Controlled Foreign Corporations
A controlled foreign corporation (CFC) is a foreign company in which “United States shareholders”, usually meaning United States citizens or residents, own stock with more than 50% of the vote. CFCs are important to United States tax law as they potentially allow United States taxpayers to defer taxation on income earned through a foreign corporation. The ability to defer taxation is referred to as deferral, which came under the spotlight with the 2017 Tax Cuts and Jobs Act.
Under section 951 of the Internal Revenue Code, CFCs are subject to special taxation rules since they have a potential to be used to “shift income” or “defer income” from the United States to foreign countries with lower tax rates. While Congress and the Internal Revenue Service (IRS) have long been focused on preventing this happening and preventing tax evasion, the 2017 Tax Cuts and Jobs Act, in conjunction with subsequent Treasury regulations, provided a more comprehensive set of rules for CFCs.
The rules governing CFCs are complex, but include, broadly, provisions that limit the ability to earn passive income, the ability to deduct expenses, and the ability to distribute dividends. The new rules introduced increased penalties for companies that violated the previous rules and also imposed stricter reporting requirements. In addition, companies may be liable for a 10 percent penalty on income accrued, but not distributed, to United States shareholders.
In summary, CFCs are subject to additional taxation and reporting rules based on the concept of deferral and Congress has been progressively introducing new, more stringent rules in an effort to limit attempts to use CFCs to shift income and avoid paying tax in the US. Therefore, US taxpayers have to be aware of these rules and the increased penalties to avoid unintentionally violating CFC provisions.
Nevertheless, despite the additional complexities, CFCs can still be used in a compliant manner to achieve legitimate business and tax planning objectives. As such, they can still provide potential tax advantages to US taxpayers and, depending on the overall structure, may still be useful and viable solutions to US businesses seeking to lower effective tax rates abroad.
