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Controlled Foreign Corporations (CFC)

Controlled Foreign Corporations (CFC)

SIRC OF ICAI, Bangalore

8th August, 2009
CA. Rashmin Chandulal Sanghvi

(Note: this article has been written long before Direct Taxes Code has been passed into law. This will be updated after the law is passed.)

As on today India does not have any Income-tax regulations for CFC. The Kelkar committee, in its report dated January, 2003 had recommended bringing about a legislation for CFC. And more & more authorities are now talking about CFC. Hence we may be prepared for CFC legislation.

This note briefly explains what is a CFC. Why & how they are formed. And how they are taxed. Since India does not have a tax law provision for the same, at present one may study the U.S. & the U.K. legal provisions.

2. Introduction of the Concept.

2.1 An Indian resident assessee is taxed on his / its world wide income. However, the income is liable to tax only if the assessee has either received the income or earned it.

2.2 When an Indian resident invests outside India, he may get foreign income. When those investments yield incomes – say interest, dividend etc., they will be taxable in India. These incomes will also be liable to Indian FEMA (Foreign Exchange Management Act) discipline.

2.3 In case, the Indian investor wants to earn foreign income but does not want to pay the Indian taxes on the same; or does not want the Indian FEMA discipline for the same [also see Note (i)] then he may invest through an intermediary company. The intermediary company – being a foreign company will not be liable to Indian tax, and the FEMA discipline will be much less – See Chart IV.

This concept is explained considering an illustration of Patel India Ltd., an Indian company having investments abroad.

Note (i) Now under FEMA there is hardly any control for income. There is no compulsion to repatriate foreign incomes of the CFC. Patel India Ltd. can open an EEFC account and deposit the dividends. Thereafter, the funds can be used in any manner it likes. However for business operations, there is still considerable benefit for opening a CFC.

Chart I – Foreign Investment.

This company will manufacture goods in Germany and market all over the European Union.

The dividends, when declared, will be taxable in India. After considering the Indo-German Double Tax Avoidance Agreement (DTA) the Indian tax will be less harsh. But there will be some tax. For tax impact, see Chart II.

Chart / Table II
Impact of Repeated Tax.

Notes: (i) For the sake of simplicity, all amounts are maintained in DM. In practice, the Indian company will convert DM 540 into Indian rupees & all further transactions will be in rupees.

Observation – On a profit of DM 1000, total tax paid is DM 646 and the net benefit to ultimate shareholder is only 354.

Note (ii) German Corporate tax is assumed @ 40%. Actual rate is different. This is just an illustration.

Table III.

Just one Country Tax on DM 1,000
German Tax Indian Tax
1 Corporate Income 1,000 1,000
2 Corp. Tax 40%
3 Dividend 600 690
4.1 Tax on Dividend @ 20%   120
4.2 Distribution Tax @ 17%   100
5 Total Tax 520 410
6 Net PAT 480 590
Compare with - German & Indian Tax together -DM 644 as per chart II.

2. In reality, the DTA does not eliminate double tax fully. And to avoid the double tax, people will resort to several different means. One of them is having a CFC and saving the tax.

U.S. Government has passed legislation and curbed this loophole. If tax rates are made reasonable and full credit is given for ‘double tax’, the attraction for CFC can be reduced.

3. Tax Avoidance measures employed by tax payers :

3.1 Some businessmen will see to it that the tax is saved at German company level itself. The German company will buy goods from / sell goods to the Indian company in such a manner that its German profits are reduced and Indian profits are increased. So it will straightaway save the German corporate tax (DM 400) as well as the German dividend tax (DM 60) and get the money into India.

3.2 This is what is called "Over Invoicing" and "Under Invoicing".

3.3 In simple words, it is called "Havala". In tax jargon, it is called "Transfer Pricing". German tax base is transferred to India by employing transfer pricing mechanism.

4.1 To curb this tax avoidance, German Government has already made provisions against ‘Transfer Pricing’.

4.2 For Indian Government, the process (of transferring the profits to India) is beneficial. So India will not curb this.

4.3 There can be a different situation. Indian subsidiaries of foreign companies want to avoid the Indian tax. To curb this avoidance, India has also made transfer pricing provisions – Chapter (X) Sections 92 to 94.

5. It can be seen that the same profit suffers tax at two levels – the corporate tax in the hands of the company and the dividend tax in the hands of the shareholder.

India has adopted this tax system from Britain. After 1947, Britain has made the system more reasonable by providing "Underlying Tax Credit". India has not yet adopted this system.

6. While avoiding "double taxation", India gives credit against the Indian tax; only for the dividend tax paid in Germany. India does not give credit for the corporate tax paid by Patel Gmbh. Many countries have adopted the system of providing this credit also. If provided, in this illustration, it would mean that Patel India will get credit against its own corporate tax; credit for the corporate tax paid by Patel Gmbh in Germany.

Such a provision will greatly reduce the assessee’s need for a CFC.

Chart IV.

Note - If the Patel group needs money abroad, it will accumulate the funds in Mauritius. There is no law compelling the Mauritian company to declare dividends. Hence the amount will not be paid to India and the future tax of DM 184 (126 + 60) will not be paid in India.

Chart V Indian Holding Co.

This chapter so far, has explained the concept & assessee’s need for CFC. It has also referred to ‘transfer pricing’ and ‘underlying tax credit’.

Now let us see, how does a Government deal with this tax avoidance measure of CFC. It is simple.

The Government assumes that the dividend earned by Patel Mauritius is declared as dividend and then levies tax in India on this deemed dividend.

The whole chapter on CFC is to curb this tax avoidance. Normally, there are provisions for avoiding undue hardship to companies not declaring dividends for genuine business purposes.

It would provide definitions for :

(i) Controller or Domestic Holding Company/Domestic Shareholder.
(ii) Control.
(iii) Controlled Foreign Company.
(iv) Foreign Income liable to CFC provisions.

In simple words, once all the four provisions are applicable, the foreign income would be taxable in India.

Normally, the domestic shareholder would include any corporate or other shareholders having a control over a foreign company. Control may be exercised individually or jointly.

Control may be simple – (i) shareholding; (ii) Voting right at shareholders’ meetings; (iii) voting rights at Board meetings; or any other right by which the domestic shareholder can influence the foreign company.

If a foreign company is controlled by domestic shareholder/s it is considered to be a CFC.

Foreign Income. Normally, only unearned incomes are taxed. If a CFC has regular manufacturing or trading activity, profits from such activities is not considered liable to CFC provisions.

If the CFC is declaring normal dividends (say more than 90% of its distributable profits) it may be exempted from CFC provisions.

Issues :

1. Is it constitutionally okay for a country to tax foreign income of a Non-Resident? Is it an issue of "Extra Territorial Jurisdiction"?

2. Consider combined impact of CFC & Underlying tax credit.

Thanks & Best Wishes,

Rashmin C. Sanghvi