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Worldwide tax view — Controlled foreign corporation regimes

Subject : International Taxation
Month-Year : Dec 2007
Author/s : Declan Gavin
Tax Consultant
Topic : Worldwide tax view — Controlled foreign corporation regimes
Article Details :

Introduction :

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 dividend repatriation.

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 regimes :

CFC legislation 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 corporate entities.

The rules 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 both.

Most countries 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.

CFC Regulations in some key jurisdictions :

AUSTRALIA :

Identification of 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.

Implications :

Under Australia’s 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.

Exemptions :

The principal 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.

FRANCE :

Identification of 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 similar situations.

Implications :

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.

Exemptions :

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.

Similarly, the 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

  • The total profits derived from the items mentioned in the first bullet, from inter-company services represent more than 50% of the profits of the foreign entity.

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.

JAPAN :

Identification of a CFC :

Under Japanese 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.

A foreign 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 basis).

Implications :

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.

Exemptions :

Under Japan’s legislation, the CFC status is not applicable if the foreign subsidiary satisfies the exemption criteria stated below :

  • Business criterion : The main business of the foreign subsidiary is not holding stocks, offering patents, rights or copyright, etc., or leasing vessels or aircraft;

  • Substance 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;

  • Management and control criterion : The foreign subsidiary manages and controls its own business in the country where its main office is located;

  • Non-related 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 persons;

  • Location 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 :

Identification of a CFC :

The 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’.

A non-resident 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.

Implications :

Resident 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.

Exemptions :

The CFC legislation does not apply if any one of the tests below is met :

  • De minimus test : The CFC’s profits are less than British Pounds 50,000 for a 12-month period;

  • Exempt 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.

  • Acceptable distribution test : The CFC follows an ‘acceptable distribution policy’ by remitting a high portion of the profits back to the UK;

  • Excluded 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

  • Public 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 :

  • The primary purpose of the CFC’s activities is not to reduce UK tax; and

  • The diversion of profits from the UK is not the underlying reason for CFC’s existence.

UNITED STATES OF AMERICA :

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.

Identification 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 Test’).

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.

Implications :

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 :

There are 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 activities.

Active businesses 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).

An important 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 :

  • De Minimus 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;

  • Full 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;

  • High Tax 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., 31.5%); and

  • Earnings and 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 box’ rules.

Conclusion :

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.

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