Remarks on, and a comparative
overview of, controlled foreign
company (CFC) regimes
PROFESSOR WILLIAM H BYRNES, IV
REGENT ...
The next courses start in August 2000. Applications and registration may occur
until June 5, 2000.
All students have inter...
SYLLABUS
INTRODUCTION
I. A “POLICY”
(1) The term “CFC”
(2) Is anti-deferral a social “negative”?
A simple example of the e...
• planning techniques.
When asked to speak on CFC regimes, I first thought : how un-interesting?
Treaty planning : interes...
As in previous years, if you would like a E-copy of this presentation or my
transparencies, please email me at williambyrn...
Thus, tax deferral, in the context of a CFC regime, is generally the situation when
foreign profits5
are not taxed “presen...
In year 3, TP earns 12.4 (rounded) from investment of years’ 1 and 2 profits, plus
another 100 of foreign profits. TP pays...
at the end of year 4 after tax of 53.2, whereas without deferral, TP would have
earned 71.3 after cumulative taxes of 47.7...
foreign investment. Thus, considering higher costs for maintenance of two
vehicles, TP should choose a local entity to hou...
all other treasury management functions. The CFC regime acts to further a
State’s policy of leveling capital accumulation ...
The general description of a “targeted” tax competitive regime is to call it a tax
haven. Another way to characterize tax ...
Barbados, the Bahamas, and Bermuda in such as way as to effect industrial jobs
in the OECD. However, the OECD is concerned...
SYLLABUS
II. The fundamental elements of CFC regimes
Generally, CFC regimes are enacted by States in which tax liability i...
In relation to the topic of CFC, the nexus between the taxpayer and the foreign
income is more important. The operative cr...
(3) The nexus between the taxpayer and foreign entity
The entity must be separate and distinct, that is, the entity must n...
Generally, the State exercises fiscal jurisdiction under a CFC regime when the
taxpayer’s nexus reaches “control” of the r...
which a taxpayer grants control, expressed as voting rights, to a third party, but
retains the right to benefit from a maj...
(6) Deemed distribution
The presumption of deferral is that the foreign profits are not repatriated (if
repatriated, then ...
 France : to foreign permanent establishments (because of its territorial
based system)
 Canada : to trusts
 South Afri...
“Sum the shares of related parties as one shareholder to determine the portion of
ownership of the underlying company”.
 ...
 UK, Finland, Norway, Sweden, Germany, Japan, Italy, Portugal
(alternative definition)
At what point in time is control t...
 Black/Grey list
Spain (rebuttable presumption)
Germany (rebuttable presumption)
Mexico, Indonesia, Italy
 Comparable ta...
Upcoming SlideShare
Loading in …5
×

Controlled Foreign Company Regimes (Mumbai 1999)

518 views

Published on

Bombay Management Association International Tax Conference 1999

Published in: Education, Technology, Business
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
518
On SlideShare
0
From Embeds
0
Number of Embeds
1
Actions
Shares
0
Downloads
3
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Controlled Foreign Company Regimes (Mumbai 1999)

  1. 1. Remarks on, and a comparative overview of, controlled foreign company (CFC) regimes PROFESSOR WILLIAM H BYRNES, IV REGENT SCHOOL OF LAW Political Economics, Tulane University; Juris Doctorate, Loyola Law School; LL.M., University of Amsterdam; Fellow, International Bureau of Fiscal Documentation; Visiting Professor, University of the Witwatersrand Attorney-at-Law Regent University offers the world’s first on-line Masters and an LLM of International Taxation. The School of Law is accredited by the American Bar Association (ABA) and the Southern Association of Colleges and Schools (SACS). NOTES PREPARED FOR THE FIFTH INTERNATIONAL TAX PLANNING CONFERENCE DECEMBER 3 AND 4, 1999 TAJ MAHAL HOTEL, MUMBAI BOMBAY MANAGEMENT ASSOCIATION Copyright remains solely with the author – William Byrnes
  2. 2. The next courses start in August 2000. Applications and registration may occur until June 5, 2000. All students have internet access to Kluwer international tax materials, Lexis- Nexis, Westlaw, CCH international tax materials, RIA international tax materials, IBFD international tax materials, Tax Analysts international tax materials, Foreign Law and Tax Publishers, as well as other online services, as part of their tuition. The student body is broken into class sections of 25 students per one professor. Most students are sponsored by their employer and come from the big accountancy firms, law firms, multinational companies, the financial service industry, and offshore service providers. Students must come to the US for one week for lectures at Regent University. The campus is spread out over 700 wooded acres in Virginia Beach (on the Atlantic Ocean), near Washington, DC. Non-US nationals must pay US$7,500 for each of two years, a total of US$15,000. Non-US nationals are neither eligible for financial aid from Regent University for the International Tax program nor eligible for US government student loans. US nationals are eligible for US government student loans. 2
  3. 3. SYLLABUS INTRODUCTION I. A “POLICY” (1) The term “CFC” (2) Is anti-deferral a social “negative”? A simple example of the effects of deferral (3) Policy reasons for CFC regimes Balance of payments Less accumulation of capital through foreign investment Shoring up the tax base White lists and Black lists Transfer pricing regulations that shore up the tax base Acceptable and un-acceptable outflows II. The fundamental elements of CFC regimes (1) Breaking down the term accrual (2) Breaking the nexus between taxpayer and income (3) The nexus between the taxpayer and foreign entity (4) Exercise of fiscal jurisdiction on resident shareholder/s (5) The location of the foreign entity in lower tax jurisdiction (6) Deemed distribution III. Comparative overview of characteristics of CFC regimes (1) Application of CFC regime to entities (2) Definition of control (3) Transactional v jurisdictional approach (4) Calculation of income subject to attribution (transactional v entity approach) INTRODUCTION (and how to get the transparencies?) With great pleasure, I present to you again on a topic of anti-avoidance, this time on a “General Overview of CFC Regimes”. This lecture presentation presumes that you are familiar with my previous presentations to BMA on General Anti-Avoidance Rules (1996) and on Transfer Pricing (1998), to which I refer in this presentation. This E-presentation and my lecture/transparencies overlap only regarding a review of CFC regimes beginning in part III. This E-presentation focuses on policy from an argumentative Liberal perspective. My lecture before you focuses on • examining four example regimes • exceptions to CFC “tainted” income, not dealt with herein, • CFC regimes and tax treaties conflicts, and 3
