Controlled Foreign Corporation  Tax Strategies By Vernon K. Jacobs, CPA  & J. Richard Duke, J.D., LLM

Many years ago, it was legal for U.S. persons to invest in foreign corporations which in turn invested in various U.S. securities and debt obligations on a tax free basis. When the stock of the foreign corporation was sold, the gain was treated as a capital gain - usually eligible for preferred tax treatment.

That's no longer true - even though many promoters of offshore tax schemes will tell you it is. Here's a very brief summary of what is true - today.

A U.S. person who invests in the stock of a foreign corporation that is engaged in a trade or business outside the U.S. is subject to most of the same basic tax rules as investors in domestic corporation stocks. If that foreign corporation does business in the U.S. it will be subject to tax on its U.S. source income. The U.S. investor is not required to file any special tax reports regarding the foreign corporation unless the corporation is

• a "controlled foreign corporation" that is controlled by "U.S. shareholders" or
• a passive foreign investment company or
• a foreign personal holding company..

If more than 50% of the foreign corporation stock is owned (directly or indirectly) by U.S. persons who each own at least 10% of the stock, then the corporation will be a controlled foreign corporation. Those shareholders who own 10% or more of the stock are required to file Form 5471 each year with their tax return. If the foreign corporation has any "sub-part F income", the U.S. shareholders who own 10% or more of the stock will be required to include that income in their personal tax return even though it is not distributed by the corporation. The simplest explanation of "sub-part F income" is that it includes passive investment income and certain types of income derived from buying or selling goods or services to or from a related U.S. person or entity.

Those promoters who advocate the creation of a foreign corporation as a way to avoid taxes on investment income are either ignorant of the U.S. tax rules relating to controlled foreign corporations or they are scoundrels who are not concerned about the problems they may be creating for U.S. persons.

If a foreign grantor trust or partnership is a 10% or greater shareholder of a controlled foreign corporation, then the grantor of the trust or the partners will be treated as shareholders of the foreign corporation in proportion to their beneficial interest or owwnership interest.

An international business company (IBC) is a corporation formed in a non U.S. country that is usually exempt from tax in the country where it is formed -- but it may not conduct any business in that country. For U.S. tax purposes, an IBC is treated the same as a foreign corporation. U.S. persons who form and own a foreign corporation or an IBC may elect to be treated as a partnership or as a corporation by filing Form 8832 within the prescribed period of time. A single owner IBC may elect to be taxed as a corporation or as a disregarded entity.  Certain types of foreign corporations are not eligible to make this election.

A foreign limited liability company (LLC) will be treated as a foreign corporation unless the members (owners) make an election on Forrm 8832 to be treated as a foreign partnership (multiple owners) or foreign disregarded entity (single owner) within 75 days after forming the foreign LLC.

If a foreign corporation receives more than 25% of its gross income from passive investment sources (interest, dividends, capital gains), it will be deemed to be a passive foreign investment company (PFIC) and the U.S. shareholders are required to pay current taxes on their share of the investment company income or to pay a penalty for the deferral of tax. A Form 8621 must be filed by any U.S. shareholder of a passive foreign investment company. There is no minimum percentage of ownership with respect to foreign investment companies as there is with controlled foreign corporations.  However, if the foreign corporation is also a CFC, then the 10% or greater shareholders will be taxed under the CFC rules rather than under the PFIC fules.

This is a very brief and non-technical summary of the key tax rules applicable to the ownership of stock of a foreign corporation by U.S. persons. A 170+ page book on this subject is available from Offshore Press, Inc.  For details see http://www.offshorepress.com/cfc-ibc-tax.htm