4.61.7 Controlled Foreign Corporations

Manual Transmittal

October 08, 2019

Purpose

(1) This transmits revised IRM 4.61.7, International Program Audit Guidelines, Controlled Foreign Corporations.

Material Changes

(1) Rewrote IRM 4.61.7.1 to conform to new requirement to include internal control information at the beginning of the IRM.

(2) This transmittal updates procedures to reflect updated tax law per the Tax Cuts and Jobs Act (TCJA) (P.L. 115-97). The following subsections were updated or added for TCJA changes:

IRM Section Title
4.61.7.2 Controlled Foreign Corporations (CFC) Subpart F
4.61.7.4 Identification and Qualifications of CFCs and U.S. Shareholders
4.61.7.5 Identification Qualification and Guidelines
4.61.7.6.1 Amounts Included Under IRC 951(a)
4.61.7.6.2 Subpart F Income in IRC 952 Defined
4.61.7.7.1 Exclusion of U.S. Source Effectively Connected Income
4.61.7.7.2 Limitation as to Earnings and Profits
4.61.7.8 Certain Prior Year Deficit
4.61.7.16 Foreign Based Company Income
4.61.7.21 Global Intangible Low-Taxed Income (GILTI)
4.61.7.39 Special Rules for Foreign Tax Credit
4.61.7.39.1 Foreign Tax Credit Guidelines

(3) The following subsections were removed and subsequent subsections were renumbered:

IRM Section Title
4.61.7.27 Foreign Base Company Shipping Income Defined
4.61.7.28 Foreign Base Company Shipping Income Exclusion and Special Rules
4.61.7.29 Foreign Base Company Shipping Income Guidelines
4.61.7.30 Foreign Base Company Oil Related Income Defined
4.61.7.31 Foreign Base Company Oil Related Income Exclusions
4.61.7.32 Foreign Base Company Oil Related Income Special Rules

(4) These procedures have also been updated to include organizational and editorial changes.

Effect on Other Documents

This IRM supersedes IRM 4.61.7, Controlled Foreign Corporations, dated May 1, 2006.

Audience

Large Business & International (LB&I), Small Business & Self Employed (SB/SE)

Effective Date

(10-08-2019)

John E. Hinding
Director, Cross-Border Activities (CBA) Practice Area
Large Business and International Division

Program Scope and Objectives

  1. Purpose: This IRM provides guidance and technical information in international audit techniques involving controlled foreign corporations (CFC).

  2. Audience: The primary users of this IRM are LB&I and SB/SE examiners.

  3. Policy Owner: Director, CBA Practice Area, LB&I.

  4. Program Owner: The CBA Practice Network manages and administers technical policy matters.

  5. Primary Stakeholders: IRS examiners in LB&I and SB/SE.

Authority

  1. See IRM 4.46.1.1.2, LB&I Examination Process, General Information and Definitions, Authority.

Responsibilities

  1. LB&I and SB/SE examiners are responsible for following the guidelines provided in this IRM.

Program Controls

  1. The effectiveness of the subject matter presented in this IRM section is dependent on the monitoring of tax law developments, the technical expertise of the subject matter experts who have responsibility for authoring this section, and obtaining feedback from the field on best practices for audit techniques. To that end, the controls developed to monitor this IRM and program include periodic updates to this section as mandated by LB&I’s Internal Management Documents (IMD) program, making updates to the section in response to tax law changes, asking a team of subject matter experts from the practice networks and exam function to review existing language, asking experts to draft updates to the section, and allowing impacted stakeholders to review and comment on the section through the document clearance process.

Acronyms

  1. The following table contains commonly used acronyms:

    Abbreviation Definition
    ADS Alternative Depreciation System
    CBA Cross Border Activities
    CFC Controlled Foreign Corporation
    DFIC Deferred Foreign Income Corporation
    EPDFC Earnings and Profits Deficit Foreign Corporation
    FPHCI Foreign Personal Holding Company Income
    GILTI Global Intangible Low-Taxed Income
    IMD Internal Management Documents
    IRC Internal Revenue Code
    LB&I Large Business & International
    PTEP Previously Taxed Earnings & Profits
    QBAI Qualified Business Asset Investment
    SB/SE Small Business Self Employed
    SFC Specified Foreign Corporation

Controlled Foreign Corporations (CFC) Subpart F

  1. The taxation of foreign income earned by foreign corporations owned by U.S. persons drastically changed with the introduction of subpart F into the Internal Revenue Code (IRC) in 1962. Subpart F deals with the U.S. taxation of amounts earned by CFCs. It provides that certain types of income of CFCs, though undistributed, must be included in the gross income of the U.S. shareholder in the year the income is earned by the CFC. Taxation of foreign income earned by CFCs also significantly changed with the passage of TCJA in late 2017. Certain previously deferred earnings were immediately taxable under the IRC 965 transition tax, and going forward, a new taxation subpart F regime was established for global intangible low-taxed income (GILTI) and a dividends received deduction for foreign source dividends were enacted.

  2. The rules contained in subpart F are to be applied after the income of the CFC has been adjusted to conform to U.S. income tax concepts.

  3. It is essential that the relationships between CFCs and domestic entities be at arm’s length. Any allocations of income and deductions between the CFC and its related organizations under IRC 482 are made before the application of the provisions of subpart F. For a discussion of IRC 482 see IRM 4.61.3 Development of IRC 482 cases.

  4. The provisions of subpart F contain many general rules, special rules, definitions, exceptions, exclusions, and limitations that require careful consideration.

Preliminary Information Needed

  1. The first step in beginning any examination should be to become familiar with the scope and mode of the taxpayer’s operations (e.g., the products and entities involved, etc.). The following information and documents should be secured to meet this objective.

    1. Obtain consolidated financial statements (if available) showing balance sheets and operating results of all related and foreign entities.

