 Hello and welcome to this session. This is Professor Farhad. In this session, we would look at controlled foreign corporation and the subpart F income. This topic is covered in international accounting as well as international taxation. If you have not connected with me only then please do so. YouTube is where you would need to subscribe. I have 1500 plus accounting, auditing, finance and tax lectures. If you like my lectures, please like them, share them, put them in playlists, let the world know about them. If you're benefiting from my lectures, it means other people might benefit as well. So please share the wealth on my website. In addition to my lectures, I do have additional resources such as the PowerPoint slides, notes, multiple choice through false additional exercises, 2000 plus CPA questions. Please check out my website. Studypal.co is an artificial intelligence study by the platform that match you with someone who's studying for the CPA or CFA. If you're interested, please check them out. They're in 85 countries in 2800 city. Let's talk about controlled foreign corporation or CFC. What is the big idea behind this controlled foreign corporation? Well, it's a foreign. It's located outside the U.S. It's a corporation and somehow someone controls it. So what's the big idea? The big idea is before 1962 U.S. companies would set up a subsidiary in a tax haven country like the Cayman Island and the Cayman Island will record the sales to non-U.S. customers. The money comes into the Cayman Island and it's tax haven, it's tax at a low rate. Then the subsidiary would lend money to the parent company in the U.S. The money will transfer to the U.S., but it will be in form of loans rather than dividend. So simply put, the money will sit in the Cayman Island tax deferred. That's the idea. So Congress obviously figured this out in 1962. They decided to have what's called a new tax classification for corporations, which is controlled foreign corporation, CFC. The purpose was again, obviously to crack down on the use of tax haven by U.S. companies so you can avoid paying U.S. taxes. Now bear in mind, you cannot avoid paying taxes forever if you bring the money into the U.S. via dividend. Then you have to pay taxes, but also the Tax Cuts and Jobs Act changed that as well and just giving you a historical overview. So U.S. Congress created this controlled foreign corporation rules in 1962. So what is a controlled foreign corporation? Is any corporation in which U.S. shareholders hold more than 50% of the voting power or the fair market value of the stocks? Simply put, if they control the company more than 50%, then this is a foreign corporation, a CFC. A foreign controlled corporation. Now we have to understand how do we account for that 50%? So who is counted in the 50%? Are all shareholders counted in the 50%? Well, only those shareholders, it could be a corporation, individual, tax resident, they either directly or indirectly own 10% or more. So when we're counting, so if this individual owns 6%, this individual owns 12%, this individual owns 15%. Well, guess what? The six individual is not counted. This individual is counted 12%. This individual is counted 15%. So when we're counting toward the 50%, only the individuals or the entities, again, it doesn't have to be individuals. It could be a corporation. It could be a partnership. It could be a trust. But the point is, as the stockholders, they have to own more than 10% to be accounted in the aggregate up to 50%. So simply put, if you have a corporation that owns entirely by one shareholder and it's structured overseas, that's clearly a CFC. Why? Because it's one shareholder and one shareholder owns how many of the shares? Who 100%? That's more than 50%. So this rule is starting corporation owned by one or few US individuals. So you have maybe three people or four people. Each one owns 25%. For example, if we have a corporation with 100 individuals and each own 4%, then that's not a CPC. That's not a controlled foreign, not CPC controlled foreign corporation. That's not a controlled foreign corporation. So what if it's not a controlled foreign corporation? It means, if it is, if it's not, then it's good. If it's not, we don't have to worry about anything. But if it is, means you are a shareholder with 10% or more, this individual here in yellow and this individual in green, or more than taxed on certain income, whether they receive the cash or not. Then under those circumstances, those individuals that own more than 10%, if it's a controlled foreign corporation, whether certain income is taxed or not, whether they receive the money or not, it's taxed to them. It's basically like a tax, tax through entities like a partnership or an S corporation. Simply put, you cannot shelter that money because you are part of this controlled foreign company corporation and you own more than 50% as part of the, more than 10% as part of the 50% ownership. More about controlled foreign corporation. All majority foreign subsidiaries are controlled foreign corporations. Simply put, if a company outside the US, if it's, if the subsidiary of the US, it is a controlled foreign corporation. It's simply put, it's the majority of the owners will be, sometimes it's the parent company is the owner of that subsidiary and the parent company is a US citizen. Therefore, it's controlled foreign corporation. Okay. So generally speaking, the United States exempt from US taxation income, income earn, remember the subsidiaries. So if you, if you're operating as a subsidiary, remember what we talked about subsidiary? Well, as long as you don't bring the money to the US, you don't have to be taxed. Remember, if you are operating as a branch, then that's different. Remember, we talked about the branch versus the subsidiary. So if you're a subsidiary and again, most subsidiaries are CFCs. If you're a subsidiary, that's not a big deal. Okay. However, you don't have an exemption for the so-called subpart F income earned by this corporation. Now we need to talk about this subpart F income. So basically, if you are a subsidiary, you don't have to worry about anything unless you have this type of income. Now, what is this type of income? That's the question. Well, look at it this way. Subpart F income is taxed currently similar to foreign branch. What is foreign branch? Simply, if you have a foreign branch, it means you are, it's as, it's as if you are operating in the US. In subpart F income, it's as if you are operating in the US. Okay. So