A Controlled Foreign Corporation (CFC) is a critical designation under U.S. tax law used to identify foreign companies substantially owned by U.S. shareholders. Specifically, a CFC is any non-U.S. corporation where U.S. persons owning 10% or more of the voting stock collectively hold more than 50% of the corporation’s voting power or value. This tax classification is designed to prevent U.S. taxpayers from indefinitely deferring tax by placing income in foreign entities.

Background and Purpose of CFC Rules

The CFC rules originated with the Revenue Act of 1962, introduced to combat widespread tax avoidance through offshore subsidiaries. Prior to this, U.S. taxpayers could defer U.S. tax on foreign earnings simply by leaving profits in low-tax countries. The government responded by creating “Subpart F income” rules, requiring current U.S. taxation on certain passive or easily movable income earned by CFCs, even if the money remains offshore.

The rules have evolved, notably with the Tax Cuts and Jobs Act (TCJA) of 2017, which introduced Global Intangible Low-Taxed Income (GILTI). GILTI expands the scope of income subject to immediate U.S. taxation to broadly include active income earned in low-tax jurisdictions.

How the IRS Defines a CFC

  • Ownership Test: A foreign corporation is a CFC if U.S. shareholders (each holding at least 10%) own more than 50% of the corporation’s voting power or value.
  • U.S. Shareholder: This includes U.S. persons such as individuals, corporations, partnerships, trusts, or estates.

Taxation of CFC Income

The CFC rules require U.S. shareholders to include in their income their pro rata share of certain CFC earnings, even if these earnings are not distributed as dividends:

  • Subpart F Income: Includes passive income such as interest, dividends, rents, royalties, and certain income from related-party transactions. It is taxed currently to prevent tax deferral.
  • GILTI: A more recent category under the TCJA covering intangible income and active income in low-tax countries. U.S. corporate shareholders must generally include GILTI in their taxable income but can use deductions and foreign tax credits to reduce the burden.

Reporting and Compliance

U.S. shareholders of a CFC are obligated to file Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations,” with their tax returns each year. This form requires detailed disclosures about the CFC’s income, expenses, and ownership. Failure to file can result in severe penalties.

Learn more about Form 5471 and related international tax compliance topics on FinHelp.

Examples

1. U.S. Owners of an Irish Tech Startup: If three U.S. individuals collectively own over 50% of an Irish company’s voting stock, it is a CFC. Their share of the company’s passive income such as royalties or investment returns may be taxable in the U.S. annually.

2. U.S. Company Owning Mexican Manufacturing Subsidiary: If a U.S. corporation owns over 50% of a Mexican subsidiary, the subsidiary is a CFC. Income from passive investments or related-party sales may be currently taxable, though active manufacturing income generally is not subject to immediate U.S. tax.

Who Must Comply?

The rules affect any U.S. person owning at least 10% of a foreign corporation, where combined U.S. ownership exceeds 50%. It applies across sizes—from small investor groups to multinational corporations.

Common Misunderstandings

  • Not all foreign corporations are CFCs; only those meeting the U.S. ownership test.
  • U.S. tax applies to certain incomes even if earnings remain overseas, contrary to the belief that offshore profits are tax-free until repatriated.
  • Reporting responsibilities, including Form 5471, apply regardless of income size, with penalties for non-compliance.

FAQs

Q: Do I always pay U.S. tax on all income from a CFC?
A: No, taxation generally applies only to specified types of income, primarily Subpart F and GILTI. Active business income in high-tax countries might be exempt from immediate U.S. tax.

Q: What if I own less than 10% of a foreign company?
A: If ownership is under 10%, you generally are not a “U.S. shareholder” for CFC rules, so Subpart F and GILTI inclusion typically do not apply. But other foreign asset reporting rules may still be relevant.

Q: Can I avoid CFC status?
A: Avoiding CFC status usually means ensuring U.S. ownership stays below 50%. Legitimate business operations often focus on managing tax implications through planning, not just avoidance.

For detailed IRS guidance, see IRS.gov – Controlled Foreign Corporations.

This explanation aims to clarify Controlled Foreign Corporation rules, helping U.S. shareholders understand their tax responsibilities and compliance requirements related to foreign business ownership.