What Is a Controlled Foreign Corporation?
A controlled foreign corporation (CFC) is a U.S. corporation that operates overseas with U.S. shareholders who have 50 percent or more of the control of that corporation. If you are a U.S. shareholder, director, or officer of one of these corporations, you must report your income from the foreign corporation and, of course, pay tax on that income.
What's the Background of a Controlled Foreign Corporation?
Every business tries to pay as little income tax as possible legally (it's called tax avoidance).
But the global nature of business in the 21st century has created a phenomenon called offshoring—taking jobs and business out of the U.S. to evade taxes (not legal).
The U.S. and other countries try to control attempts to take income out of the country. Usually, this income is in the form of reporting requirements. According to Investopedia, a company that is controlled is defined according to the number of shares owned by U.S. citizens. A company that has fewer than the required number of foreign shareholders is considered as independent rather than as controlled.
Corporate shareholders pay taxes on the income of the corporation only when they take dividends. If they take dividends on U.S. domestic corporations, these dividends must be reported each year, using Form 1099-DIV. But if these shareholders take dividends or other income from foreign corporations, they may think they don't have to report that income or pay taxes on it.
That's where the controlled foreign corporation comes in, as a way to tax U.S. business owners on their income from foreign corporations.
What Is a Foreign Corporation?
The word "foreign" in the context of business incorporation has two meanings. A foreign corporation is generally any corporation that is incorporated to do business in a state or country other than its original state.
For example, a corporation is originally incorporated in Delaware; it is considered a domestic corporation in that state. But the corporation also does business in New York, so it must file for foreign corporation status with the state of New York. The corporation may also do business in Ireland. It may set up a subsidiary corporation in Ireland, and its Ireland corporation is considered a foreign corporation.
For the purpose of CFC status, the IRS considers only non-U.S. companies, and only companies that are taxed as corporations (including LLC's that elect to be taxed as a corporation).
How Is a Controlled Foreign Corporation Defined By the IRS?
CFC status was set up under Subpart F of the Internal Revenue Code, so it's sometimes called a Subpart F regulation. The category of Controlled Foreign Corporation was created to gather information on the income from foreign corporations controlled by U.S. citizens and to collect tax on that income. Officers, directors, and shareholders of CFC's must report income received from earnings of these corporations.
The IRS defines a foreign corporation as being controlled if:
"more than 50 percent of the total combined voting power of all classes of stock of such corporation entitled to vote, or more than 50 percent of the value of all its outstanding stock, is owned (directly, indirectly, or constructively) by U.S. shareholders on any day during the foreign corporation’s tax year."
The IRS also looks at individual shareholders, defining a U.S. Shareholder of a foreign corporation as
"...a U.S. person who owns 10 percent or more of the total voting power of that foreign corporation"
In other words, a foreign corporation is categorized by the amount of stock owned by U.S. shareholders. If more than 50 percent of the stock is owned by U.S. shareholders, the corporation is considered a controlled foreign corporation (CFC).
The IRS publishes information to auditors about the criteria the IRS looks at in regard to CFC's. A quick look
- Whether the individual owns shares in a foreign corporation.
- Whether the shareholder is a "U.S.Shareholder" for the purpose of the CFC designation. The shareholder's residency or citizenship and percentage of ownership are considered.
- Whether the business is a Controlled Foreign Corporation - it must be a non-U.S. business that is treated as a corporation for tax purposes.
Under Subpart F, the IRS treats the individual shareholder as if he or she "actually received its proportionate share of certain categories of the CFC’s current earnings."
How Must Income From a Controlled Foreign Corporation Be Reported?
U.S. shareholders who have a controlling interest in a foreign corporation must report their share of income from the CFC and their share of earnings and profits of the CFC that are invested in United States Property. This property includes investments, tangible property (assets), and stock in the foreign corporation.
The corporation must file an annual report on IRS Form 5471-Information Return of U.S. Persons With Respect to Certain Foreign Corporations. This form is completed and attached to the corporation's income tax return.
Form 5471 is filed by the company for a tax year. and it requires information on:
- Individuals (U.S. citizens): officers, shareholders, and directors
- A listing of all U.S. shareholders and the stock they hold
- The corporation's classes of stock and shares outstanding
- The corporation's balance sheet and income statement for the tax year.
In addition to the 5471 information return filed by the corporation, a separate report is needed for each U.S. shareholder, officer, or director who meets the 50 percent criterion above. This report lists the person's income from the foreign corporation in dividends and other income and investments. This individual report, called a Summary of Shareholder's Income from Foreign Corporation, is given to the person, who must include the income on his or her tax return.
The income received by the individuals and the tax on that income is separate from the corporate income tax the company pays.
You will need an experienced tax preparer who is knowledgeable about foreign corporations and taxes to prepare this form.
Do Other Countries Have Controlled Foreign Corporations?
Several other countries besides the U.S. have a controlled foreign corporation designation, including Russia, The United Kingdom, Germany, Japan, Australia, New Zealand, Brazil, and Sweden. Each country has its own rules for determining CFC status and for identifying individuals and requiring them to report and pay taxes on foreign income.
How Is CFC Income Taxed?
The Summary Report described above for the individuals listed on Form 5471 is included on the person's individual income tax return. The section of the return where the information is included depends on the type of income. For example, if the income is dividends, the income might be included on Schedule B-Interest and Ordinary Dividends.
How the income is taxed depends on the type of income. Dividend income, for example, is taxed depending on the type of dividend and the length of time it is held.
For more details on where your CFC income is included on your income tax return, see this IRS article with instructions for Form 5471.
The Controlled Foreign Corporation status is complicated and knowing whether you must report your income as a shareholder in a CFC is tricky. The general information in this article is just an overview, and it's not intended to be tax or legal advice. Talk with your tax professional if you think you might need to report income from your foreign earnings and pay tax on that income.