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Anti-Tax Avoidance Measures and Controlled Foreign Companies: - An Analysis of the US Rules from the UK Legal Perspective"

By Dr. George L. Salis**

Dean George L. Salis, PhD. LLM, LLB (Hons), BS, CMA, RFA, MFP Mas. Fin. Prof. , CEPA Dean and Programme Director, Legal Studies Dept., Keiser College, CEO & Principal JurisConsults International Group, LLC Member: ABA, IBA, London Court International Arbitration, Royal Society of Fellows Florida,USA. Member: ABA, IBA, London Court International Arbitration, Royal Society of Fellows.

I. Introduction

This short treatise comprises a comparative examination of the Controlled Foreign Corporation, or CFC rules of two countries: the US and the UK. It examines their purpose, necessity, and practicality in a "new" global economy. As foreign companies can be used effectively as vehicles to avoid or evade taxes, countries around the world, especially those which are contracting members of the Organisation for Economic Co-operation and Development (OECD), have devised complex set of anti-avoidance rules specifically designed to curve and eradicate tax avoidance practices by individual and company taxpayers, and thus, effectively confronting the growing economic menace presented by tax havens, and their harmful tax competition. The proposition presented here is that tax avoidance (and evasion) practices, such as using CFCs to avoid tax, are, per se, inequitable and unfair, as these practices violate the principles of tax equity among citizens of the same nation, as well as the principles of inter-nations equity, by seriously undermining the economic balance of regions, their economic development and sustainability through the erosion of a country's tax base.

Therefore, it can be safely concluded that tax avoidance is not only inequitable, but also violates tax neutrality systems and poses severe hazards to the economic, social, and political infrastructures of nations and the economic efficiency of countries and regions. The arrival of the global economy has changed the infrastructure of countries, and it has moved nations from internal economic nationalism to external international economic co-operation and towards integration. Thus, elimination of borders, boundaries, and barriers in all economic sectors has now become a reality. Together with the advent of greater telecommunication technology capabilities, the availability of opportunities now exists to accumulate assets throughout the world and to keep them beyond the sight of most domestic revenue authorities.

Both the US and the UK are the world's principal and most authoritative "global" tax systems. This means that in taxing income, their trans-national character tends to focus more upon the "status" of the taxpayer as opposed to the type of income earned, or whether the income is foreign or domestic . Global tax systems tend to emphasise less, and make fewer distinctions, on the type of income earned abroad, and are inclined to subject all income to taxation at the same rate. Global tax systems, also known as "unitary" systems, stress the status of the taxpayer, then connects the taxpayer to the taxing country by citizenship, residency, or some other standard, by which the taxpayer must then pay a tax on its global income. The other important system of taxation present in the world today is known as the "schedular" system. This system emphasises more the distinction and categorisation of income in accordance to its source, whether it is dividends, capital gains, sales of goods, or professional services. Many European and Latin American countries prefer to be classified as schedular tax jurisdictions. Therefore, global systems of taxation are said to be "domiciliary, territorial, or residence" based jurisdictions, whereas the schedular systems are considered "source" based jurisdictions, as these are more concerned with the source or origin of the income itself.

In fact, the number of nations joining the ranks of global tax jurisdictions is increasing. This is occurring more as international organisations, such as the OECD, promote tax co-operation and harmonisation and as the numbers of international tax treaties, which are designed to prevent double taxation, also multiply. Although the tax codes of both the US and the UK do distinguish between some kinds of income, they are unusual among jurisdictions to tax their citizens on their world-wide income, regardless of residence. Early on, in 1924, the United States Supreme Court, in the case of Cook v Tait, held that taxation of US citizens abroad, on their world wide income, violated neither the US Constitution, nor the principles of international law . The Supreme Court justified its rationale by explaining that the advantages and benefits of citizenship extended well beyond territorial boundaries.

As most nations of the world will continue to tax their citizens and residents, whether individuals or companies, on a world-wide basis, all income earned abroad must be accounted in order to assess tax fairly and to maintain an adequate well-diverse tax base. If taxpayers of one country can keep certain assets concealed, or at least beyond the sight of their country's tax authority, those taxpayers are able to exclude such assets or income from their yearly tax liability for an indefinite period of time. Even if taxpayers are "candid" about their earnings and intend to declare all income earned abroad, they will nevertheless, attempt to minimise their tax liability in as much as possible through the use of foreign base entities. We are here reminded once again, that generally the mind-set of most taxpayers anywhere is to arrange their affairs in such ways as to minimise their tax obligation, as much as possible. This long held belief can be seen of in landmark cases such as the UK's Inland Revenue Commissioners v Duke of Westminster's Case.

