Taxand Asia Senior School CONTROLLED FOREIGN COMPANIES

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1 Taxand Asia Senior School CONTROLLED FOREIGN COMPANIES

2 OUTLINE Controlled Foreign Company ( CFC ) - the concept CFC The international scenario A comparative with other jurisdictions CFC and the Indian Direct Taxes Code ( DTC ) CFC references in the DTC What constitutes a CFC under the DTC Some definitions Specified income and attributable income CFC impact Key issues and way forward 1

3 The Concept Quality tax advice, globally

4 CFC THE CONCEPT CFC rules are prevalent in more than 25 countries In general, CFC is a foreign company that: Is directly or indirectly controlled by resident taxpayer; Earns substantial passive income; and Is subject to substantial lower taxation than in resident state Passive income arising in overseas jurisdictions is attributed to resident shareholders Passive income interest, rent, dividends, royalties and capital gains Nature of control Generally > 50% ownership (eg US, UK) Voting power (eg US) 3

5 Quality tax advice, globally The International Scenario

6 CFC THE INTERNATIONAL SCENARIO Most advanced economies have tax regulations dealing with CFC. Typically, CFC regulations deal with the following: Define control thresholds that need to exist to be classified as a Controlled Corporation Define exemption / activity thresholds that need to be satisfied for exclusion Active business exemption Australia Business criteria, substance criteria, management and control criteria Japan De-minimus test, exempt activity test, acceptable distribution test UK Same country exception for dividend and interest, rents and royalties, De-minimus test, Full inclusion, Earnings and Profits Limitation Test - USA 5

7 CFC THE INTERNATIONAL SCENARIO Most advanced economies have tax regulations dealing with CFCs. Typically, CFC regulations deal with the following: Define tax rate thresholds that can act as reference point vis-à-vis home country tax rates Excluded country test - UK Listed country and non-listed country test - Australia Provide taxing mechanisms to enable current taxation of undistributed profits of the CFC Provide tax credit mechanisms for taxes paid / underlying tax credits / participation exemptions to mitigate the effects of any potential double current taxation 6

8 CFC THE INTERNATIONAL SCENARIO Two broad approaches to CFC legislation in OECD countries Transactional approach Location of CFC disregarded but rules will result in taxing specific incomes, which are generally passive ( bad or tainted income) Entity / jurisdictional approach Low tax jurisdictions are identified and all income of CFC in such countries taxed irrespective of their source ( all or nothing effect ) Fairly advanced CFC regulations exist in US, UK, Australia, Japan, France 7

9 CFC THE INTERNATIONAL SCENARIO Analysis of CFC legislation in a few countries on following key aspects: Background Definition of CFC Applicability and tax impact Type of target income Tax credit Exemptions 8

10 BEPS Action Plan 3 Develop recommendations regarding the design of CFC rules To address the BEPS concern on excessive deductible payments such as interest and other financial payments Recommendations regarding the design of domestic rules expected by September

11 Quality tax advice, globally CFC and the Direct Taxes Code in India

12 CFC AND THE DIRECT TAXES CODE DTC has specific regulations covering the income earned by a CFC Taxability Attributable income of a CFC to a resident, would be taxable in India as Income from residuary sources [section 58(2)(q)] Deduction Deduction is available for any dividend received from a CFC to the extent the amount has been included in the total income of the Resident in any preceding Financial Year [Section 59(1)(c) ] Treaty Override Generally, provisions of the DTC or a tax treaty whichever are more beneficial shall apply to the taxpayer. However, CFC Rules shall apply whether or not these are beneficial to the taxpayer [Section 295(10)(c) ] Second Schedule of the DTC contains Method and manner of computation of attributable income Definitions of CFC, territory with lower rate of tax, associated enterprise, deemed active trade or business 11

13 CFC AND THE DIRECT TAXES CODE Territory with a lower rate of taxation Control threshold > 50 percent Not engaged in active business Specified Income > INR 25 lacs Tax paid is less than one half of tax payable as determined under DTC Shareholding /voting rights/ right to secure assets / decisive or dominant influence / by Indian resident Passive income and income from associated enterprises is less than 25 percent Profits after reducing provisions for unascertained liabilities, accumulated losses, dividend Undistributed Income of CFC would be taxed under DTC Subsequent dividend distributions would not be taxed to extent taxed earlier Dynamic in nature and would need to be tested annually 12

