Andy Powers-A Professional who cares..About YOU!
Chinese Wholly Foreign Owned Entities "WFOE" <sometimes called "WOFE">-Subparf F Foreign Base Company Income
Sometimes the obvious is too obvious is too obvious to find an answer, be it in US Treasury Regulations, IRS Pronouncements or Instructions, articles or anywhere. However in my decades of experience dealing with U.S. tax law, compliance, audits and planning I have learned to never take anything for granted and not to assume that the obvious answer won't be challenged by the IRS.
This is the case with a wholly owned foreign subsidiary if a foreign entity that is a CFC. The rules are written for foreign entities business with related parties with the original legislative intent specifically addressing U.S. entities avoiding paying tax by selling through tax haven subsidiary entities and then reselling to foreign distributors (all wholly owned subsidiaries) and then reselling to third party customers while shifting all profits to the entity created in the tax haven. It has not caught up to the fact that now there are Americans living in foreign countries, such as China, who want to do business in the country or their residence, say in China, but need to adhere to local laws and also deal with issues of foreign currency and in order to deal wit these issues they need to set up another foreign entity, usually either in Hong Kong or Singapore that owns the Chinese wholly Foreign Owned Entity In many cases these are relatively small businesses, either small Chinese manufacturers or product resellers and sometimes the owner provides consulting services. The entity structure has noting to do with their U.S. tax liability. They are more than happy to draw a salary from their one or both of their foreign business entities which, as they are bonafide residents of China and pay income tax to China, a portion or all of their personal foreign earned income (salary) is excluded under Section 911 or offset by foreign tax credits to avoid double taxation, and the difference would either be Subpart F income, taxable currently, or partially deferred. In many cases, unless the money is needed to be invested in infrastructure needed to operate the business, the money will be taxed eventually so why not now some say.
Regardless of the tax consequences, these Americans living in countries such as China face a myriad of tax compliance requirements, and any error could be deemed as being subject to substantial penalties for "failure to comply with tax rules". Well the rules are so darn complicated it is very easy to misinterpret something or not understand it and make a mistake. But rather than a slap on the wrist, they could face penalties that could cause them to loses their businesses and their lively hood. Also, under recently enacted rules, if the IRS issues a bill for either tax, penalties or both and the amount is $50,000 or more, their passports can be revoked. So while the large multinational business have full time attorneys on staff to address these problems, the little guy (and his or her family) could be ruined for life.
Here is an example. Say an American who lives in Shanghai is an engineer who provides consulting to businesses located both within and without China through his businesses. Because of local laws in China he needs to establish a wholly owned foreign entity in China (WFOE), which can be owed either directly, or indirectly through the other foreign entity that is formed to do business with customers outside mainland China because of local restrictions. These entities are usually limited companies formed either in Hong Kong or Singapore (where the banking laws are less restrictive). Here is the rub. If the HK or S entity reimburses the WFOE for the salary paid to the American expatriate, and bills customers outside of HK or S, (including customers in mainland China), the income is deemed FBCI and must be reported as such by the CFC parent company in HK or S. OK you say, what's the big deal. The easiest thing to do would be to consolidate the income and expenses of the WFOE into the Form 5471 filed by the HK or S parent company and pay tax on the net income. But the IRS will penalize for consolidating the income of the two entitles and not reporting them separate as this is deemed to be "not in substantial complieance". But what if the Chinese WFOE pays all the salary of the American owner but does not bill it plus incurs other expenses. The rules state that all the billing revenue gets reported by the CFC parent which is Subpart F FBCI, taxable to the American owner, but the salary and other expenses of the Chinese entity (as it can't be treated as a branch of the CFC parent) are suspended until the Chinese WFOE has positive E&P that is greater than the aggregate expenses. But, the regulations go on to say, the even a registered Branch, if it does not follow certain rules, can be treated as a separate CFC even though it is indirectly owned by the American individual through ownership of the HK or S parent.
Needless to say all this is very confusing and difficult to follow even by a seasoned CPA, no less the average guy who knows noting abut taxes no less international tax.