  4. 4. • planning techniques. When asked to speak on CFC regimes, I first thought : how un-interesting? Treaty planning : interesting for inward and outward Indian investment. Transfer pricing : topical to outward Indian business with the OECD. But CFC : India does not have CFC legislation and India is a “high tax” country for inward investment, so why worry about CFC? First I sat down with a pot of coffee and without any books or references and thought about why we have CFC regimes today. The last time that I thought about CFC policy was in writing a book on suggested tax policy reform for South Africa in 1995. Two days later, I opened the books to check my thoughts and emerged with this presentation and lecture. First, I now understand that CFC regimes were the first volley (the wedge) in the usurpation of State sovereignty over economic choices, now advocated openly by the OECD Report. Just like the OECD Report on Tax Competition effects all international business, trade, and investment, the call by the OECD for more and stricter CFC regimes effects all international business, trade, and investment. We need to be concerned before a decision is railroaded over us (business and non-OECD members). Secondly, my research of India shows that India may be considered a low tax jurisdiction by some OECD countries regarding application of their CFC regimes. Thus, Indian inward investment could feasibly be targeted (if not now, then later). How will this effect the investment planning choices of the foreign decision- makers? Thirdly, much Indian inward investment is bifurcated between direct investment and treaty – offshore routes. How do the CFC regimes affect the use of the treaty - offshore routes? What do you need to know to understand your foreign investor’s CFC-tax considerations? Are you suggesting a structure for inward investment that does not work in light of the CFC regime? Is there a way to mitigate the effects of the CFC regime? Hopefully I have asked some interesting questions for your clients. Next to the determination of tax credits, CFC regimes are the most complex of tax rules to learn and “memorize”. I find it easier to decipher CFC regimes after understanding the policy behind them (part I: policy). After understanding the policy, it is essential to know the choices faced by the regulations’ redactors (part II: fundamental elements). What good is theory without examining practice (part III and the lecture)? Finally, after learning what you can no longer do – it is time to focus on planning and mitigation options, of which some should be new to you (lecture). 4
  5. 5. As in previous years, if you would like a E-copy of this presentation or my transparencies, please email me at williambyrnes@hotmail.com next week with “BMA transparencies and/or presentation” in the subject line. I will be available during the conference to discuss my presentation with you. Regards to the BMA Professor William H Byrnes Regent University School of Law SYLLABUS I. A “POLICY” (1) The term “CFC” CFC is an abbreviation for “controlled foreign corporation” and “controlled foreign company” tax rules. As a general definition, CFC rules impose a tax liability upon resident shareholders for profits generated in foreign corporate entities.1 However, in a broader sense, “CFC” is a recognized acronym (“buzzword”) for the entire set of regulations that create a tax liability for resident taxpayers for foreign profits properly allocated to non-resident (foreign) entities.2 For purposes of this lecture, the term CFC is generally used in this broader sense. (2) Is anti-deferral a social “negative”? CFC rules may also be termed “anti-(tax)deferral rules”. Deferral is a temporal concept meaning, for these purposes, “holding off inevitable taxation”. If income will suffer taxation at some point in time, then the taxpayer will have a greater after-tax retention of income if tax is paid during a future year as opposed to being paid in the present year.3 Conversely, for the State, assume that the State operates on the premise that tax collected in the present year is worth more than tax collected in a future year.4 1 As of 1997, Sandler reported that 18 States had enacted CFC regimes. 2 For example, the US enacted “foreign personal holding company” (FPHC) legislation in 1937 that is not per se CFC legislation, in that the term CFC did not exist until its 1962 enactment by the US. But the FPHC legislation acts like CFC legislation as will be described in the lecture. Sweden enacted anti-deferral rules in 1933, and the UK in 1937. 3 Assume that the deferral from tax liability is long enough to offset any subsequent dramatic increase in future tax rates and of course, that the foreign tax actually paid is less than will have to be paid upon repatriation of foreign profits. 4 Though most States hold this premise to be an axiom, it is sometimes flawed. The degree of the flaw depends on the political nature of the economist reviewing the State’s economic policy. Liberals identify that there is an inverse relation to the collection of tax and economic activity, including savings and investment (e.g. capital accumulation and capital investment). Moderate liberals replace “the collection of tax” with “a higher rate 5
  6. 6. Thus, tax deferral, in the context of a CFC regime, is generally the situation when foreign profits5 are not taxed “presently” under domestic taxation because the profits are generated by a foreign entity. Anti-deferral refers to the situation when profits, if repatriated to the resident taxpayer, would be liable to tax. Tax deferral generates a (hyper) return to the taxpayer because of: • the (taxpayer’s) opportunity cost of money, • compounding return, and • return on investments of scale. The taxpayer’s opportunity cost of money is the rate of return on investment that the taxpayer normally earns. The compounding return is the return generated on the return from a previous period (accumulation of previous year’s returns). The return on investments of scale assumes greater return on larger amounts of investment. A simple example of the effects of deferral Assume that a taxpayer’s opportunity cost of money is 10%, unless the taxpayer invests 300, in which case the return is 13% (i.e. scale of return), or 500 in which case the return is 15%. Effect of anti-deferral (scenario 1) In year 1, a taxpayer (“TP”) earns 100 foreign profits and pays 40 tax (its State’s tax rate is 40%), TP retains 60 profits for year 2. In year 2, TP earns 6 from investment of year 1 profit, plus another 100 of foreign profit. TP pays 42.4 tax (6 x 40% = 2.4 + 40), retaining (63.6 + 60) 123.6. of tax”. Lower economic activity generates lower tax revenues but places higher burdens upon the State’s budget, thus undermining the State’s economic, and thus, social stability. Socialists put forward the proposition that the State can better determine society’s capital expenditure and investment requirements, such as redistribution of income and investment in public health care and education facilities. Pursuant to this policy, public good is not to be measured by loss of gross economic production but by equality of distribution of necessities and services. In essence, a dollar saved for investment in tomorrow’s technology is worth less than a dollar spent on a homeless shelter today. 5 The reason that domestic profits do not need to be taken into account for this presentation is that it is assumed the domestic State exercises fiscal jurisdiction over income from domestic sources, and thus the income has suffered tax (no deferral is achieved). 6