14 CFC AND THE DIRECT TAXES CODE Country with Lower tax rates means a country in which tax paid in respect of profits accrued during the accounting year is less than one half of the tax payable on the profits as determined under the DTC Person resident in India shall be said to exercise control if such persons individually or collectively Entitled to acquire directly or indirectly, shares carrying not less than 50 percent of voting power or not less than 50 percent of capital of the company Control Threshold Entitled to secure that not less than 50 percent of income or assets shall be applied directly or indirectly for their benefit Exercise dominant influence on the company due to a special contractual relationship Directly or indirectly have sufficient votes to exert decisive influence in a shareholder meeting of the company 13

15 CFC AND THE DIRECT TAXES CODE Activity Test Positive Test Active participation It should actively participate in either industrial, commercial or financial undertakings through employees or other personnel in the economic life of the territory of tax residence Negative Test Less than 25 percent of income should be from deemed passive sources: Dividend Interest Income from house property Capital Gains Annuity payments Royalty Sale and licensing of intangibles Income from supply of goods and services to AE Income from management, holding or investment in securities, shareholdings, receivables or financial assets Income from residuary sources 14

16 CFC AND THE DIRECT TAXES CODE Specified Income What is taxable under the DTC Specified Income = (A + B - C D) X (E/F) A - Net profit after tax of the CFC as per Profit and Loss account B - Provisions for meeting liabilities (other than ascertained liabilities) or diminution in value of assets of CFC C - Interim dividend paid out of profits of CFC (but not debited to the Profit and Loss account) D - Brought forward losses of the CFC not considered under this provision earlier E - Number of days the company is a CFC F - Number of days in an accounting period Attributable income = Specified Income X (B/100) X (C/D) Attributable income B - percentage of value of capital or voting share / interest, whichever is higher C - Number of days out of D, the voting share or capital or interest held by assessee D - Number of days the company remained as CFC during the accounting year 15

17 Quality tax advice, globally Impact, Key Issues and Way Forward

18 CFC IMPACT India has witnessed a spate of outbound investments using special purpose vehicles in tax friendly jurisdictions. These are usually set up for various commercial reasons such as raising funds in international markets for acquisitions, consolidation for global listing, etc With CFC coming into play, passive income earned by controlled entities in low tax jurisdictions would be taxable in India High on Radar Low risk Minimal management control All entities carrying out active business and whose revenues from non related parties exceeds the passive income/revenues CFC mitigation if: Test of control not satisfied Test of listed entity satisfied 17

19 KEY ISSUES AND WAY FORWARD Minimum shareholding requirement before CFC income can be included to the Indian shareholders. For example, most of the countries provide that shareholders holding less than 10% shares in a CFC will not be subject to tax on the income in the CFC Meaning of dominant influence / decisive influence / directly or indirectly Key Issues The CFC test is dynamic in nature and would need to be satisfied on a year-on-year basis (based on the Indian tax year) Set off between profits and losses between different CFCs Mechanism to compute CFC income in case shareholding is increased or reduced or acquired or sold during the year viz, should the income be proportioned based on the number of days of shareholding In cases where income of a CFC is brought to tax in India, possibility of the tax paid by the CFC being allowed as a credit under the relevant tax treaty needs to be explored further in absence of specific mechanism provided in the DTC 18

20 KEY ISSUES AND WAY FORWARD What about multiple layered structures all of them qualify for CFC test? Existing overseas holding company structures for investment holdings and intellectual property rights impacted and need review Dilutes ability to pay principle - Taxation before receipt of income Key Issues Distortion of capital import neutrality Blunts competitive edge currently available to compete with foreign owned companies in foreign markets 19

21 COMPARATIVE ANALYSIS USA Country Background Introduced in First country to adopt CFC rules UK South Africa Country USA UK South Africa Introduced in 1984 to prevent UK residents from reducing their UK tax liabilities by diverting profits to foreign companies which they control and situated in low tax jurisdictions Introduced in 1997 under Section 9D of the Income Tax Act to protect the South African taxation base. Section 9D initially only taxed passive income but later the scope was extended to include active income also Definition of CFC A CFC is one in which the US shareholders own more than 50%, by vote or value. A CFC is a non-uk company which is controlled by UK residents and which operates in a low tax jurisdiction A non-resident company is regarded as to be controlled by UK residents if UK residents hold more than 50% interest in the company or if UK residents hold 40% or more interest and a non-resident holds at least 40% but not greater than 55% interest. A foreign company, interalia, becomes a CFC when more than 50% of the participation rights or voting rights are held directly or indirectly by South African residents 20

