CFC rules and the problem of the current proposal

Let’s imagine that a Slovak tax resident FO (“FO“) has a joint-venture company in the Czech Republic (“Company 1“) with a Czech partner. Firm 1 is just a holding company without a permanent office and employees (objectively, there is no reason for it to have an office and employees). This company has invested in a company outside the EU (e.g. USA or Israel) (‘Company 2‘). Firm 2 carries out R&D on the basis of which it is subject to a preferential tax regime in its jurisdiction (here the equivalent of section 30c or 13a of the Income Tax Act). Firm 2 makes a profit of EUR 1,000 in 2021, but taxes it at a rate of only 5% (because of the R&D tax incentives that we also have in Slovakia). The net profit is thus EUR 950. Of this profit, 50% = 475 EUR is attributable to the FO .

This net profit will be paid to the Company in 2022 1. Assume that the dividend payment from Firm 2 to Firm 1 is not subject to dividend tax at the level of Firm 2’s country and the Czech Republic (for example, because of the corporate dividend tax exemption).

The FO has to file a tax return in 2022, where he pays “CFC tax 1” of (25% of €475) – €25 = €93.75.

Despite the fact that Firm 1 does not pay dividends because it sets off the profit against past losses or reinvests it or decides not to pay them for some other reason, the FO must file a tax return in 2023 where it will pay “CFC tax 2” also for Firm 1 – the Czech company (as it is an “empty” holding company). The amount of this “CFC tax 2” is 25% of €475 = €118.75.

The total tax liability of the FO is thus EUR 93.75 (“CFC tax 1”) + EUR 118.75 (“CFC tax 2”) = EUR 212.5.

And note that no profits need to be paid to the FO. And that’s more about 44% of the profit share actually produced in the group (but not paid up to the FO).

The CFC rules are completely inconsistent with the concept of income taxation in the first place (and quite possibly with constitutional principles as well). Indeed, the CFC rules do not aspire to tax income, but rather function as a kind of wealth tax. The FO in the above example has no income and yet taxes some sort of deemed income. But what if the FO therefore does not have the funds in the account to pay such a tax liability? In principle, he has three options:

• failure to declare income = criminal offence
• declares income but fails to pay = tax execution
• borrows

The second problem is the amount of the tariff. 25% is a lot, even given the example above. Even if the dividend is distributed in full to the shareholders as soon as possible, e.g. for a direct shareholding in a non-EU/EEA production company, the real rate would remain 25% and not 7%. This is in stark contrast to the stated aim of the law to tax unpaid dividends on artificial profits declared in tax havens.

I therefore propose to retain the 7% and to extend the exemption under § 51h para. 3, lit. (c) to all jurisdictions with which we have a double tax treaty.

The third problem is the taxation of indirect shareholdings and holding companies. This is because here the same profit is taxed several times in succession as it is paid out through the different levels in the ownership structure.

I therefore propose, for example, the non-application of the CFC tax to holding companies and the possibility of offsetting the dividend tax on indirect business holdings against the CFC tax paid by the subsidiary of the holding company (today’s legislation does not allow this in section 51i(3)) so as to exclude multiple taxation of the same profit.

The fourth problem is the definition of “substance.” The proposal says in § 51h par. 3, para. (c) “…the economic activity actually carried on in the State for which it has personnel, facilities, tangible property, and intangible property.” Based on this definition, it appears that all 4 conditions must be met cumulatively. This is not feasible in critical cases.

In practice, the possibilities for the FO to prove that the above conditions are met are doubtful, as the foreign company is not governed by Slovak law. Moreover, neither the law nor the tax administration specifies in what specific way the fulfilment of the conditions is to be demonstrated.

I therefore propose to specify this condition while not requiring all 4 of the above conditions to be met.

The fifth problem I see in the too low proportion (10%), as defined in § 51h par. 2, lit. c). Such a “shareholding” (i) impinges on legitimate private fund structures, (ii) increases the risk of being “forgotten” (since 10% is enough to be held with dependents, which the taxpayer may not really notice; at the same time, the definition of a dependent is very broad and extremely incomprehensible not only to non-experts – Section 2(n) of the Income Tax Act); and (iii) it is inconsistent with other “shareholdings” that the Income Tax Act is already familiar with – creating a disjointed environment with different rules.

I therefore propose a 50% share as is already the case with the CFC rules for corporations (section 17h).