Comparative CFC Rules

7 Outbound taxation: passive income

A US person owns 100 percent of the shares of a foreign corporation. The corporation earns foreign-
source income (for example, from importing purchased goods into the US with title passing offshore). The
corporation has no assets or employees – it is a pure shell – and all decisions are made by the shareholder
who is also the CEO and the Board of Directors. What is the tax result?
Generally, the surprising answer is no current US tax. US tax law generally does not “pierce the corporate
veil” by ignoring the separateness of a corporation, even if it is a shell. Establishing corporate status is
easy under today’s “check-the-box” entity-classi ication rules, which generally allow taxpayers to elect
whether an entity is to have corporate or pass-through treatment; and establishing foreign status even
easier since any corporation incorporated out of the US is foreign. Attempts by the IRS to attribute income
to the shareholder have generally failed both under transfer pricing and under judicial doctrines like
assignment of income, substance over form, economic substance, or sham. As long as the shareholder is
careful about documenting the sales as made through the corporation the shareholder is safe, even
though no actual business is done by the corporation (the goods are shipped directly from the supplier to
the US, without passing through the tax haven that the corporation would typically be located in).
To be sure, what is achieved here is, under the US worldwide approach to taxation, deferral, not
exemption. The individual US shareholder will be taxed if the corporation distributes a dividend or the
shareholder sells the shares, and the only way out (if the shareholder is an individual) is to die since heirs
can sell the shares with no income tax liability (before 2008, it was also possible to give up US citizenship,
move, and live off the accumulated earnings, but that avenue of converting deferral to exemption was
closed in 2008). But deferral, if it lasts for a long time, can be virtually as valuable as exemption because
of the time value of money. Moreover, if the US shareholder is a corporation, then under the participation
exemption enacted in 2017 for 10 percent shareholders, there will generally be no US tax even upon
distribution of a dividend from the foreign corporation.
If the same scenario happened in the UK, arguably the result would be different because of the managed-
and-controlled test for corporate residence, although in many jurisdictions this just boils down to having
the Board meet offshore.
Because deferral (or exemption, in those countries that exempt dividends from foreign subsidiaries
through a participation exemption, including the US) is easy to achieve, there are two types of anti-
deferral/exemption provisions that are designed to ensure residence-based taxation of passive income:
FIF and CFC rules.
7.1 FIF rules
There are two kinds of FIFs. The irst is “incorporated pocketbooks” that a taxpayer controls to earn
passive income (dividends, interest, royalties, capital gains) offshore. The second is a FIF in which the
taxpayer is a passive investor and which he or she does not control.
The “incorporated pocketbook” is typically de ined as a foreign corporation controlled by ive or fewer
domestic individuals whose income is mostly passive. The solution is either to ignore its existence or to
have a deemed dividend of its income (all or just passive) to the shareholders. A deemed dividend is
possible because the shareholders control the “pocketbook” and can distribute a dividend whenever they
want to.
The non-controlled FIF presents a harder problem because the lack of control means that the shareholder may

not be able to know what the income of the FIF is, and certainly cannot force a dividend distribution. This type

of FIF is simply de ined as a foreign corporation with a high level of passive income and/or assets
generating passive income, with no control requirement. Under the US Passive Foreign Investment

Company (PFIC) rules, the solution is to give the shareholder a choice of three methods of taxation:

(1) If the PFIC consents, it can let the shareholder know how much passive income it has and the
shareholder declares the income on its tax return; this is typically possible when US
shareholders form the majority or a large minority in a FIF.
(2) If the FIF is publicly traded, shareholders can opt to be taxed on the rise in value of the shares as a proxy
for the underlying income, but this carries the risk of not getting a refund if the stock declines.
(3) The most common alternative is an interest charge regime: when the shareholder receives a
distribution from the PFIC or sells PFIC shares, the dividend or gain is spread backward to the
shareholder’s holding period and an interest charge is added to the tax amount based on the
( luctuating) interest rate on tax underpayment and the (changing) top individual tax rate.
FIF rules give rise to many problems. For example, holding companies may be FIFs even if the companies
they control are active, and absent a look -through rule the FIF rules will apply. Another example is start-
ups, which may be FIFs in their early years of operations because their only income is investment income.
In general, FIF rules are tough on paper, but the big question is compliance: the residence country tax
authority needs to know that the FIF exists and that the resident individual owns shares in it, which
subjects the tax administration to the same information issuer as those discussed for inbound passive
investment in Chapter 4.
7.2 CFC rules
The US was the irst country to adopt CFC legislation, called “Subpart F”, in 1962. The basic characteristics

of US CFC legislation are the following:

