Anti-tax Avoidance Directive (ATAD) on CFC rules

Anti-tax Avoidance Directive (ATAD) on CFC rules

Controlled foreign company

A controlled foreign company rule is part of ATAD under article 7. CFC rule tries to achieve its objective by taxing companies that are controlled by the EU taxpayers. The target taxpayers are those residents in low tax jurisdictions. Article 7 of the ATAD strictly aligns itself with the BEPS action plan 3. This plan exclusively stipulates the CFC rules. According to action plan 3, MNEs are likely to shift their profits to area considered to be low-tax jurisdictions. This shift will lead to a long-term tax evasion.  Active profits of foreign subsidiaries enjoy freedom of not getting taxed in countries that champion the exemption system and credit systems. The exemption system works for the case whereby capital gets repatriated back to high-tax parent jurisdiction. The credit system allows its players to differ to the point of repatriating their foreign profits. The issue of foreign subsidiary creates unfair business environment, moreover in the countries considered low-tax jurisdictions. These low-tax jurisdictions create a mere passive business income without necessary aiming at repatriating the profits. These passive business incomes shift the profits hence need for the CFC rules. These rules aim at regulating such economic behaviors and thus creating a fair business environment. In restoring the business environment, Action Plan 3 states the structure   of CFC rules. For easy Article 7 elaboration, first it is essential to illustrate the dictates of Article 7. Secondly, it is important carry out logical examination of the CFC rules. This examination will emphasize on its economic perspective with the aim of establishing whether the CFC rules do counter profit shifting as well as base erosion. Also, this examination will establish whether CFC rules are fair to the taxpayers without necessarily disorienting direct investments from foreign entities as well as the competition environment. Thirdly, it is essential to understand the CFC rules as stipulated in the ATAD and its non-conformity to the fundamental EU principles. Hence establishing the correlation and relationship between the EU primary law and the CFC rules. Lastly, it is significant to understand the administrative difficulties that arise from the CFC legislation as illustrated in economic and legal model. The non-legal issues that arise from the legislation shall be addressed.

provisions of the Anti-tax Avoidance Directive (ATAD) on CFC rules

under Article 7(1), there is an established criterion on how member states can classify an entity. Member states can classify a permanent establishment as a controlled foreign company, provided that profits of such entity or permanent establishment are not subjected to taxation or are exempted from taxation by member states. There are two cumulative conditions that determines whether an entity is a controlled foreign company.

The first condition dictates that in the case of legal entity, a parent located in the member states should himself or together with associated enterprises hold indirectly or directly the participation of not less than 50% of the voting rights. Alternatively, this condition requires the parent to own directly or indirectly not less than 50% of the profits of the entity. In Article 2(4) of the ATAD, an “associated enterprise” is defined has (a) an entity in which the taxpayer holds directly or indirectly a participation in terms of voting rights or capital of 25 percent or more is entitled to receive 25 percent or more of the voting rights or capital ownership of 25 percent or more is entitled to receive 25 percent or more of the profits of that entity. (b) an individual or entity which holds directly or indirectly a participation of voting rights or capital ownership in a taxpayer of 25 percent or more is entitled to receive 25 percent or more of the profits of the taxpayer.

The second condition emphasizes on actual corporate tax. This condition illustrates that the actual corporate payable tax by a foreign entity or a permanent establishment ought to be lower than the difference payable corporate tax and actual corporate tax of an entity or permanent establishment within a Member State.

When an entity qualifies as a CFC, Article 7(2) gives out two options on what income of the foreign entity or permanent establishment can be taxed for a Member state. Point (a) of the article 7 paragraph 2 champions an entity type of approach. This approach allows a member state to willingly tax the non-distributed income of a foreign entity. The member state may as well willingly tax the income of a permanent establishment that is established from six specific categories: income from leasing, interest, dividends, royalties and any other financial services and income from invoicing companies that earn sales and services income from goods and services purchases from and sold to associated enterprise and add no or little economic values. However, the CFC rules do not apply whenever a foreign entity or permanent establishment carries “substantive economic activity supported by staff, equipment and premises.” These CFC rules do not apply when the substantive economic activity is evident by reliable facts and situations. Whenever a member state is non-partisan to the EEA agreement, the exception is optional. Lastly, pursuant to paragraph 3 of article 7, if a foreign entity or permanent establishment has one third or less of the total income falling in the six specified categories then the member states may willingly choose not to consider the foreign entity or permanent establishment has a CFC.

