U.S. shareholders of foreign corporations are generally not subject to U.S. federal income tax on the earnings of such corporations until those earnings are repatriated to the shareholders in the form of a dividend. Where a foreign corporation is classified as a “controlled foreign corporation” (“CFC”), however, its “United States shareholders” must include in income currently their pro rata share of the Subpart F income of the CFC for that taxable year whether or not such earnings are distributed at that time.
As a result, the detriments of U.S. shareholders owning shares in a CFC that earns subpart income are:
- No deferral is available if the income of the CFC consists of subpart F income and
- Subpart F income is treated as ordinary income, regardless of whether the CFC is resident in a jurisdiction that has a comprehensive income tax treaty with the United States, and therefore would be able to repatriate its profits at qualified dividend rates (currently taxed at a maximum federal income tax rate of 20 percent).
In general, a CFC is a foreign corporation, more than 50 percent of which is owned (by vote or value), directly or indirectly, by “United States shareholders.” A United States shareholder is a U.S. person who owns, directly, indirectly or constructively, at least ten percent of the combined voting power with respect to the foreign corporation.
The primary categories of Subpart F income consists of certain types of income determined by Congress to be subject to manipulation, such as:
- Passive investment income (e.g., interest, dividends, rents, royalties, capital gains, etc.)
- Icome from sales of goods purchased from or sold to related persons
- Icome from services performed for or on behalf of related persons.
Assuming it is not possible to structure around the subpart F rules, it may be possible to circumvent them by taking advantage of the so-called “high-tax exception” to subpart F income. This may be able to be accomplished with the use of a CFC that is a tax resident of Malta. Under Section 954(b)(4) of the Internal Revenue Code, a U.S. shareholder of a CFC is able to exclude from subpart F income an item of income earned by a CFC if the taxpayer can show that the income was subject to an effective foreign income tax rate greater than 90 percent of the maximum U.S. federal income tax rate, which is currently 35 percent. Therefore, the high-tax exception will apply to income earned by a CFC that is subject to an effective foreign tax rate greater than 31.5 percent.
For purposes of this provision, the effective tax rate equals (1) the foreign income taxes paid, accrued, or deemed accrued with respect to the net item of income, divided by (2) the net item of subpart F income (increased by the income taxes on the item). What is notable about these provisions is that they specifically provide that the amount of foreign income taxes paid, accrued, or deemed accrued with respect to an item of income will not be affected by a subsequent reduction in foreign income taxes attributable to a distribution to shareholder of all or part of such income. This is also made clear in another set of regulations, which further provide that if the effective foreign tax rate imposed on a foreign corporation is reduced under foreign law upon the distribution of that income, the rules of Section 954(b)(4) are applied without regard to the possibility of a subsequent foreign tax reduction.
Malta’s Corporate Tax Refund System
It may be possible to take advantage of the high-tax exception to subpart F income, even though the effective foreign tax rate is substantially below the requisite 31.5 percent rate, by using a CFC that is tax resident in Malta. In general, Malta has a corporate income tax rate of 35 percent. Malta, however, applies an “imputation system” whereby the corporate income tax paid by the company is refunded to the shareholders when distributions are made to them. The amount of the refund depends on the type of income earned by the company.
Generally, when dividends are paid by a Maltese company, the shareholders become entitled to claim refunds of 6/7 of the Maltese corporate income tax paid. This results in an effective corporate income tax rate of 5 percent. The refunds are payable within 14 days from the last day of the month in which the request is made to the Maltese tax authorities.
Therefore, if a Maltese CFC earns certain types of income that would otherwise be considered subpart F income (e.g., gains from the sale of stocks or securities), that income may not be considered as subpart F income as it initially will be subject to corporate income tax in Malta at a 35 percent rate. Based on the regulations discussed above, this result should not be affected by a subsequent distribution of the earnings of the Maltese company that causes a reduction in the effective corporate income tax paid in Malta to a rate as low as 5 percent.
It also may be possible to continue to defer the income earned by the Maltese CFC from U.S. federal income tax by using a Maltese holding company to own the shares in the Maltese operating company. This would allow the dividend (and the corresponding Maltese tax refund) to be received by such Maltese holding company without those amounts being subject to U.S. federal income tax until repatriated by the holding company, to the United States. When the Maltese holding company does pay a dividend to the United States, such dividend should be eligible for qualified dividend rates because the United States and Malta have a comprehensive income tax treaty.
Accordingly, if successful, this structure would allow a U.S. taxpayer to defer from U.S. federal income tax certain types of income or gains that would otherwise be characterized as subpart F income (e.g., short-term or long-term capital gains, dividends, royalties, etc.) and convert such income from ordinary income (currently taxed at a maximum rate of 39.6 percent) into qualified dividend income (currently taxed at a maximum income tax rate of 20 percent), despite the fact that the effective foreign income tax rate paid would only be 5 percent.