Newsletter
Introduction of MOF's CFC Audit Guidelines for Individuals
Taiwan's new anti-tax avoidance rules on controlled foreign companies (hereinafter, "CFC") for individuals will take effect on January 1, 2023. Unless exempted, when an individual files his/her 2023 income tax return in May 2024, the individual must follow Article 12-1 of the Income Basic Tax Act (also known as the Alternative Minimum Tax Act or the "AMT Act") and the "Regulations Governing Application of Accrued Income from Controlled Foreign Company for Individuals" (hereinafter, "Individual CFC Regulations") in calculating offshore business income based on the percentage of shareholdings in CFCs and period of holding shares in CFCs and include such offshore business income as part of his/her basic income under the AMT Act. In order for the tax authorities to review the calculation of the aforesaid offshore income consistently, the Ministry of Finance (MOF) announced on December 21, 2018 the "Audit Guidelines for Recognizing Accrued Income from Controlled Foreign Company for Individuals" (hereinafter, "Audit Guidelines"). This article is a brief introduction for your reference.
Determination of CFC
Where an individual and his/her related parties directly or indirectly hold 50% or more of the shares or capital of a foreign affiliated company registered in a low-tax burden country or jurisdiction (hereinafter, "Foreign Company in a Low-Tax Burden Country or Jurisdiction"), or have a significant influence on such a foreign affiliated company, the foreign affiliated company is deemed the CFC of the individual. In order to determine whether a company is an individual’s CFC, the tax authorities will verify the scope of the related parties of the individual by reviewing the organizational structure of the individual and his/her purported related parties as well as the information thereon provided by the individual and other data collected by the tax authorities. The tax authorities will also verify the country of incorporation of the foreign affiliated company by reviewing its registration documents, and will check whether such country is on the list of low-tax burden countries and jurisdictions under the CFC rules announced by the MOF. Thereafter, the tax authorities will verify whether the individual and his/her related parties directly or indirectly hold over 50% of the shares or capital of the Foreign Company in a Low-Tax Burden Country or Jurisdiction by reviewing the change(s) in the shareholdings of the individual and his/her related parties as well as the investment transactional information thereon.
In addition, the tax authorities will check whether the individual and his/her spouse and relatives within the second degree of kinship directly hold 10% or more of the shares or capital of a Foreign Company in a Low-Tax Burden Country or Jurisdiction, in relation to which the aforementioned regulations of the Audit Guidelines shall be applied.
In order for both the tax authorities and the tax payer to determine whether the individual and his/her related parties have a significant influence over a Foreign Company in a Low-Tax Burden Country or Jurisdiction consistently, the Audit Guidelines provide that an individual and his/her related parties would be deemed to have a significant influence over a foreign company if any one of the following situations exists:
1. Through agreements with other investors, having more than one-half of the voting rights of the foreign company.
2. According to the law or agreements, having the power to make financial and operating policies of the foreign company.
3. Having the power to appoint more than one-half of the board of directors (or a similar governing body) of the foreign company.
4. Having the power of control over one-half of the voting rights of the board of directors (or a similar governing body) of the foreign company.
5. Other evidential documents showing control over the personnel, financial and operating policies of the foreign company.
If an individual and his/her related parties directly or indirectly hold less than 50% of the shares or capital of a Foreign Company in a Low-Tax Burden Country or Jurisdiction, the individual and his/her related parties should check whether any of the aforesaid situations applies in order to determine whether or not they have substantial control/influence over the foreign company, so as to avoid under reporting their offshore business income due to mistakenly applying the CFC exemption.
CFC Exemption Review–Substantial Operating Activities and Little Passive Income
For a foreign company that is subject to the Individual CFC Regulations, where its home country or jurisdiction only levies taxes on onshore income, the tax authorities should check whether or not the foreign company is eligible for the CFC exemption. If a foreign company is incorporated in Hong Kong or Singapore and has substantial operating activities and thus, exempted from the CFC rules, the tax authorities would likely conduct an in-depth review to determine whether or not the foreign company has any assets and reports rental expense, utilities and salary expense in its registered place. Therefore, if a foreign company has no fixed place of business or its registered address is a post office box and it hires an agent or trust company to handle its local administrative affairs, the foreign company may be questioned by the tax authority for not having substantial operating activities.
