In the previous
Article in the series ‘Worldwide Tax review’ published in BCAS Journal, October
2007, edition, we saw that the repatriation of dividends to India is not
efficient from a tax point of view. This inefficiency arises because dividends
from overseas subsidiaries are generally taxed in India on a net basis without
any credit for underlying foreign taxes paid on the profits of the paying
company. This encourages companies to defer repatriation of earnings,
potentially permanently. As discussed in that Article, deferral can be achieved
by routing overseas Investments through holding companies located in tax-favourable
jurisdictions and ensuring that profits from overseas subsidiaries are retained
outside India, thereby deferring the Indian tax liability that would arise on
While the Indian
scenario provides an extreme case of the additional tax costs that can arise on
repatriating profits, India is far from unique in having an additional cost on
repatriation. Most developed countries (where the majority of global
multi-nationals are based) have high tax rates relative to developing countries,
many of which use low tax rates as a way of attracting inward investment. As a
result, when dividends are repatriated from these lower tax countries, the
recipient will generally suffer additional tax on those profits. Therefore, many
companies tend to leave the profits from these low-taxed subsidiaries offshore,
with the aim of deferring home country taxation.
In the US, the
volume of profits held offshore was so large that a special ‘amnesty’ was
introduced in 2004, whereby companies could repatriate dividends for a one year
period, and pay tax on these dividends at a rate of 5.25% as against the normal
35% tax rate. It is estimated that some USD 350 billion was repatriated under
this provision, with one company alone repatriating USD 37 billion. These
figures give an indication that the ‘deferral trap’ is a major issue for
companies around the globe.
As one might
expect, governments are not always happy that multinationals based in their
countries are keeping large amounts of profits offshore. In order to address
this issue, governments in various countries have introduced legislation aimed
at eliminating the benefits of deferral, by currently taxing income in the
parent country even when the income has not been repatriated or remitted to that
country. These laws are generally referred to as Controlled Foreign Corporation
(CFC) laws. In this Article, we will review the CFC regimes currently in
operation in a number of major jurisdictions around the world.
Overview of CFC
in most countries will have a number of components. The first part will set out
rules for determining what type of entity will be viewed as ‘controlled’ for the
purposes of its CFC regime, with the starting point generally being that the
entities are not tax resident in the parent jurisdiction. One important point
here is that while we refer to the rules as controlled foreign ‘corporation’
rules, they are not necessarily limited to dealing with entities viewed as
generally have an ownership/control test, so that an entity will be treated as a
CFC only if a certain percentage of ownership/control is in the hands of
residents of the parent country.
Once the CFC has
been identified, the rules then set out the consequences of being treated as a
CFC. Generally speaking, the consequence is to tax certain income of the CFC
‘currently’ in the hands of the parent, as if it had been remitted to the parent
or was the income of the parent, even though there is no actual remittance and
the income clearly remains in the legal ownership of the CFC itself.
The methods of
taxing CFC income and the type of CFC income taxed will vary, but in general,
CFC rules attempt to tax ‘passive’ type income, income received by foreign
entities taxed at a lower tax rate than applies in the parent country or income
from related parties. With regard to ‘passive’ income, this typically includes
dividends and certain types of interest and royalties. CFC regimes which target
income taxed at a lower rate typically do so by either listing countries with
low tax rates or by setting a minimum tax rate threshold, or by a combination of
that have CFC rules have in place mechanisms such as participation exemptions or
underlying tax credits to mitigate the effect of the CFC provisions. Further, as
we shall see below, there are also exemptions, available under most CFC regimes.
This Article will
examine CFC Regulations in five major world economies : Australia, France,
Japan, the U.K., and the US.
in some key jurisdictions :
a CFC :
In Australia, CFC
rules are triggered where five or fewer Australian residents hold at least 50%
of a foreign company or have de facto control of a foreign company. The
CFC rules are also triggered if a single Australian entity holds a 40% interest
in a foreign company, unless it can be shown that the 40% holding does not
result in actual control.
