Multinationals will be concerned about additional complexity in controlled foreign company proposals 7 April 2015 In brief Multinational enterprises (MNEs) will be concerned about the Base Erosion and Profit Shifting (BEPS) discussion draft on controlled foreign company (CFC) rules published over the Easter weekend. This discussion draft relates to Action 3 of the BEPS Action Plan as agreed by the Organisation for Economic Cooperation and Development (OECD) with the G20 countries. The proposals are complex and, in practice, the difficulties are likely to be worsened by the degree of latitude accorded to states in applying or varying the proposed approach. The OECD notes that many countries already have CFC rules. It suggests that these rules do not always counter BEPS in a comprehensive manner though they could reduce the incentive to shift profits to a third, low-tax country. Harsher CFC rules will in principle lead to inclusion of more income in the residence country of the ultimate parent but a high level proposal to add a secondary form of taxation in another jurisdiction would add further complexity if it is taken forward. This discussion draft considers all the constituent elements of CFC rules and breaks them down into the building blocks necessary for effective CFC rules. The building blocks include: definition of a CFC threshold requirements definition of control definition of CFC income rules for computing income rules for attributing income rules to prevent or eliminate double taxation As with the discussion draft as a whole, the approaches to defining CFC income do not reflect a consensus view and there are clearly some material concerns from a tax competitiveness perspective. www.pwc.com
One proposal MNEs will want to consider carefully is an excess profits approach under which income attributable under the CFC rules would be the profits in excess of a normal return, being a specific rate of return on the equity properly to be regarded as utilised in the business of the CFC. In detail Background and scope CFC rules tax certain income of controlled foreign subsidiaries in the hands of shareholders resident in the country of the ultimate parent. Policy objectives for CFC regimes vary. Some countries with worldwide tax systems focus on long-term base erosion rather than profit shifting. Other countries with more territorial tax systems do not currently have CFC rules or have more limited CFC regimes. The suggestion in this discussion draft is that CFC rules should address base erosion but also seek to prevent profit shifting from third territories (with a particular focus on developing countries). The main target of many CFC regimes is passive income. For example, both intellectual property (IP) royalties and interest income would generally be characterised as passive income and therefore included in the CFC income attributable to the parent. Some countries have proposed that in addition to primary rule CFC measures, countries could introduce a secondary rule. It would apply to income earned by CFCs that does not give rise to sufficient CFC taxation in the parent jurisdiction. This secondary form of taxation would apply in another jurisdiction (for example the source country of the income earned by the CFC). It might include a transfer pricing special method or digital economy rule covered in BEPS Actions 8-10 and Action 1, respectively. The CFA has not yet considered whether this high level proposal should be taken forward. Observation: It will be interesting to see the response to the question of whether CFC rules should prevent foreign-to-foreign profit stripping or whether it is acceptable for rules to focus only on whether the parent jurisdiction has been base eroded by the CFC. Countries have different views on this and the UK, for example, has a very limited focus on whether the profits of the CFC are attributable to UK significant people functions (SPFs). The paper doesn't deal in any great detail with financing. While, as noted, non-trading intra-group finance profits will almost always be fully attributable under a best practice CFC regime, if a CFC is not overcapitalised and has the substance to generate finance income itself, it seems it may be excluded. Definition of a CFC The recommendation is to define broadly entities that are within scope so as to include not just corporate entities. CFC rules would also apply to various partnerships, trusts, and permanent establishments (PEs). The key consideration would be whether those entities are owned by CFCs or treated in the parent jurisdiction as taxable entities separate from their owners. For example, PEs should be treated as CFCs if they are treated as exempt in the country of the head office. A further recommendation is to include a modified hybrid mismatch rule that would prevent entities from circumventing CFC rules by being treated differently in different jurisdictions. Threshold requirements The paper notes that a blacklist of affected territories and/ or a whitelist of acceptable regimes may be used as simple way to identify lower levels of tax. The recommendation is to include a low-tax threshold where the tax rate calculation is based on the effective tax rate. There are some questions as to how the effective tax rate should be calculated. The low-tax threshold should also use a tax rate that is meaningfully lower than the tax rate in the country applying the CFC rules. A figure of 75% or lower of the percentage of the corresponding tax that would be payable in the home territory is contemplated based on existing rules. This may be made subject to conditions, for example regarding the nature of the income. The paper makes no general recommendation as regards a low profits exemption. But if countries do opt for this then a complementary anti-abuse provision would be needed. Observation: Thresholds are generally welcomed as they make the rules more targeted and effective and reduce the level of administrative burden. There remain a number of specific details to be determined as to how thresholds should be structured. Definition of control The OECD states that the definition of control requires two different determinations: of the type of control that is required and of the level of that control. The discussion draft recommends that control should be determined both at a legal and an economic control level. Satisfaction of either test would result 2 pwc
