OECD Member States Tighten Up Their CFC Rules

by Jason Gorringe, Tax-News.com, London

11 April 2001

It is already a long time since companies in high-tax areas of the world worked out that by having subsidiaries in lower-tax areas which retained their earnings rather than remitting them to the holding company, they could defer or even perhaps avoid taxation altogether on the profits concerned.

It's only a slightly shorter time since the relevant tax authorities responded either by creating 'controlled foreign corporation' rules which imposed taxation on the unremitted profits or adopted generalised 'anti-avoidance' laws which had the same effect.

Originally, such rules or laws usually followed a majority test to determine control, but have increasingly moved to lower barriers as taxpayers started to divide ownership. They often also distinguish between 'passive' or investment income (taxed) and trading or commercial income (not taxed); and sometimes they have complex rules exempting certain types of permitted income from tax.

The OECD has encouraged its member countries to adopt CFC rules if they don't already do so - Italy is one recent new recruit to the CFC club - and a number of other countries have strengthened or adapted their CFC rules in recent months. This report surveys these recent changes, and sums up the regime in place in a number of countries.

Italy

With Law no. 342 of 21st November 2000, the Italian government introduced CFC rules. The general statement of its purpose is as follows:

'If a person resident in Italy holds directly or indirectly a controlling interest in an entity resident or located in a country with a preferential tax regime then such income is to be attributed to the controlling person in proportion to the participation held.'

'Person' in this statement means of course individuals, partnerships, corporations and other bodies with tax personality in Italy.

'Control' means more than 50% of the voting rights in the CFC, and 'indirectly' means, for instance, through one or more interposed corporations, trusts or other bodies. 'Effective' control through contracts would also fall under the law.

'Preferential' means, for instance, having a level of taxation considerably lower than the Italian one, or the lack of information exchange provisions in a bilateral treaty. Italy proposes to issue a list of what it takes to be preferential tax regimes and under the law must do so within 9 months of 21st November 2000.

CFC income which is attributed to an Italian resident tax-payer will be taxed in a separate basket using the average taxation rate paid by the taxpayer concerned during the tax period in question; but with a minimum rate of 27%. Income tax actually paid abroad on the income involved can be credited against the tax due in Italy.

There are some exemptions (but subject to administrative consent) including one for an enterprise which is manufacturing or trading in the country where it is located (not 'through' it, perhaps?), and, quaintly, if the taxpayer 'is not trying to locate revenues in the country with a privileged tax regime'. That should give rise to some inventive explanations: 'Well, you see, my aunt met this Caymanian man in Rome . . .' and so on.

'Manufacturing or trading activities' is further defined to include only:

• Manufacturing of goods and the provision of services;
• Trading of goods;
• Shipment services by land, sea and air;
• Banking and insurance services;
• Other auxiliary activities.

This is just an approximate statement of some key aspects of the new law, and should not be relied upon as more than a general indication of its direction. There has not been such a law in Italy before, and there are many uncertainties of interpretation and application which will keep Italian tax lawyers busy for the next few years.

 

France

France has a CFC law dating from 1980, which is more akin to a general anti-avoidance law since it applies taxation to income earned by any foreign subsidiary which is taxed at a 'significantly lower rate of tax' than the mainstream French corporation tax rate. In practice, this is interpreted as being less than two-thirds of the French rate.

The French CFC rules were not very strenuously applied for the first few years, but the tax authorities have recently begun to apply them more frequently, no doubt due to the increasingly international nature of French groups.

However, the CFC rules exist independently of France's bilateral tax treaties in most cases, and a Paris appeal court has recently decided that the Swiss/French tax treaty prevents France from applying its CFC rules to the Swiss subsidiary of a French company., unless that subsidiary in turn has a permanent establishment in France.

The French authorities may appeal this ruling to a higher court, but it is in fact in line with the opinion of most jurists, so a more likely course of action is to try to change France's tax treaties to take on board CFC rules when possible. Recently signed treaties do just that - but the great bulk of them predate understanding of this problem.

 

United Kingdom

The UK's CFC rules are some of the most stringent in the world - but this didn't stop the Chancellor Gordon Brown from tightening them significantly in his 2000 Finance Act. No amount of pressure from business and the professions was effective in moderating the changes he proposed in the budget, and they were duly enacted, unlike his parallel proposals on 'offshore mixing' which were considerably softened during the post-consultation exercise.

The changes to the CFC rules covered a number of areas:

For periods beginning on or after 21 March 2000, the conditions to be met before a holding company passes the exempt activities test ('EAT') were tightened so that the 90% income test can only be met by the receipt of dividends from exempt subsidiaries. Previously, this test could also be met through the receipt of other income, notably interest and royalties.

For periods beginning on or after 21 March 2000 the list of excluded businesses under the EAT was extended to include all types of intra-group services. Companies mainly engaged in such businesses no longer pass the EAT if 50% or more of their income is from affiliates. Joint ventures are also now included with the rules, and the the definition of control changed from 50% to 40%.

The tightening of the EAT significantly increased the number of foreign companies falling within the CFC rules. Many groups have needed to change their international structures quite substantially in order not to fall under the new rules, and many others have had to reconsider to what extent the motive test can be relied upon to prevent the CFC rules applying.

The Chancellor returned to the CFC attack in his 2001 budget, closing a loophole in the 'Acceptable Distribution Policy' rules, which the Treasury said was a 'wholly artificial tax avoidance scheme'.

For a number of years, it has been possible, in effect, for a UK holding company to 'sell' a dividend to a bank, allowing both organisations to remain within the 90% EAT rule. Such dividends, from 7 March 2001, no longer satisfy the ADP exemption.

The famous threat by Chris Gent of Vodaphone to remove his company from the UK was in fact due to the CFC changes rather than to the removal of 'offshore mixing'. There is no doubt that these CFC changes have significantly worsened the attractiveness of the UK's tax regime for multinational companies.

The United States

On December 29th, more than a year after it was first promised, the US Treasury Department finally released its comprehensive report on subpart F (sections 951-964) of the IRC. Subpart F deals with the tax treatment of passive income earned by foreign subsidiaries of US companies, and which is not remitted to the US.

The report is 226 pages, entitled 'The Deferral of Income Earned Through U.S. Controlled Foreign Corporations: A Policy Study'. Basically the law of the US, like the law of the UK and some other OECD nations, seeks to tax income held back by the remote subsidiary, as if it had been remitted, but the various nations go about this in a different way.

Said Assistant Treasury Secretary for Tax Policy Jonathon Talisman at a press conference: "The study, we believe, provides a useful framework for analyzing the antideferral rules on a going-forward basis."

The report concludes 'that the best policy for the advancement of economic welfare is for governments to impose equal taxation on domestic and foreign investment income', apparently without concerning itself about the use to which the profits are put. The UK legislation, on the other hand, distinguishes between income which is 'permanently employed' in the foreign business, and income which is held back purely for purposes of tax avoidance.

As is not unusual in the conduct of international tax policy, and has been especially marked during the Democrat administration, the US has one more time attempted to impose its fiscal sovereignty over other jurisdictions.

Talisman emphasized that the report was not a final opinion, and did not yet constitute legislative proposals. He also denied that the long delay in the report's release was politically motivated or otherwise influenced by the presidential campaign.

The two documents issued by the Treasury do not yet appear to be available on the Treasury web-site:

Treasury study on subpart F. Doc 2000-492 (226 original pages)

Treasury fact sheet on subpart F study. Doc 2000-493 (2 original pages).

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