Newsletter
Introduction of MOF's CFC Audit Guidelines for Profit-Seeking Enterprises
Taiwan's new anti-tax avoidance rules on controlled foreign companies (hereinafter, "CFC") for profit-seeking enterprises will take effect in 2023. Unless exempted, when a profit-seeking enterprise files its 2023 income tax return, it should abide by the regulations in Article 43-3 of the Income Tax Act and the "Regulations Governing Application of Accrued Income from Controlled Foreign Company for Profit-Seeking Enterprises" (hereinafter, "Profit-Seeking Enterprises CFC Regulations") in calculating and recognizing investment income from CFCs and include such income in its taxable income of the current year. In order for the tax authorities to review the recognition of the aforesaid income by profit-seeking enterprises consistently, the Ministry of Finance (MOF) announced the "Audit Guidelines for Recognizing Accrued Income from Controlled Foreign Company for Profit-Seeking Enterprises" (hereinafter, "Audit Guidelines") on December 14, 2018. This article is a brief introduction for your reference.
Identification of CFC
Where a profit-seeking enterprise and its 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 over such affiliated company, the affiliated company is deemed the profit-seeking enterprise's CFC. In order to review whether a profit-seeking enterprise has correctly identified its CFC(s), the tax authorities will verify the scope of the profit-seeking enterprise's related parties by reviewing the profit seeking enterprise's annual financial report, the organizational structure of the profit-seeking enterprise and its purported related parties as well as the information thereon that is provided by the profit-seeking enterprise and other data collected by the tax authorities. The tax authorities will also verify the foreign affiliated company's country or jurisdiction of incorporation by reviewing its registration documents, and will check whether such country or jurisdiction is on the list of low-tax burden countries and jurisdictions under the CFC regulations announced by the MOF. Furthermore, the tax authorities will verify whether the profit-seeking enterprise and its related parties directly or indirectly hold 50% or more 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 profit-seeking enterprise and its related parties as well as the investment transactional information thereon.
Deciding whether a profit-seeking enterprise and its related parties have significant influence over a Foreign Company in a Low-Tax Burden Country or Jurisdiction often involves subjective judgments. Therefore, in order that both the tax authorities and the tax payer may be guided by some guidelines, the Audit Guidelines provide that a profit-seeking enterprise and its 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 direct the foreign company's financial and operating policies.
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 a profit-seeking enterprise and its 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 profit-seeking enterprise should carefully evaluate whether any of the aforesaid agreements or circumstances exists in order to determine whether it and its related parties have a significant influence over the foreign company, so as to avoid mistakenly under reporting the profit-seeking enterprise's income. In particular, it is necessary to pay attention to whether there is a transfer of shares at year-end in an attempt to improperly circumvent the holding percentage requirements, in which case, the tax authorities may determine the holding percentage of the shares or capital in the Foreign Company in a Low-Tax Burden Country or Jurisdiction based on the highest holding percentage on any day of the current year.
Determining whether the CFC has substantial operating activities
One of the circumstances for exemption from the CFC reporting requirements is if the CFC has substantial operating activities in the country or jurisdiction in which it is located. Paragraph 2, Article 5 of the Profit-Seeking Enterprises CFC Regulations clearly stipulates the requirements for substantial operating activities: A CFC must have a fixed business place in its registered place, employ employees to carry out operations in the local area and the sum of its investment income, dividends, interest, royalties, rental income and gains from the sale of assets for the current year (also known as "Passive Income") should account for less than 10% of the sum of its net operating income and non-operating income (hereinafter, "Total Income") in order to be exempted from the CFC reporting requirements. During its review, the tax authorities will check whether the CFC has assets in its registered place and reports rental expense, utilities and salary expense; having only a post office box as its registered address or engaging a secretarial company or a trust company to appoint personnel to handle its local administrative affairs does not meet the requirements pertaining to "substantial operating activities".
The tax authorities will calculate the percentage of the CFC's Passive Income to Total Income based on the CFC's audited financial statements prepared in accordance with Taiwan GAAP, detail of revenue and other information. 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, other documentary evidence to prove the authenticity of the CFC's financial statements may be accepted by the tax authorities (e.g., the CFC's internal management reports or accounting books). However, there is currently no clear guidance on what kind of "other documentary evidence" could replace the CFC's audited financial statements. Before submitting financial statements and accounting books, tax payers should pay special attention to whether past transactions between the CFC and domestic companies are at an arm's length. If there is any non-arm's length transaction and the information thereon is provided to the tax authorities, the tax authorities might scrutinize the income tax return for the year of such transaction if it is within the statute of limitations.
