United States

OECD releases discussion draft on strengthening CFC rules


In March 2014, the Organisation for Economic Co-operation and Development (OECD) released a discussion draft on BEPS Action 3: Strengthening CFC Rules. The draft does not give specific recommendations on implementing controlled foreign corporation (CFC) legislation but rather addresses several possible options that will allow individual countries to consider various “building blocks” to implement their own regimes. The building blocks include:

  1. Definition of a CFC
  2. Threshold requirements
  3. Definition of control
  4. Definition of CFC income
  5. Rules for computing income
  6. Rules for attributing income
  7. Rules to prevent or eliminate double taxation.

Policy considerations

The report begins with the overarching policy principles that countries should consider when adopting CFC legislation. Such considerations include:

  1. The purpose of CFC rules
  2. How to strike a balance between taxing foreign income and maintaining competitiveness
  3. Limiting administrative and compliance burdens while not creating opportunities for avoidance
  4. The role of CFC rules as preventative measures
  5. The scope of base stripping prevented by CFC rules
  6. How to insure that CFC rules do not lead to double taxation
  7. The interaction between CFC rules and transfer pricing rules.

Throughout this section, and the report in general, the OECD discusses Cadbury Schwepes Overseas Ltd v. Commissioners of Inland Revenue (and subsequent cases), one of Europe’s most notable cases which set the standard for European CFC legislation. In Cadbury, the European Court of Justice states that CFC rules, and other tax provisions that apply to cross border transactions must “specifically target wholly artificial arrangements which do not reflect economic reality and whose only purpose would be to obtain a tax advantage.” Recognizing the restrictions of Cadbury, the OECD provides recommendations in light of the limitations placed on EU member states.

Definition of a CFC

The OECD notes that the first step to applying any CFC regime is to determine what constitutes a CFC. The OECD recommends a broad scope that includes not only corporations and their corporate subsidiaries but also partnerships, trusts and permanent establishments under certain circumstances. Specifically, those entities will be considered CFCs when they are either owned by CFCs or are treated in the parent jurisdiction as separate taxable entities. Additionally, the OECD suggests that a subsequent report will include proposals addressing modified hybrid mismatch arrangements in order to prevent entities from circumventing CFC rules by seeking differing treatment in varying jurisdictions.

With regard to transparent entities, the report suggests that entities such as partnerships should not be treated as CFCs to the extent their income is taxed in the parent jurisdiction on a current basis. However, there are two situations in which they recommend CFC treatment for transparent entities. The first, when entities that are not taxable by the country of residence are subject to tax in the parent jurisdictions. The other, when partnerships are owned by CFCs. The OECD reasons that such exceptions are necessary because the CFC itself could be eligible for deferral thus allowing strategic tax planning to blend low and high income tax rates underneath existing CFC structures. The U.S. already has sophisticated branch disparity rules in place to address this concern.

The OECD also recommends two alternative approaches to addressing the CFC rules in the case of hybrid instruments or hybrid entities, a narrow option and a broad option. Both options recommend a hybrid mismatch rule that requires intragroup payments made to CFCs to be taken into account in calculating the parent company’s CFC income. Under the narrow option, an intragroup payment would be taken into account if:

  1. The payment is eroding the tax base of one jurisdiction,
  2. The payment is not included in the CFC’s income, and
  3. The payment would have been included in the CFC’s income if the parent jurisdiction had classified the entities and arrangements in the same way as the payer or payee jurisdiction.

In contrast, the broad option takes a brightline approach that is not concerned with whether the payment is eroding the tax base of a jurisdiction. The broad option could include a rule that an intragroup payment would be taken into account if:

  1. The payment is not included in CFC’s income, and
  2. The payment would have been included in CFC’s income if the parent jurisdiction had classified the entities and arrangements in the same way as the payer or payee jurisdiction.