In most jurisdictions, when a taxpayer conducts business in another country outside its own tax home base, that foreign income earned will be taxed in some way. That tax imposed, however, will depend upon the type of business conducted, the manner in which the business was conducted, and how was that business conducted, that is, the type of entity or organisational vehicle used to conduct business abroad. In some cases, depending on a country's network of international tax treaties with other jurisdictions, and upon treatment of foreign transactions by its domestic tax rules, such tax may be reduced by tax credits, or it may be exempted altogether. At times, it may be deferred until a later time when some connected (taxable) event occurs such as distribution to shareholders, dissolution or sale of the company, etc. Regardless of jurisdiction, when taxpayers operate in low tax jurisdictions, not only do they enjoy so-called "tax holidays," but they may also enjoy a deferment in paying those taxes. Such is the case in the US, the UK, and other developed nations. Consequently, when companies and individuals operate abroad, they may be able to avoid taxation of that foreign income or minimise it greatly to the point of escaping most, if not all, of the taxes due in any particular year. Needless to say, when individuals or companies operate other entities or companies in jurisdictions that are classified as a tax havens, or considered to be havens by other countries, then those taxpayers will not escape taxation of the income earned abroad, but they will also be able to avoid taxes on the income earned by the accumulation of their assets kept abroad.

It is essential that the deferral principle is introduced here, since the CFC rules that regulate foreign company income could not possibly function effectively without it. The principle of deferral, which was first introduced in America, characterises the consequence of treating the foreign subsidiary as a complete and separate foreign legal entity and taxpayer. This means that the separate legal (company) personality of country X is respected regarding domestic tax purposes in country Y and that no domestic taxes will usually be imposed on those foreign earnings, until some later time. At that later time, such income will be taxed in some form by the country of residence of the company, by the country of the stockholders, or as provided by treaty under the exemption method or the credit method. The deferral system, when coupled with the exemption and credit methods, become the most efficient manner currently in use for the elimination of economic or juridical double taxation. The deferral approach is used as a rule of convenience world-wide, and it has been adopted by the US, the UK, Canada, and other capital-exporting nations to treat foreign company income. It has also become important concept in the realm of international commerce, trade, and economics.


II. UK / US Statutory and Regulatory Analysis

Unlike the United States, which deals with CFC in a single body of tax regulations, the UK has now consolidated and codified its CFC regulations into a single body of legislation. Originally enacted in 1984, the UK's CFC legislation was eventually consolidated into what is now, the Income and Corporation Taxes Act 1988, (ICTA) Chapter IV, §§ 747-756, and Schedules 24-26. Altogether these are known as the Taxes Acts, (or TA 1988). In the US, CFC regulation can be found particularly in Part III, Subpart F, Internal Revenue Code (I.R.C.) 26 U.S.C.A. §§ 951-960. The UK CFC legislation, similar to its US counterpart, has been primarily enacted to discourage companies from redirecting income outside the UK in order to avoid taxation of their foreign base income. Although the anti-avoidance purpose and objectives are very similar indeed, the focus and approach are distinct in substance, and quite different in procedure. The first major difference in the approach of these two systems, is the model each use. Many, if not most, of the US trading partners in Europe and elsewhere, tend to conform much more to the OECD Model Treaty. However, the US, although a contracting member of the OECD, is inclined to follows its own (US) Model Income Tax Treaty.

Although first glance the CFC rules of the UK and the US appear similar in substance, this can be misleading, as the procedure in these two systems are vastly unlike. For example, the US rules, contained in sections 951-960 IRC, are a strictly a creature of legislation, although aided at times by case law. In Britain, many of the key concepts and definitions have been kept outside the legislation, kept in their original common law explications, and are left Courts for interpretation, almost the reverse of their American counterpart. These differences will be discussed below without the necessity of outlining the entire code, or legislation, whilst still highlighting their major differences and similarities.

The UK continues to amend its CFC rules in order to deal more effectively with its internal tax avoidance dilemma and the harmful tax competition caused by low tax jurisdictions and "tax havens" that are currently British Territories, or former colonies. It does so in response to the continuing development of the OECD's effort to eliminate harmful tax competition and due to the continuing supra-national unification endeavours of the European Union (EU). Although minor amendments to the CFC rules have been made since 1984, the most remarkable and radical changes were made in 1998, and the ensuing years. The most significant of these 1998 modifications to the CFC legislation, is that it now functions automatically, and it is self-enabling. It no longer needs pre-requisites or any further direction by Inland Revenue, as covered in the provision in made in section 743(3) of the Act.