(1) It requires over 50 percent control to designate a foreign corporation as a “CFC”. In order to
be counted, each shareholder must have at least a 10 percent share in the foreign corporation.
(2) It follows a transactional approach according to which the rules apply to foreign companies wherever they
are located (so the CFC rules also apply to foreign companies that are not located in tax havens).
(3) The income earned by the CFC is treated as deemed dividend only if it can be classi ied as tainted
income, which is passive income (that is, primarily, with certain exceptions, dividends, interest,
capital gains and royalties), base company income (that is, income arising from transactions
between companies within the same group) and 956 income (generally, loans of the subsidiary
companies to the shareholders). From 2018 on, tainted income also includes Global Intangible Low-
Taxed Income (GILTI), discussed below.
Because of the effects of globalization and the free movement of capital, many countries faced the same
problem of the movement of income to zero- and low-tax affiliates of multinational groups. The US
approach to taxing CFCs, as a way to limit tax deferral, was widely followed by many jurisdictions,
including purely territorial jurisdictions (where the consequence of income shifting is exemption rather
than deferral): Germany (1972), Canada (1975), Japan (1978), France (1980), the UK (1984) and over 20
other countries since then. Despite the significant degree of convergence in CFC legislations, on a more
detailed level, significant differences persist even for countries that have adopted CFC rules (and most
countries do not have them yet), although all EU member countries are bound to adopt them by 2019
As a result of the wide adoption of CFC rules, the distinction between global and territorial jurisdictions
has lost much of its importance. On one hand, territorial jurisdictions seek to tax passive income earned
by their residents from foreign sources through the operation of the CFC rules, and many have endorsed
worldwide taxation of individuals. On the other hand, global jurisdictions tend to allow deferral for active
income earned by their residents through CFCs, and the recent trend has been to go even further and
exempt dividends distributed by CFCs to their parents. This was always the rule in territorial jurisdictions
(the so-called “participation exemption”), but it has been adopted by global jurisdictions such as the UK,
Japan, and now also the US.
Four major structural variables serve to distinguish between CFC regimes: the level of ownership of a

foreign corporation required to designate it as a CFC; whether the foreign tax system is relevant to the

operation of the CFC rules; the type of income or activities of the CFC subject to the rule; and the approach

adopted in taxing the CFC.

7.2.1
The level of ownership of a foreign corpora on required to designate it a CFC
CFC legislation applies when domestic shareholders have a “substantial in luence” on the foreign
corporation. However, each country has a different concept of “substantial in luence”. In most cases,
“substantial in luence” is de ined as control, because of the assumption that only controlling shareholders
can really in luence the foreign company’s distribution policy.
Generally speaking, most countries have one or two tests that must be met in order to qualify a foreign
entity as a CFC: a single ownership test (each domestic shareholder must hold more than a certain
percentage or interest of the foreign corporation), and a global domestic ownership test (domestic
shareholders as a group must hold more than a certain percentage or interest of the foreign corporation).
In this latter case, some countries consider every domestic shareholder in order to quantify the global
domestic ownership percentage; others require a minimum ownership requirement test (in other words,
each domestic shareholder must hold more than a certain percentage in order to be counted in the global
percentage).
The tests can be structured in a formal or in a substantive way. As will be explained, formal tests are very
simple (so that compliance and administrative costs stay low) but easy to manipulate. The more formal
the tests are, and the higher the percentages of ownership, the easier it is for domestic shareholders to
escape the application of CFC rules.
In order to avoid manipulation, some countries (as, for example, Australia, Italy, Israel and New Zealand)
have more substantive tests (like de facto control tests) that make it harder for domestic -shareholders to
avoid CFC rules.
A subsidiary issue is the time of the year the ownership tests should be met: most countries check the
status of the foreign company at the end of the year (this solution is very simple, but easy to manipulate);
in other countries a foreign company may be considered a CFC at any time in the year (this solution is
harder to manipulate, but quite complex to implement).
The US rule is very formal on this regard. Under Subpart F a foreign corporation is a CFC if any group of
US shareholders, each holding an ownership stake of at least 10 percent, hold, by vote or value, over 50
percent of the foreign corporation. Being very formal, the US rules are relatively simple, but easy to
manipulate. For example, if 11 US shareholders own as a group 100 percent of the stock of a foreign
corporation, but each of them owns no more than 9.9 percent, the CFC legislation is not applicable.
Likewise, if one US shareholder owns precisely 50 percent of a foreign corporation, and the rest of the
stock is held by foreign investors, the CFC legislation is again not applicable.
7.2.2
The relevance of the foreign tax system to the opera on of the CFC rules
In regard to this issue CFC rules can be divided into global and jurisdictional approaches.

Some countries (for example, the US, Canada, Indonesia, New Zealand, Israel and South Africa) apply their
CFC rules to all CFCs wherever they are resident (or located) and regardless of the foreign tax rates. This
irst approach is de ined as a global approach. In its pure version, domestic shareholders are taxed on only
certain types of income (so-called “tainted income”). This is why this approach is also known as a
transactional approach.
Other countries (for example, Japan, Italy, the UK, Germany, France, Australia, Denmark, Portugal, Spain,

Sweden, Hungary, Argentina, Turkey and China) apply CFC rules only to foreign companies resident in low-
tax jurisdictions. This second approach is de ined as a jurisdictional (or entity) approach, because it

focuses on the rules of the foreign tax jurisdictions. In its pure version, all types of income realized by

CFCs are taxable. However, as we will see, many countries adopting the jurisdictional approach also focus

on the types of income earned by the CFC.

