Bombay Management Association International Tax Conference 1999

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. 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. 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. • 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. (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. 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. 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. (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.  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. “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.  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.  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