However, unlike the US, which specifically defines residency for a corporation, and when is a corporation resident, the UK rules does not define, or provide a specific answers to this questions. Instead, these issues are to be determined under regular common law principles of company law . Thus, the law regarding the determination of a company's residence can be found in the landmark case of De Beers Consolidated Mines Ltd. v Howe, and the law determining dual residency, appeared in Swedish Central Rlwy Co.Ltd, v Thompson, in Union Corporation Ltd v IRC. and in Unit Construction Co. Ltd v. Bullock. Furthermore, since many aspects of the law are unclear as to definition and requirements of residency, guidance may also be found in the published Practice Statements of Revenue. For example, concerning residency and CFCs, in Practice Statement SP 1/90, emphasised that in the UK, the company residence issue is ultimately a matter of fact, and as such, it must be in accordance with case law. This common law approach to residency also applies in the determination of the residency of the persons exercising control of the company or any CFC in question.

Although this legislation does not as a matter of statute determine whether or not a company is resident in the UK, it does, however, provide a definition of a non-resident company. Section 749(1), TA 1988, provides that a non-resident company in the UK is regarded as resident of the territory or jurisdiction where it is liable to tax, that is, its home tax-base, by reason of domicile, residency, or place of management. This test is at times problematic since a company may be resident in various territories or countries at the same time. When a company is resident in various territories at the same time, the test is that a company is deemed to be resident of the place of its "effective management." If the management is divided between two places, then, the company is regarded as resident of the place where the greater amount of the company's assets are held.

Unlike the rules in the US, and crucial to understanding the UK's CFC rules, is the significance of the requirement of "subject to a lower level of taxation," as provided in section 750(1). This requirement is central to the UK rules, as it key to the definition a CFC in the UK. In order to calculate the amount of corresponding UK tax and the local tax, the company's profits must first be calculated. Thereafter, any local taxes must be determined, which is; the amount of taxes due in the place where the company is resident. Then, a calculation is made on what the UK rules calls "chargeable profits," and what is the corresponding UK tax on those profits. If the local tax is less than three quarters of the corresponding UK tax, the company is regarded as being subject to a lower level of taxation, triggering automatically the (new) CFC regulations. Since in the UK the income tax rules also apply in the computation of corporate tax profits, the result is a calculation by cases and schedules of a foreign company's income. Consequently, for the purpose of CFC rules, the result is that the corresponding UK tax is what the chargeable profits would be, given certain additional assumptions plus the exclusion of any double tax relief attributable to local tax and the deduction of any UK tax already paid by the company. Therefore, unlike the US rules, which looks at stock percentage, and/ or interest ownership in the corporation, to determine what constitute a CFC, the UK rules look towards the place of effective management controlling the company's residency, and more importantly, to the lower level of taxation requirement / test, in order to determine whether a company is, or is not, a CFC.

Whereas in the US it is often simpler to determine whether a corporation is a CFC, as these are based on a prescribed formula of ownership, in the UK the complexity of the rules makes this a more difficult task. In the US, the Code's test for determining whether or not a foreign company or corporation is a CFC lies in the direct or indirect ownership and in constructive ownership. Under the US rules, a corporation is a CFC, if US shareholders own more than 50% of the total combined voting power of its stock, or more than 50% of the stock's total value. This US treatment of attributing ownership of shares is the same for foreign partnerships or trusts that own shares in foreign corporations. Section 957(a) requires that ownership must be attributed to the partners or beneficiaries accordingly.

However, though similar to the US in some ways, the UK's method of chargeable profits and/or creditable tax to the CFC, is apportioned among the persons, whether resident in the UK or not, who had an interest in the CFC at any time during the accounting period under examination. The basis of an apportionment is made broadly and follows the interests held in the CFC. The definition of "persons having an interest" in a CFC includes shareholders and any person(s) who control the company in any manner, who may participate in distributions, or who have power to enjoy the company's assets and/or income.

Giles Clark, in his book on UK offshore tax planning commented that:

".Given the complexities of the rules for determining local tax and the corresponding UK tax, those concerned with foreign companies can be forgiven for concluding that it is never possible to predicate with certainty whether a company or is not a CFC"

The new self- assessment provision of UK CFCs complicates matters further. Part XVII, Chapter IV ICTA 1988 assesses UK resident companies' taxes arising from the income of certain CFCs in which they have a controlling interest. In the UK, a company is regarded a CFC, if an overseas company is controlled by UK residents which would pay less than three quarters of the tax it would have paid on its income had it been a resident in the UK. These CFC provisions are mainly directed at companies that make use of low tax (or no-tax) jurisdictions, and/or other favourable overseas/foreign tax regimes, in order to reduce their UK tax liabilities and obligations.

