Introduction
The purpose of this paper is to compare the controlled foreign corporation legislation of the United States and Germany. The applicable legislation and codes will be identified and explored and then compared. This comparison will begin with an overall summary of the US controlled foreign corporation legislation followed by a similar summary of the German legislation. Next, the similarities between the two will be covered. Finally, the differences between the two pieces of legislation will be developed.
Background
Controlled foreign corporation (CFC) legislation is designed to prevent the accumulation of profits and income abroad. If corporations operating abroad are allowed to retain earnings indefinitely or at least for extended periods of time, the corporations home country may not ever see the funds flow from the corporation to the shareholders. Thus, taxation could be permanently or indefinitely postponed or avoided.
CFC legislation seeks to target those companies that might attempt to accumulate without distributing this type of income. Once identified the essence of this legislation is to create a liable to tax situation for the designated shareholders of the corporation. Since not all shareholders have controlling or even influencing control over a corporation, often times this legislation seeks to consider only those shareholders that have a significant influence. This type of influence is often measured by a percentage of value ownership or a percentage of profits received.
Furthermore, this legislation generally looks to controlling interest from a rather broad perspective. Ownership or control by related parties is often considered in this determination. The purpose of this consideration is to prevent the dispersal of ownership in form among relatives, business partners or trusts.
Since business is a fluid environment and ownership of a country might change throughtout the year, this legislation often establishes guidelines for the CFC designation. Once a CFC designation has been applied to a company the next phase is to assess what income will fall under the CFC legislation. Certain types of foreign business might do bussiness abroad that could potentially be designated as CFC, yet the purposes are not to avoid taxation or defer taxation to shareholders indefinitily. Therefore CFC legislation seeks to identify the company types that might engage in these transactions and the transaction types themselves.
Summary of US CFC
The United States controlled foreign corporation legislation referred to as Subpart F was the first of its kind. This legislation originally enacted in 1962 was instituted to determine pro rata tax liability on corporations operating with subsidiaries abroad that otherwise might never pay dividends.
In general there are two phases in determining CFC taxation. The first is to determine if a foreign corporation is controlled by a US citizen. If the tests according to statute determine that the foreign corporation is controlled, the next step is to evaluate the income to determine whether or not CFC income types exist and consequently taxed.
Identification
The first step is then to identify any U.S. shareholders of a foreign corporation. For CFC purposes, a U.S. shareholders would be any U.S. person owning at least 10% of the total combined voting power of the outstanding stock. Furthermore, rules of constructive ownership are applied in CFC cases as set forth in section 958 and 318(a)[1]. A stock under these rules is considered to be owned by the stockholder if the stockholder’s, spouse, child or controlled entity, which include partnerships, trusts, or corporations, owns the stock of the foreign corporation. If a foreign corporation is owned by another corporation, the ownership must be followed or flowed back to the actual person owning the stock of the corporation in question.
Subpart F identifies certain corporations that are not to be considered CFC’s under US law. The first covers foreign corporations owned by eleven unrelated U.S. people, who each own 9.09% of the outstanding shares. The second part details a U.S. person how owns 50% of the outstanding stock, and 6 or more other unrelated U.S. persons own equal portions of the remaining 50%.
Finally, CFC designation is contingent upon meeting the above qualifications for a minimum of 30 consecutive days of the tax year in question.
Taxable Income
The second step covers the taxation of the shareholders after the CFC has been designated as such. There are two areas that comprise the majority of the CFC taxation. In general the U.S. shareholders are taxed as they would be if they owned a flow-through type entity such as a partnership.
The first area is Subpart F income is composed of for income types. The first type under 954(a)(1) and (c)[2] includes foreign personal holding company income, passive income from interest, dividends, rents, royalties and gains from sales of securities. The second type of income covered by 954(a)(2) and (d)[3] is foreign base company sales income. The third type covered by 954(a)(3) and (e)[4] is foreign base company services income. The fourth type covers air and sea transportation income.
The second area includes investment earnings of the foreign corporation from investments in property located in the U.S., securities issued from the U.S., or income derived from the licensing or sale of intellectual property used in the U.S. as mentioned in 956(b)(1)[5].
