Article category: US Tax

What Makes a Company a CFC?

Under US tax law, a foreign corporation is considered a Controlled Foreign Corporation if US persons collectively own more than 50% of the total voting power or value. Any US person owning 10% or more is treated as a “US shareholder” for CFC purposes — required to file Form 5471 each year and report certain types of income earned by the CFC, even if not distributed.

What Income Must Be Reported?

Each 10%+ US shareholder is subject to US tax on their pro-rata share of the CFC’s Subpart F income and Global Intangible Low-Taxed Income (GILTI). Subpart F income includes passive income such as interest, rent, royalties, dividends, annuities, and capital gains on assets generating passive income. These deemed inclusions are taxed at ordinary income rates (up to 37%), not the preferential long-term capital gains rate.

The Practical Lesson

If you’re a US person with foreign business interests or equity in foreign startups, don’t assume silence is safe. You may have significant tax and reporting obligations even if you’ve never received a single dollar from the company.

What is a PFIC?

Under US tax laws, any non-US corporation is considered a Passive Foreign Investment Company if 75% or more of its gross income is passive income (interest, rent, royalties, dividends), or 50% or more of its assets produce such passive income. Many foreign mutual funds, offshore investment funds, ETFs, and holding companies fall into this category.

The PFIC Tax Trap — Why It’s Punitive

Gains on sale of PFIC shares are taxed as ordinary income, not at lower long-term capital gains rates. Excess distributions are taxed at the highest marginal rate regardless of the actual bracket. The IRS adds a punitive interest charge on the tax “should have been paid” in prior years. Distributions don’t qualify for reduced tax rates.

Two Elections That Can Help

Qualified Electing Fund (QEF) election: The US shareholder includes their share of the PFIC’s earnings each year, preserving income character and allowing capital gains treatment on sale. Requires annual information from the PFIC.

Mark-to-Market (MTM) election: Available only for publicly traded PFIC shares. Gains and losses are recognised based on year-end market value. Avoids the default regime’s interest charges.

Substantial Presence Test

You meet the SPT if you are physically present in the US for at least 31 days during the current year AND 183 days over 3 years (counted as: all days this year + 1/3 of last year + 1/6 of the year before).

When Does Residency Start?

If SPT is met: residency starts on the first day of physical presence. For Green Card holders where SPT is not met: residency starts on the first day of arrival as a lawful permanent resident. Income earned before the residency start date is generally not taxed unless US-sourced.

Planning Tip

If you’re planning a move to the US, timing matters — smart planning in your first year of residency can make a significant difference in your tax obligations.

The Scenario

An individual goes on a long trip to the US and unexpectedly meets the Substantial Presence Test — a rule that can make the IRS treat them as a US resident for tax purposes, taxing worldwide income.

The Closer Connection Exception

To claim this exception, you must meet all conditions: US stay during the year is less than 183 days; you maintain a tax home in a foreign country; and you can demonstrate a closer connection to that country through permanent home, family, business interests, personal belongings, and social ties.

For global professionals, NRIs, consultants, and business owners travelling to the US — days matter, but ties matter more.

What is the HIRE Act?

The Halting International Relocation of Employment Act proposes to aggressively discourage outsourcing by US companies. It introduces a 25% tax on outsourcing payments — any premium, fee, royalty, service charge, or other payment made by US persons to foreign persons for labour or services where the benefit is directed to US consumers.

Impact

No business tax deduction would be allowed for these expenses, increasing total cost. For payments relating to services benefiting both US and non-US consumers, the tax would be apportioned to cover only the US consumer portion. This would make outsourcing significantly more expensive for US businesses.

How Estate Tax Works

When a person passes away, the fair market value of their assets is aggregated. After deductions, the remaining taxable estate may face federal estate tax — up to 40%. Some states also impose their own estate taxes with lower exemption amounts.

The NRA Trap

For non-US citizens and non-domiciliaries (such as Indian residents), estate tax applies to US situs assets — including US real estate, shares of US corporations, and tangible property located in the US. The exemption is only $60,000. A US asset portfolio worth $1 million could trigger an estate tax bill of up to $376,000.

Planning Solutions Exist

While estate tax may seem daunting, there are proven US estate tax blockers and planning tools — entity structuring, trust solutions, and treaty-based planning — that can help reduce exposure.

How Blocker Structures Work

US situs assets include US real estate, tangible property in the US, and shares of US corporations. Shares of foreign corporations are not US situs assets. By holding US assets through a foreign corporation instead of directly, the estate tax inclusion is blocked.

The Double Taxation Drawback

The foreign corporation pays tax on income received from US sources, and dividends to the individual are taxed again. US tax treaties may provide different rates depending on whether the investor is a company or individual.

What If You Already Hold US Assets Directly?

Transferring existing US stocks or real estate to a foreign blocker involves capital gains tax, and for real estate, potential transfer tax and property tax implications. Planning should ideally be done before the investment, not after.

How Trust Planning Works

Placing assets into an irrevocable trust removes them from the transferor’s taxable estate. However, US tax code contains special “strings” provisions — retained powers such as control over beneficiaries, power of appointment, or ability to change terms can bring assets back into the taxable estate.

Gift Tax Considerations

For US citizens/domiciles, transferring assets to an irrevocable trust is a completed gift subject to gift tax. For non-US citizens/domiciles, no US gift tax applies on such transfers — a significant planning advantage.

Foreign Trust Complexity

US transferors remain treated as grantors for income tax purposes, meaning they remain liable for income tax on the trust’s income. Throwback tax may apply on distributions of accumulated income. Extensive information reporting (Form 3520, Form 3520-A) is required for US persons connected with foreign trusts.

Income Tax Planning

One strategy is to set up a foreign irrevocable trust before moving to the US and irrevocably transfer foreign assets into that trust (a “drop-off trust”). The non-resident should set up and fund the trust at least 5 years before becoming a US person — otherwise, the US person will be subject to US tax on future income earned on those assets.

Estate and Gift Tax Planning

An irrevocable transfer to a foreign trust of foreign assets can move those assets out of the estate. Care must be taken that the settlor does not retain any rights or powers — control over distributions, beneficial enjoyment, substitution rights — which could pull assets back.

Alternative Route

Before migrating, the taxpayer can transfer foreign assets to a foreign irrevocable discretionary trust, where they and family members become discretionary beneficiaries. The taxpayer may still be considered a grantor for US tax purposes, but if structured properly, those assets remain outside the taxable estate.

The Problem

On the death of a US citizen/domicile, all assets can be transferred to the surviving US spouse without immediate estate tax — the unlimited marital deduction. But this benefit requires the spouse to be a US citizen. Direct transfer to a surviving non-US spouse triggers immediate estate tax at up to 40%.

The QDOT Solution

Establish a trust that qualifies as a Qualified Domestic Trust. The US spouse transfers assets to the trust with the surviving non-US spouse as beneficiary. This qualifies for the marital deduction — no immediate estate tax. The surviving spouse receives all income from the trust without estate tax, though distribution of principal triggers estate tax.

Practical Example

Without planning on a $20 million estate, the tax bill is $2 million immediately. With a QDOT, the transfer qualifies for the unlimited marital deduction — no immediate tax. The surviving spouse receives income for life while planning for the eventual estate tax obligation.