Topics Covered Hide
- Understanding the CFC concept
- Becoming familiar with CFC rules
- It no longer feels like a good idea, does it?
- Take another example.
- Disclosing the idea of permanent establishment
- Ideas to reduce or avoid CFC rules
- Move to a country with no CFC rules
- Get an operating company
- Spread shares among people you trust
- Keep the profit under control
- Relocate a trusted family member
- Avoid legal control of the company
- Choose a low tax company in a whitelisted country
- Benefit from the EU freedom
- Stay away from countries with strict CFC rules
- It sounds crazy, but you are very likely to get taxed twice.
More and more entrepreneurs turn to offshore companies for a wide variety of benefits. To lots of business people, this is all about reducing tax and diversifying assets. To others, it is about minimizing the overall hassle.
If you are "lucky" enough to live in a country with lots of bureaucracy, you know how daunting it is to meet all the requirements. You need lots of paperwork, and each paper requires weeks of waiting. You end up spending hours in queues, only to be told to bring more papers.
Certain countries, on the other hand, provide extra benefits by canceling all the paperwork and easing the actual investment. Take Estonia, for instance. It is one of the most appreciated locations for offshore entrepreneurs and for some obvious reasons.
Taxes are lower. Bureaucracy is almost history. It makes sense, right? In today's society, such aspects are mandatory. You want fewer tax increases, no budget deficits, and so on. Now, while trying to go abroad, you will find different jargon terms – is offshore the same as CFC?
Not really. CFC and permanent establishment are similar, but different. In theory, they mean the same thing. CFC stands for a controlled foreign company – a business established in another country. This is also what an offshore company means.
Tax consequences are often overlooked when establishing a business abroad, and this could lead to a plethora of consequences. International taxation is an issue worth some consideration. The problem is most documents are legal and difficult to understand.
Understanding the CFC concept
So, what does CFC actually mean? You know what it stands for, but what is the legal implication of a controlled foreign company? The idea has been introduced by various countries in an attempt to reduce tax evasion and avoidance measures.
Such measures – like the CFC rules – are meant to prevent companies or individuals from reducing tax liability by moving to low tax jurisdiction. Basically, lots of people set up companies in tax havens to reduce tax – it makes perfect sense.
However, some governments have decided to come up with some measures in order to reduce this trend. Doing business abroad is perfectly legal. But then, some governments will try to grab some sort of tax regardless of where you go.
CFC legislations are common to most OECD Member States. They are introduced to combat tax evasion by shifting profits to corporations situated in low tax jurisdictions. Without the introduction of CFC legislations, residents are free to set up corporations abroad to lower their tax burden. The reason is the shielding effect of non-resident corporations.
Here are a few examples to help you understand. If you are a British citizen and you have a company in Cyprus, the Cypriot company would be considered a CFC – controlled foreign company – in the United Kingdom.
The CFC concept does not apply to people or entrepreneurs only. Instead, businesses owning other businesses will go through the same thing. If a company in Germany owns another company in Romania, the Romanian company is a controlled foreign company in Germany.
Becoming familiar with CFC rules
CFC rules are complex and difficult to understand. Moreover, each country has its own rules, yet partnerships have caused these rules to overlap. They are basically similar, despite the different formulation and enunciation.
The structure is almost identical everywhere. For the rules to be determined for a company, you need to determine if the respective entity is actually a controlled foreign company. The taxation condition should also be considered, not to mention the type of taxable income.
So, first of all, is a business defined as a CFC? It depends on several factors. To help you understand, most countries in Europe consider a foreign company to be a CFC if one of the directors owns 25% to 50% of it. The percentage varies from one country to another.
The same rule applies to both individuals and companies. For instance, a company could be owned by other companies, rather than actual people. Similar percentage rules are applied then. The country is not the only definitive factor, but also the company.
CFC rules can go even further. Apart from the owning percentage, the authorities will also consider the voting rights within the company, not to mention the entitlement to profits. Simply put, there are similar rules for the profit entitled to the respective owner.
Moving further, many countries in Europe have further rules that analyze tax payments of such companies. For instance, if a foreign company pays tax in the home jurisdiction, the tax can be under a particular tax rate.
At the same time, some companies can also receive passive income. In any of these cases, the company is considered a CFC. If all these rules kick in, the foreign company is a CFC, and the income is taxed locally.
Now, moving on to the residency country, other rules target this aspect and can determine what kind of income is taxed locally. There are countries out there that will only tax the passive income. Other countries target all the income.
So we’ve now had the final paper on Action 3 of the OECD BEPS agenda, which concerns CFCs. Now CFCs or Controlled Foreign Company rules aim to prevent the avoidance of tax through shifting profits to low tax foreign subsidiaries.
It sounds confusing, but here is an example that will make it crystal clear.