Here is an example of how some of the rules work:
TR 1.954-3---
Pursuant to TR 1.954-3 regulations, the implication is that regardless of whether the CFCs are separately owned or of a parent subsidiary relationship, they are first and foremost separate CFCs each subject to CFC Subpart F rules.
In this regard, as regards to FBC Sales Income, each would determine their respective Subpart F income to be reported by the U.S. shareholder, based on the facts and circumstances of each. Accordingly, if Hong Kong CFC Parent buys product from China CFC subsidiary manufactured by CFC Sub in China, E&P of HK CFC would be FBCSI subject to Subpart F Rules.
China CFC, manufacturing in China would have BCSI for sales to HK Parent CFC as well as third party customers located outside China. However sales of products manufactured in China to Chinese customers are not FBCSI and no Subpart F.
If HK Parent were to establish China Co as a branch, or if China CFC elected FDE treatment, special tax rules would apply to determine if China CFC were a branch deemed selling products manufactured in China on behalf of HK parent and therefore subject to Subpart F for sales to Chinese customers or if treated as separate CFC.
SERVICES
Although there is no branch rule specified in 954(d) regarding the above, IRS is looking at third country branch SALES activity as sales by CFC parent of services sourced outside country of organization and therefore Subpart F.
However as separate entity Subpart F is determined based on facts and circumstances. Thus sales of services by Parent that is provided by either subsidiary or branch outside country of parent organization, this is Subpart F Income. Correspondingly, sales by China CFC sourced in China are not FBC Service Income and no Subpart F. However PARAMOUNT THAT SALARY NOT BE PAID BY OR REIMBURSED BY PARENT CO!!!
(e) Comparison with ordinary treatment. Income derived by a branch or similar establishment, or by the remainder of the controlled foreign corporation, will not be foreign base company sales income under paragraph (b) of this section if the income would not be foreign base company sales income if it were derived by a separate controlled foreign corporation under like circumstances.
(f) Priority of application. If income derived by the branch or similar establishment, or by the remainder of the controlled foreign corporation, from a transaction would be classified as foreign base company sales income of such controlled foreign corporation under section 954(d)(1) and paragraph (a) of this section, the income shall, notwithstanding this paragraph, be treated as foreign base company sales income under paragraph (a) of this section and the branch or similar establishment shall not be treated as a separate corporation with respect to such income.
(3) Inclusion of amounts in gross income of United States shareholders. A branch or similar establishment of a controlled foreign corporation and the remainder of such corporation shall be treated as separate corporations under this paragraph solely for purposes of determining the foreign base company sales income of each such corporation and for purposes of including an amount in subpart F income of the controlled foreign corporation under section 953(a). See section 954(b)(3) and paragraph (d)(4) of § 1.954-1 for rules relating to the treatment of a branch or similar establishment of a controlled foreign corporation and the remainder of such corporation as separate corporations for purposes of independently determining if the foreign base company income of each such corporation is less than 10 percent, or more than 70 percent, of its gross income. For all other purposes, however, a branch or similar establishment of a controlled foreign corporation and the remainder of such corporation shall not be treated as separate corporations. For example, if the controlled foreign corporation has a deficit in earnings and profits to which section 952(c) applies, the limitation of such section on the amount includable in the subpart F income of such corporation will apply. Moreover, income, war profits, or excess profits taxes paid by a branch or similar establishment to a foreign country will be treated as having been paid by the controlled foreign corporation for purposes of section 960 (relating to special rules for foreign tax credit) and the regulations thereunder. Also, income of a branch or similar establishment, treated as a separate corporation under this paragraph, will not be treated as dividend income of the controlled foreign corporation of which it is a branch or similar establishment.
Here is a great link to a guide that I found on the web years ago regarding Chinese WFOEs and Subpart F Tax Archives\Challenges Ahead for Contract Manufacturing in China.doc.
The bottom line is, why doesn't Congress and the IRS keep it simple for the little guy who can't afford the services of a Big 4 International CPA firm or an International attorney.