Introduction – The Age-Old Problem of Tax Evasion
What comes to your mind when you think of the word “tax haven”?
The phrase might conjure up images of tropical islands, James Bond-style action and romance, shady business dealings under palm trees, and unimaginable amounts of capital that somehow escaped the otherwise vigilant eyes of the taxmen.
The media has done a great job of glamorizing and vilifying tax havens as well as the financial secrecy surrounding them. When the recently trending Pandora Papers were released, people who willingly shunned ‘all things finance’ on a normal day flocked to news articles to read all about the evil rich guys who were exposed in their global tax evasion schemes.
Although this might seem a bit over-the-top, tax evasion is a very real thing. Once you peel away the superficial layers of media hype and look deeper into the machinations that drive such tax evasion schemes, two specific types of entities are bound to pop up.
These are the CFCs or Controlled Foreign Corporations and PFICs or Passive Foreign Income Investments.
These two corporate entities, owing to their increased propensity for usage in tax evasion, have some of the most stringent and complex rules under the Internal Revenue Code. In this article, we will attempt to outline the nature of such corporate entities and the various intricacies of the tax laws surrounding them within the US tax system.
What is a CFC?
The general definition of a Controlled Foreign Corporation is a registered corporate entity that is involved in business operations outside the country of residency pertaining to the controlling owners. According to the official definition underlined under IRS guidelines, a foreign corporation within which more than 50% of voting stock is owned by US stakeholders is classified as a CFC.
In this case, the IRS defines two scenarios of ownership, either of which when the satisfied result in the classification of a foreign business as a CFC. These are as follows:
- US stakeholders holding more than 50% of “the combined voting power of all classes of voting stock” of a foreign corporation
- US stakeholders holding more than 50% of the “total value of the stock of the corporation”
There are several motivations behind the establishment of a CFC in the first place, especially within the context of the US corporate landscape. One of the core reasons behind the same is to shift passive incomes (rents and royalties) as well as investment income (from interest and dividends) to tax havens like Luxembourg, the Cayman Islands, Singapore, and other such countries where tax liability is negligible. Another motivation is the potential for decreasing costs of incorporation by setting up business in a less expensive country than the usual process of company incorporation in the USA.
Filing requirements for CFCs
The tax laws surrounding CFCs are specifically established to ensure that the shadow benefits that they grant to US stakeholders can be minimized or avoided completely. There were two major paradigm shifts that have shaped the modern tax laws around CFCs. The first of these is the introduction of the Subpart F regime, which was integrated into Sections 951 to 965 of the Internal Revenue Code in the year 1962. The second is the passing of the TCJA or Tax Cuts and Jobs Act of 2017, which introduced the GILTI (Global Intangible Low-Taxed Income) regime.
Both of these regimes showcase the perceptual changes towards CFCs that have occurred within the purview of the IRS over the years.
The initial crackdown
The introduction of Subpart F involved the definition of a specific type of income under CFCs which was not free from any tax liabilities within the US tax system. These income brackets, which have since been referred to as Subpart F income, include relatively benign sources, such as insurance income and foreign base company income or FBCI, as well as more controversial sources, such as income derived from specified terrorism-sponsoring activities as well as illegal bribes and kickbacks. Subpart F income also includes international boycott factor income, which is defined as the income accrued in a country where certain boycotts that are not sanctioned by the US might be at play.
The inclusion of such types of income brackets under Subpart F indicates a severe crackdown on tax deferrals through CFCs. For instance, the inclusion of the necessity for reporting income from bribes and kickbacks allows for the possibility of passing much more severe sentences against US persons and corporations that have been found guilty of indulging in such activities. Previously, such crimes did not merit nearly as much weight and severity as they do after the inclusion of Subpart F, without which there was no literal mention of the same in the tax law.
The introduction of the GILTI regime under the TCJA of 2017 reshaped the perception of CFCs in the eyes of the IRS in a major way. One of the core differences introduced via the TCJA was a redefining of the way in which tax liability was attributed to the income of CFCs and US persons associated with these corporate entities. On one hand, while Subpart F sought to decrease the possibility of tax deferrals through the definition of the types of income included within the same, on the other hand, GILTI sought to reach the same objective by defining the types of income that were excluded.
