Increase in globalization and foreign trade in the last century led to aggressive tax planning. Though these planning measures are legitimate, they are designed for shifting profits to low tax jurisdictions. There is a number of measured to deal with this tax abuse. In particular, some jurisdictions apply controlled foreign corporation (CFC) rules.
Historically, the CFC concepts were created to help prevent tax evasion achieved by setting up offshore companies in tax havens, such as Bermuda and the Cayman Islands. Increasingly countries have developed CFC legislation to counter perceived overseas abuses enveloped in a low tax overseas entity.
The aim of CFC rules is to prevent or obstruct the creation of structures used by companies, especially domestic multinationals, for pure avoidance of domestic tax liability. CFC rules are designed to prevent profit shifting without penalizing foreign subsidiaries engaged in legitimate business practices.
A controlled foreign corporation is a corporate entity that is registered and conducts business in a different jurisdiction or country than the residency of the controlling owners. A company that qualifies as a CFC generally has its profits taxed in the country where its owners are located (place of management). Thus, the rules attribute current income or profits earned by a foreign corporation to a domestic company.
In most cases, CFC rules affect passive shell companies deriving the majority of their income from passive sources, and sheltering profits in order to avoid paying taxes. Of course, there are exceptions.
Almost all the big industrial countries (the USA, the UK, Germany, France, Spain, the Scandinavian countries, the Baltic States, South Africa, Japan, Australia, Russia, etc.) have adopted their own CFC laws to a greater or lesser extent, they vary from country to country. There are States that do not have official CFC rules, but similar alternate regime, e.g. Austria, Latvia, Malta, the Netherlands, Slovenia, etc.
CFC provisions are promoted by both OECD and EU. The 1998 OECD CFA Report on Harmful Tax Competition encourages nations to put in place CFC provisions. Action Point 3 of BEPS discusses the need to strengthen CFC rules. In October 2015 the OECD released its final report on this Action Point. The report identifies six “building blocks” as the design principles for CFCs. The report notes that these are not minimum standards but are a guide to ensure that jurisdictions that choose to implement such provisions will have a set of effective CFC rules that will prevent the diversion of profits to foreign subsidiaries. The suggested building blocks are as follows:
- Definition of a CFC (including control)
- Threshold requirements and exemptions
- Definition of CFC income
- Rules for computing income
- Rules for attributing income
- Rules to prevent or eliminate double taxation
The EU adopted the Anti-Tax Avoidance Directive in July 2016, as part of its Anti- Tax Avoidance Package of January 2016. The Directive provides minimum standards for rules regarding five domestic tax measures, one of which is CFC rules (50% control test is recommended, and an effective 50% test to determine whether the jurisdiction is a ‘low tax’ state).
CFC rules are complicated and highly variable from country to country. Nevertheless, they all follow a basic structure. The first set of rules is meant to determine whether a foreign corporation is “controlled.” The main test is the level of control. The ownership thresholds is usually determined as 50% level of control held directly or indirectly by any resident within a jurisdiction.
Some countries determine CFC by applying total ownership thresholds and single-ownership thresholds (hybrid system). For example, the United States combines its 50% ownership threshold with a 10% single-ownership threshold. France has a similar rule, but the single-ownership threshold is 5%.
Some countries utilize only a single-ownership test (e.g. South Korea, Sweden, etc.). Other countries, such as New Zealand and Australia, use an either-or-approach:, a foreign entity is deemed “controlled” if either a single company owns more than 40% of the shares or five or fewer corporations own more than 50% of the shares.
Some countries use more qualitative assessments to determine CFC status. For instance, Mexico considers any foreign corporation where domestic entities have “management control” to be a CFC.
While many foreign corporations might qualify as a CFC, not all will be subject to domestic taxation. There are generally two ways in which countries determine whether CFC income is taxable by domestic tax authorities: analysis of taxation conditions and analysis of type of income earned by a CFC.
Taxation condition standard is aimed at preventing profit shifting to low tax jurisdictions (tax havens). Thus, many countries have a lower level of taxation test in their CFC provisions. The threshold can be either an arbitrarily determined rate, or a metric comparing the CFC’s taxation abroad to the treatment it would receive as a domestic enterprise, i.e. absolute percentage or percentage of home effective tax rate (usually, 20-50% lower than corporate tax in country of residence). Some countries do not formally specify a precise level of tax, but refer to a significantly lower level of tax in the overseas jurisdiction. The US has a lower than 90% of the US effective rate test. Japan looks to countries with no income taxes, or an effective tax rate of 20% or less.
Some States decide whether CFC rules apply according to the country in question – they have lists of non-participating/blacklisted countries. Every country on this list is automatically subject to corporate tax in the partner’s country of residence, no matter the rules in that of the company. There are often additional conditions involved, and sometimes certain company expenses cannot be deducted.
