BEPS Action 3
BEPS Action 3 sets out recommendations for the design of Controlled Foreign Company (CFC) rules. These rules apply to entities with a controlling interest in a foreign subsidiary. The goal is to prevent the stripping of the taxable base from the country of residence by shifting income to a foreign subsidiary. These rules are not the same as transfer pricing rules which is subject of BEPS Actions 8-10. However strong correlation exists between the two, CFC rules apply after transfer pricing rules.
A setup in which an entity in a low-tax jurisdiction provides intercompany financing and collects interest income can fit perfectly within the transfer pricing rules. However the tax jurisdiction of the parent can determine that the subsidiary is a CFC and accordingly attribute the income of the CFC to that of the parent. The CFC rules work alongside or after the transfer pricing rules and are sometimes for this reason referred to as backstop rules.
Six building blocks have been defined that countries can choose to implement in domestic law. These are:
- Definition of a CFC
- CFC exemptions and threshold requirements
- Definition of income
- Computation of income
- Attribution of income
- Prevention and elimination of double taxation
Definition of a CFC
What constitutes an entity to be a CFC has been given a wide approach. All entities that earn income can be taken into scope in the implementation in domestic law. Besides corporate entities also transparent entities and permanent establishments could be included.
For establishing an opinion on what is control the recommendation is given to apply both an economic and a legal control test at least. Countries can also add de facto tests to validate the economic and legal tests. The generic control threshold is set at 50% with the notion that countries can implement a lower control level threshold if they see fit. The manner of control – direct or indirect – should not be of importance in the application of CFC rules.
CFC Exemptions and threshold requirements
Exemptions and threshold requirements are used to make CFC rules more targeted and effective and also reduce administrative burden by excluding certain entities from the rules. This is to avoid that entities that in the opinion of the OECD pose little risk of base erosion and profit shifting are included and shift away focus from the entities that do pose a risk in the OECDs opinion.
The recommendation is to include a tax rate exemption that would allow companies that are subject to an effective tax rate that is sufficiently similar to the tax rate applied in the parent jurisdiction not to be subject to CFC taxation. Or in other words, those entities that have a substantial lower effective tax rate than the parent jurisdiction are subjected to the CFC rules.
The effective tax rate is chosen to have a like for like comparison between the CFC and its parent. Even when there is no perceived low statutory tax rate of the CFC there can be a low effective tax rate due to reducing the tax base or due to subsequent rebates or non-enforcement of taxes. The effective tax rate is calculated by taking the actual tax paid and divide with the income as calculated according to the parent’s country’s rules. This implies that tax exemptions on the level of the CFC are not taken into the equation if these exemptions do not exist in the parent’s tax regime.
Jurisdictions in their implementation of the recommendation are still free to choose what is sufficiently similar or in other words what is substantial lower.
Definition of CFC income
The recommendations simply state that CFC rules should include a definition of income. To determine what income is CFC income analysis needs to be undertaken.
In a categorical analysis income is divided into categories. Depending on the category the income is attributed differently for CFC rules. Common categories comprise of
- Legal classification (dividends, interest, insurance, royalties and IP, sales and service),
- Relatedness of parties and
- Source of the income.
In a substance analysis the question is asked whether the CFC had the ability to earn the income itself. This is to ensure that the income of the CFC is really earned by investing people, premises, assets and risk.
An excess profits analysis is used to characterize income in excess of a “normal return” earned in low tax jurisdictions as CFC income. An excess profits approach tends to apply to income from intangibles and risk shifting, such as IP income. The normal return must first be determined in this approach which required that both the rate of return and the eligible equity need to be determined. Both are hard to set objectively as these vary across industry, leverage and jurisdiction.
Independent of the analysis that a jurisdiction applies to define CFC income it has to determine if it wants to apply this analysis on an entity-by-entity basis or on a transactional basis. Using an entity approach an entity can be found not to have any attributable CFC income even if some of its income streams would be of an attributable character. On a transactional basis each individual income stream is assessed to determine if it is attributable to CFC income or not. With an entity approach all or none of the income is attributed based on the majority of the income. This is not the case with the transactional approach with which very specifically all income is attributed on a case by case basis.
Whilst the transactional approach is more accurate in the assessment this increases administrative burdens for both taxpayers and tax administrations. Jurisdictions however have the option to target only those income streams in their CFC rules that they deem to have a high risk of BEPS. In light of the goals of BEPS Action 3 the OECD recommends that the transactional approach is being implemented by jurisdictions in their CFC rules.
Rules for computing income
After the previous building blocks have helped to determine if and what income is attributable for CFC rules to applied on it needs to be considered how much income to attribute. There are two components in the income computation:
- Which jurisdiction’s rules apply and
- Whether any specific rules for computing CFC income are necessary.
The OECD clearly recommends to use the rules of the jurisdiction of the parent for computing income.
The recommendation for the second component is that, to the extent legally permitted, jurisdictions should have a specific rule limiting the offset of CFC losses so that they can only be used against the profits of the same CFC or against the profits of other CFCs in the same jurisdiction. This is to prevent that CFC losses are used to offset profits in the parent company or CFCs in other jurisdictions.
Rules for attributing income
After the income has been calculated the question is how to attribute that income to the appropriate shareholders in the CFC.
To attribute income the OECD has broken the process in five steps:
- Determining which taxpayers should have income attributed to them;
- Determining how much income should be attributed;
- Determining when the income should be included in the returns of the taxpayers;
- Determining how the income should be treated; and
- Determining what tax rate should apply to the income.
The recommendations for these 5 steps are:
- The attribution threshold should be tied to the minimum control threshold when possible, although countries can choose to use different attribution and control thresholds depending on the policy considerations underlying CFC rules. This means that all resident taxpayers who have the minimum level of control in a CFC in that jurisdiction are attributable to CFC income.
- The amount of income to be attributed to each shareholder or controlling person should be calculated by reference to both their proportion of ownership and their actual period of ownership or influence (influence could for instance be based on ownership on the last day of the year if that accurately captures the level of influence).
- and 4. Jurisdictions can determine when income should be included in taxpayers’ returns and how it should be treated so that CFC rules operate in a way that is coherent with existing domestic law.
- CFC rules should apply the tax rate of the parent jurisdiction to the income.
Rules to prevent or eliminate double taxation
The final building block of the CFC rules is aimed at preventing or eliminating double taxation. Double taxation poses obstacles to international competitiveness, growth and economic development.
At least three situations are identified where double taxation may arise:
- Situations where the attributed CFC income is also subject to foreign corporate taxes;
- Situations where CFC rules in more than one jurisdiction apply to the same CFC income; and
- Situations where a CFC actually distributes dividends out of income that has already been attributed to its resident shareholders under the CFC rules or a resident shareholder disposes of the shares in the CFC.
Other situations may also give rise to double taxation. In any case the recommendation is to design CFC rules as such to ensure that double taxation does not incur.
The first two situations are recommended to be remedied by allowing a credit for foreign taxes actually paid, including CFC tax assessed on intermediate companies and including withholding taxes. Such an indirect foreign tax credit is more effective than a deduction method as it directly sets off the foreign tax against domestic tax rather than reducing the tax base.
The third situation is addressed by recommending an exemption for dividends and gains on disposition of CFC shares from taxation if the income of the CFC has previously been subject to CFC taxation. In most cases the distribution of dividends is already taken care of by regular participation exemptions. Only if this is not implemented then additional relief provisions are recommended to be implemented by those jurisdictions.