Revenue Releases Guidance Notes on CFC Legislation has been saved
Revenue Releases Guidance Notes on CFC Legislation
On 22 July 2019, the Irish Revenue released guidance on the Controlled Foreign Company (“CFC”) rules which were brought about by Finance Act 2018. The guidance is nearly 120 pages and supplements the existing legislation introduced with effect from 1 January 2019 to provide further insight into how the rules are to operate in the context of an Irish parent company.
Background to the new rules
Part 35B of the Taxes Consolidation Act, 1997 (“TCA”) implements Articles 7 and 8 of the EU Anti-Tax avoidance Directive (“ATAD”) provisions on CFCs. The CFC rules are an anti-abuse measure, designed to prevent the artificial diversion of profits from controlling companies to offshore entities in low or no-tax jurisdictions (the CFCs).
The rules operate by attributing undistributed income of the CFCs, arising from non-genuine arrangements put in place for the essential purpose of avoiding tax, to the controlling company, or a connected company in the State for taxation, where the controlling company, or a connected company, carry out relevant Irish activities (i.e. significant people functions (“SPFs”) or key entrepreneurial risk-taking functions (“KERTs”) in the State).
The rules require an analysis as to the extent to which the CFC would hold assets or bear risks were it not for the controlling company, or a connected company, undertaking the SPFs or KERTs (hereinafter any reference to ‘SPFs’ can be taken to include KERTs) in relation to those assets and risks. A company is considered to have control of a subsidiary where (in broad terms) it has direct or indirect ownership of, or entitlement to, more than 50% of the CFC’s issued share capital, voting power or distribution amount.
A number of exemptions are provided for including exemptions for CFCs with low accounting profits or a low profit margin or where the CFC pays a comparatively higher amount of tax in its territory than it would have paid in the State. A one-year grace period is also allowed in respect of newly acquired CFCs where certain conditions apply. Relief is also available on certain distributions and on certain disposals of shares or securities in a CFC.
The CFC rules will not apply where the arrangements, under which SPFs are performed, have been entered into on an arm’s length basis or are subject to the Transfer Pricing regime under Part 35A, TCA. To prevent double taxation, a credit will be available for any tax paid by the CFC on the same income which is subject to the CFC charge in the State, whether arising in its jurisdiction or any other jurisdiction (including the State) on the chargeable income of the CFC. The rules take effect from 1 January 2019.
Essentially, a CFC charge can arise in the following circumstances:
- There must be a CFC resident in a foreign territory.
- It must be controlled by a company resident in the State.
- The controlling company, or a company connected with it, must carry out relevant Irish activities i.e. Irish SPFs, relating to those assets or risks.
- The arrangements between the CFC and the controlling company, and a connected company(s) where relevant, must be non-genuine and they must be in place for the essential purpose of securing a tax advantage.
- Irish transfer-pricing provisions have not applied and the arrangements have not been entered into at arm’s length.
- The exemptions that are available must not apply.
1. Control and residence
The concept of ‘control’ underpins the relationship between a parent and its subsidiary and determines whether a company will be considered a CFC or not.
For the purposes of the CFC rules, a person (being a body corporate or an individual) ‘controls’ a company if the person can control or acquire control, either directly or indirectly, of the company’s affairs.
In addition, the concept of control for CFC purposes includes the ability to exercise control over the composition of the board of directors (and can include circumstances where a person has what is commonly referred to as a “golden share”). The guidance outlines a number of examples regarding Revenue’s view of the meaning of control in section 1.6.4.
In order for the CFC charge to apply, the entity in question should be regarded as non-resident in Ireland for tax purposes. A key consideration is therefore how the tax residence of an entity is to be determined. The Revenue manual provides further guidance and in particular outlines the following tests:
i. Determination of whether the entity is resident in a territory by virtue of the terms of the relevant double tax agreement;
ii. In the absence of (i), residence is to be determined by reference to where the CFC is subject to tax by reason of domicile, resident or place of management;
iii. Where (ii) does not provide confirmation as to the place of residence, the company will be resident where the place of effective management is situated;
iv. Where there is more than one possible location under (iii), the CFC will be regarded as resident in the territory where more than 50% of its assets are located;
v. In the absence of confirmation from (i) to (iv) inclusive, residence is to be determined by reference to the place of incorporation for the entity.