Exceptions
There are two general exception to these rules. The first is the De minimis rule. This rule eliminates the application of CFC taxation for any corporation that has gross foreign base company income less than the smaller of 5% of gross CFC income or $1 million according to 954(b)(3)(B)[6].
Foreign Personal Holding Company Tax (FPHC)
Identification
This in application can be simillar to that of the CFC rules. It will apply to any U.S. shareholders of foreign corporations if 5 or fewer U.S. residents/citizens own at least 50% of the stock and if foreign personal holding company income accounts for at least 60% of the foreign corporation’s income section 552(a)[7]. This rule does not have a de minimis exception similar to that found in the Subpart F CFC legislation.
Taxation
Undistributed income held by the foreign corporation that is considered foreign personal holding company income would be included in the U.S. shareholders ordinary income under section 551(a)[8]. Unlike non-foreign PHC income, which is does not include gains from the sale of stock as passive income(capital gains), FPHC tax would however passive investment income gains from the sale of stock into ordinary income per section 553 (a)(2)[9]. This could result in a higher tax rate than the capital gains tax charged for non-foreign PHC .
Exception
If the CFC rules above apply, they will override the FPHC tax and the CFC legislation will be followed instead[10].
Appreciated Foreign Stock
Under IRC ss 1248, U.S. shareholders are required to treat the gains on CFC stock sales as ordinary income to the extent of undistributed earnings and profits of the CFC[11]. This section prevents shareholders that might otherwise face CFC taxation from selling their CFC stock and only facing a capital gain tax liability from the sale of stock of a foreign corporation with a higher valuation partly resulting from undistributed profits and earnings. This applies to any U.S. person that owns contructively or directly 10% or more of a CFC. Unlike the requirements for CFC reporting, this section will consider a foreign corporation as a CFC, if it met the CFC requirements at any time over the past 5 years, whether or not the company is considered a CFC in the current tax year.
The gain is reported as a dividend to the extent that earnings and profits could have been attributed to the shareholder for the entire period that the stock was held.
Under IRC ss1246, Foreign Investment Company stock sales will be treated the same as in ss1248 above. If a shareholder owns directly or constructively less than 10% and 50% or more of the CFC is owned by U.S. persons and the CFC registered as a management company or primarily engages in trading or investing in securities or commodities, the sale of the stock will be treated as ordinary income as detailed under 1248 rules.
Finally, officers, directors and any shareholders owning a minimum of 10% of a CFC or a FPHC is required to file form 5471 if they are a U.S. citizen.
Summary of Germany CFC
(Preface on citations. The information that I gained relating to CFC legislation in Germany came entirely from the following location:
“Tax Haven Legislation in Germany — A Foreign Transactions Tax Act”., Oppenhoff & Radler., Portner, Rosemarie., 29 May 2001 found at http://themis.wustl.edu/ibll/Tax/Haven.htm
My attempts to find more direct sources were partially thwarted by time requirments and recent access problems with Lexis in late May, and difficulties in downloading Adobe pdf files on my mobile computer. It would appear that a great deal more information is readily available on this topic but in pdf format, which my rather old laptop can not handle.)
German Controlled Foreign Corporation (CFC) was instituted aproximately 10 years after the United States began to reclaim foreign corporation tax revenue. Germany’s CFC legislation was introduced under the Foreign Transactions Tax Act(FTTA) in 1972.
Identification
German CFC legislation applies if one or more people or corporations or entities that are subject to Germany’s unlimited tax liability control a foreign corporation operating in a low-tax area and this corporation generates passive income. Control provisions are met if 50% or more of the share capital or voting rights are held by individuals or legal entities subject to corporate tax in Germany. This control provision would be similar to the U.S. FPHC Tax. Germany also looks to individual shareholders who own more than 10% of a foreign corporation or who who through other persons or entities could exercise substantial control.
German legislation calls for a ‘low-tax’ test as mentioned above. If the income of a controlled foreign corporation does not fall within the countries of management nor residence, the income is subject to apportionment, the portion falling outside of German control subject to a minimum tax burden of 30% on income.
Taxable Income
Under the German provisions CFC income is considered that income of capital investment characterd. This would included income from the possession, preservation or administration of securities, receivables, valuable tender or commodities.
