4.3.5.5 CFC rule

The ATAD1 CFC rule

The ATAD-rule on CFCs allocates income from a low-taxed subsidiary, which is controlled by the parent company, to the parent company.1 This income is allocated to the parent company on a pro rata basis and is then taxed in the state where that entity is resident. The application of CFC rules allows taxation at the level of the parent entity prior to the effective distribution of profits by the subsidiary. These rules are designed to prevent the shifting of income to low tax jurisdictions if the shifting is not motivated by business considerations. CFC measures are therefore aimed at combatting tax avoidance in group situations.

The first step of the CFC measure as included in ATAD1 is to answer the question whether a CFC exists. An entity or a permanent establishment2 whose profits are not subject to tax or are exempt from tax is considered a CFC if two conditions are met. First, there must be a direct or indirect share of more than 50% (voting rights, capital or profits) in the entity. Secondly, the effective corporate tax paid by the entity must be less than half of the tax that would have been levied in the country of the controlling company if the entity had been resident there. The existence of a CFC therefore depends to a large extent on the rate of corporate income tax of the country applying the CFC legislation.

It is up to the Member State to opt for the introduction of a CFC rule based on either Model A or Model B. This choice can be made in the light of a country's policy priorities.3 Under the income approach of Model A, certain undistributed income of the CFC is included in the taxpayer's tax base.4ATAD1 provides an exception for situations where a taxpayer can demonstrate that a CFC carries out substantial economic activities. This must be adequately supported by staff, equipment, assets and premises. For this exception, therefore, the substance of a CFC is relevant. A Member State may choose not to apply the abovementioned exception to CFCs in third countries. In addition, Member States may choose not to treat a subsidiary as a CFC if one third or less of its income falls within the passive income categories. Finally, there is also the possibility to include an exception for financial undertakings.5

The second option provided by ATAD1 is to impose the CFC charge to undistributed income of the CFC from non-genuine arrangements that have been put into place for the essential purpose of obtaining a tax advantage (Model B). In determining whether an arrangement or a series of arrangements is considered genuine, the significant people functions relevant to income-generating assets and risks undertaken by the CFC must be taken into account. Member States implementing Model B may still choose to exclude such income from a taxpayer’s tax base if the CFC has commercial profits within a certain range.6

The main goal of the ATAD1 CFC rule is to counter tax avoidance. The rule applies some sort of group approach due to the 50% requirement. Via this approach the rule aims to make sure that in certain group situations tax avoidance is no longer possible. Due to the lack of a full group approach the ATAD1 CFC rule can lead to economic double taxation. The term full group approach refers to the consideration of taxes already paid by the direct and indirect subsidiaries. Double taxation can be the result of the application of the CFC rule, for example when applying Model A of ATAD1 to indirectly held CFCs. Under Model A, certain undistributed income of the CFC is included in the tax base of the taxpayer. Double taxation occurs, for example, if an entity in Member State A holds the shares in a CFC through an intermediate holder in Member State B. If Model A is applied in both Member States, the income of this CFC is included twice in the tax base. To the extent that Model B is chosen, there seems to be no double taxation.7

CFC rules & the OECD MTC

Does the OECD MTC provide for rules regarding CFCs? The OECD Commentary states that CFC legislation cannot lead to conflicts with tax treaties. According to the OECD, CFC legislation can be applied completely independently of tax treaties.8 The underlying idea for this point of view seems to be that these rules are designed to combat tax avoidance and to protect against erosion of the domestic tax base.9 The answer to the question whether CFC legislation is contrary to treaty law has been the subject of discussion in the literature for some time.10 The discussion in particular revolves around the possible conflict with art. 7, par. 1 and art. 10, par. 5, OECD MTC.11 The underlying question is whether it is in line with the tax treaty that the residence state of the controlling shareholder assumes jurisdiction to tax income that is in fact attributable to a taxpayer that is resident in another country. In fact, CFC rules to some extent reject the separate entity principle.12 It can be argued that a residence state is free to tax its own residents in the manner it finds suitable and is in that respect not bound by the attribution of income by the other state.13 All in all, the OECD view – i.e., CFC legislation is not restricted by tax treaties – can be explained well in my view, given the anti-avoidance aim of CFC legislation. However, this outcome does not seem fully in line with the wording of the model.

If CFC legislation does not conflict with tax treaties, CFC legislation can be applied without any influence of a tax treaty. CFC legislation can thus, in line with the national legislation, combat tax avoidance in a multinational group. However, this may result in double taxation in group situations, as the provisions in tax treaties do not require countries that have CFC rules to provide relief for foreign taxes paid by a CFC.14 The necessity of CFC rules is in essence caused by the separate entity approach that is at the heart of the corporate tax system that is currently applied in most countries. Via CFC rules less relevance is attached to this corporate veil as income is fictitiously attributed to the controlling shareholder. To combat tax avoidance as well as double taxation in the context of CFCs two different approaches seem possible. Specific rules dealing with the taxation of CFCs could be added to the OECD MTC to make sure the application of the model is fully in line with its goals. The rule should provide for some form of elimination of double taxation, without providing opportunities for tax avoidance. However, to truly solve the problem an overarching solution would be required. This can be done by applying a full group approach in the international tax domain. I will elaborate on this in the following chapters.