KPMG report: BEPS Action 3, (strengthening CFC rules) discussion draft

BEPS Action 3, (CFC rules) discussion draft

The Organization for Economic Co-operation and Development (OECD) on April 3, 2015, released the public discussion draft under the base erosion and profit shifting (BEPS) Action 3, strengthening CFC rules. According to the “Discussion Draft,” controlled foreign corporation (CFC) rules are generally intended to prevent shifting income from the parent jurisdiction and potentially other tax jurisdictions to a different, typically low-tax jurisdiction.* The mechanism for doing so is having certain controlling shareholders include in their income the income of a foreign subsidiary as a constructive dividend or otherwise.

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*The Discussion Draft acknowledges that for countries using a territorial system, CFC rules would generally be applied to target profit shifting. However, for countries using a worldwide tax system, long-term deferral may also be a concern and therefore such countries may have CFC rules with broader policy objectives.


Public comments on the Discussion Draft are due May 1, 2015, with a public consultation to follow in Paris on May 12, 2015.

Read text of the Discussion Draft [PDF 576 KB]

The following report includes initial impressions and analysis of the Discussion Draft.

KPMG observation

The Discussion Draft is interesting and potentially controversial in a number of respects. It contains many consensus recommendations for the mechanics of CFC rules that roughly align with the structure of the U.S. Subpart F rules. There is also a consensus recommendation targeting hybrid structures, including (or especially) those made possible under the U.S. check-the-box rules. Nevertheless, the Discussion Draft otherwise contains no consensus regarding fundamental questions such as the scope of “CFC Income” subject to the deemed inclusion rules and whether and to what extent “substance” can prevent a CFC inclusion. The options set out in the discussion of CFC Income generally mirror the debates among the OECD members that are occurring in the transfer pricing components of the BEPS project (generally, Action Items 8-10). As alluded to in the Discussion Draft, this debate is about whether BEPS is meant to ensure “that profits are taxed where the economic activities giving rise to them take place” (Discussion Draft at 52) or whether it will promote more fundamental reassessment of “whether the intergroup asset and risk allocation resulting from [intergroup] contracts is what would be expected on a commercial basis” (Discussion Draft at 40).

Consensus recommendations*

*Chapters 6, 7 and 8 of the Discussion Draft respectively recommend provisions for calculating CFC income, attributing CFC Income, and alleviating double taxation of CFC Income that are broadly consistent with the U.S. Subpart F rules (e.g., Code sections 951, 952, 958(a), and 959-961, respectively) and are not discussed further herein.

Definition of a CFC

The Discussion Draft recommends broadly defining the entities that would fall within the scope of CFC rules including partnerships and trusts if these entities are either owned by CFCs or treated as taxable entities separate from their owners in the parent jurisdiction.

The Discussion Draft also recommends that permanent establishments (PEs) be taken into account for the CFC rules as separate entities if the residence jurisdiction of the PE owner exempts the PE’s income from taxation.

Additionally, the Discussion Draft recommends a “modified hybrid mismatch rule” that would prevent entities from avoiding CFC rules by being treated differently in different jurisdictions. Apparently targeting the U.S. check-the-box rules, this recommendation addresses differences in the characterization of instruments and entities that result in payments that might otherwise be included in a shareholder’s income under the CFC rules being disregarded or treated as outside the scope of the CFC rules. The Discussion Draft sets out two variations of the rule that would both regard an intragroup hybrid payment if the payment would have given rise to a CFC income inclusion if the parent jurisdiction classified the entities and arrangements in the same way as the payer or payee jurisdiction. Under the “narrow” iteration of the rule the payment would also need to be “base eroding” in order to be regarded.

