Anti-Tax Avoidance Measures and Controlled
Foreign Companies: - An Analysis of the US Rules from the UK Legal Perspective"By
Dr. George L. Salis** Dean
George L. Salis, PhD. LLM, LLB (Hons), BS, CMA, RFA, MFP Mas. Fin. Prof. , CEPA
Dean and Programme Director, Legal Studies Dept., Keiser College, CEO & Principal
JurisConsults International Group, LLC Member: ABA, IBA, London Court International
Arbitration, Royal Society of Fellows Florida,USA. Member: ABA, IBA, London Court
International Arbitration, Royal Society of Fellows. I. Introduction
This short treatise comprises a comparative examination of the Controlled Foreign
Corporation, or CFC rules of two countries: the US and the UK. It examines their
purpose, necessity, and practicality in a "new" global economy. As foreign
companies can be used effectively as vehicles to avoid or evade taxes, countries
around the world, especially those which are contracting members of the Organisation
for Economic Co-operation and Development (OECD), have devised complex set of
anti-avoidance rules specifically designed to curve and eradicate tax avoidance
practices by individual and company taxpayers, and thus, effectively confronting
the growing economic menace presented by tax havens, and their harmful tax competition.
The proposition presented here is that tax avoidance (and evasion) practices,
such as using CFCs to avoid tax, are, per se, inequitable and unfair, as these
practices violate the principles of tax equity among citizens of the same nation,
as well as the principles of inter-nations equity, by seriously undermining the
economic balance of regions, their economic development and sustainability through
the erosion of a country's tax base. Therefore, it can be safely concluded
that tax avoidance is not only inequitable, but also violates tax neutrality systems
and poses severe hazards to the economic, social, and political infrastructures
of nations and the economic efficiency of countries and regions. The arrival of
the global economy has changed the infrastructure of countries, and it has moved
nations from internal economic nationalism to external international economic
co-operation and towards integration. Thus, elimination of borders, boundaries,
and barriers in all economic sectors has now become a reality. Together with the
advent of greater telecommunication technology capabilities, the availability
of opportunities now exists to accumulate assets throughout the world and to keep
them beyond the sight of most domestic revenue authorities. Both the US
and the UK are the world's principal and most authoritative "global"
tax systems. This means that in taxing income, their trans-national character
tends to focus more upon the "status" of the taxpayer as opposed to
the type of income earned, or whether the income is foreign or domestic . Global
tax systems tend to emphasise less, and make fewer distinctions, on the type of
income earned abroad, and are inclined to subject all income to taxation at the
same rate. Global tax systems, also known as "unitary" systems, stress
the status of the taxpayer, then connects the taxpayer to the taxing country by
citizenship, residency, or some other standard, by which the taxpayer must then
pay a tax on its global income. The other important system of taxation present
in the world today is known as the "schedular" system. This system emphasises
more the distinction and categorisation of income in accordance to its source,
whether it is dividends, capital gains, sales of goods, or professional services.
Many European and Latin American countries prefer to be classified as schedular
tax jurisdictions. Therefore, global systems of taxation are said to be "domiciliary,
territorial, or residence" based jurisdictions, whereas the schedular systems
are considered "source" based jurisdictions, as these are more concerned
with the source or origin of the income itself. In fact, the number of nations
joining the ranks of global tax jurisdictions is increasing. This is occurring
more as international organisations, such as the OECD, promote tax co-operation
and harmonisation and as the numbers of international tax treaties, which are
designed to prevent double taxation, also multiply. Although the tax codes of
both the US and the UK do distinguish between some kinds of income, they are unusual
among jurisdictions to tax their citizens on their world-wide income, regardless
of residence. Early on, in 1924, the United States Supreme Court, in the case
of Cook v Tait, held that taxation of US citizens abroad, on their world wide
income, violated neither the US Constitution, nor the principles of international
law . The Supreme Court justified its rationale by explaining that the advantages
and benefits of citizenship extended well beyond territorial boundaries. As
most nations of the world will continue to tax their citizens and residents, whether
individuals or companies, on a world-wide basis, all income earned abroad must
be accounted in order to assess tax fairly and to maintain an adequate well-diverse
tax base. If taxpayers of one country can keep certain assets concealed, or at
least beyond the sight of their country's tax authority, those taxpayers are able
to exclude such assets or income from their yearly tax liability for an indefinite
period of time. Even if taxpayers are "candid" about their earnings
and intend to declare all income earned abroad, they will nevertheless, attempt
to minimise their tax liability in as much as possible through the use of foreign
base entities. We are here reminded once again, that generally the mind-set of
most taxpayers anywhere is to arrange their affairs in such ways as to minimise