in control. Countries would instead be able to include de facto tests where they achieve the same effect. Secondly, the discussion draft recommends that a CFC should be treated as controlled where residents hold, at a minimum, more than 50% control. Countries that want to achieve broader policy goals or prevent circumvention of CFC rules would be allowed to set their control threshold at a lower level. This level of control could be established through the aggregated interest of related parties or unrelated resident parties or from aggregating the interests of any taxpayers that are found to be acting in concert. Additionally, the draft suggests the CFC rules should apply where there is either direct or indirect control. Observation: While the paper highlights a need for an acting in concert rule, an amalgamation of related party interests or a concentrated ownership requirement (e.g., small number of resident taxpayers in control), it does not recommend that non-resident interests are taken into account. However, countries may choose to go beyond the minimum requirements when they implement the rules. Definition of CFC income Presumably because of the absence of consensus on the matter, the paper makes no firm recommendations on the definition of CFC income but discusses a number of options. The OECD notes that full inclusion may be appropriate depending on policy aims. However, the main focus seems to be on BEPS and therefore on types of income more likely to create risk in that regard. This puts the reliance on partial inclusion systems and specifically highly mobile and/ or passive income. The discussion draft states that in the current environment, a pure formbased approach directed at passive income is unlikely to be acceptable, i.e. there would be too much scope for BEPS using sales/ services income requirements. Rather, it is proposed that an analysis based on substance is likely to be needed, particularly within the context of EU discussions. There are three options mentioned: substantial contribution this focuses on the contribution of the CFC s employees to the income it generates. viable independent entity this looks at all significant functions in the group and asks if the CFC is the entity that is most likely to own the asset or bear the risk if the entities were all independent? "In the context of a group that continues to own, develop, and exploit IP, the location of capabilities and functions which enable the group to manage risks associated with that IP can be used to identify which group entity would own the IP under normal commercial conditions, which would determine where the substance was located." employees and establishment this approach addresses whether the CFC has the necessary business premises etc. to actually earn the CFC s income and the necessary number of employees with the requisite skills to undertake the majority of the CFC s core functions. The paper then goes on to consider how CFC rules can accurately attribute income that raises BEPS concerns. It addresses, in turn, dividends, interest and other financing income, insurance income, sales and services income, and royalties and other IP income. The paper distinguishes between the categorical approach which would have separate rules for these different types of income and, in one of the more novel sections of the paper, the excess profits approach. The latter approach is largely intended to deal with profits arising from the use of intangible property. Broadly, it suggests that the income attributable under the CFC rules should be the profits in excess of a normal return, being a specific rate of return on the equity and up to approximately 10% There is then a discussion as to whether this approach should be supported by a substance-based exclusion. The focus of the approach is very much on super-normal returns from IP and there are multiple references to IP related activity. In line with the general comments setting out the non-consensus status of the discussion draft as a whole, it should be emphasised that the approaches to defining CFC income do not reflect a consensus view. In particular, the discussion draft notes there are different views on the excess profits approach. The differences apparently arise because some countries believe that an excess profits approach will include income irrespective of whether it arises from genuine economic activity of the CFC and where there is appropriate substance. Other countries believe that excluding a normal return on eligible equity is an effective method for identifying CFC income. On hybrid mismatches, the OECD suggests that CFC rules should apply to a payment which would have been included as CFC income if the parent country treated entities and arrangements in the same way as the corresponding payer or payee jurisdiction. Observation: There is a question as to whether hybrid payments should be base eroding payments before the CFC rules would apply to them. But, in summary, the paper seems to be 3 pwc
