Subpart F: Limitations to the Deferral of U.S. Taxation for FIEs
May 7 – One of the more technical topics not included in the May issue of China Briefing Magazine (Hong Kong and Singapore Holding Companies), but highly relevant to American foreign investors, is the U.S. Internal Revenue Service Code provisions embodied in Subpart F, which is designed to limit the deferral of U.S. income tax on earnings from abroad.
This topic has recently been in the news with U.S. President Barack Obama’s repeated proposals for revisions to the U.S. tax system, including changes that would limit the ability of foreign-invested enterprises to use deductions domestically while deferring U.S. tax on income earned abroad.
President Obama’s proposals have not yet made their way into law, but they share a great deal in common with Subpart F, which specifies situations in which tax deferrals do not apply (meaning, therefore, that income earned abroad is immediately subject to U.S. taxes). All foreign-invested companies with American shareholders currently should understand the applicability of Subpart F.
“U.S. persons (individuals, corporations, partnerships and trusts) are subject to taxation on a worldwide basis, but foreign corporations that are subsidiaries of U.S. persons generally are not subject to U.S. taxation until profits are distributed back to the U.S. or the investment is sold,” explains Kay Biscopink, international services practice chair at the U.S. tax, assurance and consulting services firm Elliott Davis.
“Subpart F was initially enacted to prevent U.S. taxpayers from transferring passive assets or related party profits into foreign subsidiaries and deferring U.S. tax indefinitely.” To do so, Subpart F taints certain types of income earned by a foreign subsidiary controlled by U.S. persons.
“If U.S. persons (U.S. individuals, corporations, partnerships and trusts with an ownership share of at least 10 percent) collectively own more than 50 percent of the vote and/or value of a foreign corporation, then the foreign corporation is considered a controlled foreign corporation (CFC),” explains Biscopink. A CFC with active, operating income defers U.S. taxation on the income until distributed back to the United States, while a CFC with passive income or certain types of related party income (described below) is currently taxed in the United States, whether or not the income is distributed back to the United States.”
If the ownership by U.S. persons is less than 50 percent, the corporation is outside of the CFC rule and passive foreign investment company (PFIC) rules come into play.
“A foreign corporation with a U.S. shareholder holding any percentage of the vote/corporation value is a PFIC if greater than 75 percent of the gross income of the foreign corporation is passive or more than 50 percent of the assets of the foreign corporation generate passive income. A complex set of rules govern the treatment of PFICs, but generally all income is currently taxable to the U.S. shareholder or subject to an interest penalty for deferral,” Biscopink explains.
Subpart F also covers certain types of related party income or “foreign-based company income.”
“For example, say you have three related parties: a U.S. manufacturer that sets up a CFC in the Cayman Islands and a sales/distribution center in France,” suggests Biscopink. “The U.S. manufacturer makes a product that costs US$600 to manufacture in the United States and sells it to the Cayman Islands CFC at cost, so there is no profit in the United States. The Cayman Islands CFC sells to the sales/distribution center in France for US$1000, which then sells to the customer for US$1,100. All of the manufacturing profit is captured in the Cayman Islands, where no income tax is imposed.”
“The profit in the Cayman Islands is considered Subpart F foreign-based company income and is subject to U.S. income tax immediately. The same rules apply if you’re using Hong Kong as an intermediary between a manufacturer and a related sales/distribution company located outside of Hong Kong.”
All types of foreign-invested companies, including manufacturing and services companies, could potentially fall under Subpart F and should be aware of their ratio of active to passive income, as well as their use of taxpayer intermediaries.
Dezan Shira & Associates, one of the largest business advisory and tax practices in Asia, and Elliott Davis, PLLC, a top 50 U.S. tax, assurance and consulting services firm, are members of The Leading Edge Alliance, a worldwide association of independently owned accounting firms. Leveraging this alliance, Dezan Shira & Associates and Elliott Davis work together on inbound and outbound investment in the United States and Asia. For more information, please visit www.dezshira.com and www.elliottdavis.com.
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