Foreign Funds and Investment Entities Should Evaluate CFC Status Under New 2018 Rule
Offshore funds and investment entities (treated as corporations for U.S. tax purposes) that have U.S. investors (whether taxable or tax-exempt) should take a fresh look at the ownership of both their voting and non-voting stock to determine if they are controlled foreign corporations (“CFCs”) during 2018, due to a key change made by the Tax Cuts and Jobs Act (“TCJA”).
U.S. shareholders owning 10% of a CFC are generally required to annually file IRS Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations. A U.S. person who is required to file the form and fails to file or report all of the required information by the due date is subject to a $10,000 penalty. A CFC is any foreign corporation if more than 50% of (a) the voting power of all classes of stock of such corporation, or (b) the total value of the stock of such corporation is owned (or considered as owned through attribution) by “U.S. Shareholders” (as defined).
For tax years beginning before 1/1/18, a U.S. Shareholder (for purposes of the CFC test) was a U.S. person (including a U.S. tax-exempt person) who owned at least 10% of the total combined voting power of all classes of a foreign corporation’s voting stock. Accordingly, some offshore funds and investment entities, particularly those set up for foreign and U.S. tax-exempt investors, did not issue any U.S. investors 10% or more of the voting stock (notwithstanding that they may have owned 10% or more of the corporation’s value), thereby disqualifying such investors from being taken into account for the CFC test (which required more than 50% of the vote or value to be held by U.S. shareholders, but only counting those who owned 10% of the voting stock). As a result, the offshore fund/investment entity was not considered a CFC, U.S. tax-exempt investors were not required to annually file Form 5471, and if (for whatever reason) there was a U.S. taxable investor who owned 10% or more of the value of the offshore fund, it was still not subject to Subpart F income and/or deemed repatriation of undistributed earnings and profits as of 12/31/17.
New Law (TCJA)
For tax years of foreign corporations beginning after 12/31/17, the TCJA expands the definition of a U.S. Shareholder to include U.S. persons who own 10% of the total value of shares of all classes of the foreign corporation. Accordingly, all U.S. shareholders who own 10% of the value of all the shares (regardless of how much voting stock they own) are counted toward the “more than 50%” threshold in the CFC test. Accordingly, foreign corporations may have become CFCs as of 1/1/18 or later, whether or not there were any vote or value ownership changes during 2018.
- Offshore funds and investment entities should evaluate CFC status by
- Listing ownership of all classes of stock by investor by (a) vote and (b) value and calculating the respective percentage owned by each investor for each of vote and value.
- Classifying all investors (and their respective percentage ownership) as U.S. or foreign. Highlight all U.S. investors who own 10% or more of vote or value. If the total of all those highlighted is more than 50%, by either vote or value, then the foreign corporation is a CFC.
Note: There are complex attribution rules which would treat a US person as owning stock of the foreign corporation not actually owned by such US person. The rules typically apply between related parties, whether family members or through ownership of related entities. Consider that, where applicable, these rules could have the effect of making a U.S. person who directly owns less than 10% (and would therefore not otherwise be “counted”) as owning 10%. Consult your tax advisor if unsure.
- For offshore investment entities that had changes in ownership during 2018, which is more likely if investing in liquid assets and the investors are permitted to invest or redeem during the year, separately performing the CFC test for each period during 2018 that had different ownership percentages. It is possible that the foreign corporation was a CFC for just part of the year, and it is important to establish its status as such, especially for the last day of its tax year.
- If the offshore fund/investment entity is a CFC:
- Plan to take appropriate steps after year-end to notify all 10% U.S. shareholders that the corporation is a CFC and to consider their Form 5471 filing requirements in respect thereto (note that Form 5471 is filed by U.S. shareholders, not by the CFC itself).
- Plan for the provision of information necessary for U.S. shareholders to report on Form 5471.
- 10% U.S. shareholders that are subject to tax will need to consider their pro rata shares of Subpart F and/or GILTI from the foreign fund/investment entity. If the nature of the offshore investment entity’s income is not Subpart F, a GILTI evaluation should be considered. This can be particularly complex and accordingly it is prudent to consider as soon as possible.
- Even if the offshore fund/investment entity is not a CFC, a 10% U.S. shareholder by vote or value may be required to file Form 5471 in respect of an acquisition, disposition, or similar transaction involving ownership of the foreign corporation. In addition, a U.S. director or officer of the foreign corporation may be required to file Form 5471 in certain instances. While the foreign corporation itself is not required to file Form 5471, it is best advised to alert its U.S. investors, officers, and directors in situations where the latter may have such a filing requirement.
The expansion of the definition of a U.S. shareholder of a CFC has significant ramifications for offshore funds and investment entities, although this may not be readily apparent in a cursory reading of the TCJA. These entities and their investors should proactively consider how they may be affected and take appropriate action so as not to be unpleasantly taken by surprise at a later time.