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Subpart F rules limit deferral of foreign income by owners of foreign corporations. Earnings of a foreign corporation owned by U.S. taxpayer(s) are generally not taxable in the U.S. until remitted. This general rule is subject to several anti-deferral regimes, including Subpart F. U.S. shareholders (generally U.S. persons owning 10% or more of the vote) of a controlled foreign corporation (CFC) must include in their income currently certain types of income earned by the CFC, under the provisions of Subpart F. These inclusions are accompanied by a deemed-paid credit for corporate shareholders that operates identically to the deemed-paid credit for dividends. A Subpart F inclusion, however, is not a qualified dividend eligible for the reduced 15% tax rate.

This first of a series of articles on Subpart F deals with the basic rules. The next article in the series will discuss foreign base company sales income and manufacturing.

A CFC is a foreign corporation more than 50% owned (by vote or value) by U.S. persons who own more than 10% of the vote of the foreign corporation. The 50% and 10% are determined with attribution rules, so for example father and son are counted together, and parent corporation and subsidiary are counted together. U.S. persons include U.S. citizens, U.S. resident individuals, U.S. corporations, U.S. LLCs, and partnerships organized under the laws of any of the 50 states or DC.

A 10% or more shareholder of a CFC must include in his/her/its taxable income each year his/her/its pro rata share of:
· Net Subpart F income, and
· The CFC's investment in U.S. property (up to its total earnings and profits).

Subpart F income includes 3 key types of income for most groups:
· Interest, dividends, rents, and royalties, and gains on property that produce such income (called FPHCI or foreign personal holding company income), with several exceptions,
· Income from purchase of goods from a related party and sale to anyone or purchase of goods from anyone and sale to a related party, where the goods are both produced and for use outside the CFC's country of incorporation (FBC Sales Income), and
· Income from performing services for, on behalf of, or with substantial assistance from a related party, where the services are performed outside the CFC's country of incorporation (FBC Services Income).

If Subpart F gross income (total receipts less cost of goods sold) is both less than $1 million and less than 5% of the CFC's gross income, it is ignored. If it is more than 70%, then all of the CFC's income is considered Subpart F income.

Example: Fred, a U.S. citizen, owns 51% of Buy-Lo Ltd., a UK company. Buy-Lo purchases nuts and bolts from an Indonesian company of which Fred owns 51%. Buy-Lo makes a pre-tax profit of £2 million in 2011 selling the nuts and bolts throughout Europe, with only minor sales in the UK. Buy-Lo pays £500,000 of UK tax. Fred must include in his 2011 taxable income his share of the Buy-Lo after tax net, in dollars. If the pound is $2=£1, then Fred's taxable Subpart F inclusion is $1,530,000. That is £2,000,000 profit less £500,000 tax = £1,500,000 times FX rate of 2:1 times 51% ownership.

Net Subpart F income is Subpart F gross income less all expenses and deductions related to that gross income. Subpart F income is after reducing income for allocable income taxes. Subpart F inclusions are limited to the earnings and profits (E&P) of the CFC. Where an amount would be includible under Subpart F but for this E&P limit, future amounts of earnings are recharacterized as Subpart F. In addition, if the earnings of the CFC are subject to foreign income tax of over 31.5%, then the income is permanently excluded from Subpart F. This high tax test is determined under U.S., not foreign, principles.

Several exceptions apply. FPHCI does not include rent or royalty income from an active business of renting or licensing property, with several significant conditions. Example: Paris Rent-All Srl (PRA) rents construction equipment through its locations in France and Switzerland. All rentals are short term, including hourly. PRA's employees clean, inspect, and repair the equipment after each rental. PRA's income qualifies for the active rental exception and is not Subpart F income.

FPHCI also does not include interest or dividends received from a related party organized in the same country, or rents or royalties for property used in the same country. For 2006-2012, it does not include dividends, interest, rents, or royalties received from any related party unless the item is attributable to Subpart F income of the payor.

