Where a resident(s) of Country A is able to influence or control an entity that is resident(s) of Country B, including the profit distribution or repatriation policies of such controlled company, the income of such company may not be distributed and brought into Country A and remain outside the scope of its taxation. CFC rules are framed to enable Country A to tax its residents on the undistributed income of the company that they control, but which are located in Country B.
If a business headquartered in Country A (with a combined corporate income tax rate of 32.02 percent) has a subsidiary in the Country B (which does not tax corporate income), Country A in certain cases may assert the right to tax the income earned by the Country B subsidiary.
Work of OECD and European union for CFC rules
- OECD BEPS project and Action Plan 3 –
OECD BEPS Action Plan 3 refers to possible ways to implement CFC rules and contains set of recommendations that divides the constituent element of the rules. The Action plan recognises that by working together countries can address concerns about competiveness and level the playing field. This report sets out recommendations in the form of building blocks. These recommendations are not minimum standards, but they are designed to ensure that jurisdictions that choose to implement them will have rules that effectively prevent taxpayers from shifting income into foreign subsidiaries. The report has set out six building blocks for the design of effective CFC rules. They are as follows –
(i) Definition of CFC
(ii) CFC exemptions and threshold requirements
(iii) Definition of income
(iv) Computation of income
(v) Attribution of income
(vi) Prevention and elimination of double taxation
The report contains two standards to define a CFC.
- The first standard is used to determine which entities are defined as CFCs
- The second standard includes the definition of control and the different ways in which control can be measured (either directly or indirectly) with a threshold of 50 percent and the probability to be measured from a legal and economic standpoint
Also, the recommendations provide flexibility to implement CFC rules that combat BEPS in a manner consistent with the policy objectives of the tax system of the country concerned. Once implemented, the recommendations seeks to ensure that countries have effective CFC rules that address BEPS concerns.
- Work of European union –
European Union (‘EU’) Council in year 2010 has issued a resolution following the recommendations of the European Parliament and the Economic and Social Committee (‘ECOSOC’) regarding the coordination of CFC rules and thin capitalization rules in the European Union.
European Commission (the ‘Commission’) in year 2016 presented a proposal to incorporate CFC rules in all EU member countries as part of a package of tax anti-avoidance measures. Six months later the European Council adopted the Anti-tax avoidance directives (‘ATAD’) (EU 2016/1164)85 laying down rules against tax avoidance practices that directly affect the functioning of the internal market. The directive contains five legally binding anti-abuse measures, which all member states are required to adopt to combat common forms of aggressive tax planning. Included in the directive are CFC rules.
Article 7 of ATAD describes CFC to be a foreign entity or permanent establishment (‘PE’) of which the profits are not subject or exempt from tax, if the shareholder holds directly or indirectly (or with associated enterprises) a participation of 50 percent of the voting rights, capital, or profits of an entity. A second requirement to qualify as a CFC is that the corporate tax paid by the entity on its profits is lower than the difference between the corporate tax that would have been charged on the entity by the member state under the applicable tax system of the taxpayer or the actual corporate tax paid by the entity on its profits.
The directive proposes two alternative ways for member states to implement a CFC regime. They are –
- The first alternative focuses on passive income earned by an entity that qualifies as a CFC, which means that certain kinds of income earned by the CFC that are not distributed during a taxable year have to be included in the tax base of the shareholder.
- The second alternative targets the non-distributed income of a CFC that arises from non-genuine arrangements that have been in place for the essential purpose of obtaining a tax advantage.
The main purpose of the ATAD directive is to create certain level of protection against corporate tax base erosion and profit shifting throughout the EU more stable environment for businesses.