What is a Controlled Foreign Corporation?

A controlled foreign corporation is an entity in another nation used by investors to lower the tax burden in his or her native country. These can include a multinational corporation operating in a foreign country or simply a private company based out of another tax jurisdiction. Many nations with sophisticated tax laws consider these investments as a form of tax haven or tax shelter and thus sometimes contribute to tax evasion. In order to mitigate this instance, rules are put in place by these countries to limit the amount of money that can be deferred from taxation. Most often, controlled foreign corporation entities are established in areas with low tax rates.

Many companies create tax havens such as a controlled foreign corporation to avoid being taxed on income. Most countries do not tax shareholders on their earnings until the funds are distributed via dividends. The way companies use the concept is by creating a subsidiary in a low-taxed foreign country in which the dividends are invested. This money is then loaned back to the shareholder rather than paid to them. This means that the money is essentially tax-free.

Prior to modern laws, tax agencies had little recourse in which to attempt to collect on these funds. In 1962, the United States established a series of laws regarding the use of a controlled foreign corporation in an effort to limit this activity. Essentially, these laws required any shareholder operating in the country to declare such payouts from the entity as income. These laws, however, could only be enforced on individuals that controlled at least 10 percent of the corporation or on businesses that held 50 percent. Claims are required on any royalties, rents, interest, dividends or other gains that pass through a controlled foreign corporation.

In the United Kingdom, these laws are essentially the same with one major exception in that they do not apply to individual shareholders, only companies. This requires that the company have a 40 percent or more controlling share in the controlled foreign corporation. United Kingdom laws require the payment of tax on these funds, but the rate of taxation is lower than if the entity were located domestically. This can also be deferred if the corporation pays out 90 percent of its funds in the form of dividends each year or if it is located in a country that the United Kingdom does not consider a tax haven nation.

Germany also has strong rules regarding these tax shelters that apply to individuals and companies controlling 50 percent or more of the entity's share. According to law, the corporation can forgo additional taxation if 25 percent of the passive income being held by the body is taxed by Germany. Unique to the German controlled foreign corporation rule is the fact that the country has established many exceptions with certain nations via treaties.

Many other nations also have rules regarding foreign corporations. Japan requires taxation on entities that operate in other countries but do not pay taxes in that country. New Zealand, Australia and Sweden also have established rules, but allow businesses to establish an entity without taxation ramifications in certain approved countries.