Defining a Controlled Foreign Company (CFC)
A company qualifies as a CFC in Australia if it satisfies any one of the following three “control tests”:
Test 1: If five or fewer Australian residents, each with at least a 1% control interest, collectively hold or are entitled to acquire at least a 50% associate inclusive control interest in the foreign company.
Test 2: If a single Australian entity (and its associates) possesses at least a 40% control interest in the foreign company. There’s a presumption that such a shareholder controls the foreign company, making it a CFC.
This presumption can be challenged if the shareholder can prove that another unassociated entity is, in fact, in control.
Test 3: Regardless of interests in a foreign company, if a group of five or fewer Australian entities (alone or with associates) genuinely controls the company.
The control tests (1, 2, and 3) are applied sequentially. In other words, you first check if situation (1) applies; if it does, no further testing is required.
CFC Residency Rules
CFC residency rules are crucial in determining whether a company is considered a resident of a listed or an unlisted country.
These residency rules lead to critical distinctions in how CFCs are treated:
- Differential Treatment of Attributable Income: The calculation of a CFC’s attributable income differs based on whether the CFC is recognized as a resident of a listed or an unlisted country.
- Varied Application of Active Income Exemptions: The utilization of active income exemptions varies depending on whether the CFC is considered a resident of a listed or an unlisted country.
- Eligibility for De Minimis Exemption: Only CFCs residing in countries listed as per the rules can qualify for a de minimis exemption, specifically related to certain types of attributable income.
Determining Resident Status in a Listed Country
To be treated as a resident of a listed country, a company must fulfill both of the following criteria:
1. Not a “Part X Australian Resident”
A company may be considered a resident but not deemed a Part X Australian resident if it falls under the “dual residency” tie-breaker rules outlined in a double taxation agreement.
For instance, if a company is incorporated in Australia but primarily manages and controls its operations in New Zealand, it might have dual residency.
However, the tie-breaker provisions in the New Zealand agreement can declare the company solely a resident of New Zealand.
Consequently, even though the company qualifies as a resident of Australia as per laws, it won’t be categorized as a Part X Australian resident.
2. Treated as a Resident in the Relevant Listed Country
The company must also be regarded as a resident according to the tax laws of the specific listed country.
Residency in Cases of Dual Residence
In situations where a company is considered a resident of both a listed country and an unlisted country, the CFC rules will treat it as a resident of the listed country.
Determining Resident Status in an Unlisted Country
A company will be seen as a resident of an unlisted country under the following conditions:
- It is a resident of a particular unlisted country.
- It does not qualify as a Part X Australian resident, nor is it a resident of a particular listed country
Scope of CFC Rules
The controlled foreign company rules in Australia have a broad purpose, which is to ensure that Australian shareholders are taxed on their portion of a CFC’s “tainted income” when it’s earned, unless that income is already taxed in a comparable manner overseas, or if the CFC primarily earns its income from active business activities.
To achieve this, the rules attribute the tainted income to Australian resident controllers of the CFC. Tainted income typically includes income from investments or arrangements that are significantly influenced by tax considerations, such as interest, dividends, royalties, or income from transactions with related parties.
These CFC rules generally enforce accruals taxation in two scenarios:
- When CFCs are based in “unlisted” countries, and they earn tainted income.
- When CFCs are based in one of 7 “listed” countries and they earn “eligible designated concession income”.
However, accruals taxation typically does not apply to income earned by CFCs that pass the “active income test.” This means that if a CFC derives more than 95% of its income from genuine business activities, it won’t be subject to accruals taxation under these rules.
Countries Classified as “Listed” for CFC Rules
The term “listed” countries refers to a specific group of nations that meet certain criteria under Australia’s CFC (Controlled Foreign Company) rules. These criteria indicate that these countries have tax systems that closely resemble Australia’s.
In contrast, all other countries that do not meet these criteria are categorized as “unlisted countries.” The seven countries included in the “listed” category are as follows:
- New Zealand
- United Kingdom
- United States of America
Attributable Taxpayers under CFC Rules
The concept of “attributable taxpayers” plays a crucial role in Australia’s Controlled Foreign Company rules, which operate under a self-assessment regime.
Under the CFC rules, taxpayers have the responsibility to determine whether, in a specific income year, they are required to include income earned by a CFC in their assessable income. This determination depends on whether they qualify as an “attributable taxpayer.”
Conditions for Being an Attributable Taxpayer
A taxpayer is recognized as an attributable taxpayer in relation to a CFC if they meet one of the following conditions:
- The taxpayer holds a minimum 10% associate inclusive control interest in the CFC.
- The taxpayer holds a minimum 1% associate inclusive control interest in the CFC and is among the five or fewer Australian entities that control the CFC.
The term “associate inclusive control interest” refers to the combined control interests held by the taxpayer and their associates.
Direct Control Interests
Direct control interests are computed based on specific criteria related to interests or entitlements to acquire interests in issued capital (measured by the paid-up value), voting rights, and rights to capital distributions. These calculations also consider entities like Australian members of foreign companies limited by guarantee.
Indirect Control Interests
Indirect control interests are only traced through entities classified as “controlled foreign entities”, controlled foreign partnerships, and controlled foreign trusts.
The tracing of control interests ceases when a foreign entity either lacks interests in other entities or is not categorized as a controlled foreign entity.
These interests are determined by multiplying the control interest held by an Australian entity in the intervening entity by the control interest that the intervening entity has in the CFC being assessed. This calculation continues down the chain if there are multiple intervening entities.