The de initions of “low-tax jurisdictions” and “tainted income” are the two major points of comparison of
CFC rules. Here, we will deal with the de inition of “low-tax jurisdictions”, while the next section will be
dedicated to the de inition of “tainted income”.
Under the jurisdictional approach, there are many ways to de ine a low-tax jurisdiction. The basic
guideline is that the territorial requirement has to be structured in both a substantial and simple way, in
order to prevent the avoidance of the CFC rules or an unjusti ied complexity. The correct trade-off
between substantiality and simplicity is thus -fundamental in de ining the territorial requirement of CFCs.
On the face of it, the global approach is much stricter than the jurisdictional approach because it does not
identify target territories. It would seem that multinationals based in countries where a global approach
has been adopted (like the US) could claim that they have dif iculties in competing with those
multinationals based in countries where a jurisdictional approach has been adopted (like Italy). This
argument, however, is partially wrong.
In fact, the legislative details and mechanisms generally make the global and jurisdictional approaches
very similar to each other. By analyzing the tax details and mechanisms of CFC rules, the result is that
both global and jurisdictional approaches grant deferral or exemption with regard to high-tax income
(which is typically active income because it is less mobile) while they avoid deferral or exemption with
regard to low-tax income (which is typically movable passive income). First, CFC rules based on the
transactional approach generally “kick out of the rules” coverage income earned in high-tax countries. For
example, under Subpart F, if the tax rate of the country where the CFC is located is 90 percent or more of
the US corporate tax rate, the CFC legislation is not applicable. Second, foreign tax credit is applicable to
CFC income: the tax credit is equal to the taxes the CFC has to pay to local government. Even if the foreign
tax credit has the main goal of avoiding international double taxation, it also makes the transactional
approach very similar to the jurisdictional one: the CFC income is (partially) taxable in the hands of
domestic shareholders only if the foreign jurisdiction has a lower effective tax rate than the domestic one
(as is the case under the jurisdictional approach) .
In conclusion, the distinction between the global and the jurisdictional approach is somewhat super icial:
the tax mechanisms are different but the results are quite similar. A signi icant convergence between the
two different approaches is thus observable in practice.
7.2.3
The type of income or ac vi es of the CFC subject to the rule
Regarding the types of income and activities subject to the CFC rule, some countries adopt a tainted
income approach (also known as the transactional approach), and other countries the total income
approach (also known as the jurisdictional or entity approach).
Under the irst approach (adopted, irst, by the US in 1962), only the tainted income of the CFC is taxable to
its shareholders.
Under the second approach (adopted, irst, by Japan in 1978), either all or none of the foreign entity
income is taxable. If the foreign entity is located in a low-tax jurisdiction, its income is fully taxable in the
hands of domestic shareholders. If the foreign entity is not located in a low-tax jurisdiction, CFC rules are
not applicable (in other words, foreign entity income is not taxable).
Under the transactional approach, the big issue is the de inition of CFC income (in other words, tainted
income). The most important category of tainted income common to most countries (namely, the US,
Argentina, Australia, Canada, Denmark, Germany, Israel and New Zealand) is passive income (dividends,
interest, royalties and capital gains). This is because passive income is very mobile and thus it is generally
subject to lower tax rates, making tax deferral very attractive.

The other important category of passive income is base company income, which is active income with no
real connection to the jurisdiction in which the CFC is located. Technically, this is de ined as income from
sale and services rendered between af iliated parties (located in different countries) when there is no
signi icant modi ication of the product by the base company (US de inition) . In the US, this is one of the
most controversial provisions of Subpart F, since US multinationals believe that this speci ic rule makes
them less able to compete with other multinationals. For this reason, US taxpayers try to avoid this
provision, by having CFCs buy goods from unrelated cost plus manufacturers and distributing them
through unrelated commissionaires, with the CFC as “entrepreneur” retaining the bulk of the pro it.
7.2.4 The approach adopted in taxing the CFC
Countries vary in how they tax CFCs. The US uses a deemed dividend approach, but most countries simply

tax domestic shareholders (treating the CFC as a pass-through entity).

