U.S. Taxation: Information Reporting – Foreign Corporations and Form 5471
by George Gonzalez
As a U.S. citizen you are subject to taxation of worldwide income regardless of where you live. Also, regardless of your country of residence, you are subject to information reporting rules that may require you to file reports on your foreign assets and foreign activities.
This article discusses information reporting requirements that relate to foreign corporations. More specifically, a particular type of foreign corporation called a Controlled Foreign Corporation (CFC). In separate articles in these web pages I discuss information reporting requirements related to (a) foreign trusts and (b) bank accounts and other foreign financial accounts.
Information Reporting Premise
It is worth keeping in mind that virtually all of the various information reporting requirements have the same ultimate goal: ensuring that you include all your foreign source income in your income tax return. With many types of U.S. source income, the payor of the income reports to the IRS how much income they paid you. Examples of this are Form W-2 for employment compensation, 1099-INT for interest income, 199-DIV for dividend income, and 1099-R for pensions, annuities and other retirement benefits. With this information the IRS can compare what you report in your tax return to what should have been reported. If there is a difference, the IRS will contact you with questions or assess a tax amount different from the tax shown in your tax return.
In contrast, with foreign source income there is usually no payor that communicates to the IRS how much income they paid you. It thus becomes more difficult for the IRS to know whether you reported all your foreign source income as required by law. By requiring you to submit information reports on foreign assets and foreign activities, under the threat of potentially severe penalties for non-compliance, you are essentially obligated to fulfill a similar role to that of payors of U.S. source income. Foreign information reports submitted to the IRS alert them to watch for certain foreign source income when you file your tax return.
Premise for Information Reporting on U.S. Shareholder-Owned Foreign Corporations
A foreign corporation that invests or conducts business outside of the U.S. is not subject to U.S. jurisdiction and, thus, is not subject to U.S. taxation. If not for special rules, to be discussed shortly, a significant tax deferral strategy could be implemented as follows:
- A U.S. individual forms a foreign corporation outside of the U.S.
- The U.S. individual is the sole or primary shareholder.
- The corporation makes investments outside of the U.S.
- The investment income earned by the foreign corporation escapes U.S. taxation.
- At some point later the foreign corporation makes dividend distributions to the U.S. shareholder.
- The U.S. shareholder pays U.S. tax on the dividend income.
Depending on the length of time between the corporation earning income and dividends being distributed by the corporation to the U.S. shareholder (items #4 and #5), this could result in substantial tax deferral.
Special rules within the Internal Revenue Code prevent this type of tax deferral. The rules provide for the inclusion of the foreign corporation’s income in the tax return of the U.S. shareholder on a prorata basis.
So, for example, if a CFC had $50,000 in investment income during the year, and one of the shareholders is an individual U.S. shareholder who owns 80% of the corporation, that shareholder would have to include $40,000 ($50,000 x 80% = $40,000) of the foreign corporation’s investment income their 1040 tax return.
With the aim of ensuring that a U.S. shareholder of a foreign corporation includes their prorata share of the foreign corporation’s income in their U.S. income tax return, there is an information report filing obligation placed on certain U.S. shareholders of foreign corporations.
Form 5471 Information Report – Foreign Corporations to Which It Applies
The applicable form that must be filed with the IRS is an annual form called Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations). Who must file this form? The rules are complex and, some would argue, convoluted. There are different aspects to the filing requirements.
One aspect is the type of foreign corporation for which Form 5471 must be filed. Form 5471 applies to CFCs. A CFC is defined as a foreign corporation in which “U.S. shareholders” own more than 50% of the corporation. A “U.S. shareholder” is any U.S. person who owns or is deemed to own 10% or more of the foreign corporation. Two examples to illustrate:
- Example #1: Two U.S. citizens each own 30% of a foreign corporation. Since they each own 10% or more of the corporation, each of them is a “U.S. shareholder” and thus their share ownerships are added together: 30% + 30% = 60%. Since the total ownership by “U.S. shareholders” is more than 50%, the corporation is a CFC.
