Controlled Foreign Corporation Legislation: 

A Comparison of Regimes of the United States and New Zealand

©  2001 by Peter J. Loughlin   

Introduction

The United States was the first country to institute controlled foreign corporation (hereinafter CFC) legislation in the early 1960s. Over the years many other countries have adopted the American blueprint and have made a number of modifications and adaptations to suit their own particular needs. Naturally, CFC regulation must have some shared common interest among countries in order to justify and sustain the wholesale exportation and acceptance of the regime.

While modern CFC regulations vary from country to country, it is generally agreed that their primary purpose is to “ . . . reduce the opportunity for a resident, deriving overseas income through an offshore entity located in a tax haven or low tax regime and repatriating that income to the country of residence in a tax free form (dividends), to defer or avoid local tax on that income altogether.”[1] Naturally, these laws were designed to close a lacuna in the tax laws that were being exploited by taxpayers in a manner contrary to the express or implied intentions of legislators.  As with all laws, new means of circumvention are developed with each new Act or revision which is, perforce, followed by still new revisions in the law – the age old cat and mouse game.

Notwithstanding, CFC regulations are a most effective means of anti-avoidance and are a reality in many OECD countries today.  Such is the case with the United States of America and New Zealand.  Each has a highly developed and comprehensive CFC legislation and though they share a primary purpose each has been peppered with subtle and, sometimes, substantial differences.  This paper will examine and analyze those distinctions and similarities.

Controlled Foreign Corporations Defined

United States of America 

In the United States, CFC regulations may be found, in relevant part, in the Internal Revenue Code (hereinafter IRC), Sub part F §§ 951-964.   In particular, IRC § 957 provides a comprehensive definition from which to start our analysis:

For purposes of this subpart, the term ''controlled foreign corporation'' means any foreign corporation if more than 50 percent of the total combined voting power of all classes of stock of such corporation entitled to vote, or the total value of the stock of such corporation, is owned . . .or is considered as owned by applying the rules of ownership . . . by United States shareholders on any day during the taxable year of such foreign corporation.[2]

Let’s examine this more closely. What the IRC is saying is that a U.S. shareholder(s) (defined infra) who holds more than a 50% interest in a foreign company (defined infra) in terms of its value or voting power, that foreign company is a CFC.  Therefore, if the foreign company is a CFC any income earned by that CFC, which is not excludable, is subject to the provisions of sub part F § 951 thus subjecting the US shareholder to a tax liability on the pro rata share of his interest in the CFC – even if the income of the CFC is not distributed.[3]

New Zealand

The definition of A CFC can be found, in relevant part, in the New Zealand Tax Act sub part G, CG 4:

(1) A foreign company is a controlled foreign company for any accounting period of the company if:

            (a) at any time during that accounting period, there is a group of 5 or fewer persons resident in New Zealand whose control interest (or the aggregate of whose control interests) in the company in any one of the categories of control interest listed in subsection (4) is greater than 50%; or

            (b) at any time during that accounting period:

                        (i) a single person resident in New Zealand holds a control interest in the company equal to or greater than 40% unless, at that time, another person who is neither resident in New Zealand nor associated with the New Zealand resident has a control interest in the company (of the same category) equal to or greater than the control interest of the single person resident in New Zealand; or

(ii) there is a group of 5 or fewer persons resident in New Zealand who have the power to control the exercise of shareholder decision-making rights with respect to the company and so ensure that the affairs of the company are conducted in accordance with the wishes of that group.[4]

This means that where five or less resident persons (defined infra) control more than 50% of a foreign company, that company, by definition, is a CFC.  But what is meant by “control”?  If we look to subsection 4, we see that control is measured by the aggregate percent of total shares or the percent of voting rights or effective management and control of the CFC.[5]

A unique feature of the New Zealand CFC regime is found in the 40% Rule.  This feature extends the CFC net to include circumstances where a single resident holds a controlling interest of 40% or more as determined by subsection 4 and no other non-resident, non-associated person holds an equal or greater interest in the foreign company.[6]    This would have the effect of subjecting other resident 10% shareholders in the “CFC” to the provisions of Subpart G. where they would not have otherwise been liable under the 51% de facto/more than 50% test.