saying that the US should include in its CFC calculations those payments which are made between two disregarded subsidiaries. On the differences to the determination of CFC income, these differences are presumably compounded by the recognition in the paper of the uneasy relationship between CFC rules and tax competitiveness. Rules for computing income The discussion draft states that computing the income of a CFC requires two different determinations: which jurisdiction s rules should apply, and whether any specific rules for computing CFC income are necessary. The recommendation for the first determination is to use the rules of the parent jurisdiction to calculate a CFC s income. The recommendation for the second determination is that jurisdictions should have a specific rule limiting the offset of CFC losses so that they can only be used against the profits of the same CFC or against the profits of other CFCs in the same jurisdiction. Rules for attributing CFC income The discussion draft concludes that income attribution can be broken into five steps. 1. Which taxpayers should have income attributed to them? The draft recommends that the attribution threshold should be tied to the minimum control threshold when possible, although countries can choose to use different attribution and control thresholds depending on the policy considerations underlying CFC rules. 2. How much income should be attributed? The draft recommends that the amount of income to be attributed (see also below) to each shareholder or controlling person should be calculated by reference to both their proportion of ownership and their actual period of ownership or influence. 3. When should the income be included in the returns of the taxpayers? The discussion draft suggests jurisdictions would be free to decide this as best suits them. 4. How should the income be treated? The discussion draft again suggests this should be determined by the jurisdiction so that CFC rules operate in a way that is coherent with existing domestic law 5. What tax rate should apply to the income? The discussion draft suggests it should be the tax rate of the parent jurisdiction to the income, though a second top-up tax option is also discussed under which the rate would be less than the home rate but higher than the rate in the state of the CFC. Rules to prevent or eliminate double taxation Jurisdictions are primarily concerned with at least three situations where double taxation may arise: where the attributed CFC income is also subject to foreign corporate taxes, where CFC rules in more than one jurisdiction apply to the same CFC income, and where a CFC actually distributes dividends out of income that has already been attributed to its resident shareholders under the CFC rules or a resident shareholder disposes of the shares in the CFC. The recommendation for addressing the first two situations is to allow a credit for foreign taxes actually paid, including CFC tax assessed on intermediate companies. The recommendation for addressing the third situation is to exempt dividends and gains on disposition of CFC shares from taxation if the income of the CFC has previously been subject to CFC taxation, but the precise treatment of such dividends and gains can be left to individual jurisdictions so that provisions are coherent with domestic law. Observation: Double taxation concerns could arise in other situations, for instance where there has been a transfer pricing adjustment between two jurisdictions and a CFC charge arises in a third jurisdiction. The takeaway Most of the building blocks for best practice CFC regimes included in this discussion draft include draft recommendations. The exception to this is Chapter 5, which deals with the definition of CFC income and which does not include recommendations but instead discusses several possible options. The excess profits discussion is one of the key items on which the working group apparently couldn't reach a consensus view. Another is the high level proposal to add a secondary form of taxation, perhaps in the source country. Overall, unless countries agree to a degree of harmonisation, the ultimate proposals could add significant complexity to an already complicated array of rules given the range of objectives and ways countries have chosen to apply them. A further aspect of the proposals relates to the degree of latitude given to tax authorities in implementing CFC rules of the sort discussed, and particularly its interaction with tax competitiveness concerns of some 4 pwc
states. This suggests the draft may lead to a wider range of CFC measures being adopted by states. Given the complexity of these proposals, together with the expected variation in the way they will ultimately be implemented, taxpayers may find these CFC rules represent a significant burden for administration and compliance, particularly given their potential overlap with other BEPS proposals. The deadline for comments is 1 May 2015 and we would encourage MNEs to consider how these proposals might impact them. Those with a particular interest may wish to apply to attend a public meeting to be held in Paris at the OECD Conference Centre on 12 May 2015. The meeting will also be broadcast live on the internet. Let s talk For a deeper discussion of how these issues might affect your business, please call your usual PwC contact. If you don t have one or would otherwise prefer to speak to one of our global specialists, please contact one of the people whose details are set out below: Suchi Lee, New York +1 (646) 471-5315 suchi.lee@us.pwc.com Denis Harrington, Dublin +353 (0) 1 7928629 denis.harrington@ie.pwc.com Andy Boucher, London +44 (0) 20 721 31165 andrew.boucher@uk.pwc.com Phil Greenfield, London +44 (0) 20 7212 6047 philip.greenfield@uk.pwc.com Sherry Y Grabow, Chicago +1 (312) 298-4359 sherry.y.grabow@us.pwc.com Claus Jochimsen, Munich +49 89 5790-5420 claus.jochimsen@de.pwc.com Stef van Weeghel, Amsterdam +31 (0) 88 7926 763 stef.van.weeghel@nl.pwc.com Edwin Visser, Amsterdam +31 (0) 88 7923 611 edwin.visser@nl.pwc.com Peter Collins, Melbourne +61 (3) 8603 6247 peter.collins@au.pwc.com Stefan Schmid, Zurich +41 (0)58 792 4482 stefan.schmid@ch.pwc.com Richard Collier, London +44 (0) 20 7212 3395 richard.collier@uk.pwc.com Pam Olson, Washington +1 (202) 414 1401 pam.olson@us.pwc.com SOLICITATION This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PwC does do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. 2015 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details. 5 pwc