Countries generally do not directly tax CFCs because that might violate treaty obligations on taxing a
foreign corporation that does not have a PE in the taxing country.
The piercing the veil approach is much simpler than the deemed dividend approach (especially when
there is a chain of CFCs and the deemed dividends have to jump up the chain). Considering that
customary international tax law has changed in the last decades, so that taxing the shareholders directly
on CFC income is permissible, the US may consider changing its approach.
7.2.5 The problems of Subpart F
Subpart F used to be considered a tough CFC regime, but from 1994 to 2017 it was subject to numerous
exceptions that have tended to render it much weaker than the CFC rules of other major countries. The
most important of these are the active inancing exception, which exempts most inancial institutions for
Subpart F, and the CFC to CFC look-through rule, which together with the regulatory check-the-box rules,
makes Subpart F inapplicable to interest and royalty payments from high-tax to low-tax jurisdictions.
These exceptions enabled US-based multinationals to amass $3 trillion in low-tax jurisdictions offshore
by 2017. This income was “trapped” in that it could not be brought back without paying tax on the
dividends. Therefore, there was a lot of pressure on the US to enact a participation exemption like the
ones adopted recently by Japan and the UK. In addition, the lack of a participation exemption before 2017
together with the high US corporate tax rate on US -source income has led numerous US companies to
establish new parents in Ireland or the UK. This in turns enables them to pay interest and royalties from
the old parent to the new one without triggering a deemed dividend, since the new parent is not a CFC
even if it is majority owned by US public shareholders.
7.2.6 GILTI
In response to these problems, the US in 2017 enacted several measures to address the trapped income
issue. First, it applied a one-time tax of 8 percent to non-liquid foreign assets and 15.5 percent to liquid
foreign assets held by CFCs at the end of 2017, whether distributed or not. While lower than the full 35
percent tax rate that would have applied to the trapped income had it been distributed as a dividend, this
transition resulted in a signi icant tax being imposed on the $3 trillion accumulated in CFCs, and in signi
icant repatriations of such income. Second, the US adopted the participation exemption, so that future
income of CFCs that is not Subpart F income can be repatriated without further tax (but with no indirect
foreign tax credit for any foreign tax on the CFC) .
On the face of it, these provisions converted the US from a “worldwide” to a “territorial” jurisdiction.
However, in practice that is not the case because (a) US residents and citizens continue to be taxed on
worldwide income, as are US corporations on income not earned through CFCs; (b) because of the GILTI
rule, most US-based multinationals do not have much income eligible for the participation exemption.
GILTI is a new category of Subpart F income that imposes current tax at 10.5 percent (half the US
domestic corporate rate of 21 percent) on income of CFCs that exceeds a 10 percent deemed return on
their basis in tangible assets. Foreign tax credits are permitted to offset the GILTI tax up to 80 percent of
the foreign tax, so that if the foreign tax is 13.125 percent, it eliminates the GILTI tax (80 percent of
13.125 percent = 10.5 percent) . Averaging foreign taxes on GILTI among countries is permitted, but not
foreign taxes on other types of foreign income.
Because most US-based multinationals do not have signi icant tangible assets in their CFCs, the effect of
GILTI is to apply a minimum tax of 10.5 percent to all foreign source income of CFCs on a current basis.
This means that with the adoption of GILTI, the US abolished deferral and became a true worldwide
taxing jurisdiction, albeit with a lower rate for foreign source income earned through CFCs. This result is
signi icantly different from the pre-2017 expectation that the US would adopt “territoriality” and exempt
most income of CFCs from tax. The impact of GILTI could change over time, however, if US-based
multinationals respond by shifting more tangible assets abroad.
7.2.7 FDII
The lower rate applicable to GILTI raised the concern that US-based multinationals will respond by
shifting pro its offshore (where the tax rate is 10.5 percent) from the US (where the tax rate is 21
percent). In response, the US also adopted the foreign derived intangible income (FDII) rule. Under FDII, a
US corporation that earns income from exporting goods or services (including royalties) pays a lower
13.125 percent tax rate on such income, to the extent it exceeds a deemed 10 percent return on its basis
in US tangible assets.
FDII was intended to encourage US multinationals that export goods or services to keep pro its in the US,
and to encourage foreign multinationals to shift pro its into the US (FDII applies to goods and services
that are imported and then re-exported, as well as to goods and services that are exported, modi ied, and
then re-imported).
It remains to be seen whether FDII achieves its goals. So far, it has not attracted increased FDI, perhaps
because foreign multinationals fear it may be changed, or because they can be subject to tax rates lower
than 13.125 percent (US multinationals are already subject to a lower rate of 10.5 percent under GILTI).
In addition, because FDII is contingent on export performance, it violates the WTO export subsidy rules,
and may be challenged in that forum.
 The US CFC Rules
Reuven Avi-Yonah

Chapter Seven: Outbound Taxation of

Passive Income
• A US person owns 100 percent of the shares of a foreign corporation.
• The corporation earns foreign-source income (for example, from
importing purchased goods into the US with title passing offshore).
• The corporation has no assets or employees – it is a pure shell – and
all decisions are made by the shareholder who is also the CEO and
the Board of Directors.
• What is the tax result?

1
 Outbound Taxation of Passive Income
• Generally, the surprising answer is no current US tax.
• US tax law generally does not “pierce the corporate veil” by
ignoring the separateness of a corporation, even if it is a shell.
• Establishing corporate status is easy under today’s “check-the-
box” entity-classification rules, which generally allow taxpayers
to elect whether an entity is to have corporate or pass-through
treatment; and establishing foreign status even easier since any
corporation incorporated out of the US is foreign.

Outbound Taxation of Passive Income

• Attempts by the IRS to attribute income to the shareholder have
generally failed both under transfer pricing and under judicial
doctrines like assignment of income, substance over form,
economic substance, or sham.
• As long as the shareholder is careful about documenting the sales as
made through the corporation the shareholder is safe, even though
no actual business is done by the corporation (the goods are shipped
directly from the supplier to the US, without passing through the tax
haven that the corporation would typically be located in).

2
Outbound Taxation of Passive Income
• To be sure, what is achieved here is, under the US
worldwide approach to taxation, deferral, not exemption.
• The US individual shareholder will be taxed if the corporation
distributes a dividend or the shareholder sells the shares, and the
only way out (if the shareholder is an individual) is to die since
heirs can sell the shares with no income tax liability (before 2006,
it was also possible to give up US citizenship, move, and live off
the accumulated earnings, but that avenue of converting deferral
to exemption was closed in 2006).

Outbound Taxation of Passive Income

• But deferral, if it lasts for a long time, can be virtually as valuable
as exemption because of the time value of money.
• Moreover, if the US shareholder is a corporation, then under the
participation exemption enacted in 2017 for 10: shareholders,
there will generally be no US tax even upon distribution of a
dividend from the foreign corporation.

3
 Outbound Taxation of Passive Income
• If the same scenario happened in the UK, arguably the result
would be different because of the managed-and-controlled test
for corporate residence, although in many jurisdictions this just
boils down to having the Board meet offshore.