    2. Obtain certified (or other) statements of the individual foreign entities. (remember that the regulations provide for English translations or the services of a qualified interpreter where the books or records are not maintained in English).

    3. Obtain a statement from the taxpayer characterizing the operations of the various related foreign entities.

    4. Obtain corporate books (including the minutes of corporate meetings) of the domestic taxpayer and of the related foreign entities if available;

    5. Obtain original Form 1120 and/or Form 1120-F, or copies thereof, if such returns were filed for any related foreign entity.

    6. Obtain copies of all foreign tax returns filed by related foreign entities in which the taxpayer is a U.S. shareholder.

    7. Obtain or prepare organizational charts showing the relationship of all domestic and foreign entities(including stock ownership percentages).

    8. Ask for a briefing on changes in accounting procedures designed to meet the requirements relating to IRC 951(if possible, this should be done at the first meeting with the U.S. shareholder or his representative).

    9. Examine copies of existing company publications, manuals, instructions, or correspondence that set forth procedures dealing with foreign income reporting.

    10. Obtain and examine the original Forms 5471, or copies thereof, if such returns were filed.

  2. Subpart F contains many relief provisions. The early stages of the examination should be devoted to determining the applicability of subpart F and their exclusions, etc. starting with those most easily verified. Audit steps requiring detailed documentation and extensive analysis should be pursued only after determining that the more apparent relief provisions are not applicable.

Identification and Qualifications of CFCs and U.S. Shareholders

  1. U.S. Shareholder Defined A U.S. shareholder is a U.S. person (defined in IRC 957(c)) who owns directly, indirectly, or constructively 10 percent or more of the total combined voting power of stock entitled to vote or 10 percent or more of the total value of all classes of stock entitled to vote in a foreign corporation. IRC 958(a) provides rules for determining direct and indirect stock ownership of a corporation. IRC 958(b) provides that the constructive ownership rules of IRC 318(a) apply to the extent that the effect is to treat a U.S. person as a U.S. shareholder or a foreign corporation as a CFC. For tax years ending on or before December 31, 2017 IRC 958(b)(4) turned off “downward attribution” which prevented a U.S. person from being treated as owning stock that is owned by a Non-U.S. person. In December, 2017 IRC 958(b)(4) was repealed. As a result, for tax years beginning on or after January 1, 2018 the “downward attribution” under IRC 318(a)(3) does apply to treat U.S. persons as owning the stock of Non-U.S. persons which will have the effect of creating U.S. shareholders and, in turn, CFCs that were not treated as such in prior years.

  2. Controlled Foreign Corporation Defined A controlled foreign corporation is any foreign corporation in which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned directly, indirectly, or constructively by U.S. shareholders on any day during the taxable year of such foreign corporation or more than 50% of the total value of the stock is owned directly, indirectly or constructively by U.S. shareholders on any day during the taxable year of the corporation.

  3. Note there are special rules for determining whether a foreign corporation is a CFC for purposes of IRC 953(a) (insurance income).

  4. Note there are special rules for determining whether a foreign corporation is a specified foreign corporation (SFC) for purposes of IRC 965, which increases the subpart F income of a deferred foreign income corporation (DFIC), a type of SFC, for its last taxable year beginning before January 1, 2018 by the greater of certain of its post-1986 earnings and profits as of November 2, 2017 or December 31, 2017. Under these rules, SFCs include all CFCs and certain other foreign corporations.

Identification Qualification and Guidelines

  1. The following information should be reviewed and analyzed:

    1. Determine if Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, and income statements plus balance sheets have been filed indicating the existence of a CFC;

    2. Analyze U.S. taxpayers’ investments and stock records to detect ownership in foreign corporations;

    3. Determine direct, indirect, and constructive ownership of voting power or value of stock in any foreign corporations;

    4. Determine who is in actual control of the foreign corporation if the U.S. shareholders appear to be in the minority;

    5. Examine income and expense accounts on the U.S. taxpayer’s books if there is no investment account. Items that might suggest a foreign investment could include foreign source income, foreign legal fees, foreign travel expenses, foreign tax paid, and any other types of expenses suggesting foreign activity;

    6. The CFC’s stock record books may show ownership of a subsidiary. By applying the indirect ownership rules, a subsidiary of the CFC, if ownership is sufficient, may be considered a CFC;

    7. If the taxpayer owns 10 percent or more of a foreign corporation, an analysis of the records may indicate the existence of other U.S. shareholders. Analysis might disclose other owners of the stock that constructively or indirectly might qualify the foreign corporation as a CFC;

    8. If the taxpayer has adopted a new accounting period verify that the conditions of IRC 898, the proposed regulations thereunder, and Rev. Proc. 2002-39, Rev. Proc. 2006-45 (as modified by Rev. Proc. 2007-64), and Rev. Proc. 2018-17 are satisfied;

    9. In certain instances a taxpayer may seek CFC treatment for its foreign corporation. Review the corporate documents and related agreements to verify that U.S. shareholders own more than 50 percent of the voting power or value of the CFC. See Framatone Connectors USA Inc. v. Comm'r, 118 T.C. 32 (2002).

  2. After reviewing the above data, it may be possible to eliminate certain U.S. shareholders and foreign entities from consideration with respect to non-CFCs; entities that are not CFCs at any time during the taxable year; or shareholders of foreign investment companies where an election under IRC 1247(a) is in effect. See IRC 951(c).

Determination of Amounts to be Included in Income General Rule

  1. If the taxpayer is a U.S. shareholder under IRC 951(b) and owns stock directly or indirectly in the CFC under IRC 958(a), and if the foreign corporation in question is a CFC then further analysis may be necessary to determine the taxability under IRC 951(a) and IRC 951A.

