No Agreement On BEPS Foreign Company Income Definition

Law360, New York (April 06, 2015, 3:10 PM ET) — A draft report released Friday by the Organization for Economic Cooperation and Development on strengthening controlled foreign-company rules to crack down on tax evasion said there are substantial disagreements among member states about how to best define CFC income.

The draft report, released as part of the OECD’s base erosion and profit-shifting project, did not make recommendations on how countries should identify income earned by foreign subsidiaries that should be subject to taxation, but instead laid out approaches that could be taken and asked for suggestions on putting together recommendations for the final report.

“It should be emphasized that the approaches to defining CFC income do not reflect a consensus view,” the report said. “The differences arise because some countries believe that an excess-profits approach will include income irrespective of whether it arises from genuine economic activity of the CFC and where there is appropriate substance. Other countries believe that excluding a normal return on eligible equity is an effective method for identifying CFC income.”

In general, the CFC rules seek to define income that should be taxed in a home jurisdiction because such is likely to have been diverted to another jurisdiction to take advantage of lower tax rates. Existing rules that have been adopted by some countries tend to include so-called passive income from interest, royalties and dividends in CFC income and exclude active income a company earns from legitimate operations in a foreign jurisdiction, the report said.

Some countries use a so-called form-based analysis to define CFC income that categorizes income based on its formal classification, the report said. Under such a system, income that companies classify as being derived from dividends, interests and royalties would be defined as CFC income, while income from sales and services would be excluded, it said. A form-based analysis, however, can be easily manipulated and does not reflect the modern business environment, according to the report.

Because of those weaknesses, existing rules tend to employ a substance-based approach to defining CFC income, the report said. Under that approach, an analysis determines whether income from a company’s foreign subsidiary arose from substantial economic activities undertaken by the foreign company, it said.

There are three forms that a substance analysis could take, the report said. Under a substantial contribution analysis, tax authorities would determine whether employees of a CFC contributed to the income attributed to the foreign company. A viable independent entity analysis would seek to determine if a CFC would be the most likely to take on an economic risk or own particular assets if it was a stand-alone entity and not a member of a corporate group. An employee and establishment analysis would try to determine if a CFC has the necessary business premises in the foreign jurisdiction to actually earn the income attributed to it.

The report asked for feedback on each of the analyses and practical problems that could arise if companies implemented them, as well as ways that existing methods could be made more accurate.

The BEPS project, which is scheduled to wrap at the end of 2015, will result in the OECD making recommendations in 15 aspects of the international tax system to make it harder for businesses to exploit mismatches among different countries’ tax rules.