Analysis of BEPS Action Plan 3 Strengthening CFC Rules

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1 Analysis of BEPS Action Plan 3 Strengthening CFC Rules 1. Introduction Pavan R Kakade* Puneet Putiani** With the increase in globalization and foreign trade in the last century, taxpayers have been resorting to aggressive planning measures to minimise tax costs. Though these planning measures are legitimate, there were certain instances of shifting of profits to low or no tax jurisdictions which has led the authorities to introduce measures to curb the same. While such kind of tax abuse is dealt with by transfer pricing regulations, some jurisdictions also apply a more mechanical rule to counter such tax abuse in the form of CFC Rules. CFC or Controlled Foreign Company Rules aim at taxation in the parent company s jurisdiction, of profits which are parked outside that jurisdiction in foreign companies in low or no tax jurisdictions. Most developed countries have a detailed CFC regime which clearly lay down the parameters for invocation and implementation of CFC Rules. In the Indian context, no CFC regime exists today, although the CFC Rules did form part of the Direct Taxes Code which was proposed to replace the current Income-tax Act, Although the Direct Taxes Code has been scrapped, the CFC regime now exists in an elementary form through the Place of Effective Management residency test for foreign companies. As part of the BEPS Action Plan, the OECD published a discussion draft on Action Plan 3 which deals with strengthening CFC Rules in April 2015 calling for public comments. Post receipt of the public comments, the OECD shall release the final deliverable. In this article, we have analysed the recommendations of the OECD in its discussion draft on Action Plan 3 and how these recommendations can be incorporated in the Indian context while introducing the CFC Rules. * Pavan R Kakade, Director, Tax and Regulatory Services, PricewaterhouseCoopers (P.) Ltd. ** Puneet Putiani, Asstt. Manager, Tax and Regulatory Services, PricewaterhouseCoopers (P.) Ltd. 314 International Taxation Vol. 13 October

2 2. Overview of Action Plan 3 The OECD recognised that CFC Rules is one area where not much work has been done and that the CFC Rules of many countries does not always counter BEPS in an effective manner. Action Plan 3 reads as under: Develop recommendations regarding the design of controlled foreign company rules. This work will be co-ordinated with other work as necessary The discussion draft considered all constituent elements of CFC Rules and articulated five building blocks that are necessary for effective CFC Rules as under: 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 Prior to discussing the above building blocks in detail, the OECD has discussed a few policy considerations to be considered in Action Plan 3 as under: Purpose of CFC Rules The OECD has mentioned that for most countries, the purpose of CFC Rules would be to prevent shifting of income either from the parent jurisdiction or from parent and other tax jurisdictions and long term deferral of income Striking a balance between taxing foreign income and maintain competitiveness A balance must be maintained in designing CFC Rules between taxation of income of foreign subsidiaries and addressing competitiveness concerns. Competitiveness concerns would arise since jurisdictions with CFC Rules would find themselves at a disadvantage against jurisdictions with no or less stringent CFC Rules. Competitive concerns would also arise due to differential treatment of foreign subsidiaries vis-à-vis domestic subsidiaries. To counter such concerns, a few recommendations of the OECD are (i) including a substance analysis to subject taxpayers to CFC Rules only if the CFC did not engage in genuine business activity, (ii) applying CFC Rules equally to both domestic subsidiaries and cross-border subsidiaries, (iii) applying CFC Rules to transactions that are partly artificial, i.e. target even partly artificial transactions, (iv) Explicitly ensuring balanced allocation of taxing power CFC Rules could be permitted to apply more broadly if they could be explained by the need for a country to tax profits arising from activities carried out in its territory Limiting administrative and compliance burdens while not creating opportunities for avoidance CFC Rules need to strike a balance between reduced complexity and administration burden in mechanical rules and the effectiveness of more subjective rules which cause more burden CFC Rules as preventive measures CFC Rules are to be designed to act as a deterrent and not to raise significant revenue in the form of additional corporate taxation Scope of base stripping CFC Rules can be designed to prevent profit shifting from either the parent company jurisdiction (parent jurisdiction base stripping) or from any foreign company jurisdiction as well (foreign jurisdiction base stripping) Avoiding double taxation Double taxation concerns need to be addressed discussed in detail later CFC Rules and transfer pricing Although both, the CFC Rules and transfer pricing rules, operate in a similar field, one set of rules does not eliminate the need for the other set of rules. Neither set International Taxation Vol. 13 October