Outbound Taxation of Passive Income

• Because deferral (or exemption, in those countries that exempt
dividends from foreign subsidiaries through a participation
exemption, including the US) is easy to achieve, there are two types
of anti-deferral/exemption provisions that are designed to ensure
residence-based taxation of passive income: foreign investment
funds (FIF) and controlled foreign corporation (CFC) rules.

4
FIF Rules
• There are two kinds of FIFs.
• The first is “incorporated pocketbooks” that a taxpayer controls
to earn passive income (dividends, interest, royalties, capital
gains) offshore.
• The second is a FIF in which the taxpayer is a passive investor
and which he or she does not control.

FIF Rules
• The “incorporated pocketbook” is typically defined as a foreign
corporation controlled by five or fewer domestic individuals
whose income is mostly passive.
• The solution is either to ignore its existence or to have a deemed
dividend of its income (all or just passive) to the shareholders.
• A deemed dividend is possible because the shareholders control the
“pocketbook” and can distribute a dividend whenever they want to.

5
 FIF Rules
• The non-controlled FIF presents a harder problem because the lack
of control means that the shareholder may not be able to know
what the income of the FIF is, and certainly cannot force a dividend
distribution.
• This type of FIF is simply defined as a foreign corporation with a
high level of passive income and/or assets generating passive
income no control requirement.

FIF Rules
• Under the US Passive Foreign Investment Company (PFIC) rules,
t solution is to give the shareholder a choice of three methods
of taxation:
• If the PFIC consents, it can let the shareholder know how much
passive income it has and the shareholder declares the income on
its tax return; this is typically possible when US shareholders form
the majority or a large minority in a FIF.

6
FIF Rules
• If the FIF is publicly traded, shareholders can opt to be taxed on the
rise in value of the shares as a proxy for the underlying income, but
this carries the risk of not getting a refund if the stock declines.
• The most common alternative is an interest charge regime: when
the shareholder receives a distribution from the PFIC or sells PFIC
shares, the dividend or gain is spread backward to the
shareholder’s holding period and an interest charge is added to the
tax amount based on the (fluctuating) interest rate on tax
underpayment and the (changing) top individual tax rate.

FIF Rules
• FIF rules give rise to many problems.
• For example, holding companies may be FIFs even if the
companies they control are active, and absent a look-through rule
the FIF rules will apply.
• Another example is start- ups, which may be FIFs in their early years
of operations because their only income is investment income.

7
 FIF Rules
• In general, FIF rules are tough on paper, but the big question is
compliance: the residence country tax authority needs to know that
the FIF exists and that the resident individual owns shares in it, which
subjects the tax administration to the same information issuer as
those discussed for inbound passive investment in Chapter 4.

CFC Rules
• The US was the first country to adopt CFC legislation, called
“Subpart F”, in 19C2. The basic characteristics of US CFC legislation
are the following:
• It requires over 50 percent control to designate a foreign corp
as a “CFC”. In order to be counted, each shareholder must have
at least a 10 percent share in the foreign corporation.

8
CFC Rules
• It follows a transactional approach according to which the rules apply to
foreign companies wherever they are located (so the CFC rules also apply
to foreign companies that are not located in tax havens).
• The income earned by the CFC is treated as deemed dividend only if it can
be classified as tainted income, which is passive income (that is, primarily,
with certain exceptions, dividends, interest, capital gains and royalties),
base company income (that is, income arising from transactions between
companies within the same group) and 95C income (generally, loans of the
subsidiary companies to the shareholders).
• From 2016 on, tainted income also includes Global Intangible Low-Taxed
Income (GILTI), discussed below.

CFC Rules
• Because of the effects of globalization and the free movement of
capital, many countries faced the same problem of the movement
of income to zero- and low-tax affiliates of multinational groups.
• The US approach to taxing CFCs, as a way to limit tax deferral, was
widely followed by many jurisdictions, including purely territorial
jurisdictions (where the consequence of income shifting is exemption
rather than deferral): Germany (1972), Canada (1975), Japan (19
France (1960), the UK (1964) and over 20 other countries since then.

9
 CFC Rules
• Despite the significant degree of convergence in CFC legislations, on a
more detailed level, significant differences persist even for countries
that have adopted CFC rules (and most countries do not have them
yet, although all EU member countries were required to adopt th
by 2019).

CFC Rules
• As a result of the wide adoption of CFC rules, the distinction between
global and territorial jurisdictions has lost much of its importance.
• On one hand, territorial jurisdictions seek to tax passive income
earned by their residents from foreign sources through the
operation of the CFC rules, and many have endorsed worldwide
taxation of individuals.

10
CFC Rules
• On the other hand, global jurisdictions tend to allow deferral for
active income earned by their residents through CFCs, and the
recent trend has been to go even further and exempt dividends
distributed by CFCs to their parents.
• This was always the rule in territorial jurisdictions (the so-called
“participation exemption”), but it has been adopted by global
jurisdictions such as the UK and Japan and now also the US.

CFC Rules
• Four major structural variables serve to distinguish between
CFC regimes:
• the level of ownership of a foreign corporation required to
designate it as a CFC;
• whether the foreign tax system is relevant to the operation of the
CFC rules;
• the type of income or activities of the CFC subject to the rule;
• and the approach adopted in taxing the CFC.

