Know The Most Informative Basic Rules Of Subpart F Income for Expats

Subpart F – Why Was It Enacted

Subpart F was enacted in 1962 to prevent US. persons from using foreign corporations to defer U.S. tax on certain offshore income, including income from related-party sales and services as well as passive activities. These rules restrict the deferral of tax on foreign income for certain U.S. owners of “controlled foreign corporations” (“CFCs”). These anti-deferral rules are contained in subpart F of the Internal Revenue Code.

Subpart F is only one of a number of regimes enacted to respond to the tax avoidance opportunities provided by a tension between the U.S. tax rules of worldwide taxation and the separate tax status of corporations. Since the enactment of the first income tax laws, taxpayers have used corporations to avoid the general U.S. tax rule that subjects the worldwide income of U.S. persons to current taxation. Congress has repeatedly acted to restrict deferral when this tax avoidance has occurred.

Taxation of worldwide income leads taxpayers to search for deferral vehicles. While under U.S. tax law, deferral of income is specifically legislated into existence in some cases such as the exclusion of income contributed to and earned in retirement plans such as 401(k) plans and IRAs.

The foreign income of a foreign corporation generally is not subject to U.S. tax, even if the foreign corporation is organized by a U.S. taxpayer who would be subject to full U.S. taxation on foreign income earned by it directly. Thus, by organizing a foreign corporation, a taxpayer can, absent special exceptions, such as Subpart F defer U.S. taxation on foreign income until it is repatriated, for example, as a dividend. In this context, because of the “time value of money” advantage of postponing payments of tax that otherwise would be due currently, deferral allows the foreign income to be taxed at a lower effective rate than domestic income.

Basic Rules Of Subpart F Income

Subpart F applies to certain income of “controlled foreign corporations” (“CFCs”). A CFC is a foreign corporation more than 50% of which, by vote or value, is owned by U.S. persons owning a 10% or greater interest in the corporation by vote (“U.S. shareholders”). “U.S. persons” includes U.S. citizens, residents, corporations, partnerships, trusts and estates. If a CFC has subpart F income, each U.S. shareholder must currently include its pro rata share of that income in its gross income as a deemed dividend.

The Subpart F rules attempt to prevent the deferral of income, either from the United States or from the foreign country in which earned, into another jurisdiction which is a tax haven or which has a preferential tax regime for certain types of income. Thus, Subpart F generally targets passive income and income that is split off from the activities that produced the value in the goods or services generating the income. Conversely, Subpart F generally does not require current taxation of active business income except when the income is of a type that is easily deflected to a tax haven, such as shipping income, or income earned in certain transactions between related parties. In related party transactions, deflection of income is much easier because a unified group of corporations can direct the flow of income between entities in different jurisdictions.

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Tax Samaritan is a team of Enrolled Agents with over 25 years of experience focusing on US tax preparation and representation. We maintain this tax blog where all articles are written by Enrolled Agents. Our main objective is to educate US taxpayers on their tax responsibilities and the selection of a tax professional. Our articles are also designed to help taxpayers looking to self prepare, providing specific tips and pitfalls to avoid.

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Randall Brody is an enrolled agent, licensed by the US Department of the Treasury to represent taxpayers before the IRS for audits, collections and appeals. To attain the enrolled agent designation, candidates must demonstrate expertise in taxation, fulfill continuing education credits and adhere to a stringent code of ethics.

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