INTRODUCTION
Controlled Foreign Corporation (CFC), as the name suggests, is a foreign corporation, which is incorporated in a low tax jurisdiction and are controlled by a person (individual, company or together by both of them) who is a tax resident of a higher tax rate jurisdiction.
CFC Regulations typically provides for taxation of certain income (generally passive income like interest, dividend etc) as income of resident shareholder, which are artificially transferred to an entity in another jurisdiction (CFC) in the year of its accrual, irrespective of whether it is distributed as dividend or not to the parent company
In India, the concept of CFC was proposed to be introduced in Direct Taxes Code Bill 2010 (“DTC 2010”), but it is yet to be enacted into business consultant. Under the provision of the DTC 2010 proposal, income of the resident shall include the attributable income of CFC. Any subsequent actual distribution by CFC was deductible for resident shareholder.[1]
Controlled Foreign Corporation (CFC) rules are in place to stop companies from parking profits in low-tax countries just to avoid paying taxes back home. These rules kick in when a company owns and controls a foreign entity, especially if that entity is earning mostly passive income like interest, dividends, or royalties. Even if the money stays overseas and isn’t brought back, the home country can still tax it. That’s why it’s important for businesses to keep an eye on what their foreign subsidiaries are earning, follow all reporting rules, and structure things carefully. With the right planning, companies can stay compliant while still managing their global tax burden efficiently.[2]
To put it simply:
- CFC rules stop businesses from moving passive income to tax havens just to save on taxes.
Example: A UK parent company with a UAE subsidiary earning interest income might still owe UK taxes on that income under CFC rules.
Under CFC rules, a foreign subsidiary is considered a CFC if it is controlled by the parent company, typically defined as more than 50% ownership of the subsidiary’s voting stock. Once a foreign subsidiary is considered a CFC, the income earned by the subsidiary may be subject to taxation in the parent company’s home country, even if the income is not repatriated to the parent company.
The specific CFC rules and the tax treatment of CFC income can vary depending on the country. Some countries, such as the United States, have a “current inclusion” system, which requires the parent company to include the CFC’s income in its tax return for the year in which the income is earned. Other countries, such as the United Kingdom, have a “deferral” system, which allows the parent company to defer the tax on the CFC’s income until it is repatriated to the parent company.[3]
RESIDENT RULE OF TAXATION
Many countries, including India, follow the “Resident rule of taxation”, wherein, if a person is a tax resident of India, their global income is subject to tax in India (country of residence). These taxations are triggered at the point, when the income accrues or is received by the resident.
In the earlier example, the income accrues to ICO, when the German Co. declares dividend. Secondly, if the German Co also pays royalty, and it is received by ICO, it shall be taxable.
In order to defer/avoid taxes in India in the above case, many taxpayers set up corporations outside India (resident state) in a jurisdiction (Netherlands) which would levy no tax or lower tax on the foreign sourced incomes (Refer Case 2). In this case, if the German Co. declares dividend, it would be exempt from tax in Netherlands as there is no tax on dividend in Netherlands under their local business consultants/ under European Union Directives. Secondly, if the German Co pays royalty, there would be no tax in Netherlands, as these may be exempt under the European Union regulations, relating to free movement of income in EU without any taxation.
CRITERION TO ASCERTAIN A CFC?
The degree of control exercised over a particular corporation, would result in such organization being classified, as a CFC (“IHC” in the example). A foreign entity would be regarded as Controlled Foreign Company, if all the following conditions are fulfilled: –
- Person(s) in the State of residence (India), individually or collectively exercise control over the CFC;
- CFC is not engaged in active trade or business;
- Shares of the CFC entity are not listed on recognized stock exchange of the country of residence (Netherlands);
- Entity is resident of territory with low rate of taxation
- Specified income of the entity exceeds a given threshold (INR 2.5 million in the case of limits specified under DTC 2010).
INCOME ATTRIBUTION
Under CFC rules, certain income of the foreign corporation is attributed to the controlling shareholder(s) in the home country and taxed in the year it is earned, regardless of whether it is distributed. The attribution process typically involves:
- Pro-Rata Allocation: Income is attributed based on the shareholder’s ownership percentage.
- Taxable Income Calculation: Only specific types of income (e.g., passive income) are attributed, subject to exemptions or thresholds.