  7. 7. In year 3, TP earns 12.4 (rounded) from investment of years’ 1 and 2 profits, plus another 100 of foreign profits. TP pays 45 tax (12.4 x 40% = 5 (rounded) + 40), retaining (130.2 + 60) 190.2. In year 4, TP earns 19 (rounded) from investment of years’ 1, 2 and 3 profits, plus another 100 of foreign profits. TP pays 47.6 tax (19 x 40% = 7.6 (rounded) + 40), retaining (201.6 + 60) 261.6 By year 4, the State collects total revenues of 175 that may be worth less than 175 comparing the value of money in year 1 to year 4 because any inflationary effects, which are not taken into account in this example. TP has earned 261.6 over the four years. Effect of deferral (scenario 2) In year 1, a taxpayer (“TP”) earns 100 foreign profits. TP retains 100 profits for year 2. In year 2, TP earns 10 from investment of year 1 profit, plus another 100 of foreign profits. TP retains (110 + 100) 210. In year 3, TP earns 21 from investment of years’ 1 and 2 profits, plus another 100 of foreign profits. TP retains (231 + 100) 331. In year 4, TP earns 43 (rounded) from investment from years’ 1, 2, and 3 profits plus another 100 of foreign income. TP retains (374 + 100) 474. At the end of year 4, TP repatriates its entire foreign profits. TP pays 189.60 tax (474 x 40%) retaining 284.4. Under this very simplified deferral example, the State is better off by 14.6 revenue (an 8% revenue increase) and TP is better off by 22.8 (an 8% revenue increase). Society is better of by 37.4 greater revenues.6 Had TP waited two more years, it would have generated a 15% rate of return on its deferred foreign profits. If we isolate from the example the constant increase by 100 of foreign profits, than we may observe the compounding rate of return solely on the original deferred tax amount of 40 tax paid. With deferral, TP would have earned 79.96 6 Obviously, this is a simple example and many other variables normally come into play. One of note against the State’s perceived increase in income is that, under the Socialist model, the State will need to meet constant budget expenditures, and thus must receive present revenue’s from profits generated. A response would be that the State may borrow from years 1 through 3, and pay back with interest, in year 4. The interest would be paid from the increased tax revenue amount. The society is still better off by the increased profit amount of TP. 7
  8. 8. at the end of year 4 after tax of 53.2, whereas without deferral, TP would have earned 71.3 after cumulative taxes of 47.7 (rounded). (3) Policy reasons for CFC regimes If the above figures represent the real outcome of deferral versus anti-deferral, then why do States impose CFC regimes? Balance of payments7 Just 20 years ago, many OECD countries were dismantling their exchange control (“ExCon”) (capital outflow control) regimes. In the last five years, many non-OECD countries are in the midst of doing so. ExCon regimes generally require permission from the State authority for a person to either transfer payments outside the States ExCon borders or to non-(ExCon)residents. Also, ExCon regimes require permission for ExCon residents to maintain capital outside the ExCon borders, generally requiring repatriation of capital within a certain amount of time of its being received. Thus, a State controlled its balance of payments to a large extent and consequentially, also controlled foreign investments (and foreign income) of its residents. Deferral of income repatriation effects the State’s capital domestic account, and its balance of payments.8 Under the anti-deferral example above (scenario 1), the State may budget current public revenue9 and may budget its current capital account because it knows it yearly inflows. The risk of waiting for TP to repatriate capital at the end of year 4 may offset, from the State’s perspective, the advantage of greater amounts received in year 4 Also, the anti-deferral regime generally creates a neutrality (or discourages the use of) between the choice of using a foreign entity or resident entity for housing 7 Please refer to Sandler pp 10-13 concerning FDI data of States with CFC regimes. For example, the CFC States are home to an estimated 39,000 MNE parents that account for $2.7 trillion in FDI. These parents have 270,000 subsidiaries and branches that produce $6 trillion in sales of goods, services, and technology. Combined, the MNEs constitute 60% of world trade. The Fortune 100 (excluding banks) employ 12 million persons and have an asset value of $4.2 trillion, 7 million at home ($2.8 trillion asset value) and 5 million abroad ($1.4 trillion asset value). 8 The axiom is that capital will flow to the jurisdiction in which it obtains the highest return for the least cost. One of the significant costs on the return generated by capital is tax. Thus, low tax jurisdictions account for approximately 50-60% of the world’s capital flows. However, MNEs have consistently stated in questionnaires that tax is not in the top three factors of consideration. I think that this potential conflict in data is that the questions asked of MNEs regarding FDI should be bifurcated into financial services versus other services and production. 9 Assume that the State has no knowledge of when TP will repatriate the foreign profits in scenario 2 and that it does not use public financing measures, such as government bonds. 8
