Controlled Foreign Corporations Global Business and International Fiscal Law 307

1. Controlled Foreign Corporations

As we have seen in Chapter 5, Britain attempted to deal with the problem of the use of intermediary companies to maximise tax deferral by applying a broad rule of company residence, combined with administrative measures based on the requirement of permission for transfer of assets abroad or for raising finance through foreign intermediary companies, which enabled the Revenue to agree specific arrangements with individual companies for taxation of a proportion of retained earnings. The US authorities also were prepared to use general anti­avoidance provisions on the transfer of assets abroad to establish some control over deferral see Chapter 5 section 2d above, but this was overtaken by the emergence of the general debate over deferral, resulting in the Subpart F legislation against Controlled Foreign Corporations. 1 This approach, entailing more specificity in the definition of how far the retained earnings of a TNC could legitimately be taxed by the home country, proved influential, and similar provisions were enacted by the main developed countries over the ensuing two decades. 1.a The Spread of Anti­CFC Provisions Other countries such as Germany, applied the slightly narrower test of residence based on the location of top management; this did not include coordination and financial functions, and was therefore more easily avoided than the UKs rules by setting up holding companies Chapter 1 section 2aii above. Following the enactment of the US CFC provisions, the West German authorities methodically began to study the problem, and to develop a similar approach. The government produced a report on international avoidance the Steueroasenbericht or Tax Oases report in 1964, in response to a parliamentary request of 1962 German Government 1964. Initially, the government tried to act on the basis of administrative measures, in a decree of 1965 based on the general tax avoidance provisions of the tax administration law. 2 However, the general trend of court decisions was to restrict the scope of these general anti­avoidance provisions. Although a decision of the Bundesfinanzhof in one case allowed income received by Swiss investment companies to be treated as fiduciary income attributable to their German 1 The development of these and other US measures in the 1960s against international avoidance owed much to Stanley S. Surrey, who had come from the International Program in Taxation of the Harvard Law School to be Assistant Treasury Secretary for Tax Policy from 1961 to 1969, and whose influence on US tax policy, and international tax arrangements generally, continued until well into the 1970s. 2 Steueranpassungsgesetz ss.5, 6 11, now codified in the Abgabenordnung ss. 39, 41 42. These general provisions allow a transaction to be treated as a sham in certain circumstances, restrict the abuse of legal forms, and empower the attribution of income to other than the formal owner where property is owned or income received on behalf of another so­called Treuhand relationships. shareholders, an earlier case of 1968 held that a letter­box base company could not be regarded as a sham; subsequent decisions in 1974­6 supported this view Huiskamp, in Rotterdam IFS 1978, 309­312; A.Rappako 1987 169­174. Since the 1965 Tax Havens decree was an administrative measure which depended on these statutory rules, its effectiveness was doubtful. New legislation was necessary, and the administration published a comprehensive legislative memorandum in 1970 which, after consultation with interested parties, formed the basis of the Foreign Tax Law Aussensteuergesetz: AStG which came into force from 1st January 1972. Similar legislation has also been enacted by the other main OECD countries. Canada brought in provisions on Foreign Accrual Property Income FAPI in the 1972 tax reform which came into effect in 1976. Japan introduced a Special Tax Measures Law in 1978 which included the designation of tax havens and the requirement for Japanese owners of subsidiaries in designated havens to report the subsidiarys undistributed income. France enacted legislation on tax haven companies in 1980, 1 and the UK enacted its CFC provisions in 1984. 2 New Zealand and Australia enacted anti­CFC legislation in 1988 and 1989. Other countries have applied general anti­ avoidance provisions to tax haven intermediary companies, while considering enacting specific legislation, for example Finland and Sweden A.Rappako 1987, 208­9. Although these measures differ in detail, their broad approach is similar. Their effect is to deem residents who are shareholders of a tax haven company to be liable to tax in certain circumstances on the income of that company, even if the income is not distributed or paid over. They therefore involve a further extension of residence taxation, which in a sense is `extraterritorial ¶ This opens them to the criticism that an excessive tax jurisdiction is being claimed Park 1978; see Chapter 1 section 1.1 below. Government proposals for anti­CFC measures certainly resulted in strong campaigns by industrial and financial pressure groups in most countries; and in some cases, notably Japan and the UK, this resulted in a softening of the proposals. It is notable however that, even during the 1980s which has generally been a period of international liberalization, the business lobby has been unable to prevent measures to tax foreign retained earnings. Although anti­CFC measures may in principle involve a major extension of the jurisdictional claims of home countries to residence taxation, it is difficult for a designated haven to object that its tax base is being unfairly appropriated, if the haven itself is largely exempting that income from tax. Furthermore, the fact that similar measures were being introduced by most of the main capitalist countries made it hard to argue that international competitiveness would be damaged. Equally, it meant that the overlapping of jurisdiction involved in anti­haven measures did not lead to the sort of jurisdictional conflicts which 1 This became Article 209B of the Code General des Impots. 