On 3 April 2015 the OECD issued a public discussion draft, Strengthening CFC Rules (Paper).
The Paper is about Action Point 3 of the OECD's wider 15 point Base Erosion and Profit Shifting (BEPS) Action Plan. The BEPS Action Plan is discussed in more detail in our earlier Alert, OECD releases BEPS Action Plan.
In this Alert we consider the main issues, recommendations and options for taxation reform raised in the Paper.
The purpose of Action 3 is to address base erosion and profit shifting by using controlled foreign company (CFC) rules. CFC rules are aimed at preventing groups from establishing non-resident subsidiaries in low-tax countries and shifting income to these subsidiaries, by taxing the income earned by the non-resident subsidiaries in the hands of resident shareholders where certain conditions are met.
Australia has a comprehensive CFC regime in Part X of the Income Tax Assessment Act 1936 (Cth). The Paper notes that some countries do not currently have CFC rules and others have rules that do not always counter BEPS situations in a comprehensive manner. For any changes to Australia's CFC regime to occur, domestic law changes will be required. As can be seen from this Alert, many of the issues raised in the Paper are already to some degree covered by Australia's CFC rules, although proposals to expand the concept of attributable income would extend the reach of Australia's CFC rules.
The Paper identifies the following 7 key elements or "building blocks" that are necessary for effective CFC rules:
- definition of a CFC;
- threshold requirements;
- definition of control;
- definition of CFC income;
- rules for computing income;
- rules for attributing income; and
- rules to prevent or eliminate double taxation.
The Paper makes draft recommendations on each of these elements except for the definition of CFC income, where it instead discusses several possible options.
Prior to considering the key elements or "building blocks" of effective CFC rules, the Paper addresses the policy considerations that must be considered in designing CFC rules, such as striking a balance between taxing foreign income and maintaining competitiveness, limiting administrative and compliance burdens while not creating opportunities for avoidance, and preventing double taxation.
The key elements or "building blocks" of effective CFC rules
The Paper includes recommendations (or in the case of the definition of CFC income, options) which, if adopted as domestic law result in a broader application than the current Australian CFC rules.
(1) Definition of CFC
The Paper proposes adopting two main changes. The first is the inclusion of a broad definition of CFC so that non-corporates are included. The Paper proposes that the definition should include partnerships, trusts and permanent establishments where those entities are not otherwise taxable, but are owned by CFCs, or treated in the jurisdiction of their parent as separate taxable entities. The second main change proposed in the Paper is the adoption of a hybrid mismatch rule. This is intended to prevent entities from circumventing CFC rules by being treated differently in different jurisdictions.
The Australian CFC rules only apply to a foreign company, and a foreign hybrid (such as a limited partnership) which is treated as partnership for foreign tax purposes is treated as a partnership for Australian tax purposes (rather than as a company under the Australian treatment of limited partnerships).
(2) Threshold requirements
The Paper proposes excluding companies that are likely to pose little risk of base erosion and profit shifting from the CFC rules, and that a low tax benchmark should be set, with the rules only applying to CFCs which have a tax rate that is meaningfully lower than the tax rate in the parent jurisdiction.
The Paper proposes that benchmark for when the CFC rules would apply be set at (broadly) 75% of the parent jurisdiction's statutory rate or lower. The Paper recommends using the CFC's effective tax rate to measure that benchmark, and that the effective tax rate be either based on IFRS standards, or by applying the parent jurisdiction's tax regime. There are some issues considered in the Paper in more detail – including whether the effective tax rate should be calculated on an aggregate or entity by entity basis.
Similar to some other countries, Australia does not have a low-tax threshold, but instead has a de-minimus exclusion which applies to CFCs in a "white list" country (being countries with a comparable to tax system).
(3) Definition of control
The Paper proposes that the CFC rules should at least apply both a legal and economic control test so that satisfaction of either test results in control, and a CFC should be treated as controlled where residents hold, at a minimum more than 50% control. The Paper also proposes a number of tests to determine if shareholders who each holds less than 50% nevertheless have control, including an acting in concert test, a concentrated ownership test, and tests examining the relationship between shareholders.