FBC Sales Income includes income from buying and selling, not making and selling. Where components are purchased from related parties, issues may arise as to whether the CFC manufactured the goods. Manufacturing includes substantially transforming the goods, as well as processes generally considered manufacturing.

A special branch rule applies for FBC Sales Income. If one branch of a CFC makes goods and a branch in a different country sells the goods, the profits of the sales branch are Subpart F income if a tax reduction test is met. The branch rule treats a low tax branch as if it were a separate entity, causing a deemed sale between branches, followed by a sale to customers of goods purchased from a related party. Example: Swiss Co. makes machines in Germany and sells them throughout Europe from the Swiss sales office. The branch rule treats the machines as if they were sold by a German CFC to a Swiss CFC, who then sold them to customers. Thus, the sales portion of the profits are Subpart F income.

CFCs earning FBC Services Income may be providing services to customers or to related parties. If a related party subcontracts services to a CFC, and the CFC performs those services outside its country of incorporation, the U.S. shareholder must include the net income in his/her/its taxable income as the CFC earns the income.

A U.S. shareholder must also include in income the amount of the CFC's E&P invested in U.S. property. For this purpose, U.S. property is narrowly defined. It includes physical assets in the U.S. and amounts owed to the CFC by related U.S. parties. Thus, a loan of earnings back to the U.S. shareholder of a CFC results in an income inclusion for that U.S. shareholder almost as if a dividend had been paid. There are exceptions to the definition of U.S. property for trade payables of U.S. persons not outstanding longer than normal trade terms. A guarantee by a CFC of debts of a related U.S. party is considered an investment in U.S. property, as is a pledge of CFC shares by a U.S. shareholder.

No double tax. Subpart F also contains a mechanism to ensure that a shareholder is not taxed on distribution of E&P by the CFC. Any distribution is considered to come first from previously taxed amounts and is not included again in the distributee's income.

Conclusion: U.S. shareholders of controlled foreign corporations must include in their income each year their shares of certain of the income of the CFC, even if undistributed. They must also include in income any loans or advances to U.S. related parties. Careful planning is needed to reduce the effects of Subpart F.

Stephen C. Fox, CPA, has been helping mid-market companies reduce their international tax bills for over 30 years. He is a frequent speaker at international tax conferences, with articles published in major tax journals, including Journal of Taxation. Steve provides opportunities to save taxes through structuring, foreign tax credit planning, foreign tax reduction, pro active use of Subpart F, and IC-DISC. Learn more about how to reduce your international tax bill by clicking http://www.sfoxcpa.com/ or call Steve Fox today at 1(973) 610-5669.

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Many American expat tax returns should include each of two benefits that may reduce the expat's tax to zero: the foreign earned income exclusion and the foreign tax credit. This article tells you the basics of the exclusion on Form 2555, and how to get this benefit. A future article will discuss FTC.

Basics of exclusion: The foreign earned income exclusion is the amount of income (salary, bonus, stock options, etc.) earned for services outside the U.S. The exclusion for 2010 is limited to $250.68 per day ($91,500 for the whole year), plus housing expenses in excess of $40.11 per day. The American expat may claim the exclusion on Form 2555. The form must be filed with a timely original or amended return, a return that is no more than a year late, or a return on which no balance is due to the IRS.

Basic requirements: To qualify for the foreign earned income exclusion for a particular day, the American expat must have a tax home in one or more foreign countries for the day. The expat must also meet one of two tests. He or she must either be a bona fide resident of a foreign country for a period that includes the particular day and a full tax year, or must be outside the U.S. for any 330 of any consecutive 365 days that include the particular day. This test must be met for each day for which the $250.68 per day is claimed. Failing to meet one test or the other for the day means that day's $250.68 does not count.