The Revenue manual does not make explicit reference to the Multi-Lateral Instrument (“MLI”) and the impact of same with respect to tax residence (Article 4, Dual resident entities) but this may have implications for points i. to iii. above.
2. Tax essential purpose considerations
The CFC charge is disapplied where income arises from arrangements where it is reasonable to consider that the essential purpose of the transaction is not to secure a tax advantage. The Revenue guidance provides that where a mix of arrangements are in place where some elements have a tax advantage as the essential purpose, then the income must be segmented with the CFC charge arising only on the undistributed income attributable to the tax essential purpose element.
In addition, the legislation provides a separate tax essential purpose test where during an accounting period of a CFC, the CFC did not hold assets or bear risks under an arrangement where it would be reasonable to consider that the essential purpose of the arrangement was to secure a tax advantage. The Revenue manual notes that this section is an “all or nothing scenario” as opposed to the segmentation method applied above.
Section 4.5 of the manual notes that these essential purpose tests are a less stringent requirement than the ‘main purpose’ test used in other areas of tax legislation in that obtaining the tax advantage must not have been the ‘decisive’ factor to entering into such arrangements as opposed to ‘one of the main factors’ applied in other contexts. Furthermore, section 4.5.2 provides examples of factors which might indicate whether the tax essential purpose of a transaction was to secure a tax advantage.
3. Non-genuine arrangement
A non-genuine arrangement is defined as one where the CFC wouldn’t own the assets or have borne the risks which generate all, or part of, its undistributed income, but for relevant SPFs in Ireland relating to those assets and risks, and it would be reasonable to consider that the SPFs in Ireland were instrumental in generating that income.
Where no such non-genuine arrangements exist and provided all other conditions are met, a CFC charge may be avoided. The Revenue guidance provides a very broad definition of what might be considered an ‘arrangement’ for the purpose of the test and notes that an objective application must be applied when determining whether it would be ‘reasonable to consider’ whether the SPFs in Ireland are instrumental in generating that income.
A number of examples are included in the Revenue guidance in relation to this test. One of the examples is as follows:
Example 10 - Genuine arrangements test
A CFC is resident in Luxembourg for corporate income tax purposes (“LuxCo”). LuxCo is performing intra group financing activities e.g. the advance and administration of loans to group entities in foreign territories. LuxCo is taxed on a low effective corporate income tax rate which fails the Effective Tax Rate (“ETR”) test (discussed below). It also fails the essential purpose test. It is considered to be a CFC from an Irish tax perspective. Its Irish parent must consider whether income should be included as taxable income of IrishCo under the CFC charge.
Genuine arrangements test
LuxCo controls the decision to lend, and the terms on which monies are advanced, to group companies. It does more than exercise stewardship functions, but it carries out its intra-group lending activities with the benefit of significant support and analysis from its group management based in Ireland.
In the case of these intra-group lending activities, the relevant KERT is the decision whether to lend the money and on what terms. Where such decision making is done in Luxembourg (and not in Ireland) the arrangements are considered to meet the requirements of the genuine arrangements test.
If Irish Co’s support arrangements with LuxCo arise in the course of a trade taxable under Case I, Irish transfer pricing principles should require IrishCo to reflect this pricing adjustment in its taxable Case I income. This might be done by LuxCo paying a service fee or commission to the loan origination team based in Ireland.
In circumstances where the genuine arrangements test is not met, and either the arrangements are not on arm’s length terms or Ireland’s transfer pricing regime does not extend to these arrangements, the application of transfer pricing principles under the CFC rules should see an equivalent amount of profits taxed as a CFC charge where the arrangements fail the non-genuine arrangements test. This is because the CFC charge taxes an amount that would be payable by persons dealing at arm’s length in relation to those activities.
4. Guidance with respect to “Significant People Functions”
Under CFC legislation, the amount of distributable profits (less relevant distributions) which can be subject to the CFC charge are limited to the profits attributable to relevant Irish activities, i.e. the SPFs and KERTs. A key step in the CFC analysis is to identify the Irish activities in question. Revenue guidance recognises the practical difficulty in capturing the definition of such activities in legislation, and therefore the meaning is to be construed in line with the OECD 2010 Report on the Attribution of Profits to Permanent Establishments (“PE”).
