cfc regulations

INTERNATIONAL TAXATION

THE CHARTERED ACCOUNTANT jANUARy 2011 93

Controlled Foreign Companies

The Direct Tax Code (DTC) 2010 has proposed a host of new and revised provisions concerning cross-border taxation of income. One of the major provisions proposed by DTC 2010 relates to introduction of Controlled Foreign Company (CFC) regulations. CFC regulations are a broad set of regulations which are primarily aimed to prevent avoidance/deferral of tax by resident taxpayers by establishing intermediate foreign subsidiaries in low tax jurisdictions and parking income in those entities. This article attempts to decode the CFC regulations. With the opening of world-trade,

more and more companies have tried to spread their operations in a number of countries by either establishing a formal/informal place of business in other countries or by setting up of local subsidiaries to manage the business in those country/surrounding regions. The income earned by subsidiaries suffers from dual taxation on distribution of the same as dividend by such subsidiaries (first in the hands of the subsidiaries in the respective source country and second in the hands of the holding company on receipt of dividend). To avoid this dual taxation, companies started structuring

their overseas operations by setting up an intermediary holding company in a tax-favourable jurisdiction. The profits earned by the subsidiaries would be distributed to such intermediary holding companies as dividend and would be parked there.

While this would certainly help in reducing the overall tax cost (or at least deferment of tax till the income is distributed by such foreign company), non-repatriation of funds to the parent company jurisdiction results in a loss of revenue for the country where the parent is located. With a view to prevent such accumulation and non-distribution of income by

(Contributed by the Committee of Interna-tional Taxation of the ICAI. Comments can be sent to [email protected])

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The Indian tax authorities have woken up to the

needs of having CFC regulations as an effective anti-avoidance regulation. DTC 2010 proposes to introduce the CFC regulations to prevent avoidance/ deferral of tax by parking income in tax friendly jurisdictions. The CFC regulations under DTC 2010 propagate an ‘entity-level approach’. Under this approach, the focus is on the CFC as an entity rather than on its income, although the nature of its income (whether active or passive income) is an important factor in the determination of whether or not the CFC rules apply.

intermediate holding company, many countries started introducing the CFC regulations in their tax laws. The main aim of CFC regulations is to prevent the accumulation of income/funds in tax-favourable jurisdiction by including the undistributed income of such foreign companies in the total income of parent company.

CFC regulations were initially introduced in the United States of America as early as 1962. With the passing of time, CFC regulations grew in prominence with a number of coun-tries incorporating similar provisions in their tax laws. Currently, many develo-ped countries like Canada, Germany, japan, France, UK, New Zealand, Australia and emerging economies like Mexico, Argentina, Indonesia and China have CFC regulations in their tax laws.

Incorporation of CFC regulations in the tax laws to counter use of tax-friendly jurisdictions for avoidance/ deferment of tax is encouraged even by the Organisation for Economic Co-operation and Development (OECD) in its report on Harmful Tax Competition.

CFC Regulations – ConceptAs explained earlier, CFC regulations are a broad set of regulations designed to prevent the deferral and avoidance of tax by residents, (including domestic companies) by establishing foreign entities/subsidiaries, in low tax jurisdictions and parking income in those countries. The International Bureau of Fiscal Documentation (IBFD) has explained CFC legislations as under:

“The term is generally used in the context of tax avoidance rules designed to combat the diversion by resident taxpayers of income to companies they control and which are typically resident in countries imposing low-or-no taxation. Under these rules income of the controlled company is typically either deemed to be realised directly

by the shareholders or deemed to be distributed to them by way of dividend. Often only part of the controlled company’s income is dealt with in this way, typically passive income such as dividends, interest and royalties (“tainted income”). Many, but not all controlled foreign company regimes apply only to corporate shareholders.”

Operation of a typical CFC regulation is explained by the following illustration:

India

- Parent company

- Intermediate Holding company

- Operating company

Mauritius 100%

USA 100%

XyZ Inc

XyZ Co.

XyZ Limited

The above is a typical illustration of an organisation structure wherein the CFC regulations may become applicable. In the above case, XyZ Co. is an intermediate holding company established in favourable tax jurisdiction as a holding company for various operating companies in other jurisdictions. The profits earned by XyZ Inc would be distributed as dividend to XyZ Co and parked there to escape higher tax rate in the parent company XyZ Limited’s country, India. Under the CFC regulations, XyZ Co. would be deemed to be a controlled foreign company/corporation and the undistributed income of the same would be taxed in the hands of XyZ Limited, even though actual dividend is not declared by XyZ Co., Mauritius.