Another exemption under the CFC rules is that the percentage of passive income should account for less than 10% of total income, as determined by the tax authorities based on the CFC’s financial statements prepared in accordance with Taiwan GAAP and certified by a CPA in the country or jurisdiction where the CFC is incorporated or in Taiwan and detail of revenue. If the CFC is not in the stage of operation (including in the establishment stage or going through liquidation after dissolution), since engaging a CPA to audit its financial statements may not be cost efficient, in principle, other documentary evidence to prove the authenticity of CFC's financial statements would be accepted by the tax authorities (e.g., CFC's internal management statements or accounting books). However, as of now, there is no clear ruling on how the tax authority of the individual's domicile should determine whether such “other documentary evidence” could replace the CFC’s financial statements certified by a CPA.
Other Tax Risk Arising from the Implementation of the CFC Rules
After an individual files his/her income tax return to report CFC income, in principle, the tax authorities would conduct a review on the basis of the CFC’s financial statements and documents attached to his/her income tax return. During the review, the tax authorities may request the tax payer to provide additional documents (e.g., the CFC’s accounting books, original documents, bank statements, etc.) thereby giving rise to the following risks to the tax payer:
1. Tax risk arising from the tax review on the funds registered as the CFC's share or capital or the funds remitted from the CFC's shareholders
The tax authorities may check whether or not there is any remittance to the CFC from the tax payer and his/her related parties by checking the organizational structure of the individual and his/her related parties as well as the information thereon against the remittance documents of CFC's registered share or capital and remittance between the CFC and its shareholders. If the fund was remitted from the tax payer or taxpayer's relatives within the second degree of kinship and the amount was significant, the tax authority may check whether there is any cash gifting or other improper transfer of property.
2. Tax risk of miscalculation arising from cross-shareholding
The tax authorities may reassess the percentage of the individual’s and his/her related parties’ shares or capital of a foreign company on the basis of change(s) in shareholding of the individual and his/her related parties as well as investment transactional information thereon and then review shareholding information of each portfolio company and the shareholding structures of the portfolio companies of a family enterprise to check whether there is an error with the CFC’s income calculation arising from cross-shareholding.
New Obligation of Keeping the Documents for Income Calculation
Individuals should calculation a CFC's current year earnings pursuant to Article 5(5) of the Individual CFC Regulations. The calculation of a CFC's current year earnings was introduced in our bulletin "Income Recognition and Calculation under Taiwan CFC Rules – Individuals" in June. To verify the calculation of a CFC's current year earnings, the tax authorities will review the CFC's financial statements, change(s) in the shareholdings of the individual and his/her related parties, shareholding information of each invested company, financial statements of each invested company, investment gain or loss calculation of each invested company, shareholders' agreements/shareholders' meeting minutes showing the distributed earnings of each invested company and proof of tax payment on the distributed dividends or earnings of each invested company issued by the tax authority of a non-low-tax burden country or jurisdiction.
When an individual reports his/her basic income, he/she should submit the seven required documents: the organizational structure of the individual and his/her related parties, CFC's financial statements, statement of CFC's losses for the past ten years, CFC's business income calculation, proof of tax payment issued by the tax authority where the income is sourced, shareholders' agreements/shareholders' meeting minutes of the invested companies of the CFC and proof of investment losses of the invested companies of the CFC (authenticated by the R.O.C. embassy, consulate or representative office). For the tax authority’s review, the individual should also prepare to provide details of any change in shareholdings of the individual and his/her related parties and the financial statements of the invested companies in a non-low-tax burden country or jurisdiction. In short, before the CFC rules take effect, individuals should prepare CFC's financial statements, accounting books and original documents for the tax authorities' review. Meanwhile, documents on unsettled accounting events or accounting vouchers relating to the existence of rights and responsibilities should be kept permanently; for example, documents proving CFC's registration should be kept separately.
Where the CFC's invested company is in a non-low-tax burden country or jurisdiction and the CFC recognizes investment income for such CFC under the equity method, the calculation of the CFC's current year earnings should be based on the distributed earnings stated in such invested company’s shareholders' meeting minutes. The investment loss that can be recognized for such invested company should be limited to the realized investment loss of the invested company; the investment loss shall not be deducted unless the loss resulting from a capital reduction (for making up loss), merger, bankruptcy or liquidation of the invested company and the CFC's original capital has reduced. The CFC rules only include as taxable income the distributed earnings of the CFC's invested company actually received by the CFC, in line with the provisions on anti-tax avoidance; however, when the individual files his/her income tax return, the CFC should make additional adjustments and provide supporting documents for tax compliance, which may increase the individual’s tax compliance costs.