11
 CFC Rules
• CFC legislation applies when domestic shareholders have
a “substantial influence” on the foreign corporation.
• However, each country has a different concept of
“substantial influence”.
• In most cases, “substantial influence” is defined as control, because
of the assumption that only controlling shareholders can really
influence the foreign company’s distribution policy.

CFC Rules
• Generally speaking, most countries have one or two tests that must
be met in order to qualify a foreign entity as a CFC: a single
ownership test (each domestic shareholder must hold more than a
certain percentage or interest of the foreign corporation), and a
global domestic ownership test (domestic shareholders as a group
must hold more than a certain percentage or interest of the foreign
corporation).
•

12
CFC Rules
• In this latter case, some countries consider every domestic
shareholder in order to quantify the global domestic ownership
percentage; others require a minimum ownership requirement test
(in other words, each domestic shareholder must hold more than a
certain percentage in order to be counted in the global percentage).

CFC Rules
• The tests can be structured in a formal or in a substantive way.
• As will be explained, formal tests are very simple (so that com
and administrative costs stay low) but easy to manipulate.
• The more formal the tests are, and the higher the percentages of
ownership, the easier it is for domestic shareholders to escape
the application of CFC rules.

13
 CFC Rules
• In order to avoid manipulation, some countries (as, for example,
Australia, Italy, Israel and New Zealand) have more substantive
tests (like de facto control tests) that make it harder for domestic
shareholders to avoid CFC rules.

CFC Rules
• A subsidiary issue is the time of the year the ownership tests
be met: most countries check the status of the foreign company at
the end of the year (this solution is very simple, but easy to
manipulate); in other countries a foreign company may be
considered a CFC at any time in the year (this solution is harder to
manipulate, but quite complex to implement).

14
CFC Rules
• The US rule is very formal on this regard.
• Under Subpart F a foreign corporation is a CFC if any group of US
shareholders, each holding an ownership stake of at least 10 percent, hold,
by vote or value, over 50 percent of the foreign corporation.
• Being very formal, the US rules are relatively simple, but easy to
manipulate.
• For example, if 11 US shareholders own as a group 100 percent o
of a foreign corporation, but each of them owns no more than 9.9 percent,
the CFC legislation is not applicable.
• Likewise, if one US shareholder owns precisely 50 percent of a foreign
corporation, and the rest of the stock is held by foreign investors, the CFC
legislation is again not applicable.

CFC rules
• In regard to the relevance of the foreign tax system, CFC rules can
be divided into global and juris- dictional approaches.
• Some countries (for example, the US, Canada, Indonesia, New
Zealand, Israel and South Africa) apply their CFC rules to all CFCs
wherever they are resident (or located) and regardless of the
foreign tax rates.
• This first approach is defined as a global approach. In its pure
version, domestic shareholders are taxed on only certain types of
income (so-called “tainted income”).
• This is why this approach is also known as a transactional approach.

15
 CFC Rules
• Other countries (for example, Japan, Italy, the UK, Germany,
France, Australia, Denmark, Portugal, Spain, Sweden, Hungary,
Argentina, Turkey and China) apply CFC rules only to foreign
companies resi-dent in low-tax jurisdictions.
• This second approach is defined as a jurisdictional (or
entity) approach, because it focuses on the rules of the
foreign tax jurisdictions.
• In its pure version, all types of income realized by CFCs are taxable.
• However, as we will see, many countries adopting the jurisdictional
approach also focus on the types of income earned by the CFC.

CFC Rules
• The definitions of “low-tax jurisdictions” and “tainted income” are
the two major points of comparison of CFC rules.
• Here we will deal with the definition of “low-tax jurisdictions”,
while the next section will be dedicated to the definition of
“tainted income”.

16
CFC Rules
• Under the jurisdictional approach, there are many ways to define
a low-tax jurisdiction.
• The basic guideline is that the territorial requirement has to be
structured in both a substantial and simple way, in order to prevent
the avoidance of the CFC rules or an unjustified complexity.
• The correct trade-off between substantiality and simplicity is thus
fundamental in defining the territorial requirement of CFCs.

CFC Rules
• On the face of it, the global approach is much stricter than the
jurisdictional approach because it does not identify target territories.
• It would seem that multinationals based in countries where a global
approach has been adopted (like the US) could claim that they have
difficulties in competing with those multinationals based in countries
where a jurisdictional approach has been adopted (like Italy).
• This argument, however, is partially wrong.

17
 CFC Rules
• In fact, the legislative details and mechanisms generally make the
global and jurisdictional approaches very similar to each other.
• By analyzing the tax details and mechanisms of CFC rules, the
result is that both global and jurisdictional approaches grant
deferral or exemption with regard to high-tax income (which is
typically active income because it is less mobile) while they avoid
deferral or exemption with regard to low-tax income (which is
typically movable passive income).

CFC Rules
• First, CFC rules based on the transactional approach generally “kick
out of the rules” coverage income earned in high-tax countries.
• For example, under Subpart F, if the tax rate of the country where
the CFC is located is 90 percent or more of the US corporate tax
rate, the CFC legislation is not applicable.

18
CFC Rules
• Second, foreign tax credit is applicable to CFC income: the tax credit
is equal to the taxes the CFC has to pay to local government.
• Even if the foreign tax credit has the main goal of avoiding
international double taxation, it also makes the transactional
approach very similar to the jurisdictional one: the CFC income is
(partially) taxable in the hands of domestic shareholders only if
the foreign jurisdiction has a lower effective tax rate than the
domestic one (as is the case under the jurisdictional approach).

