Subpart F: Taxation of Foreign Income Earned by U.S.-Controlled Foreign Corporations

In 2012, Google made headlines when it was revealed that the multinational company had avoided approximately $2 billion in worldwide income taxes the previous year by funneling the equivalent of 80% of the company’s pre-tax profit through a Bermuda shell company. The tax avoidance techniques used by the company (the “Double Irish” and the “Dutch Sandwich”) were perfectly legal–Google’s mere 3.2% effective tax rate on its overseas income certainly raised awareness and more than a little embarrassment to European governments.

As we have noted in previous blog posts, an ever-increasing number of tax avoidance loopholes are being closed by governments throughout the globe. In this post, we focus on rules that predate the Google tax expos – taxation of the active trade or business income of a U.S.-based company’s foreign subsidiary (also known as a “controlled foreign corporation”, or “CFC”). A CFC is defined under I.R.C. Code 957 as any foreign corporation in which more than 50% of either the voting stock or the stock value is owned by U.S. shareholders on any day of the taxable year.

No shifting of passive foreign income to low-tax jurisdictions

Congress’ initial intent in the enactment of 26 U.S. Code Part III, Subpart F was to prevent taxpayers from shifting “passive” income from the U.S. and other countries with high tax rates to low-tax foreign jurisdictions. What this means is that while active trade or business income of a controlled foreign corporation may be deferred (and therefore not taxed) until distributed as a dividend to the U.S. parent company, income that is passive in nature is subject to immediate taxation even if it is retained by the foreign company and not transferred to the U.S.

What is Subpart F income?

Subpart F does not tax the CFC. It applies to any United States person (U.S. citizen or resident, or domestic corporation, partnership, estate or trust) that owns 10% or more of the voting stock of a CFC. For the most part, Subpart F income includes:

  • Foreign base company income (FBCI) such as foreign personal holding company income from investments in the form of interest, dividends, royalties, rents and annuities; foreign base company sales income from the purchase or sale of personal property from a related person; and foreign base company services income from the services performed by or on behalf of a related person
  • Insurance income as defined under I.R.C. 953(a)(1)
  • Income from countries subject to an international boycott
  • Illegal bribes, kickbacks, or other payments paid by the CFC to government officials or employers and others noted in I.R.C. 162(c)
  • Income derived from countries that sponsor terrorism or are otherwise not recognized by the U.S. under I.R.C. 901(j)