Calculation of an Individual's CFC Business Income
An individual's CFC business income shall be calculated based on the current year earnings of the CFC, less any legal reserve and restricted distributable earnings under the law of the country or jurisdiction in which the CFC is located and any losses in the prior years as assessed by the tax authorities, in proportion to the shares or capital of the CFC held directly by and the period of ownership of the individual. To confirm the legal reserve and restricted distributable earnings, the tax authorities will review the CFC's shareholders' agreements, shareholders' meeting minutes and financial statements. The tax authorities will review any loss carryforward based on the CFC's financial statements. If a CFC has incurred losses, and such losses has been declared in accordance with the law and has been approved by the tax authority of the individual's domicile, such losses can be deducted from the earnings of the CFC for 10 years from the year following the year in which the losses were incurred in calculating the individual’s CFC business income. In practice, in an individual’s income tax return, prior years’ losses which had been declared in accordance with the law but have not been assessed by the tax authorities could still be deducted. If there is any difference between the assessed amount and the reported amount, the assessed amount will prevail.
If an individual is in any of the following situations whereby the individual is exempted from the CFC rules, the CFC's losses in prior years assessed by the tax authority must still be deducted from the CFC's current year earnings, and the remaining losses would be the deductible amount of the CFC's earnings for the following years:
1. Where each CFC's current year earnings do not reach NT$7 million, and the total current year earnings or losses of all CFCs, which are controlled by the individual and his/her spouses/dependents who file a consolidate income tax return in accordance with the Income Tax Act, do not reach NT$7 million; or
2. According to Article 12-1(1) of the AMT Act, the total annual offshore income per household is less than NT$1 million.
Regardless of whether or not a tax payer is exempt from the CFC rules, for the year in which a CFC has a loss, it is advisable to report the loss in accordance with the law and have the loss assessed by the tax authority of the taxpayer's domicile, so that such loss could be carried forward and deducted from the earnings of the following years. If the tax payer fails to report the loss in the year of the CFC's loss, such loss would not be allowed to be deducted from the CFC's current year earnings.
Treatment of the CFC's Dividends or Earnings distributed to Individuals
To avoid double taxation, where an individual has received dividends or earnings from each of his/her CFCs, the portion that has been calculated as the individual's CFC business income and included in the individual’s basic income in prior years shall not be included in the basic income of the distribution year; the portion exceeding the recognized business income shall be included in the basic income of the distribution year. The tax authorities will review a CFC's shareholders' agreements and/or shareholders' meeting minutes to check the year in which an individual has received dividends or earnings from the CFC. Where an individual has received the CFC's dividends or earnings and has paid income tax thereon in accordance with the tax laws of the country or jurisdiction of the source of the income, within five years from the day following the deadline for filing income tax returns for the year in which such business income is included in the individual's basic income, the amount of tax paid can be deducted from the tax payable amount of the year in which the business income is included in the basic income, by applying for amendment of tax credit or tax refund. Such tax credit or refund shall not exceed the basic tax amount calculated as a result of including therein the business income amount calculated under CFC rules. Where an individual has received the CFC's dividends or earnings in a given year that includes (i) any amount that had been declared as the business income in prior years; and (ii) any amount that shall be a part of the basic income in the year of the distribution thereof, the credit of the taxes paid on aforementioned income at the place where it is generated shall be calculated in proportion to the amount of the business income, dividends or earnings recognized in prior years to the amount of dividends or earnings actually received. To verify an individual’s calculation of tax credit and assess tax credit or refund, the tax authorities will review the overseas tax credit calculation for the year in which the individual calculated his/her offshore income, the CFC's shareholders' agreements or shareholders' meeting minutes, the CFC's financial statements, and a tax certificate issued by the tax authorities of the country or jurisdiction where the CFC is located.
Conclusion
The Taiwan CFC rules will take effect soon, and the CFC’s financial statements will be the basic documents required for individuals to report CFC income in the future. When individuals consider tax planning in response to the CFC rules, individuals should understand the tax authorities' rules and regulations and focus of their audit after the implementation of the CFC rules. In addition to determining whether a foreign company is a CFC and calculating the CFC's current year’s earnings and business income, an individual needs to prepare the documents required for filing his/her income tax return as early as possible, in order to avoid facing the risk of paying additional tax as a result of insufficient documents. Our tax team consists of tax lawyers and certified public accountants licensed in Taiwan and overseas who are familiar with the latest developments and changes in domestic and international tax laws. We work closely with L&L, Leaven & Co., CPAs and have an in-depth knowledge of tax practices in Taiwan. If you have any questions on the CFC rules, please do not hesitate to contact our Tax Practice Group.