Dateline: Kuala Lumpur, Malaysia
In the world of business, we’re taught to keep things as simple as possible, so we often think of concepts in the simplest possible terms.
So, when we think of offshore companies, the first thought that might pop into our heads is “tax savings.”
In reality, however, the offshore world can be a bit more complicated.
You see, an offshore company is just a company that’s based in a country other than where you’re living, and while that country may offer certain tax benefits, setting up a company offshore doesn’t guarantee that your taxes will disappear overnight.
In fact, if you do it wrong, setting up your offshore company may cost you more than it saves you.
There’s a certain piece of the offshore puzzle that often gets in people’s way when they try to optimize their offshore strategy for tax savings – Controlled Foreign Corporation (CFC) rules.
People tend to become so laser-focused on the incorporation side of things – i.e. where the money is going to – that they forget how the laws in their country of residence might impact their offshore strategy.
And forgetting this essential piece can have some serious tax consequences.
The problem with a lot of the resources out there about CFC rules is that they’re just plain complicated. Although CFC rules certainly aren’t exactly light reading, I want to clear the air on some of these concepts and make them more accessible to the average businessperson.
Additionally, the specific rules that apply to you and your company will depend on your country of residence, the location of your company, and the nature of your company. This article isn’t meant to provide specific guidance, so if that’s what you’re looking for, I would click here to apply for a strategy call.
This article will therefore tell you in plain English:
- What a Controlled Foreign Corporation is;
- What CFC rules are;
- The different types of CFC rules around the world;
- How CFC rules should influence your offshore planning; and
- The importance of a holistic offshore strategy.
If you’re still dipping your toe into the offshore world, then you should check out these resources first:
- What is an Offshore Company?
- 11 Reasons to Use an Offshore Company for Business
- 8 Questions to Ask to Find the Best Offshore Company for You
What is a Controlled Foreign Corporation?
After reading the introduction, your first question might be, “what the heck is a Controlled Foreign Corporation anyway?”
CFCs are companies that are not registered in a particular country but are owned or controlled by a resident of that country.
For example, if I was a UK citizen who owned a company that was registered in Panama but not the UK, my company would be considered a CFC.
Additionally, CFCs must also not be tax residents of your country of residence, so if your hypothetical Panamanian corporation paid UK taxes, then it would not be considered a CFC.
Individual countries also have various rules as to what a CFC is or is not. New Zealand, for instance, considers a company to be a CFC if over 40% of the company is owned by a New Zealand tax resident and if more than 10% of the company’s income is derived from passive sources, such as investments or dividends.
Therefore, while the specifics of what exactly falls under the umbrella of CFCs might depend on your country of residence, you can generally assume that your company is a CFC if it is located in a foreign jurisdiction and if you own or have decision-making power over it.
What are CFC Rules?
If you live in a high-tax country like the US, Australia, or Canada, then your government likely has rules in place to regulate CFCs.
These rules generally exist to prevent people from using foreign companies to avoid high taxes, meaning that you’re transferring profits to another jurisdiction for the sole purpose of tax savings.
These rules were primarily designed to target “shell companies” that people use to shelter profits from the long arm of the tax man, but as with all of these kinds of laws that govern the offshore world, people who move their businesses offshore for nearly any reason get swept up in them, too.
For instance, say that you’re an Australian citizen who decides to incorporate in a zero-tax jurisdiction like the Cayman Islands.
However, after setting up that company, you go back to live in Australia and go about your business as usual.
If you do that, the Australian government is going to turn around and say, “hold on for a second – you own the majority of that company, and you manage its day-to-day affairs. Your company isn’t truly a Cayman Islands company.”
CFC rules in countries like Australia were thus designed to stop you from doing just that – setting up a company in a low-tax jurisdiction while continuing to reside in a high-tax one.
These CFC rules do not prevent you from setting up offshore companies in low-tax jurisdictions, and doing so can still yield some tax benefits. However, under these CFC rules, you may need to pay corporate tax in your country of residence if your company meets certain requirements.
