Tax AdvisoryNovember 8, 2023by fiecon

Understanding Controlled Foreign Company (CFC) Rules for Multinationals

Taxes (2)

Controlled Foreign Company (CFC) rules are tax laws that are designed to prevent multinational companies from shifting profits to subsidiaries located in low-tax jurisdictions in order to avoid paying taxes in their home country. These rules aim to ensure that multinational companies pay their fair share of taxes on the income generated by their foreign subsidiaries.

Under CFC rules, a foreign subsidiary is considered a CFC if it is controlled by the parent company, typically defined as more than 50% ownership of the subsidiary’s voting stock. Once a foreign subsidiary is considered a CFC, the income earned by the subsidiary may be subject to taxation in the parent company’s home country, even if the income is not repatriated to the parent company.

The specific CFC rules and the tax treatment of CFC income can vary depending on the country. Some countries, such as the United States, have a “current inclusion” system, which requires the parent company to include the CFC’s income in its tax return for the year in which the income is earned. Other countries, such as the United Kingdom, have a “deferral” system, which allows the parent company to defer the tax on the CFC’s income until it is repatriated to the parent company.

CFC rules can have a significant impact on multinational companies, as they can increase the overall tax burden on foreign subsidiaries and limit the ability of companies to take advantage of lower tax rates in other countries. As a result, many multinational companies engage in tax planning strategies to minimize the impact of CFC rules, such as transferring intellectual property to foreign subsidiaries or using intercompany financing techniques.

CFC Rules Design

It should be noted that the increase in global tax transparency, automatic exchange of information, and the Base Erosion and Profit Shifting (BEPS) initiative led by the Organisation for Economic Co-operation and Development (OECD) have made it harder for companies to avoid taxes by shifting profits to low-tax jurisdictions.

This has been made possible by OECD under the inclusive framework on BEPS, introduced Action 3 CFC Rules which is meant to hold parent companies liable for their subsidiary profits. The building blocks for effective CFC Rules include;

Rules for defining a CFC: In order to establish whether CFC rules apply, a jurisdiction must consider two questions;

  • whether a foreign entity is of the type that would be considered a CFC and
  • whether the parent company has sufficient influence or control over the foreign entity for the foreign entity to be a CFC.

Therefore, this rule applies where more than 50% of the control of the CFC is held by residents of the parent jurisdiction, whether that control is direct or indirect. The offshore subsidiaries include corporate company, permanent establishments and transparent entities.

CFC Exemptions and Thresholds: Under this rule, the requirements can be used to limit the scope of CFC rules by excluding entities that are likely to pose little risk of base erosion and profit shifting and instead focusing attention on cases that are higher-risk because they exhibit some characteristic or behaviour that means there is a greater chance of profit shifting.

The recommendation is to include a tax rate exemption that would allow companies that are subject to an effective tax rate that is sufficiently similar to the tax rate applied in the parent jurisdiction not to be subject to CFC taxation. The effect of this tax rate exemption would be to subject all CFCs with an effective tax rate meaningfully below the rate applied in the parent jurisdiction to CFC rules. This exemption could be combined with a list such as a white list which illustrates countries that the rules does not apply

Definition of CFC Income: Under this rule, once a foreign company has been determined to be a CFC, the next question is whether the income earned by the CFC is of the type that raises concerns and should be attributed to shareholders or controlling parties.

It is recommended that the CFC rules should include a definition of income that ensures that income that raises BEPS concerns is attributed to controlling shareholders in the parent jurisdiction.

The report allows countries to define CFC income in a way that addresses the BEPS risks it faces, including whether all of an entity’s income or only certain types of income should be covered by CFC rules which include;

  • Full-Inclusion Approach Analysis which means simply to apply in practice. Can include other tests so as to only focus on BEPS risks, for example;
    • Substance test: A substance analysis looks to whether the CFC engaged in substantial activities in determining what income is CFC income. It can apply as either a threshold test or a proportionate analysis
    • Excess Profit test: This would characterise income in excess of a “normal return” earned in low tax jurisdictions as CFC income. Such an approach could, for instance, be relevant in the context of IP income as generally taxpayers cannot expect to earn a profit in excess of the normal returns from simply purchasing and selling and providing services or manufacturing, unless those activities involve the use of IP
  • Categorical Approach: It focuses on types of income that gives rise to greatest risks. It can focus on;
    • Legal classifications e.g., dividends, interest, insurance income, royalties, service income
    • Where the income is derived from e.g., related parties
    • Where the income is derived from e.g., parent jurisdiction

Rules for computing income: under this rule, Once CFC rules have determined that income is attributable, they must then consider how much income to attribute. Computing the income of a CFC requires two different determinations;

  • Which jurisdiction’s rules should apply
  • Whether any specific rules for computing CFC income are necessary

The OECD report recommends for the first determination is to use the rules of the parent jurisdiction to calculate a CFC’s income and  for the second determination is that, to the extent legally permitted, jurisdictions should have a specific rule limiting the offset of CFC losses so that they can only be used against the profits of the same CFC or against the profits of other CFCs in the same jurisdiction.

Rules for attributing income: Under this rule, Once the amount of CFC income has been calculated, the next step is determining how to attribute that income to the appropriate shareholders in the CFC.

Income attribution can be broken into five steps;

  • determining which taxpayers should have income attributed to them
  • determining how much income should be attributed
  • determining when the income should be included in the returns of the taxpayers
  • determining how the income should be treated
  • determining what tax rate should apply to the income.

Eliminating double taxation: Under this, CFC rules should include provisions to ensure that the application of these rules does not lead to double taxation. There are at least three situations where double taxation may arise:

  • Situations where the attributed CFC income is also subject to foreign corporate taxes.
  • Situations where CFC rules in more than one jurisdiction apply to the same CFC income
  • Situations where a CFC actually distributes dividends out of income that has already been attributed to its resident shareholders under the CFC rules or a resident shareholder disposes of the shares in the CFC.

However, double taxation concerns could arise in other situations, for instance where there has been a transfer pricing adjustment between two jurisdictions and a CFC charge arises in a third jurisdiction. CFC rules should be designed to ensure that these and other situations do not lead to double taxation.

In conclusion, CFC rules are a tool used by governments to prevent multinational companies from avoiding taxes by shifting profits to low-tax jurisdictions. These rules can have a significant impact on multinational companies and may limit their ability to take advantage of lower tax rates in other countries. However, with the increase in global tax transparency and the implementation of the BEPS initiative, it is becoming harder for companies to avoid taxes through profit shifting.

Author: Eddie Opiyo