Author: Dominik Stuiber
As the world becomes increasingly globalized and cross-border activities become the norm, tax administrations need to work together to ensure that taxpayers pay the right amount of tax to the right jurisdiction. A key aspect for making tax administrations ready for the challenges of the 21st century is equipping them with the necessary tools for verifying compliance of their taxpayers.
Against this backdrop, the Base Erosion and Profit Shifting (BEPS) project and the Common Reporting Standard (CRS) was developed in response to the G20 request and approved by the Organisation for Economic Co-operation and Development (OECD). The BEPS project consists of 15 Actions dealing with a comprehensive set of international tax issues of which Action 3 deals with Controlled Foreign Corporations (CFCs) - to prevent corporations from deferring taxation by shifting income into foreign subsidiaries without significant economic substance.
BEPS is a project that aims to fundamentally change the behaviour of multinational organisations with a view to realigning taxation with economic substance and value creation. With the realignment of taxation, loopholes in national tax laws that have been exploited by multinational corporations to avoid taxation will be closed. Legitimate tax avoidance and its strategies deployed by individuals and corporations alike has been the centre of the LuxLeaks and the Paradise Papers. Information on the BEPS implementation in Hong Kong is provided in an earlier article.
CRS – The Common Reporting Standard is the reporting and due diligence regulation to facilitate the automatic exchange of financial account information (AEOI). CRS was developed to enhance international transparency of financial assets held by individuals in overseas accounts or entities. CRS and AEOI requires financial institutions to report account balances and assets held by overseas residents to tax authorities.
Controlled Foreign Companies (CFCs) are subsidiary corporations that are incorporated in a foreign jurisdiction and “controlled” directly or indirectly by domestic shareholders of a given country.
Since the first CFC rules were enacted in 1962, an increasing number of jurisdictions have implemented these rules. However, existing CFC rules have often not kept pace with changes in the international business environment, and many of them have design features that do not tackle BEPS effectively. In response to the challenges faced by existing CFC rules and to harmonize national rules, the Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan, OECD, 2013) called for the development of recommendations regarding the design of CFC rules.
CFC Rules generally aim, as anti-avoidance rules, to include the income of overseas corporations with no economic substance under domestic taxation, often including certain deeming provisions that regards attributable income as distributed. This also follows the general principles of ‘substance over form’. It can be argued that CFCs would likely fall under the domestic tax regime by way of the place of management or control anyway. However, this is a potentially very complex subject and down to individual assessments. Whereas CFC legislation can throw a wider net.
The US has a very comprehensive set of CFC rules attached in Subpart F to the Income Tax Act. Whereas in other countries CFC rules are just breaking ground. The first CFC rules in China were introduced as specific anti-avoidance rules (SAAR) into the Corporate Income Tax Law (CIT) in 2008. But the first enforcement case was only in 2014. Since then however a number of CFC cases were initiated by provincial tax bureaus.
Is the Financial Account Information Reporting under CRS disclosing CFCs?
The existence of a CFC often only comes to the attention of tax authorities if they conduct a thorough tax audit. With CRS being implemented and the automatic report of financial account information of tax residents with overseas bank accounts and other financial assets back to their jurisdiction of tax residence, tax authorities might no longer need to commit substantial resources to investigate. The indicia to successfully enforce CFC rules and collect tax revenues and penalties might now just be one automatic exchange of information away.
For instance, if an entity is to be considered a tax resident of a reportable jurisdiction, the financial account information is to be reported to the relevant tax authorities of the financial institution which will then automatically exchange this information with the tax authorities of the jurisdiction of tax residence. In an earlier article, we explored the CRS Risk of Overseas Managed Companies.
Thus, CRS may assist in disclosing previously unreported CFCs through the exchange of financial account information. The simultaneous development of both standards could potentially mean that tax authorities become aware of a CFC before the owner of the CFC does. Presently, CFC rules are not equally developed and codified around the world and a rapid implementation of OECD’s BEPS causing a change in tax laws may bypass the CFC owner and result in non-compliance.
Case Study - Tax Bureau Enforces Controlled Foreign Corporation (CFC) Taxation
In a recent case, tax authorities attributed undistributed profits of a Hong Kong company to its Chinese parent company based on CFC rules and collected about CNY 7.79 million in taxes. According to the CFC rules, the profits of a CFC established in a low-tax jurisdiction will and must be included in the Chinese corporate shareholder's taxable income in the current year if the CFC does not distribute profits without a reasonable commercial need. A low-tax jurisdiction refers to a jurisdiction where the effective income tax rate is lower than 50% of the CIT rate (i.e. lower than 12.5%).
Case FactsThe HK company was a wholly-owned subsidiary of the Chinese domestic entity and by the end of 2015, had accumulated CNY 31.16 million in undistributed retained earnings. The tax bureau discovered the undistributed profits when it reviewed the foreign investment report and subsequently decided to launch an investigation. Based on the tax bureau’s findings, the HK company's main business was corporate management consultancy while it derived most of its income from dividends and capital gains.The tax bureau further discovered that the HK company did not pay any taxes in Hong Kong due to Hong Kong’s tax regime only taxing profits derived from or arising in Hong Kong from a business or profession. Dividends and capital gains are not subject to profits tax in Hong Kong. Thus, even though the Hong Kong headline profit tax rate is 16.5%, the effective tax rate was much lower.
The tax bureau determined that the deferral of the distribution of profits did not fulfil the “reasonable commercial need’s test”. After several rounds of negotiation, the Chinese taxpayer eventually agreed to pay CNY 7.79 million in taxes.
The cases show a greater willingness of tax authorities to enforce CFC rules. It is however, yet to be seen what the stance of the tax bureaus will be on the matter of economic substance.
Out of the many consequences, one primary concern is that MNEs will need to allocate resources to actively protect their privacy and control what information is exchanged where possible as this is not a given under the applicable regulations. MNEs may be confronted with data privacy issues, regardless of their tax structure.