Amounts Included Under IRC 951(a)

  1. Subpart F Income (IRC 952)

  2. The amount determined under IRC 956

  3. In addition to the amounts defined as subpart F income in IRC 952, listed in IRM 4.61.7.6.2 below, subpart F income includes IRC 965(a) inclusion amounts, which are determined taking into account certain post-1986 earnings and profits of a DFIC reduced by certain deficits in post-1986 earnings and profits of E&P deficit foreign corporations (EPDFC).

Subpart F Income in IRC 952 Defined

  1. Insurance income as defined in IRC 953.

  2. Foreign base company income as defined in IRC 954 consisting of:

    1. Foreign personal holding company income (FPHCI)

    2. Foreign base company sales income

    3. Foreign base company services income

  3. Income as determined under IRC 952(a)(3) (amounts subject to the international boycott rules of IRC 999).

  4. Illegal bribes, kickbacks, or other payments unlawful under the Foreign Corrupt Practices Act of 1977.

  5. Income derived from any foreign country when IRC 901(j) applies to such country.

Exceptions to the General Rule

  1. Before further considering the "includible" amounts, the following exclusions, limitations, etc. should be noted and kept in mind during an examination. The examining agent can conserve audit time by recognizing the applicability of these limitations early in the examination. Additional discussions of certain of these items appear later in the guidelines.

Exclusion of U.S. Source Effectively Connected Income

  1. Subpart F income does not include any item includible in the CFC’s gross income as income from sources within the United States that is effectively connected with the conduct by the CFC of a trade or business in the U.S., unless the income is exempt from tax (or subject to a reduced rate of tax) pursuant to a treaty obligation of the U.S. IRC 952(b) . For purposes of determining exclusions of U.S. income under IRC 952(b), any exemption (or reduction) with respect to the tax imposed by IRC 884 will not be taken into account.

  2. Post-1986 earnings and profits attributable to effectively connected income or previously taxed earnings and profits are generally excluded for purposes of determining whether an SFC is a DFIC for purposes of IRC 965. However, post-1986 earnings and profits attributable to effectively connected income or previously taxed earnings and profits are not excluded for purposes of determining whether an SFC is an EPDFC.

Limitation as to Earnings and Profits

  1. Subpart F income includible in gross income by a U.S. shareholder for any taxable year may not exceed the CFC's earning and profits for the taxable year. IRC 962(c)(1)(A) and IRC 951A(c)(2)(B)(ii).

  2. In the computation of earnings and profits determine that earnings and profits are reported according to U.S. standards. See IRC 964(a) and the regulations thereunder. However, for purposes of IRC 952(c), earnings and profits will be determined without regard to IRC 312(n)(4), IRC 312(n)(5), and IRC 312(n)(6) (the preceding clause will not apply to the extent it would increase earnings and profits by an amount which was previously distributed by the CFC).

  3. The limitation described in IRM 4.61.7.9(1) does not apply to amounts of post-1986 earnings and profits included in subpart F income with respect to a DFIC. For purposes of IRC 965, an SFC’s post-1986 earnings and profits are earnings and profits accumulated in taxable years beginning after December 31, 1986, but only taking into account periods during which the foreign corporation was an SFC and without diminution by reason of dividends distributed during the inclusion year other than dividends distributed to another SFC.

Certain Prior Year Deficit

  1. The amount of subpart F income included in the U.S. shareholder’s gross income may be reduced by his pro rata share of the CFC’s prior year qualified deficits. IRC 952(c)(1)(B).

    1. A qualified deficit is post-1986 deficit in earnings and profits that is attributable to the same qualified activity as the activity giving rise to the income to be offset and which has not previously been taken into account. See IRC 952(c)(1)(B)(ii).

    2. A qualified activity is any activity giving rise to 1) foreign base company sales income, 2) foreign base company services income, 3) in the case of a qualified insurance company, insurance income or foreign personal holding company income or 4) in the case of a qualified financial institution, foreign personal holding company income. See IRC 952(c)(1)(B)(iii).

  2. For purposes of IRC 965, an EPDFC is, with respect to any taxpayer, a SFC with respect to which the taxpayer is a U.S. shareholder, if, as of November 2, 2017, the SFC has a deficit in post-1986 earnings and profits. For purposes of determining whether a SFC is an EPDFC, all post-1986 earnings and profits must be taken into account.

Certain Deficits of Chain Members

  1. A CFC may elect to reduce the amount of subpart F income attributable to a qualified activity by a current year qualified deficit of a qualified chain member. IRC 952(c)(1)(C) .

Manufacturing Operations

  1. If the CFC is strictly a manufacturing operation, (without a sales, purchasing or manufacturing branch in another jurisdiction) then no further steps as to that entity need to be taken. However, other related CFCs that purchase from a manufacturing CFC could have subpart F income. If the CFC has a branch operation, it is possible that there could be subpart F income. Refer to the "branch rule" in Treas. Reg. §1.954–3(b).

  2. Income of the CFC from the sale of goods manufactured in its country of incorporation by anyone is not subpart F income.

Currency and Other Restrictions

  1. No part of the earnings and profits of a CFC for any taxable year is included in earnings and profits for purposes of IRC 952, or IRC 956 if such part could not have been distributed by the CFC to U.S. shareholders because of currency or other restrictions or limitations imposed under the laws of any foreign country. Treas. Reg. §1.964–2 sets forth definitions, exceptions, and limitations that should be reviewed before an exception is permitted under this provision.

De Minimis Rule and Full Inclusion Test

  1. IRC 954(b)(3)(A) provides a de minimis 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. Under the full inclusion rule of IRC 954(b)(3)(B) if more than 70 percent of the CFC’s gross income is foreign base company income and insurance income then all of the CFC’s gross income will be treated as foreign base company income or insurance income.

De Minimis Rule and Full Inclusion Test Audit Steps

  1. Verify the taxpayer’s determination of gross income for the application of the de minimis test. Be alert to attempts to reduce foreign base company income to qualify for a de minimis exception.