2 OECD 1987A­I, paras 62­4, 99­114 and Annex II, Arnold 1985, and Arnold 1986. occured with other `extraterritorial ¶ regulation of international business see ch.11 below and Picciotto 1983. However, in this case the jurisdictional question focussed on the scope and application of tax treaties to be discussed in the next section. It is significant, also, that in formulating anti­CFC measures, states were sensitive to the question of the effective limits of their jurisdiction, and this has been harmonized to some extent through the OECD Committee. 1.b Defining CFC Income Important limits have been imposed on taxation of CFCs, flowing from the very basis of tax jurisdiction. Since the residence country is essentially asserting its own jurisdiction over a proportion of the tax base generated by an internationally operating business, it must use clear and acceptable criteria if it is to avoid conflict with other countries. Such criteria must establish definitions i of the income which is claimed to be liable to tax, and ii of the relationship of resident taxpayers to that income, essentially based on their `control ¶over the CFC. i The Income Liable to Tax Two approaches have been used in the definition of the `tainted ¶income. The US, and later Canada, adopted a `transactional ¶ or `shopping¶ approach, by defining certain types of activity as tainted, and therefore asserting the right to tax only the income from such activities. Such income is essentially passive investment income and foreign base company sales and service income see Chapter 5 section 2 above. This approach does not require any definition of a tax haven nor listing of recognised havens. The alternative approach specifies that all the income of certain subsidiaries resident in countries where they benefit from a low­tax regime is taxable. This is the `locational ¶or `designated jurisdiction¶approach, adopted by Japan, France and the UK Arnold 1985, Arnold 1986, pp. 432­444, OECD 1987A­I para 63. However, this approach also provides exemption for companies with certain types of income; while the `transactional ¶ approach may also exclude a foreign subsidiary not substantially used for a tax avoidance purpose which is determined by comparing the tax rates involved. Thus, the two approaches reach a substantially similar result Arnold 1985; indeed, the German method combines elements of both. Both approaches essentially use two basic concepts, differently combined: a location in a `low­tax ¶country: i.e. that substantially less tax is paid in the companys country of residence than would be paid in the designating country; and b receipt of `passive income: i.e. income which is earned without carrying out any substantial activity in the country of residence. In defining a low­tax jurisdiction, the easiest method is to compare nominal tax rates. This is somewhat crude, since the nominal rate may be considerably different from the actual effective rate, because some countries are much more generous than others in the deductions they allow to arrive at taxable income; but it is administratively complex to calculate and compare annually the effective rates. Thus, Japan relies on a comparison of nominal tax rates to produce its definitive black list of tax havens. France and Germany, on the other hand, publish haven lists which are for guidance only `grey ¶ lists, and can be more flexible ­ France appears to rely largely on nominal tax rates, while Germany takes into account the effective rate see Chapter 6, section 3 above, and Arnold 1985 p.288­90. The most sophisticated approach, perhaps because it was enacted later, is that of the UK, which compares the actual tax paid by the target company in its country of residence with what would be paid under UK tax rules. This principle is the broadest and most effective; in fact, the British legislation 1 makes no reference to designated havens, and thus recognises that in principle any country may be a haven in relation to another see Chapter 6 section 2 above. However, the provisions are subject to an overriding `motive ¶test; and in response to pressures for more precision to assist tax planners, the Inland Revenue announced an informal `white list ¶ of countries presumed not to be havens. 2 However, to be exempt a company must not only be resident in one of these presumed exempt high­tax countries, but also must be deriving at least 90 of its income from doing business in that country; otherwise, a comparison must be made of the actual tax paid, and if it is not at least 50 of what would have been paid under UK tax law, the company may be a CFC. The UK legislation is very comprehensive, and in principle gives the Revenue very broad powers, and discretion in deciding whether to invoke them, which is done by Direction. However, its potential scope is checked by several exemptions and an overriding statutory exclusion. A company is exempt if i it has an `acceptable distribution policy ¶ ­ essentially, if it distributes at least half of the proportion of profits to which the UK shareholders are entitled 90 for a non­trading company; or, ii it is genuinely carrying on business other than `investment business ¶ in its country of residence and is effectively managed there; or, iii it is publicly quoted elaborately defined in Schedule 25 III; or iv it has chargeable profits of less than £20,000 in the accounting period. The overriding exclusion for `motive ¶ allows exemption where the reduction in taxation was minimal or not a main purpose of the transactions; or where it was not one of the main reasons for the CFCs existence to achieve a reduction in UK tax by diversion of profits from the UK. 3 1 Finance Act 1984 ss. 82­91 and Schedules 16­18; now ICTA 1988 ss. 747­756 and Schedules 24­26. 