- First, you live in Finland, and you own a company in Belize.
- You own more than 25% of it, which is the minimum requirement in Finland.
- Second, your company in Belize pays 0% tax.
- The amount is lower than the 60% of the tax requirement in Finland.
- The company meets the requirements to be a CFC company, so all the income will be taxed domestically in Finland.
The first few rules are met, so the company is considered a CFC. What does that mean? If you live in Finland, you will be personally taxed there for the profit your company makes in Belize, even if you do not receive any income or dividends whatsoever.
It no longer feels like a good idea, does it?
It is important to know that EU or EEA subsidiaries of other companies in the same area could avoid these CFC rules. Such rules are quite common in Europe these days, but other countries have also stepped in – Canada, Australia, and, of course, the USA.
Then, some countries have no CFC rules at all – Switzerland is obviously one of them, but no one knows if the situation may change. Then, there are multiple exceptions too. Different countries have whitelists and blacklists to determine whether or not a company can be considered a CFC.
Take another example.
A company in Finland owns another company in Estonia. The EU and EEA exception applies here. Besides, the Estonian company is doing business in Estonia – genuine business that can be verified. At this point, the Estonian company is not seen as a CFC in Finland.
These were only a few examples. Keep in mind that each country has different rules. To successfully reduce tax and keep more of your income, you will have to be extremely flexible and assess the situation in your home country particularly.
Of course, double-check the rules for different countries, too – the country where you want to start a business. Your home country may have different rules for different countries. Take your time to assess each aspect of your plan.
Disclosing the idea of permanent establishment
Permanent establishment and CFC rules often go hand in hand. Most people can barely understand the CFC concept – things can get even more confusing when reading about the permanent establishment. However, the idea is not that difficult.
The term is most commonly used in double taxation treaties. The permanent establishment refers to the place associated with the business. It is the fixed place for your business. This is where the company activities are carried from – mainly or wholly.
For instance, you live in the UK, and you set up a business in Latvia. You manage this small business yourself without even living in Latvia – you do it entirely from the UK. At this point, tax authorities in the UK might come out and say that your Latvian company has a permanent establishment in the UK.
It relates to the location of the management. The local tax authorities may also demand you to pay tax in the UK, rather than in Latvia. On the other hand, the permanent establishment from Latvia should be taxed in Latvia.
This is when it gets confusing because tax must be split, but it is hard to tell how. There are different guidelines related to how the profits must be attributed to permanent establishments, but then again, they are just as confusing.
While not always a general rule, profits associated with a personal establishment are the ones that the establishment would have made if it were an independent business. Basically, the foreign management is virtually removed to identify the potential profits.
All in all, the job is confusing and will most likely require legal help. Then, each country defines CFC standards in completely different ways, despite the common structure. Then, the permanent establishment issues will also kick in.
Given all these recent changes, there is a higher chance to be better off if you move more than just your business operations. Basically, you might be better off if you actually relocated completely, rather than try to run a business abroad.
Ideas to reduce or avoid CFC rules
CFC rules are now common in many high-tax countries. After all, such countries have a reputation for robbing everything you work for – they obviously aim to take it even further, as a response to going offshore.
Switzerland is currently the only exception out there. Furthermore, while not always a rule, small countries do not come with CFC rules. But then, if you live in a high tax country – such as the UK or USA, you do need to research CFC rules as part of your offshore strategy.
Every high tax country out there has the same message – if you own a company in a low tax country, they want a share of your profits. Numbers and percentages vary widely – you might be asked for 10% in some countries or over 50% in other countries.
Sometimes, having an offshore company will give you more headache than running a local company. You may also end up paying more. But then, offshore companies are not all about reducing tax. Sometimes, they are about diversifying and protecting assets.
In this case, you will be perfectly fine with paying more.
Most people – especially the least experienced ones – hear about offshore scandals and imagine you can create a company in a zero-tax country while living in a high-tax country. CFC rules do not necessarily allow all these.
Here are a few clever ways to work your way around a high tax jurisdiction.
Move to a country with no CFC rules
This is the simplest option out there. Move your legal residence to a country that has no CFC rules. Many high-tax countries have CFC rules because they realize people have found ways to avoid their robbing necessities.
Most of the world does not have such rules, especially in small countries. Forget about the EU, UK, or USA. How about Panama? How about Monaco? Territorial tax countries make a good choice because they have no CFC rules.
Get an operating company
Many countries will provide exceptions for operating companies – double check upfront. Laws are mostly aimed at controlled companies, as they often distribute passive income. On the other hand, operating companies are fine.
For instance, you could have a foreign company with employees and offices – such things may not fall under the new CFC rules. Imagine running a factory in Brazil, while living in the UK. This concept would not go under the CFC rules.