CFC Rules
• In conclusion, the distinction between the global and the
jurisdictional approach is somewhat superficial: the tax
mechanisms are different but the results are quite similar.
• A significant convergence between the two different approaches
is thus observable in practice.

19
 CFC Rules
• Regarding the types of income and activities subject to the CFC rule,
some countries adopt a tainted income approach (also known as the
transactional approach), and other countries the total income
approach (also known as the jurisdictional or entity approach).
• Under the first approach (adopted, first, by the US in 19C2), only
the tainted income of the CFC is taxable to its shareholders.

CFC Rules
• Under the second approach (adopted, first, by Japan in 1976),
either all or none of the foreign entity income is taxable.
• If the foreign entity is located in a low-tax jurisdiction, its income
is fully taxable in the hands of domestic shareholders.
• If the foreign entity is not located in a low- tax jurisdiction, CFC
rules are not applicable (in other words, foreign entity income is
not taxable).

20
CFC Rules
• Under the transactional approach, the big issue is the definition
of CFC income (in other words, tainted income).
• The most important category of tainted income common to
most countries (namely, the US, Argentina, Australia, Canada,
Denmark, Germany, Israel and New Zealand) is passive income
(dividends, interest, royalties and capital gains).
• This is because passive income is very mobile and thus it is ge
subject to lower tax rates, making tax deferral very attractive.

CFC Rules
• The other important category of passive income is base company
income, which is active income with no real connection to the
juris-diction in which the CFC is located.
• Technically, this is defined as income from sale and services
rendered between affiliated parties (located in different countries)
when there is no significant modification of the product by the base
company (US definition).

21
 CFC Rules
• In the US, this is one of the most controversial provisions of Subpart
F, since US multinationals believe that this specific rule makes them
less able to compete with other multinationals.
• For this reason, US taxpayers try to avoid this provision, by having
CFCs buy goods from unrelated cost plus manufacturers and
distributing them through unrelated commissionaires, with the CFC
as “entrepreneur” retaining the bulk of the profit.

CFC Rules
• Countries vary in how they tax CFCs. The US uses a deemed
dividend approach, but most countries simply tax domestic
shareholders (treat- ing the CFC as a pass-through entity).
• Countries generally do not directly tax CFCs because that might
vio-late treaty obligations on taxing a foreign corporation that
does not have a PE in the taxing country.

22
CFC Rules
• The piercing the veil approach is much simpler than the deemed
dividend approach (especially when there is a chain of CFCs and
the deemed dividends have to jump up the chain).
• Considering that customary international tax law has changed in the
last decades, so that taxing the shareholders directly on CFC income
is permissible, the US may consider changing its approach.

The Problems of Subpart F

• Subpart F used to be considered a tough CFC regime, but since 1994
until 2017 it was subject to numerous exceptions that have tended to
render it much weaker than the CFC rules of other major countries.
• The most important of these are the active financing exception,
which exempts most financial institutions for Subpart F, and the
CFC to CFC look- through rule, which together with the regulatory
check-the-box rules, makes Subpart F inapplicable to interest and
royalty payments from high-tax to low-tax jurisdictions.

23
 The Problems of Subpart F
• These exceptions enabled US-based multinationals to amass
J3 trillion in low-tax jurisdictions offshore by 2017.
• This income was “trapped” in that it could not be brought
back without paying tax on the dividends.
• Therefore there was a lot of pressure on the US to enact a
participation exemption like the ones adopted recently by Japan
and the UK.

The Problems of Subpart F

• In addition, the lack of a participation exemption before 2017
together with the high US corporate tax rate on US-source income
has led numerous US companies to establish new parents in Ireland
or the UK.
• This in turns enables them to pay interest and royalties from the
old parent to the new one without triggering a deemed dividend,
since the new parent is not a CFC even if it is majority owned by
US shareholders.

24
GILTI
• In response to these problems, the US in 2017 enacted
several measures to address the trapped income issue.
• First, it applied a one-time tax of 6: to non-liquid foreign assets and
15.5: to liquid foreign assets held by CFCs at the end of
2017, whether distributed or not.
• While lower than the full 35: tax rate that would have applied to the
trapped income had it been distributed as a dividend, this transition
resulted in a significant tax being imposed on the J3 trillion
accumulated in CFCs, and in significant repatriations of such income.

GILTI
• Second, the US adopted the participation exemption, so that
future income of CFCs that is not Subpart F income can be
repatriated without further tax (but with no indirect foreign tax
credit for any foreign tax on the CFC).

25
 GILTI
• On the face of it, these provisions converted the US from
a “worldwide” to a “territorial” jurisdiction.
• However, in practice that is not the case because:
• (a) US residents and citizens continue to be taxed on worldwide
income, as are US corporations on income not earned through CFCs;
• (b) because of the GILTI rule most US-based multinationals do not
have a lot of income eligible for the participation exemption.

GILTI
• GILTI is a new category of Subpart F income that imposes current
tax at 10.5: (half the US domestic corporate rate of 21:) on income
of CFCs that exceeds a 10: deemed return on their basis in tangible
assets.
• Foreign tax credits are permitted to offset the GILTI tax up to
the foreign tax, so that if the foreign tax is 13.125:, it eliminates
the GILTI tax (60: of 13.125:=10.5:).
• Averaging foreign taxes on GILTI among countries is permitted,
but not foreign taxes on other types of foreign income.

