Subpart F Inside a Canadian Corporation: The Passive Income the IRS Taxes Immediately, and How It Differs From GILTI

Short version: Subpart F Income Explained: Passive Income in a CFC

Subpart F is the older of the two regimes and the one people confuse with its younger sibling. It taxes a US shareholder of a controlled foreign corporation currently — without any dividend — on the corporation's "Subpart F income," a defined set of categories dominated in practice by foreign personal holding company income: interest, dividends, rents, royalties, and gains from the sale of property that produces those items, plus certain related-party sales and services income and a few narrower categories. It does not tax active business income as such; that was the gap the tested-income regime (GILTI, now renamed) was enacted to close. The two regimes therefore divide the corporation's income: Subpart F takes the passive slice first, the tested-income regime takes most of what remains, and the two do not overlap on the same dollar. For the ordinary Canadian operating company owned by a US citizen — a consulting corporation, a medical professional corporation, a small manufacturer — Subpart F is quiet in the early years because the corporation earns active income and holds little beyond working capital. It becomes loud the year the owner starts investing the retained earnings inside the corporation: the portfolio of Canadian dividend stocks, the bond fund, the rental property held in the corporation, the interest on a large cash balance — each generates foreign personal holding company income that is Subpart F income taxed to the owner on their 1040 in the year the corporation earns it, at ordinary rates (not qualified-dividend rates), with no US deferral and with the foreign tax credit machinery as the only relief. The relief that usually works: the high-tax exception. Subpart F income that is subject to foreign income tax at an effective rate greater than 90% of the US corporate rate (currently 21%, so the threshold is 18.9%) may be excluded from Subpart F income by election — and Canadian passive investment income earned inside a private corporation is taxed at combined federal-provincial rates around 50%, far above the threshold, so the exception is available for essentially all of it. The exception is elective, made annually on the return with the Form 5471 reporting, and applies item by item; where it is elected, the passive income stays deferred for US purposes until distributed. Two cautions on relying on it: the effective rate is measured on the income as computed for US purposes against the Canadian tax actually imposed, so items that Canada taxes lightly or not at all — the non-taxable half of a Canadian capital gain, for example — can fail the test on their own; and the Canadian refundable-tax mechanism (the refundable dividend tax on hand system, covered separately) means part of the Canadian tax on passive income is refunded when dividends are paid, which raises the question of whether the "tax paid" for the exception is the gross or the net — a technical point on which the computation should be documented. The de minimis and full-inclusion rules bracket the analysis: if the corporation's gross Subpart F income is less than the lesser of 5% of gross income or US$1 million, none of it is Subpart F income (the de minimis rule that keeps small interest balances out); if Subpart F income exceeds 70% of gross income, all the corporation's income becomes Subpart F income (the full-inclusion rule that catches a corporation that has become an investment holding company). Interaction with the tested-income regime: Subpart F income is excluded from tested income, so the same dollar is never taxed under both; high-tax-excepted Subpart F income is also excluded from tested income (it is deferred entirely); and the tested-income regime has its own high-tax exclusion at the same 18.9% threshold, which most Canadian active business income taxed at general corporate rates (around 26.5% combined) passes, but small-business-rate income (around 12% combined) fails — the reason the tested-income regime, not Subpart F, is the live problem for most small Canadian corporations. Reporting runs through Form 5471 (Schedule I for Subpart F, Schedule I-1 for tested income), the shareholder's inclusion on Form 1040, previously taxed earnings tracking so that the later dividend of income already taxed under Subpart F is not taxed again, and the foreign tax credit computation in the applicable basket — the mechanics that make the CFC return a professional document rather than a schedule.