In terms of the calculation, the gross gain from the sale of assets should be included in Passive Income while the loss from the sale of assets should not be deducted. To illustrate, if the CFC sold three real properties (A, B and C) in one year, whereby A was sold at a loss of NTD 3 million, B was sold with a gain of NTD 4 million, C was sold with a gain of NTD 5 million and there is no other Passive Income, the Passive Income of the CFC should be NTD 9 million (NTD 4 million plus NTD 5 million).
In addition, if the CFC researches and develops intangible assets, or develops, builds and produces tangible assets at its registered place, the royalties and rental income derived from providing such assets to others for use and the gains from the sale of such assets should be excluded from Passive Income. A profit-seeking enterprise should prepare records of its R&D plans, inventory of intellectual property rights, factory operation documents, records of product manufacturing and sales and related income and gain schedules for the tax authorities' review. For example, if a CFC has dividends income of NTD 1 million, interest income of NTD 0.5 million and royalty income of NTD 16 million (derived from licensing its self-developed intangible assets to others) and has no other Passive Income, operating income or non-operating income in the current year, the CFC's Passive Income would be 8.6% of its Total Income (the sum of NTD 1 million and NTD 0.5 million (NTD 1.5 million) divided by the sum of NTD 1 million, NTD 0.5 million and NTD 16 million (NTD 17.5 million)).
Calculation of CFC's current year earnings
A profit-seeking enterprise should calculate a CFC's current year earnings pursuant to Paragraph 5, Article 5 of the Profit-Seeking Enterprises CFC Regulations. The calculation of a CFC's current year earnings was introduced in our June bulletin "Income Recognition and Calculation under Taiwan CFC Rules - Corporations". 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 profit-seeking enterprise and its related parties, shareholding information of each invested enterprise of the CFC (hereinafter, "Invested Enterprise"), financial statements of each Invested Enterprise, investment gain or loss calculation of each Invested Enterprise, shareholders' agreement or shareholders' meeting minutes showing the distributed earnings of each Invested Enterprise and proof of tax payment on the distributed dividends or earnings of each Invested Enterprise issued by the tax authorities of a non-low-tax burden country or jurisdiction.
In terms of calculation, when a CFC invests in an enterprise in a non-low-tax burden country or jurisdiction, considering that the earnings of the Invested Enterprise may be retained for working capital or for reinvestment, and there is no tax avoidance intent, the CFC's current year earnings should include the earnings actually distributed by such Invested Enterprise and exclude investment income or loss recognized by the CFC using the equity method. Realized investment losses of the Invested Enterprise may be recognized by the CFC. Except where the CFC's original capital contribution has been reduced due to a capital reduction for making up loss, merger, bankruptcy or liquidation of the Invested Enterprise, losses cannot be deducted.
Documents presented by the profit-seeking enterprise to support a capital reduction for making up loss, merger, bankruptcy or liquidation of the Invested Enterprise must be verified or certified by the embassy or consulate of the Republic of China, commercial representative office or foreign trade agency; if the Invested Enterprise is located in China, a certificate issued by an institution or group designated by the Mainland Affairs Council to handle relations between the people of the Taiwan area and the Mainland area is required. Depending on the reason for the investment loss, the time of recognition of the investment loss of the Invested Enterprise shall be the date of the capital reduction as resolved by the shareholders' meeting, the date of the capital reduction stated in the reorganization plan determined by the court, the date of the merger, the date of the court’s bankruptcy ruling or the date on which the liquidation statements and the like are approved by the shareholders of the Invested Enterprise or the shareholders' meeting after the liquidator has completed the liquidation in accordance with the law.
The CFC rules only include the distributed earnings of an Invested Enterprise in a non-low-tax burden country or jurisdiction in the CFC's current year earnings. Although this is in line with the provisions on anti-tax avoidance, when the profit-seeking enterprise files its income tax return, it has to make adjustments and provide supporting documents, which may increase the profit-seeking enterprise's tax compliance costs.