3 of rules fully captures the income that the other set of rules intends to capture. The discussions on the various building blocks have been analysed in the ensuing paragraphs. 3. Definition of a CFC The first element which needs to be discussed is what or which kind of an entity constitutes a CFC. In this context, the recommendations of the OECD are as under: Although the name CFC suggests that the CFC Rules would apply only to corporate entities, the definition of CFC should include within its scope other entities such as partnerships, trusts etc. In case CFC Rules are only extended to corporations, it could be possible to escape CFC taxation merely by changing legal form of subsidiaries CFC Rules should also apply to a PE in a case where the residence country where the parent of the PE is situated, applies the exemption method to the income of the PE A modified hybrid mismatch rule should be included where intra group payments should be covered under CFC Rules if the payment would have otherwise been included in CFC income if the parent jurisdiction had classified the entities and arrangements in the same way as the payer or the payee jurisdiction. 4. Threshold requirements The next element which needs to be considered is the level of threshold beyond which attributable income of an entity should be categorised as a CFC income and the CFC Rules should apply. In this context, the OECD discussed various approaches as under: De minimis threshold As per this approach, a de minimis amount of income is set and entities earning income or entities having attributable income lower than such threshold are not treated as a CFC. Such an approach would be beneficial from an administrative and compliance burden perspective. For eg: a country may have a rule whereby attributable CFC income is not taken into account if the income is Iess than 5% of the total income or USD 10,00,000 whichever is lower. However, given that the de minimis threshold can be circumvented by fragmentation, ie splitting of income of the CFC into various entities or CFC s, it is necessary to incorporate suitable anti-abuse rules in the CFC Rules. Possible anti-abuse rules could be whereby income of all CFC s in a particular jurisdiction is clubbed with a rebuttable presumption that the principal purpose for separately managing various CFC s or entities is to circumvent CFC Rules. Anti-avoidance requirement An anti-avoidance threshold requirement would only subject transactions and structures designed for tax avoidance to CFC Rules. Such a threshold being too narrow may not be effective in tackling BEPS and would increase the administrative and compliance burden since such a threshold is very subjective and requires in-depth verification and analysis. Low-tax threshold Most countries apply a low-tax threshold since it provides certainty to taxpayers and reduces the administration and compliance burden. However, at the same time, such a threshold does not counter BEPS arising on account of profit shifting from high tax jurisdictions to medium tax jurisdictions. A low-tax threshold can be applied by a jurisdiction on a case-to-case basis or by incorporating a negative or a black list of lowtax jurisdictions. A low-tax threshold would require that the CFC is paying tax either below (i) a fixed rate which is considered as a low tax, eg: 15% or (ii) a percentage (say 60%) of the tax the CFC would have paid had it been a resident in parent jurisdiction. Whichever option is adopted, the threshold 316 International Taxation Vol. 13 October

