The CFC Rules Do Not Have to be So Complicated: Proposal for a New CFC Regime in the State of Israel

Abstract

In 2003, the state of Israel enacted a significant reform in its tax system, under which tax is imposed on a worldwide basis rather than on a territorial basis. Consequently, a new need for an anti-deferral regime has arisen, so Israeli investors who conduct their business outside of Israel through controlled foreign corporations (CFC) would be taxed on their worldwide income, similar to those who conduct business through Israeli corporations. The major purpose of this dissertation is to take an active part in the process of structuring the new Israeli CFC tax regime by performing a comparative research. Specifically, the dissertation analyzes the relevant U.S. CFC rules as a major case study. However, in light of the unique characteristics of the Israeli system and given the complexity of U.S. CFC rules, tax systems of other major developed countries are also being analyzed by this dissertation.

The basic thesis of the dissertation is that the CFC rules do not have to be so complicated in order to be effective. The dissertation argues that simple rules can also be adequate in dealing with tax deferral. To demonstrate this thesis, a specific comparison between U.S. CFC rules and other relevant CFC regimes is made. This comparison illustrates that the U.S. CFC rules do not always achieve justified results.

The structure of this dissertation includes a step-by-step analysis of the proposed CFC regime. It begins with a theoretical discussion of policy considerations regarding anti-deferral regimes. In general, “tax deferral” occurs when domestic persons conduct their business in low-tax jurisdictions through foreign companies, which are not subject to domestic taxation. As a result, the earnings of the foreign corporation enjoy tax deferral until these earnings are repatriated. This dissertation demonstrates that the constructive dividend is the preferable method to deal with tax deferral. The dissertation further discusses the elements essential to the new Israeli CFC regime: (i) ownership test; and (ii) income test. The ownership test refers to domestic shareholders maintaining "control" in a foreign corporation. The dissertation proposes an ownership test of domestic shareholders owning, directly or indirectly, more than 50% of “means of control” in the foreign corporation. For this purpose, domestic shareholders are defined as domestic persons owning, directly or indirectly, 5% or more of the relevant “means of control”.

The role of the income test is to target "tainted" income that should not enjoy the privilege of tax deferral. This dissertation proposes an income test based on the jurisdiction-based approach. The argument is that, when corporate tax rate is 20% or more in the foreign country of the CFC, the entire income of the CFC should not be taxable because tax deferral is not actually involved. The dissertation further proposes a "safe harbor" rule, borrowed from the U.K. and Japanese tax laws, to exempt genuine active income from taxation.

Finally, this dissertation suggests a set of additional anti-avoidance rules, along with several operating rules to combat tax avoidance and ensure the effectiveness of the new Israeli CFC regime.