Understanding Subpart F Income

What is Subpart F Income?

‘Subpart F’ literally refers to a specific area of the internal revenue code (IRC) which addresses the Subpart F regime. Subpart F consists of IRC sections 951 – 965, the specific code section that defines Subpart F is IRC 952.

Subpart F is one of several anti-deferral / anti-avoidance regimes within the IRC. In the context of an individual, it is most common that the regime prevents deferral of tax on passive income within a controlled foreign corporation (CFC). Broadly a CFC is defined as a non-US corporation which is more than 50% US owned.

Within Subpart F IRC 953, 954 and 956 detail certain items of foreign income, which if made by a CFC, subject the US owners to current taxation, regardless of whether the income is distributed. Understanding the implications of Subpart F income is essential for individuals to ensure compliance with the Internal Revenue Service (IRS) regulations and optimize their tax planning strategies.

Subpart F planning is particularly key for individuals in jurisdictions where it is beneficial to hold investments or operate as individuals through a corporation, i.e., it is common to hold rental assets in a Ltd in the UK, it is common to hold investment assets in an AB in Sweden.

Subpart F income includes various categories of income, such as:

1. Foreign Personal Holding Company Income: This category includes passive income, such as dividends, interest, royalties, and rents. The goal is to prevent US taxpayers from using CFCs to accumulate passive income offshore and defer US taxation.
2. Foreign Base Company Income: This refers to income derived from certain types of activities, such as services, sales, or manufacturing, conducted outside the CFC’s home country. It aims to prevent US taxpayers from shifting profits to foreign subsidiaries in low-tax jurisdictions.
3. Insurance Income: Subpart F rules also apply to income derived from insurance or reinsurance activities conducted by a CFC. This ensures that US taxpayers cannot use CFCs to shift insurance-related income to low-tax jurisdictions.

Implications for Individuals

For individuals who are US shareholders of CFCs, Subpart F income has significant implications on their US tax liability. The inclusion of Subpart F income in their taxable income means that they are subject to immediate US taxation on the earnings, even if the income remains offshore and is not distributed to them. In addition the income is taxed as ordinary at up to 37% and qualified dividend rate is not available.

US shareholders of CFCs are required to report their ownership interests and transactions on various tax forms, including Form 5471 and Form 8938. These forms provide the IRS with detailed information about the CFCs’ operations, financial activities, and potential tax liabilities such as Subpart F pick up. Failure to comply with the reporting requirements can result in severe penalties.

Tax Planning Strategies

While Subpart F income can result in immediate US taxation, there are tax planning strategies that individuals can employ to minimize their overall tax liability. These strategies include:

1. Utilizing Foreign Tax Credits: Individuals may be able to offset their US tax liability by claiming foreign tax credits for the taxes paid on the Subpart F income by the CFC in the foreign jurisdiction. This helps avoid double taxation on the same income.
2. Entity Classification Elections: It is possible to change the classification of a foreign entity, typically from a corporation to a partnership (or disregarded entity which is effectively a partnership with a sole owner). Doing this can mean the Subpart F rules do not apply as the individual is deemed to own the assets directly. There are many items to consider when making an entity classification election.
3. IRC 962 Election: in some scenarios it might be beneficial for taxpayers to elect to be taxed at corporate tax rates under IRC 962 when also considering future distributions and their tax residency.