CFC Regulations – ApproachesCFC regulations typically have the following approaches

1) jurisdictional approach2) Transactional approach3) Entity-level approach

1) Jurisdictional approachUnder the jurisdictional approach of CFC regulations, foreign companies

set-up by resident companies in low-tax jurisdictions are targeted. Accordingly, where a resident company sets up a subsidiary mainly to act as an intermediate holding company or non-operating holding company in a low-tax jurisdiction, such foreign company is deemed to be a controlled foreign company for the purpose of CFC regulations. In such a scenario, CFC regulations are deemed to be applicable on such foreign companies in low-tax jurisdiction and all the income earned by such foreign companies is taxed in the hands of the resident company.2) Transactional approachUnder the transactional approach, the focus is generally restricted to the passive income earned by foreign subsidiaries of resident companies. Passive income would tend to include incomes like royalty, interest, rent, capital gains, etc.3) Entity-level approachThis is a hybrid approach combining the principles of jurisdictional app-roach and transactional approach. Under this approach, CFC regulations are triggered both when the foreign

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subsidiary is set up in a low-tax jurisdiction and when the foreign subsidiary has passive income stream.

The CFC regulations proposed under DTC 2010 follow the entity level approach.

CFC Regulations – Indian PerspectiveThe Indian tax authorities have woken up to the needs of having CFC regulations as an effective anti-avoidance regulation. DTC 2010 proposes to introduce the CFC regulations to prevent avoidance/ deferral of tax by parking income in tax friendly jurisdictions.

The CFC regulations under DTC 2010 propagate an ‘entity-level approach’. Under this approach, the focus is on the CFC as an entity rather than on its income, although the nature of its income (whether active or passive income) is an important factor in the determination of whether or not the CFC rules apply. Once a foreign company qualifies as a CFC (and none of the exemptions apply), all of the income of the CFC is taxed in the hands of the resident-controlling shareholder on a proportionate basis. The future dividend distribution of the attributed income by the CFC is deductible.

CFC regulations under the DTC 2010 are applicable on all Controlled Foreign Companies. Controlled Foreign companies have been defined to include all the foreign companies which fulfill the following conditions:a) A minimum of 50 per cent control

either by way of equity or voting power is exercised by a resident taxpayer or a significant influence over the foreign company is exercised by such resident taxpayer;

b) Is a resident in tax jurisdiction having an effective rate of tax less than 50 per cent of the rate of tax it would have paid under the

provisions of DTC 2010 if it were a domestic company. Accordingly, if a controlled foreign company is paying tax at an effective rate which is more than 50 per cent of the tax rate applicable under the DTC 2010, then the income of such company would be exempted from the CFC regulations;

c) Shares of such foreign company are not listed on any stock exchange in the foreign country of which it is a resident;

d) The specified income of such foreign company does not exceed R25 lakh or equivalent of such income; and

e) It is not engaged in active trade or business (meaning it only earns passive income).

A company would be deemed to carry on active trade or business if it fulfills the following conditions:i) It actively participates in

industrial, commercial or financial undertakings through employees or other personal in the country of residence of such foreign country; and

ii) The following income constitutes less than 50 per cent of the total income of such foreign company:a) Dividend;b) Interest;c) Income from house

property;d) Capital gains;e) Annuity payment;f) Royalty;g) Sale or licensing of intan-

gible rights on industrial, literary or artistic property;

h) Income from sale of goods or supply of services including financial services to persons controlled by such foreign company or an associated enterprise of such foreign company.

Accordingly, if the foreign

The proposed CFC regulations, when made effective could

have a significant impact on the many corporate houses of India having global presence with likelihood that the profits of their foreign subsidiaries be taxable in India. Given the same, it would be advisable for such companies to review their current business structure and if required, restructure the same to adequately address the challenges which would be posed by the CFC regulations.

company derives a majority of income from onward selling of goods/services to its group concerns only, then in spite of being involved in active trade or business, such foreign company may still be considered as a CFC for the purpose of applicability of these regulations. To illustrate, in the earlier figure of CFC, if XyZ Co. (Mauritius) purchases its goods for XyZ Limited and more than 50 per cent of its income is derived from sales made to XyZ Inc and/or other associated enterprises, then the XyZ Co. would be deemed to be a controlled foreign company and its income would be liable to tax in India.

i) Income from management, holding or investment in securities, shareholdings, receivables or other finan-cial assets;

j) Income falling under the head residuary sources.