Key takeaways

• Subpart F taxes passive income currently: interest, dividends, rents, royalties, and gains on passive assets earned inside your Canadian corporation are taxed on your 1040 in the year earned, at ordinary rates, with no US deferral.
• The high-tax exception usually turns it off: passive income Canada taxes above 18.9% (nearly all corporate investment income, taxed around 50%) can be excluded by annual election — item by item, with the computation documented, and with care around lightly-taxed items like the untaxed half of capital gains.
• The brackets: de minimis (under the lesser of 5% of gross income or US$1 million — none is Subpart F) and full inclusion (over 70% — everything is) define where the analysis starts and where a holding company lands.
• Subpart F and tested income don't overlap: the passive slice goes to Subpart F (or is excepted); the rest is tested income; the tested-income regime's own high-tax exclusion saves general-rate income and fails small-business-rate income — which is why it, not Subpart F, is the usual problem.
• The trigger is investing inside the corporation: an operating company with working capital is quiet; the same company holding a portfolio, a rental, or a large interest-bearing balance is a Subpart F filer every year.
• Reporting is the substance: Form 5471 Schedules I and I-1, the 1040 inclusion, previously-taxed-earnings tracking, and basket-specific credits — the machinery that prevents double taxation of the same dollar on later distribution.

The annual Subpart F review for a Canadian corporation

Identify each category of income the corporation earned: active business (tested income), passive (foreign personal holding company income), related-party items. Apply the de minimis test to the passive total. For passive income above de minimis, compute the Canadian effective rate on each item as measured for US purposes; elect the high-tax exception where it passes; include the rest on the 1040 with credits. Track previously taxed earnings by year and category so distributions are matched. Then run the tested-income regime on the remainder — a separate computation with its own exclusion and its own election (the section 962 guide covers the individual's rate choice). One review per year, documented, prevents the two classic errors: taxing excepted income twice, and missing the year the corporation quietly became a holding company.

Worked example

A US citizen in Vancouver owns a consulting corporation earning C$300,000 of active income annually and, after eight profitable years, holding C$1.4 million of retained earnings invested in a Canadian dividend portfolio and a GIC ladder. Year nine's Subpart F review: passive income of C$62,000 (dividends and interest) against gross income of C$362,000 — over the de minimis threshold. Effective Canadian rate on the passive income as measured for US purposes: about 50% — the high-tax exception is elected, item by item, and the C$62,000 stays deferred for US purposes; the computation memo notes the refundable-tax question and documents the position taken. The active C$300,000 is tested income: taxed in Canada at the small-business rate (about 11%), it fails the tested-income high-tax exclusion and is included on his 1040 through the tested-income regime — the section 962 election is modeled and made. His counterfactual: the same year without the review, his US preparer includes the C$62,000 as Subpart F income at ordinary rates (about US$16,000 of US tax before credits, then a credit computation that mostly but not fully absorbs it), no exception elected, and the previously-taxed-earnings account never opened — so that the dividend he pays himself three years later is taxed again on the portion already included. The exception was available every year; someone had to elect it.

Official sources

"In general, a CFC is a foreign corporation that has U.S. shareholders that own (directly, indirectly, or constructively, within the meaning of section 958(a) and (b)) on any day of the tax year of the foreign corporation, more than 50% of: 1. The total combined voting power of all classes of its voting stock, or 2. The total value of the stock of the corporation." — Internal Revenue Service, Instructions for Form 5471, https://www.irs.gov/instructions/i5471

"Certain U.S. citizens and residents who are officers, directors, or shareholders in certain foreign corporations file Form 5471." — Internal Revenue Service, About Form 5471, https://www.irs.gov/forms-pubs/about-form-5471

Practitioner note

Subpart F is the regime clients fear and the tested-income regime is the one that bills them: for a Canadian operating company the passive slice is almost always rescued by the high-tax exception, elected annually and documented, while the active income at small-business rates is what actually lands on the 1040. Our annual CFC review sorts income into its regimes, elects the exceptions that apply, and keeps the previously-taxed-earnings ledger that prevents the same dollar being taxed twice on the way out.

See also: Browse every cross-border tax topic guide, organized by situation.

Next step

Fairlight prepares the annual CFC income review — categorization into Subpart F and tested income, de minimis and high-tax exception analysis with documented computations, Form 5471 Schedules I and I-1, previously-taxed-earnings tracking, and coordination with the section 962 decision. See cross-border pricing or book a call.