There also is no single and precise definition of "company" included in Chapter IV. Therefore, the meaning given by Section 832(1) ICTA applies here. The definition of "company control" is to be determined broadly according to Section 416 ICTA 1988.

Under the TA 1988, s. 747(1) a company is a CFC, if it meets three conditions in any accounting period:

a) the company must be resident outside of the UK;
b) it must be controlled by persons resident in the UK;
c) the company must be subject to a lower level/rate of taxation in the jurisdiction or territory in which it is resident.

Moreover, in 1998, Section 113 and Schedule 17, of the Finance Act 1998 (FA 1988), amended the CFC legislation and brought it within "self-assessment." Under self-assessment, companies in the UK are now required to assess their own CFC liability. This new requirement will apply to all UK companies for their accounting periods ending on, or after 1 July 1999, if:

(1) they have a relevant and applicable interest in a CFC, and

(2) the accounting period of that CFC, ends within their own accounting period.

In general, the CFC legislation requires that:

a) a computation of the profits (exclusive of capital gains) of a controlled foreign company for an accounting period, broadly on the lines of corporation tax profits,

b) an apportionment of the profits among those with an interest in the company, then,

c) a self-assessment on tax, by all UK companies to which 25%, or more, of all profits which have fallen to be apportioned. (Amounts apportioned to associates are taken into account in calculating whether the 25% threshold is passed, but not in calculating the amount of tax due.)

Tax relief is usually available for any foreign taxes that the CFC has already paid and also for any other tax allowances to which any UK company is entitled. Also, any taxes charged under Chapter IV may then be credited against the UK Company's liability under Case V, in respect of any dividend(s) paid by the CFC out of the profits, regarding the charge arising from Chapter IV.

Unlike the US, the assessment of a CFC in the UK is determined from accounting period to period and does not hold such "enduring" CFC classification, as per the provisions of section 951 IRC. The UK's CFC rules provide for a number of statutory "exclusions of apportionment" which are designed to ensure that the provisions in Chapter IV are directed principally at CFCs that are created and used primarily for the purpose of reducing or mitigating UK taxes. Thus, a foreign company may not necessarily be a CFC in each of its accounting periods and it may meet the requirements of exclusion in one accounting period even if it fails to do so in another. In reality most foreign companies that are under UK control will not be subject to a charge under Chapter IV of the Act.

Accordingly, no apportionment of profits will be due for any accounting period of a CFC if during that period the company fulfils any one of the statutory exclusions provided by the Act. These exclusions (or conditions), outlined below, are designed expressly as anti-avoidance measures. They are also a sort of anti-deferral regime used to minimise the abuse or misuse of the foreign company as a vehicle to avoid UK tax by focusing on the source of profits.

a) Excluded Countries Regulations
b) Acceptable Distribution Policy
c) Exempt Activities Test
d) Public Quotation Condition
e) De Minimis Exclusion
f) Motive Test

a) In order to fall within the "excluded countries" exemption, a company must be resident in a jurisdiction listed in either Parts I or II of the "Excluded Countries Regulations" and also meet the income and gains requirements, as provided in Regulations 4 and 5 of either part.

b) To be included in the "acceptable distribution policy," a company must pay within 18 months of the end of its accounting period, a dividend equal to or greater than 90% of its chargeable profits (broadly taxable profits) to persons resident in the United Kingdom. Rules are laid down for computing the profits out of which the dividends have been paid. Restrictions are placed on the payment of dividends out of specified profits, and there is a scaling-down of the dividend requirement for certain companies whose shares are partly held by non-residents. There are also specific regulations dealing with CFCs that conduct insurance business and those that may use an accounting or fiscal method other than on an annual basis. Moreover, holding companies that also satisfy (1) and (2) below, and satisfy other specific requirements, e.g., regarding the sources of their foreign income, may satisfy the required test.

c) For a foreign company to satisfy the "exempt activities test" a company must meet three primary conditions throughout the entire accounting period examined, the company:

(1) must have a "business establishment" in its territory of residence;

(2) business affairs must be "effectively managed" in its territory of residence; and

(3) main business must at no time consist of certain defined activities (for example, investment business).

