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Controlled Foreign Corporations (CFCs)

Canadian Corporations that are considered CFCs for U.S. shareholders

The U.S. tax system went through a major overhaul as a result of the Tax Cuts and Jobs Act (TCJA). Beginning in 2018, the U.S. taxes individuals on worldwide income whereas corporations on a Quasi-territorial system. Controlled Foreign Corporations (CFC) of a U.S. taxpayer play an important role in the determination of a U.S. taxpayer’s tax liability. 

Disclaimer: This post is for general information purposes, mere reading of it alone should not be a reason for tax planning. Readers must seek independent tax advice from a cross-border income tax professional. Be mindful of the date of publishing of this post as it may not be updated post publishing.

Caution: Please note that this article explores CFC rules for U.S. tax purposes at a very high level. These rules play an important part in the tax preparation for U.S. Citizens and residents. These rules are quite different from Canadian income tax rules for Controlled Foreign Affiliates (CFAs) and are not interchangeable. This post focuses on the U.S. outbound taxation with respect to Canadian CFCs of U.S. taxpayers. For Canadian outbound income tax, please refer to the relevant sections of the Income Tax Act and Income Tax Regulations. 

Read about IRS form 5471 filing requirements here.

Controlled Foreign Corporations (CFC)

Controlled foreign corporations’ rules are not new. These rules are part of Subpart F of the Revenue Code. TCJA did make a few changes to these rules, in particular, turning on the downward attribution of stock by repealing 958(b)(4). 

CFC & It’s Ownership

As per Section 957(a), a foreign corporation is a CFC if on any day during the year more than 50% of its stock, by vote or value, was owned by the U.S. shareholders. U.S. shareholder is further defined in Sec 951(b) as a U.S. person who owns 10% or more of stock either by vote or value.

Who is a U.S. person? Sec 7701(a)(30) defines that, along with modification by Sec 957(c). In general, an individual who is a U.S. citizen or resident, a domestic corporation, a domestic partnership, estate, or trust. 

The ownership can be direct, indirect, or constructive. For the aforementioned U.S. Citizens, owning the majority of stakes in Canadian corporations either directly or indirectly through tiered structures, it could be simple to determine CFC status. With attribution rules, sometimes an otherwise unsuspecting individual or entity may become a U.S. shareholder! 

CFC determination is critical for a U.S. person, failing which may result in substantial penalties either due to underreporting of income or missed filings of required forms. Information returns such as 5471 alone can fetch a USD 10,000 penalty. 

Canadian tax residents with Canadian corporations must plan and take necessary actions before moving to the United States, as such corporations are likely to become CFCs. If not CFC, can be a Passive Foreign Investment Corporation (PFIC). 

What is “Control”?

The criteria to determine the control under U.S. tax laws can be different than the one under Canadian tax laws.

A U.S. person has control if she owns 10% or more of any class of shares that has voting rights attached to it, or has a deeming control if there are other rights that give her the power to elect or replace directors. If the control or deeming control is less than 10%, it is not considered a U.S. person for the purpose of determining of CFC status of a foreign corporation. So combined control of the U.S. shareholders (who have 10% or more only) must be more than 50%, either by vote or value. 

For example, if a U.S. individual owns 9% of voting stock and another U.S. individual owns 42%, the foreign corporation is not a CFC since there is only one U.S. shareholder with 42% control. 

Direct, Indirect, and Constructive Ownership 

Whether a U.S. person is a U.S. shareholder or not depends on direct, indirect, and constructive ownership of a foreign corporation. In the case of direct or indirect ownership, it could be simple but constructive ownership rules make it a lot more challenging. 

A very important note here, constructive ownership rules are used to determine whether a foreign corporation is a CFC or not. Whereas, for income inclusion of U.S. shareholders with reference to Global Intangible Low Taxed Income (GILTI) and Subpart F Income, only direct and indirect ownership is used. In simple words, constructive ownership can make a foreign corporation CFC for the purpose of including GILTI and Subpart F income even if direct and indirect ownership of U.S. shareholders is less than required. 

Direct ownership

In its simplest form is if the U.S. person’s name is written on the share certificate. If the stock is owned for a U.S. person that is also considered direct ownership (deemed ownership). These “by or for” rules are important as both indirect and constructive ownership use the same basis for calculation purposes. 

For example, a U.S. person holding 15% of common shares of an Ontario corporation is having 15% control. If there are one or more other U.S. persons who also own 10% or more common shares, they will be the U.S. shareholders too, if collectively they own more than 50%, the same Ontario Corporation is a CFC now. 

Indirect Ownership 

Section 958(a) provides indirect ownership rules. When the stock of a foreign corporation is owned through another foreign entity, it creates proportional indirect ownership. If the direct owner, or deemed owner, is:

  • Foreign Corporation – shareholders are indirect owners 
  • Foreign partnership – partners are indirect owners
  • Foreign estate – beneficiaries are indirect owners

Indirect rules do not apply to shareholders of U.S. domestic corporations.

If someone tries to artificially lower or alter the indirect ownership using various creative techniques, the U.S. tax law does not recognize such arrangements. 

For example, if a U.S. citizen owns a holding corporation in Canada with a subsidiary in Canada, the U.S. person indirectly owns the same subsidiary. 