Threshold requirements

The OECD recommends that threshold rules can be used to limit the scope of CFC rules by creating a threshold to exclude companies that pose little risk to the tax base through base erosion and profit shifting. The recommendation under this section of the discussion draft is to include in CFC legislation a low-tax threshold where the tax rate calculation is based on the effective tax rate. The OECD suggests the use of a tax rate that is meaningfully lower than the tax rate in the country applying the CFC rules. In other words, if the CFC is taxed on a substantially similar basis as the income would be in the home country, the risk of base erosion is lessened. The OECD considers three types of threshold requirements:

  1. A de minimis amount below which the CFC rules would not apply
  2. An anti-avoidance requirement, which would focus CFC rules on situations where there was a tax avoidance motive or purpose
  3. A low tax threshold where CFC rules would only apply to CFCs resident in countries with a lower tax rate than the parent company.

The OECD outlined both a broad and narrow approach to determine the threshold. Under the broad approach, the effective tax rate could be calculated on an entity-by-entity basis or on a country-by-country basis in order to aggregate income. Under the narrow approach, effective tax rates would be calculated on each individual item of income. The OECD recognizes that many countries have similar legislation and that fragmentation of income through multiple subsidiaries can be used to circumvent these rules. While additional anti-avoidance legislation can add significant complexity to the rules, it is recommended as part of a holistic CFC proposal.

Definition of control

Existing regimes often refer to “control,” “participation,” and “influence” over a foreign entity. The OECD notes that control is important in the context of base erosion and profit shifting as it can be an indicator as to whether resident shareholders have sufficient influence over a foreign company to effectuate profit shifts. The OECD suggests that CFC rules should look at two different determinations:

  1. The type of control that is required
  2. The level of that control.

First, the discussion draft suggests both a legal and an economic test and satisfaction of either test would result in an entity be defined as controlled. For this purpose, legal and economic control may be defined as follows:

  1. Legal control—This test looks at a resident’s holding share capital to determine the percentage of voting rights held in a subsidiary. By looking at voting rights and the ability to elect a board of directors, this is a relatively mechanical test that is easy to apply.
  2. Economic control—This test looks at the rights to profits, capital and assets of a company in certain circumstances such as dissolution or liquidation. This test recognizes that a resident can control an entity through certain economic rights even if they do not hold a majority of the shares.

Second, a CFC should be treated as controlled where residents exert, at a minimum, 50 percent control. The OECD recognizes that countries with broad policy goals could set that standard lower. The level of control could be determined through aggregation of the interest of related and unrelated resident parties or by aggregating the interests of any taxpayers found to be acting in concert. Control may exist directly or indirectly. The draft also recognizes that in some cases it may be appropriate to apply other tests in addition to legal and economic control including:

  1. De Facto control—This test looks at factors such as who makes the top-level decisions regarding the affairs of the foreign company and who has the ability to direct or influence day-to-day activities. This test could also look at contractual ties with the CFC that permit taxpayers to exert influence over its activities.
  2. Control based on consolidation—This test looks at whether a non-resident company is consolidated in the accounts of a resident company based on certain accounting principles. This is not a fundamentally different test than those above and simply acts to compliment those tests.

Definition of CFC income

Whether the income earned by the CFC is of the type that raises concerns of base erosion and profit shifting and whether that income should be attributed to controlling parties are important determination according to the OECD. The discussion draft notes that existing CFC regimes currently implement one of two approaches. The first approach is a full inclusion system which treats all income earned by a CFC as CFC income regardless of its character. The second approach is a partial inclusion system which attributes only certain income. The Subpart F regime in the U.S. largely considered a partial inclusion system.

The OECD does not provide recommendations for how to define CFC income but rather discusses the various approaches to address the issue. The discussion draft lists categories of income that may evidence base erosion including:

  1. Dividends
  2. Interest and other financing income
  3. Insurance income
  4. Sales and services income
  5. Royalties and other IP income.

Two possible approaches of accounting for income are discussed. First, under the Form Based Analysis approach, passive income (i.e., income not typically derived from an active trade or business) would be taxed in the parent jurisdiction. While a pure form based analysis has some administrative and mechanical advantages, it can easily be manipulated and would allow much of the base erosion planning currently in vogue to continue. For example, taxpayers could reclassify royalty income as sales income in order to escape a CFC regime that applies to royalty income.

