Understanding Controlled Foreign Companies rules

This legislation is used to tax people in one country who have shares in a company in another country.

Controlled Foreign Companies (CFC) legislation is intended to stop people from shifting passive investments offshore.

Without it, one would be able to invest money in a low-tax jurisdiction and enjoy the fruits of the investment at a lower tax rate than would have been paid in one’s home country.

Instead, CFC legislation seeks to tax people on profits earned in the foreign, low-tax jurisdiction.

The legislation is a major impediment to offshore tax planning, but there are exceptions to the rules. Generally, if the controlled foreign company earns ‘active’, as opposed to ‘passive’, income, it will escape the tax in the home jurisdiction.

(An example of active income is that earned by a farming or construction company in another country.)

It also pays to remember that, when operating offshore, a variety of rules apply: the home jurisdiction rules, which would typically incorporate CFC rules, the rules of the foreign, low-tax jurisdiction, and, sometimes, a double tax avoidance treaty set-up between the countries for purposes of trade.

This treaty often overrides the domestic rules.

But are CFC rules compatible with double tax avoidance treaties? This question has been debated in international tax planning circles for at least 40 years.

Most treaties deal with business profits, and in all cases, these profits are taxable only in the state where the enterprise is based. The CFC rules and the agreed treatment of business profits under Article 7 of double tax avoidance treaties therefore seem to be at odds with each other.

Academics hold divergent views on this important question. Conflicting rulings have also been cited in different courts in Europe.

Some have held that the CFC rules are indeed compatible with the business profits clause.

Others, such as a 2002 French Supreme Administrative Court ruling, maintain that the rules are incompatible and those regarding business profits are to be followed, effectively nullifying the CFC rules.

In South Africa, this particular question is of academic interest only, because the drafters of the CFC rules cleverly did not make the profits of the CFC taxable in South Africa as such, but an amount equal to the profits.

This subtle shift means that any double tax avoidance treaty does not apply, because it is not the profits themselves that are subject to tax in CFC circumstances, but an amount equal to such profits!