their tax obligation, as much as possible. This long held belief can be seen of
in landmark cases such as the UK's Inland Revenue Commissioners v Duke of Westminster's
Case. In most jurisdictions, when a taxpayer conducts business in another
country outside its own tax home base, that foreign income earned will be taxed
in some way. That tax imposed, however, will depend upon the type of business
conducted, the manner in which the business was conducted, and how was that business
conducted, that is, the type of entity or organisational vehicle used to conduct
business abroad. In some cases, depending on a country's network of international
tax treaties with other jurisdictions, and upon treatment of foreign transactions
by its domestic tax rules, such tax may be reduced by tax credits, or it may be
exempted altogether. At times, it may be deferred until a later time when some
connected (taxable) event occurs such as distribution to shareholders, dissolution
or sale of the company, etc. Regardless of jurisdiction, when taxpayers operate
in low tax jurisdictions, not only do they enjoy so-called "tax holidays,"
but they may also enjoy a deferment in paying those taxes. Such is the case in
the US, the UK, and other developed nations. Consequently, when companies and
individuals operate abroad, they may be able to avoid taxation of that foreign
income or minimise it greatly to the point of escaping most, if not all, of the
taxes due in any particular year. Needless to say, when individuals or companies
operate other entities or companies in jurisdictions that are classified as a
tax havens, or considered to be havens by other countries, then those taxpayers
will not escape taxation of the income earned abroad, but they will also be able
to avoid taxes on the income earned by the accumulation of their assets kept abroad. It
is essential that the deferral principle is introduced here, since the CFC rules
that regulate foreign company income could not possibly function effectively without
it. The principle of deferral, which was first introduced in America, characterises
the consequence of treating the foreign subsidiary as a complete and separate
foreign legal entity and taxpayer. This means that the separate legal (company)
personality of country X is respected regarding domestic tax purposes in country
Y and that no domestic taxes will usually be imposed on those foreign earnings,
until some later time. At that later time, such income will be taxed in some form
by the country of residence of the company, by the country of the stockholders,
or as provided by treaty under the exemption method or the credit method. The
deferral system, when coupled with the exemption and credit methods, become the
most efficient manner currently in use for the elimination of economic or juridical
double taxation. The deferral approach is used as a rule of convenience world-wide,
and it has been adopted by the US, the UK, Canada, and other capital-exporting
nations to treat foreign company income. It has also become important concept
in the realm of international commerce, trade, and economics.
II. UK
/ US Statutory and Regulatory Analysis
Unlike the United States, which deals
with CFC in a single body of tax regulations, the UK has now consolidated and
codified its CFC regulations into a single body of legislation. Originally enacted
in 1984, the UK's CFC legislation was eventually consolidated into what is now,
the Income and Corporation Taxes Act 1988, (ICTA) Chapter IV, §§ 747-756,
and Schedules 24-26. Altogether these are known as the Taxes Acts, (or TA 1988).
In the US, CFC regulation can be found particularly in Part III, Subpart F, Internal
Revenue Code (I.R.C.) 26 U.S.C.A. §§ 951-960. The UK CFC legislation,
similar to its US counterpart, has been primarily enacted to discourage companies
from redirecting income outside the UK in order to avoid taxation of their foreign
base income. Although the anti-avoidance purpose and objectives are very similar
indeed, the focus and approach are distinct in substance, and quite different
in procedure. The first major difference in the approach of these two systems,
is the model each use. Many, if not most, of the US trading partners in Europe
and elsewhere, tend to conform much more to the OECD Model Treaty. However, the
US, although a contracting member of the OECD, is inclined to follows its own
(US) Model Income Tax Treaty. Although first glance the CFC rules of the
UK and the US appear similar in substance, this can be misleading, as the procedure
in these two systems are vastly unlike. For example, the US rules, contained in
sections 951-960 IRC, are a strictly a creature of legislation, although aided
at times by case law. In Britain, many of the key concepts and definitions have
been kept outside the legislation, kept in their original common law explications,
and are left Courts for interpretation, almost the reverse of their American counterpart.
These differences will be discussed below without the necessity of outlining the
entire code, or legislation, whilst still highlighting their major differences
and similarities. The UK continues to amend its CFC rules in order to deal
more effectively with its internal tax avoidance dilemma and the harmful tax competition
caused by low tax jurisdictions and "tax havens" that are currently
British Territories, or former colonies. It does so in response to the continuing
development of the OECD's effort to eliminate harmful tax competition and due
to the continuing supra-national unification endeavours of the European Union
(EU). Although minor amendments to the CFC rules have been made since 1984, the
most remarkable and radical changes were made in 1998, and the ensuing years.