what is subpart F income? This is what we need to talk about next. So simply put, we're going to talk a little bit more about it. There's no easy, you know, one answer for it. It can be characterized as income with little or no economic connection with the F, with the foreign controlled country. So simply put, it's an income that can be easily shift, easily movable. It has no economic connection to that country. It can be moved to another country if need be. So you're moving it to a low tax jurisdiction just for the purpose of gaining a tax advantage. Not because there's economic benefit. There's not no economic sense. It just for tax purposes. So what are those typical type? Typically, what does those income include? It includes income derived from insurance of US risk like insurance income because you could move insurance income anywhere you want to. Income from countries engage in international boycott, certain illegal certain illegal payments. But the fourth category is what we're going to be focusing on because this is the most common. It's when you have income, foreign based company income. Okay. That's the most important category of support F income and includes the following. So we're going to focus on this. We don't really don't care about the other three, but the other three are if you saw them in a multiple choice questions, they are considered support F income. So if you have insurance income, that's a part income. If you if you're getting income from a country where it's being where we're boycotting that support income. If you receive a legal payment that support income, but we don't worry about this. So we need to worry about those FBC FBC income. What those FBC income have three types passive income FBC, which is kind of the foreign personal holding company like personal holding company in the US sales income. Or we call it FBC sales income or service income, which we call it FBC service income. Those are the three that we're going to be focusing on starting with the first one passive income. Well, hopefully, you know what passive income is passive income is when you're earning the money without doing anything. For example, if you have stocks, bonds, if you are have rental property. So this include interest. If you receive interest dividend, royalties rent, okay, capital gains from sales of assets, access of foreign gains over foreign currency losses other than the one that has to do with your business. Okay. So all of those are passive income and because they are passive income. They are under foreign based company income. That's part of subpart F. So if you receive any of those, then guess what? You cannot shelter that income. That's the point. Another type of income that you cannot shelter is foreign based company sales income. So what is that? Well, it's when the controlled foreign corporation or the control controlled foreign company makes sales outside its country of incorporation. Well, let's let's kind of look at an example. We have the USA here. USA and we have Ireland. Okay. So the US company created a subsidiary in Ireland, sub in Ireland. And guess what? This Irish company, all what they do is they sell to Germany. That's all. That's all what they do. So they sell to Germany. That's their income. So simply put, they make sales outside its country of incorporation. Well, if that's the case, then that's considered subpart F income. Simply put, it means it has to be taxed. Now it's not considered sales from a subsidiary. Okay. Now you might be asking, hold on a second. Why doesn't Apple then pay taxes in the US on that sales? Here's the thing with Apple. Yes. The Apple Inc. in the US, we have Apple Inc. in the US owns Apple subsidiary in Ireland. They own Apple subsidiaries in Ireland. So what's the problem? And most of the sales of the Irish sub is around for in other countries around the world. So why does the Irish sub, the Irish Apple sub does not pay taxes in the US? Here's why. Because the Irish sub, what happens is they own the intellectual property, the intellectual property of Apple. They own at least half of it. I don't know the amount that they own the intellectual property. Simply put, the Irish Apple subsidiary is getting their merchandise from China, getting their merchandise from China. Therefore, this relationship is basically broken because they're getting the merchandise from China because they own the intellectual property. Then they're selling it to Germany. So the sales income, the foreign-based company income, it's when the US company sells it to Ireland and Ireland sells it to Germany. So it's just like a conduit. That's not the case in Apple. And this is why, in case you're wondering why, how does Apple doesn't pay taxes on that foreign income? And it's not only Apple. Remember, I told you about Skype owned by Microsoft. They operate in Luxembourg as well as Google and all the other big companies. That's what they do. So simply put, it's income derived by the foreign corporation where the controlled foreign corporation has little connection with the process that generate the income and the related party is involved. Simply put, they're not participating in producing the item. And there is a related party involved. What does mean a red party? It means the parent company is selling them the assets. If the controlled foreign corporation earns income from the sale of property to customers outside of their country of incorporation. Again, think about the US and Ireland that don't think about Apple. And either the supplier or the customer is a related party. So let's assume now the US is a related party that subsidiary. This constitute foreign-based company sales. And foreign-based company sales usually involve three countries. The parent company in the main country selling the product to the subsidiary then the subsidiary selling the product to a third country. Simply put, a US parent manufactures a product that it sells it to its controlled foreign corporation in Hong Kong. In which it turns itself into a customer in Japan. So you have USA, we have Hong Kong and we have Japan. First we sell it to Hong Kong. Then Hong Kong sells the product to Japan. So the Hong Kong is not really selling it within Hong Kong. So Hong Kong is just a conduit. It's on the route. Therefore the sales made here, it can no longer be considered a sales by a subsidiary that's considered sub part of income. And it has to be taxed in the US now. Tax in the US now. Another example would be Ulysses Limited is a controlled