Under the OECD approach, the overall focus rests on functions that require active decision making. An analysis is to be carried out as to the capital, assets and risks of an entity by reference to where the people functions, relevant to the assets and risks are performed. Revenue guidance makes a distinction with respect to the shareholders initial decision to establish and capitalise the CFC, noting that “The SPFs or KERTs related to the shareholder’s decision to establish and capitalise the CFC are not the SPFs or KERTs that are the subject of the CFC rules. These SPFs relate to the position of the shareholder of the CFC and not to either the assets or the business risks undertaken in relation the management of the assets of the CFC itself. The SPFs and KERTs in question for each CFC are those related to the assets of the CFC and the management of the CFC’s business risks.”
Some key principles of note outlined in the Revenue guidance with respect to Irish activities include the following:
i. The relevant SPFs or KERTs will differ depending on the nature of the assets held by the CFC. For example, there are different SPFs or KERTs associated with holding and managing loans advanced to group members in comparison with SPFs and KERTs related to holding intangible assets and managing the business risks related to those intangibles.
ii. In the case of the financial assets of financial enterprises, it is generally the case that the same SPFs will be relevant both to the assumption of risk and to the economic ownership of the assets. For this reason, it is necessary to distinguish between the SPFs of financial enterprises and the SPFs of other enterprises.
iii. Significant people functions relevant to the assumption of risk and the significant people functions relevant to the economic ownership of assets will vary from business sector to business sector.
iv. An enterprise may have one or more significant people functions relevant to the assumption of risk and to the economic ownership of assets, each of which should be considered in the analysis. The extent of the overlap between the significant people functions relevant to the assumption of risk and the significant people functions relevant to the economic ownership of assets will also vary from business sector to business sector and from enterprise to enterprise within sectors.
v. In relation to the allocation of risks, while risks will initially be attributed to the entity, inherent in or created by the entity’s own significant people functions, regard should be had to any subsequent dealings or transactions related to the subsequent transfer of the risk or transfer of the management of those risks to another entity. A risk is to be attributed to the entity which bears the benefits and burdens of that risk and in particular the exposure to gains and losses arising from the realisation or non-realisation of that risk.
This means that for a CFC charge to arise, the SPFs must be carried out by an Irish company or an Irish branch or agency of a non-resident company. The significance of this is that there must be an Irish nexus with the income. For example, individuals performing SPFs could be doing so in the course of their employment with the CFC or they could be performing duties in these roles for persons other than the CFC but ‘on behalf’ of the CFC. The SPFs that can trigger the CFC charge are those that are performed in the State on behalf of the CFC in relation to the assets and risks of the CFC.
If an Irish controlled CFC owned intellectual property but all the DEMPE functions were performed by employees of a US company in the US then it is unlikely a CFC charge can arise. It would appear to be a matter for the US transfer pricing regime.
5. Arm’s length arrangements
The CFC charge is disapplied where the income arises from arrangements where it would be reasonable to consider that such an arrangement would have been entered into by parties dealing with each other on an arm’s length basis. Further guidance on such arrangements is not provided by the Revenue manual published other than the confirmation that “reasonable to consider” is to be treated as an objective test.
6. Arrangements subject to Transfer Pricing
In addition to the above, no CFC charge will arise where the arrangements concerned are already subject to Irish transfer pricing rules and the manual confirms, at section 4.6.4, that where the transfer pricing regime does not extend to the non-genuine arrangements, then transfer pricing principles should ensure an equivalent amount of profits are taxed under the CFC charge.
7. Undistributed income and accounting periods
For the purposes of the charge, the undistributed income of a CFC shall be regarded as the distributable profits of the accounting period less any relevant distributions made. A key question therefore is the mechanism by which an accounting period of a CFC is identified.
In accordance with the legislation, the undistributed income which can be subject to the CFC charge is to be reduced by specific relevant distributions made. However, the legislation as drafted (and confirmed in the Revenue manual) provides that the distributable income is to be determined without regard to any local company law prohibitions that may exist on the making of distributions. The Revenue guidance provides for no carve out or exception to this which would limit the application of this provision. This further confirms the difference in “distributions” for the purposes of the CFC charge in comparison to the same treatment for the purposes of Irish close company provisions. Under the latter, restrictions on the making of distributions due to the operation of company law provisions may be regarded as an exclusion from the close company surcharge. By contrast, no such exemption is allowed for either in legislation or in Revenue guidance on the CFC rules.
