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Controlled foreign companies

A controlled foreign company (CFC) is a business entity that is registered in a separate jurisdiction to that in which the owners reside. CFCs used to be established in low-tax countries in order to provide a means by which companies could expand globally with less tax expense.

Legislation concerning CFCs was then created to ensure that the owner or shareholder’s country of residence taxed the profit produced by an offshore company as though the profits were accrued domestically. This was designed primarily to prevent companies setting up offshore entities in low-tax countries and using them to avoid paying tax on passive income, eg financing. CFC legislation varies between countries, but most jurisdictions will tax the owners or majority shareholders directly before the profits are distributed by the CFC.

CFC legislation began in the US in 1962 with what are known as the Subpart F rules. In response to large capital outflows in the years after World War II, and to allow domestic operations to remain competitive with those conducted abroad, the US government decided to impose an annual tax on the shareholders of corporations that operated subsidiaries outside the US tax boundaries. Since then, countries around the world have initiated similar tax laws to prevent companies avoiding domestic taxes. Germany introduced CFC legislation in 1972, Japan in 1978, France in 1980 and the UK in 1984.

CFC legislation is a broad measure with various goals. These include promoting tax neutrality by ensuring that foreign and domestic business operations remain on an equal competitive footing, as well as stabilising and reducing capital outflows from a high-tax to a low-tax regime. In addition, CFC legislation is intended to discourage companies from taking advantage of low-tax jurisdictions – commonly known as ‘tax havens’ (eg the Bahamas, Cayman Islands and Switzerland) – and setting up entities there in order to avoid paying domestic tax.

The majority of countries try to avoid double taxation (ie the taxation of a company’s profits in both the foreign jurisdiction and the domestic country where the shareholders reside) through the use of tax credits. These enable the company to deduct from the total tax due to the domestic authorities, the taxes already paid by the CFC in the foreign country.

In most countries, a shareholder is liable to pay tax if he/she owns a percentage of the CFC, or holds a percentage of the voting rights of the share capital. However, some countries will assess someone’s ability to pay tax on a de facto basis. This happens when a domestic resident is deemed to be able to influence company policy without having majority voting rights.


Particular country exemptions to CFC rules are usually built around one or more of the following criteria:

  • Evaluating the nature of the activities, eg passive versus active.

  • Assessing the shareholder threshold.

  • Ascertaining the existence of a ‘low’ tax rate.

For example, if a company is established in a low-tax jurisdiction but is active and is genuinely trading with third parties, then more often than not such a company will be exempted from being a CFC. Equally, if the shareholder doesn’t own a controlling interest (eg 40%) then again, in many jurisdictions the company would not be a CFC for the shareholder.

However, while following similar principles, CFC legislation is different in each jurisdiction and this is particularly the case when it comes down to the precise mechanics of the exemption criteria. It should also be borne in mind that in the EU most countries, with the (current) exception of the UK, Germany and Denmark, include an exemption for EU companies within their domestic tax law.

We would like to acknowledge the assistance of Martin Bardsley, Head of Treasury & Financing Tax, Alvarez & Marsal Taxand UK LLP, in the preparation of this article.