The most significant of these 1998 modifications to the CFC legislation, is that
it now functions automatically, and it is self-enabling. It no longer needs pre-requisites
or any further direction by Inland Revenue, as covered in the provision in made
in section 743(3) of the Act. However, unlike the US, which specifically
defines residency for a corporation, and when is a corporation resident, the UK
rules does not define, or provide a specific answers to this questions. Instead,
these issues are to be determined under regular common law principles of company
law . Thus, the law regarding the determination of a company's residence can be
found in the landmark case of De Beers Consolidated Mines Ltd. v Howe, and the
law determining dual residency, appeared in Swedish Central Rlwy Co.Ltd, v Thompson,
in Union Corporation Ltd v IRC. and in Unit Construction Co. Ltd v. Bullock. Furthermore,
since many aspects of the law are unclear as to definition and requirements of
residency, guidance may also be found in the published Practice Statements of
Revenue. For example, concerning residency and CFCs, in Practice Statement SP
1/90, emphasised that in the UK, the company residence issue is ultimately a matter
of fact, and as such, it must be in accordance with case law. This common law
approach to residency also applies in the determination of the residency of the
persons exercising control of the company or any CFC in question. Although
this legislation does not as a matter of statute determine whether or not a company
is resident in the UK, it does, however, provide a definition of a non-resident
company. Section 749(1), TA 1988, provides that a non-resident company in the
UK is regarded as resident of the territory or jurisdiction where it is liable
to tax, that is, its home tax-base, by reason of domicile, residency, or place
of management. This test is at times problematic since a company may be resident
in various territories or countries at the same time. When a company is resident
in various territories at the same time, the test is that a company is deemed
to be resident of the place of its "effective management." If the management
is divided between two places, then, the company is regarded as resident of the
place where the greater amount of the company's assets are held. Unlike
the rules in the US, and crucial to understanding the UK's CFC rules, is the significance
of the requirement of "subject to a lower level of taxation," as provided
in section 750(1). This requirement is central to the UK rules, as it key to the
definition a CFC in the UK. In order to calculate the amount of corresponding
UK tax and the local tax, the company's profits must first be calculated. Thereafter,
any local taxes must be determined, which is; the amount of taxes due in the place
where the company is resident. Then, a calculation is made on what the UK rules
calls "chargeable profits," and what is the corresponding UK tax on
those profits. If the local tax is less than three quarters of the corresponding
UK tax, the company is regarded as being subject to a lower level of taxation,
triggering automatically the (new) CFC regulations. Since in the UK the income
tax rules also apply in the computation of corporate tax profits, the result is
a calculation by cases and schedules of a foreign company's income. Consequently,
for the purpose of CFC rules, the result is that the corresponding UK tax is what
the chargeable profits would be, given certain additional assumptions plus the
exclusion of any double tax relief attributable to local tax and the deduction
of any UK tax already paid by the company. Therefore, unlike the US rules, which
looks at stock percentage, and/ or interest ownership in the corporation, to determine
what constitute a CFC, the UK rules look towards the place of effective management
controlling the company's residency, and more importantly, to the lower level
of taxation requirement / test, in order to determine whether a company is, or
is not, a CFC. Whereas in the US it is often simpler to determine whether
a corporation is a CFC, as these are based on a prescribed formula of ownership,
in the UK the complexity of the rules makes this a more difficult task. In the
US, the Code's test for determining whether or not a foreign company or corporation
is a CFC lies in the direct or indirect ownership and in constructive ownership.