4 or benchmark should be meaningfully lower than the tax rate in parent jurisdiction. The threshold needs to be compared to the tax payable by the CFC. This is done in one of the following ways, by comparing the threshold to (i) the statutory tax rate in CFC jurisdiction or (ii) the effective tax rate paid by CFC. It is recommended that the second approach, ie the effective tax rate approach is adopted since the first approach can lead to circumvention of CFC Rules by locating the CFC in a jurisdiction with a medium tax rate but plenty of exemptions in tax base. Further, in calculation of the effective tax rate, the tax base needs to be computed as per the laws or rules in the parent jurisdiction or according to an international accounting standard or IFRS, since considering the tax base as per CFC jurisdiction would equate the effective tax rate to the statutory tax rate. The OECD also discussed the various approaches to calculation of effective tax, ie income-byincome, company-by-company or countryby-country basis and recommended that the company-by-company basis would be the most effective. The OECD recommends that the low-tax threshold with the effective tax rate approach should be adopted. 5. Definition of control The next element for discussion is the definition of control. This element is important since CFC Rules should not be applied to entities not having control or influence over the CFC but merely a shareholding in the CFC. Type of control Legal control This type of control looks at the percentage holding of share capital or percentage of voting rights in a subsidiary. Such type of control can be easily circumvented through avoidance structures and hence countries usually focus more on economic control. However, tests such as entitlement to acquire shares, contingent rights (eg: options etc) help mitigate some weaknesses of legal control. Economic control This type of control recognises that a person can control an entity through entitlement to underlying value of company even where the person does not hold majority of the shares. This control may result in rights over proceeds of company either at time of distribution of profits or winding up. This control is a majorly mechanical test which can be determined in an objective manner. However, even such kind of control test can be circumvented through insertion of new group holding companies. De facto control This type of control is similar to the residency test and looks at the test of control and management over the CFC, ie who takes the top-level decisions or who exercises dominant influence over the CFC. Thus, such a test is very factual and hence requires significant analysis resulting in added costs, complexity and uncertainty for taxpayers. Further, based on countries experience in operating residency rules, such kind of control can also be circumvented easily. Control based on consolidation This type of control looks at whether the CFC is consolidated in the accounts of the parent company in accordance with the IFRS or the accounting standards. This type of control will not provide very different results from the legal or the economic control since the criterias for consolidation are usually similar to the legal or economic control test. Basis the above discussion, the OECD has recommended adoption of a combined International Taxation Vol. 13 October

5 rule which focusses on atleast legal and economic control. Level of control The next question for consideration is how much control needs to be maintained for the CFC Rules to apply. The OECD mentioned that to catch all cases where control is exercised to shift profits to a CFC, the CFC Rules would need to capture situations where the resident shareholder has more than 50% control (ie legal or economic as discussed above). In case the resident shareholder owns 50% or less, the holding company can still exert influence in certain situations and hence, the resident shareholder may not have the necessary control. The next question for consideration is how to determine whether more than 50% interest is held by the resident shareholder. In case a single shareholder holds more than 50%, the threshold is clearly met. However, in cases where minority shareholders act together to exercise control, an acting-in-concert test may need to be applied, which is a fact based analysis as to whether the shareholders together have influenced the CFC. If yes, their interests are aggregated for the purposes of checking the control test. However, this approach is not very common since it creates significant administrative and compliance burdens. The second way of determining whether minority shareholders are acting together is to look at the relationship of the parties and include the interests of all the related parties when determining the 50% threshold. Such an approach would be less fact based and also address most of the BEPS concerns. The third way of determining whether minority shareholders are exerting influence is to impose a concentrated ownership requirement which requires aggregation of all resident shareholders shareholding exceeding a prescribed limit, say 10%. The recommendation of OECD is to not include interest of non-resident shareholders under all the three approaches to reduce complexity. Additionally, the OECD has recommended that CFC Rules should apply to direct as well as indirect shareholding. 6. Definition of CFC Income The next element which the OECD has discussed is the definition of attributable income which is referred to as CFC income. Countries today either adopt a full inclusion system or a partial inclusion system in their CFC regimes. The full inclusion system means all income of a CFC is included in the income of the resident shareholder and hence there is no need for a definition of CFC income. Although such system is more mechanical and results in less administrative and compliance burden, it also results in inclusion of income which may not necessarily be arising from profit shifting or giving rise to BEPS concern. On the other hand, a partial inclusion with suitable attribution rules would be a more appropriate approach. The OECD further mentions that CFC Rules need to be capable of dealing with at least incomes in the nature of dividends, interest and other financing income, insurance income, sales and services income and royalties and other IP income. The OECD mentions that the general principal surrounding partial inclusion system is that highly mobile and passive income such as interest, royalties and dividend should be attributed to the shareholders. The OECD first discusses the general approaches which could be used to define CFC income: Form based analysis This approach categorises CFC income based on its formal classification. This analysis would therefore categorise interest, royalty and dividend as CFC income and exclude sales and services income since the latter would be associated with an active trade or business carried out by the CFC. Although such approach is more mechanical and has the benefits of reduced administrative and 318 International Taxation Vol. 13 October

