Overview and implementation status
CFC rules under ATAD: Background
In July 2013, the OECD published its Action Plan on Base Erosion and Profit Shifting (BEPS), which provided governments with concrete strategies to address tax avoidance and ensure that profits are taxed where economic activity is performed. Action 3 had the objective of strengthening controlled foreign companies (CFCs) rules and resulted in a final report in October 2015, which set out recommendations for the design of rules that could effectively prevent taxpayers from shifting income to foreign subsidiaries established in low (or lower) taxed jurisdictions.
At the European level, the idea of a comprehensive approach to improve corporate taxation in the European Union (EU) was launched in December 2014 as part of the Commission’s Work Programme 2015 and was followed in June 2015 by the publication of an Action Plan, in which the European Commission announced its intention to relaunch the Common Consolidated Corporate Tax Base (CCCTB). Luxembourg, which held the Presidency of the EU at the time, subsequently put forward the idea of splitting off certain international anti-BEPS aspects of the CCCTB proposal and adding these to the OECD proposals, that would together lead to an "anti-BEPS Directive." The anti-tax avoidance directive (ATAD), which was first presented in January 2016 and adopted by all Member States six months later on July 12, 2016, builds upon this initial draft.
The ATAD is intended to strengthen protection against aggressive tax planning in the EU and lays down common minimum rules in the areas of interest limitation, exit taxation, general anti-abuse rules (GAAR), CFCs, and hybrid mismatches. These standards, which should generally apply as of January 1, 2019, are intended to provide a minimum level of protection to Member States.
CFC rules under ATAD: An overview
CFC regimes are anti-abuse provisions aimed at preventing tax avoidance by domestic companies that divert their operations through foreign subsidiaries resident in states with a more advantageous corporate tax regime. The ATAD lays down common rules to effectively prevent taxpayers from shifting income to CFCs (see articles 7 and 8). The directive, which builds upon the work performed at the OECD level, sets out common definitions and provides some flexibility to implement CFC rules that target either specific categories of income (Model A) or that are limited to income which has artificially been diverted to the CFC (Model B).
Definition of a CFC
Two cumulative criteria—control by a resident parent company (or companies) and a low level of local country taxation—have to be fulfilled for a foreign entity to qualify as a CFC:
- A resident parent company or companies have a direct or indirect participation of more than 50 percent of the capital or the voting rights or are entitled to receive more than 50% of the profits of the foreign entity.
- The actual corporate tax paid on the foreign entity’s profits in the state where it is established is lower than 50 percent of the corporate tax that would have been chargeable, had the foreign entity been established in the Member State of the parent company.
The ATAD provides only minimum defensive rules. This means that a Member State can implement stricter standards as long as these rules are in line with EU law, for example lowering the control thresholds (to, for example, 25pecent of the voting rights or capital) or implement additional control test methods (e.g., define control as the power of a person to elect or revoke board members).
However, the principle of proportionality enshrined in the EU law requires that CFC rules implemented by the Member States specifically target artificial arrangements.
Tainted income approach (Model A)
Under the tainted income approach, CFC income includes specific types of (nondistributed) passive income (i.e., interest, dividends, income from the disposal of shares, royalties, income from financial leasing, income from banking, insurance and other financial activities, and income from invoicing associated enterprises as regards goods and services where there is no or little economic value added).
In accordance with previous case law from the Court of Justice of the EU on this matter, the ATAD requires that CFC rules be combined with a substance carve-out, meaning that the rules do not apply where a controlled entity established in an EU/European Economic Area (EEA) country carries on a substantive economic activity supported by staff, equipment, assets, and premises. Member States may, however, choose not to implement this substance exemption with respect to controlled entities established in a third country.
In order to limit the compliance costs for entities that have lower risks of tax avoidance, Member States may also implement exemptions for:
- Entities whose income consists of one-third or less of the previously listed types of passive income, and/or
- Financial undertakings, if one-third or less of the CFC passive income comes from intragroup transactions.
The income to be included in the tax base of the controlling entity shall be calculated in accordance with the corporate tax rules of the Member State where it is situated and in proportion to its participation in the CFC.
Transactional approach: Application of the arm’s-length principle (Model B)
Under the transactional approach, CFC income is defined as nondistributed income arising from nongenuine arrangements, which have been put in place for the essential purpose of obtaining a tax advantage.
An arrangement will be regarded as nongenuine to the extent that the CFC would not have owned assets or would not have undertaken risks if it were not controlled by a company where the significant people functions, which are relevant to those assets and risks, are carried out and are instrumental in generating the controlled company's income.
Similar to the tainted income approach, the Directive gives Member States the ability to implement exemptions, in this case, for CFC entities or PEs with:
- Low total profits (accounting profits of no more than EUR750.000 and nontrading income of no more than EUR75.000), or
- Low profit margin (accounting profits account to no more than 10 percent of its operating costs for the tax period).
In accordance with the arm's-length principle, income to be included in the tax base of the controlling entity will then be limited to amounts generated through the significant people functions that it carries out.
Elimination of double taxation
The Directive provides additional rules in order to avoid double taxation of profits subsequently distributed by a CFC, as well as proceeds from the disposal of a participation in a CFC entity or of the business carried out by a CFC PE. To the same end, income tax paid by a CFC in its state of residence shall be deductible from the tax due by the controlling entity on its CFC income.
However, the ATAD does not include provisions preventing multiple taxation resulting from (e.g., the cascading application of multiple countries’ CFC rules to chains of subsidiaries or the concurrent application of transfer pricing legislation).
Implementation overview in the EU
In some Member States, CFC regimes were implemented before the entry into force of the ATAD. However national CFC rules were not harmonized at the EU level and therefore some CFC regimes were incompatible with the fundamental freedoms guaranteed under EU law. Following the adoption of common rules under ATAD 1, certain CFC regimes will have to be amended to be fully compliant with EU law.
Among countries which need to adjust their national CFC rules under ATAD 1 or introduce them into their legal systems are Austria, Belgium, Bulgaria, Croatia, Cyprus, Czech Republic, Estonia, Ireland, Latvia, Luxembourg, Malta, the Netherlands, Slovakia, and Slovenia.