  9. 9. foreign investment. Thus, considering higher costs for maintenance of two vehicles, TP should choose a local entity to house the foreign investment. Therefore, a CFC regimes replaces an ExCon regime to a certain extent.10 The difference lies in regulatory persuasion (through tax) versus permission (through application to the authorities) on foreign investment by resident. Excon regimes are viewed unfavorably by the OECD and other international financial institutions, such as the World Bank and IMF, because of the effect that ExCon regimes have on discouraging inward investment rather than their effect on outward investment. CFC presents a method to regulate capital outflows and capital repatriation of residents while leaving the non-resident alone. CFC regimes discourage foreign investment to the extent of greater need of return to offset increased compliance costs. Also, CFC regimes generally prohibit developing States and dependent economy jurisdictions from offering a competitive (lower) tax rate to tempt investment because profits generated will be subject to the developed State’s tax rate based on the required current year CFC tax assessment and payment.11 Less accumulation of capital through foreign investment Arguably, CFC regimes may only tax capital savings, which harms the economy. Resident shareholders (to whom CFC regimes apply) will repatriate foreign profits pursuant to their needs for domestic expenditure. Expenditure in this sense is meant simply as any type of domestic expenditure, e.g. personal consumption, shareholder distribution, or to finance domestic corporate needs. Excess foreign profits above these needs would normally be accumulated and put into use through treasury investments, such as research and development, project development, corporate investment, finance, acquisition, risk-control, and 10 See Spitz and Byrnes Tax Reform for South Africa (International Law & Tax Institute, 1995) wherein we presented the policy position that South Africa could replace its exchange control regime with a controlled foreign entity regime attaching passive income in combination with a tax incentive regime for local long term savings accounts in order to increase domestic reserves. 11 Many CFC regimes exempt from current tax foreign profits produced solely within a local economy, but require current year taxation for all profits produced outside the economy. Through this type of regime, the developed State allows a tax competitive foreign investment entity that generates income, and thus future inbound capital transfers, from the other State’s economy. But the developed State discourages that same foreign investment entity from generating other foreign income from outside the other State with its deferred profits, significantly reducing the opportunity for the other State to obtain balancing capital inflows (to the outflows of repatriated profits). Also, CFC regimes generally do not allow significant passive income to be earned by a foreign entity. Consequently, the less developed the other State’s economy, the less incentive the taxpayer has to defer repatriation, the more strain on the other State’s balance of payments. 9
  10. 10. all other treasury management functions. The CFC regime acts to further a State’s policy of leveling capital accumulation by siphoning from the tank at the expense of growth oriented treasury investments. From the State’s perspective, the CFC regime creates tax neutrality between using domestic and foreign entities. In doing this, the State also enforces a heterogeneous fiscal policy between government and economic actors. Capital accumulation (outside of government) pursuant to the Socialist perspective may not be desirable because: creates inequity of distribution of wealth, thwarts the ability to pay principle, and corporate treasuries do not make “good” public choices. Shoring up the tax base The number one reason for CFC regimes if, of course, to shore up the domestic tax base from tax mitigation techniques and foreign competitive tax regimes.12 Thus, most CFC regimes are designed to “target” tax competitive regimes.13 12 Argumentatively, the number one reason may be a Socialist policy of “getting” the rich, an oft quoted reason cited by the Kennedy Administration in 1962. Correspondingly, one may argue that a CFC regime re-affirms the ability to pay principle for a tax system. 13 States that did not experience development in the modern industrial and services revolution, be it for whatever reasons, must still compete for a share of world investment in the order to economic survival. The OECD States have become an oligopoly, like a trade bloc, similar to OPEC in the 1970’s. This oligopoly seeks through predatory practices to enforce price controls on capital, primarily through their united action on punitive fiscal regimes against targeted jurisdictions on foreign capital outflows. The fall of the cold war world order has eliminated the past political barriers that discouraged focused attacks on States that compete for capital inflows based on tax rates or sensible regulatory regimes because the former “cold war” States needed these jurisdictions for certain aspects of the “war”. The OECD has discarded the 1950’s to 1980’s Lockean era doctrine that, at least publicly, stated the premise of the world order was the sovereignty of States to control their economies from outside influences. The new OECD Hobbsian era doctrine of the 1990’s and next decade is that the OECD States “can do no wrong” and thus are not subject even to their own laws, such as anti-trust and correspondingly anti-trade competition. Certain of the OECD States act concertedly to fix the tax price on capital and income through their dominant political, financial, and policing position. This anti- competitive price fixing practice seeks to maintain the OECD’s economic dominance at the expense of the developing and uni-economy (generally tourism and banana economies) States and para-States. By re-characterizing foreign capital movements with broad terminology such as “money laundering”, “unfair” tax competition, “black listing”, tax “mitigation” and “avoidance” as the equivalent of (illegal) “evasion”, “de-stabilizing” international financiers, “tainted” income, the OECD seeks to stigmatize financial and service operations in the lesser developed States, para-States, and regions. Through these re-characterizations, the OECD can maintain its present, higher cost, less efficient economies regarding the certain sectors of the financial and service industries. 10
  11. 11. The general description of a “targeted” tax competitive regime is to call it a tax haven. Another way to characterize tax havens is to refer to them as jurisdictions that are safe-havens from anti-competitive tax burdens enforced by the modern industrialized States. White lists and Black lists The targeting of para-States that do not enforce a similar tax burden upon economic actors or transactions is accomplished through the high-tax State drafting either a list of favored jurisdictions (White list14 ) or a list of non-favored jurisdictions (Black list15 ). These lists create presumptive determinations of whether capital outflows seek to mitigate tax costs. Alternatively, or in conjunction, high-tax States enact either a comparable foreign tax rate or comparable local tax burden criterion on foreign capital outflows to determine the cause of the capital outflow. Transfer pricing regulations that shore up the tax base Note that this presentation does not address the topic of transfer pricing that I addressed last year. A transfer pricing audit does not play a role in a CFC regime. Transfer pricing is a separate method to shore up the State’s tax base. Transfer pricing may be applied to a foreign entity regardless