & Parent LLP does it all. We are tax accountants, business consultants, research & planning attorneys, along with being dedicated client advocates. Call 888-727-8796 or email email@example.com to book an initial consultation.
This article was originally published July 24, 2017 and updated September 12, 2017, February 12, 2018, and March 5, 2018 . We will be updated this page more as the final regulations and guidance is published.