As we all know, the Council Directive (EU) 2016/1164 of July 12th, 2016 (also known as Anti-Tax Avoidance Directive 1 or ATAD 1 for short) laid down a set of rules aimed at strengthening the average level of protection against aggressive tax planning in the internal market, which came as a direct response to Organisation for Economic Cooperation and Development (OECD)’s call for action against base erosion and profit shifting (BEPS).
As these rules would have to fit in 27 separate tax systems, they were designed in very general – maybe too general terms – leaving much in the way of implementation to Member States, who were thought to be in a better position to shape the specific elements of those rules in a way that fits best its corporate tax systems.
As such, ATAD 1 was only truly designed to create a set of rules that establish a minimum level of protection for national corporate tax systems against tax avoidance practices across the Union.
In this sense, ATAD 1 obliges Member States to uniformly introduce these anti-tax avoidance measures to achieve a “minimum standard level playing field”, but it does not prevent them – in the least – to go beyond that minimum standard.
One such set of rules are the widely known – and equally feared – Controlled Foreign Company (CFC) rules.
CFC rules basically work as top-up tax aimed at disincentivizing businesses from shifting their profit to low-tax jurisdictions – understood as countries with an Effective Tax Rate (ETR) lower than a certain threshold set by the jurisdiction of the ultimate beneficial owner (“UBO”) – since it allows that profit to still be subject to domestic taxation regardless of dividend distribution, and thus protect the domestic tax base.
CFC rules usually target only purely (or mostly) passive income generating foreign companies. For example, if a taxpayer resident in France (which has a combined corporate income tax rate of up to 31%) is the UBO of a Bahamas Company (which does not tax corporate income), France may assert the right to tax the profit earned by the Bahamian Company, regardless of actual dividend distribution.
Most countries have lived with this types of rules for several year. Some of them way before ATAD came into force.
What people may not realize is how shockingly different CFC rules (at least when applied at individuals – as opposed to corporations) work throughout the EU, even before ATAD, which seems to not have helped at all creating a “level playing field” but only contributed further to establishing a “mining field”.
Here are some examples:
Please note that of the four randomly picked jurisdictions (coff…coff), two (France and Portugal) tax under CFC all the profit regardless of the nature of the income (as opposed to only the profit deriving from the passive income business).
Also, the same two of them (Portugal and France) use an ownership threshold of just 25% and 10%, respectively, but only one of them (Germany) uses a fixed ETR (25%) – as opposed to a comparative ETR – to determine if a given jurisdiction is a low tax jurisdiction (despite, funnily enough, certain regions in Germany not reaching that threshold themselves).
Oh and Malta doesn’t even have a CFC for individuals…
And this is just the tip of the iceberg.
There are also many key – but very impactful – differences in terms of what constitutes «passive income» in each jurisdiction, specifically in what concerns to the real estate sector.
So, why so many differences? And – most importantly – do these differences constitute a violation of EU fundamental freedoms?
The EU treaty freedoms that need to be considered here are the freedom of establishment and the free movement of capital.
The freedom of establishment applies to cases where the shareholder would be able to exercise a significant influence over the entity, while the free movement of capital applies to cases where the shareholder acquired the shares for the sole purpose of making a financial investment without participating in the decision-making process of the entity.
The aim of CFC rules is to discourage the use of entities located in low-tax jurisdictions to defer or possibly reduce the payment of taxes (by re-directing income of a low-taxed controlled subsidiary to its shareholder).
As such, there is little doubt that CFC rules, which entail a disadvantageous treatment of resident shareholders having a significant influence over a company subject to a lower level of taxation in another country, constitutes a restriction on the freedom of establishment (when that company is based on an EU country at least).
However, it has been widely understood (see ECJ case-law C-364/01; C-212/97; C-167/01; C-196/04), that a restriction on the fundamental freedoms is permissible if:
- It is justified by overriding reasons of public interest;
- It is appropriate to ensuring the attainment of the objective pursued; and
- It does not go beyond what is necessary to attain the object (proportionality).
Regarding point 1):
- Although the ECJ pointed out that the mere fact that an entity in another EU State is subject to a lower taxation should not be understood as general presumption of tax evasion, meaning that any measure that acts on that premises – such as CFC – must only be justified if it specifically relates to wholly artificial arrangements (otherwise it will constitute a violation of freedom of establishment);
- It follows that, for a restriction on the freedom of establishment to be justified on the ground of prevention of tax avoidance, the specific objective of such a restriction must be to prevent conduct involving the creation of wholly artificial arrangements that do not reflect economic reality, with a view to escaping the tax normally due on the profits generated by activities carried out on national territory.
- Meaning that in order to assess whether or not the taxpayer’s conduct in a particular case amounts to a wholly artificial arrangement, regard has to be had to the objective pursued by the freedom of establishment, i.e. the actual pursuit of an economic activity.
Regarding point 2):
- The ECJ held that the CFC legislation is suitable to achieve the objective for which it was adopted insofar it makes possible to thwart practices that have no purpose other than to escape the tax normally due on the profits generated by activities carried on in national territory.
Regarding point 3):
- The ECJ emphasized that the CFC legislation must ensure that the CFC rules are not applied if the incorporation of a CFC reflects economic reality.
- In determining whether or not such an economic reality exists, objective circumstances must also be taken into account in addition to the subjective element consisting in the intention to obtain a tax advantage. These objective factors, which should be ascertainable by third parties, are, in particular, the extent to which the CFC physically exists in terms of premises, staff and equipment.
- In conclusion, the CFC rules are proportionate if they allow the taxpayer to produce evidence that the CFC is actually established and that its activities are genuine in the assessment in respect of which the objective factors referred to previously must be taken into account.
Based on the aforementioned, it seems clear that CFC provisions will only be considered to be aligned with EU freedom of establishment if:
- There is a sound base to conclude that it was established with the purpose of artificially escaping domestic tax liability* (restriction of freedom of establishment based of protection of public interest);
* It is important to note that within the territory of EU, taking advantage of a more favourable tax regime is not considered to be sufficient to constitute abuse (See ECJ’s case-law C-196/04; C-167/05). As such, a mere lower level of taxation should not be enough to presume abuse. The emphasis must, instead, be in the artificiality of such structure.
- There is a sound base to conclude that it does not have sufficient proxies of substance, such as premises, equipment and staff* (restriction of freedom of establishment based on attainment of the objective pursued);
* It is important to note that exclusive focus on a lack of physical presence of the CFC may result in false conclusion that CFC is a wholly artificial arrangement. Care must be taken to reconcile the substance of the entity with the type of business the entity operates, especially in the cases when substantial physical presence is not required, such as in the case of holding or financing structures, or many digital markets operating today.
As such, it seems that although having a CFC regime (at least when applied at individuals – as opposed to corporations) is not in direct violation of EU fundamental freedoms, there are grounds to sustain that the current unharmonized minefield of different requirements and carve-outs (in a manner that makes owning foreign companies in some countries more CFC risky than in others) is, indeed, in violation of EU fundamental freedoms.
Luís Castilho
May 2023