foreign corporation organized in the UK and owned 100% by Joyce, a US company. So Joyce owned this company. Ulysses purchases finished inventory from Joyce and sell the inventory to a customer in Hong Kong. Simply put, we go a company in England that's owned by a US company. They buy the stuff from the US company and they sell it to Hong Kong. Well, guess what? This is a foreign-based company sales income. What does that mean? This is sub part F income. It means it's taxed now. It's taxed. The profit is taxed now. You cannot defer it. This is what we mean by that. There are some exceptions to the sub chapter or sub part, sub chapter F income. An exception applies to the property that is manufactured, produced or grown, or if it's extracted in the country in which the controlled foreign corporation was organized or created and to property sold for use, consumption, or disposition within that country. So if you're manufacturing the country, if you're manufacturing the product there, or if you're extracting the product there and it's being consumed there or being sold within that country, then that's an exception. Then it's no longer foreign-based company sales. In both of these situations, fewer than three countries are involved and the controlled foreign corporation has participated in the economic process. So the point is that that subsidiary is not only a conduit. It's actually doing something. It's producing the product, manufacturing the product, growing the product, producing the product. The resources are being extracted in that country. They're being consumed there. If that's the case, then it's no longer sub chapter. I call it sub part, sub chapter F income. For example, in the previous example of that UK subsidiary purchase raw material from Joyce and prefer substantial manufacturing activity in the UK before selling the inventory to customers in Hong Kong, then the income is not FBC income. So as long as they do some transformation in the UK, then they will no longer be considered under sub chapter F income. Even without the manufacturing activity, sales to customer within the UK would also be precluded. They will be because it's not, would not produce FBC sales income because there's no third country involved. If they buy the stuff from the US and they sell it in the UK subsidiary, sell the product within the UK, then guess what? It's no longer subject to sub chapter F income. Service income is another category. Foreign-based service income is income derived from the performance of services for or on behalf of a related person and perform outside the country in which the controlled foreign corporation was created or organized. Basically the same concept except here, rather than selling goods, you are providing services, but it's exact same concept, exact same concept. Income from services performed in connection with the sale of property by a controlled foreign corporation that has manufactured, produced, grown or extracted. Such property is not. Of course, if that's the case, if it's manufactured, produced or grown within that territory, then it's not. Now you have to remember that a large amount of offshore profit is active trade or business income not involving related person. So most of the subsidiaries outside the US, US subsidiaries that are outside the US, they don't participate in that sub chapter F income. The escape, the definition, what does that mean? If they escape the definition, their income is the third until we bring it back to the US. They're not subject to immediate taxation. And remember, the rules were changed. The rules were changed recently where you can bring it back and you have a dividend received deduction. So the determination of the amount of controlled foreign corporation income currently taxable, how do we determine how much of it is currently taxable? If the sub part F income is less than 5% of the controlled foreign corporation. So simply put, if you make that much money and that much is considered sub part F income, then you don't have to worry about this part. So if it's a small amount of your income is sub part F income, which is less than 5%. If the sub part F income is between 5% and 70% of the foreign controlled corporation. So if it's that much, well, guess what? If it's between 50 and 70, if it's 30% is then 30% of it is taxable now. If the sub part sub chapter F income or sub part F income is greater than 70%. So if you have, if it's greater than 70%, then all of your income is taxed now because the majority of your income is sub chapter F income. Therefore, even if it's only 80 or 72 or 75, more than 70, then it's 100% taxable. Now there is a safe harbor rule. What is the safe harbor rule? And hopefully if you understand the safe harbor rule, you say, okay, this makes sense now. Simply put, if the foreign tax rate is greater than 90% of the US corporate income tax rate, then none of the controlled foreign company or corporation income is considered to be sub part F income. What does that mean? In the US right now, the tax rate is 21%. So as long if we multiply this by 90%, it's approximately 19%, give or take like 18.9 to be more specific. So as long as the tax rate in that country in which you are operating is 18.9 or greater, which is 90% of the US tax rate, then you don't have to worry about this sub part or sub chapter sub chapter F income. With the current tax rate of 21%, US multinational corporation need not to be concerned with this rule as in countries where the rate, where the effective rate is 18.9% or higher. Because guess what, if you're operating in a place where the tax rate is higher than the US, then you're not really trying to avoid paying taxes because you are paying more than 90% of US taxes. So these countries are not considered tax haven as far as sub part F purposes are concerned. So the country effective rate, the way we compute the county effective rate is a combination of the corporate income tax and the withholding tax rate applicable to dividend. This is how you determine whether the effective rate is 90% or more of US tax rate, which happens to be 21%. Now, if you have any additional questions about this topic, please email me. If you want additional resources about this topic, visit my website. If you want to access the PowerPoints as well as other features. In the next session, we would look at foreign tax credit. Again, if you visit my website, please consider subscribing. It's a lot of resources and it's an investment in your career. Good luck and study hard.