Under the US rules, a corporation is a CFC, if US shareholders own more than 50%
of the total combined voting power of its stock, or more than 50% of the stock's
total value. This US treatment of attributing ownership of shares is the same
for foreign partnerships or trusts that own shares in foreign corporations. Section
957(a) requires that ownership must be attributed to the partners or beneficiaries
accordingly. However, though similar to the US in some ways, the UK's method
of chargeable profits and/or creditable tax to the CFC, is apportioned among the
persons, whether resident in the UK or not, who had an interest in the CFC at
any time during the accounting period under examination. The basis of an apportionment
is made broadly and follows the interests held in the CFC. The definition of "persons
having an interest" in a CFC includes shareholders and any person(s) who
control the company in any manner, who may participate in distributions, or who
have power to enjoy the company's assets and/or income. Giles Clark, in
his book on UK offshore tax planning commented that: ".Given the complexities
of the rules for determining local tax and the corresponding UK tax, those concerned
with foreign companies can be forgiven for concluding that it is never possible
to predicate with certainty whether a company or is not a CFC" The
new self- assessment provision of UK CFCs complicates matters further. Part XVII,
Chapter IV ICTA 1988 assesses UK resident companies' taxes arising from the income
of certain CFCs in which they have a controlling interest. In the UK, a company
is regarded a CFC, if an overseas company is controlled by UK residents which
would pay less than three quarters of the tax it would have paid on its income
had it been a resident in the UK. These CFC provisions are mainly directed at
companies that make use of low tax (or no-tax) jurisdictions, and/or other favourable
overseas/foreign tax regimes, in order to reduce their UK tax liabilities and
obligations. There also is no single and precise definition of "company"
included in Chapter IV. Therefore, the meaning given by Section 832(1) ICTA applies
here. The definition of "company control" is to be determined broadly
according to Section 416 ICTA 1988. Under the TA 1988, s. 747(1) a company
is a CFC, if it meets three conditions in any accounting period: a) the
company must be resident outside of the UK;
b) it must be controlled by persons
resident in the UK;
c) the company must be subject to a lower level/rate of
taxation in the jurisdiction or territory in which it is resident. Moreover,
in 1998, Section 113 and Schedule 17, of the Finance Act 1998 (FA 1988), amended
the CFC legislation and brought it within "self-assessment." Under self-assessment,
companies in the UK are now required to assess their own CFC liability. This new
requirement will apply to all UK companies for their accounting periods ending
on, or after 1 July 1999, if: (1) they have a relevant and applicable interest
in a CFC, and (2) the accounting period of that CFC, ends within their own
accounting period. In general, the CFC legislation requires that: a)
a computation of the profits (exclusive of capital gains) of a controlled foreign
company for an accounting period, broadly on the lines of corporation tax profits, b)
an apportionment of the profits among those with an interest in the company, then, c)
a self-assessment on tax, by all UK companies to which 25%, or more, of all profits
which have fallen to be apportioned. (Amounts apportioned to associates are taken
into account in calculating whether the 25% threshold is passed, but not in calculating
the amount of tax due.) Tax relief is usually available for any foreign
taxes that the CFC has already paid and also for any other tax allowances to which
any UK company is entitled. Also, any taxes charged under Chapter IV may then
be credited against the UK Company's liability under Case V, in respect of any
dividend(s) paid by the CFC out of the profits, regarding the charge arising from
Chapter IV. Unlike the US, the assessment of a CFC in the UK is determined
from accounting period to period and does not hold such "enduring" CFC
classification, as per the provisions of section 951 IRC. The UK's CFC rules provide
for a number of statutory "exclusions of apportionment" which are designed
to ensure that the provisions in Chapter IV are directed principally at CFCs that
are created and used primarily for the purpose of reducing or mitigating UK taxes.
Thus, a foreign company may not necessarily be a CFC in each of its accounting
periods and it may meet the requirements of exclusion in one accounting period
even if it fails to do so in another. In reality most foreign companies that are
under UK control will not be subject to a charge under Chapter IV of the Act. Accordingly,
no apportionment of profits will be due for any accounting period of a CFC if
during that period the company fulfils any one of the statutory exclusions provided
by the Act. These exclusions (or conditions), outlined below, are designed expressly
as anti-avoidance measures. They are also a sort of anti-deferral regime used
to minimise the abuse or misuse of the foreign company as a vehicle to avoid UK
tax by focusing on the source of profits. a) Excluded Countries Regulations
b)
Acceptable Distribution Policy
c) Exempt Activities Test
d) Public Quotation
Condition
e) De Minimis Exclusion
f) Motive Test a) In order to fall
within the "excluded countries" exemption, a company must be resident
in a jurisdiction listed in either Parts I or II of the "Excluded Countries
Regulations" and also meet the income and gains requirements, as provided
in Regulations 4 and 5 of either part. b) To be included in the "acceptable
distribution policy," a company must pay within 18 months of the end of its
accounting period, a dividend equal to or greater than 90% of its chargeable profits
(broadly taxable profits) to persons resident in the United Kingdom. Rules are
laid down for computing the profits out of which the dividends have been paid.
Restrictions are placed on the payment of dividends out of specified profits,
and there is a scaling-down of the dividend requirement for certain companies
whose shares are partly held by non-residents. There are also specific regulations
dealing with CFCs that conduct insurance business and those that may use an accounting
or fiscal method other than on an annual basis. Moreover, holding companies that
also satisfy (1) and (2) below, and satisfy other specific requirements, e.g.,
regarding the sources of their foreign income, may satisfy the required test. c)
For a foreign company to satisfy the "exempt activities test" a company
must meet three primary conditions throughout the entire accounting period examined,
the company: (1) must have a "business establishment" in its territory
of residence; (2) business affairs must be "effectively managed"
in its territory of residence; and (3) main business must at no time consist
of certain defined activities (for example, investment business).
