ELITE ADVISOR BEST PRACTICES
Do You Have Clients Setting Up Foreign Companies?
Watch out for U.S. tax reporting
By Deepa Venkatraghvan
- Generally, the earnings of foreign corporations are not taxed in the U.S. until the foreign corporation repatriates its earnings through the distribution of dividends. A Controlled Foreign Corporation (CFC) is an exception to this rule.
- A CFC by default gets taxed in the U.S. on any net earnings earned in the foreign country, even if those earnings are not repatriated.
- If your clients want to set up foreign companies, you must first try to avoid CFC status.
- Failing that, you must know the exceptions to CFC rules that your client can take advantage of.
Diversification has been a buzzword for investors for quite some time now. Apart from asset diversification, geographic diversification is a big part of businesses today. And if your clients are indeed global businesspeople with private limited companies in other countries, here are some important facets of the U.S. tax law that you must not forget:
1. Is your client’s company a CFC?
Generally, the earnings of foreign corporations are not taxed in the U.S. until the foreign corporation repatriates its earnings through the distribution of dividends. There is, however, an exception. If the foreign corporation is a Controlled Foreign Corporation (CFC), a different set of rules applies.
Generally, a CFC by default gets taxed in the U.S. on any net earnings earned in the foreign country, even if those earnings are not repatriated. That is, the “current” earnings are taxed even if there is no dividend declared from the CFC. This is called subpart F income.
So, the first thing you need to check is whether the company your client sets up overseas is a CFC. Broadly put, a foreign corporation is a CFC if on any day during its taxable year, either more than 50 percent of the combined voting power of all classes of stock OR more than 50 percent of the total value of the foreign corporation is owned by U.S. shareholders.
A U.S. shareholder is defined as a U.S. corporation, partnership, citizen or resident, or U.S. estate or trust owning at least 10 percent of the total combined voting power of all classes of voting stock of the foreign corporation. U.S. shareholders don’t have to be related to each other.
It is important to understand these definitions clearly so that the shareholding can be planned efficiently. For instance, a Foreign Private Limited Company owned equally by 11 U.S. residents is not a CFC, but if it was owned equally by 10 U.S. residents, it would be a CFC.
So before the foreign company is set up, first see if you can help your client avoid CFC status completely. You can do that with some smart planning and by arranging ownership in such a way that it does not attract CFC status.
If your client cannot avoid CFC status, the next step would be to explore the exceptions for subpart F income. The tax laws exempt certain foreign income of CFCs from being taxed as current income.
2. How can your client qualify for subpart F exceptions?
There are five types of companies that fall under subpart F income: oil companies, shipping companies, foreign personal holding companies, foreign base company sales and foreign base company services. Each type of company has its own set of exceptions, and it would be best to explore each one in detail, depending on your client’s business.
Further, there is a de minimus rule that excludes all gross income from being considered as foreign base company income or insurance income if the sum of the CFC’s gross foreign base company income and gross insurance income is less than the lesser of 5 percent of gross income or $1 million.
Experts say that U.S. taxpayers often start a foreign company for genuine business reasons, but because they are unaware of the complex CFC and subpart F rules, they end up making costly mistakes in either the ownership or the operations—or both—of the foreign corporation.
3. What reporting would you need to do? If you have a business in a foreign country, in addition to the subpart F rules, you would attract certain reporting requirements.
i. Form 5471
You must file Form 5471 if you are a U.S. resident, green card holder or citizen, and if:
- You are an officer or director and own 10 percent or more of the stock in a foreign corporation in the current year (Category 2)
- You are not necessarily an officer or director, but you acquire stock in a foreign corporation in the current year to own 10 percent or more during the year (Category 3)
- You dispose of stock in a foreign corporation in the current year to bring your shareholding to 10 percent or less (Category 3)
- You own more than 50 percent of the vote or value of all shares in a foreign corporation (Category 4)
- You own an interest in a Controlled Foreign Corporation (Category 5)
ii. Form TD F 90-22.1—Foreign Bank Account Report (FBAR)
You must file the FBAR paperwork if you are a U.S. resident, green card holder or citizen, and have either financial interest or signature authority over a bank account overseas. For instance, if a U.S. person owns more than 50 percent of a foreign Pvt. Ltd., then that person must file an FBAR because he or she has a financial interest in the bank accounts maintained by that foreign Pvt. Ltd.
iii. Form 926
If a U.S. taxpayer invests or transfers at least $100,000 to a foreign company, that taxpayer must file Form 926 in the year he or she makes the transfer or acquires 10 percent of the stock in a foreign corporation.
The Subpart F rules can be complicated, and the purpose of this article is to bring your attention to only some of the rules. Do conduct a thorough study of the rules depending on your client’s needs.