of whether the foreign entity is subject to the State’s CFC regime. If the foreign entity is subject to the State’s CFC regime, then application of transfer pricing rules to the foreign entity, though potentially redundant, is allowable. From last year’s presentation, you should recall that a transfer pricing regime seeks to allocate the arm’s length price to economic activities. From the perspective of the application of a CFC regime, it is unimportant whether the income generated by a foreign entity from trading with or providing services to a State’s resident is arm’s length. The CFC regime is only concerned with the fact that there is foreign source income that has suffered less tax in the hands of a foreign entity that it would under the local regime and that the foreign entity has a nexus with a resident taxpayer. Acceptable and un-acceptable outflows Industrial manufacturing generally requires fixed, long term, capital investment (this model has changed slightly in the last decade). The industry investment criteria include proximity to labor supply, proximity to resources, infrastructure, low political risk, amongst the other criteria often cited. The OECD is not concerned that, for example, car manufacturers will begin setting up plants in 14 Examples include Australia, New Zealand, Sweden, Finland, UK, and in the context of international capital flows, the UN. 15 Examples include Spain, Germany, Mexico, Indonesia, Italy and the OECD as an organization. 11
  12. 12. Barbados, the Bahamas, and Bermuda in such as way as to effect industrial jobs in the OECD. However, the OECD is concerned about manufacturing outflows to lesser industrialized economies such as China, India, and Ireland.16 The financial industry has far less fixed capital requirements and the services industry is catching up. Both these industries are changing and adapting pursuant to the communications revolution. Incorporeal capital (money) can move freely and quickly, administered and controlled by a relatively small amount of labor. Some consumer services may be offered from anywhere that has an internet infrastructure. The OECD is concerned that financial institutions (e.g. treasury management centers, insurance, banking), software manufacturers, airline reservation agencies, etc, are setting up facilities in tax competitive jurisdictions, taking from OECD treasuries and job opportunities. First, the OECD CFC regime policy strongly attacks all forms of passive income (generally generated by financial institutions, such as treasuries)17 , followed secondly by attacks on service income, especially if the services are performed for a related party18 . Manufacturing capital outflows are also under attack as the OECD measures the severity of the movement of manufacturing investment to competitive tax rate States.19 However, the OECD would literally leave the uni- economy jurisdictions to starve if it promulgated the taxation of all income under CFC regimes (this may be coming in the next decade). Thus, many CFC regimes do not apply to, or have carved out exceptions for, active business income, especially if generated within the local economy.20 16 Regarding the manufacturing industry, the OECD (and EU) has turned its focus on developing countries that offer competitive labor, State aid, and less regulation pursuant to their current level and needs of development. The OECD has re-characterized the labor, aid, and regulatory issues as “human” rights issues, and “fair” as opposed to “free” trade. As with the fiscal competition issues, the OECD has begun a process of usurping State sovereignty over economic policy under the guise that “father knows best”. One may argue that the OECD has become what “World Order and Domination” conspiracy buffs thought the UN would become. 17 All CFC regimes attempt to eliminate deferral on passive income. 18 Related party service income is characterized as “tainted” income in the US, and this term has picked up usage elsewhere. However, the general term for this income is “base company” income. 19 Refer to the 1998 OECD Report on Unfair Tax Competition that lists as a point of action the enactment of a CFC regime in OECD States to shore up the depleting tax bases and the corresponding EU Report adopted to stop capital transfers based on tax factors to lesser developed EU States and regions. Because State aid to promote regional development is already under attack, presumably the future consequence of the EU policy will be large-scale migratory labor movements from less developed regions to developed regions. 20 Obviously, an Island State can not produce significant business income within its own economy and must look to foreign business income in order to secure a balance of payments that allows it to import necessities and increase its living standard. CFC 12
  13. 13. SYLLABUS II. The fundamental elements of CFC regimes Generally, CFC regimes are enacted by States in which tax liability is imposed on the world-wide income of a resident taxpayers (though we will see examples of source based tax States enacting CFC regimes21 ). Academically speaking, we say that the State imposes “unlimited” tax liability on its resident taxpayers. Thus, the tax base of the resident taxpayer is composed of income generated both from domestic and foreign sources. The income generated from foreign sources is the concern of this lecture. Two operative factors are key to worldwide tax liability (and to the generation of tax revenues on foreign source income) : • the nexus between the State and the taxpayer, and • the nexus between the taxpayer and the foreign income. The operative criterion of the nexus between the State and the taxpayer is the concept of the “resident” taxpayer. The two primary criteria of determining the residency of a corporate entity are (1) the state of incorporation and (2) the state in which management and control of the entity is exercised.22 The criteria for establishing residency of an individual vary.23 If a taxpayer eliminates the nexus of residency, then the taxpayer will no longer be subject to tax on foreign source income (be aware that many countries are enacting anti-avoidance rules that penalize individuals that shift residence24 ). regimes grant, in varying degrees, allowances for locally generated income and then allowances for business income generated from foreign sources, as long as the income is not “base company” income. 21 Examples are France and South Africa. 22 For academic purposes, the criterion of real seat, employed by Civil law countries, is generally considered a subset of the criterion of management and control. 23 The criteria for establishing fiscal jurisdiction over an individual vary from country to country, and involve both objective and subjective tests. Objective tests usually refer to a maximum number of days per year that an individual may spend in a State before fiscal jurisdiction will be enforced. Other objective criteria include home ownership, work permit, and nationality. The subjective criteria are generally summarized in a “facts and circumstances” test that employs the principles of “closest economic ties” of the individual. Refer to the OECD Model Treaty article 4 and its commentaries for a quick analysis of treaty residency issues. 24 Generally, the resident shifting rules require natural persons that are former residents of a State to be subject to that State’s tax liability for a further 10 years, with corresponding enforcement provisions, such as immediate collection of future tax liabilities. A newer trend requires residents to settle up tax liability with the State upon becoming non- 13