HOW A CFC IS TAXED?[4]
If a company is identified as a CFC, some of its income is taxed in the hands of its parent, as income of the parent or assuming it were remitted to the parent, even though there is no actual remittance. Income of a CFC can be taxed based on various criterions, such as location specific entities, specific income of residents of a country:-
- Income from a specific location
In such cases, income of a foreign corporation, residing in a particular country or a location is classified as a CFC income.
While applying this approach, low tax rate in a country, should not be the sole criterion. One should further evaluate the taxation system of the country, existence of KYC norms, willingness to exchange information of assets/investments made by residents /citizens of the country making the requisition.
In such cases, the following additional criterions may further be applied, before the entities are classified into a particular category : –
- Substance over form;
- Look through approach;
- Business purpose rule; and
- Other Anti-Avoidance rules including Transfer pricing regulations,.
- Income specific CFC legislation
Under Income specific CFC legislation, certain income, which is considered as passive , like dividend and interest, income from properties owned by the foreign corporation, are taxed under the CFC legislation, subject to certain conditions. The existence of a malafide intention is presumed under the CFC legislation and such income is assumed to have been deliberately parked outside the home country to avoid taxes thereon.
iii. Entity level approach
Under the Entity level approach, an entity is classified as a CFC with respect to ‘tainted income’ in ‘tainted jurisdiction’. India proposed to follow the entity level approach, in the provision of DTC 2010.
TYPES OF INCOME SUBJECT TO CFC RULES
CFC rules typically target specific types of income, often referred to as “tainted” or “passive” income, including:
- Passive Income: Dividends, interest, royalties, rents, and capital gains.
- Base Company Income: Income derived from intra-group transactions, such as sales or services, designed to shift profits to low-tax jurisdictions.
- Other Income: Some jurisdictions include broader categories, such as income from illegal activities or certain types of active income if deemed to lack economic substance.
CONTROLLED FOREIGN CORPORATION EXAMPLES[5]
We have developed our own set of controlled foreign corporation examples. While these types of entities come in many shapes and sizes, there a few common CFCs we work with at Golding & Golding, in which having U.S. shareholders is the norm. They include:
- A Sociedad Anonima, in which the U.S. Person usually owns 90% of the Foreign Corporation, with a local resident owning 10%
- A Wholly Owned Foreign Corporation such as Hong Kong Ltd., BVI, or Australia PTY Ltd.
- A Foreign Corporation (Even if established just as a Foreign Trust), but is considered a Per SeCorporation under IRC§ 301.7701-2
CONCLUSION[6]
The whole chapter on CFC is to curb this tax avoidance. Normally, there are provisions for avoiding undue hardship to companies not declaring dividends for genuine business purposes.
It would provide definitions for:
(i) Controller or Domestic Holding Company/Domestic Shareholder.
(ii) Control.
(iii) Controlled Foreign Company.
(iv) Foreign Income liable to CFC provisions.
In simple words, once all the four provisions are applicable, the foreign income would be taxable in India. Normally, the domestic shareholder would include any corporate or other shareholders having a control over a foreign company. Control may be exercised individually or jointly. Control may be simple – (i) shareholding; (ii) Voting right at shareholders’ meetings; (iii) voting rights at Board meetings; or any other right by which the domestic shareholder can influence the foreign company.
If a foreign company is controlled by domestic shareholder/s it is considered to be a CFC. When it comes to Foreign Income; Normally, only unearned incomes are taxed. If a CFC has regular manufacturing or trading activity, profits from such activities is not considered liable to CFC provisions. If the CFC is declaring normal dividends (say more than 90% of its distributable profits) it may be exempted from CFC provisions.
[1] https://sortingtax.com/controlled-foreign-corporation/
[2] https://www.iodglobal.com/blog/details/international-tax-planning-and-management#:~:text=Controlled Foreign Corporation (CFC) Compliance & text=These rules kick in when,country can still tax it.
[3] https://fieconsult.com/understanding-controlled-foreign-company-cfc-rules-for-multinationals/
[4] https://fieconsult.com/understanding-controlled-foreign-company-cfc-rules-for-multinationals/
[5] https://www.goldingbusiness consultantyers.com/controlled-foreign-corporation-guide-2017-faq-common-questions-answers/#Controlled_Foreign_Corporation_Examples
[6] https://www.rashminsanghvi.com/articles/taxation/international-taxation/controlled-foreign-corporations-(CFC).html