d)
The "public quotation condition" can be fulfilled if all shares carrying
at least 35% of the voting rights of the company must be held by the public, and
there must be dealings in those shares on a recognised stock exchange. Restrictions
are imposed in respect of shares held by "principal members." e)
In order for the "de minimis test" to apply, the required chargeable
profits of a company must be in the amount of £50,000, or less, in a twelve-month
accounting period. f) For a foreign company to satisfy the "motive
test" for any accounting period, it must fulfil both of the following conditions: (1)
where a transaction(s) reflected in the company's profits in the accounting period
has, or have achieved a reduction in UK taxes, either the reduction was minimal,
or it was not the main purpose, or one of the main purposes, of the transaction(s)
to achieve that reduction; and, (2) it was not the main reason, or one of
the main reasons, for the company's existence in that period to achieve a reduction
in UK taxes by a diversion of profits from the UK. In closely related, but
distinct manner the US also apportions the income taxable to shareholder of CFCs.
For example, if a foreign corporation is considered a CFC for an uninterrupted
period of 30 days or more, during a taxable year, each US holder that owns stock
by the end of that year, must include in income the sum of two major factors:
the individual shareholder's pro rate share of any subpart F income plus any earnings
of the CFC invested in US property . In fact, the IRS treats US shareholders as
having obtained a current distribution from Subpart F income plus any foreign
earnings invested in US property. Unlike the US, the UK's CFC regulations
actually provide for a list of Exempt Activities and Forbidden Businesses. A CFC
is conducting exempt activities if its main business falls outside of certain
proscribed and forbidden fields and if it satisfies two conditions as to the way
the business is conducted. These two conditions are that: 1) the company
must have a business establishment in the place in which it is resident;
2)
its business affairs in that territory must be effectively managed there. Thus,
if the company avoids the forbidden businesses and earnestly operates where it
is resident, the exempt activities requirement is satisfied. The forbidden businesses
included in Schedule 25, paragraph 6(2), of the Act, are: a) Investment
business,
b) Dealing in goods for delivery to or from the UK, or to or from
connected or associated persons,
c) Wholesale, distributive, or financial business
if 50% or more of the gross trading receipts are derived from connected or associated
persons or from persons to whom 25% or more of the company's profit would be apportionable.
These forbidden practices or measures are taken as to prevent the easy
transfer of assets and/ or funds to or from the UK that would circumvent the quick
(or disposable) mobility of such assets in order to avoid tax. Last, we
shall examine the structure and regulation of foreign holding companies in both
countries, as these are frequently used tax avoidance vehicles. Although both
jurisdictions deal with foreign "holding" companies, their approach
to regulating them, as to prevent the use of tax avoidance schemes, is highly
different. The use of foreign holding companies as "base" business structures
for tax avoidance has increased dramatically around the world in the last thirty
years. Principally, many these companies are used as an income and asset "storage
facility" to keep foreign earned income out of the sight and reach of revenue
authorities. Together with the added features of income and/or asset mobility,
and easy transferability, these holding companies can make efficient mediums for
avoiding taxes, and consequently, revenue authorities must regulate their use
and operation in order to circumvent any potential tax avoidance scheme. In
the US, the Internal Revenue Code of 1986 (IRC) and its subsequent amendments
comprise the Internal Revenue Code of the United States. Part III, of the Code,
entitled "Income from sources without the United States" contains Subpart
F, which is the body of legislation dealing with controlled foreign corporations
in the US, particularly Sections 951-964, which contain specifically the CFC rules.
Principally, subpart F is levelled at two kinds of foreign income: passive investment
income and any income deriving from related or associated corporations or companies
that are using a foreign base company to allocate income away from its associated
entities in the high-tax jurisdictions. For purposes of this proviso the
term "subpart F income" means, in the case of any CFC, the sum of: (1)
insurance income (as defined under section 953),
(2) the foreign base company
income (as determined under section 954),
(3) an amount equal to the product
of:
(a) the income of such corporation other than income which:
(i) is attributable
to earnings and profits of the foreign corporation included in the gross income
of a United States person under section 951, or,
(ii) is described in subsection
(b), multiplied by, (b) the international boycott factor (as determined
under section 999), (4) the sum of the amounts of any illegal bribes, kickbacks,
or other payments (within the meaning of section 162(c)) paid by or on behalf
of the corporation during the taxable year of the corporation directly or indirectly
to an official, employee, or agent in fact of a government, and, (5) the
income of such corporation derived from any foreign country during any period
during which section 901(j) applies to such foreign country.
As stated
before these two types of incomes can be easily transferred between jurisdictions
in order to minimise or avoid taxation. What the IRC calls Subpart F income is
comprised of: foreign base company income (which is the most significant of these),
income arising from insurance derived from US risk activities, income arising
from countries engaged in international boycotts, and definite illegal payments,
such as bribes, etc.