Types of CFC Rules
Because CFC rules are implemented by individual countries, they can vary widely around the world.
What qualifies as a CFC in the US, for instance, may not meet the same thresholds in Indonesia.
However, as a general rule, companies that are located in jurisdictions with low-to-no taxes, that generate mostly passive income, and that you have a major share in will often trigger CFC rules, which might require you to pay all or part of your country of residence’s corporate income tax.
Although each country has its own laws and requirements regarding CFCs, these laws can be divided into three primary categories:
- Strict CFC rules against all offshore companies;
- CFC rules against passive companies; and
- No CFC rules.
The following section will address these three types of CFC rules, and it will then discuss common exceptions to these laws.
Strict CFC Rules Against All Offshore Companies
Most developed countries have strict CFC rules that apply to all foreign companies regardless of that company’s activities.
This means that even if your company is generating active income from business activities abroad, it will still be subject to your country of residence’s CFC rules.
For example, if you – a UK resident – own a company that manages a restaurant chain in Thailand, you may still be subject to UK CFC rules.
Therefore, even if your company clearly isn’t acting as a tax shelter, it still may be subject to CFC rules in these countries, which can substantially increase your tax burden.
From there, rules will vary on a country-by-country basis. For example, the US considers a company to be a CFC if US citizens own more than 50% of the company, and in Finland, a company qualifies as a CFC if corporate tax is lower than 12% in the company’s local jurisdiction.
Countries with strict CFC rules against all offshore companies include: Brazil, China, Egypt, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Israel, Italy, Japan, Norway, Portugal, Russia, South Africa, South Korea, Spain, Sweden, the US, and the UK.
CFC Rules Against Passive Companies
Some countries tend to apply CFC rules in a way that’s a bit more true to their purpose – preventing people from using shell companies to evade taxes – by primarily targeting offshore companies with large shares of passive income.
While the exact definition of passive income can vary by country, it generally includes things like rental income and capital gains.
Similarly, the amount of a company’s passive income that triggers CFC rules will also vary by country.
Some countries, such as Argentina or Indonesia, only consider companies to be CFCs if their passive income amounts to 50% or more of the company’s total income, whereas in Australia, CFC rules apply if your foreign company earns as little as 5% of its income from passive sources.
Countries with CFC rules against companies that earn passive income include: Argentina, Australia, Canada, Denmark, Indonesia, Lithuania, Mexico, New Zealand, Peru, Poland, Turkey, Uruguay, and Venezuela.
No CFC Rules
Although the majority of developed countries have CFC rules in place, the majority of countries around the world have chosen to forego CFC rules in favor of a tax regime that’s a bit more offshore-friendly.
That being said, a handful of these countries do have rules in place to catch persons who use offshore companies for the purpose of tax reduction. Latvia, for instance, requires the owners of offshore companies in low-tax zones to pay a 15% tax on all profits.
Exceptions: Blacklists and Whitelists
Certain states have blacklists and whitelists that determine whether CFC rules apply to companies located in a particular jurisdiction.
On one hand, some countries blacklist certain jurisdictions and apply CFC rules to all companies located within that jurisdiction – regardless of whether CFC rules would apply otherwise.
Most of these blacklists include what I call “classic offshore jurisdictions” like the British Virgin Islands or Belize. Because these jurisdictions are known tax havens, bureaucrats tend to assume that if you have a company there, you’re surely up to no good.
On the other hand, other countries may whitelist certain jurisdictions to prevent CFC rules from applying in certain cases. EU countries, for instance, effectively whitelist each other through mutual agreements.
Therefore, if a particular country is black- or whitelisted, then a company within that jurisdiction automatically is or is not a CFC.
A company’s substance generally refers to the economic interest that it has in the jurisdiction that it operates in.
For example, a company that operates factories in Vietnam would have substance since it has employees, a physical presence, and a vested economic interested in Vietnam, whereas a drop-shipping company in Panama would not have much substance since it could theoretically operate from anywhere.
