By Harrison Dell, Director.
The Australian Controlled Foreign Corporation (CFC) rules are designed to tax Australian residents on income from foreign companies that they own or control. These rules were introduced in 1991 and are similar to the USA’s Subpart F rules.
They operate to try and prevent Australian tax residents from using foreign companies to earn income, to evade Australia tax. However, they are not meant to stand in the way of active businesses that operate overseas.
The application varies for companies in listed countries: Canada, France, Germany, Japan, New Zealand, the UK, and the US. This article will cover the application in unlisted countries (ones not in the above list).
What is a controlled foreign company or CFC?
A CFC is a foreign company under Australian control, determined by:
- Actual Control Test: Five or fewer foreign entities collectively hold at least 50% in the Australian company.
- Assumed Control Test: A single foreign entity holds at least 40% control, with no other entity (except associates) controlling the Australian company.
- Associate Controlled Test: Five or fewer foreign entities, with or without associates, control the company.
If one of these are passed, the company is a CFC for an income year. The CFC’s income will be attributed to shareholders unless the active income test is passed.
Note that to have attribution apply, a shareholder needs to own more than 10%.
Tainted Income and the Active Income Test
If a CFC passes the active income test, broadly that less than 5% gross turnover as tainted income, the shareholders are exempted from the CFC’s income being attributed to them. Income from “tainted assets” is considered “tainted income” as is other kinds of income from related parties, tainted services income, and tainted sales income.
Tainted assets include:
- Loans, including bank deposits
- Securities like debenture stock, bonds, and promissory notes
- Shares in companies
- Interests in trusts or partnerships
- Futures and forward contracts
- Swap contracts (interest rate, currency)
- Life assurance policies
- Rights or options relating to these assets
- Assets held primarily for deriving tainted rental income
- Assets not used solely in business operations, excluding trading stock and commodities
Some Loopholes in the Active Income Test
One unintentionally exempt asset – Cryptocurrency is not specifically a tainted asset. It may fall into the “similar financial instrument” definition, but certainly not all crypto assets.
The CFC rules have been effectively abandoned by the Australian government, so it is unlikely to change. Crypto assets must be assessed carefully on a case-by-case basis if they are “tainted” as some crypto assets may be “similar financial instruments” including some stablecoins which are redeemable for currencies or other non-crypto assets.
Another exemption is trading stock, which can be useful in a variety of contexts. It isn’t clear whether this exemption overrides an asset being included as a tainted asset, as this has never been tested in the courts. This is an area of much complexity which is rarely litigated due to risk appetite, and the ATO is extremely harsh on Australian’s suspected of using foreign companies to evade tax.
This treatment has the potential to simplify Australian tax compliance for foreign companies that issue tokens, with the active income test being able to be passed. This can allow for tax-free token raises and also reduced compliance by operating in countries will les crypto and financial services regulation. This can apply to NFT projects, token issuing businesses, DAO’s and more.
Practically, all shareholders and controllers of CFC’s should note the following:
- Seeking Advice: It’s recommended to consult an experienced tax professional when establishing a CFC, to annually test the active income and review international tax risks. International tax is changing rapidly with OECD changes being suggested and enacted in various countries constantly.
- Specialist Australian Accounting: A CFC needs to prepare specialised CFC accounts to show compliance with the active income test (or not) ensure your accountant can assist you. If requested, the ATO can force you to provide this. You may also be required to declare the CFC in your tax return or fill out an International Dealings Schedule (IDS)
- Australian Tax Concessions: There are concessions for foreign dividends and capital gains on shares if received by an Australian holding company. Structuring advice is essential by tax lawyers in Australia.
- Corporate Tax Residency Post-Bywater: The Bywater Investments case has made corporate tax residency more complex, necessitating extra caution for those with CFCs. Some CFC’s are simply, Australian tax residency companies. Ensure that you consider ATO guidance.
Proper understanding and management of the Australian CFC rules are essential for Australian residents with foreign subsidiaries, especially considering the complexities in corporate tax residency and the need for strategic tax planning and compliance.
Getting it wrong can be extremely expensive, and the ATO is not sympathetic to shareholders of foreign companies.
Disclaimer: This material is produced by Cadena Legal, a NSW-registered legal practice. It is intended to provide general information and opinions on legal topics, current at the time of first publication. The contents do not constitute legal advice and should not be relied upon as such. Contact us here for advice.