  14. 14. In relation to the topic of CFC, the nexus between the taxpayer and the foreign income is more important. The operative criterion of the nexus between the taxpayer and income is based on accrual of income. (1) Breaking down the term accrual Income must have a nexus with a source (an economic “object” or “subject”) that generates it. The source in this context refers to the economic factors (associated with an object like capital) and economic activities (associated with a subject like a consultant) that generate the income. In turn, the activities must be generated by, and/or the factors must belong to, a person (an economic actor like a company or individual).25 Income will accrue (“be allocated to”) to an economic actor that has a nexus with the economic factors and economic activities.26 Consequently, to break the accrual of income to the taxpayer, the taxpayer must transfer the economic factors and activities to another person. (2) Breaking the nexus between taxpayer and income If breaking the nexus between the State and taxpayer is not a practical option, then the taxpayer must focus on breaking the nexus between himself/itself and the foreign income. The taxpayer must establish a nexus between the foreign income and an entity that has a separate, distinct, identity from the taxpayer.27 Referring back to the concept of fiscal jurisdiction, the entity must not be established in a way that it has a nexus to the State. Consequently, the taxpayer should establish a foreign incorporated entity with foreign management in order to avoid attracting the State’s unlimited fiscal jurisdiction.28 residents on the basis of estate-tax on world-wide wealth. In the US, enforcement provisions of its resident shifting rules include permanent loss of re-entry into the US. 25 Economic activities include activities such as services, investing, trading, whereas economic factors include such factors as money and risk. The legal term person includes a natural person (human being) and a juridical person, like a company and other types of entities with legal personality). 26 I presented this concept of a test for the determination of nexus with income in my 1996 BMA lecture and paper on General Anti-Avoidance Rules. I referred to the Civilian law concept of correct accrual of income (as exemplified in Danish law) and to the Common law concept of substance over form, (exemplified in US jurisprudence). 27 A CFC regime does not generally include the taxation of beneficiaries of foreign trusts though, and separate regimes are enacted for this purpose. However in South Africa, the term CFE is employed, referring to controlled foreign “entity” legislation, capturing trusts in its scope. 28 Because of this result, the regime of exercising fiscal jurisdiction over foreign profits always deals with “foreign” entities, meaning “non-(tax) resident”, thus the “F” in CFC. Though not dealt with herein, we could pursue at a later time whether the criterion “foreign” applies to non-(tax)resident, local companies, such as a dual resident company 14
  15. 15. (3) The nexus between the taxpayer and foreign entity The entity must be separate and distinct, that is, the entity must not be transparent from the tax perspective. If the entity is, for example, either a partnership or a grantor trust in the US, then from the tax perspective, the entity’s tax base is directly calculated into the taxpayer’s tax base. Thus, deferral is not achieved. Generally, in order to obtain the legal right to receive benefits from the profits generated by the foreign entity, the taxpayer must either be a shareholder or in relation to a trust, the taxpayer must be a beneficiary.29 Presumably, the taxpayer will not establish a charity for the foreign income to benefit other persons because deferral for the benefit of he taxpayer will not be achieved. The nexus between the taxpayer and the entity is the “right” to receive distributed income and possibly, the ‘right’ to control the timing and amount of the distribution. The taxpayer will naturally want to receive the benefits of the income generated by the foreign entity in relation to the taxpayer’s transfer of value relative to any other parties that have transferred value.30 Also, presumably, the taxpayer will want proportional representation (to the initial investment’s value) in respect of the decision when and how much distribution will be made from the foreign entity. In developing its CFC regime, the State must seek to exercise fiscal jurisdiction based on these two nexus. in which the State of incorporation has lost a tax treaty “tie-breaker” test to the State of management and control. 29 The taxpayer must give the economic activities and factors to a foreign person to break the nexus establishing fiscal jurisdiction. However, unless the taxpayer has a corresponding legal right of recourse to the income, then the taxpayer will probably be defeating his goal of deferral (in that the taxpayer will never benefit from the income). Generally, two types of legal rights to benefit from generated profits of a foreign entity are recognized: beneficiary of a trust (considered an entity for the purposes of this presentation), and shareholder of a corporation. But, refer to Charles Cain’s deferral strategy solution based on contractual beneficial rights rather than shareholder rights to income that he presents at www.skyefid.com. Alternatively, refer to the deferral strategy solution of “membership” rights to income presented by Sovereign Trust at www.sovereigngroup.com under the topic “guarantee membership hybrid companies of the Turks and Caicos Islands”. 30 This is not meant to infer that a taxpayer will not employ a strategy of establishing a foreign charity foundation in which the taxpayer is a potential recipient of income, along with many other bona fides charities. This strategy topic will be dealt with under “trusts”. 15
