- 4.61.7 Controlled Foreign Corporations
- 184.108.40.206 Controlled Foreign Corporations (CFC) Subpart F
- 220.127.116.11 Preliminary Information Needed
- 18.104.22.168 Identification and Qualifications of CFCs and U.S. Shareholders
- 22.214.171.124 Identification Qualification and Guidelines
- 126.96.36.199 Determination of Amounts to be Included in Income General Rule
- 188.8.131.52 Exceptions to the General Rule
- 184.108.40.206 Exclusion of U.S. Source Effectively Connected Income
- 220.127.116.11 Limitation as to Earnings and Profits
- 18.104.22.168 Certain Prior Year Deficit
- 22.214.171.124 Certain Deficits of Chain Members
- 126.96.36.199 Manufacturing Operations
- 188.8.131.52 Currency and Other Restrictions
- 184.108.40.206 De Minimus Rule and Full Inclusion Test
- 220.127.116.11 De Minimis Rule and Full Inclusion Test Guidelines
- 18.104.22.168 Foreign Base Company Income Defined
- 22.214.171.124 Foreign Base Company Income Guidelines
- 126.96.36.199 Foreign Personal Holding Company Income Defined
- 188.8.131.52 Foreign Personal Holding Company Income Guidelines
- 184.108.40.206 Foreign Base Company Sales Income Defined
- 220.127.116.11 Foreign Base Company Sales Income Guidelines
- 18.104.22.168 Special Rule for Certain Branch Income
- 22.214.171.124 Branch Guidelines
- 126.96.36.199 Property Manufactured, Produced, Grown, or Extracted
- 188.8.131.52 Determination of Country of Use, Consumption, or Guidelines
- 184.108.40.206 Foreign Base Company Services Income Defined
- 220.127.116.11 Foreign Base Company Services Guidelines
- 18.104.22.168 Foreign Base Company Shipping Income Defined
- 22.214.171.124 Foreign Base Shipping Income Exclusion and Special Rules
- 126.96.36.199 Foreign Base Company Shipping Income Guidelines
- 188.8.131.52 Foreign Base Company Oil Related Income Defined
- 184.108.40.206 Foreign Base Company Oil Related Income Exclusions
- 220.127.116.11 Foreign Base Company Oil Related Income Special Rules
- 18.104.22.168 Final Determination of Includible Subpart F Income
- 22.214.171.124 Increase in Earnings in U.S. Property
- 126.96.36.199 U.S. Property Defined
- 188.8.131.52 Exceptions to U.S. Property Definition
- 184.108.40.206 Earnings Invested in U.S. Property Limitation For Tax Years Priorto 1993
- 220.127.116.11 Investment in U.S. Property Guidelines
- 18.104.22.168 Earnings and Profits
- 22.214.171.124 Earnings and Profits Guidelines
- 126.96.36.199 Exclusion of Previously Taxed Earnings and Profits
- 188.8.131.52 Adjustments to Basis of Stock Guidelines
- 184.108.40.206 Special Rules for Foreign Tax Credit
- 220.127.116.11 Foreign Tax Credit Guidelines
- 18.104.22.168 General Rules and Record Keeping Requirements of U.S. Shareholders
- 22.214.171.124 Special Rules and Record Keeping Requirements of U.S.Sharedholders
Part 4. Examining Process
Chapter 61. International Program Audit Guidelines
Section 7. Controlled Foreign Corporations
The taxation of foreign income earned by U.S. controlled foreign corporation drastically changed with the introduction of Subpart F into the Internal Revenue Code in 1962. Subpart F deals with the U.S. taxation of amounts earned by controlled foreign corporations (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.
It is important to note that the Subpart F sections of the Code take precedence over the foreign personal holding company sections. Further, the rules contained in Subpart Fare to be applied after the income of the CFC has been adjusted to conform to U.S. income tax concepts.
Under certain circumstances, current earnings of a CFC may be deferred from U.S. tax if not actually distributed to the U.S. shareholder. Since domestic entities are currently taxed, 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 section 482 take precedence over the application of the provisions of Subpart F.
The provisions of Subpart F contain many general rules, special rules, definitions, exceptions, exclusions, and limitations that require careful consideration.
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.