  2. Determine that the de minimis test is applied separately to each CFC.

  3. Check that when computing gross foreign base company income for the de minimis test, that there are no reductions for dividends, interest, or deductions allocable to foreign base company income.

  4. Determine that gross income is computed based on U.S. accounting and tax standards.

  5. Determine whether, for purposes of applying the de minimis test, the anti-abuse rule of Treas. Reg.§1.954–1(b)(4) applies to aggregate the income of two or more CFCs.

Foreign Base Company Income

  1. Foreign base company income consists of:

    • Foreign personal holding company income

    • Foreign base company sales income

    • Foreign base company services income

  2. Remember, IRC 954(b)(5) requires that such income will be reduced by taking into account deductions (including taxes) properly allocable to such income.

Foreign Base Company Income Audit Steps

  1. When examining the accuracy of foreign base company income, the following actions should be taken:

    1. Inspect CFC operating statements to ascertain the amounts and general nature of income reported.

    2. Discuss the general pattern of foreign operations with the taxpayer or representative.

    3. Determine the type of activity, physical facilities, number of employees in the foreign country, products, processes, major suppliers, and material customers.

    4. Analyze the nature and type of income reported by each CFC to determine the correctness of the reported subpart F income (or to ascertain the existence of subpart F income where none is reported). This analysis should include the origin and destination of the products and services that produce the CFC’s income.

Foreign Personal Holding Company Income

  1. FPHCI consists of the following items:

    • Dividends, interest, rents royalties, and annuities

    • Net gains from the sale and exchange of certain properties (including gains from the sale or other disposition of any interest in a partnership or trust)

    • Net gains from commodities transactions

    • Net currency gains from nonfunctional transactions

    • Income equivalent to interest

    • Income from notional principal contracts

    • Payments in lieu of dividends

  2. The following items are excluded from FPHCI:

    1. Dividends: From corporations that are related persons organized in the same country with a substantial part of assets (more than 50 percent) used in its trade or business in the same country. (Treas. Reg. §1.954-2(b)(4)).

    2. Interest: from corporations that are related persons organized in the same country with a substantial part of assets (more than 50 percent) used in its trade or business in the same country (Treas. Reg. §1.954-2(b)(4)), and from export financing interest derived in the conduct of a banking business (IRC 954(c)(2)(B)).

    3. Rents: From unrelated persons in ordinary conduct of business (IRC 954(c)(2)(A)), from related persons for property in country of organization (IRC 954(c)(3)(A)(ii))

    4. Royalties: From unrelated persons in active conduct of a trade or business of the CFC (IRC 954(c)(2)(A)), from related persons for property used in the country of organization (IRC 954(c)(3)(A)(ii)).

    5. Gains: From the sale or exchange of inventory, dealer property, property that gives rise to active rent or royalty income, property that gives rise to income from the active conduct of a financing or insurance business, and property that was used in the CFC's trade or business, from commodities transactions that are from the sale of commodities In the active conduct of commodities business or from bona fide hedging transactions with respect to such sales; from currency gains and losses directly related to the business needs of the CFC (IRC 954(c)(2)(C) and Treas. Reg. §1.954-2(f)(1)(ii)).

    6. Income derived from the active conduct of a banking, financing or similar business (see IRC 954(h)).

    7. Income derived in the active conduct of an insurance business (IRC 954(i)).

Foreign Personal Holding Company Income Audit Steps

  1. The CFC records should set forth the basic inclusions in FPHCI even though exclusions are involved. The examining agent should determine the extent of ownership of the various foreign or domestic stocks to ascertain if the CFC owns most of other foreign corporations. Determine if its interests along with other stockholders, suggest that any of these foreign corporations are CFCs by indirect or constructive ownership by the U.S. person or perhaps another U.S. person. If investments are in U.S. assets, this fact could indicate possible income under IRC 951(a)(1)(B) and IRC 956 due to an increase in earnings invested in U.S. property.:

  2. The examiner should be aware that any passive income received by the CFC claimed under IRC 954(c)(2) and IRC 954(c)(3) as excluded from subpart F should be checked against the CFC’s records to determine that the income does qualify for the exclusion as required by the regulations. To qualify for exclusion, the answer must be a "yes" to the following questions:

    • If rents or royalties are excluded from this type income, did they come from the active conduct of a trade or business conducted with unrelated persons?

    • If dividends, interests, rents, or royalties came from related persons, did the relationship qualify for exclusion under IRC 954(c)(3)and IRC 954(d)(4))?

    • Was the export financing interest derived from the conduct of a banking business under IRC 954(c)(2)(B)?

    • If the CFC is a regular dealer in property described in IRC 954(c)(1)(B), forward contracts, option contracts or similar financial instruments, does the income otherwise satisfy the requirements of IRC 954(c)(2)(C)?

Foreign Base Company Sales Income

  1. Foreign base company sales income is income derived from the sale or purchase of personal property with a related person where the property which is purchased (or sold) is manufactured outside the country of incorporation and the property is sold for use (or purchased for use) outside such foreign country. (IRC 954(d)(1)). Foreign base company sales income can arise in the following types of transactions:

    1. The purchase of personal property from a related person and its sale to any person

    2. The sale of personal property to any person on behalf of a related person

    3. The purchase of personal property from any person and its sale to a related person

    4. The purchase of personal property from any person on behalf of a related person

Foreign Base Company Sales Income Audit Steps

  1. Analyze gross income figures to ensure that proper costs are deducted from the gross receipts figures.

    1. Ascertain that the costs are limited to the cost figures according to U.S. tax accounting concepts.

    2. Determine if, in arriving at the cost of goods sold for subpart F income sales, the taxpayer was consistent in the method of computation so the de minimis and full inclusions tests are not distorted.

