controlled foreign corporation

Motivations

The tax law of many countries, including the United States, does normally not tax a shareholder of a corporation on the corporation's income until the income is distributed as a dividend. Prior to the first U.S. CFC rules, it was common for publicly traded companies to form foreign subsidiaries in tax havens and shift "portable" income to those subsidiaries. Income shifted included investment income (interest and dividends) and passive income (rents and royalties), as well as sales and services income involving related parties (see transfer pricing). U.S. tax on this income was avoided until the tax haven country paid a dividend to the shareholding company. This dividend could be avoided indefinitely by loaning the earnings to the shareholder without actually declaring a dividend, because interest on the loans could be deducted and such interest payments would not be considered income. The CFC rules of Subpart F, and later of other countries' provisions, were intended to cause current taxation to the shareholder where income was of a sort that could be artificially shifted or was made available to the shareholder. At the same time, such rules were intended not to interfere with active business income or transactions with unrelated parties.

Basic mechanisms

The rules vary, so this paragraph may not exactly describe a particular tax system. However, the features listed are prevalent in most CFC systems. A domestic person who is a member of a foreign corporation (a CFC) that is controlled by domestic members must include in such person's income the person's share of the CFC's subject income. The includible income (often determined net of expenses) generally includes income received by the CFC:

From investment or passive sources, including

Interest and dividends from unrelated parties,

Rents from unrelated parties, and

Royalties from unrelated parties;

From purchasing goods from related parties or selling goods to related parties where the goods are both produced and for use outside the CFC's country;

From performing services outside the CFC's country for related parties;

From non-operating, insubstantial, or passive businesses, or

Of a similar nature through lower-tier partnerships and/or corporations.

In addition, many CFC rules treat as a deemed dividend earnings of the CFC loaned by the CFC to domestic related parties. Further, most CFC rules permit exclusion from taxable income of dividends paid by a CFC from earnings previously taxed to members under the CFC rules.

CFC rules may have a threshold for domestic ownership, below which a foreign entity is not considered a CFC. Alternatively or in addition, domestic members of a foreign entity owning less than a certain portion or class of shares may be excluded from the deemed income regime.

Belgian law

The Belgian CFC legislation is incorporated in article 185/2 of the Belgian Income Tax Code. Belgium has chosen the transactional approach rather than the entity approach.

However, Belgian CFC legislation is obsolete in practice given that the application of Belgian transfer pricing rules (i.e. article 185, § 2 of the Belgian Income Tax Code, allowing the Belgian tax authorities to implement an upwards adjustment of the profits in case of a breach of the arm's length principle) take precedence over CFC legislation.

United States Subpart F rules

Enacted in 1962, these rules incorporate most of the features of CFC rules used in other countries. Subpart F was designed to prevent U.S. citizens and resident individuals and corporations from artificially deferring otherwise taxable income through use of foreign entities. The rules require that:

A U.S. Shareholder

of a Controlled Foreign Corporation ("CFC")

must include in their/its income currently

Their/its share of Subpart F Income of the CFC ("Subpart F income"),

Their/its share of aggregate income of 10% owned foreign corporations in excess of an aggregate return on depreciable tangible property of such 10% owned foreign corporations ("§951A"), and

Their/its share of earnings and profits ("E&P") of the CFC that are invested in United States Property ("§956"),

and further exclude from his/its income any dividends distributed from such previously taxed income.

Each of the italicized terms above is defined:

A Controlled Foreign Corporation is any corporation organized outside the U.S. (a foreign corporation) that is more than 50% owned by U.S. Shareholders.

A U.S. Shareholder is any U.S. person (individual or entity) that owns 10% or more of the foreign corporation. Complex rules apply to attribute ownership of one person to another person.

United States Property specifically includes obligations of or investments in related parties, tangible property with a physical situs in the U.S., and stock of a domestic corporation. It does not include bank deposits or obligations of unrelated persons.