Bona fide resident: An American expat is a bona fide resident of a foreign country if he/she is legally entitled (under that country's law) to live there, and actually does live there. If he/she has a visa that prohibits residency, he/she is not a bona fide resident. If he/she files a nonresident tax return in that country for a year, he/she is not a bona fide resident of that country for that year. Example: Mary lived and worked in Hong Kong from 2008 to May 1, 2010. She took three months of extended R&R traveling in the U.S., and returned to Hong Kong August 1, 2010, for a new job. Mary made $95,000 in 2010. If Mary had a resident visa for Hong Kong, she could get the full $91,500 exclusion. If she did not, she could only qualify for a partial exclusion under the 330 day test.

330 of 365 Days: The physical presence test is easy to say but can be hard to count. No particular visa is required. The American expat need not live in any particular country, but must live somewhere outside the U.S. to meet the 330 day physical presence test. The American expat merely counts the days out. A day qualifies if the day is in any 365 day period during which he/she is outside the U.S. for 330 full days or more. Partial days in the U.S. are considered U.S. days. 365 day periods may overlap, and every day is in 365 such periods (not all of which need qualify).

The mechanism for counting days can be confusing. I find it easiest to draw a time line and add up the days in and out. The results are often better than expected.

Here are two examples: Fred and Julie each lived outside the U.S. and filed nonresident tax returns in the relevant countries.

Fred was in Africa on multiple assignments during all of 2009. His tax home was in Zaire from 2008 through 2011. He returned to the U.S., arriving on March 1, 2010, for extended R&R, and left May 6 to return to Zaire. He was out of the U.S. only 288 days in 2010. He did not return to the U.S. through May, 2011, when he filed his American expat tax return. He earned no U.S. income. His 2010 salary was $91,000. Two of his qualifying periods are April 4, 2009, through April 3, 2010 (35 days in the U.S.) and April 3, 2010 through April 2, 2011 (34 days in the U.S.). These two periods together include all of the days in 2010. Fred can exclude the whole $91,000, because he met a 330 day test for each day during the year.

Julie lived in a rented apartment in Madrid but had a visa that did not permit her to be resident. She paid $1500 per month in rent. She had to leave every 90 days and renew the visa, and did weekend trips in Europe. She was out of the U.S. all of 2009 and 2011. In 2010, she returned to the U.S. to take a course during all of July, and visited friends for three weeks in March and three weeks in October, for a total of 73 days. She earned $100,000 for her work in Spain. Julie qualifies for the foreign earned income exclusion, but not all of her 2010 days qualify. Her two best qualifying periods are July 15, 2009 to July 14, 2010, and July 18, 2010, to July 17, 2011. If she extends her tax return filing deadline and files after July 17, she will have 362 qualifying days, for an exclusion limit of $90,747.

Housing Exclusion: Julie is in luck, though. She can also claim part of the housing exclusion as part of the foreign earned income exclusion. This exclusion is for housing in excess of $40.11 per day. She paid $18,000 in rent, or $49.32 per day. She can exclude the difference times 362 qualifying days, or $3,332.

Julie's total exclusion is $94,079. On her American expat tax return she also gets to claim a personal exemption ($3,650) and standard deduction ($5,700). Thus, her taxable income is negative. She owes no U.S. tax.

Count days before travel. Julie should carefully plan 2011 travel. If she had returned to the U.S. for three weeks in before July 2011, her days after July 14, 2010, would not qualify. Such a trip would have resulted in over $10,000 additional tax. Counting the days can save you a lot of money.

Conclusion: Claim the foreign earned income exclusion using Form 2555 on your American expat tax return to reduce your U.S. tax. You can qualify for the exclusion if you meet either the bona fide resident test or the 330 day test. If you still have taxable income after the exclusion, also claim the foreign tax credit for any foreign income taxes paid. The rules can be complex. Call or e-mail Steve Fox, CPA for the professional help you need to qualify for the exclusion.

Stephen C. Fox, CPA, has been helping expats reduce their international tax bills for over 30 years. He is a frequent speaker at international tax conferences, with articles published in major tax journals. Steve helps clients with tax return preparation, pre move tax and personal planning, and live personal service. Learn more about how to manage your taxes by clicking http://www.sfoxcpa.com/Expatriate-Tax.php or call Steve Fox today at 1(973) 610-5669.

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