Controlled foreign corporation (CFC)

A foreign corporation becomes a CFC when U.S. shareholders collectively own more than 50% of the company on any day during its tax year. This ownership can be measured by either voting power (the right to vote on corporate decisions) or total value (the worth of the company's stock).

However, not all U.S. owners count toward this calculation. Only "U.S. shareholders" matter for this test. A U.S. shareholder is defined as a who owns at least 10% of either the company's voting stock or the total value of all its shares. When determining whether the 50% threshold is met, the IRS only counts these qualifying U.S. shareholders and adds up their combined ownership.

The ownership calculation includes both direct ownership (shares held directly) and (shares attributed through family members, partnerships, or other relationships). These attribution rules follow a modified version of of the Internal Revenue Code.

When a foreign corporation qualifies as a CFC during a tax year, each U.S. shareholder must include specific types of CFC income in their own taxable income. This inclusion happens immediately, even if the U.S. shareholder never actually receives any cash distributions from the CFC during that year.

Congress created this system to prevent U.S. shareholders from avoiding taxes by keeping profits overseas indefinitely. Instead of allowing indefinite deferral, the law requires U.S. shareholders to pay taxes on certain foreign earnings as they accrue.

U.S. shareholders must recognize their proportional share of the CFC's "" on a current basis. Subpart F income includes specific categories of income that Congress determined should not benefit from tax deferral.

These categories include dividend and interest payments received by the CFC, annuity income, gains from buying and selling securities, specified gains from commodities transactions, certain insurance-related income, and income from transactions with related companies. Each category has specific exceptions and limitations that depend on the CFC's business activities.

In addition to , U.S. shareholders must also report their share of the CFC's (GILTI). GILTI captures the CFC's income that exceeds a specified threshold based on the corporation's tangible assets (physical property like buildings and equipment).

The GILTI calculation targets income that appears to come from like intellectual property, which can easily be moved to low-tax jurisdictions. For tax years through 2025, corporate U.S. shareholders can claim a deduction equal to 50% of their GILTI inclusion. This deduction effectively subjects GILTI to a 10.5% federal tax rate before considering foreign tax credits.

Under legislation enacted on July 4, 2025, this deduction became permanently set at 40% for tax years beginning after December 31, 2025. This change results in an approximate effective federal rate of 12.6% on GILTI inclusions. Additionally, corporations may credit foreign income taxes they paid, though the credit is limited to 80% of foreign taxes attributable to tested income.

When a U.S. shareholder is itself a partnership (such as a domestic hedge fund), the treatment of CFC-derived income becomes more complex. establish different rules for GILTI and Subpart F income.

For GILTI purposes, the regulations apply "partnership-level look-through." This means each individual partner in the U.S. partnership who owns at least 10% of the CFC (directly or indirectly) must recognize their share of GILTI income. For Subpart F income, there is an optional look-through regime under regulations finalized after 2019. This regime similarly requires that only beneficial owners meeting the 10% threshold recognize Subpart F inclusions.

A U.S. shareholder's tax basis in CFC stock generally increases by the amount of any CFC income included in the shareholder's gross income under these anti-deferral rules. Tax basis represents the shareholder's investment for tax purposes and affects gain or loss calculations when the stock is sold.

When the shareholder later receives cash or property distributions that relate to previously taxed income, the shareholder's basis in the CFC stock decreases by the same amount. This basis mechanism prevents double taxation by ensuring shareholders don't pay tax twice on the same income—once when it's included under the CFC rules and again when it's actually distributed.

When a foreign corporation qualifies as both a CFC and a , special coordination rules prevent overlapping tax treatments. A U.S. taxpayer holding 10% or more of either the voting power or total value of such a corporation is not treated as a PFIC owner for that portion of their holding period.

However, this relief does not extend to U.S. taxpayers whose interest falls below the 10% threshold on both measures. These minority owners must still comply with PFIC rules. When income would be taxable under both the Subpart F regime and the PFIC rules, the Subpart F inclusion takes precedence to prevent double taxation of the same earnings.

The CFC rules create significant complications for hedge fund structures, particularly offshore funds with substantial U.S. investor participation. Key implications include:

• Subpart F income: U.S. shareholders may be required to include certain types of passive income in their current taxable income
• GILTI inclusions: Additional inclusion requirements for certain foreign-source income beyond the Subpart F categories
• Basis adjustments: Complex calculations for determining tax basis in CFC stock
• Coordination with PFIC rules: Overlapping anti-deferral regimes requiring careful analysis

Hedge funds employ various strategies to manage CFC implications including:

• Structural design: Avoiding CFC status through ownership limitations
• : Isolating U.S. tax-exempt and taxable investors
• Income management: Careful management of income types to minimize Subpart F inclusions
• Timing strategies: Planning for distributions and redemptions
• Coordination: Working with other anti-deferral regimes such as PFIC rules

CFC status triggers significant reporting obligations. U.S. shareholders must file (Information Return of U.S. Persons with Respect to Certain Foreign Corporations). This form requires detailed financial information, ownership structure disclosure, and CFC-related items that may affect the U.S. shareholder's income.

Updates to Form 5471 that took effect in December 2024 now require:

• Form 5471 Main Schedules: Detailed information returns for U.S. shareholders
• CAMT Reporting (Schedule H-1): New schedule reporting the CFC's adjusted net income or loss for corporate alternative minimum tax purposes
• Top-up Tax Disclosure: New lines 20a and 20b requiring reporting of any top-up tax paid or accrued related to rules
• Comprehensive financial information reporting: Balance sheets, income statements, and detailed transaction disclosure
• Coordination requirements: Integration with other international tax provisions including and requirements

Hedge funds must carefully monitor ownership levels and implement appropriate systems to track and report CFC-related information to ensure compliance with these complex requirements. Failure to file Form 5471 can result in significant penalties. The IRS assesses $10,000 per year and potentially an additional $10,000 per month (capped at $50,000 annually) if filing is not completed within 90 days of IRS notice.