Companies located in low-tax burden countries or jurisdictions such as Singapore, Hong Kong and Malaysia that meet the requirements for substantial operating activities will have different tax implications depending on whether the ultimate domestic parent company is a direct or indirect investor. Under Article 4 of the Profit-Seeking Enterprises CFC Regulations, Singapore, Hong Kong and Malaysia meet the definition of low-tax burden countries or jurisdictions. If the ultimate domestic parent company indirectly invests through a CFC in a company located in any of such countries or jurisdictions that meets the requirements for substantial operating activities, the earnings of such company should be included in the CFC's current year earnings. In contrast, if the ultimate domestic parent company directly invests in a company located in a low-tax burden country or jurisdiction that meets the requirements for substantial operating activities, such foreign company is exempted from the CFC reporting requirements. Under current regulations, the earnings from indirect investments in low-tax burden countries or jurisdictions that meet the requirements for substantial operating activities cannot be excluded from the CFC's current year earnings. Tax payers may seek to exclude the earnings of such companies from the CFC's current year earnings.
Calculation of CFC's investment income
A CFC's investment income should be calculated based on (1) the current year earnings of the CFC, less any legal reserve or restricted retained 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, (2) the percentage of the shares or capital of the CFC held directly by the profit-seeking enterprise and (3) the period of the profit-seeking enterprise's holding in the CFC during the year. To confirm the legal reserve and restricted earnings, the tax authorities will review the CFC's shareholders' agreement or shareholders' meeting minutes, financial statements and other documents. If a CFC has incurred a loss and such loss has been reported in accordance with the law and assessed by the tax authorities, such loss can be deducted from the earnings of the CFC for 10 years from the year following the year in which the loss was incurred in calculating the profit-seeking enterprise's CFC investment income. In practice, when filing the current year's profit-seeking enterprise income tax return, prior years' losses which have been reported 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. Furthermore, the losses of a CFC can only be deducted from the current year earnings of that CFC. Where each CFC's current year earnings do not exceed NT$7 million, and the total current year earnings or losses of all CFCs do not exceed NT$7 million, thereby meeting the conditions for exemption from the CFC reporting requirements, a CFC's prior years' losses as assessed by the tax authorities must still be deducted from the CFC's current year earnings, and the remaining losses would be deductible from the CFC's future earnings.
Regardless of whether or not a tax payer is exempt from the CFC reporting requirements, for the year in which a CFC incurred a loss, it is advisable to report the loss in accordance with the law and have the loss assessed by the tax authorities so that such loss could be carried forward and deducted from the CFC's future years' earnings. If the tax payer fails to report the loss in the year it is incurred, such loss would not be allowed to be deducted from the CFC's future years' earnings.
Treatment of the CFC's dividends or earnings distributed to profits-seeking enterprises
To avoid double taxation, where a profit-seeking enterprise has received dividends or earnings from each of its CFCs, the portion that has been recognized as the CFC's investment income and included in the profit-seeking enterprise's taxable income in prior years shall not be included in the taxable income of the distribution year; the portion exceeding the recognized investment income shall be included in the taxable income of the distribution year. Where a profit-seeking enterprise has paid income tax on the CFC's dividends or earnings in accordance with the tax laws of the country or jurisdiction where the income is sourced, within five years from the day following the deadline for filing income tax returns for the year in which such investment income is included in the profit-seeking enterprise's taxable income, the amount of tax paid can be deducted from the tax payable amount of the year in which the investment income is included in the profit-seeking enterprise’s taxable income, and the profit-seeking enterprise may apply for a refund of any excess tax paid. The year in which the distributed dividends or earnings are allocated should be identified by the profit-seeking enterprise based on the CFC's shareholders' agreement or the minutes of the shareholders' meeting. Where the dividends or earnings distributed by a CFC in a given year include (1) any amount that had been reported as investment income in prior years; and (2) any amount that should be a part of the taxable income in the year of the distribution thereof, the tax paid in the source country on the aforementioned income shall be allocated in proportion to the amount of investment income, dividends or earnings reported each year to the amount of distributed dividends or earnings.
Conclusion
The Taiwan profit-seeking enterprises CFC regulations will take effect soon, and the CFC's financial statements will be the basic documents required for profit-seeking enterprises to report CFC investment income in the future. When a profit-seeking enterprise plans its response to the new profit-seeking enterprises CFC regulations, it should understand the main points and focus of the tax authorities' audits, correctly identify CFCs, calculate CFCs' current year earnings and investment income and prepare the relevant documents required for filing its income tax return as early as possible so as to reduce the administrative and labor costs during a tax audit and the risk of having to pay 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 profit-seeking enterprises CFC regulations, please do not hesitate to contact our Tax Practice Group.