CFC rules are designed to prevent taxpayers with a controlling interest in a foreign subsidiary from stripping the tax base of their country of residence by shifting income into a CFC.
However, existing CFC rules are not always adapted to the current business environment and do not permit to tackle BEPS effectively. Taxpayers have developed practices that allow them to circumvent CFC rules. For example, they may manipulate the definition of CFCs through the choice of the legal form of the subsidiary, the fragmentation of the level of control, or the splitting of income across multiple subsidiaries.
The OECD/G20 Final Report puts forward options for the design of CFC rules in the form of six building blocks: (i) definition of a CFC, (ii) CFC exemptions and threshold requirements, (iii) definition of CFC income, (iv) rules for computing income, (v) rules for attributing income to shareholders, and (vi) rules to prevent or eliminate double taxation. It aims at preventing the stripping of jurisdictions' tax bases, while avoiding excessive administrative and compliance burdens for companies as well as double taxation issues.
Regarding the definition of CFC income, it is worth noting that the Final Report presents a non-exhaustive list of approaches to attribute income that raises BEPS concerns:
i) a categorical approach, which consists in classifying income into categories, usually according to its legal designation (as dividend, royalty, IP income, etc.), but also according to other criteria, such as the relatedness of parties or the source of income. CFC rules would apply to those categories of income;
ii) a substance-based approach, which looks at whether the attribution of income to a CFC refers to genuine activity, either through a threshold test or a proportionate analysis;
iii) an excess profit returns test, which targets extraordinary returns on equity (notably, in the form of interest or royalties) that would remain with the CFC even after transfer pricing rules have been applied.
States may choose one of these approaches or combine two of them. The above-described approaches can be applied on an entity-by-entity basis 53 or on a transactional basis 54 .