Obtain consolidated financial statements (if available) showing balance sheets and operating results of all related and foreign entities;
Obtain certified (or other) statements of the individual foreign entities. (Remember, the regulations provide for English translations or the services of a qualified interpreter where the books or records are not maintained in English.);
Obtain a statement from the taxpayer characterizing the operations of the various related foreign entities;
Obtain corporate books (including the minutes of corporate meetings) of the domestic taxpayer and of the related foreign entities if available;
Obtain original Form 1120 and/or Form 1120–F, or copies thereof, if such returns were filed for any related foreign entity;
Obtain copies of all foreign tax returns filed by related foreign entities in which the taxpayer is a U.S. shareholder;
Obtain or prepare organizational charts showing the relationship of all domestic and foreign entities. . Be sure stock ownership percentages are included;
Ask for a briefing on changes in accounting procedures designed to meet the requirements relating to IRC section 951. If possible, this should be done at the first meeting with the U.S. shareholder or his representative;
Examine copies of existing company publications, manuals, instructions, or correspondence that set forth procedures dealing with foreign income reporting.
Obtain and examine the original Forms 5471, or copies thereof, if such returns were filed.
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 analyzes should be pursued only after determining that the more apparent relief provisions are not applicable.
U.S. Shareholder Defined . A U.S. shareholder is a U.S person (defined in IRC section 957(c)) who owns directly, indirectly, or constructively 10 percent or more of the total combined voting power of all classes of stock entitled to vote in a foreign corporation.
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.
Note there are special rules for determining whether a foreign corporation is a CFC for purposes of IRC section 953(a) (insurance income).
Check the Foreign Information Systems (FIS) Tables for names and stock ownership of U.S. shareholders.
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;
Analyze U.S. taxpayers’ investments and stock records to detect ownership in foreign corporations;
Determine direct, indirect, and constructive ownership of voting power of stock in any foreign corporations. It is important to note that the ownership rules for defining a U.S. shareholder relate to voting power of stock. IEs should be alert to attempts to shift formal voting power to avoid qualification. See Regs. 1.951–1(g)(2) and 1.957–1(b)(2) and the examples thereunder for illustrations. For purposes of determining whether the foreign corporation is a CFC determine the value of stock, including whether any shares have different rights resulting in different values, and ownership of value of stock.
Determine who is in actual control of the foreign corporation if the U.S. shareholders appear to be in the minority;
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;
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;
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;
If the taxpayer has adopted a new accounting period verify the conditions of IRC 898, the proposed regulations thereunder and Rev. Proc. 2002-37 and 2002-39 are satisfied.
In certain instances a taxpayer may seek CFC treatment for its foreign corporation, review the corporate documents and related agreements to verify that the United States shareholder has more than 50 percent of the voting power of the CFC. See Framatone Connectors USA Inc. v. Comm'r, 118 T.C. 32 (2002).
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 for an uninterrupted period of 30 days or more during the taxable year; or shareholders of foreign investment companies where an election under IRC section 1247(a) is in effect. See IRC section 951(c).
If the taxpayer qualifies as a U.S. shareholder under IRC section 951(b) and owns stock directly or indirectly in the CFC under Section 958(a), and if the foreign corporation in question is a CFC for the requisite period, then further analysis may be necessary to determine the taxability under IRC section 951(a).
Subpart F Income (IRC section 952) See 126.96.36.199.2 below,
Previously excluded subpart F income withdrawn from investment in less developed countries as defined in IRC section 955,
Previously excluded subpart F income withdrawn from investment in shipping operations as defined in IRC section 955,
The amount determined under IRC section 956
Insurance income as defined in section 953.
Foreign base company income (IRC section 954) consisting of:
Foreign personal holding company Income,
Foreign base company sales Income,
Foreign base company services Income,
Foreign base company shipping income, and
Foreign base company oil related income.
Income as determined under IRC section 952(a)(3) (amounts subject to the International Boycott rules of IRC section 999).
Illegal bribes, kickbacks, or other payments unlawful under the Foreign corrupt Practices Act of 1977.
Income derived from any foreign country when IRC section 901(j) applies to such country.
Before further considering the " includible" amounts, the following exclusions, limitations, etc. should be noted and kept in mind during an examination. The IE 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.
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 on business or 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. Section 952(b). For purposes of determining exclusions of United States income under IRC section 952(b), any exemption (or reduction) with respect to the tax imposed by IRC section 884 will not be taken into account.
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 section 962(c)(1)(A).
In the computation of earnings and profits determine that earnings and profits are reported according to U.S. standards. See IRC section 964(a) and the regulations thereunder. However, for purposes of IRC section 952(c), earnings and profits will be determined without regard to IRC section 312(n)(4), (5), or (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).
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 section 952(c)(1)(B).
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. . IRC section 952(c)(1)(B)(ii).
A qualified activity is any activity giving rise to: 1) foreign base company shipping income, 2) foreign base company oil related income, 3) foreign base company sales income, 4) foreign base company services income, 5) in the case of a qualified insurance company, insurance income or foreign personal holding company income or 6) in the case of a qualified financial institution, foreign personal holding company income.