Note: these are not all the rules, one must go through the code and the regs depending on the situation such as varying income and voting rights. 

Attribution rules for indirect ownership:

  • There is no minimum ownership requirement here. (Sec 958(a)(1)(B))
  • There is no attribution from owners to entities. 
  • There is attribution from entities to their owners. 
  • There is no indirect attribution between individuals. 
  • Indirect ownership attribution does not travel or passed on above the lowest-tiered U.S. entity or first U.S. person in the chain of ownership. 

Constructive Ownership

Reference: Section 958(b) using modified rules under section 318(a). These constructive ownership rules determine if a U.S. person is a U.S. shareholder or a foreign corporation is a Controlled foreign corporation. These rules are also used to determine the related parties of a CFC. Finally, if a CFC owns a U.S. corporation per Sec 956(c)(2). 

Oftentimes, many unsuspecting U.S. persons become constructive owners. Again, always remember, constructive ownership has a different purpose than indirect ownership! 

Attribution Rules for Constructive Ownership:

For the sake of simplification, code section references are removed from the below lines.

Family attribution:  

  • Stock owned by a non-resident alien is not attributed to a U.S. citizen or resident. This may be a sigh of relief at first reading, however, be mindful of the non-residents who elected to be treated as U.S. resident aliens for U.S. federal tax purposes!
  • Stock owned by Spouse, children, parent, or grandchildren is deemed to be owned by a person. There is no attribution from grandparents to grant children. 
  • There is no attribution between siblings. 
  • There can be attribution of the same stock to multiple family members. 

For example, if a U.S. Citizen owns 11% of the stock of a Canadian corporation, her son constructively owns the same 11%. If the husband owns 10%, the wife 10%, and the son 35%, all three of them have CFC, hence, their share of Subpart F and GILTI income inclusion. 

Attribution ‘from’ Corporations:

  • Stock owned by a corporation is attributed to its shareholders if the same corporation owns 10% or more (direct or indirect) of the value of the stock.
  • This attribution applies to the shareholders that own 10% or more of the stock of such a corporation.

Attribution ‘to’ Corporations:

  • If a person owns 50% or more of the value of the stock of a foreign corporation, that person is considered to own 100% of the stock of that corporation for constructive rules purposes. In other words, that person is attributed all of the stock of that corporation to determine constructive ownership in a third corporation.
  • If the person owns less than 50%, then there is no constructive ownership from the shareholder to the corporation. 

Attribution due to Partnerships and Estates:

  • Stock owned by partnerships or estates is considered proportionately owned by partners or beneficiaries respectively. 
  • Stock owned by partners or beneficiaries is considered to be owned by partnerships or estates.
  • These attribution rules do not require any minimum ownership 

Final Word 

Whenever a U.S. person owns stock in a foreign corporation (other than the U.S. domestic corporation), a careful analysis is needed to determine the exact reporting. When a foreign corporation is a Controlled foreign corporation, the reporting gets complex. Even if a corporation is not CFC, there are still reporting requirements, and that can get complex quickly. 

The above article is scratching the surface of attribution rules only. If you are a U.S. person who has ownership in Canadian entities, get in touch with us to determine the right reporting requirement. If you are moving from Canada to the U.S. with Canadian corporations, plan ahead. 

For all your cross border income taxes, get in touch with us today!

Maroof Hussain Sabri

Maroof Hussain Sabri

Maroof is a CPA, CA in the province of Ontario and Alberta in Canada. He is also a licensed CPA from North Dakota in the United States. He lives in Toronto.

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Maroof Hussain Sabri

Maroof Hussain Sabri

Maroof is a CPA, CA in the province of Ontario and Alberta in Canada. He is also a licensed CPA from North Dakota in the United States. He lives in Toronto.

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5 thoughts on “Controlled Foreign Corporations (CFCs)”

  1. Wonderful article. You summed it up so beautifully. I was lost in the instructions of form 5471 with so many references to other regs and cross-referencing them was a nightmare. Thanks to you, I have a better understanding now. I also understand I should seek formal advice now. How can I start working with you?

  2. Excellent article. I am a US Resident and have a Quebec Family Holding Company whereby I own 100 Class C Shares worth $100 and my father a Non US person owns 1000 Class A Shares worth $1000 shares. My father has total control and voting rights in this HC. In turn he has his own HC which my HC owns 25 out of 100 Class C Shares. I have zero voting rights or control. Thus I am a US shareholder of a CFC and by laws of Attribution or Constructive Ownership or Indirect Ownership? I file both 8621 for PIFIC and 5471 for CFC my HC. Do the above laws of Attribution Constructive Ownership and or Indirect Ownership apply to me?

    1. Maroof Hussain Sabri

      Hi Nina, your question is very specific to your situation, and short of seeking tax advice. When a foreign corporation is CFC, PFIC rules do not apply to those holdings. So you are providing conflicting information here. Or you might be saying that one corp is PFIC and the other is CFC! Attribution rules as mentioned in this article are at a very high level and do not explain complex scenarios. I strongly recommend you check with your accountant as she will be the best person to determine direct, indirect, or constructive ownership of that entity.

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