United States: Changes To C.F.C. Rules – More C.F.C.'s, More U.S. Shareholders, More Attribution, More Compliance

One of the principal revisions to U.S. tax law made by the Tax Cuts and Jobs Act ("T.C.J.A.") was a series of changes to the definition of the term Controlled Foreign Corporation ("C.F.C."). Some changes were prospective. Others were enacted retroactively as of the beginning of the 2017 tax year.

As a result, cross-border joint venture arrangements between U.S. and non-U.S. parties that contained economic and legal provisions designed to prevent the creation of a C.F.C. were unceremoniously deconstructed by the T.C.J.A., in some instances on a retroactive basis.

This article examines the T.C.J.A. changes that were made to C.F.C.'s and their "U.S. Shareholders." In so doing it discusses

• the conditions for a U.S. person¹ to be considered a U.S. Shareholder of a C.F.C.,
• the attribution rules applied to determine the ownership percentage of a U.S. person in a C.F.C. under prior law that remained unchanged, and
• the major changes introduced by the T.C.J.A. to the C.F.C. regime that expanded the scope of provisions in this respect.²

Generally, U.S. persons that are shareholders of foreign corporations pay U.S. tax on the earnings derived from corporate profits at the time a distribution is received. Within certain limits, shareholders may indefinitely defer their taxes by deferring distributions.

In comparison, U.S. persons that hold sufficient shares in a C.F.C. to be categorized as U.S. Shareholders are required to include in their taxable income their pro rata share of the C.F.C.'s Subpart F Income and taxable investments in "United States Property" on a current basis, without the requirement of a cash or property distribution.³

CHANGES TO THE C.F.C. PROVISIONS

Definition of C.F.C.

Under prior and current law, a C.F.C. is defined in the following terms: A C.F.C. is a foreign corporation from the viewpoint of the U.S. for which more than 50% of its authorized and outstanding shares, measured by total voting power or value, is owned by U.S. Shareholders, as defined.⁴

As demonstrated in Treas. Reg. §1.957-1(c), examples 8 and 9, preferred stock is counted for the purpose of determining whether a foreign corporation is a C.F.C., based on the test for value.

U.S. Shareholder Under the T.C.J.A. – Control by Vote or Value

Under pre-T.C.J.A. law, a U.S. Shareholder was defined as a U.S. person that owned shares of stock representing 10% or more of the total voting power of all stock of the foreign corporation.⁵ Thus, a U.S. person holding non-voting preferred shares representing 10% or more of the value of all shares of the foreign corporation was not treated as a U.S. Shareholder. That U.S. person could not be taken into account for purposes of determining whether a foreign corporation was a C.F.C., and if it was a C.F.C., it was not subject to U.S. tax under Subpart F.

The T.C.J.A. expanded the definition of a U.S. Shareholder to include a U.S. person that owns shares representing 10% or more of the value of all shares of the foreign corporation.⁶ As a result, U.S. person holding only non-voting preferred shares will now fall under the definition of a U.S. Shareholder.

To illustrate, assume that a U.S. person owns shares representing 5% of voting power of a foreign corporation and 3% of the value. Assume the same person owns non-voting preferred shares representing 8% of the total value of the stock of a foreign corporation. That U.S. person is not a U.S. Shareholder under prior law that looked only at voting power. However, under the T.C.J.A., it will be treated as a U.S. Shareholder because the total value of voting and non-voting shares held in the foreign corporation amounts to more than 11% of the value of all shares authorized and outstanding (value of voting shares equals 3% and value of non-voting shares equals 8%).

Footnotes

1 The term U.S. person encompasses U.S. citizens, green card holders, individuals meeting the substantial presence test, domestic partnerships, domestic corporations, estates subject to U.S. income tax and domestic trusts. Code §951(b) with reference to Code §957(c).

2 The T.C.J.A. also expanded the scope of the definition of U.S. Shareholders. According to Code §951(b), as amended by the T.C.J.A., the definition of a U.S. Shareholder applies "for purposes of this title," i.e., the Code (enacted by Congress in Title 26 of the United States Code (26 U.S.C.)) and not just the Subpart F rules as under prior law.

3 In the following, references to "Subpart F Income" are meant to include certain investments in the United States that are also subject to the anti-deferral rules under Subpart F of the Code. Also note in this context that applicability of the C.F.C. rules is expanded under the T.C.J.A. to new regimes such as taxation of global intangible low taxed income ("G.I.L.T.I.") and the transition tax under Code §965.

4 Code §957(a). Vote refers to the total combined voting power of all classes of stock. Code §957(a)(1).

5 Code §951(b) under the pre-T.C.J.A. law.

6 Code §951(b) as amended by the T.C.J.A.; Section 14214(a) of the T.C.J.A.

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