26
GILTI
• Because most US-based multinationals do not have significant
tangible assets in their CFCs, the effect of GILTI is to apply a minimum
tax of 10.5: to all foreign source income of CFCs on a current
• This means that with the adoption of GILTI the US abolished
deferral and became a true worldwide taxing jurisdiction, albeit
with a lower rate for foreign source income earned through CFCs.
• This result is significantly different from the pre-2017 expectation
that the US will adopt “territoriality” and exempt most income of
CFCs from tax.
• The impact of GILTI could change over time, however, if US-based
multinationals respond by shifting more tangible assets abroad.

FDII
• The lower rate applicable to GILTI raised the concern that US-based
multinationals will respond by shifting profits offshore (where the
tax rate is 10.5:) from the US (where the tax rate is 21:).
• In response, the US also adopted the foreign derived
intangible income (FDII) rule.
• Under FDII, a US corporation that earns income from exporting
goods or services (including royalties) pays a lower 13.125: tax rate
income to the extent it exceeds a deemed 10: return on its basis in
US tangible assets.

27
COMPARATIVE CFC RULES

PROF. REUVEN AVI-YONAH

UNIVERSITY OF MICHIGAN
April 3, 2025
1
¤
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192 US Subpart F
1972 Germany
1975 Canada
19 countries
2019 32 countries with CFC rules
Number will likely increase (EU ATAP requires CFC rules)
µ
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 United States (192) Israel (2003)
Germany (1972)
Canada (1975)
Japan (197)
France (190)
United Kingdom (194)
New Zealand (19)
Australia (1990)
Sweden (1990)
Norway (1992)
Denmark (1995)

2
 Possible Tax Regimes
3 possible regimes for taxation of foreign source income of foreign
corporations:
1. domestic tax on accrual basis with credit for foreign tax

2. Exemption from domestic tax

2. Deferral with credit for foreign tax

3. Minimum tax regime

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Income of Subsidiary is not taxable
by Country A (deferral or exemption)
If CFC rules apply, income of
Subsidiary is attributed to Parent and
taxed by Country A

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Level of share ownership in
foreign corporation

Foreign tax system

Type of income or activities of foreign

corporation
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 Level of share ownership in foreign corporation
• Control or substantial interest
• France: ownership of 10; or more of shares
• Several countries: legal control – ownership of 50;
plus

Foreign tax system

Type of income or activities of
foreign corporation

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Level of share ownership in foreign corporation

Foreign tax system

• Global or designated jurisdiction approach
• Canada and US: CFC rules apply to all
CFCs wherever resident
• Other countries: CFC rules apply only to CFCs
in low-tax countries

Type of income or activities of foreign corporation

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Level of share ownership in foreign corporation
Foreign tax system
Type of income or activities of foreign corporation
• Passive and base company income
(tainted income)
• Not relevant for New Zealand and Sweden
• Other countries: CFC rules apply only if CFC has
tainted income or is engaged in tainted activities

5
§
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 Exemptions

Which resident shareholders of a CFC are

taxable?

Relief measures

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Are CFC rules necessary for all countries? Or
only major capital exporting countries?

What alternatives are available to limit

deferral?
◦ Transfer pricing rules
◦ Anti-avoidance rules or doctrines
◦ Exchange controls
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8
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CFC rules distinguish between good deferral
and bad deferral
Not all deferral is bad
◦ In some cases deferral is justified by
international competitiveness
Not all deferral is good
◦ In some cases deferral must be eliminated to
protect the domestic tax base
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Most countries apply CFC rules to foreign
corporations controlled by residents

A few countries apply these rules to foreign

corporations in which residents own a substantial
interest
◦ For example, the French rules use a 10; ownership test
-
 Should deferral be eliminated for
◦ Only passive, investment income?
◦ Passive income and base company income?
◦ All income?
Should deferral be eliminated for CFCs that are
used to avoid foreign tax?

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Income from transactions in
residence country
Income from transactions with
related parties
Other income?

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 CFC in high-tax country engages in transactions with
related party in low-tax country

Effect is to erode tax base of high-tax country

not residence country

Justifiable?

14
%
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Under transactional approach active business income
is exempt
Under designated jurisdiction approach CFCs in high-
tax countries are exempt
Under entity approach CFCs engaged primarily in
active business or earning primarily active business
income are exempt
◦ Nature of business
◦ Type of income
◦ Level of presence in foreign country

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15
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 Why do the following countries not have CFC rules?
Austria?
Brazil?
Belgium?

Effectiveness of CFC Rules? Netherlands?

India?
Chile?

16
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General anti-avoidance rules
and doctrine
◦ Role and effectiveness of rules in
dealing with the use of low-tax
regimes by Multinational Enterprises

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Restrictions on the exemption of income
distributed by foreign subsidiaries subject to a
low-tax regime
◦ Combination with CFC rules
◦ Consequences on the use of tax credits attached
to participation’s revenue not exempted
19
Tax treaties with low-tax countries

◦ What strategy?

◦ Practical effects of the

OECD Guidelines
 Conventional means for
limiting use of low-tax regimes
◦ Limitation on benefit of the
treaty

◦ Exchange of information

20
21