Controlled foreign corporation (CFC) rules are features of an income tax system designed to limit artificial deferral of tax by using offshore low taxed entities. The rules are needed only with respect to income of an entity that is not currently taxed to the owners of the entity. Generally, certain classes of taxpayers must include in their income currently certain amounts earned by foreign entities they or related persons control.
A set of rules generally defines the types of owners and entities affected, the types of income or investments subject to current inclusion, exceptions to inclusion, and means of preventing double inclusion of the same income. Countries with CFC rules include the United States (since 1962), the United Kingdom, Germany, Japan, Australia, New Zealand, Brazil, Russia (since 2015),[1] Sweden, and many others. Rules in different countries may vary significantly.
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[2] was designed to prevent U.S. citizens and resident individuals and corporations from artificially deferring otherwise taxable income through use of foreign entities.[3] 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[4] 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.[5]
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.[6]
Foreign personal holding company income (FPHCI), including dividends, interest, rents, royalties, and gains from alienation of property that produces or could produce such income. Exceptions apply for dividends and interest from related persons organized in the same country as the CFC, active rents and royalties, rents and royalties from related persons in the same country as the CFC, and certain other items.[8]
Foreign base company sales income from buying goods from a related party and selling them to anyone or buying goods from anyone and selling them to a related party, where such goods are both made and for use outside the CFC's country of incorporation. A branch rule may cause transfers between a manufacturing branch of a CFC in one country and a sales branch in another country to trigger Subpart F income.[9]
Foreign base company services income from performing services for or on behalf of a related person. A substantial assistance rule can cause services performed for unrelated parties to be treated as performed for or on behalf of a related party.[10]
Foreign base company oil-related income from oil activities outside the CFC's country of incorporation.[11]
Insurance income from insurance or annuity contracts related to risks outside the CFC's country of incorporation.[12]
but it does not include:
Items of income which (after considering deductions, etc., under U.S. concepts) were subject to foreign income tax in excess of 90% of the highest marginal U.S. tax rate for the type of shareholder;
De minimis amounts of Subpart F income in absence of other Subpart F income in the period;
Such income if the CFC has a deficit in E&P, in which case it is deferred from recognition until the CFC has positive E&P.[13]
Any dividend received which is considered paid from amounts previously taxed under Subpart F.[14]
In addition, after 2017 10% U.S. shareholders of CFCs must include in their income currently their share of aggregate return on depreciable tangible assets in excess of 10% for CFCs in which they are shareholders.[15] Corporations that are U.S. shareholders get to deduct 50% of this inclusion.[16]
Corporate U.S. shareholders are entitled to a foreign tax credit for their share of the foreign income taxes paid by a CFC with respect to E&P underlying a Subpart F inclusion. Creditable taxes are reduced by 20% for §951A inclusions.[17]
To prevent avoidance of Subpart F, U.S. shareholders of a CFC must recharacterize gain on disposition of the CFC shares as a dividend.[18] In addition, various special rules apply.
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.[19] 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.[20]
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.[21] 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 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,
The foreign company is publicly quoted on a recognized securities exchange, or
The group meets a no-tax-reduction motive 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.[22] 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.[23]
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[24] 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.[citation needed]
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.[25]
European civil law may provide opportunities for formalistic agreements whereby practical control is maintained but formal definitions of control are not met.[citation needed]
↑ "The test is not a mechanical one based simply on, for example, shareholding or voting rights. The aim is to establish whether a person (or persons) has the power to ensure that the affairs of a company are conducted in accordance with his (or their) wishes." INTM202020Archived 2009-07-17 at the Wayback Machine .
A holding company is a company whose primary business is holding a controlling interest in the securities of other companies. A holding company usually does not produce goods or services itself. Its purpose is to own stock of other companies to form a corporate group.
A dividend tax is a tax imposed by a jurisdiction on dividends paid by a corporation to its shareholders (stockholders). The primary tax liability is that of the shareholder, though a tax obligation may also be imposed on the corporation in the form of a withholding tax. In some cases the withholding tax may be the extent of the tax liability in relation to the dividend. A dividend tax is in addition to any tax imposed directly on the corporation on its profits. Some jurisdictions do not tax dividends.