d) The "public quotation condition" can be fulfilled if all shares carrying at least 35% of the voting rights of the company must be held by the public, and there must be dealings in those shares on a recognised stock exchange. Restrictions are imposed in respect of shares held by "principal members."

e) In order for the "de minimis test" to apply, the required chargeable profits of a company must be in the amount of £50,000, or less, in a twelve-month accounting period.

f) For a foreign company to satisfy the "motive test" for any accounting period, it must fulfil both of the following conditions:

(1) where a transaction(s) reflected in the company's profits in the accounting period has, or have achieved a reduction in UK taxes, either the reduction was minimal, or it was not the main purpose, or one of the main purposes, of the transaction(s) to achieve that reduction; and,

(2) it was not the main reason, or one of the main reasons, for the company's existence in that period to achieve a reduction in UK taxes by a diversion of profits from the UK.

In closely related, but distinct manner the US also apportions the income taxable to shareholder of CFCs. For example, if a foreign corporation is considered a CFC for an uninterrupted period of 30 days or more, during a taxable year, each US holder that owns stock by the end of that year, must include in income the sum of two major factors: the individual shareholder's pro rate share of any subpart F income plus any earnings of the CFC invested in US property . In fact, the IRS treats US shareholders as having obtained a current distribution from Subpart F income plus any foreign earnings invested in US property.

Unlike the US, the UK's CFC regulations actually provide for a list of Exempt Activities and Forbidden Businesses. A CFC is conducting exempt activities if its main business falls outside of certain proscribed and forbidden fields and if it satisfies two conditions as to the way the business is conducted. These two conditions are that:

1) the company must have a business establishment in the place in which it is resident;
2) its business affairs in that territory must be effectively managed there.

Thus, if the company avoids the forbidden businesses and earnestly operates where it is resident, the exempt activities requirement is satisfied. The forbidden businesses included in Schedule 25, paragraph 6(2), of the Act, are:

a) Investment business,
b) Dealing in goods for delivery to or from the UK, or to or from connected or associated persons,
c) Wholesale, distributive, or financial business if 50% or more of the gross trading receipts are derived from connected or associated persons or from persons to whom 25% or more of the company's profit would be apportionable.

These forbidden practices or measures are taken as to prevent the easy transfer of assets and/ or funds to or from the UK that would circumvent the quick (or disposable) mobility of such assets in order to avoid tax.

Last, we shall examine the structure and regulation of foreign holding companies in both countries, as these are frequently used tax avoidance vehicles. Although both jurisdictions deal with foreign "holding" companies, their approach to regulating them, as to prevent the use of tax avoidance schemes, is highly different. The use of foreign holding companies as "base" business structures for tax avoidance has increased dramatically around the world in the last thirty years. Principally, many these companies are used as an income and asset "storage facility" to keep foreign earned income out of the sight and reach of revenue authorities. Together with the added features of income and/or asset mobility, and easy transferability, these holding companies can make efficient mediums for avoiding taxes, and consequently, revenue authorities must regulate their use and operation in order to circumvent any potential tax avoidance scheme.

In the US, the Internal Revenue Code of 1986 (IRC) and its subsequent amendments comprise the Internal Revenue Code of the United States. Part III, of the Code, entitled "Income from sources without the United States" contains Subpart F, which is the body of legislation dealing with controlled foreign corporations in the US, particularly Sections 951-964, which contain specifically the CFC rules. Principally, subpart F is levelled at two kinds of foreign income: passive investment income and any income deriving from related or associated corporations or companies that are using a foreign base company to allocate income away from its associated entities in the high-tax jurisdictions.

For purposes of this proviso the term "subpart F income" means, in the case of any CFC, the sum of:

(1) insurance income (as defined under section 953),
(2) the foreign base company income (as determined under section 954),
(3) an amount equal to the product of:
(a) the income of such corporation other than income which:
(i) is attributable to earnings and profits of the foreign corporation included in the gross income of a United States person under section 951, or,
(ii) is described in subsection (b), multiplied by,

(b) the international boycott factor (as determined under section 999),

(4) the sum of the amounts of any illegal bribes, kickbacks, or other payments (within the meaning of section 162(c)) paid by or on behalf of the corporation during the taxable year of the corporation directly or indirectly to an official, employee, or agent in fact of a government, and,

(5) the income of such corporation derived from any foreign country during any period during which section 901(j) applies to such foreign country.


