International Business Structures And Their Tax Treatment

US entities doing business overseas can use a variety of structures. Some of the most important are listed below with notes about their taxation characteristics:

Controlled Foreign Corporation

The foreign subsidiary of a US corporation or a foreign company owned by US shareholders is typically a Controlled Foreign Corporation (CFC).

A CFC means any foreign corporation if on any day during the foreign corporation's taxable year US shareholders own more than 50% of:

• The total combined voting power of all voting stock, or
• The total value of all the stock.

A foreign corporation is any corporation not created or organized in the United States. A US shareholder is a US person that owns 10% or more of the voting power of all classes of stock entitled to vote of the foreign corporation. A US person is a citizen or resident of the United States, a domestic partnership or corporation, or any estate or trust unless its income from sources outside the US (other than income that is effectively connected with a US trade or business) is not includable in gross income under US tax law.

In determining whether a US person is a US shareholder, the US person will be considered to own stock that it owns:

• Directly;
• Indirectly through foreign entities; or
• Constructively under certain rules that attribute stock ownership from one entity to another.

A US shareholder includes actual distributions from a CFC in taxable income, plus under Subpart F of the Tax Code certain types of undistributed income of a CFC, including:

• Passive investment income;
• Income from the purchase of goods from, or sale to, certain related entities;
• Income from the performance of services for or on behalf of certain related entities;
• Certain types of shipping and oil-related income;
• Insurance income from insuring risk located outside the CFC's country of incorporation;
• Income from bad conduct activities, such as participation in an international boycott, payment of illegal bribes and kickbacks, and income from a foreign country during any period that country is "tainted" under IRC 901(j); and
• In addition, the US shareholders of a CFC are required to include in income their share of the CFC's increase in earnings invested in US property.

The Subpart F rules are extremely complex, and professional advice is absolutely necessary in interpreting them.

Foreign Sales Corporation

Under legislation dating from 1984, which was eventually declared unacceptable by the World Trade Organization after a complaint from the European Union, the US Internal Revenue Code authorized the establishment of foreign sales corporations (FSCs), being corporate entities in foreign jurisdictions through which US manufacturing companies could channel exports. 15% of the revenue concerned was exempted from corporation tax, meaning (at 35% tax) that companies kept 5.25% more of their revenue.  

The FSC rules generally replaced the domestic international sales corporation (DISC) rules. IC-DISCs exist, however, for small domestic taxpayers. See here for details.

The FSC tax regime and its replacement ETI legislation are described in detail here.

The FSC and ETI regimes were replaced with general other tax concessions under the American Jobs Creation Act 2004.

Possessions Corporations

Possessions corporations may operate to obtain the benefits of section 936 in all US possessions including the US Virgin Islands. However, the overwhelming majority of possessions corporations are operating in Puerto Rico.

Possessions corporations must have:

• Filed a valid Form 5712, Election To Be Treated as a Possessions Corporation Under Section 936 (an election cannot normally be revoked for the first ten years);
• Derived 80% or more of their gross income from sources in a US possession during the applicable period immediately before the tax year ended, and
• Derived 75% or more of their gross income from the active conduct of a trade or business in a US possession during the applicable period immediately before the tax year ended. In 1976 the amount was 50%. This amount increased over the years to 75%.

The 'applicable period' is generally the shorter of 36 months or the period when the corporation actively conducted a trade or business in the US possession.

A domestic international sales corporation (DISC) or a former DISC, or a corporation that owns stock in a DISC, former DISC, foreign sales corporation (FSC), or a former FSC is ineligible for Section 936 relief.

A possessions corporation is allowed a credit against its US tax liability equal to the portion of its tax that is attributable to:

• The taxable income from non-US sources from the active conduct of a US trade or business within a US possession, and
• The qualified possession source investment income.

The credit is not allowed against environmental tax, tax on accumulated earnings, personal holding company tax, additional tax for recovery of foreign expropriation losses, tax increase on early disposition of investment credit property, tax on certain capital gains of S corporations or recapture of low income housing credit.

A possessions corporation may elect either the cost sharing or profit split method of computing taxable income with respect to a certain possession product.