If implemented by regulations in the United States, this recommendation would appear to implicate Notice 98-35 (June 19, 1998), pursuant to which the IRS and Treasury Department announced in part (and subject to limitations), that any regulatory amendments to the Subpart F rules addressing hybrid transactions would not apply for five years from the date of finalization of such regulations with respect to hybrid structures entered into between June 19, 1998, and the date of finalization of the regulations. Nevertheless, the Discussion Draft’s recommendation is consistent with the approach suggested in the Obama Administration’s CFC minimum tax proposal in its FY16 proposed budget. Accordingly, the U.S.’s concurrence is perhaps best viewed in light of these proposed legislative changes.

Low-tax threshold

The Discussion Draft recommends limiting the scope of the CFC rules by implementing a low-tax threshold under which the CFC rules would only apply to an entity that is resident in a country with a lower tax rate than the parent company. This rate disparity test would be applied on an effective tax rate basis.

The recommended low-tax threshold would be applied through a two-step process.

  • First, the CFC’s effective tax rate is computed by dividing the CFC’s income tax paid by the CFC’s tax base determined under either the parent or shareholder’s jurisdiction or according to an international accounting standard.
  • Second, this effective rate is then compared to an applicable benchmark to determine if the CFC is low taxed. The recommended benchmark would be no greater than 75% of the statutory rate in the parent or shareholder jurisdiction.

Definition of control

For a jurisdiction’s CFC rules to apply to an entity, a jurisdiction’s residents must control that entity. The Discussion Draft gives recommendations as to the type and amount of control required.

The recommendation is that both legal control (i.e., voting power) and economic control (i.e., rights to capital, assets, and capital) tests can be used and that the satisfaction of either test is sufficient to bring a foreign entity within the CFC rules. Regarding the amount of required control, the Discussion Draft recommends a more than 50% control standard by residents (including corporate, noncorporate, and natural persons) in order for the foreign entity to be treated as a CFC.* This level of control could be established through the aggregated interest of related or unrelated parties or from aggregating the interest of taxpayers acting in concert. Lastly, the CFC rules would apply when direct or indirect control is found.


*The Discussion Draft acknowledges that countries could set this at a lower level to achieve broader policy goals.

The acting in concert standard would introduce substantial uncertainty into a CFC test. In part, the Discussion Draft contemplates that the acting in concert standard could be used as a substitute for related-party ownership attribution rules. Nevertheless, outside the related-party context, such a rule introduces a high degree of subjectivity into the analysis. For example, if a foreign corporation is owned 50:50 between unrelated persons resident in different countries, the entity would not be a CFC under a mechanical control test, but there seems an inherent risk that the shareholders are “acting in concert” such that the shares of each owner could be attributed to the other.

More generally, the Discussion Draft repeatedly refers to the underlying policy as identifying shareholders that “exert influence” on the foreign corporation. It could be argued that CFC rules should be looking to “control” and the ability to direct the activities of the foreign corporation, perhaps demarcating a line between investing in and operating a business.

KPMG observation

The Discussion Draft appears to be addressing only non-publicly traded corporations, but that is not clear. It discusses “concentrated ownership requirements,” such as “United States Shareholder” rules (requiring a 10% voting interest to be counted in determining CFC status), but does not mandate such rules. It makes little sense to subject the portfolio shareholders of publicly traded companies to CFC rules, based on their usual lack of any effective control and the likelihood of local resident ownership for publicly traded corporations. This point may be clarified in the final report.

Options for defining “CFC Income”

While not making any specific recommendations, the Discussion Draft discusses various options for defining CFC Income. The range of options is extreme. At one end, the options could be viewed as consistent with a worldwide/full inclusion tax system, which would provide limited exceptions if the CFC has developed intangible property (IP) it exploits (including through sales and services) and derives dividends only from related CFCs. The least inclusive regime would appear to be one that targeted passive income, including business income not tied to substantive business operations.

