International Tax: Taxation of Residents (CFC and FIF rules)

ITP

  • CFC RULES
    • Tax avoidance opportunity:
      • Deferring or completely avoiding domestic tax on foreign source income by establishing a foreign corporation (or other legal entity) to earn and defer income
        • The avoidance benefits: the difference between the domestic and foreign tax rates, the rate of return on the deferred taxes, and the period of deferral
        • Type of foreign income: passive income -> because passive income can easily be diverted to or accumulated in an offshore entity in a tax haven
    • CFC rules: general
      • Target
        • Resident shareholders that control (or have substantial interest in) a foreign corporation established in a no-tax or low-tax country are subject to residence country tax currently on their proportionate share of all/some of the income of the foreign corporation (except generated from legitimate commercial activities), whether or not the income is actually distributed to them.
      • Example:
        • ACo (resident in country A, tax rate 40%) wholly owns BCo (=CFC, resident in Country B -> a low-tax country, tax rate 10%).
        • BCo earns passive income of 1,000 and pays tax of 100 to its Country B. However, BCo does not distribute any of its after-tax income to ACo.
        • With CFC rules:
          • ACo’s income = 1,000; tax before credit = 400; credit = 100; tax payable = 300.
      • Two competing policies in CFC rules:
        1. a desire to prevent tax avoidance and to promote fairness and economic efficiency
        2. a need of not interfering unreasonably in the ability of resident corporations to compete in foreign markets
      • Shared policy considerations of CFC rules
        1. their role as a deterrent measure (deterrent effect)
        2. they complement transfer pricing rules
          • CFC rules may capture some income that is not captured by transfer pricing rules (and vice versa)
          • Neither set of rules fully captures the income that the other set of rules intends to capture
        3. the need to balance effectiveness with reducing administrative and compliance burdens
        4. the need to balance effectiveness with preventing or eliminating double taxation (exemptions, foreign tax credits)
    • CFC rules: structural features
      1. Feature 1: Definition of a CFC
        1. With respect to the entity’s form
          • Yes: Corporations
          • Yes, in certain conditions: foreign branches / PEs (some countries such as France)
            • Rationale: In those countries, income of a foreign branch/PE is exempt. Because passive income of a foreign corporation is subject to CFC rules, such countries must have an equal treatment to passive income of a branch/PE. Therefore, they include branches/PEs in the definition of CFC.
          • No: Partnership
            • Because partnership are taxable on a conduit/flow-through basis: partners are subject to residence country’s tax on their share of the partnership’s income
        2. With respect to control
          1. In general: voting shares (e.g., ownership of 50% of the outstanding voting shares
          2. Other factors applied by some countries:
            1. Shares value (Brazil, Denmark, Portugal)
            2. Certain circumstances, even if the ownership < 50%
              • Australia and NZ: 40% of voting shares and no nonresident person has voting control of the corporation
            3. De facto test
              • is: based on all facts and circumstances, the resident has the means to control the affairs of the corporation (even where the resident does not have voting control).
              • Example: a resident holding 20% of widely held shares in a foreign corporation may in fact have control in the corporation.
              • Issues: uncertainty (difficult for tax authorities to apply)
          3. Some terms:
            • Usually include indirect control
              • The calculation:
                • ACo owns 51% of shares in BCo and BCo owns 51% of shares in CCo
                • Because ACo has control in BCo, for the purpose of the calculation of indirect control, ACo is deemed to have control of 100% in BCo.
                • Therefore, ACo has indirect control of 51% in Cco (i.e., 100% x 51%)
            • Usually include shares ownership among related persons
              • Example:
                • A1Co owns 40% of the voting interest of HCo
                • A2Co (a related person of A1Co) owns 20% of the voting interest of HCo
                • Their total ownership in HCo is 60%. Therefore, HCo is a CFC of both of them
            • Some countries require concentrated ownership (control is concentrated in a small number of resident shareholders)
              • Example:
                • Australia, Canada, New Zealand: control of a foreign corporation must be concentrated in 5 or fewer resident shareholders
                • the US: only resident shareholders owning ≥ 10% of the shares of the foreign corporation are counted
              • Rationale:
                • widely held shareholders are unlikely to be able to exercise sufficient power over the corporation to determine its income-earning activities or require it to make distributions
              • However, some countries do not require concentrated-ownership
                • Norway and Germany: widely held foreign corporations can be considered as CFCs.
      2. Feature 2: Designated jurisdiction vs global approach [of the foreign entities]
        1. Designated jurisdictions (tax haven countries)
          • Used by most countries
          • Rationale: by limiting the CFC rules to designated jurisdictions, the compliance cost and administrative burden of the CFC rules are relatively lower
          • Rules to determine the residence of the foreign entities are crucial
        2. Global approach (any countries)
          • Used by a few countries (such as Brazil, Canada, the US)
          • Rationale: all countries, including high-tax countries, have aspects of their tax system that permit the earning of preferentially or low-taxed income
          • The residence of the foreign entities is irrelevant to determine
