BEPS Action 3: How Not to Engage with CFC Rules

Action 3 of the OECD’s Base Erosion and Profit Shifting (BEPS) agenda promised to address how countries could use controlled foreign corporation (CFC) rules to combat BEPS. Unfortunately (or fortunately, depending upon one’s vantage point), as is pretty much universally agreed, the OECD’s draft report on CFC rules (the “draft”)1 failed in every conceivable way to address the issues presented by the use of CFCs. The draft’s incoherence was principally attributable to the fact that its authors never came to grips with two fundamental questions of how CFC rules might be relevant to BEPS. First, the draft failed to acknowledge the very different role that CFC rules play in territorial and in worldwide taxation systems. Second, the draft exhibited a puzzling inconsistency and hypocrisy on the extent to which CFC rules should be designed to discourage foreign-to-foreign profit shifting, as opposed to merely profit shifting from the owner’s residence country.

The Different Role of CFC Rules in Territorial and Worldwide Taxation Systems

Chapter 1 of the draft, discussing policy considerations, early made a key observation:

Some countries which give more importance to the principle of territoriality do not currently apply CFC rules. For those countries CFC rules would have to be limited to targeting profit shifting. However, where countries have worldwide tax systems, they may also be concerned about long-term deferral and therefore their rules may have broader policy objectives (for example, preventing long-term base erosion rather than only preventing profit shifting). (Draft ¶ 7)

As this paragraph acknowledged, CFC rules play a very different role in countries, such as the United States, that employ worldwide taxation systems than the role they play in countries, such as most EU countries, that employ territorial systems that avoid double taxation through exemption of foreign-source income from parent country tax. Generally, when a French multinational enterprise (“MNE”) pays U.S. tax, it pays no residual tax in France. But when a U.S. MNE pays French tax, it will eventually pay a residual tax in the United States if U.S. rates are higher than those prevailing in France, and that residual tax will be increased by the failure of the U.S. foreign tax credit system to allocate interest deductions on a worldwide basis.2 When a U.S. MNE receives a dividend from a CFC, it will pay U.S. tax thereon; generally, the French MNE will not.

Having acknowledged at the outset the important difference between the roles that CFC rules play in the two basic systems of taxing foreign-source income, the draft never mentioned the point again. The balance of the draft is limited to addressing the function of CFC rules in territorial regimes. For example:

Chapter 2 of the draft discusses whether the definition of CFC should encompass pass-through entities. Question 6 in Annex IV of the draft asks about the situation where a permanent establishment is subject to a different tax rate than a CFC. This is an issue only in territorial regimes that exempt income earned through branches and partnerships. A worldwide tax system taxes any income that a U.S. person derives through a pass-through entity, making this question irrelevant.

The draft assumes that an MNE would never “set up” a CFC in a high-tax country and would “set up” a CFC in a low-tax country only to avoid parent country tax on passive income otherwise not exempted under a territorial regime. It conceived of CFC rules as a means to prevent behavior and thus as rules that would rarely raise revenue.3 In a worldwide system, CFC rules apply without regard to whether the country in which the CFC resides is a high-tax or low-tax country, and are quite definitely about raising revenue.

The draft at ¶ 82 suggests that one approach to taxing CFC income is a “full
inclusion” rule. Such a rule makes sense only if CFC rules are limited to
tackling the shifting of passive income to low-tax countries.

More broadly, the entire draft assumes that CFC rules have to do only with setting up CFCs in low-tax jurisdictions. A worldwide tax system is concerned with far more, as evidenced by the Code’s foreign base company sales and services rules.

The draft at ¶ 26 assumes that an MNE can simply relocate to a country without CFC rules. Of course, this is not possible for an MNE based in a country that employs a worldwide tax system.

Chapter 6 of the draft wonders whether the income of a CFC should be calculated under the parent jurisdiction’s tax rules, or not. This is not a question in a worldwide regime, which seeks to tax the income of CFCs on a current or deferred basis. The “top-up” alternative presented in the draft is moot in a worldwide system.

The draft speculates about the level of control that a shareholder needs to have over a CFC to render the rules applicable. In a territorial system, which uses CFC rules only as a preventative anti-abuse measure, it may make sense to define control loosely. But in a worldwide system, control must be clearly defined, because the stakes are so much higher.4

The draft never mentions any analog to §956. This is because territorial countries do not presume to employ CFC rules to prevent deferral.