- Example #2: Six unrelated U.S. citizens each own 9% of a foreign corporation (a total of 54%) and a seventh, unrelated U.S. citizen owns 46%. Since none of the first six individuals own 10% or more of the corporation, none of them is a “U.S. shareholder” and thus none of their share ownerships are included in the calculations. The seventh individual does own 10% or more of the corporation, so their 46% ownership share is included in the calculations. Total ownership by “U.S. shareholders” is therefore 46%. Accordingly, since this is not more than 50%, the corporation is not a CFC.
A ”U.S. shareholder” does not have to be an individual. Any of the following types of taxpayers can fall under the definition of a “U.S. shareholder”:
- U.S. citizens and residents
- U.S. partnerships
- U.S. corporations
- U.S. estates
- U.S. trusts
Form 5471 Information Report – Who Must File
Having established that a foreign corporation is a CFC, the next thing is to determine who must file Form 5471. There is a variety of different types of U.S. taxpayers that can be ensnared by the form’s filing requirements.
The filing requirement can be imposed not only on shareholders of a foreign corporation, but also on U.S. officers and directors of a foreign corporation. Hence, you could have a situation, for example, in which some U.S individuals are officers and directors of a foreign corporation but have no ownership in the CFC, and other U.S. individuals are more-than-10% shareholders in the CFC. The officers, directors and more-than-10% shareholders would all be subject to the Form 5471 filing requirements. However, where there are multiple filers of the same information, it is possible to file a joint information report for all the filers.
Form 5471 Information Report – General Types of Information Required
Information that Form 5471 asks for include:
- Information on the person filing the form
- Information about the CFC
- Information about the CFC’s stock
- Information about the CFC’s shareholders
- The CFC’s income statement
- The CFC’s balance sheet
Form 5471, as of this writing, is six pages long. This does not include the three pages of Worksheet A, which is discussed in the next section.
Form 5471 Information Report – Subpart F Income
At the beginning of this article I stated that the aim of Form 5471 is to ensure that a U.S. shareholder of a CFC includes their prorata share of the CFC’s income in their own U.S. income tax return. Here I modify that statement to replace “prorata share of the foreign corporation’s income” with “prorata share of the foreign corporation’s Subpart F income”.
Worksheet A of Form 5471 is the portion of a Form 5471 filing that gets to the heart of this. It is long in itself, running three pages long. The title of the worksheet is “Summary of U.S. Shareholder’s Pro Rata Share of Subpart F Income of a CFC”.
The CFC income taxation rules that define “Subpart F income” are quite complex. Essentially what those rules get at is that a U.S. shareholder’s prorata share of a foreign corporation’s passive income from investments is what gets taxed by the U.S. In general, the foreign corporation’s active business income is not subject to U.S. taxation under the CFC taxation rules.
There are different categories of Subpart F income:
- Foreign-Based Holding Company Income (passive income such as dividends, interest, royalties, rents and annuities)
- Foreign-Based Company Sales Income (income from the sale or purchase of personal property to (or from) a related person where the property is manufactured and sold outside the country of incorporation)
- Foreign-Based Company Service Income (income from the performance of personal services by a CFC for or on behalf of a related person outside the country in which the CFC is organized)
- Insurance Income (income from the issuance of any insurance or annuity contracts in connection with property in, liability arising out of activity in, or the lives or health of residents of a country other than the country in which the CFC is created or organized)
A key purpose of Worksheet A for Form 5471 is to bring together the above types of Subpart F income. There are many lines and calculations involved. The amounts from some of the lines in Worksheet A are carried to one of the schedules in Form 5471 (Schedule I, Summary of Shareholder’s Income From Foreign Corporation).
The above simplified description is the process through which the IRS ensures that a U.S. shareholder’s prorata share of a foreign corporation’s Subpart F income gets taxed. As described above, Form 5471 is long and complex. Nevertheless, if you are subject to its filing requirements, you should ensure that you file it. The penalties for not filing a required Form 5471 are severe.