      3. Feature 3: Attributable income
        • The approaches:
          1. Entity approach
            • The determining factor is the entity’s status
              • All-or-nothing result
                • If a foreign entity qualifies for any of the exemptions (i.e., it engages primarily in genuine business activities), then all of its income is exempt (even if it has passive income)
                • On the contrary, where the foreign entity does not qualify for any of the exemptions, all of its income is attributable to its domestic shareholders.
            • Pro: minimizes compliance cost and administrative burden; Con: less precise
          2. Transactional approach
            • The determining factor is the types of income
              • Only certain types of income (called tainted income) are subject to attribution
              • Tainted income usually consists of:
                1. passive investment income
                  • interest (except interest generated by financial institutions), dividends, royalties, rent, capital gains
                2. base company income
                  • other than passive income with these criteria:
                    1. income derived by a CFC from the country in which its controlling shareholders are resident
                      • ACo owns BCo; BCo earns income from Country A. This erodes Country A’s tax because ACo could earn the income directly
                    2. income derived by a CFC from transactions with related parties
                      • To back up transfer pricing rules
                    3. income derived by a CFC from transactions outside the country in which it is resident
                      • ACo owns BCo; BCo earns income from country C
                      • Rationale: If BCo does a business outside country B, then what is commercial reasons for it to be established in country B?
              • but tainted income may not include inter-company transactions between CFCs
          3. Hybrid approach
            • Uses the transactional approach (i.e., types of income are the determining factor) but provides an exemption for a CFC whose tainted income is less than a specified percentage of its total income (i.e., the entity itu may be exempt)
            • Australia, New Zealand, the US
      4. Feature 4: Exemptions
        1. Exemption for genuine business activities (active business income)
          • The factors:
            • engaged in certain defined active business income or not engaged in investment activities; and
            • has a substantial presence in the foreign country; and
            • tainted income is not dominant (usually tainted income must be less than 50%)
          • Compatible with entity approach of attributable income
            • If a foreign entity engages primarily in genuine business activities based on the above factors, then all of its income is not attributable income (even if it earns passive income)
          • Not compatible with transactional approach of attributable income
            • Under transactional approach, only tainted income (which consists of passive income) is attributed. Exemption for genuine business activities is not needed because the transactional approach automatically exempt active business income.
        2. Exemption for distribution
          • Illustration:
            • BCo distributes a dividend to ACo
            • Where distribution is exempt in CFC rules, the dividend is not attributable income of ACo to the extent that it is subject to Country A’s tax
            • Rationale: ACo does not defer BCo’s profits
          • However, no country currently provides exemption for distribution because it is complex.
        3. De minimis exemption
          • Is: the minimum amounts of CFC’s income at which CFC rules do not apply
          • Reason: political considerations
            • to allay fears that CFC rules will impose significant compliance costs on taxpayers in respect of relatively small amounts of income subject to tax
        4. Motive exemption
          • A CFC that are not used for the purpose of avoiding/reducing tax is not subject to CFC rules
          • Gives considerable discretion to tax authorities; flexibility in determining exemptions
      5. Feature 5: Resident taxpayers subject to tax
        • Types of shareholders: individual and/or corporate shareholders
        • Shareholding status: shares ownerhsip at the end of the taxation year
          • Pro: simple
          • Con: unfair (the CFC’s income is for the entire year, but the shares ownership may be only for part of the year)
            • However, once the rule has been established, potential buyers will make adjustment to take into account the rule in setting the purchase price of the shares
        • Minimum shareholding (usually 10%)
          • Rationale: small investment means little influence over the foreign corporation
      6. Feature 6: Relief from double taxation
        • Taxes paid by the CFC (HCo) is creditable for the resident shareholder (ACo)
          • Example 1:
            • ACo owns HCo. In 2006, HCo earns passive income of 1,000 in country H and pays tax of 100 to country H on its income.
            • ACo is taxable on HCo’s income at a rate of 40% and qualifies for a foreign tax credit of 100 for the tax paid by HCo to country H.
          • With this type of relief, CFC rules effectively treat a CFC as a branch/PE of a resident taxpayer (HCo’s income is deemed as ACo’s income; HCo’s tax is creditable to ACo).
        • Foreign tax paid by the CFC is creditable
        • Dividends received from the CFC is exempt
          • Example 2a: just like example 1 with additional facts: 1) in 2018, HCo pays a dividend to ACo of 900; 2) Country H imposes WHT of 10% with respect to the dividend
            • With respect to ACo, the dividend is exempt from Country A’s tax because ACo has been taxed on the profits of 1,000
            • Country A should provide relief for that WHT by allowing ACo to claim the WHT against any tax on CFC income for 2018 or future years; or carried back and claimed as a foreign tax credit in 2016