For the purposes of the CFC rules, the Revenue manual further details a range of circumstances that will not give rise to distributable profits:
i. Where there is a loss for the accounting period with the result that there are no profits available for distribution, then no CFC charge will apply.
ii. Profits available for distribution for an accounting period do not include retained earnings related to prior accounting periods.
iii. Profits available for distribution for an accounting period do not include reserves which may be distributable under local law but which arose from capital contributed to the company during the period e.g. share premium, informal capital contribution reserve.
iv. The profits available for distribution for the period is generally the profit after tax figure in the profit and loss account or income statement of the company’s financial statements for the period (excluding profits in the character of capital gains).
8. Negligible Undistributed Income & Low Profit
Where the assets/risks held by a CFC increase the undistributed income of the CFC by only a negligible amount (when compared with the undistributed income of the CFC had these assets/risks not been held by the CFC), then the CFC charge may not apply.
The Revenue guidance notes of ‘negligible’ that it “…takes its ordinary meaning of an amount so insignificant as to be not worth considering”. This should be taken in the context of the particular CFC whose amount of undistributed income is being considered. For example, the guidance explains that where the value of the undistributed income amount is €10,000 and it would have been €5,000 had the CFC not held the assets at all or borne the risk at all, the difference can hardly be said to be ‘negligible’. However, where the income would have been €1,000,000 rather than €995,000 then it may be more reasonable to consider that difference ‘negligible’.
Further exemptions are provided for low profit margin and low accounting profits and these are covered in sections 5 and 6 of the Revenue manual respectively. The low profit margin exemption provides that where a CFC’s accounting profits are less than 10% of its relevant operating costs for the relevant period, no CFC charge will apply.
The low accounting profit exemption provides that a CFC charge won’t apply where a CFC’s accounting profits are either:
- Less than €750,000 with non-trading income of less than €75,000, or
- Less than €75,000.
Both exemptions are subject to an anti-avoidance provision which provides that where arrangements were entered into and it is reasonable to consider that the main purpose (see section 2 above) of which is obtaining these exemptions, then the exemptions won’t be available.
9. Effective Tax Rate
Section 10 of the guidance provides details of the Effective Tax Rate (“ETR”) test, or the “exemption of last resort” as it is referred to. This provides that profits may come within the scope of the CFC charge where the corporate tax, including any tax on chargeable gains, paid by the CFC is less than half the tax that would have been paid had the income been taxed on the basis that the CFC was resident in the State.
This requires calculating a hypothetical Irish tax charge on the CFC’s income under Irish principles. A number of assumptions are required to be made to calculate the corresponding profits in Ireland for the purpose of determining this hypothetical tax charge and these are outlined in sections 10.3.5 of the manual as follows:
- that the CFC is resident in the State during the accounting period,
- that the company has been resident in the State since its first accounting period,
- that the CFC will continue to be resident in the State in subsequent accounting periods (unless it ceases to be regarded as a CFC),
- that, if the company was resident in the State when it wasn’t a CFC, that there is a break in residence between that accounting period where it was resident in the State and was not a CFC, and its first accounting period as a CFC,that the company is within the charge to corporation tax,
- that the accounting periods of the company are accounting periods for corporation tax purposes,
- that there is no change in the place or places at which the company carries on its activities,
- that the company is not a close company,
- that the company has made any necessary election or claim for the maximum amount of any relevant allowance, credit, deduction, relief or repayment allowable where necessary,
- that the company is not a member of a group or consortium,that the company is not entitled to double tax relief under the laws of its territory of residence.
Further guidance on these assumptions is contained in 10.3.6 and a detailed working example of the practical application of this exemption at section 10.5.5.
However, given the complexities involved in calculating this hypothetical Irish tax charge, it may be appropriate to determine whether any of the other exemptions which are available might apply before considering the ETR test.
The new Revenue manual provides detailed guidance and practical examples of the new CFC legislation and will be a useful tool for taxpayers when assessing whether they may be subject to a CFC charge. However, it is vital to note that the CFC rules as they apply from 1 January 2019 are very much a new piece of Irish tax law. The above commentary is to be used for general guidance only and should not be regarded as a definitive interpretation of the legislation on this matter. Given complexities involved with the new rules and in carrying on a CFC analysis, we would always recommend that you consult with your usual Deloitte contact when making such an assessment.