INTERNATIONAL TAXATION

THE CHARTERED ACCOUNTANT JANUARY 2011

93
Controlled Foreign Companies
The Direct Tax Code (DTC) 2010 has proposed a host of new and revised provisions concerning cross-border
taxation of income. One of the major provisions proposed by DTC 2010 relates to introduction of Controlled
Foreign Company (CFC) regulations. CFC regulations are a broad set of regulations which are primarily
aimed to prevent avoidance/deferral of tax by resident taxpayers by establishing intermediate foreign
subsidiaries in low tax jurisdictions and parking income in those entities. This article attempts to decode the
CFC regulations.
With the opening of world-trade,
more and more companies have tried
to spread their operations in a number
of countries by either establishing
a formal/informal place of business
in other countries or by setting up
of local subsidiaries to manage the
business in those country/surrounding
regions. The income earned by
subsidiaries suffers from dual taxation
on distribution of the same as dividend
by such subsidiaries (first in the hands
of the subsidiaries in the respective
source country and second in the
hands of the holding company on
receipt of dividend). To avoid this dual
taxation, companies started structuring
their overseas operations by setting up
an intermediary holding company in a
tax-favourable jurisdiction. The profits
earned by the subsidiaries would
be distributed to such intermediary
holding companies as dividend and
would be parked there.
While this would certainly help
in reducing the overall tax cost (or at
least deferment of tax till the income is
distributed by such foreign company),
non-repatriation of funds to the
parent company jurisdiction results
in a loss of revenue for the country
where the parent is located. With a
view to prevent such accumulation
and non-distribution of income by
(Contributed by the Committee of Interna-
tional Taxation of the ICAI. Comments can
be sent to citax@icai.org)
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The Indian tax
authorities have
woken up to the
needs of having CFC regulations
as an effective anti-avoidance
regulation. DTC 2010 proposes
to introduce the CFC regulations
to prevent avoidance/ deferral
of tax by parking income in
tax friendly jurisdictions. The
CFC regulations under DTC
2010 propagate an entity-
level approach. Under this
approach, the focus is on the
CFC as an entity rather than on
its income, although the nature
of its income (whether active or
passive income) is an important
factor in the determination of
whether or not the CFC rules
apply.
intermediate holding company, many
countries started introducing the CFC
regulations in their tax laws. The main
aim of CFC regulations is to prevent
the accumulation of income/funds in
tax-favourable jurisdiction by including
the undistributed income of such
foreign companies in the total income
of parent company.
CFC regulations were initially
introduced in the United States of
America as early as 1962. With the
passing of time, CFC regulations grew
in prominence with a number of coun-
tries incorporating similar provisions in
their tax laws. Currently, many develo-
ped countries like Canada, Germany,
Japan, France, UK, New Zealand,
Australia and emerging economies
like Mexico, Argentina, Indonesia and
China have CFC regulations in their tax
laws.
Incorporation of CFC regulations
in the tax laws to counter use of tax-
friendly jurisdictions for avoidance/
deferment of tax is encouraged even
by the Organisation for Economic Co-
operation and Development (OECD) in
its report on Harmful Tax Competition.
CFC Regulations Concept
As explained earlier, CFC regulations
are a broad set of regulations designed
to prevent the deferral and avoidance
of tax by residents, (including
domestic companies) by establishing
foreign entities/subsidiaries, in low
tax jurisdictions and parking income
in those countries. The International
Bureau of Fiscal Documentation
(IBFD) has explained CFC legislations
as under:
The term is generally used in the
context of tax avoidance rules designed
to combat the diversion by resident
taxpayers of income to companies
they control and which are typically
resident in countries imposing low-or-
no taxation. Under these rules income
of the controlled company is typically
either deemed to be realised directly
by the shareholders or deemed to be
distributed to them by way of dividend.
Often only part of the controlled
companys income is dealt with in this
way, typically passive income such
as dividends, interest and royalties
(tainted income). Many, but not all
controlled foreign company regimes
apply only to corporate shareholders.
Operation of a typical CFC
regulation is explained by the following
illustration:
India
- Parent company
- Intermediate Holding company
- Operating company
Mauritius 100%
USA 100%
XYZ Inc
XYZ Co.
XYZ Limited
The above is a typical illustration
of an organisation structure wherein
the CFC regulations may become
applicable. In the above case,
XYZ Co. is an intermediate holding
company established in favourable
tax jurisdiction as a holding company
for various operating companies in
other jurisdictions. The profits earned
by XYZ Inc would be distributed as
dividend to XYZ Co and parked there
to escape higher tax rate in the parent
company XYZ Limiteds country, India.
Under the CFC regulations, XYZ Co.
would be deemed to be a controlled
foreign company/corporation and
the undistributed income of the same
would be taxed in the hands of XYZ
Limited, even though actual dividend
is not declared by XYZ Co., Mauritius.
CFC Regulations
Approaches
CFC regulations typically have the
following approaches
1) Jurisdictional approach
2) Transactional approach
3) Entity-level approach
1) Jurisdictional approach
Under the jurisdictional approach of
CFC regulations, foreign companies
set-up by resident companies in
low-tax jurisdictions are targeted.
Accordingly, where a resident company
sets up a subsidiary mainly to act as
an intermediate holding company or
non-operating holding company in
a low-tax jurisdiction, such foreign
company is deemed to be a controlled
foreign company for the purpose of
CFC regulations. In such a scenario,
CFC regulations are deemed to be
applicable on such foreign companies
in low-tax jurisdiction and all the
income earned by such foreign
companies is taxed in the hands of the
resident company.
2) Transactional approach
Under the transactional approach,
the focus is generally restricted to the
passive income earned by foreign
subsidiaries of resident companies.
