In many countries across the world, governments use the Controlled Foreign Company designation to ensure that domestic tax bases are not eroded and to discourage their citizens from shifting their income to jurisdictions that either do not impose tax or that have very low tax rates. However, while the concept of a controlled foreign company is important to overarching tax evasion regulation, the concept can be a confusing one to break down and make sense of. Here is what you should know about controlled foreign companies.
What Is a Controlled Foreign Company?
Generally, a controlled foreign company, often abbreviated as a CFC, is a company outside of its controller’s resident jurisdiction. While criteria vary from jurisdiction to jurisdiction, a company will typically qualify as a CFC if the following three criteria are met:
- A domestic tax payer “controls” the company
Not all foreign companies are CFCs. In order for a company to be classified in this way, the company must be controlled by a domestic taxpayer. In the United States, control is deemed to exist if the shareholder holds 50 percent or more of voting interests. Therefore, if a US citizen holds 54 percent of voting interests in a company headquartered in Barbados, the company would likely qualify as a foreign controlled company. This ensures that shareholders can’t evade income that would otherwise be taxable through the use of offshore entities.
However, it should be noted that different jurisdictions have different ways of defining “control.” In the UK, for example, the definition is less specific. A company is said to be controlled from the UK if its UK shareholders are able to conduct the affairs of the company in accordance with their wishes. In Canada, control is recognized as one or more persons holding a sufficient number of shares to obtain a majority in the election of the board of directors.
- The company is located in a different jurisdiction from the one in which its controller resides, typically a low tax or no tax jurisdiction
In many jurisdictions, a foreign company would only qualify as a CFC if the tax rate in the CFC’s home jurisdiction were lower than the rate in the jurisdiction of its controller. However, some countries are tightening up on this point. In the UK, for example, a company can still be classified as CFC even if the tax regime is comparable to that of the UK.
- The CFC derives a specific type of income as outlined per regulations
Different jurisdictions have different rules and regulations around the types of income from CFCs that are taxed. A number of jurisdictions just tax types of active income. However, in Canada, for example, passive income is taxed along with certain types of designated income.
The specifics of the criteria can be confusing, but the gist is that if a company is controlled by a resident of jurisdiction but registered in a lower tax offshore jurisdiction, there is a chance it will qualify as a CFC. For example, a non-resident UK company (such as one held in the Cayman Islands or in Malta) that is controlled by a UK resident would be a CFC. Similarly, a non-resident US company controlled by several US-based shareholders would also qualify as a CFC.
How Are Foreign Controlled Companies Regulated?
A number of countries have rules and regulations around foreign controlled companies to ensure that its citizens aren’t able to avoid paying taxes by registering their companies in low tax offshore jurisdictions. The US was the first country to impose regulations on CFCs back in 1962. The United Kingdom, Germany, Japan, Australia, New Zealand, Brazil, Russia and Sweden now also have regulations around CFCs to ensure that the profits of these companies that are apportioned to individuals are taxed appropriately.
Each of these countries has its own unique rules when it comes to ascertaining how CFCs and the individuals that control them are taxed. The overarching commonality tends to be that they are geared toward ensuring individuals aren’t able to evade tax using CFCs. Therefore, as a general rule of thumb, these regulations tend to be aimed more at individuals as opposed to multinational corporations. Therefore, if a company qualifies as an “independent” company, it will often be exempt from CFC regulations.
Are There Any Exemptions?
Just because a company is registered in a jurisdiction other than the jurisdiction where its controller resides does not automatically mean that it qualifies as a CFC. Many jurisdictions have exemptions around CFC status. For example, a controller may not have to pay if income does not exceed a minimum threshold or if the CFC is located in a “white list” country that is not considered to be a tax haven.
In conclusion, the rules and regulations around CFCs can be quite complicated. If your taxes may be affected by CFCs regulations, it is critical to do your research and fully understand any applicable criteria and exemptions.