In comparing the CFC definitions of the U.S. and New Zealand, we see that the provisions regarding greater than 50% interest are, by and large, the same. The New Zealand provisions seems to be more precise and comprehensive with respect to identifying the requisite factors and level of control, however, the end result is that where resident/U.S. shareholder interest, as measured by value or control, does not exceed 51%, the foreign company will not be deemed a CFC in either jurisdiction.

The obvious and glaring difference in the two regimes is found with the 40% Rule. The U.S. has no such provision, thus a single U.S. shareholder could hold 40% or more in a foreign company and not subject himself or other U.S. shareholders in the foreign company to sub part F, notwithstanding the relative interest of a non-resident, non- associated person, providing, in aggregate, the U.S. shareholder(s) do not exceed more than 50% interest in the foreign company.   

Persons Subject to Controlled Foreign Corporation legislation

United States of America

U.S. Shareholder:  IRC § 951(b) defines a “U.S. shareholder as a United States person,[7] who owns (defined infra) at least 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation. Note that a U.S. person is further defined as (a) a citizen or resident

 of the United States, (b) a domestic partnership, (c) a domestic corporation, and (d) any estate or trust (other than a foreign estate or foreign trust).[8]

For U.S. citizens, who are determined to be U.S. shareholders of a CFC, this means that their CFC income is subject to sub part F even if they are not resident in the U.S.  This is so because the United States taxes its citizens on their world-wide income. Furthermore, the U.S. has a substantial presence test to determine residency for income tax purposes (and applicable for defining a U.S. shareholder for CFC purposes).  The test will generally find any individual to be a resident who is present in the U.S. for more than 183 days.

Also, of note is that U.S. corporations are taxable on their world-wide income, inclusive of sub part F income, irrespective of where that company is situated, managed and controlled.

For example, “USA” Inc., a U.S. incorporated company, may have no offices in the United States and conduct all of their business in, let’s say, France – notwithstanding, “USA” Inc. will still be subject to U.S. income tax on its word-wide income – including sub part F income.  (Some relief may be found depending on the provisions of double tax treaties, if any). 

New Zealand 

For purposes of the Controlled Foreign Companies Regime, an individual “ . . . is resident in New Zealand if he or she has a permanent place of abode in New Zealand . . . is personally present . . . 183 days in any 12 month period.”  A company is resident if “ . . . it is incorporated in New Zealand, its head office is in New Zealand, its centre of management is in New Zealand or the directors [exercise the effective management and control in New Zealand)”.[9]

Again, the two country’s definitions are both broadly drafted to include nearly all conceivable classes of persons subject to the legislation.  However, in this case the United States, it is by far the more extensive of the two regimes. Each jurisdiction is comparable in the use of a 183 day type of residency rule, but U.S. citizens and domestic corporations are treated as being resident notwithstanding their physical absence or, in the case of domestic corporations, whether the main office is situated or managed in the U.S.  The New Zealand residency test for companies, on the other hand, focuses on its head office/centre of management and control being situated in New Zealand. 

How Ownership is Determined

United States of America

IRC § 958 defines ownership, for purposes of CFC legislation, in terms of direct and indirect ownership and by constructive ownership.[10]   Therefore ownership may be direct in the traditional sense of an individual or company “owning” the requisite interest or shares in a foreign company, however, ownership may be found were the individual or company indirectly owns an interest in the foreign company. For example, if three persons individually hold equal interests in a foreign company of, let’s say, 5%, they would not meet the requisite “more than 50%” rule and would thus not fall within sub part F.  On the other hand, if those same individuals each held a 1/3 share of a corporation that owned the remaining 85% interest in the foreign company then the foreign company would be a CFC under the indirect ownership rules thus subjecting the three U.S. shareholders to sub part F.

The concept of constructive ownership is based on the same logic that gave impetus to the indirect ownership rules, that is, as an anti-avoidance measure to counter the avoidance strategies of taxpayers.  The IRC § 954 offers a very broad but somewhat obscure definition of just what a related person is: 

Related Person Defined
For purposes of this section, a person is a related person with respect to a controlled foreign corporation, if -

such person is an individual, corporation, partnership, trust, or estate which controls, or is controlled by, the controlled foreign corporation, or such person is a corporation, partnership, trust, or estate which is controlled by the same person or persons which control the controlled foreign corporation. For purposes of the preceding sentence, control means, with respect to a corporation, the ownership, directly or indirectly, of stock possessing more than 50 percent of the total voting power of all classes of stock entitled to vote or of the total value of stock of such corporation. In the case of a partnership, trust, or estate, control means the ownership, directly or indirectly, of more than 50 percent (by value) of the beneficial interests in such partnership, trust, or estate. For purposes of this paragraph, rules similar to the rules of § 958 shall apply.[11]