    3. Be aware that purchases or sales may be made for a related person with a commission paid to the CFC. The commission paid could be subpart F income. The commission could come from the unrelated third party.

Special Rule for Certain Branch Income

  1. A CFC may carry on procurement, manufacturing, or distribution activities through branches in countries other than the CFC’s country of organization. In some situations the use of a branch has substantially the same tax effect as if the branch were a separate corporation. In that case, the branch is treated as a separate corporation and the income attributable to carrying on activities through the branch is foreign base company sales income. IRC 954(d)(2) .

  2. For instance, a CFC may establish a selling branch in another country to escape a 50 percent tax on manufacturing and sales income in the CFC country of organization. The branch country may only tax sales income at 10 percent. The tax advantage would occur only in situations where the CFC country does not tax the branch income. The branch rule in Treas. Reg. §1.954–3(b)(1) requires that under such conditions the branch must be treated as a separate corporation. The branch’s foreign base company income, if any, must be computed separately from the CFC home office income. In essence, the branch rule treats the branch as a wholly-owned subsidiary of the CFC and, if it is a selling branch, treats the branch as selling on behalf of the remainder of the CFC, or, if the branch is a manufacturing branch, treats the CFC as selling on behalf of the branch.

Branch Guidelines

  1. Determine the extent to which a CFC operates through branches outside the country of organization of the CFC. This can be accomplished by an examination of financial statements and by discussion with appropriate shareholders or officers.

  2. Review the relevant foreign tax law to learn the advantages of such branch operations.

  3. Determine whether a branch should be treated as a separate corporation by comparing effective tax rates and applying the 90 percent, 5 percentage point tests set forth in the Regulations. (Treas. Reg. §1.954-3(b)(1)(i)(b) and 3(b)(1)(ii)(b).

  4. Review the manner in which branch income and expenses are segregated from amounts applicable to the home office or other branches. Consider reallocation if appropriate and material.

Property Manufactured, Produced, Grown, or Extracted

  1. Foreign base company sales income does not include income derived from property manufactured, produced, grown, or extracted in the CFC’s country of incorporation. The regulations provide detailed guidelines for making this determination. (Treas. Reg. §1.954–3(a)(2).) Before pursuing this area, the examining agent should contact the Practice Network technical specialist who handles the subpart F area for guidance.

Determination of Country of Use, Consumption, or Disposition Guidelines

  1. The regulations contain rules for making this determination. The ultimate destination of the personal property producing the income is of prime importance. (Treas. Reg. §1.954–3(a)(3).)

  2. Check sales to determine the ultimate destination of the goods. A sale to a third party within the country of manufacture could be questionable if the third party exports the good.

Foreign Base Company Services Income

  1. Foreign base company services income is income derived in connection with the performance of:

    • Technical

    • Managerial

    • Engineering

    • Architectural

    • Scientific

    • Skilled

    • Industrial

    • Commercial

    or "like services" for or on behalf of any related person outside the country under the laws of which the CFC is created or organized.

  2. Foreign base company services income also includes services performed by a CFC in a case where substantial assistance contributing to the performance of such services has been furnished by a related person. Treas. Reg. §1.954–4(b)(1)(iv) and (b)(2)(ii).

  3. Exclusions from foreign base company services income are provided for services that are directly related to:

    1. The sale or exchange by the CFC of property manufactured, produced, grown, or extracted by it that are performed before the time of the sale or exchange, or

    2. An offer or effort to sell or exchange such property.

Foreign Base Company Services Audit Steps

  1. Ascertain whether the services are performed outside the country of incorporation of the CFC for, or on behalf of, a related corporation and to what extent.

    1. Separate tests must be made to determine the subpart F income if the CFC is both a selling and service organization.

    2. Generally, services will be considered performed where the persons performing the services are physically located at the time services are rendered. (See Treas. Reg. §1.954-4(c)).

    3. The regulations require an allocation when the services are performed partially within and partially without the foreign corporation’s country under the same contract or arrangement. [(See Treas. Reg §1.954–4(c)].

    4. Analyze service contracts performed for, or on behalf of, the related person contract by contract. Income from services performed within the country of incorporation of the CFC is not subpart F income. Income from services performed outside the country of incorporation is subpart F income. The term "on behalf" , for example, means the service could be performed for an unrelated party who had purchased a machine from a related party. This service income could still be subpart F income. [See Treas. Reg §1.954–4(b)].

Global Intangible Low-Taxed Income (GILTI)

  1. IRC 951A(a) requires a U.S. shareholder of a CFC to include GILTI in its taxable income each year. The amount included in taxable income for the tax year is called the GILTI inclusion.

  2. The GILTI inclusion with respect to any U.S. shareholder is the excess of:

    1. Net CFC tested income, over;

    2. Net deemed tangible income return, where net deemed tangible income return is defined as 10% of the aggregate pro rata share of qualified business asset investment (QBAI) less specified interest expense.

    .

  3. Net CFC tested income refers to the excess of the aggregate U.S. shareholder’s pro-rata share of tested income from all its CFCs over the U.S. shareholder’s pro-rata share of tested loss from all its CFCs.

  4. Tested income equals the excess of gross tested income over allocable deductions. A CFC has tested income if its gross tested income exceeds the deductions properly allocable to that income. A CFC’s tested gross income is the CFC’s gross income excluding the following items:

    • U.S. source income effectively connected with the conduct by the CFC of a trade or business in the United States (also known as effectively connected income or ECI);

    • Gross income taken into account in determining its subpart F income;

    • Gross income excluded from the CFC’s FBCI and insurance income by reason of the high-tax exception in IRC 954(b)(4);

    • Dividends received from a related person; and

    • Foreign oil and gas extraction income.