United Kingdom rules

Controlled foreign company rules in the UK do not apply to individual shareholders, but otherwise they are similar to the U.S. rules. UK resident companies are subject to a charge for tax on undistributed income of low tax controlled foreign companies of which they are shareholders. Control for this purpose is not a mechanical test, rather one of factual control. However, control is considered to exist if the shareholder (or shareholder group of companies) owns 40% or more of voting interests.

A controlled company is a controlled foreign company if it is tax resident outside the UK and it is subject to a charge to tax less than it would have been were it a UK resident company. This is determined by comparing the actual charge to tax to a corresponding UK tax. In computing the corresponding tax, lower UK rates of tax on small companies are considered. Further, there are taken into account certain adjustments to income and fiscal years.

Certain exemptions apply. Generally, a foreign company will not be considered a controlled foreign company if it meets any of the following tests:

It is tax resident in a "white list" of countries not considered to be tax havens, as maintained by HMRC. The list of exempt jurisdictions has 103 states and territories, including 20 of the 27 EU Member States. The 7 EU countries not on the list are Bulgaria, Cyprus, Estonia, Hungary, Ireland, Latvia and Lithuania. Countries on the exempt list include Panama and Belize, which are on the EU's list of non-cooperative tax jurisdictions.

The foreign company maintains a policy whereby it distributed 90% or more of its available earnings each year (no longer applicable since 1 July 2009),

The company qualifies for a De Minimis level of accounting profits being less than £200,000. This level of income has been in place since 1 January 2011. Previously the level was set at £50,000 of profits that would be chargeable to UK corporation tax if the company were UK resident (not necessarily the same as accounting profits).

The foreign company meets an active business test,

German rules

The CFC provisions in Germany (§§ 7-14 AStG, Foreign Tax Act) apply to both individual and corporate shareholders of a controlled foreign company. Such shareholders must include in their currently taxable income as a deemed dividend their share of passive income if two tests are met:

German residents control the non-German corporation and

That corporation is taxed at a rate of less than 25% on the passive income.

Control in this case is ownership by all German residents of more than 50% of the vote or capital of the foreign corporation. Such ownership includes both direct ownership and ownership through related persons. In determining the 50% threshold, all German residents are considered, even those owning very minor amounts.

Passive income is all income which is not active income, as extensively defined. Active income, however, excludes income where there has been substantial assistance by a German related party in earning the income. Active income also excludes all income of a foreign corporation lacking sufficient substance. Generally, passive income resembles U.S. foreign personal holding company income (discussed above). However, deemed dividends may be exempted under some treaties.

India

The CFC Rules were first introduced in Indian taxation as part of the proposed Direct Tax Code 2010. The CFC provisions was also retained in revised draft of Direct Tax Code, 2013. However, Direct Tax Code is yet to become law in India and consequently, there are no statutory provisions in existing Income Tax Act (Income Tax Act 1961) for the enactment of CFC Rules.

Other countries

Japan taxes shareholders of foreign corporations where the operation of such corporation results in no or minimal foreign tax. However, there is a waiver where the foreign corporation conducts a substantial business.

New Zealand and Sweden each have CFC rules, following a "grey list" and a "white list" approach, respectively.

Australia has CFC rules similar to UK rules, but relies more on a "white list" of safe countries.

Other anti-deferral measures

Several countries have adopted other measures aimed at preventing artificial deferral of passive or investment income. U.S. passive foreign investment companies (PFICs) require that shareholders in foreign mutual funds must include in their current taxable income their share of ordinary income and capital gains, or face a tax-and-interest regime.

Avoiding CFC status

Under U.S. tax rules, a foreign entity may be classified for U.S. tax purposes as a corporation or a flow-through entity somewhat independently of its classification for foreign purposes. Under these "check-the-box" rules, shareholders may be able to elect to treat their shares income, deductions, and taxes of a foreign corporation as earned and paid by themselves. This permits U.S. individuals to obtain credits for foreign taxes paid by entities they own, which credits might otherwise not be available.

Artificial arrangements to avoid CFC status may be ignored in some jurisdictions under legislative provisions or court-developed law, such as substance over form doctrines.

European civil law may provide opportunities for formalistic agreements whereby practical control is maintained but formal definitions of control are not met.