  16. 16. Generally, the State exercises fiscal jurisdiction under a CFC regime when the taxpayer’s nexus reaches “control” of the right to receive income. Regarding Trusts, the nexus is generally reached merely by the right to receive income.31 (4) Exercise of fiscal jurisdiction on resident shareholder/s The high-tax State can not exercise fiscal jurisdiction, under present international law principles of State fiscal Sovereignty, upon foreign source income of non- (tax)resident entities. Thus, its CFC regime is limited to exercising fiscal jurisdiction upon its (tax)residents’ nexus with any non-resident entity that has foreign source income. The CFC regime must establish the necessary level of nexus between the taxpayer and the non-resident entity in order for the CFC regime to be imposed. Generally, the CFC nexus test is based upon one or both of the following criteria: • some minimum portion of share ownership in a foreign entity to constitute a resident “shareholder” under the CFC regime32 • some level of potential control or influence by resident shareholders over a foreign entity33 Another potential nexus between the taxpayer and the foreign entity is whether the taxpayer holds a certain portion of the value of the foreign entity. Generally, a value test is established in CFC regimes as a separate, but conjunctive, test from that of control. The test is based on determining the value of all beneficial interest in the entity pursuant to free market conditions.34 Thus, strategies in 31 The application of CFC regimes to corporations generally focuses on the criterion of “control”. However, as will be examined later, “control” is not necessary for application. Recent developments in CFC legislation of Civilian law jurisdictions, such as France and Portugal, show a movement away from control as a criterion for application of anti- deferral rules. As regards application of the anti-deferral regime in a broader sense, such as to trusts, control is generally no longer a required element. 32 By example, the United States defines a shareholder under its CFC regime as a US taxpayer that has at least a 10% shareholding in the foreign corporation. US taxpayers with less than a 10% shareholding (taking into account constructive and indirect ownership) are not considered in the calculations to determine whether a foreign corporation is a CFC. Alternatively, a minimum shareholding test may be used to determine which shareholders will have a deemed (taxable)distribution from the foreign entity. 33 An issue in the application of this criterion is whether a concentrated group (less than some number of shareholders) is necessary to deem control. By example, if 100 residents hold 1% of a foreign entity, some CFC regimes will not define the foreign entity as a CFC, thus the regime will not apply. 34 For sake of argument, we could examine whether the value test derived from the recognition of a need to initially shift the economic factors to the entity (see France’s regime regarding control through a threshold investment of FF150m as an example). In 16
  17. 17. which a taxpayer grants control, expressed as voting rights, to a third party, but retains the right to benefit from a majority of the generated profits, may be thwarted.35 (5) The location of the foreign entity in lower tax jurisdiction The foreign entity should be located in jurisdiction with a favorable tax rate compared to the taxpayer’s State’s tax rate.36 This may be in a traditional no-tax jurisdiction, such as the Cayman Islands, Bahamas, or Turks & Caicos. Alternatively, it could feasibly be in a foreign jurisdiction with a rate just one percent lower (one percent of $100 m profits is $1 m deferral). Thus, in order to quash tax competition for investment, most CFC regimes apply to foreign entities based on the rate of tax that the foreign entity is subject to, or alternatively actually pays, on its profits.37 The topic of White and Black lists has been covered above. order for the foreign entity to be established and operate, the taxpayer must transfer capital to it, even be it only goodwill, a database of contacts, or a trademark. Generally the taxpayer must shift money to the entity in order to establish a capital fund (e.g. the corpus of a trust). If a third party receives shares but does not correspondingly contribute capital, then in the initial formation of the company, the third party would be contributing far less value than the taxpayer. Regardless, the value test focuses on a fair market determination of the value of rights allocated to all parties that have an interest in the entity and is thus retrospective rather than prospective. However, corresponding legislation may tax outward remittances of capital or money to a foreign entity that is a CFC. 35 The bifurcation of the control of the entity and the right to receive income may be achieved through establishing different classes of shares. In relation to a trust entity, this bifurcation is presumed. 36 As already stated, paying a higher rate of foreign tax defeats the purpose of deferral. The international policy of the OECD is not to create international tax transparency (variant States are New Zealand and Sweden) because this would probably lead to a tax revenue decrease for States with only high effective tax rates. Not having considered it for this presentation, but for sake of argument, States with very high total effective tax rates on foreign investment (for argument, above 50%) may be the beneficiary of transparency if corresponding credits or deductions were given. 37 Interestingly, the US Congress studied whether the US should adopt an unlimited liability tax approach that would end all deferral through “looking through” (transparency) all foreign entities, regardless of shareholding (like an international consolidation regime contemplated originally by Kennedy in 1961). The study showed that the US would end up with less tax receipts than under the present system because the US fisc. would correspondingly need to account for the total losses and tax credits suffered by US corporations in their foreign operations. On the other hand, New Zealand has instituted a system of international transparency, but for the inclusion of six high-tax countries on its White list, and Sweden has a quasi-system of transparency, but for the inclusion of White list (DTA) countries. 17
