A Controlled Foreign Company (CFC) is essentially a non-resident company that is controlled by Australian resident shareholders or a small group. For a typical Australian SME, a CFC will usually be any foreign company that is controlled by your client directly or indirectly at the shareholder level. Of course if a foreign company is in fact a resident of Australia because of the corporate residency tests, then it cannot be a CFC.
When it comes to CFCs there are specific rules in place regarding the records a client is required to keep and what is required to be disclosed in Australian income tax returns. Unfortunately, often due to the complexity, or lack of awareness many SME taxpayers get these aspects of their reporting and compliance wrong.
In addition, where a CFC is not reported, there is a risk of undeclared assessable income if the client or their advisors has not had the opportunity to think through how the CFC rules apply. Commonly we find that clients proceed to establish overseas companies without any understanding of these issues or an understanding that is too basic.
The Simple Way To Identify Whether Your Client May Have A CFC
If your client has a foreign company then there is every chance that they will have to consider the CFC rules.
If you are advising an SME client, it will be important to ask as many questions as possible if it appears that they have an overseas subsidiary or business interests. Often clients will assume that no news is good news, but that approach leaves them exposed if they have not sought advice. It also leaves the accountant potentially exposed if there is an expectations gap or lack of clarity regarding the engagement and the services being performed by the accounting firm.
If a client notifies you that they own a foreign company then the client should be advised that they need to assess the residency of the overseas subsidiary first and then if the company is found to be non-resident, whether it is a CFC.
Determining Whether The Foreign Subsidiary Is A CFC
The technical definition of a CFC can be found in the Income Tax Assessment Act 1936- Section 340.
Typically your client’s subsidiary company will be a CFC if they have at least a 40% ownership or control of the subsidiary. Often in an SME context the client will have 100% ownership.
Specifically there are three tests to consider whether a subsidiary is a CFC.
1 – Strict Control Test
This is a simple test of direct control of 50% or more of the foreign company.
Under Section 340(a) the foreign company will be a CFC when your Australian client has control of at least 50% of the foreign company.
Note that this 50% ownership may be held by a single Australian resident or a group of 5 or fewer Australian resident entities. Entities include individuals for these purposes.
2 – Deemed Control Test
The deemed control test in Section 340(b) considers situations where a company has less than 50% ownership, but still has effective control of the overseas company.
If the following two tests are met then the foreign company will be a CFC. There are two factors to consider for this test, which is detailed in Section 340(b).
i) Your client has at least a 40% interest (a controlling interest) in the foreign company.
Note that a ‘control interest’ incorporates direct and indirect interests.
ii) There is no other controller of the foreign company.
For example if your client owns 40% of the foreign company but the client has an overseas business partner (not an associate) who controls the other 60% of the company, then the foreign company is not a CFC. However, if there are multiple unrelated owners of the remaining 60%, then there is no alternative controlling owner and the foreign company would be a CFC.
3 – Actual Control Test
The third test, in Section 340(c), covers offshore companies that are in fact controlled by Australian residents irrespective of whether an actual control interest can be found.
This means that even if your Australian resident client is not actually the direct or indirect owner of the shares, they may still be caught under the CFC rules if, in reality, they actually have controlling power over the foreign company.
Under this test your client’s foreign company may be a CFC, even if the control interests are held by foreign residents.
These rules ensure that an Australian company cannot use form over substance arrangements (nominee shareholders) to avoid the CFC rules.
When Your Client Has A CFC
Once you have identified that your client has a CFC you need to:
- Obtain a set of the financial statements of the CFC to review;
- Identify any tainted income;
- Complete any reporting requirements in your client’s tax return.
Identifying Tainted Income
Identifying tainted income is about applying the Active Income Test. The Active Income Test has a number of limbs to it, which must be met to avoid income attribution.
For simplicity, the main point is to know that attribution of income can be avoided if less than 5% of the gross turnover of the CFC is from tainted income.
This means that a CFC with a $1,000,000 turnover, can have up to $50,000 in tainted income before it is caught under the CFC rules.
Tainted Income is passive income, tainted sales income and tainted services income.
Passive income is a familiar concept to accountants and includes such usual suspects as dividends, share trading, interest, rent and royalties.
Tainted sales income is essentially income generated from sales that are made between an Australian associate and the CFC.
Tainted services income is essentially income generated from services provided by the CFC to an Australian resident.
If your client’s company fails the Active Income Test by having more than 5% tainted income, then that needs to be declared.
Why Accountants May Miss That A Client Has An Interest In A CFC
In the cut and thrust of running a busy accounting practice, it can be easy to miss situations where a client has an interest in a CFC, with the possible flow on impact of undisclosed income or incomplete or incorrect income tax return disclosures.
Most commonly, this is because a client may not have advised that they have set up a foreign company or even if they have provided notice, most often the foreign company is running a genuine foreign business or operation, without a tax avoidance motive.