2 This is based on an extra­statutory concession exempting companies operating in countries accepted by the Revenue not to be havens, which it was estimated would exempt 90 of non­resident subsidiaries Simon 1983­, D4.131. The list designates 48 countries unconditionally, and a further 29 provided the subsidiary does not benefit from defined tax privileges Simon 1983­, D4­141. 3 That is, where it is reasonable to suppose that but for the existence of the CFC a UK resident would have received all or a substantial part of its income and consequently have had a higher UK tax liability: s.7483 and Schedule 25IV. These tests give the targeted taxpayer a legal basis for objection against an unreasonable application of the Revenues powers; but there is no provision for a remedy against the generous treatment of one taxpayer in relation to another Deutsch 1985 p.8. Perhaps the aim, and certainly the effect, of this legislation was as much to discourage the use of some types of tax haven intermediary company as to raise revenue. The provisions included a power to require relevant books, accounts and documents to be produced by any UK company which appears to be the controlling company of a foreign subsidiary which may be a CFC, and it was reported that the Revenue promptly wrote to UK multinational groups asking for lists of their non­ resident controlled subsidiaries and copies of their accounts Deutsch 1985 p.8, and chapter 10 below. The second step in defining the tainted income is the characterization of passive income not earned by actively carrying out a genuine activity in the country of residence. Normally, passive income includes that resulting from carrying out a holding company function: e.g. what is described in the British rules as `investment business ¶ ­ holding securities, patents or copyrights; leasing; dealing in securities other than as a broker; or making investments for related companies. 1 However, it is more difficult to define if the income results, at least formally, from carrying on a business, whether it is manufacturing, wholesale buyingselling, or services, including construction, design or research, and financial services such as banking and insurance. Under the US Subpart F, detailed regulations have been made to try to distinguish substantial foreign manufacturing from a notional assembly operation. Most countries regard income from service activities as tainted if the activity is carried out for a related company outside the CFCs country of residence; in the case of countries using the locational rather than the transactional approach, where more than a certain proportion is carried out for related companies. However, there are many types of activity, in services, or construction, or offshore drilling, which require a minimal physical base, while specialists and equipment which need not be located at that base are despatched to various global locations as needed; provided at least a significant proportion of their business is done with unrelated clients, such services and the costs of associated personnel can be channelled through a tax haven subsidiary which may be considered as having an `active ¶ business US Treasury 1981, p.79­84. ii Control and Residence The second main limb of the definition of a CFC is the connection with taxpayers resident in the designating jurisdiction, and the relationship of the CFC itself with the privileged tax regime or low­tax haven. The basis of imposing liability to tax on the 1 ICTA 1988 Schedule 25 s.9. undistributed income of a CFC is that it is `controlled ¶ by residents of the taxing country; it is necessary to use a broad definition of control, to minimise potential loopholes, but most CFC laws specify that at least 50 of the shares in the CFC must be held by resident taxpayers in the taxing country. As the OECD report states, `Minimum ownership formulae vary and one of the main problems is apparently how to counter strategies used by taxpayers to avoid these criteria ¶ OECD 1987A­I, para.63. The definition of the connection between the CFC and the haven poses special problems under the locational or designated jurisdiction approach Arnold 1985, p.365, since a company may benefit from low taxation by separating its country of incorporation from that of residence; or by carrying out its intermediary company activities through a branch. Thus, a company incorporated in the UK which is not designated as a haven by countries using the locational approach such as Japan and France could have been managed in a haven where its intermediary business was carried on: this loophole was closed when the UK changed its residence rule to include all UK­incorporated companies see Chapter 1 above. Equally, a French company could carry on its intermediary activities through a branch in a haven, which would not be taxed under French law which exempts foreign income earned through a foreign permanent establishment. This must be dealt with both by a broad connection principle, and a provision such as that in the UKs informal exemption, that a high proportion of the companys business in that case 90 must be done in the exempt country. 