Foreign base company income is actually defined in the
five main categories as provided in section 954 IRC.
a) Foreign Personal
Holding Company (FPHC) - defined in section 954(a)(1)-(c). Which states that for
purposes of subsection (a)(1), the term "foreign personal holding company
income" means the portion of the gross (passive) income which consists of: (a)
Dividends, etc, (Dividends, interest, royalties, rents, and annuities).
(b)
Certain property transactions,
The excess of gains over losses from the sale
or exchange of property, which:
(i) which gives rise to income described in
subparagraph (A) (after application of paragraph (2)(A)) other than property which
gives rise to income not treated as foreign personal holding company income by
reason of subsection (h) or (i) for the taxable year,
(ii) which is an interest
in a trust, partnership, or REMIC, (real estate mortgage investment conduit) or,
(iii)
which does not give rise to any income. (c) Commodities transactions
(d)
Foreign currency gains
(e) Income equivalent to interest
(f) Income from
notional principal contracts-
(g) Payments in lieu of dividends. The
second category is the Foreign Base Company Sales Income, as provided in section
954(a)(2) and (d). For purposes of subsection (a)(2), the term "foreign base
company sales income" means income (whether in the form of profits, commissions,
fees, or otherwise) derived in connection with the purchase of personal property
from a related person and its sale to any person, the sale of personal property
to any person on behalf of a related person, the purchase of personal property
from any person and its sale to a related person, or the purchase of personal
property from any person on behalf of a related person where: a) the property
which is purchased (or in the case of property sold on behalf of a related person,
the property which is sold) is manufactured, produced, grown, or extracted outside
the country under the laws of which the controlled foreign corporation is created
or organised, and, b) the property is sold for use, consumption, or disposition
outside such foreign country, or in the case of property purchased on behalf of
a related person is purchased for use, consumption, or disposition outside such
foreign country. However, it should be noted that for purposes of determining
foreign base company sales income, in situations in which the carrying on of activities
by a CFC through a branch or similar establishment outside the country of incorporation
of the foreign corporation, has substantially the same effect as if such branch,
or similar establishment, were a wholly owned subsidiary corporation deriving
such income. Under certain regulations, any income attributable to the carrying
on of such activities, from such a branch or similar establishment, will be treated
as income derived by a wholly owned subsidiary of the controlled foreign corporation
and may constitute foreign base company sales income of the CFC. For these
purposes, a "person" has been defined as a "related person"
with respect to CFC if: (a) such person is an individual, corporation, partnership,
trust, or estate which controls, or is controlled by, CFC, or,
(b) such person
is a corporation, partnership, trust, or estate which is controlled by the same
person or persons which control the CFC.
The third category covered under this
section is the Foreign Base Company Services Income, which for purposes of subsection
(a)(3), the term "foreign base company services income" means income
(whether in the form of compensation, commissions, fees, or otherwise) derived
in connection with the performance of technical, managerial, engineering, architectural,
scientific, skilled, industrial, commercial, or like services that: (a)
are performed for or on behalf of any related person
(b) are performed outside
the country under the laws of which the CFC is created or organised. The
fourth category is that of the Foreign Base Company Shipping Income. For purposes
of subsection (a)(4), the term "foreign base company shipping income"
means any income derived from, or in connection with, the use (or hiring or leasing
for use) of any aircraft or vessel in foreign commerce, or from, or in connection
with the performance of services directly related to the use of any such aircraft,
or vessel, or from the sale, exchange, or other disposition of any such aircraft
or vessel. Such definition usually includes, but is not limited to: (1)
dividends and interest received from a foreign corporation in respect of which
taxes are deemed paid under section 902, and gain from the sale, exchange, or
other disposition of stock or obligations of such a foreign corporation to the
extent that such dividends, interest, and gains are attributable to foreign base
company shipping income, and, (2) that portion of the distributive share
of the income of a partnership attributable to foreign base company shipping income. The
fifth and last category is that of Insurance Companies Income, which is provided
for in section 952(a)(1). This rule is essential for anti-avoidance purposes,
as it prevents US citizens from avoiding US taxes by organising the so-called
"captive insurance company, " which is an insurance that insures its
own US stockholders. For purposes of section 952(a)(1), the term "insurance
income" means any income which: (a) is attributable to the issuing
(or reinsuring) of an insurance or annuity contract, and,
(b) would (subject
to the modifications provided by subsection (b)) be taxed under subchapter L of
this chapter if such income were the income of a domestic insurance company. As
already explained above, section 954 defines "foreign base company income."
