A Study On The Controlled Foreign Company Rules

Controlled Foreign Company (hereinafter the CFC) refers to those companies which are controlled directly or indirectly by domestic shareholders and residing in a tax haven with an independent corporation capacity. With the increase in global cross-border investment, the CFC has become the main device used by multinational companies and their shareholders to avoid tax through tax deferral.This tax avoidance device stems from the inner framework conflicts of modern income taxation system and the different tax burden among countries. On one hand, based on the resident jurisdiction, government tax on resident's global income; on the other hand, based on the corporate personality of companies, shareholders and the CFC are two independent legal entities. This is the principal of independent levy between shareholders and the CFC that embodied in tax laws. In other words, if the foreign subsidiary does not attribute its profit to domestic shareholders, the residency country of shareholder can not tax on this profit. Taxpayers make use of no other than this framework conflicts in tax system and the different tax burden among countries to explore the space for tax deferral even for tax avoidance. As to the different tax burden, it is largely due to the existence of tax haven. Just because of the existence of non-tax or low-tax region in the global economic environment, parent companies seek to transfer income of whole group to the CFC residing in those regions through transfer pricing and transactions without business substance. Through these arrangements, on one hand, the CFC can enjoy the local tax exemption or low-tax policy and pay little or no tax; on the other hand, parent companies can defer the tax on the dividend until the dividend is distributed.In the early 1960s, with the increasing statutory tax rate of US corporate income tax, US companies began to use the CFC residing in tax haven to defer tax. The reality, on one hand, resulted in large amount of capital outflow which further decreased the surplus on the international balance of payments; on the other hand, the domestic tax base was eroded seriously by tax deferral of foreign sourced income. In these conditions, the United States enacted the Kennedy Act (generally called section"F"), which enable the government to impose US income tax on US shareholder's portion of the undistributed profits of CFC, i.e., the undistributed profit is deemed to be distributed. Those profits which were deemed as distributed and hence taxed then can be kept from being taxed again when actually distributed to US shareholders, and foreign tax credit will be entitled accordingly. At the same time, Section F included strict definition of CFC and its target territory. Although this legislation did not eliminate the tax deferral of US shareholders, it deprived US shareholders of their rights of tax deferral through CFCs in a tax haven. After the United States, there are 22 countries enacted their CFC legislations successively, including Germany, Canada, Japan, France, United Kingdom, New Zealand and etc.The introduction of CFC legislation, on one hand, reflects those countries'reality demands to regulate the accumulation of profit in CFC in tax haven or low-tax region and domestic tax deferral of domestic resident through CFC legislation; on the other hand, embodies the adherence to Capital Export Neutrality principle of government's fiscal policies.An overview of those CFC legislations shows that there are many common elements in the basic framework of those legislations despite of the existence of various national conditions and tax systems. These common elements mainly include:1. Definition of a CFC. The key is the definition of control. Various tests of control have been adopted in those CFC regimes, including de jure control, de facto control, indirect control, control by a concentrated group, constructive ownership and when is controlled determined.2. Taxpayers. In general, CFC rules apply to domestic shareholders of CFCs. In most countries, CFC rules apply to individuals and companies, since CFCs can be used by both individuals and companies to avoid tax. In addition, some countries have additional conditions such as minimum share ownership and timing of share ownership.3. Target territory. CFC rules mainly aim to limit the tax avoidance of CFCs in tax haven. Therefore, in general, residence country of parent company applies the rules to foreign subsidiary only in the case that the residence country of foreign subsidiary is deemed as a tax haven by residence country of parent company. However, not all of the countries enacting CFC rules only apply the rule to tax haven. Some countries apply the legislation to a CFC wherever resident.4. Tax basis. The tax basis of CFC rules is the"tainted income"attributable to shareholders earned by CFC, which normally refers to passive income and base company income. As to how to define the tainted income, there are two approaches adopted widely by countries: transactional approach and entity approach.5. Losses. In general, the losses of CFC cannot be attributed to domestic shareholders to offset its taxable income in the same way as income. But the losses in respect of one component of tainted income activities can offset income of other tainted sources. 6. Method of avoiding double taxation. A majority of CFC regimes adopt indirect credit method to avoid double taxation on CFC income attributed to domestic taxpayers.7. Exemptions. To save tax administration cost and reduce negative impact on overseas investment, exemption articles have been adopted in CFC rules,including: de minimis exemption, motive exemption, active business activity exemption, publicly traded CFC exemption.As capital barriers have been removed and business has become more international, it has been a world-wide trend to enact and tighten CFC rules. As to two controversial questions about CFC rules, i.e. whether CFC rules conflict with tax treaties and whether they affect domestic companies'international competitiveness, the paper discussed those issues and gave a negative answer.In recent years, with the development of economic globalization and more and more close relationship between China's and world economy, China has relaxed its exchange control and the adverse impact of tax avoidance by way of tax haven would become more serious given taxpayers'inherent motive for interest and great pressure of competition. Not only would this affect state tax revenue, but also distort taxpayers'investment decisions, thereby not being conductive to healthy development of our country's economy and society.In response to our country's current position of overseas investment and for protecting taxation rights, we should take immediate actions to perfect our anti-avoidance tax system and limit use of CFC by taxpayers which results the unacceptable tax deferral. In the light of this, the Corporate Income Tax Law of the People's Republic of China introduced the CFC rules. However, many core elements of this legislation have not been clarified and it seems to be deficient compared with other developed countries'mature CFC rules. This paper attempted to propose some detail suggestions for the improvement of our CFC legislation to make it practicable through the comprehensive analysis and summary of other CFC legislations.