The Australian CFC provisions already includes a legal and economic control test and also a de facto test involving significant influence, and includes a lower control threshold of 40% in some cases.
(4) Definition of CFC income
The Paper does not make any recommendations regarding the definition of CFC income but instead considers income being dividends, interest and other financing income, insurance income, digital sales and services income and royalties and IP income. At a minimum, the Paper considers that income that raises BEPS issues should be attributed other than where that income arises from value-creating activity in the CFC jurisdiction. The two possible approaches to determining CFC income which are analysed are:
- A categorical approach, which uses separate rules for different types of income listed above.
- An excess profits approach, which involves calculating a "normal return" and then subtracting this from the income earned by the CFC.
The categorical approach described in the Paper is not too dissimilar from the Australian CFC rules, which divide income into categories of "tainted" income, including passive income and income from transactions with Australian residents and related parties, and also applies a substance analysis in the form of an "active income test" which limits the amount of income generally attributed.
Some countries believe that the excess profits approach would include income irrespective of whether it arises from genuine economic activity of the CFC. Other countries believe that excluding a normal return on eligible equity is an effective method for identifying CFC income.
(5) Computing CFC income
There are two options considered – whether the domestic rules of the parent jurisdiction should be utilised to compute income or whether specific standardised rules are needed. The Paper considers that the rules of the parent jurisdiction should be used to calculate CFC income, and jurisdictions should have specific rules limiting the offset of CFC losses so that they can be used against the profits of the same CFC or against the profits of other CFCs in the same jurisdiction.
In Australia, the attributable income is calculated on the basis that the CFC is a resident Australian company (based on the Australian rules) but with some modifications, and CFC losses are quarantined in the CFC that incurred them.
(6) Rulesfor attributing income
The Paper breaks this down into a five step process and makes the following recommendations, which are broadly in line with the Australian CFC rules. The Paper states that:
- to determine which taxpayers should have income attributed to them, there should be an attribution threshold tied to the minimum control threshold when possible;
- the amount of income attributed should be calculated by reference to both proportion of ownership and actual period of ownership or influence;
- 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;
- the tax rate of the parent jurisdiction should be applied to the income.
(7) Rules to prevent or limit double taxation
The Paper sets out recommendations for preventing or eliminating double taxation. The Paper states that:
- Double taxation that can arise by attributed CFC income being subject to foreign corporate taxes, and CFC rules applying to the same income in more than one jurisdiction, should be addressed by allowing foreign tax credits.
- Double taxation that can arise by taxation of dividends out of income that has already been attributed under CFC rules, or the disposal of shares in a CFC, should be addressed by exempting dividends and gains on dispositions of CFC shares from taxation if the CFC's income of the CFC has previously been subject to CFC taxation.
Australia currently the foreign income tax offset that applies where income is attributed under the CFC rules, although complex issues can arise where there are foreign hybrids. Also in Australia, dividends received out of previously attributed income are generally exempt. There is no separate regime in Australia for the disposal of CFCs, although capital gains and losses derived by an Australian company on the disposal of foreign companies with an active business may be wholly or partly disregarded under the capital gains tax participation exemption. To prevent double taxation on disposal gains which are not disregarded under the participation exemption, Australia's CFC rules provide for the disposal consideration to be reduced for attributed income that has not been distributed.
The Paper reflects preliminary considerations of the issues since the publication of the BEPS Action Plan and seeks to identify issues for public comment. The Action Plan calls for this work to be completed by September 2015.
Interestingly, the Paper notes that some countries have proposed secondary rules that would apply to income earned by CFCs which does not give rise to sufficient CFC taxation in the parent jurisdiction. These secondary rules would introduce tax in another jurisdiction (for example, the source country of the income earned by the CFC). The Paper notes that the OECD is currently considering special measures in the transfer pricing area as part of Action Items 8, 9 and 10, which could be implemented as possible secondary rules, and that the options to address the tax challenges of the digital economy could also be adapted to be applied as secondary rules. As yet the OECD has not concluded its position on this secondary rule proposal.