Passive income would tend to include
incomes like royalty, interest, rent,
capital gains, etc.
3) Entity-level approach
This is a hybrid approach combining
the principles of jurisdictional app-
roach and transactional approach.
Under this approach, CFC regulations
are triggered both when the foreign
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subsidiary is set up in a low-tax
jurisdiction and when the foreign
subsidiary has passive income
stream.
The CFC regulations proposed
under DTC 2010 follow the entity level
approach.
CFC Regulations Indian
Perspective
The Indian tax authorities have
woken up to the needs of having
CFC regulations as an effective anti-
avoidance regulation. DTC 2010
proposes to introduce the CFC
regulations to prevent avoidance/
deferral of tax by parking income in tax
friendly jurisdictions.
The CFC regulations under DTC
2010 propagate an entity-level
approach. Under this approach,
the focus is on the CFC as an entity
rather than on its income, although the
nature of its income (whether active or
passive income) is an important factor
in the determination of whether or not
the CFC rules apply. Once a foreign
company qualifies as a CFC (and none
of the exemptions apply), all of the
income of the CFC is taxed in the hands
of the resident-controlling shareholder
on a proportionate basis. The future
dividend distribution of the attributed
income by the CFC is deductible.
CFC regulations under the DTC
2010 are applicable on all Controlled
Foreign Companies. Controlled
Foreign companies have been defined
to include all the foreign companies
which fulfill the following conditions:
a) A minimum of 50 per cent control
either by way of equity or voting
power is exercised by a resident
taxpayer or a significant influence
over the foreign company is
exercised by such resident
taxpayer;
b) Is a resident in tax jurisdiction
having an effective rate of tax less
than 50 per cent of the rate of
tax it would have paid under the
provisions of DTC 2010 if it were a
domestic company. Accordingly,
if a controlled foreign company
is paying tax at an effective rate
which is more than 50 per cent of
the tax rate applicable under the
DTC 2010, then the income of such
company would be exempted from
the CFC regulations;
c) Shares of such foreign company
are not listed on any stock
exchange in the foreign country of
which it is a resident;
d) The specified income of such
foreign company does not exceed
R25 lakh or equivalent of such
income; and
e) It is not engaged in active trade or
business (meaning it only earns
passive income).
A company would be deemed to
carry on active trade or business if
it fulfills the following conditions:
i) It actively participates in
industrial, commercial or
financial undertakings through
employees or other personal
in the country of residence of
such foreign country; and
ii) The following income
constitutes less than 50 per
cent of the total income of such
foreign company:
a) Dividend;
b) Interest;
c) Income from house
property;
d) Capital gains;
e) Annuity payment;
f) Royalty;
g) Sale or licensing of intan-
gible rights on industrial,
literary or artistic property;
h) Income from sale of goods
or supply of services
including financial services
to persons controlled by
such foreign company or
an associated enterprise of
such foreign company.
Accordingly, if the foreign
The proposed CFC
regulations, when
made effective could
have a signicant impact on
the many corporate houses of
India having global presence
with likelihood that the prots
of their foreign subsidiaries
be taxable in India. Given the
same, it would be advisable
for such companies to review
their current business structure
and if required, restructure the
same to adequately address
the challenges which would be
posed by the CFC regulations.
company derives a majority
of income from onward
selling of goods/services
to its group concerns only,
then in spite of being
involved in active trade
or business, such foreign
company may still be
considered as a CFC for
the purpose of applicability
of these regulations. To
illustrate, in the earlier figure
of CFC, if XYZ Co. (Mauritius)
purchases its goods for
XYZ Limited and more than
50 per cent of its income is
derived from sales made
to XYZ Inc and/or other
associated enterprises,
then the XYZ Co. would be
deemed to be a controlled
foreign company and its
income would be liable to
tax in India.
i) Income from management,
holding or investment in
securities, shareholdings,
receivables or other finan-
cial assets;
j) Income falling under the
head residuary sources.
If the above conditions are fulfilled
by a foreign company controlled by a
resident person, then CFC regulations
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would be applicable to such a foreign
company. The above can be explained
by way of the illustration:
Where E is the number of days
during which the foreign company
remained a CFC; and
Illustration 2:
If in illustration 1 above, XYZ Limited
had acquired its stake only on
1
st
January 2010, then the income
would be worked out as under:
Specified Income = (2,00,00,000 +
5,00,000 20,00,000) X (90 / 365)
= (1,85,00,000) X
0.2466
= 45,62,100
Income to be attributed to XYZ Limited
= (45,62,100) x (60/100) x (90/90)
= 45,62,100 X 0.6
= 27,37,260
Way forward
The proposed CFC regulations, when
made effective could have a significant
impact on the many corporate houses
of India having global presence with
likelihood that the profits of their foreign
subsidiaries be taxable in India. Given
the same, it would be advisable for
such companies to review their current
business structure and if required,
restructure the same to adequately
address the challenges which would
be posed by the CFC regulations. n
Under the
jurisdictional
approach of CFC
regulations, foreign companies
set-up by resident companies
in low-tax jurisdictions are
targeted. Accordingly, where
a resident company sets up a
subsidiary mainly to act as an
intermediate holding company or
non-operating holding company
in a low-tax jurisdiction, such
foreign company is deemed to be
a controlled foreign company for
the purpose of CFC regulations. In
such a scenario, CFC regulations
are deemed to be applicable
on such foreign companies in
low-tax jurisdiction and all the
income earned by such foreign
companies is taxed in the hands
of the resident company.
Particulars Conditions fulfilled
Minimum 50 per cent of equity/ voting power in foreign
company is held by resident taxpayer or significant influence
is exercised by such resident taxpayer