GILTI is generally defined as the income earned by a CFC through its intangible assets, which includes sources such as patents, trademarks and copyrights. However, the tax laws around GILTI are not specifically directed towards income earned from such intangible sources. Rather, by integrating a clause that provides the opportunity to apply for a 10% return on income earned through tangible assets by a CFC, GILTI presumes that all profits earned above and beyond the exemption amount are from intangible assets. This additional income is subject to the GILTI tax under the presumption that the excess earnings are from mobile assets that are easier to move around and hide.
The TCJA as a whole, along with its integration of the GILTI regime (a possible play on the word “guilty”), can be defined as a move to dispel some of the earlier uncertainties that were fleshed out over years of implementing the Subpart F regime. The exclusion-based definition of GILTI along with the decrease in overall corporate tax on US corporations from 35% to 21% under the TCJA indicate that the law is specifically focused on discouraging CFCs from shifting easily-movable sources of income, such as intangible assets, to countries with lower tax rates.
What is a PFIC?
There are two main aspects, or tests, which are used to define a Passive Foreign Investment Corporation. They are as follows:
- At least 75% of the corporation’s income falls under the category of passive income (rent, interest, dividends, etc) rather than income from active business operations, such as selling products or services
- At least 50% of the corporation’s assets exist in the form of investments (stocks, saving accounts, mutual funds, etc)
Owing to the broad nature of the definition, a corporation might be deemed as a PFIC at a specific point in time, specifically in the initial phases where capital generation from passive means is given a priority to kick-start active business operations down the line. After the initial years, the same corporation that was once considered a PFIC might no longer fit within this category due to the reshaping of its asset types and investment behaviours.
Fact File: if you own a start-up that has active business operations as well as passive investments, you will be exempt from the PFIC tax laws for the first taxable year of operations. However, if you want to avoid the complexities of tax reporting under PFIC laws, you better start making some major changes in your balance sheet before your startup’s second birthday. This also applies to businesses transitioning from one area of commercial focus to another.
Filing requirements for PFICs
The tax rules around PFICs, for the most part, come from the inability to accurately track foreign investments in passive sources of income. This uncertainty has allowed more than one taxpayer to conveniently leave out their investments in instruments like foreign mutual funds while reporting for tax payments. Moreover, foreign investments in passive instruments deprive the US economy of additional generated income tax, which is derived from the mandatory payout schedule associated with mutual funds within the country.
In order to solve this problem, the Tax Reform Act of 1986 was passed, which ushered in some really complex reporting procedures for PFIC, all with the aim of scaring foreign investors interested in passive instruments from continuing their behaviour.
According to the Tax Reform Act of 1986, income from PFICs will not be subjected to the leisure capital gains tax that was once enjoyed by foreign investors, but rather will be subject to the maximum income tax rate of 37%, which is usually reserved only for the highest earners.
There are certain ways in which you can mitigate this high tax liability as an owner of a PFIC, namely through the QEF (Qualifying Electing Fund) election and the Mark to Market (MTM) election. There is also a separate class of purging elections, known as Deemed Sale Election and Deemed Dividend Election.
The QEF election allows taxpayers to treat income earned through PFICs along the same lines of income earned through domestic investments, with the same tax rates as the latter being applicable for the former. When opting for this election, a part of the income from PFICs is taxed at the personal income tax rate, while the other part is taxed at the capital gains rate. This is a better option as opposed to deferring unrealized gains from PFICs, which in turn could result in the levying of a non-deductible interest penalty that compounds on a daily basis for the entire deferral period.
The MTM election allows PFIC investments to be valued at their current fair market price every year while filing the tax return, thereby enabling both realized and unrealized gains from these instruments to be taxed at the marginal income tax rate as per your income level. This election further allows you to file loss claims, which could lead to further tax savings.
In essence, both CFCs and PFICs are discouraged by the IRS, specifically due to the potential that they offer for subversion of the established tax system through the inherent uncertainties within each of these instruments/entities. It is best to opt for professional CFO consulting services when it comes to filing requirements for both CFCs and PFICs.