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 section 952(c)(1)(C).
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 Reg. 1.954–3(b).
Income of the CFC from the sale of goods manufactured in its country of incorporation by anyone is not subpart F income.
No part of the earnings and profits of a CFC for any taxable year is included in earnings and profits for purposes of IRC section 952, IRC section 955, or IRC section 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. Reg. 1.964–2 sets forth definitions, exceptions, and limitations that should be reviewed before an exception is permitted under this provision.
IRC section 954(b)(3)(A) provides 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. Under the full inclusion rule of IRC section 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.
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.
Determine that the de minimis test is applied separately to each CFC.
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.
Determine that gross income is computed based on U.S. accounting and tax standards.
Determine whether, for purposes of applying the de minimis test, the anti-abuse rule of Reg. 1.954–1(b)(4) applies to aggregate the income of two or more CFCs.
Foreign base company income consists of:
Foreign personal holding company income
Foreign base company sales income
Foreign base company services income
Foreign base company shipping income
Foreign base company oil related income.
Remember, IRC section 954(b)(5) requires that such income will be reduced by taking into account deductions (including taxes) properly allocable to such income.
Inspect CFC operating statements to ascertain the amounts and general nature of income reported.
Discuss the general pattern of foreign operations with the taxpayer or representative.
Determine the type of activity, physical facilities, number of employees in the foreign country, products, processes, major suppliers, and material customers.
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 (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
The following items are excluded from FPHCI:
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)),
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).
Rents: From unrelated persons in ordinary conduct of business (IRC section 954(c)(2)(A), from related persons for property in country of organization (IRC section 954(c)(3)(A)(ii)),.
Royalties: From unrelated persons in active conduct of a trade or business of the CFC (IRC section 954(c)(2)(A)), from related persons for property used in the country of organization (IRC section 954(c)(3)(A)(ii)),
Gains: From the sale on 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 section 954(c)(2)(C) and Treas. Reg. §1.954-2(f)(1)(ii).
Income derived from the active conduct of a banking, financing or similar business (see IRC section 954(h)),
Income derived in the active conduct of an insurance business (see IRC section 954(i)).
The CFC records should set forth the basic inclusions in FPHCI even though exclusions are involved. The IE 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 sections 951(a)(1)(B) and 956 due to an increase in earnings invested in U.S. property.
Be aware that any passive income received by the CFC claimed under IRC section 954(c)(2) and (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 section 954(c)(3) and (d)(4)? Was the export financing interest derived from the conduct of a banking business under 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 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 section 954(d)(1)). Foreign base company sales income can arise in the following types of transactions:
The purchase of personal property from a related person and its sale to any person;
The sale of personal property to any person on behalf of a related person;
The purchase of personal property from any person and its sale to a related person;
The purchase of personal property from any person on behalf of a related person.
Analyze gross income figures to ensure that proper costs are deducted from the gross receipts figures.
Ascertain that the costs are limited to the cost figures according to U.S. tax accounting concepts.
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.
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.
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 section 954(d)(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 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.
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.
Review the relevant foreign tax law to learn the advantages of such branch operations.
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).
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.
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. (See. Treas. Reg. §1.954–3(a)(2).) Before pursuing this area, the IE should contact the International Technical Advisor who handles the Subpart F area for guidance.
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).)
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 is income derived in connection with the performance of:
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.
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).
Exclusions from foreign base company services income are provided for services that are directly related to:
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
An offer or effort to sell or exchange such property.
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.
Separate tests must be made to determine the Subpart F income if the CFC is both a selling and service organization.
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)).
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 Regulation 1.954–4(c)].
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)].
The term foreign base company shipping income means:
Gross income derived from, or in connection with, the use (or hiring or leasing for use) of any aircraft or vessel in foreign commerce.
Gross income derived from, or in connection with, the performance of services directly related to the use of any aircraft or vessel in foreign commerce.
Gross income incidental to income described above.
Gross income derived from the sale, exchange, or other disposition of any aircraft or vessel used or held for use in foreign commerce.
Certain dividends, interest, and gains received from certain foreign corporation as described in Treas Reg. §1.954–6(f).
Income described in Treas. Reg. §1.954–6(g) relating to partnerships and trusts.
Exchange gain to the extent allocable to foreign base company shipping income (see Treas. Reg. §1.954-6(b)(1)(vii)).
Any income derived from space and ocean activity.