This term "foreign base company income" means for any tax year, the
sum of the foreign personal holding company income and the foreign base company
sales, services, shipping, (and oil related) income. If the sum of foreign base
company income and the gross insurance income for the tax year is less than the
lesser of 5 percent of gross income or $1,000,000, then, no part of the gross
income for the tax year is foreign base company income or insurance income. However,
if the sum of the foreign base company income and the gross insurance income for
the tax year exceeds 70 percent of gross income, then, the entire gross income
for the tax year is foreign base company income or insurance income. Moreover,
"de minimis" rule, applies to CFCs in any taxable year. That is; if
the sum of foreign base company income and the gross insurance income for the
taxable year is less than the lesser of: (a) 5 percent of gross income,
or,
(b) $1,000,000, then, no part of the gross income for the taxable
year shall be treated as foreign base company income or insurance income The
Check-the-Box regulation, which became effective on January 1st, 1997, was intended
to simplify the entity classification process for the IRS. Sections 701, et seq.,
of the IRS regulations now serve that purpose. These new classifications rules,
designed to replace the old method established by the "Kitner Regulations,"
now simplify the process of classifying entities for the purpose of US taxation. The
UK's CFC legislation also provides for definition, classification, and regulation
of holding companies. There, holding companies are classified under paragraphs
6(3) - 6(4)(a), of Schedule 25, as: a) Local holding companies,
b) Ordinary
holding companies, and
c) Superior holding companies Holding companies,
as stated earlier, must operate within certain exempt business, and only these
three types come within the exempt activities test exemption. The definition of
a holding company in the UK is provided by Paragraphs 6(6), and 12(1)-(3) Schedule,
25 ICTA 1988, stating that: A controlled foreign company will be treated
as a holding company for the purposes of the exempt activities test if it is:
a) a company the business of which consists wholly or mainly in the
holding
of shares or securities of either of the following types of companies: i)
"local holding companies" (or a 'local holding company') which are its
90 per cent subsidiaries (see paragraph 3.3.82 onwards), or ii) trading
companies (or a trading company) which are either 51 per cent subsidiaries or
"maximum permitted shareholding companies" (see paragraph 3.3.65); or,
b) a company which would fall within (a) above if it were disregarded,
as so much of its business as consists in the holding of the property or rights
or any description, for use wholly or mainly by companies which it controls and
which are resident in the territory in which it is resident. A company
may engage in activities other than the holding of shares or securities in the
types of company specified above, provided that its business consists wholly or
mainly in the holding of such shares or securities (or would so consist if the
part of its business relating to the holding of property etc for use by its subsidiaries
resident in its own territory of residence were disregarded). For example, the
existence of some trading activity, shareholdings not of the type specified, (as
in associated companies or dormant subsidiaries) or portfolio investments will
not prevent the company from qualifying as a holding company, provided that its
business consists wholly or mainly in the holding of shares or securities in the
types of company specified by paragraph 3.3.61 of the Act. 'Wholly or mainly'
here refers to more than 50% of the actual business.
The superior holding company
was first introduced by the Finance Act 1998, (FA 1998), and for the purpose of
Paragraph 6(6), and 12A(1)-(3) Schedule, 25 ICTA 1988, the definition of a "superior
holding company" is as follows: A controlled foreign company will be
treated as a superior holding company for the purposes of the exempt activities
test if it is a) a company the business of which consists wholly or mainly
in the
holding of shares or securities of companies (or a company) which are: (i)
holding companies or local holding companies, or, (ii) are themselves superior
holding companies, or, b) a company which would fall within (a) above if
there were disregarded
so much of its business as consists in the holding
of property or rights of any description, for use wholly or mainly by companies
which it controls and which are resident in the territory in which it is resident. Income
required of holding companies under paragraph 6(4) Schedule, 25 ICTA 1988, states
that for a holding company other than a "local holding company" to satisfy
the exempt activities test, at least 90 per cent of its gross income during the
accounting period under consideration must be derived directly either from companies
which it controls or from companies which are "maximum permitted shareholding
companies" in relation to it and which, throughout that period: a)
are not themselves holding companies (whether local or not) or superior holding
companies but otherwise are, in terms of Schedule 25, engaged in exempt activities
or are exempt trading companies; or,
b) are "local holding companies". For
superior holding companies, the income requirement by paragraph 6(4A) is that
for a superior holding company to pass the exempt activities test at least 90%
of its gross income must: 1) represent qualifying exempt activity income
(paragraph 3.3.73) of its subsidiaries, 2) be derived directly from (paragraph
3.3.79) companies which it controls which either: (a) are not superior holding
companies but are engaged in exempt activities or are exempt trading companies
or, (b) are superior holding companies throughout the period and at least
90% of their gross income represents qualifying exempt activity income (paragraph
3.3.73), and is derived directly from companies which they control and which are
either carrying on exempt activities or are exempt trading companies or are themselves
superior holding companies satisfying the income requirement. Under the
income test provided for superior holding companies, such income "must"
be traced (or traceable) through intermediate companies in order to establish
whether it represents income from exempt trading companies or companies engaged
in exempt activities. Section 799 provides the rules to ascertain the profits
out of which dividends are paid. Generally speaking, dividends are considered
to be paid out of the profits of any specified period or, where no period is specified,
out of profits that are specified. The rules further state that "where a
dividend is paid neither for a specified period nor out of specified profits,
the dividend is considered to be paid out of the profits for the last period for
which accounts were produced which ended before the dividend became payable."
