The Hindu Business Line : Controlled Foreign Corporations — Is India ready for this tax regime?

The CFC regime extends the domestic law rules to tax the profits, whether distributed or not, on foreign income be paid by resident taxpayers. Normally, the CFC rules apply only to foreign companies controlled by residents, but certain countries extend it to foreign permanent establishments and trusts.

There is no stopping the Indian juggernaut! Year 2006 will be remembered in India's corporate history as one of the most exciting on the mergers and acquisitions (M&A) front. Corporate India spent close to $7 billion in 2006 on cross-border acquisitions.

It is astonishing, and entirely unpredicted, that India's outbound investment should begin to rival inbound Foreign Direct Investments. According to an Assocham study, in calendar 2007, the outbound investments are estimated at $15 billion, surpassing the FDI inflows.

Indian corporates not only scaled up the size of their overseas acquisitions but in several instances bought out companies much larger than them. The time now seems to be right to re-look the Controlled Foreign Corporation (CFC) recommendations of the Kelkar Working Committee report on tax reforms in India.

Before looking into the India perspective, a quick look at some of the concepts surrounding CFC Regulations, as prevalent in other countries.

Meaning of CFC

Income from a foreign source is taxed usually after it is accrued or received as income in the country of residence of the taxpayer. The use of intermediary entities in a tax-free or low-tax jurisdiction enables a tax resident to defer (or avoid) the domestic tax on the income until it is repatriated to the residence state.

This tax deferral could lead to an unjustifiable loss of domestic tax revenue. As countries increasingly ease their exchange control rules, some have enacted Controlled Foreign Corporation rules to prevent the use of low-tax jurisdictions by their tax residents to defer the taxability of foreign income. Under the CFC rules, the domestic law effectively extends the residence rules to tax the income. It requires that the tax on profits, whether distributed or not, be paid by resident tax-payers. Normally, the CFC rules apply only to foreign companies controlled by residents, but certain countries extend it to foreign permanent establishments and trusts.

Many years ago, in the US, the income of foreign corporations was not taxed unless it was derived from US sources. In 1962, new tax laws were created to deter the use of foreign corporations as a way to avoid taxes. These rules have evolved into the complex rules referred to as the "controlled foreign corporation" rules.

CFCs are a legal construction of the tax authorities around the world. A CFC is a legal entity that exists in one jurisdiction but is owned or controlled primarily by taxpayers of a different jurisdiction. The CFC rules may also be termed `anti-deferral rules'. If income is taxed at some point of time, then the taxpayer will have a greater after-tax retention of income if tax is paid during a future year as opposed to being paid in the present year. An anti-deferral tax regime could compel the foreign company to repatriate the profits, thus resulting in a favourable impact on the foreign exchange inflows as well as shoring up the domestic tax base.

The US, the UK, Germany and 25 other countries have adopted CFC regulations. Generally, the CFC regime is enacted by states in which tax liability is imposed on the worldwide income of resident taxpayers. Two operative factors are key to worldwide tax liability and to the generation of tax revenues on foreign source income, that is, the nexus between the state and the taxpayer; and the nexus between the taxpayer and the foreign income, the latter being more important vis-à-vis CFC.

How to identify CFCs?

Foreign companies controlled directly or indirectly by residents are usually covered in the ambit of CFC rules. The test of `control' is complemented by a policy that facilitates identification of CFCs in line with certain philosophies.

Many countries apply `legal control tests' which provides for a threshold of percentage to qualify as a CFC. The threshold varies significantly, for example, in the US more than 50 per cent voting rights/value of the shares is the trigger whereas for France, it just 10 per cent.

The definition of `control' may also extend to factors other than legal, such as `constructive ownership test' and `indirect ownership test', to supplement the concept of legal control. For identification of CFCs, either of the following two alternative approaches is adopted:

Global approach: In this approach, no target jurisdiction is defined. The CFC rules apply to specific types of incomes, usually passive income (discussed later).

Designated Jurisdiction approach: In this approach, the CFC rules apply to controlled corporations resident of an identified foreign low-tax jurisdiction specially designated by the relevant countries.

It is also possible to follow a hybrid approach, that is a mix of the above two.

