An Economic Rationale for Controlled-Foreign-Corporation Rules

By introducing controlled-foreign-corporation (CFC) rules, the parent country of a multinational firm reserves the right to tax the income of the firm's foreign affiliates, if the tax rate in the affiliate's host country is below a specified threshold. In this paper, we identify the conditions under which binding CFC rules are part of the optimal tax mix chosen by governments. We show that this is the case when the financial structure of the multinational firm responds elastically to the introduction of the CFC rule, outweighing the negative effects on the firm's investment decision in the parent country, and on the profits of the home-owned firm in the parent country's welfare objective. We also show that if the government is mostly interested in maximizing tax revenues, a tighter CFC rule is associated with a tighter thin capitalization rule in its policy optimum.