As stated before these two types of incomes can be easily transferred between jurisdictions in order to minimise or avoid taxation. What the IRC calls Subpart F income is comprised of: foreign base company income (which is the most significant of these), income arising from insurance derived from US risk activities, income arising from countries engaged in international boycotts, and definite illegal payments, such as bribes, etc.
Foreign base company income is actually defined in the five main categories as provided in section 954 IRC.

a) Foreign Personal Holding Company (FPHC) - defined in section 954(a)(1)-(c). Which states that for purposes of subsection (a)(1), the term "foreign personal holding company income" means the portion of the gross (passive) income which consists of:

(a) Dividends, etc, (Dividends, interest, royalties, rents, and annuities).
(b) Certain property transactions,
The excess of gains over losses from the sale or exchange of property, which:
(i) which gives rise to income described in subparagraph (A) (after application of paragraph (2)(A)) other than property which gives rise to income not treated as foreign personal holding company income by reason of subsection (h) or (i) for the taxable year,
(ii) which is an interest in a trust, partnership, or REMIC, (real estate mortgage investment conduit) or,
(iii) which does not give rise to any income.

(c) Commodities transactions
(d) Foreign currency gains
(e) Income equivalent to interest
(f) Income from notional principal contracts-
(g) Payments in lieu of dividends.

The second category is the Foreign Base Company Sales Income, as provided in section 954(a)(2) and (d). For purposes of subsection (a)(2), the term "foreign base company sales income" means income (whether in the form of profits, commissions, fees, or otherwise) derived in connection with the purchase of personal property from a related person and its sale to any person, the sale of personal property to any person on behalf of a related person, the purchase of personal property from any person and its sale to a related person, or the purchase of personal property from any person on behalf of a related person where:

a) the property which is purchased (or in the case of property sold on behalf of a related person, the property which is sold) is manufactured, produced, grown, or extracted outside the country under the laws of which the controlled foreign corporation is created or organised, and,

b) the property is sold for use, consumption, or disposition outside such foreign country, or in the case of property purchased on behalf of a related person is purchased for use, consumption, or disposition outside such foreign country.

However, it should be noted that for purposes of determining foreign base company sales income, in situations in which the carrying on of activities by a CFC through a branch or similar establishment outside the country of incorporation of the foreign corporation, has substantially the same effect as if such branch, or similar establishment, were a wholly owned subsidiary corporation deriving such income. Under certain regulations, any income attributable to the carrying on of such activities, from such a branch or similar establishment, will be treated as income derived by a wholly owned subsidiary of the controlled foreign corporation and may constitute foreign base company sales income of the CFC.

For these purposes, a "person" has been defined as a "related person" with respect to CFC if:

(a) such person is an individual, corporation, partnership, trust, or estate which controls, or is controlled by, CFC, or,
(b) such person is a corporation, partnership, trust, or estate which is controlled by the same person or persons which control the CFC.
The third category covered under this section is the Foreign Base Company Services Income, which for purposes of subsection (a)(3), the term "foreign base company services income" means income (whether in the form of compensation, commissions, fees, or otherwise) derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services that:

(a) are performed for or on behalf of any related person
(b) are performed outside the country under the laws of which the CFC is created or organised.

The fourth category is that of the Foreign Base Company Shipping Income. For purposes of subsection (a)(4), the term "foreign base company shipping income" means any income derived from, or in connection with, the use (or hiring or leasing for use) of any aircraft or vessel in foreign commerce, or from, or in connection with the performance of services directly related to the use of any such aircraft, or vessel, or from the sale, exchange, or other disposition of any such aircraft or vessel. Such definition usually includes, but is not limited to:

(1) dividends and interest received from a foreign corporation in respect of which taxes are deemed paid under section 902, and gain from the sale, exchange, or other disposition of stock or obligations of such a foreign corporation to the extent that such dividends, interest, and gains are attributable to foreign base company shipping income, and,

(2) that portion of the distributive share of the income of a partnership attributable to foreign base company shipping income.

The fifth and last category is that of Insurance Companies Income, which is provided for in section 952(a)(1). This rule is essential for anti-avoidance purposes, as it prevents US citizens from avoiding US taxes by organising the so-called "captive insurance company, " which is an insurance that insures its own US stockholders. For purposes of section 952(a)(1), the term "insurance income" means any income which:

(a) is attributable to the issuing (or reinsuring) of an insurance or annuity contract, and,
(b) would (subject to the modifications provided by subsection (b)) be taxed under subchapter L of this chapter if such income were the income of a domestic insurance company.

