CFC rules from 2022 – how they work and what errors they show

In 2020, the Income Tax Act was amended to include provisions introducing rules for the inclusion of income from controlled foreign companies to individuals (so-called. CFC rules). Účinnosť týchto pravidiel bola posunutá z 1.1.2021 na 1.1.2022. Podstatou týchto pravidiel je taxation of Slovak tax residents, natural persons, from the profits made by their foreign shell companies and companies based in the so-called. non-cooperative states.

We can thus say that the CFC rules pursue a legitimate objective and that is to limit artificial foreign structures, the purpose of which is to evade the payment of taxes in Slovakia. However, as we will show below, it is questionable whether the CFC rules really pursue only this objective and whether it would not be appropriate to modify them to pursue this objective more specifically.

One of the stated reasons why the CFC rules were postponed to 2022 was that they were not ready to be put into practice. Part of this problem was, and to a large extent still is, a number of terminological ambiguities and illogicalities embedded in the rules. Moreover, the concept of the CFC rules contradicts the basic philosophical principles of taxation and constitutional principles. Thus, in this article, I will try to name several problems we have encountered in the application of these rules in practice.

For the purpose of grasping the various points of concern, let us imagine a situation where:

• A Slovak tax resident (“FO”) has a joint venture company in the Czech Republic (“HoldCo”) which he has set up with his Czech partner, and he and his Czech partner share 50-50 in the profits and share capital of HoldCo;
• HoldCo is a holding company that invested capital in a start-up in the Czech Republic (“Startup”) for which it received a 25% equity and profit interest;
• HoldCo is just a holding company with no permanent office and no employees (objectively it doesn’t need them);
• The startup will report a profit of EUR 1,000,000 in 2021 and distribute dividends; HoldCo will thus receive dividends of EUR 250,000 in 2022;
• HoldCo has no other expenses, so the EUR 250,000 dividend from Startup represents its bottom line;
• As such dividend income is not subject to income tax in the Czech Republic (as it would be in Slovakia), HoldCo does not pay any income tax on the EUR 250,000 profit.

(“Example“)

If you want to know more about the CFC rules, watch a training session with Peter Varga or arrange a consultation with him

Do the CFC rules apply to this Example?

Yeah.

FO must pay 25% “CFC tax” in 2023 tax return for 2022. The FO will thus pay EUR 31 250 to the State. If the FO subsequently pays a dividend from HoldCo to Slovakia, it will also pay 15% dividend tax in the Czech Republic in the amount of EUR 18,750. The total tax liability of the FO is thus EUR 50 000. If they set up the joint venture with a Czech partner in Slovakia, the FO’s total tax liability would be EUR 8 750.

Taxation of property

The CFC rules do not aspire to tax income, but rather function as a quasi-tax on wealth. The FO has not earned any income in the “Example”, but nevertheless taxes a sort of deemed income in the form of its HoldCo’s profits.

The concept of the CFC rules as thus set up is contrary to the basic principles of taxation and it would be appropriate for it to be subjected to a constitutional legal excursus.

In connection with the taxation of some presumed income of the FO, the question arises what if the FO does not have the funds in the account to pay such tax liability? Indeed, the CFC rules tax the FO in situations where the FO does not have such income and it is not even certain whether it will ever receive it (i.e. the absence of the so-called ability to pay).

In principle, it has three options:

• Failure to acknowledge income = criminal offence;
• Admits income but fails to pay tax = tax execution;
• It will borrow the money to pay the tax liability.

An obvious problem with the above example is that the CFC rules also penalise controlled foreign companies (such as HoldCo) which, if they were tax resident in Slovakia, would not tax the gain anyway.

Principled injustice

Let us imagine a situation where a taxpayer, an individual with unlimited tax liability in Slovakia, has a company controlled abroad by a company from a non-cooperative country and the company achieves the following results:

Accounting period	Economic result	CFC tax
2022	– EUR 150 000	0 EUR
2023	+ 120 000 EUR	EUR 42 000

Amount of rates

The 25% tax rate is also disproportionately high in light of the above Example. The stated intention of the CFC rules was to force individuals, Slovak tax residents, to pay themselves dividends from their foreign companies.

35% tax rate for the so-called. non-cooperative states can be understood. However, the set of so-called. The set of non-cooperative states is broad and so even a standard and traditional company located in such a country would be liable to pay a 35% “CFC tax” for FOs . Moreover, such a universal application of the 35% tax rate appears to be contrary to the free movement of capital as defined by the case law of the CJEU.

What is substance?

For companies from the so-called. cooperating countries (e.g. HoldCo) can be exempted from the CFC rules if the company in question has personnel, premises, tangible assets and intangible assets. Thus, the company must have so-called substance.

I specifically address the topic of “substance” in my training on the tax exemption for the sale of shares in Slovakia. A certain discourse has emerged in the professional community on this topic, which helps to create substance for this institute. In the case of the CFC rules, I have not yet seen such a discussion, and so more exposure to arbitrariness on this topic by the tax administrator.

A 10% shareholding in a foreign company is sufficient for the CFC rules to apply

In our fund practice, we have established a number of smaller investment funds within the Highgate Group, where often some investors will take a stake in the fund in excess of 10%. Fund investing is passive investing and it does not entirely make sense for it to be subject to CFC rules which are designed to penalise active taxpayers moving profits offshore (or not remitting profits to Slovakia as the Explanatory Memorandum says).

Under the CFC rules, up to a 50% threshold applies to foreign companies . Therefore, this 10% threshold seems to me to be unreasonably low, which may also mean that in practice the taxpayer may not even be aware that the CFC rules apply to him. This is also what the OECD report recommends. And even if the threshold should fall below 50%, it should only be for aggregated dependants’ shares.

How about tax transparent companies?

In tax-transparent companies, the profits of such companies are not taxed at their level, but this profit or tax base is shifted to the individual shareholders, who tax it. Is a tax transparent company capable of triggering an individual’s liability to CFC tax? Unfortunately, the law does not give us a clear answer to this.

What about trusts or mutual funds and other atypical entities?

For the CFC rules, the Act refers to the term “taxpayer“, which has a clear definition in the Act. Thus, can entities, pools of assets or various forms of legally transparent companies not be considered as a taxpayer for the purposes of the CFC Rules?

The effective tax rate is below 10%

One of the prerequisites for the application of the CFC rules is that the foreign company in question taxes at an effective rate lower than 10%. However, by comparing the profit or loss(it is not clear whether net or gross) with the tax paid, this condition does not take into account, for example, the various tax-advantaged schemes (in our case, for example, the Patent Box or the Super Deduction) or the application of accumulated tax losses. In such a case, even the country with the highest corporate tax rate may simply fall into the “tax haven” regime.

Given the limitations of this paper, it is not possible to grasp the entire issue of CFC rules in this one place. If you would like more information, please see training with Peter Varga or you can book a consultation with him.

Sources:

1. OECD (2015), Designing Effective Controlled Foreign Company Rules, Action 3 – 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris. http://dx.doi.org/10.1787/9789264241152-en , dostupné k 12.11.2021 na https://www.oecd.org/publications/designing-effective-controlled-foreign-company-rules-action-3-2015-final-report-9789264241152-en.htm

If you are interested in this topic, please do not hesitate to contact us.