The new Swedish CFC legislation and the CFC legislations in other European jurisdictions

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1 The new Swedish CFC legislation and the CFC legislations in other European s By Lars Jonsson and Ann Ziefvert As a part of the recently introduced Swedish holding regime, new Swedish CFC legislation came into force on 1 January 2004, to apply to fiscal years starting after 31 December Some of the European s that at present have CFC legislation are Denmark, Finland, France, Germany, Italy, Norway, Spain and the UK. A comparison between the CFC legislations in Sweden and the other European s mentioned, shows that the rules in the different s are similarly structured, involving prerequisites such as definitions of low-tax s and using certain minimum participation thresholds for the holder of an interest in the foreign entity. The purpose of this article is to briefly summarise the new Swedish CFC legislation as well as compare the current CFC legislations in Sweden and some of the other European s mentioned, focusing on the following six features: definition of low tax targeted entities participation threshold triggering CFC legislation taxable base rules to avoid compatibility with tax treaty law and EC law The article is based on information provided in the end of 2003 by the Linklaters offices in the Europeans s mentioned, save for Norway where the Norwedian law firm Wiersholm has been helping us. The CFC legislation in Sweden and the European s mentioned are summarised in a table, please see Appendix 1. 1 Definition of low tax According to the new Swedish rules, as a main principle, a foreign state is considered a low-tax, if the income of the foreign entity in question is subject to an effective corporate tax rate of less than 15.4 %. Furthermore, there is a white list of states that are not considered as low tax s, subject to exceptions for income derived from certain businesses etc. The technique of defining a low tax by deciding a lowest acceptable level of taxation of the income of the foreign entity is similar in Sweden and most European s except for Italy, although the lowest acceptable level of taxation differs. In Italy, a low tax is solely defined with reference to a general black-list of low tax s, subject to exceptions for income derived from certain businesses etc. However, in addition to definitions which refer to a certain level of taxation, Germany, Sweden, Spain and the UK also have a black list or a white list. In Denmark, a foreign entity is also subject to CFC taxation if the entity is taxed according to a specific tax

2 agreement with the particular foreign tax authorities regarding the tax base or the actual tax rate. In the UK, the CFC rules also target designer tax rates, where a foreign entity is able to exercise significant control over the tax that it pays in a local territory. 2 Targeted entities Directly and indirectly held or controlled non-resident entities and indirectly held permanent establishments resident in low tax s can be subject to CFC taxation under the new Swedish rules. As regards targeted entities, the definition is similar in Sweden and most of the European s. However, permanent establishments are not always covered. 3 Participation threshold The participation threshold under the new Swedish rules is 25 % of the capital or the voting rights in the foreign entity. The participation threshold varies quite a lot in the other s. The Danish, Swedish and UK participation threshold is similar 25 % of the capital. In Denmark, 50 % of the votes also trigger CFC taxation. In Finland and in France (principally, but subject to certain grand fathering rules), the participation threshold is relatively low; only a 10 % interest (or a cost price of EUR 22,8 million or more in France). In Germany and Spain, the participation threshold is the highest 50 % of the capital or the votes in Germany and 50 % of the share capital, equity, profits or votes in Spain. It should, however, be noted that the participation threshold in Germany is extremely low, only 1 % or less of the capital or the votes, if the foreign entity exclusively receives passive portfolio income (interest etc.). If the foreign company receives passive income inter alia, the participation threshold is 1 %. In Italy, the participation threshold follows the civil definition of control of an entity, i.e typically more than 50 %. However, in some s the triggering of CFC taxation is not only dependent upon the participation threshold of the person (and closely related persons) that may be taxed for the income of the foreign entity. In Finland and in the UK, CFC taxation can only be triggered if the foreign entity is controlled by shareholders resident in the in question. This additional test can thus be used to pool foreign investment. Sweden used to have such an additional test as well, but it has been abolished with the adoption of the new rules. In Norway, the triggering of CFC taxation is dependent upon how much of the share capital is held by Norwegian residents (normally 50 %). 4 In Sweden, the pro rata income of the foreign entity constitutes the taxable income. The principles for determining the taxable base are similar in Sweden, Finland, France, Italy and the UK. In these s the pro rata income in the foreign entity constitutes the taxable base. However, in the UK capital gains are excluded. In Sweden, tax exempt capital gains are excluded. In Italy, income from industrial or commercial activities can escape CFC taxation. In Denmark, Germany and Spain only certain income, typically defined as passive income, is included in the taxable base. In Denmark for example, the passive income includes inter 2