Treatment of Temporary Residents
Temporary residents do not fall under the category of attributable taxpayers according to the CFC rules.
Attribution of CFC Income to Attributable Taxpayers
If someone is considered an “attributable taxpayer” in relation to a CFC, they must include their share of the CFC’s income, known as “attributable income,” in their assessable income for their own tax year.
Calculating Attribution Percentage
The attribution percentage represents the portion of a CFC’s income that is attributed to a specific attributable taxpayer. This percentage is calculated by combining the taxpayer’s direct and indirect interests in the CFC.
Direct interests are straightforward and are based on ownership or control percentages. Indirect interests are more complex and involve tracing interests through other foreign entities.
Exceptions to Attribution
Not all control or ownership interests lead to income attribution. The tax authorities recognize that some individuals or entities may have de facto control without holding direct or indirect attribution interests. In such cases, income attribution rules may not apply.
Changes in Residence and Attribution
If a CFC changes its country of residence, the rules around income attribution may come into play. For instance, if a CFC moves from an unlisted country to a listed country or Australia, attribution to resident attributable taxpayers may occur.
The rules for this scenario can be quite complex and are subject to modification based on various factors.
The Active Income Test under CFC Rules
The Active Income Test is a significant component of Australia’s Controlled Foreign Company rules. It provides an exemption from accruals taxation for certain income earned by a CFC, which would otherwise be attributed to Australian resident shareholders.
This exemption is especially important for Australian enterprises engaged in legitimate business activities in unlisted countries.
Conditions for Passing the Active Income Test
To qualify for the Active Income Test, a CFC must meet the following essential conditions:
- Existence and Residency: The CFC must be in existence at the end of its statutory accounting period, which is typically a 12-month period ending on June 30th. Additionally, it must be a resident of either a listed or an unlisted country throughout its accounting period.
- Business Operations via Permanent Establishment: The CFC must continuously conduct business through a permanent establishment in its country of residence.
- Maintenance of Proper Accounts: The CFC must maintain accounts that adhere to accounting standards and accurately represent the company’s financial position.
- Limitation on Tainted Income: The CFC should have less than 5% of its gross turnover, as reported in its recognized accounts, derived from tainted income. This calculation includes considerations like capital gains or losses associated with intra-group asset transfers, particularly when the roll-over relief is reversed.
“Tainted income” encompasses various categories:
- Passive Income: This category includes dividends, tainted interest, rent, royalties, income from trading in tainted assets, and net gains from the disposal of tainted assets. It’s essential to note that not all income derived during business activities is considered passive income.
- Tainted Sales Income: Broadly, this refers to income generated from the sale of goods to associated persons or income from goods originally purchased from an associate with connections to Australia.
- Tainted Services Income: This category involves income from services provided by a CFC to specific entities. For example, services to an Australian resident not connected to a foreign permanent establishment are considered tainted services income. Similarly, services to a non-resident in connection with a business conducted in Australia through a permanent establishment are also categorized as tainted services income.
To prevent the circumvention of tainted income rules through interposed entities, there are anti-avoidance measures in place. These measures treat services provided indirectly through such entities as if they were provided directly.
Attributable Income Calculation
Attributable income must be calculated for a CFC under the following conditions:
- The company must qualify as a CFC at the end of its statutory accounting period.
- There must be at least one attributable taxpayer related to the CFC.
The Calculation Process
The process of calculating attributable income for a CFC in Australia is somewhat related to determining taxable income for resident companies.
However, several modifications are applied to account for differences in rules. These modifications include considerations for capital gains, depreciating assets, trading stock, currency conversion, and taxes paid.
Notably, certain provisions that apply to resident companies, such as commercial debt forgiveness, thin capitalization, or debt creation rules, do not apply in the same manner to CFCs.
Types of Income Included
The types of income included in the attributable income of a CFC depend on two primary factors:
- Whether the CFC is resident in a listed or unlisted country.
- Whether the CFC clears the active income test.
In general, attributable income comprises adjusted tainted income, trust income, and income attributed under transferor trust measures. The specific income categories may vary depending on the CFC’s residency and compliance with the active income test.
Exclusions from Attributable Income
Certain types of income are excluded from the attributable income of a CFC, resulting in what is termed “notional exempt income.” This exclusion encompasses:
- Income assessable for Australian tax independently of CFC measures.
- Franked dividends.
- Certain excluded insurance premiums.
Unlisted country CFCs can further exclude income derived from carrying on a business in a listed country, provided that this income is not eligible designated concession income.
De Minimis Exemption for Listed Country CFCs
Listed country CFCs benefit from a de minimis exemption. This exemption allows for the exclusion of specific income if it does not surpass specific thresholds based on the CFC’s gross turnover.
The thresholds differ based on the CFC’s gross turnover, with lower thresholds applying to CFCs with higher gross turnover.
Prior Year Losses
Prior year losses can be used to reduce a CFC’s attributable income. However, certain conditions must be met for these losses to be considered. Notably, a notional deduction for prior year losses may not be available when a CFC changes its country of residence from a listed country to an unlisted country, or vice versa.
Rules for converting foreign currency amounts into Australian or functional currency are followed to ensure consistency and accuracy in the calculation of attributable income.
Modified Application of CGT Provisions
Capital Gains Tax (CGT) provisions are subject to modifications when calculating the attributable income of a CFC. Some key modifications include:
- Treating certain assets as if they were acquired on a specific “commencing day.”
- Disregarding certain CGT provisions applicable to non-resident entities.
- Adjustments for capital gains or losses on assets transferred between wholly-owned group companies.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.