Unlike blacklists and whitelists, the notion of substance is a bit more nebulous and up to interpretation, and whether or not your country of residence will consider that in designating your company as a CFC depends on its individual laws and regulations.
If you plan to use this exception, then, I highly recommend that you consult tax and legal professionals to see if it could be an effective strategy.
How CFC Rules Can Impact Your Offshore Structure
Depending on your country of residence and the structure of your business, CFC rules may have a major impact on how your offshore structure is taxed.
Before we dive too deep into this section, let’s clear one issue up – you’re not going to get into legal trouble if your company is designated as a CFC.
CFC rules aren’t meant to prevent you from setting up a company offshore. Instead, they’re intended to ensure that you’re paying some level of tax on your company’s profits.
The only way that you will face any legal consequences is if you decide to not pay taxes. Even if you disagree with how your country of residence handles CFC rules, you still need to be pragmatic and follow them.
You also can’t avoid CFC rules through “clever” structuring “hacks” that supposedly allow you to skirt your tax burden.
Regardless of what the misinformation on the internet has to say, using strategies like non-resident nominee shareholders to dodge CFC regulations isn’t going to work. Your government has figured that kind of trick out already, and you’re going to pay more in fines than you would in CFC-based taxes.
The fact is that you can’t simply go to Nevis, set up a company, return to the UK or Germany, and enjoy the tax benefits of Nevis while living at home.
If your country of residence has CFC rules, then it’s going to see through your corporate structure, designate your company as a CFC, and force you to pay tax, and avoidance measures are just going to land you in a world of trouble.
So, what can you do?
To optimize your tax strategy, you have to be willing to optimize your life on both a personal and business level. This means that not only does your business need to be in a tax-friendly jurisdiction, but you need to be, too.
Opening an offshore company in a low-tax country is, frankly, quite easy, but to see how it will affect your overall tax strategy, you’ll need to think holistically.
When discussing tax and offshore strategies with the people I work with, I often advise them to think of their life in quadrants. On one side is your personal life and your business life, and on the other is where you’re leaving and where you’re arriving.
To have a successful offshore strategy, you have to satisfy all of those quadrants.
So, suppose you have a US C-Corporation. That corporation obviously needs to leave the US, but you also need to leave, too, if you want to truly optimize your tax strategy.
People tend to focus too heavily on the arriving part and the business part without paying much attention to where they need to leave on the personal side. While it’s great that your company is in the tax-friendly Seychelles, that doesn’t matter if you reside in a country that has Seychelles blacklisted.
With CFC rules, your personal residency heavily impacts your tax burden, so you’ll ultimately need to move to a country without them if you want to legally avoid them.
Granted, there’s a bit more nuance here if you’re dealing with a large, multinational company with branches and employees all over the world. However, for the average six- or seven-figure entrepreneur running smaller businesses, moving to a low-tax jurisdiction can make a massive difference.
From here, there are a variety of strategies that you can use. You can live in a low- or no-tax country like Panama or the Cayman Islands; you can use my trifecta method and live primarily in territorial tax countries; or you can even be a perpetual traveler (though with developments like CRS, that’s getting substantially harder to pull off).
If you need some assistance with forming this low-tax lifestyle, then I might be able to help.
The Bottom Line: You Have to Move Your A** – Not Just Your Assets
At the end of the day, you need to become a resident of a country without CFC rules in order to avoid them.
So many people see these CFC rules and they think that they’re smart or clever enough to dodge them while keeping their Canadian or Australian residency.
However, you’re not. Your country of residence is going to see your corporate structure and designate it as a CFC, and if you try any cheeky maneuvers, you might end up in even more trouble.
The fact is that many countries have CFC rules that are triggered by tiny ownership or passive income percentages, and many countries outright classify anything in a low-tax jurisdiction as a CFC.
Therefore, to legally avoid CFC rules, you have to establish residency somewhere that doesn’t have them.
You can’t just move your assets, you need to move your a**.