    The rules for determining the deductions properly allocable to a CFC’s gross tested income are similar to the rules for determining deductions properly allocable to foreign base company income under IRC 954(b)(5).

  5. If the CFC’s allocable deductions equal or exceed its gross tested income, the CFC has a tested loss.

  6. If a CFC has tested income for the tax year, the CFC is a "tested income CFC" whereas if it has a tested loss for the year, the CFC is a "tested loss CFC." In any given year, a CFC is either a "tested income CFC" or a "tested loss CFC" but not both.

  7. QBAI is the average of a tested income CFC’s aggregate adjusted bases as of the close of each quarter of the CFC’s year in specified tangible property that is used in a trade or business of the tested income CFC, and is property to which a depreciation deduction is allowable under IRC 167.

    1. Specified tangible property is tangible property used in the production of tested income;

    2. If specified tangible property is used to produce both tested income and income other than tested income (dual-use property), a proportionate amount of property is treated as specified tangible property;

    3. The adjusted basis is generally determined using the alternative depreciation system ("ADS" ) under IRC 168(g) and allocating the depreciation deduction ratably to each day during the taxable year.

  8. Specified interest expense generally refers to the aggregate of the U.S. shareholder’s pro rata share of each CFC’s tested interest expense less the aggregate of the shareholder’s pro rata share of each CFC’s tested interest income. Tested interest expense is the interest expense that is in the properly allocable deductions to gross tested income. Tested interest income is interest income that is in the gross tested income.

  9. A corporate taxpayer can generally claim a foreign tax credit for foreign income taxes deemed paid with the GILTI inclusion:

    1. The foreign income taxes deemed paid equals 80 percent of the product of the U.S. shareholder’s inclusion percentage, multiplied by the aggregate tested foreign income taxes paid or accrued by the CFCs.

    2. The inclusion percentage is the U.S. shareholder’s GILTI inclusion divided by the U.S. shareholder’s pro rata share of the aggregate tested income of the CFCs (unreduced by tested losses).

    3. Only foreign income taxes paid or accrued by the CFC that are attributable to the CFC's tested income taken into account by the U.S. shareholder are eligible for the deemed paid credit.

    4. For purposes of computing the foreign tax credit limitation under IRC 904, there is a separate limitation applicable for foreign taxes associated with GILTI.

    5. Under IRC 78, the U.S. shareholder is required to include an amount in its taxable income equal to the foreign income taxes deemed paid on the GILTI inclusion as if such amount had not been limited by 80 percent.

Final Determination of Includible Subpart F Income

  1. After the amount of the U.S. shareholder’s subpart F income has been determined, reference should again be made to the exceptions, exclusions, etc. as listed earlier. In addition, the following factors should be considered at this point.

    1. The income to be imputed to the U.S. shareholder is net of all deductions attributable to the income. Deductions must be allocated or apportioned to each item or category of income under Treas. Reg. §1.954–1(c).

    2. IRC 959 is designed to prevent previously taxed earnings and profits from being taxed again, when the earnings are distributed to another CFC in a chain of ownership or when the earnings are distributed to the U.S. shareholders of the CFC. "Previously taxed earnings and profits (PTEP)" generally include amounts previously included in income for U.S. federal income tax purposes.

Increase in Earnings in U.S. Property

  1. In general a U.S. shareholder is taxed on his pro rata share of the CFC’s increase in earnings invested in U.S. property.

  2. The amount determined under IRC 956 is the lesser of:

    1. The excess of such shareholder's pro rata share of the average of the amounts of U.S. property held by the CFC as of the close of each quarter over the amount of earnings and profits previously included in the U.S. shareholders gross income as a IRC 956 amount (or that would have been included but for IRC 956 ), or

    2. The shareholder’s pro rata share of the applicable earnings of the CFC.

  3. Applicable earnings is the sum of current and accumulated earnings and profits reduced by distributions during the year and previously taxed IRC 956 amounts under IRC 959(c)(1) .

  4. In general, the source of CFC earnings and profits considered invested in U.S. property for IRC 956 purposes is immaterial. For example, earnings and profits derived from manufacturing activities would be subject to this provision.

  5. The amount determined under IRC 956 with respect to a U.S. shareholder for a taxable year of a CFC is reduced to the extent that the U.S. shareholder would be allowed a deduction under IRC 245A if the U.S. shareholder had received a distribution from the CFC.

U.S. Property Defined

  1. U.S. property means any property acquired after December 31, 1962 that is:

    1. Tangible property located in the United States

    2. Stock of a domestic corporation

    3. Any obligation of a U.S. person, including any obligation that the CFC is deemed to hold by reason of its being a pledger or guarantor of such obligation

    4. Any right to the use in the United States of a patent, copyright, invention, model, design, secret formula or process, or any other similar right, which is acquired or developed by the CFC for use in the United States

Exceptions to U.S. Property Definition

  1. Exceptions from the definition of U.S. property include:

    1. Obligations of the U.S. government, money or deposits with persons carrying on a banking business in the United States

    2. Property located in the United States purchased in the United States for export to, or use in, foreign countries

    3. Any obligation of a U.S. person arising in connection with the sale or processing of property. The amount of these obligations cannot exceed the amount that would be ordinary and necessary to carry on a trade or business with unrelated parties

    4. Any aircraft, railroad rolling stock, vessel, motor vehicle, or container used in the transportation of persons or property in foreign commerce and used predominantly outside the United States

    5. Certain insurance reserves

    6. Stocks and obligations of certain domestic corporations. The acquired stock or obligations may not be in a domestic corporation that is a U.S. shareholder of the CFC. The acquired stock or obligations may not be in a corporation in which immediately after the acquisition a U.S. shareholder of the CFC owns 25 percent or more of the total combined voting power of the domestic corporation,

    7. Any movable property (other than a vessel or aircraft) used for exploring, developing, removing, or transporting resources from ocean waters or under such waters when used on the U.S. continental shelf