1.c The Effectiveness of Anti­CFC Measures The complexities of CFC measures have certainly made them a fruitful source of revenue for lawyers and accountants, but in practice much less for governments, as can be seen from the figures that some countries have released. Thus, the German figures show that both the total amounts recovered and the average recovery per case are relatively low. The amounts collected under the AStG Table 3, column 3 are less than 1 of the total revenues from Germanys corporation taxes. 1 This may partly be due to cases being dealt with on other grounds, or not being dealt with at all: the German authorities reported to the OECD Committee that only 15­25 of suspected cases had been audited OECD 1987A­I para 102. The Japanese government reported that in 1983 428 firms had filed returns under the anti­haven law in respect of 1,914 subsidiaries in 17 designated havens, which resulted in additional income liable to tax of Y31.4bn; also, 386 audits between July 1983 and June 1984 had revealed errors in 49 cases, resulting in additional taxable income of Y3.4bn ibid.. This combined total of Y35bn once again is tiny: less than one­half of one percent of Japans revenue from corporation tax. 2 For the UK, the tax yield from 1 Taken from OECD Revenue Statistics. 2 The figure for revenues from corporation tax is given in Japan, Ministry of Finance 1985, p.299. CFC cases dealt with by the International Division of the Inland Revenue was £12.5m in 1987­9. 1 __________________________________________________________________________ _ Table 3 Tax Revenues Recovered under German CFC Rules AStG ss­7­14 __________________________________________________________________________________ Year Cases Total amounts Average per case No. Million DM Million DM __________________________________________________________________________________ 1972 99 25.953 .262 1973 492 50.455 .103 1974 449 35.543 .79 1975 439 34.089 .78 1976 461 20.757 .45 1977 477 23.310 .49 1978 509 41.483 .82 1979 443 11.111 .25 1980 358 14.634 .41 1981 553 59.382 .11 1982 496 28.232 .57 1983 394 29.833 .76 __________________________________________________________________________________ Totals may not correspond due to rounding. Compiled from Deutscher Bundestag 1986, p. 7. Thus, it is likely that the main effect of CFC legislation has been to induce firms to reorganise their offshore subsidiary structures. This may have resulted in the repatriation of a higher proportion of retained foreign earnings; but to a significant extent companies have been able to avoid the CFC rules. The US experience after two decades of operation of Subpart F, detailed in the Gordon report, was that the use of tax haven intermediary companies by US corporations had continued to grow US Treasury 1981 p.39­40. It may also be the case that CFC legislation, by bringing the retained earnings of some foreign subsidiaries into the tax net, will have pushed some offshore activities more clearly over the line from doubtful avoidance to illegal evasion. Equally, however, some practices which fall outside CFC rules have been legitimised. In particular, activities which can be said to be genuine trading activities of a tax haven company cannot easily be included in the CFC net. This includes businesses such as construction, shipping and offshore drilling, as mentioned above. Above all, CFC measures find it hard to deal with financial services, such as banking and insurance, carried out by `captive ¶subsidiaries, which are in many cases regulated by specific rules under the CFC laws; but under these rules services such as banking or insurance are generally considered to produce `passive ¶ income only if they are provided in respect of the home­country business of the shareholder or related companies. This excludes services provided for foreign operations, which can be charged to operating companies and reduce taxable business profits at source unless the source country disallows deduction of such payments if made to a tax haven 1 Given in UK Board of Inland Revenue 1988, vol. 3, though it is not clear whether this is from cases investigated or the total yield from all CFCs. affiliate. Furthermore, if a significant proportion of such services is provided to unrelated third parties, for example by using pooling arrangements, then the `captive ¶ could be regarded as carrying on an independent insurance or banking business, and therefore fall outside the CFC net US Treasury 1981, p.89. Furthermore, parent companies may derive direct benefit, by `secondary sheltering ¶ of tax­exempt income. The simplest method is for the subsidiary carrying on the CFC­exempt business in a low­tax country to make loans to the parent, or to other affiliates. Such an `upstream loan ¶ is not taxed as income to the recipient as a dividend would be, and indeed the interest payments on the `loan ¶are normally tax deductible by the `borrower ¶ This was described as `a rather naive and straightforward form of tax avoidance ¶ by the OECD Fiscal Committee OECD 1987A­II para. 72; but although some countries such as the US have provisions to tax such loans in some circumstances, others have found it more difficult to counteract. In the UK, the Revenue was forced to withdraw its proposals on upstream loans, following criticism, especially that it would interfere with the carrying out of the central treasury function of multinational company groups based in the UK, which might therefore move this function, and the important associated investments, elsewhere IFS 1982, p.31.

2. Anti­Avoidance and Tax Treaties