Effective tax rate of foreign company is less than the 50 per
cent of tax rate under DTC 2010

Shares of foreign company is not listed on stock exchange in
foreign companys country

Specified income of foreign company does not exceed
equivalent of R25 lakh

It is not engaged in active trade or business

Foreign company is CFC for the purpose of CFC regulations

In such case, the income of the
foreign company, which would form part
of the resident taxpayer controlling the
foreign company, would be computed
as per the below formula:
Income attributed to
resident taxpayer
= A X
B
100
X
C
D
Where A is the specified income of
foreign company to be determined as
the formula provided;
Where B is the percentage of
capital/ voting share or interest held in
the foreign company;
Where C is the number of days out
of D, voting shares/ interest held by
resident taxpayer in foreign company;
and
Where D is the number of days,
the foreign company remained as
controlled foreign company.
The formula to compute the value
of A is provided as under:
Specified Income = (A + B - C - D) X
E
F
Where A is the net profit of the
foreign company as per its profit and
loss account;
Where B is provisions made for
liabilities (other than ascertained
liabilities);
Where C is amount of interim
dividend paid, if such dividend was not
already debited to the profit and loss
account;
Where D is the loss which was
not earlier deducted while computing
income of such foreign company;
Where F is the total number of days
in the accounting period of the foreign
company.
The above formulae can be
explained with the help of the following
illustrations:
Illustration 1:
XYZ Co is a foreign company. During
the FY 2009-10, its net profit was
equivalent of R2 crore. It had made a
provision for unascertained liabilities
to the tune of R5 lakh. It paid an
interim dividend of R20 lakh during
FY 2009-10. During the whole of
FY 2009-10, XYZ Limited held
60 per cent of the total paid up capital
of XYZ Co. In such a case, the income
to be attributed to XYZ Limited for
FY 2009-10 would be determined as
under:
Specified Income = (2,00,00,000 +
5,00,000 20,00,000) X (365 / 365)
= (1,85,00,000) X 1
= 1,85,00,000
Income to be attributed to XYZ Limited
= (1,85,00,000) x (60/100) x (365/365)
= 1,85,00,000 X 0.6
= 1,11,00,000
In the above case, if the income
earned by the foreign company,
XYZ Co is accumulated by it and
remains undistributed, then as per the
provisions of DTC 2010, R1,11,00,000
would be added to the total income of
XYZ Limited.
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