The second approach is a Substance Based Analysis. This approach looks to whether the income arose from substantial activities undertaken by the CFC itself. This rule could exist on a standalone basis or as a sort of hybrid rule with the Form Based Analysis. Under this approach, governments could apply a “substantial contribution” analysis to determine if the employees of the CFC have made a substantial contribution to the income earned by the CFC. Alternatively a “viable independent entity” analysis could be used. Under this approach, a government would look at all significant functions performed by entities within the group to determine whether the CFC is the entity which would be most likely to own particular assets or undertake particular risk if they were independent parties. Under a third alternative, the “employees and establishment” test, a CFC would be treated as undertaking substantial activities if the CFC has the requisite employees and business premises in the CFC’s jurisdiction necessary to earn its income. As stated above, potential final CFC legislation could blend these ideas to reach certain policy goals.

Rules for computing income

According to the OECD, computing the income of a CFC requires two different determinations. First, which jurisdiction’s rules should apply? Second, are additional specific rules for computing CFC income necessary? The OECD recommends using the rules of the parent jurisdiction to calculate a CFC’s income. and also recommend the adoption of rules that allow CFCs to deduct costs only against profits of the same CFC or against the profits of other CFCs in the same jurisdiction.

Rules for attributing income

Building on the rules for computing the income the OECD turns to the determination of how to attribute income to the appropriate shareholders of the CFC. The discussion draft notes that income attribution can be broken into five steps:

  1. Determining which taxpayers should have income attributed to them
  2. Determining how much income should be attributed
  3. Determining when the income should be included in the returns of the taxpayers
  4. Determining how the income should be treated
  5. Determining which tax rate should apply to the income.

The OECD’s recommended approaches to these questions are as follows:

  1. The attribution threshold should be tied to a minimum control threshold when possible. The draft notes that countries should be free to choose different control thresholds and attribution rules based on the underlying policy of their CFC rules.
  2. The amount of income to be attributed to each shareholder or controlling person should be calculated taking into account proportion and period of ownership or influence.
  3. The tax rate of the parent jurisdiction should be applied to the income. Alternatively a “top-up” tax could apply the home country’s statutory rate if the CFC’s effective tax rate is below a certain threshold.

Rules to prevent or eliminate double taxation

The OECD notes that adequate rules to prevent or eliminate double taxation are an underlying principle of international taxation. The discussion draft focuses on three areas where double tax could arise in the context of CFC rules:

  1. Situations where the attributed CFC income is also subject to foreign corporate taxes
  2. Situations where CFC rules of more than one jurisdiction apply to the same CFC income
  3. Situations where a CFC actually distributes dividends out of income that has already been attributed to its resident shareholders under the CFC rules, or a resident shareholder disposes of the shares of the CFC in a taxable transaction.

The discussion draft notes that there are other situations, particularly in the transfer pricing context, where issues could arise. The OECD’s recommendation in the first two situations is to allow a credit for foreign taxes actually paid. The credit should include CFC taxes assessed on intermediate companies. This system would work similarly to the United States’ Foreign Tax Credit regime. With regard to the third situation, the OECD would exempt dividends and gains on disposition of CFC shares from taxation if the income of the CFC has already been subject to CFC taxation. The OECD notes that the precise treatment may vary depending on how each country sets up their CFC regime.


While the draft is not a final document, it sets out a basic framework for countries to consider in their domestic CFC legislation. While it is not a consensus based approach, it does provide building blocks to try to create some uniformity as this type of legislation is adopted in OECD and non-OECD countries. 

Taxpayers should closely monitor the OECD’s work in this area because these proposals are likely to have a significant impact on taxpayers with European entities. If these proposals are adopted in whole or in part, taxpayers will likely be exposed to additional current tax in the countries that adopt them. Taxpayers should evaluate the impact of these proposals and consider potential planning alternatives before the proposals go final. If final OECD BEPS proposals are adopted through a multilateral instrument adopted by a multiple of countries, the tax landscape could change very quickly. Taxpayers who are unprepared will be caught by surprise but those that have studied the proposals may be able to adapt quickly.


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