But it must be kept in mind that the CFC rules do not require any tax avoidance motive and often in practice it is the case that the CFC rules apply to genuine commercial foreign operations, meaning that attributable income must be declared in Australia regardless. This is difficult for clients to understand but it is a burden that the client’s accountant or advisor must accept. They have a duty to flag the issue, and either provide the advice themselves or recommend that the client seeks specialist advice about their CFC position, if that is necessary.
When Your Client’s Overseas Business Is A Real Business But Still Is Caught By The CFC Rules
As an anti avoidance measure, the CFC rules have been designed to try to provide an exemption for an ‘Active Business’’. The hope is that the active income exemption is sufficiently fair to prevent genuine arrangements from being caught by the rules but that is often not the case. Therefore in thinking about how the CFC rules apply to a client, the accountant should be encouraged to put aside general notions about equity and fairness and focus squarely on the requirement of the Active Income Test.
It can be easy to dismiss any need to consider the CFC rules without properly looking into the books and activities of your client and their foreign subsidiary.
It is not uncommon to find that CFC issues have been overlooked in practice because it has been assumed that because the client has a genuine overseas business that there should not be a CFC concern. That assumption is unwise and can lead to errors with all the associated problems of undeclared income.
Every overseas entity that is controlled by your Australian client, no matter how big or small, needs to answer this question: Does it pass the Active Income Test?
If 5% or more of the CFC’s income is tainted income, then the Australian company needs to declare this.
Consider the following examples of how easy it can be to miss the CFC requirements:
Example A: Overseas Business Sets Up Another Overseas Company To Purchase A Warehouse
An Australian company, Company A, owned a foreign company, Company B. Company B operated a genuine business overseas, with income generated from local sales. As such it passes the Active Income Test without any problem. As the business grew, they decided to purchase a warehouse. If Company B had purchased its own warehouse there wouldn’t have been an issue, since it would have just become an active asset of the business. However, as many companies do, they decided to set up another foreign company, Company C, to purchase the warehouse. Company C would then rent the warehouse to Company B.
Given the income paid from Company B to Company C was all internally generated it didn’t occur to them that this could cause issues with the CFC rules. The business also failed to realise that rent is tainted income. This means that all the income of Company C was tainted income and should have been declared in the Australian company.
Example B: Australian Company Involved In Share Trading
Australian company, Company D, was operating a successful share trading business in Australia. Seeing the opportunity to replicate the same financial success overseas they set up Company E in a foreign country.
Company E leased genuine commercial premises overseas, hired overseas staff, and commenced operations. There was no intent to avoid Australian tax, the only motivation being a desire to access a new talent pool and new markets. The foreign region they chose to establish Company E in provided a prime opportunity to do so.
Unfortunately, they didn’t realise that income from share trading is included as tainted income under the CFC rules.
When Your Client Sets Up A Foreign Company Without Telling You
Sometimes a client will set up a foreign company without seeking advice or even notifying their accountant in Australia.
Say you’ve been working on Bob’s accounts for years. He comes over annually to get his taxes sorted. He runs a successful business and is pretty savvy when it comes to staying on top of his requirements. Everything seems to be going well.
Then one year you notice a large transfer into Bob’s company from a foreign account. When you ask Bob about this he says it’s from the foreign company he set up 5 years ago. Turns out he never bothered mentioning it to you because he felt like he knew what he was doing, he had accountants local to his foreign business to take care of that side of things, and it didn’t occur to him that an overseas company could have anything to do with his Australian taxes!
The Problems With Missing A CFC
If your client wants to set up a business overseas, the entity itself is most likely going to be a CFC.
This means that the nature of the income that is earned by the foreign company may be problematic if you don’t get the right advice regarding the CFC rules and tainted income.
While it can be all too easy to miss identifying when a company needs to consider the CFC rules, it isn’t an easy fix.
Fixing the issues caused can be very time consuming, requiring voluntary disclosure and may even require legal advice.
As you will be aware, the tax rules regulating tax accountants mean that we cannot lodge a tax return when we are aware that it is incorrect. This means that once you become aware that there has been a missed CFC, you either need to fix the mess before you can lodge the current tax returns, or you will have to resign as their accountant.
PODCAST: How To Handle A Client Who Has A Foreign Company
In this podcast, we talk to Matthew Marcarian, the Principal of our CST office in Sydney who will guide us through ‘How To Handle A Client Who Has A Foreign Company’.
Matthew is a Chartered Accountant with over 25 years of international tax experience.
In this podcast he covers key issues including:
- Common issues accountants have raised when seeking assistance with their clients who have a foreign company.
- How to avoid exposing yourself to undue professional risk in handling a client who has a foreign company.
- What to do when your client tells you that their company is in a Tax Haven.