3 alia interest, capital gains on certain assets, dividends and royalties. In Spain, no CFC taxation is triggered if the passive income is less than 15 % of the total income or 4 % of the total revenue obtained by the non-spanish resident entity or its group. In Denmark, no CFC taxation is triggered if the passive income is 1/3 or less of the income of the foreign entity. In Germany, if the passive portfolio income does not comprise more than 10 % of the total income and does not amount to more than EUR 62,000, no CFC taxation is triggered. In the UK, CFC taxation could be avoided if the foreign entity makes an acceptable distribution, carries out exempt activities or if shares in the foreign company are listed and publicly held. 5 The Swedish shareholder subject to CFC taxation is granted a tax credit for taxes paid by the CFC and dividends received by the controlling shareholder from the CFC are tax exempt to the extent they have been taxed under the CFC rules. However, no credit is allowed for third country tax costs incurred on principally the same income in the hands of the CFC. In all the other s, there are rules granting some kind of tax credit for the foreign state taxes paid by the CFC. 6 Compatibility with tax treaty law and EC law There have been discussions in some of the European s whether the CFC legislation is compatible with tax treaty law or not. In Sweden it has been questioned whether it is compatible with tax treaty law that business income from a CFC resident in a tax treaty (A) is taxed in other tax treaty state (B), when the tax treaty between A and B only allows A to tax such income of B if B has a permanent establishment in A. According to the preparatory works of the new Swedish CFC rules, taxation of the income of the CFC in the state where the controlling shareholder is resident, is not incompatible with tax treaty law. In France, according to a judgement from the Conseil d État from 2002, the tax treaty law overrides the domestic CFC legislation. As a consequence, the tax authority is unable to apply CFC rules if the tax treaty does not especially provide for their application. So far this question has not come before a Swedish court, but it would be of considerable interest to have such a case tried. There have also been discussions about whether CFC legislation may conflict with EC law, especially the freedom of establishment and the free movement of capital principles. The freedom of establishment principle includes the right for a resident of one member state to establish a business in another member state by holding an interest in an entity in that other member state. A member state must, therefore, not prevent its residents from establishing in other member states through subsidiaries. It could be argued that the CFC legislation could make it less favourable to hold shares in an entity resident in such other member state and therefore violates EC law, since it could result in the shareholder being taxed on income that has not yet been realised by the shareholder, or tax basis being calculated in a less favourable manner causing disadvantages from liquidity perspectives etc. Thus, the CFC legislation could conflict with the freedom of establishment principle, unless any of the conditions for restricting the freedom of establishment that are allowed under EC law are fulfilled. The free movement of capital principal implies a right for a resident of one member state to make investments in other member states. Similar arguments could be made regarding the freedom of establishment to support the view that CFC legislation makes it less favourable 3

4 to invest in other member states than to invest in the state of residence and thus conflicts with the free movement of capital. In addition, potential double and triple tax effects should be considered. So far, no case regarding the compatibility of CFC legislation with EC law has been brought to the European Court of Justice s attention. This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other issues of law, please contact one of your regular contacts at Linklaters, or contact the editor. Linklaters. All Rights reserved 2004 Please refer to for important information on the regulatory position of the firm. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com 4