If the above conditions are fulfilled by a foreign company controlled by a resident person, then CFC regulations

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would be applicable to such a foreign company. The above can be explained by way of the illustration:

Where E is the number of days during which the foreign company remained a CFC; and

Illustration 2:If in illustration 1 above, XyZ Limited had acquired its stake only on 1st january 2010, then the income would be worked out as under:Specified Income = (2,00,00,000 + 5,00,000 – 20,00,000) X (90 / 365) = (1,85,00,000) X 0.2466 = 45,62,100

Income to be attributed to XyZ Limited = (45,62,100) x (60/100) x (90/90)= 45,62,100 X 0.6= 27,37,260

Way forwardThe proposed CFC regulations, when made effective could have a significant impact on the many corporate houses of India having global presence with likelihood that the profits of their foreign subsidiaries be taxable in India. Given the same, it would be advisable for such companies to review their current business structure and if required, restructure the same to adequately address the challenges which would be posed by the CFC regulations. n

Under the jurisdictional approach of CFC

regulations, foreign companies set-up by resident companies in low-tax jurisdictions are targeted. Accordingly, where a resident company sets up a subsidiary mainly to act as an intermediate holding company or non-operating holding company in a low-tax jurisdiction, such foreign company is deemed to be a controlled foreign company for the purpose of CFC regulations. In such a scenario, CFC regulations are deemed to be applicable on such foreign companies in low-tax jurisdiction and all the income earned by such foreign companies is taxed in the hands of the resident company.

Particulars Conditions fulfilled

Minimum 50 per cent of equity/ voting power in foreign company is held by resident taxpayer or significant influence is exercised by such resident taxpayer

Effective tax rate of foreign company is less than the 50 per cent of tax rate under DTC 2010

Shares of foreign company is not listed on stock exchange in foreign company’s country

Specified income of foreign company does not exceed equivalent of R25 lakh

It is not engaged in active trade or business

Foreign company is CFC for the purpose of CFC regulations

In such case, the income of the foreign company, which would form part of the resident taxpayer controlling the foreign company, would be computed as per the below formula:

Income attributed to resident taxpayer

= A XB 100

XC D

Where A is the specified income of foreign company to be determined as the formula provided;

Where B is the percentage of capital/ voting share or interest held in the foreign company;

Where C is the number of days out of D, voting shares/ interest held by resident taxpayer in foreign company; and

Where D is the number of days, the foreign company remained as controlled foreign company.

The formula to compute the value of A is provided as under:

Specified Income = (A + B - C - D) X E F

Where A is the net profit of the foreign company as per its profit and loss account;

Where B is provisions made for liabilities (other than ascertained liabilities);

Where C is amount of interim dividend paid, if such dividend was not already debited to the profit and loss account;

Where D is the loss which was not earlier deducted while computing income of such foreign company;

Where F is the total number of days in the accounting period of the foreign company.

The above formulae can be explained with the help of the following illustrations:

Illustration 1:XyZ Co is a foreign company. During the Fy 2009-10, its net profit was equivalent of R2 crore. It had made a provision for unascertained liabilities to the tune of R5 lakh. It paid an interim dividend of R20 lakh during Fy 2009-10. During the whole of Fy 2009-10, XyZ Limited held 60 per cent of the total paid up capital of XyZ Co. In such a case, the income to be attributed to XyZ Limited for Fy 2009-10 would be determined as under:Specified Income = (2,00,00,000 + 5,00,000 – 20,00,000) X (365 / 365) = (1,85,00,000) X 1 = 1,85,00,000

Income to be attributed to XyZ Limited = (1,85,00,000) x (60/100) x (365/365)= 1,85,00,000 X 0.6= 1,11,00,000

In the above case, if the income earned by the foreign company, XyZ Co is accumulated by it and remains undistributed, then as per the provisions of DTC 2010, R1,11,00,000 would be added to the total income of XyZ Limited.

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