6 compliance burden, it can be easily manipulated by characterising a passive income as a sales and service income to escape CFC applicability. Further, such an approach would cover all interest, royalty and dividend as CFC income even though such income may have been earned through an active trade or business. Substance based analysis This analysis looks at whether the CFC undertook substantial activities to earn the income. Substance analysis could take either of following forms: Substantial contribution analysis This would be a threshold test and entities or CFC s would be factually tested to determine whether their employees have made substantial contribution in earning income for the CFC. If the threshold is fulfilled, no income would be attributed to the CFC. Viable independent entity analysis This analysis would include looking at all the significant functions carried out by the entities within the group and determining whether the CFC is the entity most likely to own the necessary assets, carry out the necessary functions and undertake the necessary risks to earn the income. If it is not likely that the CFC should own a particular asset, the income associated with that asset should be included in CFC income and accordingly taxed in the resident shareholder company. One of the major advantages of the viable independent analysis is that it can be used in the context of IP related profits since the analysis would cover whether the CFC is the appropriate entity to hold the IP. Also, another advantage of this analysis is that it is similar to a transfer pricing analysis which the resident shareholder would any way be undertaking, thereby reducing additional compliance. However, this approach is generally very fact specific and requires element of judgment which makes it administratively burdensome. Employees and establishment analysis This approach uses the employees and establishment as a more mechanical way and benchmark. This approach involves comparing the employees and establishment available in the CFC with the employees and establishment which would ideally be required to earn the income earned by the CFC. In case the CFC does not have the requisite employees and/or establishment as per the analysis, the income is included in the CFC income. This approach is more mechanical and less fact intensive as compared to the viable independent entity analysis. However, one disadvantage of this approach is that it is difficult to ascertain the ideal requirement of employees and establishment to earn the income, thereby making the comparison difficult. Both the second and third approaches can either be applied as a threshold or proportionate tests. In case the approaches are applied as a threshold test, the fulfilment of the level of activities or employees or establishment as required by the approach would remove all CFC income from the rigours of taxation. Conversely, the failure to fulfil the level of activities/employees would trigger taxation for all the income. In case however, the approaches are applied as a proportionate test, only the proportionate income between the comparative level and the actual level would be subject to CFC taxation. Although the proportionate test is more burdensome, it ensures that only the income that arose from BEPS is attributed. International Taxation Vol. 13 October

7 The OECD has next discussed how CFC Rules can accurately attribute income that raises BEPS concerns: Dividend The OECD has mentioned that dividend income should first be treated as passive income but then excluded from CFC income if it was paid out of active income (or by related parties out of active income) or if the CFC were in the active trade or business of dealing in securities. This would require a factual analysis of whether the CFC was carrying out an active business. The dividends should be exempt in the resident shareholder jurisdiction if the dividends would have been exempted if directly earned by the resident shareholder. Interest and other financing income Interest and other financing income should first be treated as passive but then excluded from CFC income if the CFC was in the active trade or business of financing and it was not overcapitalised. This would require a factual analysis of whether the CFC was carrying out an active business of financing and whether the CFC was overcapitalised or not. Insurance income Income from insurance will generally be treated as active (and therefore excluded) unless (1) the income was derived from contracts or policies with a related party or (2) the parties to the insurance contract or the risks insured were located outside the CFC jurisdiction. However, income from insurance that falls under these two exceptions will only be treated as passive (and therefore included) if the CFC was overcapitalised or did not have sufficient substance to assume and manage the risks on its own accord. This would require a substance analysis to determine if the CFC was overcapitalised or did it have substance to manage risk on its account. Sales and service income, royalties and IP income Due to the particular difficulties or challenges posed by IP income (such as easy to disguise, highly mobile etc), all sales and services income including IP income should be treated as passive unless the CFC has engaged in substantial activities to earn the income. The OECD has next discussed two different approaches that jurisdictions could use to accurately attribute income earned by a CFC: Categorical approach This approach basically means having separate set of attribution rules for different incomes as discussed above. The advantage of this approach is that each type of income is treated accurately. However, since such approach requires a substance analysis for accurate attribution, it increases the administrative and compliance burden. Excess profits approach This involves a more simpler and mechanical approach and is intended to target situations that give rise to BEPS by characterising as CFC income excess profits in low tax jurisdictions. There are different views on the excess profits approach 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. An excess profits approach must calculate the normal return and then subtract this normal return from the income earned by the CFC. The difference is the excess return, all of which is treated as CFC income. The normal return would be calculated as (rate of return) x (eligible equity). The rate of return would generally be a risk free return increased by an equity premium. 320 International Taxation Vol. 13 October