5 Appendix: CFC legislation in Europe Definition of low-tax Denmark There is no longer a definition of a "low tax " in Danish CFC tax law. However, when the tax payable by the entity under the foreign tax rules applicable to the entity is less than 3/4 of the amount payable if the taxable income was calculated under Danish tax rules and more than 1/3 of the income is characterised as "CFC income" the entity is subject to Danish CFC tax rules. Further, an entity is automatically covered by Danish CFC rules if the entity is taxed according to a specific tax agreement with the Directly and indirectly held entities resident in a low tax. Permanent establishments are not specifically governed by the Danish CFC rules. 25% of the share capital of the entity or more than 50% of the votes. Associated companies are considered as one shareholder when determining whether the CFC "control" criteria is met. Closely related physical persons as well as trustee companies, etc. are considered as one shareholder when determining whether the CFC "control" criteria is met. Pro rata CFC income. CFC income is specifically defined in the Danish corporate tax act and includes: interest; capital gains on claims, debt and financial contracts; commission from granting of loans, guarantees, etc. dividends and taxable gains on shares; royalty income from granted use of intangible assets such as copyrights, patents trademarks, etc. and capital gains on sale of such assets; financial leasing income; and The Danish company subject to CFC taxation will be granted a tax credit for all taxes payable by the CFC according to specific rules. Credit is normally allowed for third country tax costs incurred on the same CFC income. It is uncertain whether there is treaty protection on indirect holdings. 5

6 foreign tax authorities regarding tax rate or tax base. The applicability of Danish CFC tax rules to the foreign entity is made on a year-byyear basis. income from insurance, banking, mortgage credit and other financial activities. Finland Actual income tax burden of the non-resident entity is lower than 3/5 of the Finnish corporate tax rate (29 %), i.e. 17.4% An entity in a tax treaty country does not fall into the scope of the CFC regime if the tax burden under the general corporate tax system of its resident state is comparable to the Finnish corporate tax burden (should not be less than Any directly or indirectly held entity resident in a low tax, which is treated as separately taxable corporate body for Finnish tax purposes and that is not engaged in industrial or comparable production, shipping, sales and marketing, or companies of the same group provi- A 10% interest in a nonresident entity, if the nonresident entity is controlled by Finnish residents, i.e. 50% of the capital, voting rights or 50% share of the return of capital of the nonresident entity is controlled by one or more Finnish residents. Pro rata income in CFC, determined in accordance with Finnish tax rules. Losses may be offset only against income from the same CFC. Tax credit for the taxes paid in the state level, and for municipal or other local taxes only if so provided in a tax treaty. Dividends from the CFC are tax exempt to the extent taxed as CFC income if received during the same year or the five following years. If a CFC owns another CFC entity, chain taxation is prevented by excluding dividends received from another CFC entity in the profits of the parent CFC. 6

7 be less than 75% of the Finnish corporate tax), and no special tax regime is applicable. ded that the other group company reside in the same state and is engaged in business defined in the first three paragraphs France In general, an effective corporate tax of less than 2/3 of the French corporate tax. Directly and indirectly held entities and permanent establishments resident in a low tax. 10% holding or a cost price of EUR 22.8 million or more (if the structure is created or modified as of 30 September 1992) 25% holding (if the structure is created before 30 September 1992) Pro rata income in the CFC. Losses attributed to a specific CFC may only be offset against income from the same CFC. Double taxation is avoided by granting the resident company a pro rata credit for foreign underlying income tax (if similar to French tax) and withholding tax, if any, which is credited against French corporation tax paid on CFC income. If a foreign intermediary entity is subject to CFC taxation, double taxation is avoided thanks to the agreement procedure provided for in the tax treaty signed between 7

8 France and this third party country. There should be treaty protection on indirect holdings, but if the treaty does not provide specifically for application of French CFC rules, the French tax administration will not be able to apply CFC rules. Germany Subject to income tax at a rate lower than 25% in both its state of seat and its state of management. The Federal Ministry of Finance regularly publishes a list of low-tax s. Directly and indirectly held entities resident in a low tax. More than 50% of capital or voting power; 1% of capital or voting power, if the foreign company receives i.a. passive portfolio income; or 1% or less of capital or voting power, if the foreign company exclusively receives passive portfolio income. If the passive portfolio income comprises not more than 10% of the total income and does not amount to Pro rata all passive income (mainly interest and royalties) in the CFC. The taxpayer can choose between an income calculation on a cash basis or on an accruals basis. A distribution of CFC income that has already been taxed with the German shareholder under the CFC regime is tax exempt. Any foreign withholding tax levied on the CFC income will be credited against the tax liability or deducted from the CFC taxable income of the shareholder. This applies also for third country tax costs (i.e. if a foreign intermediary 8