For purpose of the foreign base company shipping income rules, an aircraft or vessel is used in foreign commerce to the extent it is used in the transportation of property or passengers between a port (or airport) in U.S., or in a U.S. possession and a port (or airport) in a foreign country, or between a port (or airport) in a foreign country and another in the same foreign country or another foreign country (See Treas. Reg. §1.954-6(b)(3)). However, foreign base company shipping income, does not include income from the operation of a vessel between two points within the foreign country in which the CFC is created and/or organized and the aircraft or vessel used is registered. See IRC section 954(b)(7).
Income of a corporation that is foreign base company shipping income will not be considered as any other form of foreign base company income and if distributed through a chain of ownership as described in IRC Section 958(a), will not be included in foreign base company income of another CFC in that chain.
Ascertain if aircraft or vessel income and related service income have been properly determined.
Be aware that, although the 1986 Tax Reform Act repealed the exception for reinvested shipping income, the withdrawal of pre-1987 previously excluded investments in foreign base company shipping operations will be included in Subpart F income under IRC section 951(a)(1)(A)(iii). See Treas. Reg. §1.955A.
Remember that oil drilling ships, trawlers, and factory ships are not considered used in foreign commerce (see Treas Reg. §1.954-6(b)(3)). They are not considered as qualified investments in foreign base company shipping operations. See Regs. 1.955A–2(b)(2) and 1.9546(b)(3)(i).
Foreign base company oil related income is defined in IRC section 954(g) as foreign oil related income (within the meaning of IRC section 907(c)(2) and (c)(3)) with certain exclusions. Foreign oil related income is income from sources outside of the U.S. and its possessions from minerals extracted from oil and gas wells into their primary products and the processing, transportation, distribution and sales of such minerals or primary products, Also included is income from the sale or exchange of certain oil-relat ed assets and other amounts from the performance of any other related service.
The taxpayer's distributive share of partnership income to the extent it is attributable to foreign oil related income.
Exclusions are provided for income derived from a source within a foreign country in connection with:
Oil or gas extracted from a well located in such foreign country, and
Oil, gas, or a primary product of either that is sold by the CFC or a related person for use or consumption in such foreign country, or is loaded in such foreign country on a vessel or aircraft as fuel for such vessel or aircraft.
Special rules applicable only to foreign base company oil related income are as follows:
The term "foreign base company oil related income" applies only where the CFC qualifies as a " large oil producer" .
The IRC section 954(b)(4) high tax exception does not apply to foreign base company oil related income.
Under IRC section 954(b)(8) income that is foreign base company oil related income is not foreign base company sales income, and foreign base company services income.
Under IRC section 954(g)(1) foreign base company oil related income does not include any foreign personal holding company income as defined in section 954 (c).
After the amount of the U.S. shareholders 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.
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).
IRC section 959 is designed to prevent previously taxed earnings 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 United States shareholders of the CFC. "Previously taxed earnings" generally include amounts previously included in income for U.S. federal income tax purposes.
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.
The amount determined under section 956 isthe lesser of:
the excess of such share holder'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 that has previously been included in the U.S. shareholders gross income as a 956 amount (or that would have been included but for Section 956), or
The shareholders pro rata share of the applicable earnings of the CFC.
Applicable earnings is the sum of current and accumulated earnings & profits reduced by distributions during the year and previously taxed 956 amounts under IRC section 959(c)(1).
In general, the source of CFC income considered invested in U.S. property for section 956 purposes is immaterial. For example, income derived from manufacturing activities would be subject to this provision.
U.S. property means any property acquired after December 31, 1962 that is:
Tangible property located in the United States;
Stock of a domestic corporation;
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;
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 from the definition of U.S. property include:
Obligations of the U.S. government, money or deposits with persons carrying on a banking business in the United States,
Property located in the United States purchased in the United States for export to, or use in, foreign countries
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;
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;
Certain insurance reserves,
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,
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;
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 section 952(b),
Property held by a foreign sales corporation that would otherwise be U.S. property and related to the export activities of the FSC;
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,
An obligation of a US 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,
Certain trade or service receivables acquired from related U.S. persons. (IRC section 956(c)(3).
For taxable years of a CFC beginning before September 30, 1993, a U.S. shareholders 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 section 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.
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.
Where a U.S. shareholder has reduced the basis of property of the CFC by the amount of a liability or excluded property by reason of IRC section 954(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).
Under IRC section 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 section 956(a) and Treas. Reg. §1.956-1(e)(1) and (e)(3).
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).
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.
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).
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. §1.956-3T.
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. §1.956–2T(d)(2)(B).
Be aware that certain financing arrangements are permitted. See the special rules contained in Reg. 1.956–2(c)(2).Be aware that certain financing arrangements are permitted. See the special rules contained in Treas. Reg. §1.956–2(c)(2) and (c)(4).