8 The OECD has suggested four alternatives to determine a rate of return: A fixed percentage such as 10% - simpler but less accurate A 10 year government bond yield in the parent jurisdiction increased by a fixed equity premium of 5% or 7% - more complicated but more accurate on a country by country basis The group s cost of capital as per capital asset pricing method (CAPM) or any other accepted calculation more accurate for individual groups but more complex for administration Alternative approach in which first or second approach is available by default but groups could opt to use their individual cost of capital increases accuracy for some groups and reduces compliance burden for ones selecting simpler option. In calculation of the eligible equity, only equity invested in assets used in the active conduct of a trade or business, including IP assets, should be treated as eligible equity. Further, one way of calculation of eligible equity would be to use the book value of eligible assets less the liabilities apportioned to the eligible equity. The excess profits would be calculated as the CFC income not subject to tax under other CFC Rules less the normal return as calculated above. With respect to substance based exclusion, as mentioned above, countries have different views. The OECD has recommended that those jurisdictions which are of the view that excess profits approach can attribute income which is not on account of profit shifting, can include a substance based exclusion in the excess profits approach. The OECD has lastly discussed whether CFC Rules should apply an entity or transactional approach. Once income has been determined to be within the definition of income to be caught by a CFC regime, the next question is how CFC Rules should attribute that income. CFC Rules generally take one of two approaches to this question: the entity approach, which attributes income entity-byentity, and the transactional approach, which attributes individual streams of income. Under the entity approach, an entity that does not earn a certain amount or percentage of attributable income or an entity that engages in certain activities will be found not to have any attributable income, even if some of its income would be of an attributable character. Under the transactional approach, in contrast, the character of each stream of income is assessed to determine whether that stream of income is attributable. The difference between the two approaches is that, under the entity approach, either all or none of the income will be included depending on whether the majority falls within the definition of CFC income. Under the transactional approach, some income can still be included even if the majority does not fall within the definition of CFC income, and some income can be excluded even if the majority does fall within this definition. 7. Rules for computing income The next element is the rules for computing the income. In this context, the OECD has first discussed the aspect as to which rules should be used to compute the taxable income. The OECD has provided 4 options: The law of the parent jurisdiction (i.e., the jurisdiction that is applying the CFC Rules), which would be logically consistent with BEPS concerns particularly if CFC Rules focus on the erosion of the parent jurisdiction s tax base. This option would also reduce costs for the tax administration. The law of the CFC jurisdiction, but this would be inconsistent with the goals of International Taxation Vol. 13 October