9 more than 62,000 German CFC rules do not apply. foreign intermediary entity is also subject to CFC taxation) on the same CFC income. German CFC rules contain a broad treaty override. Therefore treaty protection is available for neither direct nor indirect holdings. Greece No CFC legislation. Ireland No CFC legislation. Italy CFC black list, subject to exceptions for income derived from certain business etc. Directly and indirectly held entities and indirectly held permanent establishments resident in a low-tax. A direct or indirect controlling (using the civil code definition of control) participation in a foreign enterprise, company or any other entity. Art. 2359, first and second indent, of the civil code: it applies where the Italian resident (directly or indirectly, even through fiduciary companies or other intermediaries) has: the majority of the Pro rata profits in the CFC, computed according to the Italian ordinary rules (accruals basis). Under the Italian system, the income of the CFC is attributed to the resident tax; payers in proportion to the participation held piercing the veil of the CFC. This method can be defined as an entity approach, but, to a certain extent the nature of the income earned by the CFC i f i t Italy grants a credit for the taxes paid in the CFC s state of residence against the tax charged under the CFC regime. Relief is also given where dividends are actually distributed by the CFC out of previously attributed income; such relief is granted in Italy by means of exemption (in proportion to the income previously taxed under CFC l ) 9

10 votes that can be exercised at the ordinary shareholders meeting of the CFC, votes sufficient to exercise a dominant influence at the ordinary meeting of the CFC, or dominant influence by virtue of particular contractual arrangements with the CFC. It is to be taken into consideration that a comprehensive tax reform is expected in Italy in 2004; the current version of the draft of the new text of ITC contains some provisions amending CFC legislation CFC is of importance, as income from industrial or commercial activities can escape attribution. Solely the income, and not the losses, of the CFC is attributed; however, CFC losses can be carried forward in the computation of the CFC income for subsequent years CFC rules). Where the CFC is indirectly controlled by a resident tax payer through a non resident intermediate subject, exemption is granted for the profits distributed by the non-resident intermediate subject directly controlled by the tax payer. The Italian tax payer can claim the tax credit for the taxes paid abroad by the non resident intermediate subject on the exempted distributed profits up to the amount of taxes paid under CFC rules. With reference to the subsequent transfer of the participation in the CFC, the Italian regime provides that the cost of the participation in the CFC is increased by the amount of attributed 10

11 income, and decreased, up to the amount of such income, by the amount of distributed profits. There is a debate among commentators on the compatibility of the CFC regime with the tax treaty law. Luxembourg No CFC legislation. Norway An effective income tax rate less than 2/3 of Norwegian tax on similar income. The Norwegian corporate tax rate is presently 28%. Directly and indirectly held or controlled entities resident in a low tax. 50% or more of shares or capital directly or indirectly held or controlled by Norwegian residents at both end and beginning of fiscal year. CFC taxation in the year before the fiscal year. More than 60% of shares or capital directly or indirectly owned or controlled by Norwegian residents at year end. CFC s taxable income calculated according to Norwegian rules of taxation will be taxed directly as if incurred by Norwegian participants, in proportion to participation at year end. Taxes paid in the CFC s are creditable against taxes levied according to the Norwegian CFC rules. Direct distributions from the CFC to Norway will be exempt from tax in Norway, if the distributions are based on profits in fiscal years in which the CFC has been taxed according to Norwegian CFC rules. Indirectly owned or controlled entities will only be taxed as CFC 11