It should be evident that in a worldwide system CFC rules must be objective and narrowly defined. When a foreign corporation is a CFC and there is no possibility of exemption – at best only deferral – the stakes are far higher than those prevailing in a territorial system. Conversely, a worldwide system takes pressure off transfer pricing rules, because the sole relevance of source is to determine what foreign taxes qualify for a foreign tax credit.

It is noteworthy that the draft spends an inordinate amount of time fussing over whether a given CFC has “substance” in its country of residence. This is not ordinarily a concern in a worldwide system. Although U.S. tax rules do give effect to whether a CFC actively conducts certain businesses (such as receiving rents or royalties, or acting as a bank or insurance company) through its own employees in its country of incorporation, it does so simply as a means of asking the question whether there is a good reason for the CFC to be in the country it was formed in. The assumption – which is quite opposite to the assumption prevailing in territorial systems – is that if there is no good reason for a CFC to be in the country where it is formed, then its income could just as well have been earned in the United States.

The draft’s failure to follow through on this fundamental distinction must have been traceable to an assumption made by the drafters that the broader role of CFC rules in worldwide regimes was irrelevant to its analysis. It seems likely that the drafters believed that if they could get the CFC rules right for territorial regimes, worldwide regimes could simply “tack on” whatever rules they believed might be needed to address the interplay of CFC rules with foreign tax credit and repatriation or other timing rules. That notion is seriously misguided.

Should CFC Rules Address Foreign-to-Foreign Stripping?

Chapter 1 of the draft addresses scoping by stating that some CFC regimes “focus only on protecting the parent jurisdiction’s base, but others protect against both stripping of the parent jurisdiction’s base and stripping of third countries’ bases,” and goes on to state that CFC rules would be more effective against BEPS if they did both.5 Yet at ¶ 85, the draft suggests that it is not that important if a country’s CFC rules did not bother to address foreign-to-foreign stripping.

The CFC rules of the United States, a worldwide taxing jurisdiction, were originally designed to prevent both erosion of the U.S. tax base and to prevent artificial shifting of profits by a CFC in a high-tax country to a CFC in a low-tax country. This design did not emanate from any desire on the part of the United States to protect the tax base of other countries; rather, it emanated from a desire to discourage U.S. MNEs from preferring foreign investment to U.S. investment under the doctrine of capital export neutrality (“CEN”). It will be noted that this doctrine is not employed in territorial systems. In fact, most territorial systems employ the opposite approach, encouraging local “champions” to invest abroad and subsidizing their foreign operations by allowing interest and other expenses to be deducted against home country income.

The draft focuses on foreign-to-foreign stripping not because the OECD has suddenly been converted to CEN dogma, but to address stripping as a practice it desires to minimize. A centerpiece of the draft is the Example shown and discussed in ¶¶ 35-41, which illustrates the paradigm case of a U.S.6 MNE using check-the-box planning to reduce its foreign taxes by stripping interest out of a high-tax CFC into a disregarded entity formed in a low-tax country. This paradigm case was at one point targeted by the United States as violating CEN,7 but has since essentially been accepted and codified in §954(c)(6).

It is often said that this type of planning has “repealed” the U.S. CFC rules. But this would be true if and only if one postulated that the purpose of CFC rules is to protect the tax base of third countries, or to defend CEN. The United States has determined that this is not the purpose of its CFC rules.8 Since a majority of OECD countries reject CEN, and since the draft apparently condones CFC rules (such as those in the United Kingdom) that allow foreign-to-foreign stripping, the Example would seem to have nothing to do with CFC rules as envisioned by the draft. It is pure hypocrisy to place this Example at the heart of the draft’s chapter on defining what is a CFC.

Conclusion

One, of course, cannot in a few pages construct a “theory of everything” to deal with the application of CFC rules, and it is unreasonable to expect that the OECD could have done so even using 70 pages. But there is no point in the exercise unless these fundamental issues are engaged at the outset. By failing to engage these issues, the draft has done a disservice to the BEPS project. It should be withdrawn, and perhaps eventually replaced with something more reflective, even if that means the BEPS timetable must be extended.