Requiem for the controlled foreign companies – The European Anti-Tax Avoidance Directive, Part 1
In the following, we are going to discuss the international provisions applicable to controlled foreign companies, in particular the so-called ATAD (Anti-Tax Avoidance Directive), which is about: laying down rules against tax avoidance practices that directly affect the functioning of the internal market. The other, similarly friendly word is EBITDA, which stands for earnings before interest, tax, depreciation, and amortization. In connection with the latter, the more important elements will be highlighted in Part 2 of our article.
When we hear the term controlled foreign company, the term tax avoidance comes to mind almost immediately. The word “requiem” in the title is intended to indicate that previous, classic tax avoidance practices are increasingly being repressed and regulated. According to one of the objectives of ATAD it is necessary to lay down rules against the erosion of tax bases in the internal market and the shifting of profits out of the internal market.
Rules in the following areas are necessary in order to contribute to achieving that objective:
- limitations to the deductibility of interest,
- exit taxation,
- a general anti-abuse rule,
- controlled foreign company rules and rules to tackle hybrid mismatches.
Thus, the rules should not only aim to counter tax avoidance practices but also avoid creating other obstacles to the market, such as double taxation.
What exactly are the provisions for?
Controlled foreign company (CFC) rules have the effect of re-attributing the income of a low-taxed controlled subsidiary to its parent company. Then, the parent company becomes taxable on this attributed income in the State where it is resident for tax purposes. Accordingly, it is necessary that the CFC rules extend to the profits of permanent establishments where those profits are not subject to tax or are tax exempt in the Member State of the taxpayer.
According to ATAD, it should be acceptable that, in transposing CFC rules into their national law, Member States use white, grey or blacklists of third countries, which are compiled on the basis of certain criteria set out in this Directive and may include the corporate tax rate level or use whitelists of Member States compiled on that basis.
Controlled foreign company rule
The Member State of a taxpayer shall treat an entity, or a permanent establishment of which the profits are not subject to tax or are exempt from tax in that Member State, as a controlled foreign company where the following conditions are met:
- the taxpayer by itself, or together with its associated enterprises holds a direct or indirect participation of more than 50 percent of the voting rights,
- or owns directly or indirectly more than 50 percent of capital
- or is entitled to receive more than 50 percent of the profits of that entity; and
- the actual corporate tax paid on its profits by the entity or permanent establishment is lower than the difference between the tax payable in the Member State of the taxpayer and that actually paid (foreign).
Let us stop here for a moment, because the last condition sounds complicated, even though it is defined simpler than it is in the directive. If the entity, or a permanent establishment had to pay HUF 1 million in corporate tax abroad, but HUF 5 million at home (in Hungary), we would simply deduct HUF 1 million from HUF 5 million, which is HUF 4 million. We can see that the company paid HUF 4 million less corporate tax at home for tax avoidance purposes. In what follows, we examine how unpaid corporate tax relates to the amount of corporate tax paid abroad. It is clear that the tax paid by HUF 1 million is much less than the HUF 4 million, so if the conditions in point 1 are met, we are talking about a controlled foreign company.
What if an entity or permanent establishment is treated as a controlled foreign company? In this case the Member State of the taxpayer shall include in the tax base:
- the non-distributed income of the entity or the income of the permanent establishment which is derived from the following categories:
- interest or any other income generated by financial assets;
- royalties or any other income generated from intellectual property;
- dividends and income from the disposal of shares;
- income from financial leasing;
- income from insurance, banking, and other financial activities;
- the non-distributed income of the entity or permanent establishment arising from non-genuine arrangements which have been put in place for the essential purpose of obtaining a tax advantage.
It is important to emphasize, that an entity, or a permanent establishment does not qualify as a controlled foreign company in the tax year in which it has income only from a real legal transaction (not for tax avoidance purpose), a series of real legal transactions, which is also certified by the taxpayer. A legal transaction or series of legal transactions is not real if, for example, it is carried out primarily for the purpose of obtaining a tax advantage.
Why is a real legal transaction important?
First of all, it will be clear, that we do not try to use the institution of tax evasion in this way, so we do not risk obtaining this fundamentally negative rating.
If the Hungarian taxpayer receives the dividend from a foreign person who qualifies as a controlled foreign company, he may not reduce his earnings before taxes.
However, the Hungarian Corporate Tax Act allows an exception, according to which the earnings before taxes (EBT) are reduced by the income recognized as a result of dividends and shares received from the controlled foreign company in the tax year. This is possible to the extent previously taken into account as an increase and not yet deducted.