. It is a question of fact "what" the source of the profits is,
in a situation where a holding company receiving only interest or royalties from
its exempt trading subsidiaries pays a dividend out of that income to its own
holding company, the dividend will derive from exempt trading companies. In
assessment, the gross income of a holding or superior holding company is taken
as the total amounts received or receivable in respect of its various sources
of income, as shown in the accounts for the accounting period in question. The
term 'Income' here is meant to exclude any capital receipts. No deductions (of
any nature) should then be made from these gross receipts subject to the following
exceptions: (a) There should be left out of account so much of the company's
gross receipts as is derived from any activity which, if it were the business
in which the company is mainly engaged, it would be such that paragraph 6(2) Schedule
25 would apply to the company, (b) To the extent that the receipts of the
company from any other activity include receipts from the proceeds of sale of
any description of property or rights, the cost to the company of the purchase
of the property or rights is (to the extent that the cost does not exceed the
receipts) to be a deduction in calculating the company's gross income, and no
other deduction (for example, for business expenses) is to be made in respect
of that activity. The term 'property or rights' includes the stock of a trading
company with the effect that gross profits of such a company are a deduction in
calculating the company's gross income. The final deductions to be made
in accordance with (a) above deal with the situation of a holding company which
would be able to satisfy the 90 % gross income; however, for income from trading
or any other activity which, if it were the company's main business, would enable
it to satisfy the exempt activities test. The main purpose of paragraph 12(4)
Schedule 25 is to exclude the receipts of any such activity from consideration
so that the 90 % gross income requirement is applied directly to the company's
remaining gross receipts.
Conclusion
The chief purpose of CFC
rules, is to prevent a taxpayer's accumulation of income and assets abroad through
the use of foreign base companies. CFC rules compel the allocation of all foreign
earned income to domestic company shareholders of foreign companies, in order
for taxpayers to be taxed accordingly by domestic revenue authorities. CFC rules
are therefore, effective anti-avoidance measures and devices. Basically
speaking, CFC rules are guidelines designed to determine how foreign entities
or companies are taxed, how they will be taxed, and even if they need to be taxed
at all. Moreover, these rules also provide guidance on whether or not, there is
tax due on foreign earned income, and if there are any tax credits or exemption
to be received under tax treaties and to be granted by the foreign revenue authorities.
CFC rules are also important tax avoidance and evasion measures taken by countries
in order to preserve their domestic tax base, and prevent further erosion of their
social and economic systems.
The most important and significant characteristic
of any sound and effectively designed tax system, whether it is based upon the
territoriality, residence of the taxpayer or source of income, is the concept
of tax equity. Tax equity is tax fairness, and in order to sustain a nation's
integrity in their legal, social, and economic tax distributive systems, the revenue
laws and their consequent tax aggregation, must be seen as creditable and fair,
above all. Thus, the standard measure of any effective equitable tax system, has
been the progressive distribution of the tax burden. If the principles
of tax equity are the cornerstone of a progressive tax system that considers itself
fair and equitable across the board for all citizens, then, the avoidance of tax
by some individuals and companies by relocating their operations abroad, or by
transferring their assets outside of their home tax base jurisdiction, in order
to avoid or evade taxes, violates the principle of tax equity, which is crucial
to all nations for the preservation of their economic systems, their growth and
development. Therefore, by examining the purpose, substance, and structures
of the CFC rules that regulate foreign base earned income and the use of foreign
holding companies in both countries, as these are frequently used as tax avoidance
vehicles, we can improve the rules and close the gaps in each respective tax systems
in order to further prevent their use in tax avoidance schemes. Dean
George L. Salis, PhD. LLM, LLB (Hons), BS, CMA, RFA, MFP Mas. Fin. Prof. , CEPA
Dean and Programme Director, Legal Studies Dept., Keiser College, CEO & Principal
JurisConsults International Group, LLC Member: ABA, IBA, London Court International
Arbitration, Royal Society of Fellows
Florida,USA. Member: ABA, IBA, London
Court International Arbitration, Royal Society of Fellows.
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