What does all this mean?  It seems the section defining related persons was intentionally broadly drafted to bring all conceivable entities within the ambit ofconstructive ownership rules. However, a broadly as it is drafted, there are limitations. For example, with adult children of “potential” U.S. shareholders vis-à-vis minor children, one popular avoidance scheme would be for five or less parent/shareholders of a foreign company to own a 50% or less aggregate interest (e.g., 5% each) while their minor children held interests that would otherwise in combination exceed the 50% interest.  Constructive ownership rules avoid this by deeming the child’s share to be that of the parent for purposes of determining the company to be a CFC. The constructive nexus between parents and their adult children would be less tenable.

One notable point is that once the U.S. shareholder is determined to be so by virtue of constructive ownership, the CFC income subject to sub part F will be based upon the actual pro rata ownership of the CFC. 

New Zealand 

New Zealand CFC rules also define ownership in terms of direct and indirect terms.  Direct control determined by a strict application of the more than 50% or the 40% rule described supra. Indirect ownership is determined by identifying “ . . . an interest held in a foreign company through an interposed CFC”[12]   For example, by or through an “associated person”.

The tax law of New Zealand is particularly explicit in defining who an associated person is for purposes of determining indirect ownership of a CFC: 

Under New Zealand law a separate definition of “associated persons” applies to the international tax regime and only applies for the purposes of that part of the Act. Interests held in foreign companies by a person who is associated with a New Zealand resident are included in determining the resident’s control in connection with that foreign country. Associated persons include:

a)        any two companies where-

- any group of persons has voting interests in each of the companies totalling in aggregate 50% or more; or has market value interests in each of the companies totalling in aggregate 50% or more; or has control of each of the companies by any other means whatsoever; or

- any group of persons holds income interests in each company totalling in aggregate 50% or more;

provided that those two companies are not deemed to be associated if one company is not resident in New Zealand; or

b)        any company and any person holding an income interest of 50% or more in that company; 

c)        any company and any person when the person is associated with another person who is associated with the company other than by this paragraph (this restricts a continuous chain of associations that might otherwise occur);

d)        any two persons who are relatives

e)        a partnership and any of its partners;

f)          a partnership and any person when that person and any partner are associated persons other than by this paragraph (this restricts a continuous chain of associations that might otherwise occur);

g)        a trustee and a direct or indirect beneficiary of the same trust, or a trustee and any other person who stands to benefit under the trust by his or her association with the trust’s settlor (the provision does not apply to employment-related trusts so long as the beneficiary (or an associate) is not in a position to exercise control, either directly or indirectly, over that trust’s management);

h)        any two trustees having at least one common settlor (this does not apply if the settlor settles property on the terms of a trust for the benefit of its employees or, in the case of a company, no executive, director or any person holding a direct voting interest or a direct market value interest of at least 25% either directly or indirectly manages or controls the affairs of the trust);

i)          a trustee and a settlor (except in regard of certain employment-related trusts); or

j)        two persons who habitually act in concert with respect to the holding or exercising of interests in foreign companies provided that they are only associated persons in respect of the thing or things in relation to which they act in concert.[13]

As you can see the general criteria here is remarkably similar to the U.S. model, however, the New Zealand rules break things down more specifically.  For example, referring to § J above we see that any two persons who are relatives may qualify as associated persons in determining indirect ownership of a CFC.  By and large this would not be the case with the U.S. model.  For example, on a strict interpretation of the New Zealand Rules, it would seem that both adult and minor children of a parent potential “owner” of a CFC may help complete the requisite nexus for indirect ownership.

With regard to constructive ownership, the term is not present in the New Zealand CFC rules, however, owing to the breadth and specificity of the definition of an “associated person” for purposes of determining CFC ownership, the net result is effectively the same. 

What Income is Subject to CFC Legislation? 