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 section 964 and the regulations thereunder. The proper determination of earnings and property is vital in the examination of a CFC.
Earnings and profits calculations are required for Subpart F income attributable to a U.S. shareholder, computing foreign tax credits allowed to U.S. shareholders with respect to subpart F income, adjustments required for withdrawals of previously excluded subpart F income and investments in U.S. property.
The audit of a given year may give rise to the determination of correct earnings and profits at different time levels as follows; current taxable year, prior years beginning after December 31, 1962, for purposes of IRC section 955(a), any prior year beginning with the most recent and going back as far as February 28, 1913, for purposes of IRC section 956(a), post 1986 pool for computing deemed paid taxes with respect to IRC section 951 inclusions.
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.
Determine that the earnings and profits have not been reduced by amounts included in gross income of U.S. shareholders under IRC section 951(a).
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.
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 in accordance with the rules of Treas. Reg. §1.969–1T(g).
Determine if the proper adjustments have been made to reflect U.S. tax standards such as, method of accounting provisions under IRC section 446; Inventories under IRC section 471 and 472, depreciation under IRC section 167, compensation plans under IRC section 404A, and elections made under other applicable provisions of the Code.
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.
The purpose of IRC section 959 is to avoid double taxation that could occur when amounts that have been previously included in the gross income of a US shareholder under IRC section 951 are actually distributed to such shareholders.
IRC section 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 section 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.
See IRC section 986(c) for calculation of exchange gain or loss on a distribution of previously taxed earnings and profits.
Basis of stock should be:
Increased by the amount of the undistributed IRC section 951 (a) income in the U.S. shareholder’s tax return, and
Decreased by a distribution previously taxed as IRC section 951(a) income.
Income included in gross income under the provisions of Subpart F as a deemed dividend, is eligible for the indirect foreign tax credit. Credits so allowed will not be allowed again when actual distributions are made. In situations where foreign taxes are imposed at the time of actual distribution (a withholding tax), a foreign tax credit will be allowed, where otherwise allowable, even though the amounts distributed are not taxable because they were previously included in the U.S. shareholder’s income.
The workings of IRC section 960 with respect to the inclusion of subpart F income are generally similar to the workings of IRC sections 901 and 902 with respect to a dividend distribution from a foreign entity. The gross up provision of IRC section 78 similarly applies.
The receipt of the funds representing previously taxed earnings and profits for purposes of IRC section 951(a) does not produce additional indirect foreign tax credits, but may lead to an additional direct foreign tax credit or increase in limitation under IRC section 960(b). Under Treas. Reg. §1.960–4, the year in which the Subpart F income was reported will be called the "year of inclusion." The year in which the funds are received relative to the included income will be called the "year of exclusion."
If, in the year of exclusion, the taxpayer claims a deduction for foreign taxes paid on the amount excluded under IRC section 959(a)(1), check the Federal income tax return of the year of inclusion to verify that no foreign tax credit was claimed relative to the income included under IRC section 951(a).
With respect to the increase under IRC section 960(b)(1) in the limitation under IRC section 904(a) verify that:
the increase in the IRC section 904 limitation of the year of inclusion is correctly computed,
the amount of foreign taxes allowed as credit because of such increases in the year of inclusion is properly computed. The credit allowed may have exceeded the taxes deemed paid on the income included under IRC section 951(a),
the increase in limitation under this section for intervening years is properly computed,
the increase in limitation in the year of exclusion does not exceed the taxes paid, accrued, or deemed paid for such taxable year on the amount to be excluded under IRC section 959(a)(1).
Note that if the increase in limitation under IRC section 960(b)(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 section 6401 and following).
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 Area Director, give the Area Director:
Such permanent books of account or records as are sufficient to satisfy the requirements of IRC section 6001 and IRC section 964(c) or true copies thereof, as are reasonably demanded,
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.
The requirements of IRC section 6001 and IRC section 964(c) will be considered satisfied if the books or records produced are sufficient to verify for the taxable year:
The Subpart F income (and exclusions therefrom) of the CFC,
The previously excluded Subpart F income of such corporation withdrawn from qualified investment (IRC section 955),
The increase in earnings invested by such corporation in U.S. property.
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:
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
If certain conditions are met for certain insurance companies.
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.
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 previously excluded subpart F income, and the increase in investments in U.S. property by the CFC.
lEs should recognize that submission of the required records can be extremely burdensome upon taxpayers if requested indiscriminately. IEs should carefully consider such requests. Request only records most pertinent to each particular situation.
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.
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.