12 at year end. Less than 40% of shares or capital directly or indirectly owned or controlled by Norwegian residents at year end will bring the entity out of the CFC regime. entities in Norway if income from the intermediate entities are not taxed directly as incurred by Norwegian participants (as CFC entities or other transparent entities for tax purposes). Taxes paid due to CFC rules in intermediate countries will at the outset not be creditable in Norway in taxes applied according to Norwegian CFC rules. Double taxation may be the result of such payment structures. Spain The effective corporate income tax should be lower than 75% of the Spanish Corporate Income Tax ( CIT ) which would have been levied on the income obtained by the non- Spanish resident entity, Directly and indirectly held entities (i.e. any type of foreign legal entity) resident in a low tax. Please note that according to pro- Spanish resident companies that solely or in conjunction with related parties hold 50% or more of a non-spanish resident entity s share capital, equity, profits or voting rights at the closing date of the latter s business year. Pro rata passive income in the CFC. As regards the passive income to which Spanish CFC rules apply, the Spanish resident company must include the passive income (i.e. no business related) obtained by the CFC from The Spanish resident company will be entitled to deduct the following tax credits up to the limit of Spanish tax liability: The underlying corporate income taxes paid on the income included in 12

13 according to Spanish CIT rules. If the non-spanish resident entity is resident in a territory classified as tax haven it is presumed that its effective corporate income tax is less than 75% of the Spanish CIT. There is a specific list of the countries that are considered to be tax havens for Spanish tax purposes. according to proposed legislation under current discussion at the Spanish Parliament, Spanish CFC rules will not apply to entities located in a member state of the EU unless such entities are resident in a territory classified as a tax haven. year. obtained by the CFC from the following sources: real estate or rights in rem or real estate, capital sourced income (i.e. from shares, securities, loans, bonds, etc.), and transfer of the goods and rights mentioned in the first two paragraphs. No inclusion is required if such passive income is ultimately derived from second or further tier foreign subsidiaries which income is at least in 85% derived from developing business activities. income included in the taxable base. The withholding tax effectively paid abroad on dividend distributions. Taxes paid in territories classified as tax havens for Spanish tax purposes will be not deductible, in any case. Finally, no CFC rules should apply if the total passive income is less than 15% of the total income or 4% of the total revenues obtained 13

14 by the CFC or its group. Other income subject to CFC legislation: The Spanish resident company must include the income obtained from credit, financial or insurance activities and from the rendering of services, except those related to export services, obtained either directly or indirectly from Spanish resident related entities, when such transactions have produced tax deductible expenses for the latter. Sweden An effective corporate tax rate of less than 15.4%. CFC white list, subject to exceptions for income derived from certain businesses etc. Directly and indirectly held or controlled entities and indirectly held permanent establishments resident in a low tax. 25% of the capital or voting rights. Pro rata low taxed income in the CFC. Solely the income, and not the losses, of the CFC is attributed; however, CFC losses can be carried forward in the computation of the CFC income for subsequent years Dividends from the CFC are tax exempt to the extent taxed under the CFC rules. The Swedish shareholder subject to CFC taxation is granted a tax credit for taxes paid by the CFC. No credit is allowed for third country tax costs incurred on the same 14

15 CFC income. According to the preparatory works, there is no treaty protection for indirect holdings. Switzerland No CFC legislation UK An effective corporate tax of less than 75% of the UK corporate tax. CFC rules also target designer rates of tax where a company is able to exercise significant control over the tax that it pays in a local territory. There is a specific list of countries that are considered to be low tax s and a further list of countries (which is revised from time to time) that are excluded from CFC legislation, in some cases subject to a Directly and indirectly held entities resident in a low tax. 25% of the undistributed profits of a non-resident company, if the non-resident company is UK controlled. A UK resident must hold more than 50% (or at least 40% in the case of certain joint ventures) of the share capital or voting rights. CFC taxation could, however, be avoided if certain requirements are met. These include making an acceptable distribution; carrying out wholesale, distributive and exempt activities (defined as financial businesses and the provision of services); satisfying a de minimis test; Pro rata income in the CFC but not capital gains (save for close CFCs) (only active income). The charge is based on CFC profits, as notionally computed for UK corporation tax. Where a UK company is charged to corporation tax on a proportion of the profits of the CFC, credit will be given for the relevant portion of any foreign tax paid by the CFC on those profits. No account is taken of any CFC charge under the legislaion of a third party country. 15

16 qualification. having publicly held quoted shares; and satisfying a motive test. 16