Tax Rules for Foreign Corporations and IBCs Owned by U.S. Persons
Before 1962, it was legal for U.S. persons to invest in foreign corporations which in turn invested in various U.S. securities and debt obligations on a tax free basis. Control by the U.S. investors was not an issue.
When the stock of the foreign corporation was sold, the gain was treated as a capital gain - usually eligible for preferred tax treatment.
That's no longer true - even though many promoters of offshore tax schemes will tell you it is. Here's a very brief summary of what is true - today.
Although the U.S. Treasury Department and IRS do not have legal jurisdiction over a foreign corporation that does not have a presence in the U.S., they do have legal jurisdiction over any U.S. persons who are shareholders of foreign corporations. Thus, the imposition of taxes on the income of a foreign corporation is done at the shareholder level and not at the corporate level.
A U.S. person who invests (directly) in the stock of a foreign corporation is subject to the same basic tax rules as investors in domestic corporation stocks unless the foreign corporation is controlled by U.S. persons or is a passive foreign investment company.
The U.S. investor is not required to file any special tax reports regarding the foreign corporation unless the corporation is
- a "controlled foreign corporation" that is controlled by "U.S. shareholders" or
- a passive foreign investment company or
- a foreign personal holding company.
If the foreign corporation is a passive foreign investment company (mutual fund), special rules apply. The U.S. shareholders are required to report their share of the income of the foreign investment company on their tax return each year, or to pay a penalty on any deferred income from the foreign investment company. To avoid the penalty, U.S. shareholders of a passive foreign investment company can elect to pay taxes on their share of the income of the corporation each year, using Form 8621 for each such fund. (In a few cases, a foreign company might be a foreign personal holding company without also being a passive foreign investment company, but that's an unlikely circumstance.)
If more than 50% of the foreign corporation stock is owned (directly or indirectly) by 5 or fewer U.S. persons, then the corporation will be a controlled foreign corporation. Those shareholders who own 10% or more of the stock are required to file Form 5471 each year with their tax return. If the foreign corporation has any "sub-part F income", the U.S. shareholders who own 10% or more of the stock will be required to include that income in their personal tax return even though it is not distributed by the corporation. The simplest explanation of "sub-part F income" is that it includes passive investment income and certain types of income derived from buying or selling goods or services to or from a related person or entity.
Those promoters who advocate the creation of a foreign corporation as way to avoid taxes on investment income are either ignorant of the U.S. tax rules relating to controlled foreign corporations or they are scoundrals who are not concerned about the problems they may be creating for U.S. persons.
If a foreign grantor trust or partnership is a 10% or greater shareholder of a controlled foreign corporation, then the grantor of the trust or the partners will be treated as shareholders of the foreign corporation. If such a trust or partnership owns any stock of a passive foreign investment company, it will need to file Form 8621.
An international business company (IBC) is a corporation formed in a non U.S. country that is usually exempt from tax in the country where it is formed -- but it may not conduct any business in that country. For U.S. tax purposes, an IBC is generally treated the same as foreign corporation. U.S. persons who form and own a foreign corporation or an IBC may elect to be treated as a partnership or as a corporation by filing Form 8832 within the prescribed period of time. A single owner IBC may elect to be taxed as a corporation or as a disregarded entity.
If a foreign corporation receives more than 25% of its gross income from passive investment sources (interest, dividends, capital gains), it will be deemed to be a passive foreign investment company and the U.S. shareholders are required to pay current taxes on their share of the investment company income or to pay a penalty for the deferral of tax. There is no minimum percentage of ownership with respect to foreign investment companies as there is with controlled foreign corporations.
This is a very brief and non-technical summary of the key tax rules applicable to the ownership of stock of a foreign corporation by U.S. persons. A 60+ page report on this subject is available on our paid subscriber's web site at no extra cost to subscribers. Printed copies of Controlled Foreign Corporation Tax Guide are also available.
Copyrighted material is provided by Vernon K. Jacobs, author of the Jacobs Report on International Financial Planning