22 COMPARATIVE ANALYSIS Country USA UK South Africa Applicability and tax impact Only those shareholders that own (directly or indirectly) 10% or more of the foreign corporation stock are included in the more than 50% ownership test Equal partnership between foreign persons and US shareholders not hit by CFC Regulations A CFC is subject to a lower level of taxation if the tax paid in its country of residence is less than 75% of the corresponding UK tax that would have been payable had it been resident in the UK Currently, UK companies are required to include amounts chargeable under the CFC Regulation in their tax returns A South African resident is taxable on his share of income in a CFC only if it holds 10% or more in a CFC (whether alone or together with connected persons). Thus, less than 10% holding does not trigger any profit imputation in the hands South African resident shareholder. 21

23 COMPARATIVE ANALYSIS USA Country Target income subject to CFC Rules Passive undistributed income of CFC taxable in the hands of US shareholder sum of US shareholders pro-rata share of CFC s income for the year Pro-rata share of certain amount withdrawn from investment in less developed countries Pro-rata share of certain amount withdrawn from investment in shipping operations for the year UK South Africa Country USA UK South Africa Pro-rata share of the corporation s earnings invested in US property for the year Share of the profits (excluding capital gains) of the CFC taxable in UK The net income of a CFC is an amount equal to the taxable income of the CFC for the foreign tax year which ends during the year of assessment of the resident Tax Credit Foreign taxes are deemed paid on taxable distributions from foreign corporations NA A South African resident is entitled to a credit (or rebate) of South African tax for foreign taxes paid by the CFC on income attributed to the resident 22

24 COMPARATIVE ANALYSIS USA Country Exemptions from CFC Rules CFC is not established for avoidance of domestic tax UK De-minimis test where the total income of the CFC does not exceed a certain amount CFC distributes dividend to persons resident in UK which is equal to at least 90% of its chargeable profits within 18 months of the end of its accounting period De-minimus rule - chargeable profits of the CFC is less than 50,000 Pounds Low profit margin CFC s account profits < 10% of its relevant operating expenditure Low level of tax exemption CFC has paid local tax of atleast 75% of the corresponding UK tax CFC has a business establishment in the territory where it is resident and effectively manage its business affairs in that territory from that establishment OR qualifies under one of the specific tests (i.e. > 50% non related business) It is proved that reduction in UK tax by a diversion of profits from the UK is not the main reason behind the CFC s existence Public holds shares carrying at least 35% of the voting rights of the CFC, the shares not being preference and quoted on the stock exchange official list The CFC is resident in a territory listed in the Excluded Countries Regulations and satisfies certain income and gains requirements Exemptions in case of group finance companies 23

25 COMPARATIVE ANALYSIS Country South Africa Net income of the CFC which: Exemptions from CFC Rules Is attributable to suitable equipped business establishment outside South Africa used for bona fide business purposes; Relates to passive income, foreign exchange differences and certain capital gains which arise from transactions between the CFC and another foreign entity which forms part of the same group of CFC; Is attributable to any foreign dividend declared to the CFC by another CFC in relation to the South African resident to the extent that the foreign dividend has been or will be included in the income of the resident in terms of the imputation rules 24

26 THANK YOU ABOUT TAXAND Taxand provides high quality, integrated tax advice worldwide. Our tax professionals, more than 400 tax partners and over 2,000 tax advisors in nearly 50 countries grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business. We're passionate about tax. We collaborate and share knowledge, capitalising on our expertise to provide you with high quality, tailored advice that helps relieve the pressures associated with making complex tax decisions. We're also independent ensuring that you adhere both to best practice and to tax law and that we remain free from time-consuming audit-based conflict checks. This enables us to deliver practical advice, responsively. Taxand is a global organisation of tax advisory firms. Each firm in each country is a separate and independent legal entity responsible for delivering client services. Copyright Taxand Economic Interest Grouping 2014 Registered office: 1B Heienhaff, L-1736 Senningerberg RCS Luxembourg C68

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