CFC rules, so-called ‘tainted’ income of a CFC is attributed to its Australian
resident owners who are required to include such income in their assessable
income. In general, the tainted income of a CFC is its passive income and also
income from certain ‘related-party’ transactions.
Whether an amount
earned by a CFC is attributable to Australian residents depends on the country
in which the CFC is a resident. The CFC rules categorise countries as ‘listed
countries’ or ‘unlisted countries’. A listed country is one whose tax system is
considered closely comparable to the Australian system and thus significantly
reduces the scope to avoid tax. These countries include Canada, France, Germany,
Japan, New Zealand, the UK and the US. All other countries are included in the
unlisted country category.
There is a
difference in the application of the CFC rules between CFCs in listed and
unlisted countries. The difference relates to the ‘active business exemption’ in
the CFC rules. To pass the active business exemption, a CFC’s tainted income
must not exceed 5% of its gross turnover. If a CFC resident in a listed country
fails the active-income test, its attributable income includes its tainted
income that is designated as concessionally taxed by the Australian tax
authorities. However, if an unlisted country fails the active-income test, its
attributable income includes all of its tainted income.
exemption is the active business exemption referred to above. To pass this test,
the CFC’s tainted income must not exceed 5% of the CFC’s gross turnover.
a CFC :
French CFC rules
provide that a CFC exists if a French entity has a foreign branch or holds,
directly or indirectly, an interest (shareholding, voting rights or share in the
profits) of at least 50%, in any type of structure benefiting from a ‘privileged
tax regime’ in its home country. The ‘per company’ requirement is reduced to 5%
if more than 50% of the foreign entity is held by French companies acting in
concert or by entities controlled by the French company.
For the purpose
of the French rules, a ‘privileged tax regime’ is a regime under which the
effective tax paid is 50% lower than the tax that would be paid in France in
If an entity is
treated as a CFC, then its profits are subject to corporate income tax in
France. Tax paid by a CFC in its home country may be credited against the French
corporate income tax.
If the CFC entity
is a legal entity, then its profits are treated as deemed dividend and taxed as
a deemed distribution in the hands of the French company. On the other hand, if
the CFC entity is a branch, then its profits are taxed as profits of the French
company, but only if the relevant tax treaty between France and such other
country, allows for the French CFC rules to apply.
French CFC rules
do not apply to profits derived from entities established in an EU member state,
unless the French tax authorities establish that the use of the foreign entity
is an artificial scheme that is driven solely by French tax avoidance purposes.
CFC Regulations do not apply if the profits of the foreign entity are derived
from an activity effectively performed in the country of establishment. However,
this exception does not apply if either of two conditions exists :
More than 20%
of the profits are derived from portfolio management activities (securities,
shares and claims) and intangible rights management; or
profits derived from the items mentioned in the first bullet, from
inter-company services represent more than 50% of the profits of the foreign
However, even if
these conditions exist, the CFC rules may not apply if the taxpayer can show
that the principal result of using the foreign entity is not to benefit from a
privileged tax regime.
a CFC :
CFC rules, if a Japanese company (and individuals who have a special
relationship with the company) owns 5% or more of the issued shares of a
“tax-haven subsidiary” of which more than 50% is owned directly or indirectly by
Japanese companies and Japanese resident individuals, the undistributed income
of the subsidiary must be included in the Japanese parent company’s taxable
income in proportion to the equity held.
subsidiary is considered a tax-haven subsidiary if its head office is located in
a country that does not impose income tax or if the company is subject to tax at
an effective rate of 25% or less (the effective rate is calculated on a company-bycompany
If an entity is
considered to be a CFC, then such portion of its undistributed income as is
appropriate to the Japanese company (based on its shareholding in the CFC) is
included in the taxable income of the Japanese parent company. Losses of the
foreign affiliate may not offset the profits of the Japanese company.
legislation, the CFC status is not applicable if the foreign subsidiary
satisfies the exemption criteria stated below :
criterion : The main business of the foreign subsidiary is not holding
stocks, offering patents, rights or copyright, etc., or leasing vessels or
criterion : The foreign subsidiary has a fixed facility such as an office,
shop or factory, which is deemed necessary to conduct its business in the
country where its main office is located;
and control criterion : The foreign subsidiary manages and controls its
own business in the country where its main office is located;
person criterion : In cases where the main business of the foreign
subsidiary is that of a wholesale business, banking, trust business,
securities business, insurance, shipping, or air transport, the foreign
subsidiary should conduct its business mainly with persons other than related
criterion : if the main business of the foreign subsidiary is other than
those stated above and the foreign subsidiary conducts its business mainly in
the country or area where its main office is situated.
