Fri 03 Apr 2015

On 3 April, the OECD published a Discussion Paper on Action 3 (Strengthening CFC Rules) of the BEPS Action Plan focusing on develop recommendations regarding the design of controlled foreign company (CFC) rules. The Committee on Fiscal Affairs (CFA) invites interested parties to send written comments on this consultation document by 1 May 2015.

Action 3 stresses the need to address BEPS using CFC rules. CFC rules have existed in the international tax context for over five decades, and dozens of countries have implemented these rules, but these rules do not always counter BEPS in a comprehensive manner. While CFC rules in principle lead to inclusions in the residence country of the ultimate parent, they also have positive spillover effects in source countries because taxpayers have no (or much less of an) incentive to shift profits into a third, low-tax jurisdiction. Working Party No. 11 (WP11) has considered many options for the design of CFC rules that would prevent base erosion and profit shifting.

This discussion draft considers all the constituent elements of CFC rules and breaks them down into the “building blocks” that are necessary for effective CFC rules. These building blocks would allow countries without CFC rules to implement recommended rules directly and countries with existing CFC rules to modify their rules to align more closely with the recommendations. The exception to this is Chapter 5, which deals with the definition of CFC income and which does not include recommendations but instead discusses several possible options.

The building blocks include:

  • 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

The design of CFC rules intended to combat BEPS raises a number of policy considerations:

  • the purpose of CFC rules,
  • how to strike a balance between taxing foreign income and maintaining competitiveness,
  • how to limit administrative and compliance burdens while not creating opportunities for avoidance,
  • the role of CFC rules as preventative measures,
  • the scope of base stripping prevented by CFC rules,
  • how to ensure that CFC rules do not lead to double taxation, and
  • the interaction between CFC rules and transfer pricing rules.

These policy issues must be considered in order to develop recommendations for CFC rules.

EU Law and CFC

A particular competitiveness concern may arise in the context of the European Union. Since 2006, it is generally acknowledged that the European Court of Justice’s case law imposes limitations on CFC rules that apply within the EU. Therefore, whilst recommendations developed under this Action Item need to be broad enough to be effective in combatting BEPS they also need to be adaptable, where necessary, to enable EU members to comply with EU law.

This policy consideration affects all jurisdictions, including those that are not Member States of the EU, because recommendations that are inconsistent with EU law would mean that Member States could not adopt those recommendations to apply within the European Union. This in turn would mean that multinational groups that are based in jurisdictions that are not EU Member States could be at a competitive disadvantage compared to multinational groups that are based in Member States since the latter groups would not be subject to equally robust CFC rules.

In Cadbury Schweppes and subsequent cases, the European Court of Justice has stated that CFC rules and other tax provisions that apply to cross-border transactions and that are justified by the prevention of tax avoidance must “specifically target wholly artificial arrangements which do not reflect economic reality and whose only purpose would be to obtain a tax advantage”.  The ECJ’s jurisprudence applies to all Member States of the EU and the EEA, and it applies when the parent jurisdiction and the CFC jurisdiction are both within the EEA.

The purpose of this discussion draft is to set out recommendations for effective CFC rules that can be implemented in all jurisdictions. These recommendations will ideally be the same for EU Member States and non-EU Member States, but this discussion draft acknowledges that, depending on the agreed recommendations, EU Member States may need to modify these recommendations to comply with EU law. Modifications to comply with EU law should only change how CFC rules that apply to other Member States are implemented by Member States of the EU, and they should not change whether they comply with the recommendations outlined in the discussion draft.

Other Issue

Some countries have proposed that in addition to CFC rules (which for the purposes of the proposal is described as the “primary rule”), countries could introduce further rules (the “secondary rule”) that applied to income earned by CFC s that did not give rise to sufficient CFC taxation in the parent jurisdiction. Such secondary rules would introduce a secondary form of taxation in another jurisdiction (for example the source country of the income earned by the CFC).

Working Party 6 is currently considering several options for special measures in the area of transfer pricing as part of Action Items 8-10, which could be implemented as possible secondary rules. Possible future work on the options to address the tax challenges of the digital economy could also be adapted to be applied as secondary rules. There is a question as to whether any of these options might form the basis for a secondary rule. The CFA has not yet considered whether this high level proposal should be taken forward.

The work on CFCs is being co-ordinated with the work on other Action Items. The Action Items that are most closely associated with CFC rules include Action Item 1 (addressing the tax challenges of the digital economy – this co-ordination involves working closely with the Task Force on the Digital Economy Liaison Group.), Action Item 2 (hybrid mismatch arrangements), Action Item 4 (interest deductions), Action Item 5 (countering harmful tax practices), Action Items 8-10 (transfer pricing), 2 Action Item 11 (methodologies to collect and analyse data), Action Item 14 (dispute resolution mechanisms), and Action Item 15 (developing a multilateral instrument).

Source: OECD website


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