Action 3 of the OECD/G20 action plan on base erosion and profit shifting (BEPS) is concerned with taking action on controlled foreign company (CFC) rules. These rules benefit the country of the ultimate parent of a group by subjecting more profits to tax. They may also benefit source countries by reducing the incentive for multinational groups to route taxable profits away from those source countries into low tax jurisdictions. The discussion draft breaks down the constituent components of CFC rules into a number of building blocks needed to put together effective CFC rules.

Policy considerations

Tax policy considerations include balancing the need to tax the foreign income with the need to remain competitive, and avoiding double taxation of that foreign income. There is also a need to limit administrative and compliance burdens but to do enough to ensure that the CFC rules are effective. The policy considerations also include the role of the CFC rules as a preventative measure, their effect in combating tax base stripping and their interaction with transfer pricing rules.

Some cases decided by the European Court of Justice (ECJ) have determined that CFC rules and other cross-border tax provisions are justified by the need to prevent tax avoidance and must specifically target wholly artificial arrangements that do not reflect economic reality and whose only purpose would be to obtain a tax advantage. So although the rules recommended by the OECD action plan would ideally be implemented by all countries the member states of the EU may need to modify the recommended rules to comply with EU law. These modifications should not however affect how the recommendations are applied to states that are not EU member states.

Definition of a CFC

With regard to the definition of a CFC the discussion draft considers whether issues arise from treating transparent entities as separate entities for CFC purposes. It also asks for recommendations on other issues concerning what entities can be considered to be CFCs. On threshold requirements the consultation paper asks for comments on problems arising from setting a low-tax threshold based on an effective tax rate and how they could be addressed.

The definition of control for CFC purposes needs to cover the type of control required and the level of the control. The draft looks at practical problems in applying a control test and issues arising from a test that takes into consideration interests held by unrelated or non-resident parties. The paper asks for comments on how these problems can be dealt with.

Definition of CFC income

As regards the definition of CFC income the discussion draft does not include recommendations but instead presents some options for countries to implement. There is no international consensus on how to define the income to be brought within the CFC legislation. Some countries consider that an “excess profits” approach that excludes a normal return on equity and looks at the excess profits of the CFC is an appropriate method. Others consider that this approach could result in the taxation of profits that are the result of legitimate economic activity of an entity with economic substance.

The discussion draft outlines the general features of CFC rules. The rules need to find a definition of CFC income that brings within the scope of the CFC legislation the highly mobile income and passive income that represents profit shifting and should be attributed to the shareholders of the CFC. Income arising from the economic activities of the CFC would normally be excluded from the attributed income.

One approach is a form-based analysis that classifies the CFC income according to its formal description, including passive income such as dividends, interest and royalties in attributed income while excluding active business income. This type of form-based analysis does not however accurately attribute income within the context of a modern business.

Many CFC rules therefore require a substance analysis and the paper therefore also includes some options for an analysis of economic substance. This approach looks at whether income has arisen from the economic activities of the CFC itself. The categories of income that present problems for current CFC rules are dividends, interest, insurance income, sales and services income, royalties and other income from intellectual property. The discussion draft invites comments on what form the recommendations on CFC income should take.

Attribution of income

The paper looks at the problems arising from the attribution of various categories of income to the shareholders of the CFC. It looks at approaches based on the categorization of income and at the use of an excess profits approach. The discussion draft also looks at the merits of an entity or transaction approach to the attribution of income. One concern is that the rules should not impose excessive administrative or compliance costs.

Computing CFC income

In computing CFC income the rules must determine which rules apply to this computation, those of the jurisdiction in which the CFC is located or those of the home country. Normally those of the home country are used. Another question regards rules of computation, for example the restriction of the offset of CFC losses so they can only be offset against profits of the same CFC or profits of CFCs in the same country.

Double tax relief

Double taxation may arise if the CFC is itself subject to foreign tax; if more than one jurisdiction taxes the profits under CFC rules; or where a CFC distributes dividends to shareholders where the CFC income has already been attributed to them. The recommendations of the discussion draft are to provide for double tax relief and to exempt dividends paid by the CFC where these are paid out of attributed profits.