The German CFC is not intended to penalize but instead to promote the distribution of dividends, which would then enable shareholders to pay taxes. However, if the CFC legislation applies to a foreign corporation under the FTTA the amount that is subsequently identified as a pro rata distribution, called the apportionment, is considered to have been distributed after the end of the fiscal year of the CFC.
Reduction
Even though the German CFC legislation is not supposed to impose penalties, the requirement to treat apportionments as dividends can be burdensome. Fortunately, the FTTA does provide relief for any CFC that distributes actual profits in a dividend. The apportionment can be reduced by the amount distributed. The reduction cannot result in a credit, however, the reduction can go back to reduce apportionments over the past 4 years.
Exceptions
There are three statutory exclusions under the FTTA. The primary exclusion results from income from a company that a CFC owns at least 10 percent. It is also important to understand that apportionments or CFC distributions are considered to be dividends from the foreign corporation. With this status they are then covered under any of the tax treaties between countries. This can result in a lighter CFC burden when these issues are aimed at countries that Germany has a double taxation agreement (DTA).
Similarities & Differences
In Germany CFC legislation can be applied to corporations controlled by corporations or entities other than actual people as in the United States. Futhermore, Germany’s CFC legislation was originally instituted to deter or prevent corporations from establishing in foreign jurisdictions offering specific tax incentives to non-residents or in tax havens in general. Germany therefore establishes a clause “low-tax” when considering which foreign corporations might be considered under the FTTA.
Germany does go to the same lengths that the subpart F legislation does in identifying or defining a shareholder, who owns 10% or more. The main German test is for control of greater than 50%. While this is dissimilar to the CFC legislation it is similar to the US Foreign Personal holding company tax, which requires as one part of its rules that 50% or more of a corporation with passive income should be owned by 6 or fewer shareholders. German legislation does not specifically detail the flow through identification of controlling interest for shareholders identification. However, similar rules to those of Subpart F are identified through a German administrative circular.
Germany’s minimum tax burden follows the motivations of the FTTA intentions. For CFC’s that fall outside the realm of German taxability a minimum tax of 30% is charged. This would reduce the benefits of treaty shopping for German shareholders looking to tax havens.
The exceptions of the U.S. and German CFC legislation are quite different. The U.S. offers a de minimis rule to help exclude those corporations that might derive CFC income throught the normal course of business. However, this income does not subject the foreign corporation to the CFC application due to the minimal levels of income as compared to all other income of the original corporation. Whereas the German CFC legislation excepts income from corporations that a designated CFC has a holding of 10% or more.
When determining the time of the distribution from a CFC the U.S. considers the tax year of the foreign corporation. The German statutes conversely identifies the distribution, apportionment, to have occurred after the end of the fiscal year of the identified CFC. The strength of the German FTTA is substantially lighter than the U.S. equivalent. The exceptions allowed for dividends per double taxation treaties substantially reduce the effectiveness of the German legislation as compared to the American Subpart F.
The U.S. Subpart F CFC legislation has a far wider scope than the German FTTA. The FPHC Tax as well covers more ground and prevents mitigation through sales of stock or investment in countries in which a DTA is in place.
_________________________
“Summary of U.S. Tax Rules Pertaining to International Corporations, LLCs, Partnerships and Trusts”., 20 May 2001., found at http://incorporateoffshore.org/index1.htm?Offshore/offshore-tax-rules.htm
“Tax Haven Legislation in Germany — A Foreign Transactions Tax Act”., Oppenhoff & Radler., Portner, Rosemarie., 29 May 2001 found at http://themis.wustl.edu/ibll/Tax/Haven.htm“Taxation of Ineternet Companies: Traditional Multinational Rules May Apply.”, Legal SiteCheck., Beck & Arad, LLP. 30 May 2001., found at http://www.legalsitecheck.com/taxation.html
[1] IRC ss958 & 318(a)
[2] IRC ss954(a)(1) and (c)
[3] IRC ss954(a)(2) and (d)
[4] IRC ss954(a)(3) and (e)
[5] IRC ss956(b)(1)
[6] IRC ss954(b)(3)(B)
[7] IRC ss552(a)
[8] IRC ss551(a)
[9] IRC ss553 (a)(2)
[10] IRC ss951(d)
[11] IRC ss1248
Saturday, June 02, 2001
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