United States of America

All CFC income that is derived from “qualified activities” is sub part F income.  Sub part F income is income that is derived from “qualified activities” of the CFC.  The Qualified activities are [A]ny activity giving rise to: [14]  

foreign base company shipping income, [passive income]

foreign base company oil related income, [income outside the foreign country on oil’ oil products emanating from the foreign country]

foreign base company sales income, [income from sales outside the foreign country income] (whether in the form of compensation, commissions, fees, or otherwise) derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services.[15]

foreign base company services income, [income from services rendered outside the foreign country and in the form as expressed above]

in the case of a qualified insurance company, insurance income or foreign personal holding company income, or

in the case of a qualified financial institution, foreign personal holding company income.

Provisions are made for proper allocation of deductions to determine the net income falling within sub part F. 

New Zealand 

As with the United States, certain provisions are made for the calculation and attribution of CFC income. Similarly, the New Zealand tax law provides for the allocation of losses and deductions of CFCs.  For example, in Subpart G  we find the section for the “Attribution of income and losses using the branch equivalent method”:

(1) Subject to section CG 6, the attributed foreign income or attributed foreign loss of any person for any income year in respect of any income interest in a controlled foreign company shall include such amount as is calculated under this section in respect of that interest for any accounting period the last day in which falls within the income year of that person.

(2) Subject to this section and section CG 9, the attributed foreign income or attributed foreign loss of any person in respect of any income interest in a controlled foreign company shall be calculated in relation to any accounting period in accordance with the following formula: a X b, where:

            a is the income interest (expressed as a percentage) of the person in the controlled foreign company for that accounting period; and

                b is the branch equivalent income or loss of the controlled foreign company calculated in relation to that person under section CG 11 for that accounting period.[16]

Concerning the attribution of losses, losses generally must actually be suffered by the CFC in order to fall within the permissible levels set forth in the provisions.

Here we find that the U.S. has defined a variety of specific forms of CFC income based on the category of activity in which the foreign company engages in.  New Zealand has, on the other hand, taken a more generalist approach to the identification of CFC income.  Notwithstanding, it is likely that all of the forms income of  U.S. sub part F “qualified activities” would fall within the scope of New Zealand CFC income as well. 

What is the accounting period used to determine CFC effective Income? 

United States of America 

A U.S. shareholder who holds an interest in a foreign company on the last day of the year, must include must include all non-excludable ”qualified” sub part F income of that foreign company in their tax return if that company is regarded as a CFC as specified above, and was so deemed for an uninterrupted period of 30 days within that year.[17]

New Zealand
 

In New Zealand a resident’s CFC income obligation is determined where the requisite level of ownership falls on a “measurement day”.  Measurement days fall quarterly on the last day of March, June, September and December.[18]

The obvious difference here is in the additional number of calculation periods in the New Zealand model.  This is actually quit significant in that it serves to prevent taxpayers from strategically shifting ownership of the CFC so as not to coincide with measurement days.  The sheer number of measurement days in the New Zealand system makes such circumvention impractical if not impossible. 

Conclusion 

By and large the two regimes are remarkably similar in function and purpose.  Each regime, by design, limits the opportunity of its residents in earning and isolating income earned in a low tax jurisdiction for the purpose of avoiding tax in their place of residence (or in the case of the U.S., citizenship).  We have noted that New Zealand is more specific in its identification of liable owners of CFC’s.  This is not particularly unusual if we consider that the U.S. taxes its citizens, domestic corporations, etc., on their world-wide income.

Other differences were noted as well, for example, New Zealand’s 40% rule or the particularity of the U.S.’s categorization of income activities of CFCs.  However, in the final analysis, each country has developed comprehensive legislation to fulfill its own particular needs -- each regime operating with some differences, but with a common goal – Anti-Avoidance. 

Notice: United States Department of Treasury Regulation Circular 230 requires that we notify you that, with respect to any statements regarding tax matters made herein, including any attachments, (1) nothing herein was intended or written to be used, and cannot be used by you, to avoid tax penalties; and (2) nothing contained herein was intended or written to be used, and cannot be used, or referred to in any marketing or promotional materials. Further, to the extent any tax statement or tax advice is made herein, Peter J. Loughlin and Goldman & Loughlin, PLLC does not and will not impose any limitation on disclosure of the tax treatment or tax structure of any transactions to which such tax statement or tax advice relates. The Information provided here is for general information only and is not intended to nor does it constitute legal or tax advice to any person or entity. You should review your particular circumstances with your independent legal and tax advisors.

Endnotes