Spread shares among people you trust
A company itself will not fall under the CFC rules just because you – the director – are a foreigner. Most rules mention a particular percentage of the shares. Controlling a particular percentage of the company will put it in the CFC category.
Most countries begin at 25%, but this is not a general rule. Some countries may start at 50%, which is even better. To avoid going in this category, spread shares among people you trust – this is a double-edged sword.
Stick to people who you truly trust, such as your family members.
If the CFC rules start at 25% and each of your family members has 20% of the company, you can legally avoid CFC rules in many countries. Individual circumstances may also be considered. Plus, there should not be an official nominee arrangement between all these people.
Keep the profit under control
In some jurisdictions, CFC rules apply if you exceed particular amounts in terms of profits. Take the UK, for instance. The HMRC cannot be bothered if you make less than £50,000 a year with your offshore company. Keep the income under control, and you could get away with it.
If you feel like you are about to make more, there are different ways to plan your overseas strategy. Excess profits can be easily diverted to different jurisdictions – again, you must consider a bunch of extra laws and rules. Such issues are complex and may require professional help.
Relocate a trusted family member
Not interested in relocating yourself? Relocate a trusted family member instead. The respective family member can hold shares in a legal way. They can manage your income without bothering about CFC rules and laws.
Relocate someone to the Cayman Islands or perhaps Monaco – you can then continue making money without wasting it on tax. Obviously, the most recommended strategy is relocating yourself. But then, this is not always the case.
All in all, if you are willing to move, you need to understand how it works. Move out of your home country and spend less than six months a year in it. The local taxes and CFC rules will no longer apply to you. Basically, you can still live in your home country for less than half a year.
Location independent companies are much easier to deal with.
Avoid legal control of the company
It sounds easy, but it is difficult. In theory, if you are not a shareholder or a director, you do not fall under CFC rules, so you can completely avoid them. You do need people who you can fully trust for this type of business structure.
For example, you could establish a company in Panama and bring in Panamanian directors only. Shares can be owned by a trust in the Cook Islands. Such a structure would not be a controlled foreign company. The scheme must be watertight and requires legal assistance.
Otherwise, you risk facing legal attacks from your home government.
Choose a low tax company in a whitelisted country
This is one of the most common ways to move below the radar. There is nothing illegal about this idea, but it requires proper planning. The strategy itself is easy to implement and can provide long-term results as well.
For instance, how about a low tax company in Ireland? What about a classic LLP in the UK? Such jurisdictions are whitelisted among other European countries, so you could get away with things without too much hassle.
Compare a company in the UK to a company in Belize or Panama. Certain countries are likely to be blacklisted because they are known as tax havens – they will face much more scrutiny as well. The concept is straightforward, yet a little unusual – onshore countries have become the new offshore trend.
You could do with less hassle in Serbia or Ireland than in the British Virgin Islands.
Benefit from the EU freedom
Planning to stick to the EU? No problem – in fact, you could actually benefit from this trend if you play your cards right. Why? Simple – it is legal to structure your business in the jurisdiction with the lowest tax percentage.
Take Ireland, Cyprus, or Malta, for example. They are part of the EU, but they also have low tax rates. There are no issues whatsoever when it comes to EU residents setting up businesses in EU jurisdictions – relocating is just as easy if you already have a business.
Stay away from countries with strict CFC rules
This idea is common sense. If you have the freedom to choose and you can move around, go for it. You have to be flexible in today’s society if you want to avoid getting robbed. Most governments take advantage of their people’s inflexibility.
Some countries, in particular, are known for having strict CFC rules. Here are some of them:
- New Zealand
- South Korea
The list is longer than that, but there are just some of the most popular countries that could be attractive. Russia, for example, has very strict CFC rules as well. But in today’s circumstances, who would go to Russia to do business?
Some countries – such as the USA – have the legal system to allow to pull any offshore entity into the local tax system. If you hold American citizenship, you will have to pay tax, even if you live, work and do business in another country.
It sounds crazy, but you are very likely to get taxed twice.
Other countries – such as Australia – are more focused on the passive income coming from abroad.
ConclusionAs a short final conclusion, CFC rules are rarely discussed among offshore professionals and entrepreneurs. Everyone believes you can just run a business abroad, get the income in a different country and get away with it.
The taxman will chase you regardless of what you are trying. Obviously, there are still a plethora of different ways to keep your income under a low tax burden. You need to be flexible and willing to move out of your comfort zone.
Sometimes, getting out of your comfort zone may even imply relocating – it sounds harsh, but it is totally worth it if it can save you thousands or hundreds of thousands on a yearly basis. There are lots of choices, but you need to analyze them individually.
What works for some people will not always work for everyone else – you need to assess your unique circumstances and make decisions with your current and long-term plans in mind. Fortunately, the CFC rules can still be avoided.