Taxation of income

Income is taxed as deemed income or deemed divided in the hands of resident shareholders. Foreign taxes paid can be set-off against home country taxes or allowed as expense deduction. Subsequent dividend distributions out of the attributed income may either be excluded or deducted. There is no deduction available for CFC losses against regular income of resident shareholder. Such losses can only be carried forward and set-off against future CFC income.

Relief provisions

Since CFC regime attributes income to shareholders before actual distribution of income, relief provisions are ordinarily built-in to prevent double-taxation of CFC's income subsequently distributed.

Such relief provisions may be:

On account of foreign taxes paid.

On account of dividend paid out of the previously attributed income.

In respect of losses incurred.

From double-taxation on subsequent capital gains arising from disposition of shares arising out of CFC by the shareholder, where the shareholders have been previously taxed on the undistributed income of the CFC.

Exemptions from CFC rules

There are usually exemptions in CFC regulations. Most countries provide one or more of the following:

Exemptions for CFC that distributes certain percentage of income in a year.

Exemptions for CFC engaged in genuine business activities.

A `motive' exemption for CFCs, which are not established for the purpose of avoiding domestic tax.

Exemptions for CFCs whose shares are listed on recognised stock exchanges.

A de-minimis exemption where the total income of the CFC does not exceed a particular threshold amount.

The UK allows all five exemptions whereas the US provides only the third and fourth

In a recent decision in the case between Cadbury Schweppes plc and Cadbury Schweppes Overseas Ltd versus the UK tax authorities, the European Court of Justice held that the taxation provided for by the CFC Rules should be excluded where, despite non-satisfaction of the `motive test', the incorporation of a CFC corresponds with actual establishment intended to carry on genuine economic activities.

Domestic law versus Treaty provisions

CFC regulations are contrary to the spirit of Article 7 of OECD Model Convention as it results in taxation of the foreign profits of foreign corporations even without a permanent establishment in the home country of foreign subsidiary. Further, it also leads to economic double taxation, which goes against the spirit of the tax treaties.

A few unresolved issues could be:

Tracking of attributed income when actual distribution takes place.

Allowance of tax credit for foreign tax withholding on income distributed, when income attributed and taxed earlier.

An Indian Perspective

India still does not have full capital account convertibility and the quantum of outbound investment is still not comparable to the levels in relation to countries where there is a free foreign exchange regime. However, the necessity of anti-abuse provisions in tax administration cannot be undermined. This is also supported by the principle of substance over form. While there are a number of decisions from the apex court decisions in the country, which give precedence to substance over form, there is a need to incorporate suitable provisions in the chapter on interpretation of DTAAs to deal with Treaty shopping, conduit companies and thin capitalisation. These may be based on the UN/OECD model or other best global practices.

The Limitation of Benefit clause in the recently amended Indo-Singapore Tax Treaty testifies India's attempt to introduce one of the anti-abuse mechanisms.

The increase in outbound investments has brought significant challenges in the context of ability of companies to park profits outside in low or nil tax jurisdictions and deferring taxes in India. It also militates against the neutrality between overseas and domestic investment. Hence, introducing CFC regulations may be desirable from a fiscal perspective.

In fact, the Finance Minister, in his latest Budget speech, announced the introduction of a new Direct Tax Code later this year. One would have to wait and watch if the CFC regulations are introduced in this new tax code, though there are enough indications that Treaty anti-abuse provisions would find its place in the new tax code.

If and when introduced, the CFC regulations could impact international tax structures including:

Holding companies, mainly created for holding finance investments, IPRs to collect royalty income.

Distribution centres.

Holding passive income in low tax jurisdictions.

Non-operational finance related activities.

However, following arguments clearly go against introduction of CFC regulations in India:

Infringement of `ability to pay' principle taxation before receipt of income.

Conflict with tax treaty provisions (Article 7).

Distortion of capital import neutrality.

Blunting the competitive edge available to compete with foreign owned companies in foreign markets.

Maybe it is early days still to usher in these regulations as they could stifle the efforts of Corporate India to compete with global companies in an efficient manner.

(The authors are Bangalore-based chartered accountants.)

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