UNITED KINGDOM :
a CFC :
legislation applies if a non-resident company is controlled by persons resident
in the UK, and is subject to a ‘lower level of taxation’.
company is considered to be controlled by UK residents if UK residents hold a
greater than 50% interest in the company or if UK residents hold 40% or greater
interest in the company and a non-resident holds an interest of at least 40%,
but no greater than 55%, in the company.
A company is
subject to a lower level of taxation if the tax paid in its country of residence
is less than three quarters of the corresponding U.K. tax that would have been
payable had it been resident in the UK.
companies that hold a 25% or greater interest in a CFC may be taxed on their
share of the profits (excluding capital gains) of the CFC in the UK.
legislation does not apply if any one of the tests below is met :
test : The CFC’s profits are less than British Pounds 50,000 for a
activities test : In general this test exempts a CFC that is carrying on
real commercial operations, such as trading, substantially with non-connected
parties or that it is a holding company deriving its income from subsidiaries
carrying on such operations.
distribution test : The CFC follows an ‘acceptable distribution policy’ by
remitting a high portion of the profits back to the UK;
countries test : The CFC is resident in an approved territory, (as listed
under the Excluded Countries Regulations) such as Belgium, Hungary, US,
Netherlands, etc.; 90% of its income is considered to be ‘local source’
(arising in the country where the CFC is resident and taxable there) and
certain anti-abuse conditions are met; and
quotation test : At least 35% of the voting shares in the CFC are listed
and traded on a recognised stock exchange. A CFC is also excluded from the
legislation if it engages in activities that fulfil both of the following
‘motive’ criteria :
purpose of the CFC’s activities is not to reduce UK tax; and
of profits from the UK is not the underlying reason for CFC’s existence.
UNITED STATES OF
As in many areas
of tax, the US has very complex rules regarding the taxation of CFCs. There are
numerous Internal Revenue Service (IRS) Regulations defining terms and meanings,
many types of income that are subject to the CFC rules and many exceptions that
can be used to mitigate the implications of the CFC rules if they apply.
of a CFC :
A CFC is defined
as being any foreign corporation if more than 50% of (1) the total voting power
of all classes of stock of the foreign corporation entitled to vote, or (2) the
total value of the foreign corporation’s stock is owned by ‘US 10% Shareholders’
on any day during the foreign corporation’s taxable year (the ‘50%
Test’). In this context, a US ‘10% Shareholder’ is any US individual citizen or
resident, US corporation, US partnership or other US entity that owns directly
or indirectly 10% or more of the total combined voting power of all classes of
stock entitled to vote of the foreign corporation (the ‘US 10% Shareholder
In applying the
‘50% Test’ and ‘US 10% Shareholder Test’, the rules look to not only the
shareholder’s direct ownership of stock, but also ‘indirect’ and ‘constructive’
ownership of stock, which are defined under specific rules. The CFC rules also
include regulations issued by the IRS which provide that in determining the
‘voting’ power of a foreign corporation all the facts and circumstances must be
weighed, and provide guidance in this regard.
In summary, a
foreign corporation will be a CFC if its US shareholders own a threshold 10% or
more of the corporation’s voting stock and such US 10% shareholders combined own
more than 50% of the vote or value of the corporation.