        • Capital gains from the disposal of shares of the CFC that reflect previously taxed income of the CFC are exempt
          • Example 2b: just like example 1 with additional facts: 1) In 2018, ACo sells the shares of HCo without receiving a dividend; 2) ACo realizes capital gain (around 900).
            • ACo should not be taxed on the capital gain because the gain reflects HCo’s after-tax income for 2016 of 900 (in other words, the gain reflects the undistributed dividend) on which ACo has been taxed.
          • If a country does not provide relief for capital gains, but does provide relief for dividends, the resident shareholder (ACo) will ask the CFC (HCo) to distribute a dividend before disposing of its shares.
    • CFC rules: application in some countries
      1. The US
        1. 1962: CFC rules (Subpart F)
          • Targets the use of foreign corporations by individuals
          • Passive income
        2. 2017: enacted GILTI (global intangible low taxed income)
          • Includes active income of a CFC
          • Minimum tax of 10.5% of the income of CFCs owned by US taxpayers in excess of a deemed 10% rate of return on a CFC’s tangible assets
          • Only 80% of the foreign tax paid by a CFC on that income is creditable against the minimum tax
      2. Brazil
        • Brazilian residents owning ≥ 20% of shares in a foreign corporations
        • Passive and active income
      3. New Zealand
        • Foreign corporations except in 7 listed countries
        • passive and active income (since 2010: only passive income)
      4.  France
        • includes foreign branches or PEs
  • FIF RULES
    • A vehicle that can be used to shift and defer passive income without being subject to CFC rules: foreign investment funds (FIF)
    • Approaches used by countries to deal with investment in FIFs:
      1. FIF rules form part of the CFC rules (Germany)
        • CFC rules apply to small investors in foreign corporations and other entities controlled by residents where the entities earn primarily passive income
      2. Deemed distribution approach
        • The resident taxpayers are subject to tax on their proportional share of the income of the FIF, irrespective of whether the income is distributed.
        • This approach is the same as the method of taxation under CFC rules (deemed distribution in this approach = attributed income in CFC rules)
        • The application is difficult if the taxpayers do not have access to information necessary to compute their share of the FIF’s income (this approach should be limited to taxpayers who own a substantial interest in the FIF)
      3. Imputed-income approach / deemed rate of return approach
        • The resident taxpayer is deemed to have earned income on the amount invested in the FIF at a specified rate (deemed income = the specified rate x investment amount), irrespective of the actual income earned by the fund
        • Advantages: simple to apply; minimizes the compliance burden on taxpayers and the administrative burden on the tax authorities
        • Disadvantages: may result in the under-or-over taxation of investors
      4. Mark-to-market method
        • Any increase/decrease in the value of a resident taxpayer’s interest in a FIF [the value at the end of the year minus the value at the start of the year] must be included in computing the taxpayer’s income for each year (= capital gains tax on an accrual basis)
        • Easy to apply if the FIF is actively traded on a stock exchange or if the FIF provides information on the current value of interests in the fund. Otherwise, difficult.
      5. Deferral charge approach
        • No domestic country tax before distributions are received or gains are realized; however, an interest charge is imposed to eliminate the benefits of deferral that the taxpayer has enjoyed.
      6. Purpose test (Canada)
        • If one of the primary purposes for the acquisition or holding of the interest in the fund is to avoid tax, residents who hold an interest in a FIF are taxable on imputed income (attributed income)
  • Recommendations in the Action 3 – 2015 Final Report (“Designing Effective CFC Rules”)
    • Definition of a CFC
      1. how to determine when shareholders have sufficient influence over a foreign company for that company to be a CFC
      2. how non-corporate entities and their income should be brought within CFC rules
    • CFC exemptions and threshold requirements
      • CFC rules only apply to CFCs that are subject to effective tax rates that are meaningfully lower than those applied in the parent jurisdiction
    • Definition of income
      • CFC rules include a definition of CFC income (the report sets out a non-exhaustive list of approaches or combination of approaches that CFC rules could use for such a definition)
    • Computation of income
      1. CFC rules use the rules of the parent jurisdiction to compute the CFC income to be attributed to shareholders.
      2. CFC losses should only be offset against the profits of the same CFC or other CFCs in the same jurisdiction
    • Attribution of income
      • when possible, the attribution threshold should be tied to the control threshold and that the amount of income to be attributed should be calculated by reference to the proportionate ownership or influence
    • Prevention and elimination of double taxation
      1. jurisdictions with CFC rules allow a credit for foreign taxes actually paid, including any tax assessed on intermediate parent companies under a CFC regime
      2. countries consider relief from double taxation on dividends on, and gains arising from the disposal of, CFC shares where the income of the CFC has previously been subject to taxation under a CFC regime

Source:

  1. Brian J. Arnold, International Tax Primer (4th ed. 2019)
  2. OECD (2015), Designing Effective Controlled Foreign Company Rules, Action 3 – 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Parishttps://doi-org.ezp.lib.unimelb.edu.au/10.1787/9789264241152-en.

 

1. Foto_AGUS DWI PUTRA

Hi, this article is summarised from Brian J. Arnold’s “International Tax Primer”. If you wish to read the book, please click FREE PREVIEW from Amazon.

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