9 Action Plan 3 as using the CFC jurisdiction s rules may allow for less income to be attributed. Allow taxpayers to choose either jurisdiction s computational rules, but this is likely to create opportunities for tax planning. Compute income using a common standard, such as IFRS or any internationally accepted accounting standard The OECD has recommended the first option since the same is consistent with the goals of the Action Plan 3. The second aspect for discussion was as to whether any specific rules are necessary. In this context, the OECD has recommended that a specific rule limiting the offset of CFC losses should be incorporated so that such losses can only be set off against the profits of the same CFC or against profits of other CFC s in the same jurisdiction. 8. Rules for attributing income The OECD has recommended rules for the different steps for income attribution as under: Which taxpayers should have income attributed to them 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 How much income should be attributed The amount of income to be attributed 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. Some jurisdictions attribute the entire portion of income based on ownership on the last day of the year. Whilst this could lead to inaccurate attribution and could create opportunities for tax planning, this may accurately capture whether or not the taxpayer was able to influence the CFC if voting or other power is determined based on ownership on the last day of the year. Other jurisdictions attribute income based on the period of ownership, which results in taxpayers being taxed on an amount that is similar to their actual share of the CFC profits When the income should be included in the returns of the taxpayers and how the income should be treated Jurisdictions can determine when income should be included in taxpayers returns and how it should be treated so that CFC Rules operate in a way that is coherent with existing domestic law. What tax rate should apply to the income The tax rate of the parent jurisdiction should be applied to the income. 9. Rules to prevent or eliminate double taxation In the context of CFC Rules, double taxation can arise in a few situations. Such situations along with the recommendation of the OECD for each situation are discussed below: Situations where the attributed CFC income is also subject to foreign corporate taxes To address the situation where the CFC income is subject to taxation in both the CFC jurisdiction and the parent jurisdiction, the OECD has recommended providing for an indirect foreign tax credit that credits taxes that were incurred by a different taxpayer. Situations where CFC Rules in more than one jurisdiction apply to the same CFC income An indirect foreign tax credit could be applied in this situation but in order to provide such a credit countries may need to change their double taxation relief provisions in order for CFC tax paid in an intermediate country to qualify as a foreign tax eligible for relief. 322 International Taxation Vol. 13 October

10 There should also be a hierarchy of rules to determine which countries should have priority, and this hierarchy could prioritise the CFC Rules of the jurisdiction whose resident shareholder is closer to the CFC in the chain of ownership. Situations 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 of OECD for addressing this 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. 10. CFC Rules in India in Direct Taxes Code Below is a brief summary of the CFC Rules which were proposed to be implemented in India vide the Direct Taxes Code and the comparative OECD recommendation in its Action Plan: The definition of CFC covered only a foreign company and no other forms of entity whereas as per the OECD, the CFC Rules should also apply to partnerships, trusts and permanent establishments A foreign company would qualify as a CFC only if it was a resident of a territory with lower rate of tax. The lowtax threshold was 50% of the tax that would have been paid by the foreign company as a domestic company per the DTC. Further, the foreign company s shares should not have been listed on any recognised stock exchange. As per the OECD as well, a low-tax threshold should be introduced in the CFC Rules; the OECD does not recommend any test with respect to listing of shares The control tests had a legal and economic control test (in the form of shareholding, dominant influence, access to income etc) and the control threshold was 50%. The OECD s has also recommended a similar test of control. An additional condition for an entity to qualify as CFC was that the entity should not be engaged in an active trade or business - hence any entity having an active trade or business would not be considered as a CFC for any stream of income whereas the OECD has not included the test of active trade or business in the definition of CFC. The OECD however has included such test in considering whether a stream of income should be attributed to the CFC. The CFC Rules had a full inclusion system and hence all income of a CFC would be taxable in India while the OECD has not included a full inclusion system since the same would result in higher income to be attributed to the CFC than which would raise BEPS concerns. The OECD has recommended a partial inclusion system with rules/approaches to attribute income to the CFC. 11. Conclusion The aforementioned recommendations of the OECD will be finalised in a final report after considering the public comments. Compared to the recommendations in the other action plans, it would be comparatively easier to incorporate the recommendations under this action plan since this would only require amendments in the domestic tax law and not any tax treaty. Nevertheless, significant amount of work and attention would need to be given to each building block or parameter as mentioned in International Taxation Vol. 13 October

11 the OECD discussion draft. As can be seen from the aforesaid discussion, the CFC Rules in India in the Direct Taxes Code were at a nascent level and would require a lot of fine-tuning and streamlining to be in line with the recommendations of the OECD. Lastly, in the Indian context, given that the amount of overseas investment by Indian entities or companies is currently not significant, the introduction of CFC Rules may not be of immediate relevance. However, given the anticipation of growth of Indian economy and correspondingly overseas outbound investment, it is important to understand these recommendations of the OECD and also plan the businesses for the same. i 324 International Taxation Vol. 13 October