Don’t let downward attribution get you down: The key to understanding US CFC attribution rules

The 2018 Tax Cuts and Jobs Act (TCJA) introduced retroactive Controlled Foreign Corporation (CFC) attribution rules that resulted in some unintended consequences. As a result, many US shareholders not otherwise caught by the CFC rules found themselves subject to extensive information reporting and in some cases, significant tax bills. US corporations may also be obligated to file information returns that can attract substantial penalties for missed or late filings.

This article focuses on the so-called “downward attribution” rules that can attribute ownership down to a corporation from its shareholders. The rule can significantly impact US persons (e.g., citizens, resident aliens, US corporations, etc.) that own 10% or more of a foreign corporation where there’s a US corporation in the group.

Testing CFC status

Under US tax principles, a CFC is defined as a foreign corporation that is owned more than 50% (by vote or value) by US Shareholders. A “US Shareholder” is defined to include only US persons (e.g., US citizens, tax residents, partnerships, corporations, estates or trusts) that own at least 10% (by vote or value) of the shares of the tested foreign corporation. For testing purposes, ownership can be direct, indirect or constructive.

Testing for indirect ownership requires looking through tiers of ownership and only “stopping” when you reach a US person.

Constructive ownership can result even where a person does not have a direct or indirect interest in the tested corporation.

In Figure 1, US Citizen is a US Shareholder as he directly owns 10% of Foreign Parent. If there are no other direct or indirect US Shareholders, neither Foreign Parent nor Foreign Subsidiary appear to meet the definition of a CFC……until the downward attribution rule is applied.

Under downward attribution, if a shareholder owns at least 50% of a corporation (by value), then shares held by that shareholder are attributed to the corporation as if the corporation actually owned the shares. In Figure 1, as Foreign Parent owns 100% of US Subsidiary, US Subsidiary is treated as owning the shares owned by Foreign Parent; meaning US Subsidiary is the 100% constructive owner of Foreign Subsidiary.

US Subsidiary is not, however, treated as owning Foreign Parent in this simple example.

As a result, assuming US Citizen is the only direct or indirect US Shareholder of Foreign Parent, Foreign Parent does not meet the definition of a CFC as US Shareholders only own 10%. Foreign Subsidiary, however, does meet the definition of a CFC as US Shareholders are deemed to own 100% (US Citizen indirectly owns 10% and US Subsidiary constructively owns 100%). The somewhat bizarre result is that within a single structure, some foreign corporations are CFCs and some are not.

But identifying CFCs in the structure is just the first step.

Implications of CFC status

In Figure 1, US Citizen would be required to annually file Form 5471, Information Return of US Persons with Respect to Certain Foreign Corporations, with respect to Foreign Subsidiary. Form 5471 contains numerous schedules and statements and will require US Citizen to report the underlying income and assets of Foreign Subsidiary annually. In addition, US Citizen may be subject to US tax under the CFC regimes which could result in dry income inclusions. Specifically, US Citizen may be subject to US tax on the underlying earnings of US Subsidiary even if he doesn’t receive any actual distributions from the company.

CFC status creates additional filing obligations within the corporate structure. As US Subsidiary constructively owns a CFC, it will also be required to annually file a Form 5471 to report information about Foreign Subsidiary (e.g., balance sheet, income statement, etc.). Unlike US Citizen, however, US Subsidiary will not be subject to US tax under the CFC regimes as a mere constructive owner of the CFC.

Again bizarrely, if instead US Citizen owned 9.99% of Foreign Parent, all the filing obligations fall away under an exception. So even though Foreign Subsidiary would still technically meet the definition of a CFC (as it’s still 100% constructively owned by US Subsidiary), all filing obligations and taxation under the CFC regimes is eliminated.

The IRS imposes significant penalties on late filing or failing to file Form 5471, even when it’s information reporting only. In Figure 1, if neither US Citizen nor US Subsidiary timely filed Form 5471, each could face a $10,000 per year penalty for each CFC. In larger group structures with multiple CFCs and where filings are missed for a number of years, the penalties can easily reach the hundreds of thousands, if not millions of dollars (and that’s before calculating any underlying tax liability). Given the cost of non-compliance, it’s essential that CFCs are accurately identified and filing is timely. In some cases, penalty abatement programs may be available.

Where to go next

Although this article focuses on the downward attribution rules in the corporate subsidiary context, the Code contains extensive attribution rules that can attribute ownership amongst family members, from a corporation to its shareholders, from a partner to a partnership (and vice versa) and more. A full review of potentially applicable attribution rules should be undertaken as part of any CFC testing analysis.

If you think you or your business may be impacted by these rules, don’t hesitate to reach out to see how we can help. Structuring opportunities may be available to prospectively manage the filing and compliance burden.