As already explained above, section 954 defines "foreign base company income." This term "foreign base company income" means for any tax year, the sum of the foreign personal holding company income and the foreign base company sales, services, shipping, (and oil related) income. If the sum of foreign base company income and the gross insurance income for the tax year is less than the lesser of 5 percent of gross income or $1,000,000, then, no part of the gross income for the tax year is foreign base company income or insurance income. However, if the sum of the foreign base company income and the gross insurance income for the tax year exceeds 70 percent of gross income, then, the entire gross income for the tax year is foreign base company income or insurance income.

Moreover, "de minimis" rule, applies to CFCs in any taxable year. That is; if the sum of foreign base company income and the gross insurance income for the taxable year is less than the lesser of:

(a) 5 percent of gross income, or,
(b) $1,000,000,

then, no part of the gross income for the taxable year shall be treated as foreign base company income or insurance income

The Check-the-Box regulation, which became effective on January 1st, 1997, was intended to simplify the entity classification process for the IRS. Sections 701, et seq., of the IRS regulations now serve that purpose. These new classifications rules, designed to replace the old method established by the "Kitner Regulations," now simplify the process of classifying entities for the purpose of US taxation.

The UK's CFC legislation also provides for definition, classification, and regulation of holding companies. There, holding companies are classified under paragraphs 6(3) - 6(4)(a), of Schedule 25, as:

a) Local holding companies,
b) Ordinary holding companies, and
c) Superior holding companies

Holding companies, as stated earlier, must operate within certain exempt business, and only these three types come within the exempt activities test exemption. The definition of a holding company in the UK is provided by Paragraphs 6(6), and 12(1)-(3) Schedule, 25 ICTA 1988, stating that:

A controlled foreign company will be treated as a holding company for the purposes of the exempt activities test if it is:

a) a company the business of which consists wholly or mainly in the
holding of shares or securities of either of the following types of companies:

i) "local holding companies" (or a 'local holding company') which are its 90 per cent subsidiaries (see paragraph 3.3.82 onwards), or

ii) trading companies (or a trading company) which are either 51 per cent subsidiaries or "maximum permitted shareholding companies" (see paragraph 3.3.65); or,

b) a company which would fall within (a) above if it were disregarded, as so much of its business as consists in the holding of the property or rights or any description, for use wholly or mainly by companies which it controls and which are resident in the territory in which it is resident.

A company may engage in activities other than the holding of shares or securities in the types of company specified above, provided that its business consists wholly or mainly in the holding of such shares or securities (or would so consist if the part of its business relating to the holding of property etc for use by its subsidiaries resident in its own territory of residence were disregarded). For example, the existence of some trading activity, shareholdings not of the type specified, (as in associated companies or dormant subsidiaries) or portfolio investments will not prevent the company from qualifying as a holding company, provided that its business consists wholly or mainly in the holding of shares or securities in the types of company specified by paragraph 3.3.61 of the Act. 'Wholly or mainly' here refers to more than 50% of the actual business.
The superior holding company was first introduced by the Finance Act 1998, (FA 1998), and for the purpose of Paragraph 6(6), and 12A(1)-(3) Schedule, 25 ICTA 1988, the definition of a "superior holding company" is as follows:

A controlled foreign company will be treated as a superior holding company for the purposes of the exempt activities test if it is

a) a company the business of which consists wholly or mainly in the
holding of shares or securities of companies (or a company) which are:

(i) holding companies or local holding companies, or,

(ii) are themselves superior holding companies, or,

b) a company which would fall within (a) above if there were disregarded
so much of its business as consists in the holding of property or rights of any description, for use wholly or mainly by companies which it controls and which are resident in the territory in which it is resident.

Income required of holding companies under paragraph 6(4) Schedule, 25 ICTA 1988, states that for a holding company other than a "local holding company" to satisfy the exempt activities test, at least 90 per cent of its gross income during the accounting period under consideration must be derived directly either from companies which it controls or from companies which are "maximum permitted shareholding companies" in relation to it and which, throughout that period:

a) are not themselves holding companies (whether local or not) or superior holding companies but otherwise are, in terms of Schedule 25, engaged in exempt activities or are exempt trading companies; or,
b) are "local holding companies".

For superior holding companies, the income requirement by paragraph 6(4A) is that for a superior holding company to pass the exempt activities test at least 90% of its gross income must:

1) represent qualifying exempt activity income (paragraph 3.3.73) of its subsidiaries,

2) be derived directly from (paragraph 3.3.79) companies which it controls which either:

(a) are not superior holding companies but are engaged in exempt activities or are exempt trading companies or,

(b) are superior holding companies throughout the period and at least 90% of their gross income represents qualifying exempt activity income (paragraph 3.3.73), and is derived directly from companies which they control and which are either carrying on exempt activities or are exempt trading companies or are themselves superior holding companies satisfying the income requirement.