A limited liability company (LLC) is the United States-specific form of a private limited company. It is a business structure that can combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. An LLC is not a corporation under the laws of every state; it is a legal form of a company that provides limited liability to its owners in many jurisdictions. LLCs are well known for the flexibility that they provide to business owners; depending on the situation, an LLC may elect to use corporate tax rules instead of being treated as a partnership, and, under certain circumstances, LLCs may be organized as not-for-profit. In certain U.S. states, businesses that provide professional services requiring a state professional license, such as legal or medical services, may not be allowed to form an LLC but may be required to form a similar entity called a professional limited liability company (PLLC).
A tax deduction or benefit is an amount deducted from taxable income, usually based on expenses such as those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and tax credits. The difference between deductions, exemptions, and credits is that deductions and exemptions both reduce taxable income, while credits reduce tax.
A private limited company is any type of business entity in "private" ownership used in many jurisdictions, in contrast to a publicly listed company, with some differences from country to country. Examples include the LLC in the United States, private company limited by shares in the United Kingdom, GmbH in Germany and Austria, Besloten vennootschap in The Netherlands, société à responsabilité limitée in France, and sociedad de responsabilidad limitada in the Spanish-speaking world. The benefit of having a private limited company is that there is limited liability.
A corporate tax, also called corporation tax or company tax, is a type of direct tax levied on the income or capital of corporations and other similar legal entities. The tax is usually imposed at the national level, but it may also be imposed at state or local levels in some countries. Corporate taxes may be referred to as income tax or capital tax, depending on the nature of the tax.
Double taxation is the levying of tax by two or more jurisdictions on the same income, asset, or financial transaction.
The schedular system of taxation is the system of how the charge to United Kingdom corporation tax is applied. It also applied to United Kingdom income tax before legislation was rewritten by the Tax Law Rewrite Project. Similar systems apply in other jurisdictions that are or were closely related to the United Kingdom, such as Ireland and Jersey.
The Internal Revenue Code of 1986 (IRC), is the domestic portion of federal statutory tax law in the United States. It is codified in statute as Title 26 of the United States Code. The IRC is organized topically into subtitles and sections, covering federal income tax in the United States, payroll taxes, estate taxes, gift taxes, and excise taxes; as well as procedure and administration. The Code's implementing federal agency is the Internal Revenue Service.
The United States federal government and most state governments impose an income tax. They are determined by applying a tax rate, which may increase as income increases, to taxable income, which is the total income less allowable deductions. Income is broadly defined. Individuals and corporations are directly taxable, and estates and trusts may be taxable on undistributed income. Partnerships are not taxed, but their partners are taxed on their shares of partnership income. Residents and citizens are taxed on worldwide income, while nonresidents are taxed only on income within the jurisdiction. Several types of credits reduce tax, and some types of credits may exceed tax before credits. Most business expenses are deductible. Individuals may deduct certain personal expenses, including home mortgage interest, state taxes, contributions to charity, and some other items. Some deductions are subject to limits, and an Alternative Minimum Tax (AMT) applies at the federal and some state levels.
International taxation is the study or determination of tax on a person or business subject to the tax laws of different countries, or the international aspects of an individual country's tax laws as the case may be. Governments usually limit the scope of their income taxation in some manner territorially or provide for offsets to taxation relating to extraterritorial income. The manner of limitation generally takes the form of a territorial, residence-based, or exclusionary system. Some governments have attempted to mitigate the differing limitations of each of these three broad systems by enacting a hybrid system with characteristics of two or more.
The Tax Increase Prevention and Reconciliation Act of 2005 is an American law, which was enacted on May 17, 2006.
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Corporate tax is imposed in the United States at the federal, most state, and some local levels on the income of entities treated for tax purposes as corporations. Since January 1, 2018, the nominal federal corporate tax rate in the United States of America is a flat 21% following the passage of the Tax Cuts and Jobs Act of 2017. State and local taxes and rules vary by jurisdiction, though many are based on federal concepts and definitions. Taxable income may differ from book income both as to timing of income and tax deductions and as to what is taxable. The corporate Alternative Minimum Tax was also eliminated by the 2017 reform, but some states have alternative taxes. Like individuals, corporations must file tax returns every year. They must make quarterly estimated tax payments. Groups of corporations controlled by the same owners may file a consolidated return.
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Foreign personal holding company income (FPHCI) is defined for U.S. controlled foreign corporation rules and, with modifications, for U.S. foreign tax credit rules. It consists of interest, dividends, rents, royalties, gains on property producing FPHCI, and certain other items. Exceptions are provided for active rents and royalties, certain related party rents and royalties, same country income, and certain other items. For purposes of the foreign tax credit, an additional exception requires look-through of certain income received from a controlled foreign corporation.
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