    8. An amount of assets of the CFC equal to the earnings and profits accumulated after December 31, 1962 excluded from subpart F income under IRC 952(b)

    9. Deposits of cash or securities in the ordinary course of a person's business as a dealer in securities or in commodities, but only to the extent such deposits are made or received as collateral or margin for certain financial transactions

    10. An obligation of a U.S. person to the extent the principal amount of the obligation does not exceed the fair market value of readily marketable securities sold or purchases pursuant to a sale or repurchase agreement or received as collateral for the obligation in the ordinary course of its business by a dealer in securities or commodities

    11. Certain trade or service receivables acquired from related U.S. persons (IRC 956(c)(3))

Earnings Invested in U.S. Property Limitation For Tax Years Prior to 1993

  1. For taxable years of a CFC beginning before September 30, 1993, a U.S. shareholder’s pro rata share of the increase for any taxable year in the earnings of a CFC invested in U.S. property is the amount determined by subtracting the amount of investment for the close of the preceding taxable year (reduced by amounts paid to which IRC 959(c)(1) applies) from the amount of investment for the close of the taxable year. To determine the amount of the increase, see the chart in Rev. Rul. 74-436, 1974-2. C.B. 214.

  2. The amount of a CFC’s earnings invested in U.S. property at the close of any taxable year is the total amount of such property held, directly or indirectly, as of that date, to the extent this amount would have been a dividend if it had been distributed on that date.

Investment in U.S. Property Guidelines

  1. Where a U.S. shareholder has reduced the basis of property of the CFC by the amount of a liability under IRC 956(a)(1) or excluded property by reason of IRC 956(c)(2), ascertain that the required statement is attached to the return. See Treas. Reg. §1.956–1(e)(4) and §1.956–2(b)(2). To determine basis:

    1. Under IRC 956 the basis of property is the adjusted basis on the applicable determination date reduced by depreciation and/or any liability specifically chargeable to it, such as a mortgage. See IRC 956(a) and Treas. Reg. §1.956-1(e)(1) and (e)(3).

    2. Be alert that a specific charge or liability was not created for the purpose of artificially increasing or decreasing the investment in U.S. property. See Treas. Reg. §1.956–1(e)(1) and (e)(3).

    3. Treas. Reg. §1.956–1(e)(1) states that a liability in excess of the adjusted basis of the property subject to a liability will not be taken into account for reducing the adjusted basis of another property that is not subject to a liability.

    4. An obligation of a U.S. person to which a CFC is a pledger or guarantor under certain conditions is considered U.S. property. See Treas. Reg. §1.956–2(c).

    5. Receivables due from U.S. persons may constitute investments in U.S. property, if acquired directly or indirectly from a related U.S. person. See Treas. Reg. §1.956-3.

    6. An obligation of a U.S. person has specific definition. It does not include certain indebtedness arising out of involuntary conversions of property that is not U.S. property or any obligation arising in connection with the provision of services by the CFC to the U.S. person if the amount of the obligation doesn’t exceed the amount that is ordinary and necessary. The regulation provides a 60-day safe harbor. See Treas. Reg. §1.956–2(d)(2)(B).

    7. Be aware that certain financing arrangements are permitted. See the special rules contained in Treas. Reg. §1.956–2(c)(2) and (c)(4).

Earnings and Profits

  1. The earnings and profits of a CFC will be computed substantially as if such corporation were a domestic corporation. The accounting principles and standards used in foreign countries may vary greatly from those used in the United States. The amounts reported in financial statements of the foreign companies must be recomputed to clearly reflect income based on U.S. tax accounting principles and methods. See IRC 964 and the regulations thereunder. The proper determination of earnings and property is vital in the examination of a CFC.

  2. Earnings and profits calculations are required to determine a U.S. shareholder’s subpart F income, foreign tax credits and investments in U.S. property.

  3. The audit of a given year may give rise to the determination of correct earnings and profits at different times.

Earnings and Profits Audit Steps

  1. Determine that the proper books and records were used to compute the profit and loss statement from which the determination of earnings and profits was calculated.

    1. Determine that the earnings and profits have not been reduced by amounts included in gross income of U.S. shareholders under IRC 951(a) .

    2. Review the written statement constituting the elections made by the CFC shareholders. Ascertain whether there have been any subsequent modifications or revocations as to these elections.

    3. Determine if the proper adjustments have been made to reflect U.S. accounting standards. For example: determine if accounting practices tend to clearly reflect income, scrutinize asset accounts from time of acquisition and determine method of asset acquisition to ascertain that when the assets are reflected at cost, it is historical cost. See Treas. Reg. §1.964–1 (b)(2) for the definition of historical costs. Verify that historical cost is the basis for depreciation, depletion, or amortization, be alert to undervalued assets or overvalued liabilities that may be allowed under foreign law, scrutinize profit and loss statements for unallowable deductions, scrutinize balance sheets for arbitrary reserves and determine how they were established. Inspect income and expense accounts to verify that income and expenses have not been equalized over two or more accounting periods. For post 1986 tax years, confirm that earnings and profits are maintained in the CFC's functional currency (determined under IRC 985 and the regulations under that section). See Treas. Reg. §1.964-1(a)(2).

    4. Determine if the proper adjustments have been made to reflect U.S. tax standards such as, method of accounting provisions under IRC 446; inventories under IRC 471 and IRC 472; depreciation under IRC 167; compensation plans under IRC 404A; and elections made under other applicable provisions of the Code.

    5. Determine that the controlling U.S. shareholders of a CFC have complied with all the requirements for an election, adoption or change of an accounting method or period. Where the controlling U.S. shareholder is included in a U.S. consolidated return with its U.S. parent, elections, adoptions or changes of an accounting method or period must be made by the U.S. parent. Remember timely filed statements are required by the regulations. All other known U.S. shareholders must be notified with respect to any action taken.