The CFC rules
require that certain passive income (including dividends, interest, rents,
royalties, certain sales and services income and certain investments made by a
CFC in US property, collectively ‘Subpart F Income’) earned by CFCs be taken
into income currently by their US 10% shareholders and be subject to US
taxation. This would be required even if no distribution is actually made by
such foreign companies. Accordingly, the US shareholders must find money from
other sources to pay the tax on such ‘phantom’ income.
exemptions to the CFC rules that apply to certain types of income or activities
of a CFC and to certain limits on the amount of income earned and the rate of
foreign tax applied to such income.
The following is
a summary of the key exemptions for passive holding company type income, but
there are other exemptions not discussed here that could apply to a specific
taxpayer’s situation dealing, for example, with insurance, sales and services
of a CFC are not subject to the CFC rules. That is a CFC’s income from
commercial operations, such as manufacturing, or trading activities is not
subject to tax under the CFC rules. In addition, even though dividends and
interest are generally Subpart F Income, if they are received from a related
corporation created or organised in the same country as the CFC, then they would
be exempt (the Same Country Exception for Dividends and Interest). Rents and
royalties, which are usually included as CFC income, would be exempt if received
from a related corporation for the use of, or privilege of using, property
within the country in which the CFC is created or organised (the Same Country
Exception for Rents and Royalties). Furthermore, rents or royalties derived in
the active conduct of a trade or business and received from a person who is not
a related person would also be exempt (the Active Trade or Business Exception
for Rents and Royalties).
exemption that was introduced in 2006 is the ‘CFC Look Through Rule’. Under this
exemption, dividends, interest, rents, and royalties received or accrued to a
CFC from a related party CFC would not be treated as CFC income to the extent
that the income is attributable to income of the related party that is not CFC
income. This exemption is limited. It applies to taxable years of foreign
corporations beginning after December 31, 2005, and before January 1, 2009.
In addition to
the exemptions that may apply to certain types of income or activities of a CFC,
there are several additional important exemptions that affect the amount of
income a US shareholder actually has that is subject to tax under the CFC rules
including the following :
Rule : Whereby, no part of a CFC’s gross income is treated as Subpart F
income if its gross CFC income for the year is less than both USD 1 million
and 5% of its total gross income;
Inclusion Rule : Whereby, all of a CFCs income could be treated as taxable
if the sum of CFC income exceeds 70% of its total gross income;
Exception : If an election is made to exclude net income subject to an
effective foreign tax that is greater than 90% of the maximum US tax rate (i.e.,
Profits Limitation Rule : Whereby the amount of CFC income that is subject
to US tax is limited to a CFC’s current year earnings and profit (recapture
rules also apply to later years).
In addition to
the exemptions mentioned above, the US also has a rule where it allows a
taxpayer to elect to treat an entity as ‘disregarded’ for US tax purposes. From
a CFC point of view, this can lead to a situation whereby the CFC rules will not
apply, as the transaction which would have triggered the application of the
rules does not itself exist. This is an area of US tax, known as the ‘check the
On a global
level, the International Chamber of Commerce (ICC) has opined that the price for
protection of the national tax base through CFC regulation is a loss of economic
efficiency for a country in the longer term. ICC therefore believes that
governments must carefully weigh the short term advantages of CFC rules against
competitive disadvantages in terms of location for business. However, the
reality is that CFC regimes are here to stay and if anything, the number and
complexity of these regimes is likely to increase over time.
In India, the
Report of the Working Group on Non-Resident Taxation, chaired by Vijay Mathur
and released in January 2003, suggested the introduction of underlying tax
credits to boost outbound investments and encourage repatriation of dividends
back into India. Simultaneously, it also suggested the introduction of CFC
rules. An underlying tax credit is a credit for any tax on the underlying
profits, out of which the dividend is paid.
At this juncture,
the government’s first priority should be to introduce a comprehensive double
tax credit system, as mentioned above, before considering CFC legislation. Once
a double tax credit system has been in place for a number of years, the
government can then review how it is working and in particular whether it is
achieving the objective of encouraging Indian companies to remit profits from
overseas for domestic investment in India. After the results of such a review
have been analysed, the government will be in a better position to determine
whether CFC rules are required in India.