Under the income test provided for superior holding companies, such income "must" be traced (or traceable) through intermediate companies in order to establish whether it represents income from exempt trading companies or companies engaged in exempt activities. Section 799 provides the rules to ascertain the profits out of which dividends are paid. Generally speaking, dividends are considered to be paid out of the profits of any specified period or, where no period is specified, out of profits that are specified. The rules further state that "where a dividend is paid neither for a specified period nor out of specified profits, the dividend is considered to be paid out of the profits for the last period for which accounts were produced which ended before the dividend became payable." .

It is a question of fact "what" the source of the profits is, in a situation where a holding company receiving only interest or royalties from its exempt trading subsidiaries pays a dividend out of that income to its own holding company, the dividend will derive from exempt trading companies.

In assessment, the gross income of a holding or superior holding company is taken as the total amounts received or receivable in respect of its various sources of income, as shown in the accounts for the accounting period in question. The term 'Income' here is meant to exclude any capital receipts. No deductions (of any nature) should then be made from these gross receipts subject to the following exceptions:

(a) There should be left out of account so much of the company's gross receipts as is derived from any activity which, if it were the business in which the company is mainly engaged, it would be such that paragraph 6(2) Schedule 25 would apply to the company,

(b) To the extent that the receipts of the company from any other activity include receipts from the proceeds of sale of any description of property or rights, the cost to the company of the purchase of the property or rights is (to the extent that the cost does not exceed the receipts) to be a deduction in calculating the company's gross income, and no other deduction (for example, for business expenses) is to be made in respect of that activity. The term 'property or rights' includes the stock of a trading company with the effect that gross profits of such a company are a deduction in calculating the company's gross income.

The final deductions to be made in accordance with (a) above deal with the situation of a holding company which would be able to satisfy the 90 % gross income; however, for income from trading or any other activity which, if it were the company's main business, would enable it to satisfy the exempt activities test. The main purpose of paragraph 12(4) Schedule 25 is to exclude the receipts of any such activity from consideration so that the 90 % gross income requirement is applied directly to the company's remaining gross receipts.


Conclusion

The chief purpose of CFC rules, is to prevent a taxpayer's accumulation of income and assets abroad through the use of foreign base companies. CFC rules compel the allocation of all foreign earned income to domestic company shareholders of foreign companies, in order for taxpayers to be taxed accordingly by domestic revenue authorities. CFC rules are therefore, effective anti-avoidance measures and devices.

Basically speaking, CFC rules are guidelines designed to determine how foreign entities or companies are taxed, how they will be taxed, and even if they need to be taxed at all. Moreover, these rules also provide guidance on whether or not, there is tax due on foreign earned income, and if there are any tax credits or exemption to be received under tax treaties and to be granted by the foreign revenue authorities. CFC rules are also important tax avoidance and evasion measures taken by countries in order to preserve their domestic tax base, and prevent further erosion of their social and economic systems.
The most important and significant characteristic of any sound and effectively designed tax system, whether it is based upon the territoriality, residence of the taxpayer or source of income, is the concept of tax equity. Tax equity is tax fairness, and in order to sustain a nation's integrity in their legal, social, and economic tax distributive systems, the revenue laws and their consequent tax aggregation, must be seen as creditable and fair, above all. Thus, the standard measure of any effective equitable tax system, has been the progressive distribution of the tax burden.

If the principles of tax equity are the cornerstone of a progressive tax system that considers itself fair and equitable across the board for all citizens, then, the avoidance of tax by some individuals and companies by relocating their operations abroad, or by transferring their assets outside of their home tax base jurisdiction, in order to avoid or evade taxes, violates the principle of tax equity, which is crucial to all nations for the preservation of their economic systems, their growth and development.

Therefore, by examining the purpose, substance, and structures of the CFC rules that regulate foreign base earned income and the use of foreign holding companies in both countries, as these are frequently used as tax avoidance vehicles, we can improve the rules and close the gaps in each respective tax systems in order to further prevent their use in tax avoidance schemes.

Dean George L. Salis, PhD. LLM, LLB (Hons), BS, CMA, RFA, MFP Mas. Fin. Prof. , CEPA Dean and Programme Director, Legal Studies Dept., Keiser College, CEO & Principal JurisConsults International Group, LLC Member: ABA, IBA, London Court International Arbitration, Royal Society of Fellows
Florida,USA. Member: ABA, IBA, London Court International Arbitration, Royal Society of Fellows.

 
    

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