Exclusion of Previously Taxed Earnings and Profits

  1. The purpose of IRC 959 is to avoid double taxation that could occur when amounts that have been previously included in the gross income of U.S. shareholders under IRC 951 are actually distributed to such shareholders.

  2. IRC 959 provides that for any taxable year, earnings and profits of a foreign corporation attributable to amounts included in gross income of a U.S. shareholder under IRC 951 will not again be included in gross income of such shareholders when distributed. In addition, amounts included in gross income of a U.S. shareholder will not be included in gross income of a foreign corporation when such amounts are distributed through a chain of ownership.

  3. See IRC 986(c) for calculation of exchange gain or loss on a distribution of previously taxed earnings and profits.

Adjustments to Basis of Stock Guidelines

  1. Basis of stock should be:

    1. Increased by the amount of the undistributed IRC 951(a) income in the U.S. shareholder’s tax return, and

    2. Decreased by a distribution previously taxed as IRC 951(a) income.

Special Rules for Foreign Tax Credit

  1. U.S. tax on subpart F income or GILTI inclusions may generally be reduced by foreign income taxes deemed paid with respect such subpart F income or GILTI inclusions. As discussed above, under IRC 78, the U.S. shareholder generally must include as taxable income an amount equal to the deemed paid foreign taxes.

  2. U.S. shareholders generally may credit foreign taxes directly paid or accrued on distributions of previously taxed earnings and profits. U.S. shareholders may generally also credit some foreign taxes that are deemed paid with distributions of previously taxed earnings and profits. Such foreign taxes must have been imposed on an upper-tier CFC upon receipt of a distribution of previously taxed earnings and profits from a lower-tier CFC. There are some restrictions on the amount and type of foreign tax credit. For example, a U.S. shareholder may not credit all foreign taxes imposed on distributions of previously taxed earnings and profits related to IRC 965. If the U.S. shareholder has no foreign source income in the year of receipt of a distribution of previously taxed earnings and profits, IRC 960(c)allows an increase to the foreign tax credit limitation in certain circumstances.

  3. No deductions are allowed with respect to foreign taxes paid or accrued on previously taxed earnings and profits if the U.S. shareholder chose to credit foreign taxes in the year of the subpart F income or GILTI inclusion.

  4. No credit is allowed under IRC 901 for the applicable percentage (as defined in Treas. Reg. §1.965-5(d)) of any foreign income taxes paid or accrued (or treated as paid or accrued) with respect to any amount for which a deduction is allowed under IRC 965(c).

Foreign Tax Credit Audit Steps

  1. If the taxpayer claims a deduction for foreign taxes paid or accrued on the amount excluded under IRC 959 because it was previously included under IRC 951A, check the Federal income tax return of the year of the GILTI inclusion to verify that no foreign tax credit was claimed

  2. With respect to the increase under IRC 960(c)(1) in the limitation under IRC 904(a) verify that:

    1. The amount of the IRC 904 limitation attributable to the subpart F income or GILTI inclusions.

    2. The amount of foreign taxes allowed as credit because of such inclusions.

    3. The increase or decrease in limitation for intervening years.

    4. That the increase in limitation does not exceed the taxes paid, accrued, or deemed paid for such taxable year on the amount to be excluded under IRC 959.

    Note:

    Note that if the increase in limitation under IRC 960(c)(1) and Treas. Reg. §1.960–4 for a taxable year of exclusion exceeds the tax (before any credits against tax) imposed by Code Chapter 1, such excess will be considered an overpayment of tax. The tax is refundable or creditable according to Code Chapter 65 (IRC 6401 and following). See Treas. Reg §1.960-6.

General Rules and Record Keeping Requirements of U.S. Shareholders

  1. Treas. Reg. §1.964–3 describes the record keeping requirements of the U.S. shareholder. The regulations specifically require that a U.S. shareholder will, within a reasonable time after demand by the director of field operations/area director, give the director of field operations/area director:

    1. Such permanent books of account or records as are sufficient to satisfy the requirements of IRC 6001 and IRC 964(c) or true copies thereof, as are reasonably demanded,

    2. If such books and records are not maintained in the English language either an accurate English translation of such books and records or the services of a qualified interpreter satisfactory to the director of field operations/area director.

  2. The requirements of IRC 6001 and IRC 964(c) will be considered satisfied if the books or records produced are sufficient to verify for the taxable year:

    1. The subpart F income (and exclusions therefrom) of the CFC

    2. The increase in earnings invested by such corporation in U.S. property

Special Rules and Recordkeeping Requirements of U.S. Shareholders

  1. Treas. Reg. §1.964–3(c) provides special rules that state that verification of the subpart F income of the CFC for the taxable year is not required if either:

    1. It can be shown to the satisfaction of the director of field operations that the locus and the nature of such corporation’s activities make it unlikely that the foreign base company income of such corporation exceeded 5 percent of its gross income for the taxable year, or

    2. If certain conditions are met for certain insurance companies.

  2. Remember that the burden of demonstrating that these conditions exist is upon the taxpayers. If they cannot carry this burden, then the general rules apply.

  3. The special rules refer solely to relief from maintaining records to verify subpart F income of the CFC. The taxpayer must still maintain records to verify the increase in investments in U.S. property by the CFC.

  4. Examiners should recognize that submission of the required records can be extremely burdensome upon taxpayers if requested indiscriminately. Examiners should carefully consider such requests. Request only records most pertinent to each particular situation.

  5. If the taxpayer has not maintained adequate records, the taxpayer should be advised of the nature of the inadequacies and the requirements of the regulations.

  6. Exhibits IRM 4.61.2-1 and IRM 4.61.2–2 provide guidelines for obtaining information, books, and records of U.S. and foreign entities.