  18. 18. (6) Deemed distribution The presumption of deferral is that the foreign profits are not repatriated (if repatriated, then tax will be levied). Thus, the tax base does not reflect the foreign source income. An accounting fiction is created by the CFC regime in that the rules must establish a deeming provision for a dividend distribution to the taxpayer. The deemed distribution may then be added into the taxpayers’ tax base, and taxed accordingly, generally with corresponding tax credits for foreign taxes suffered.38 SYLLABUS III. Comparative overview of characteristics of CFC regimes In 1996 the OECD issued a report titled “Controlled Foreign Company Legislation” that examined the 14 member countries that had by 1995 enacted CFC legislation. I suggest that you read this report. However, an updated version of some of the topics dealt with in the Report may be found in the Kluwer publication: Tax Treaties and Controlled Foreign Company Legislation by Daniel Sandler (2nd ed. 1998). The OECD Report focused on the following similarities and differences among the 14 regimes:39 (1) Application of CFC regime to entities (2) Definition of control (5) Transactional v jurisdictional approach (6) Calculation of income subject to attribution (transactional v entity approach) (1) Application of CFC regime to entities Generally, CFC regimes are not yet about ending deferral in all situations, that is creating transparency for the application of unlimited liability to fiscal jurisdiction. Exceptions are the case of New Zealand and Sweden, and also the case of France, which is extending the application of its near transparency CFC regime to individuals. Also, consider the tightening over the last two decades of CFC regimes to eliminate deferral on an expanding variety of foreign income. Normally, CFC regimes apply to corporate distinct juridical entities. However, sometimes the CFC regime applies to other entities. Examples: 38 Tax credit regimes are based on per basket (US), per country (France, Germany, Canada), per source (UK), and world-wide (Japan). OECD Report p 47. 39 See the Report regarding the other issues that it examined. Section II is based off of information from the OECD Report and Sandler. 18
  19. 19.  France : to foreign permanent establishments (because of its territorial based system)  Canada : to trusts  South Africa : to trusts  Mexico : any entity recognized by the foreign law In the broader sense, though it is not covered by the OECD Report, most OECD States have corresponding anti-deferral legislation against other types of non- corporate, but distinct entities, such as trust entities. Generally, these rules create a regime of transparency between the taxpayer and the entity. However, the regime may instead impute an interest charge against the deferred tax payment required, thus loaning the use of the tax payment amount to the taxpayer. (2) Definition of control States generally maintain some form of control test. Prima facie control means 50% of the votes plus one. However, control may mean something less than outright control, such as “at least 50%” (the OECD terms “substantial influence”), or even “at least 10%” shareholding (e.g. “influence”). What portion of shareholding determines control? Three possible definitions of control: • residents own more than 50% of the foreign entity = prima facie control  US, UK, Germany, Denmark, Japan, Canada, Italy • residents own at least 50% = substantial influence  Australia, Finland, Norway, Spain, Sweden • residents own less than 50% but more than some amount: influence  France : 10% ownership by a particular corporation or individual No summing of residents’ interests  Portugal : 25% ownership by any resident Variation Australia and NZ  Objective de facto control: if one person holds 40% or more  Subjective de facto control : five or less residents effectively control the exercise of decision making rights Constructive ownership of shares by taxpayer 19
  20. 20. “Sum the shares of related parties as one shareholder to determine the portion of ownership of the underlying company”.  Only Denmark, Norway, Portugal do not have Indirect ownership of shares by taxpayer All have some form of indirect ownership rules. Variation: Minimum shareholdering US Defines a shareholder for CFC purposes as one that holds at least 10% of the shares in the foreign company. Defining control other than through voting rights • Voting shares exclusive  Canada • Value of shares  US, Germany, Japan, Norway, Sweden, Spain • Amount of Distribution  Australia, UK, Finland, Spain • Value of distributed assets  Australia, UK, NZ, Spain Variation France : CFC applies if shareholder has a minimum of FF150m capital investment How many resident shareholders necessary to constitute concentration of control? • Only single resident shareholder  Spain, Denmark, Portugal • Five or fewer residents  Australia, US, Canada, NZ • Any amount of resident shareholders 20
  21. 21.  UK, Finland, Norway, Sweden, Germany, Japan, Italy, Portugal (alternative definition) At what point in time is control to be determined/ calculated? • Any point in time in the year  US, UK, NZ, Denmark • End of year  Spain, Portugal, Australia, NZ, Finland, Sweden, Japan, Germany, Canada (for FAPI) (3) Transactional v jurisdictional approach The transactional approach focuses on the nature of the income received by the foreign entity. In pure form, the State makes a policy choice regarding the types of income that will be “tainted” – and thus subject to the regime. Because non- tainted income is not subject to attribution, tax on it may be deferred. Generally, States make an exception if the tainted income has suffered a comparable rate of tax. On the other hand, the jurisdictional approach first focuses on the jurisdiction in which the foreign company is resident and then, secondly, may examine the type of income received. All jurisdictions (except Canada) employ a combination of the two approaches. • Transactional approach (income approach with burdensome compliance)  Canada  US (but has exception based on comparative rate test of 90% US rate)  NZ (exception for few white listed countries) • Jurisdictional approach (“targeted” approach)  White list Australia (if on list, then certain tainted income included; if not on list, all tainted income included) NZ (only six on list) Hungary (de facto based on its DTAs)  White/Grey list Sweden and Finland (list based primarily on DTAs) UK (administrative list, two-tier) Italy 21
  22. 22.  Black/Grey list Spain (rebuttable presumption) Germany (rebuttable presumption) Mexico, Indonesia, Italy  Comparable tax approach UK, Denmark, Spain, Finland, Germany, Japan, Portugal  Effective rate of foreign tax that must be paid on attributable income Germany, Japan, Portugal  Percentage of domestic tax that must be paid were CFC tax resident UK, Denmark, Spain, Finland (4) Calculation of income subject to attribution (transactional v entity approach) • Entity : “all or nothing” approach All income of CFC is attributed to resident taxpayers unless CFC exempt:- • favored jurisdiction • comparable tax rate • exemptions based on nature of activities (commercial and genuine)  Finland, France, Japan, NZ, Portugal, Sweden, UK, Norway (if not in DTA State) • Transactional : “tainted” income approach Passive and base company income always tainted  US, Canada  Spain, Australia, Denmark, Germany, Norway (if CFC in DTA country) apply after determination of CFC in targeted jurisdiction Passive income  Generally defined : US, Canada, Australia, Denmark, Norway, Sweden, Spain  As negative of active business income : Germany Base company income  Generally income generated when dealing with a related party in any part of the transaction SYLLABUS 22

×