Another way in which countries determine whether CFC income is taxable is by analyzing the type of income earned by a CFC. Countries that use income tests typically tax CFCs if a majority of their revenue is derived from passive income. Countries use the percentage of total income derived from passive sources as a benchmark to determine whether CFC rules apply to an entity. The benchmarks diverge enormously. New Zealand applies CFC rules if passive income is greater than 5 % of total CFC income, whereas Poland applies CFC rules if passive income is greater than 50 % of total CFC income.
Once a country’s CFC rules determines that CFC’s income is taxable domestically, the focus of most countries is to identify specific types of income or gains which are regarded as abusive. Once the offending income is identified, there are two different approaches that can be taken by jurisdictions: The first, the transactional approach, is to identify purely the offending income and to tax transactions as though they had arisen in the country applying the CFC provisions (e.g. Australia, Canada, France, Germany, the US and part of the UK approach). The second, the jurisdictional approach, if offending income or activities represent the major part of the foreign company’s activities, all of the incomes earned by the foreign company are subject to tax under the CFC provisions (e.g. Japan, Sweden).Some countries have both transactional and jurisdictional approaches to their CFC provisions, such as the current UK approach.
Every jurisdiction is free to decide how income is apportioned and to which shareholders, type and calculation of income to be apportioned, availability of tax credits and reliefs. In addition, every state can determine its exclusions based on type of activity, list of locations, de minimis limits, consideration of external factors such as EU sales on ‘genuine economic activity’ post Cadbury-Schweppes.
The case of Cadbury Schweppes, involved two Irish subs controlled from the UK by the UK parent company Cadbury Schweppes. The ECJ held that the UK CFC rules were discriminatory and a restriction on the freedom of establishment, since they were much broader in scope and did not target only “wholly artificial arrangements”.
The discriminatory nature of CFC provisions is also a concern to taxpayers, and within the EU the European Court of Justice is likely to consider such claims within the context of the freedom of establishment principle.
If profits are apportioned and taxed under the CFC provisions of a country there is then normally relief for the tax incurred by the foreign company on those profits. At the same time it may be possible to utilise local losses to reduce the apportioned CFC charge. If profits are apportioned under the CFC provisions, but no actual dividend payments are made by the foreign company, it may sometimes be possible to take this into account when the foreign company is disposed of – by reducing the sale proceeds for tax purposes.
In addition to these general rules, nearly every country has exemptions that determine when a CFC may not be subject to these rules or taxation. In general, there are two important exceptions to CFC rules. One is due to the law of freedom of establishment inside the European Union, and the other concerns companies that can demonstrate a certain level of “substance” in the foreign country. In accordance to an EU ruling, all EU countries have rules that exempt CFCs operating in other EU and the European Economic Area countries from domestic taxation as long as they are engaged in real economic activity. The concept of substance refers to how credible a company is, to the real economic interest the company has in the country in which it was created. To show that a company has substance, it can have its own office, workers, a manager in the foreign country, etc. Substance plays an important role in double taxation agreements. Tax advantages are still recognised when a company has enough substance. Other tests that restrict the impact of the CFC provisions can be found in various jurisdictions.
The UK has introduced new CFC rules from 1 January 2013. The key intention was to bring into the UK tax charge profits that have been artificially diverted from the UK. The UK CFC provisions, unlike those in many other jurisdictions, do not tax capital gains, although there are separate provisions which tax such gains in particular circumstances (closely held foreign company). The rules operate on a risk-based approach – there are a number of gateways and exemptions.
In November 2017, the European Commission made public its decision to open a formal State aid investigation into the group financing exemption within the UK’ controlled foreign company rules. The Commission sees the group financing exemption as a derogation which provides a selective advantage. The UK authorities see the exemptions contained within the CFC provisions as intrinsic and inherent parts of the overall framework of the legislation, not as derogations.
Principles of international tax law are mostly illustrated by the OECD works, including the OECD Model Tax Convention (MTC). The commentary to the 2017 MTC considers the compatibility of CFC rules with the MTC under Articles 1 Persons Covered, 7 Business Profits and 10 Dividends. The Commentary for Article 1, paragraphs 81 specifically comments on Controlled foreign company provisions and explains that there is no conflict with Article 7(1) or with the prohibition on extra-territorial taxation found at Article 10(5). The positon is that such rules merely result in the taxation of a country’s own residents, thus CFC rules are not contrary to the provisions of the Model Treaty.
In addition to commentary for Article 1, paragraphs 81 and 84, this is also confirmed by paragraph 3 of Article 1, commentary to Article 7, paragraph 14, commentary to Article 10, paragraphs 37 to 39.
Most CFC systems are complex by their very nature, because they have been built up over time by tax authorities becoming more aware of abuse. The growing practice for developed states is to extend jurisdiction extra-territorially over controlled foreign companies to protect their tax base.
Thus, the world needs CFC rules to encourage that profit stays in the countries where economic activities take place and value is created. This does not only help to safeguard a home country’s tax base, it benefits all countries where multinationals conduct real business activities, source and residence, rich and poor. Without such CFC rules, the whole BEPS project will very soon be outdated.