Transactional approach is the other approach used as it is presented in the Article 7 paragraph 2 point(b).  the attribute of this approach is that non-distributed income of the entity or permanent establishment to the member state provides that such incomes arise from the “non-genuine arrangements which have been put in place for the essential purpose of obtaining a tax advantage”.  In paragraph 4 of article 7, it states that member states may willingly exclude from transactional approach.

In addition, it is worthy noting that article 8 paragraphs 5 and 6 states that member states must ensure that there is no juridical double taxation. Taxation in this case must be deduced from the parent tax base of the member state; this member state must have already paid tax on the CFC income. In article 8, paragraph 7, member states must provide a deduction to the parent taxpayer for the tax paid by the CFC.

Depending on the advantages and disadvantages of individual member states may choose which method best suits them. Generally, entity-based approach is less involving in terms of administrative model. The easiness of this approach is based on the fact that once the tax administration has determined the categories of taxation, the CFC automatically applies. The application is valid when the classification criteria has been made. The main disadvantage of this type of approach is, there is a possibility that incomes that are supposed to be included in the CFC taxation are exclude whereas incomes that ought to be excluded are included.

Economic effectiveness of CFC

The economic effectiveness of CFC is determined by the evaluation of its ability to stop base erosion as well has profit shifting. The evaluation is done basing the facts on the empirical evidence has provided by CFC rule. The issue of fairness is as well paramount in regard to the economic effectiveness. This possibly means that the economic effectiveness can be evaluated on parameters like, whether there is a section taxpayer being getting favored by the system at the expense of the other, and whether the taxes are remitted equivalently. Fairness in the context of the European CFC rules means that there are no section of taxpayers getting a system favor in one-member state while there is a section of taxpayers in another member state that are not getting the same favor. This fairness in taxation is subject to the position of the taxpayers in terms of direct investments. The other factor relevant to the economic effectiveness is the double taxation among taxpayers. Double taxation is well addressed in the BEPS Action plan 3. However, this address has been left out in the ATAD CFC regime out of speculations.

The application of the benchmarks for CFC effectiveness to EU tax law

It is evident that CFC rules remain applicable in many countries for a relatively long period. Regional patterns for the CFC rules can be established when evaluating the emergence of the CFC rules around the globe. The US was the first country to introduce the CFC rules. They were introduced in 1964 contained in subpart F. shortly after, in 1972 called introduced the CFC rules, however, these rules become effective in 1976. In Europe, German was the first country to introduce the CFC rules. They used the American approach in establishing their CFC rules. In the early 1980s, France and the UK had their shot on the CFC rules. Between the year 1990 and 1995 all Scandinavian countries except for Iceland introduced CFC rules to their taxation plan. Spain and Portugal had a taste of the CFC rules in the year 1995.

Many other European countries have introduced CFC rules in the taxation system. Iceland had their CFC rules incorporated to their tax system in 2010, Greece in 2014 whereas Poland and Russia joined in 2015. This growing development of the CFC rules is a good indicator of the international efforts in fighting profit shifting and base erosion. The credit mainly goes to the EU and OECD. For example, the BEPS project emphasizes on the significance of introducing and strengthening CFC rules. Luckily, most countries have shown commitment in implementing OECD standards and recommendations.

It is justifiable that countries with high taxation rates are more likely to suffer from base erosion. Therefore, these countries are more likely to buy the idea of CFC rules a mode of anti-tax avoidance policy measure. In the 2004, a research showed that out 14 countries in Europe, Canada and the US that had introduced CFC rules, 12 of them had a statutory CIT rate above the median rate of 28%. It is only Hungary and Lithuania that had their rate below the median. There rating is subject to other factors like regional differences. Most of east Europe had their CIT rates below the media. The other factor that is most likely to be associated with this below median CIT rates is the lack of CFC regimes. This lack of the regimes may have led to the member states encouraging resident companies to set up foreign subsidiaries in order to access new markets, this is a non-fiscal goal. Possibly, these countries may have lacked the ability to build administrative policies that would instituted high statutory CIT rate to have CFC rules implemented.


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