BEPS Action Plan 3: Designing effective controlled foreign company rules

A “controlled foreign company” (CFC) is, as the name implies, a foreign company or subsidiary owned by a parent company which is situated in a country different from the parent company’s country of residence. The tax laws of many countries, including the Philippines, do not tax the CFC’s parent company on the CFC’s net income after tax (NIAT) unless the NIAT is distributed as dividends. CFC rules and other anti-deferral rules combat opportunities for profit shifting and long-term deferral of taxation by enabling jurisdictions to tax income earned by foreign subsidiaries where certain conditions are met.
In response to the challenges of Base Erosion and Profit Shifting (BEPS) through CFCs, the Organisation for Economic Co-operation and Development (OECD) Final Report on Action Plan 3 provides recommendations for the design of effective CFC rules. While the recommendations provide minimum standards, they are designed to ensure that jurisdictions that choose to implement them will have rules to effectively prevent taxpayers from shifting income into foreign subsidiaries. The report sets out six building blocks for the design of effective CFC rules; these are:

DEFINITION OF A CFC
CFC rules generally apply to foreign companies that are controlled by shareholders in the parent jurisdiction. The report recommends that to determine a CFC, the following must be defined: (1) the type of entities that are within its scope; and, (2) the type and level of influence or control over a foreign company.

The definition of a CFC should be broad enough to apply to corporations, certain transparent entities such partnerships and trusts, and permanent establishments (PEs). It also includes a form of hybrid-mismatch rule to prevent entities from circumventing CFC rules through different treatments in different jurisdictions.

In the context of control, the recommendation is to apply combined legal and economic control tests so that the satisfaction of either test results in control. These tests could also be supplemented by a de facto test or a test based on consolidation for accounting purposes. The report recommends treating a CFC as controlled when residents (including corporations, individuals or others) hold, at a minimum, more than 50% control of an entity. This level of control could be established by aggregating the interest of minority shareholders using one of three approaches: (i) an “acting-in-concert” test, (ii) a related party test, or (iii) a concentrated ownership requirement. Moreover, CFC rules should apply when there is either direct or indirect control.

CFC EXEMPTIONS AND THRESHOLD REQUIREMENTS
CFC exemptions and threshold requirements can be used to limit the scope of CFC rules by excluding entities that are likely to pose little risk of BEPS and focus attention on companies that exhibit higher risk of BEPS. The three types of CFC exemptions and threshold requirements considered in the report include: (1) a de minimis threshold, below which the CFC rules would not apply; (2) an anti-avoidance requirement which would focus CFC rules on situations where there was a tax avoidance motive or purpose; and (3) a tax rate exemption where CFC rules would only apply to CFCs subject to effective tax rates that are meaningfully lower than the rate applied in the parent company’s jurisdiction. Additionally, these approaches could be combined with a list (i.e., black list or white list) enumerating the jurisdictions where CFC rules will or will not apply. For example, Australia applies a white list approach under which companies resident in listed countries with an income tax system comparable to Australia’s tax system are not subject to CFC taxation.

DEFINITION OF CFC INCOME
Although some countries’ existing CFC rules treat all the income of a CFC as “CFC income” that is attributed to shareholders in the parent jurisdiction, many CFC rules only apply to certain types of income. The report recommends that CFC rules include a definition of CFC income and sets out a non-exhaustive list of approaches or combination of approaches that could be used by countries.

These approaches include (1) a categorical analysis, which divides income into categories and attributes income differently depending on how it is categorized; (2) a substance analysis, which looks to whether a CFC has the ability to earn the income itself, and (3) an excess-profits analysis, which would characterize income in excess of a “normal return” earned in low tax jurisdictions as CFC income and which tends to apply to income from intangibles and risk shifting transactions among related parties.

The report also states that countries must determine if the analysis shall be applied on an entity-by-entity basis or on a transactional basis, which would attribute individual streams of income. The report notes that the transactional approach is generally more accurate at attributing income, although it may increase administrative burdens and compliance costs.

COMPUTATION OF INCOME
The report recommends that CFC rules use the rules of the parent jurisdiction to compute the CFC income to be attributed to shareholders. It also recommends that CFC losses should only be offset against the profits of the same CFC or of other CFCs in the same jurisdiction.

ATTRIBUTION OF INCOME
The report recommends that, when possible, the attribution threshold should be tied to the minimum control threshold and that the amount of CFC income to be attributed should be calculated by reference to both their proportion of ownership in the CFC and their actual period of ownership or influence. The report further states that jurisdictions can determine when CFC income should be included and how it should be treated so that their CFC rules can operate in a way that is consistent with existing domestic laws. Finally, CFC rules should apply the tax rate of the parent jurisdiction to the CFC income or alternatively, apply a “top-up” tax instead of the full tax rate.

PREVENTION AND ELIMINATION OF DOUBLE TAXATION
One of the fundamental policy issues to consider when designing effective CFC rules is how to ensure that application of these rules do not lead to double taxation. Thus, the report recommends that jurisdictions with CFC rules allow a credit for foreign taxes actually paid, including any tax assessed on intermediate parent companies under a CFC regime. It also recommends that countries consider relief from double taxation on dividends and gains on the disposition of CFC shares where the income of the CFC has previously been subjected to taxation under a CFC regime. The report recognizes that double taxation can also arise through the interaction of CFC rules and transfer pricing rules. However, jurisdictions need to consider their domestic tax law and their country’s tax treaty obligations in addressing situations that give rise to double taxation on CFC income.

The building blocks contained in the report are designed to allow countries without CFC rules to implement the recommendations directly. They also allow countries with existing CFC rules to modify their rules to align more closely with the recommendations. Currently, the Philippines does not have any set of CFC rules to address BEPS concerns and this could be an area where significant developments may take place in the future. Companies should continue to stay abreast of the latest developments on Action Plan 3 in the countries where they operate or invest, evaluate how proposed changes may impact them, and consider participating in the consultation process to provide stakeholder input.