If a U.S. person invests in a closely held foreign corporation (such as a Canadian private corporation owned by a U.S. person living in Canada) or in a widely held foreign corporation that earns the majority of its income from passive sources (such as stocks, bonds or mutual funds), the reporting and disclosure requirements for U.S. tax purposes can be complex. In addition, these investments may be subject to punitive U.S. tax regimes designed to prevent tax deferrals.
A potential tax deferral exists if the U.S. person is not taxed on corporate earnings until actual distributions are made to the U.S. person by the foreign corporation. To prevent this deferral benefit on certain types of income, the U.S. has put anti-deferral regimes in place.
Two classes of foreign corporations associated with anti-deferral regimes are:
- controlled foreign corporations (CFCs), and
- passive foreign investment companies (PFICs).
Controlled foreign corporations (CFCs)
A non-U.S. corporation is considered to be a CFC if more than 50% of the total combined voting power or the total value of its stock is owned directly, indirectly, or constructively by U.S. shareholders on any day during the CFC’s tax year. For certain purposes, shares owned by close family members can be considered to be owned by the U.S. person.
If you own (directly, indirectly or constructively) 10% or more of the shares (measured in votes or value) of a corporation that meets the definition of a CFC, you may be required to include a portion of the passive income of the corporation in your taxable income in the year the income is earned by the corporation. This applies even though you may not have received an actual distribution from the corporation related to that passive income. This treatment can result in differences in the timing of income tax in the U.S. and in Canada and can therefore result in double taxation.
Even if the CFC does not earn passive income, you may be required to report undistributed corporate income in your taxable income if the CFC invests in U.S. property, such as stock of U.S. corporations or loans to U.S. persons.
In addition, you are required to file Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. The form is due when the U.S. person’s income tax return is due, including extensions. If the form is not filed on time, the IRS may impose a $10,000 penalty.
Transition tax and GILTI
The TCJA imposed a mandatory one-time tax known as a “transition tax” on U.S. shareholders that owned 10% or more of the shares of a CFC. The transition tax was imposed on the untaxed foreign earnings and profits of the CFC, particularly including undistributed profits from active business not already taxed under the aforementioned rules. The effective tax rate on this income was as high as 17.5%. For U.S. persons, this provision was generally effective for the 2017 tax year, regardless of the fiscal year end of the CFC.
The TCJA also provides for an annual tax on a U.S. shareholder’s share of global intangible low-taxed income (GILTI). GILTI is very generally the CFC’s after-tax business profits in excess of a 10% baseline return on depreciable assets. The GILTI rules are generally effective for 2018 and subsequent years. For more information regarding GILTI, please see our Tax Alert, New U.S. Tax on U.S. Citizens Owning Canadian Private Companies.
In addition, there were some changes to the definition of U.S. shareholder and constructive ownership rules for U.S. corporations.
Passive foreign investment companies (PFICs)
Generally speaking, a non-U.S. corporation is considered to be a PFIC if more than 75% of its income is "passive" income, or 50% or more of the corporation’s assets generate "passive" income. Passive income generally includes interest, dividends, capital gains and rents.
For U.S. tax purposes, Canadian mutual fund trusts may be considered to be corporations. Therefore, if you own an interest in a mutual fund trust, you may be subject to the PFIC rules.
In addition to mutual fund corporations and trusts, some privately and publicly owned companies may also be subject to the PFIC rules if they are not considered CFCs (discussed above).
If you directly or indirectly own a PFIC, any distributions received from the PFIC and any gain realized on the sale of the PFIC could be subject to a very punitive deferred tax regime. Under this regime, income received is allocated to each year of ownership and taxed at the highest marginal tax rate applicable to each year. Moreover, interest charges are added to the deferred tax.
You may be able to make certain elections which would allow you to avoid the default PFIC deferred tax regime.
If you have an interest in a PFIC, you are required to file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, along with your U.S. income tax return.
Canadian tax planning
Some Canadian estate planning for U.S. persons can put you squarely into the CFC and/or PFIC anti-deferral tax regimes. For example, although shares of an operating company may not be subject to particularly adverse U.S. tax consequences, the use of a Canadian holding company can create passive asset holdings and significant tax issues.
When U.S. persons are involved in Canadian “estate freeze” transactions, transfers of shares that are tax-deferred transactions for Canadian purposes may give rise to immediate U.S. income tax. Furthermore, new shares subscribed for by family members for nominal value may give rise to gift tax issues.
The rules regarding U.S. persons investing in CFCs and PFICs are very complex. If you think that you may have an interest in one of these types of investments, please consult with your BDO advisor.