Interestingly, the Discussion Draft makes continuous reference to the limitations on CFC rules within the European Union (EU). The Discussion Draft is premised on those limitations being permanent and therefore notes that implementation of the OECD’s CFC recommendations may have to be modified in EU jurisdictions to comply with the EU treaty. In multiple parts of the Discussion Draft, it notes that compliance with EU law may require any CFC rules to utilize a substance requirement, rather than rely exclusively on mechanical effective tax rate based, or type of income tests.

The Discussion Draft sets out two possible approaches that jurisdictions could use in defining CFC income, with neither representing a consensus view. These approaches are the categorical approach and the excess profits approach. In addition, as a best practice, the Discussion Draft provides that CFC rules should apply using a transactional approach that looks at specific income streams rather than an entity approach that would test the entity as a whole, such that all of its income is or is not CFC Income.

Under the categorical approach, the Discussion Draft states that a CFC regime must address five types of income (at a minimum) to adequately address BEPS concerns. The types of income are: (1) dividends, (2) interest and other financing income, (3) insurance income, (4) sales and services income, (5) royalties and other IP income.

In general, the approach to dividends is that they should be CFC Income if derived from investments in unrelated companies, and should not be CFC Income if derived from related CFCs. For interest and insurance income, in general related-party income would be CFC Income, while unrelated-party income would not be attributed if there is requisite substance, generally testing for whether the underlying business is an active financing or insurance business. No further detail is provided on defining such an active business.

Notably, the Discussion Draft contemplates using the same rule for sales, services, royalties, and IP income, and would treat such income as CFC Income unless the CFC had the required substance to earn the income itself.

The Discussion Draft provides three options for testing substance.

  • The first is based on “substantial contribution,” based on the U.S. contract manufacturing rules. The details of a substantial contribution rule are not discussed.
  • The second is a “viable economic entity” analysis, which defines substance based on whether the tested CFC within the multinational corporate group “is the entity which would be most likely to own particular assets, or undertake particular risks, if the entities were unrelated” (Discussion Draft at 36-37). Further, it contemplates requiring the CFC to have developed any exploited IP itself. The Discussion Draft is vague with respect to whether IP that is not developed by the CFC but is acquired or licensed from a third party leads to CFC Income. This option seemingly disregards legal ownership, risk assumption, and potentially economic contributions through employees and assets in deriving income. Accordingly, it suggests that the use of global supply chains relying on contributions from related and unrelated parties are inherently non-substantive.
  • The third option is an “employees and establishment” analysis that looks to whether the CFC had the necessary business premises and establishment, and necessary employees with the requisite skills, in the CFC jurisdiction to actually earn the income and undertake the majority of CFC’s core functions. The report describes CFCs that outsource core functions to affiliates, or that merely manage and oversee value-creating activities, as falling short of this more objective standard.

Under the excess profits approach, CFC income would be defined to include a CFC’s excess profits in low-taxed jurisdictions. Under this approach, a CFC would determine its “normal return” and then subtract this amount from its income. This difference is treated as CFC Income. No consensus was met on how to determine the normal rate of return. Nevertheless, the Discussion Draft notes that economic studies often estimate the risk-inclusive rate of return to be between 8%-10% but can vary by industry, leverage, and jurisdiction.

The perceived advantages of the excess profit approach include: (1) being a simpler and more mechanical approach; (2) potentially addressing current CFC rule concerns regarding supernormal returns earned by IP; and (3) dealing with the problem of IP cash boxes located in low-taxed jurisdictions. Nevertheless, the lack of a substance based exclusion may cause over or under inclusion, as it is using a proxy to identify shifted income. Further, the Discussion Draft suggests that an excess profits approach not ultimately tied to a substance requirement may fail under the EU CFC limitations.


For more information about the OECD’s work on CFC rules, contact a tax professional with KPMG’s Washington National Tax:

Ron Dabrowski | +1 (202) 533-4274 |

Doug Holland | +1 (202) 533-5746 |


For more information about KPMG’s BEPS-related services, contact one of KPMG’s BEPS-focused professionals or consult KPMG’s BEPS Tax Transparency website.

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