CFC rules, permanent establishments and taxation
Many entrepreneurs are registering their companies in jurisdictions like Estonia to minimize hassle and bureaucracy. There are also plenty of entrepreneurs looking to lower their tax burden, therefore choosing Estonia as their base of business. This makes perfect sense, especially in today’s environment where the ever-growing state and budget deficit is reflected in the continuous tax increases. On the other hand, some of the people are still thinking about registering a company in so-called offshore jurisdictions or tax havens. What we have seen is that most of the people in each of these categories haven’t considered the tax implications and CFC & PE rules. This can lead to some serious tax consequences. There’s a lot of material about the CFC rules and how international taxation works, but these resources are often written in a very complex manner. Before we go into explaining how the CFC rules work, I would like to note that this blog post does not constitute as legal advice, and your situation should be analyzed taking into account your country of residence, the location of your company and the nature of your business.
What does CFC mean?
CFC stands for a controlled foreign company. Countries have implemented anti-tax avoidance measures like CFC rules to prevent individuals and businesses from minimizing their domestic tax liabilities by taking advantage of low tax jurisdictions. The idea is to prevent people from setting up companies to offshore tax havens just to avoid taxes in their home countries.
Example 1: If I’m an Estonian citizen and if I had a company in Seychelles, this Seychellois company would be considered a controlled foreign company (CFC) in Estonia.
Example 2: If a company A in Finland owns another company B in Belize, this company B in Belize would be considered a controlled foreign company (CFC) in Finland.
CFC rules
CFC rules can be very complex, but in general, they follow the same basic structure. If the first two rules 1 & 2 both apply, then the company is a CFC. The third rule determines which type of income is then taxed domestically.
- Is a foreign company controlled?
- Taxation condition: minimum tax rate, income test and other conditions.
- Type of income taxable: All income or just passive income (interest, dividends, rental income, royalty income).
First, a control threshold is applied to determine if a company is considered a controlled foreign company or not. For example, most European countries consider a foreign company a CFC if one or more related domestic individuals/companies own at least 25 % — 50 % (depending on the country) of the company. The rules can also include that besides ownership the related individuals/companies own more than 25 % — 50 % of the voting rights of the company or are entitled to more than 25 % — 50 % of the profits of the company. In this case, the foreign company is a CFC.
Second, most European countries have a rule which stipulates that if the foreign company pays taxes in its home jurisdiction below a certain tax rate and/or receives a certain share of passive income, then it should be considered as CFC. For example, in Finland, the minimum tax rate rule is 3/5 (12%) of what the company would be taxed in Finland (20%).
If both rules 1 & 2 apply, then the foreign company is considered a CFC and its income are taxable domestically. The third rule means that your residency country defines what type of income earned by the foreign company is taxed domestically. Some European countries tax only CFC’s passive income while others tax all income of the CFC.
Example 1: Individual in Finland owns 100% of a company in Belize.
Rule 1: Individual living in Finland owns more than 25% (threshold in Finland) of the company à CFC applies.
Rule 2: Belize company pays 0% tax in Belize which is lower than 3/5 (12%), of the standard company rate in Finland (20%) à CFC applies.
Rule 3: All income is taxed domestically (in Finland) if a company is considered a CFC.
Both rules 1 & 2 apply, meaning the company would be considered a CFC and based on rule 3 all income of the CFC would be taxed in Finland. What does this mean? This means that the individual in Finland who owns the company in Belize would be personally taxed in Finland based on the profit of the Belize company, even if he didn’t receive any dividends or other income from the company in Belize. That’s a pretty bad result for a tax optimization.
Important addition is that EU / EEA (European Economic Area) subsidiaries of another EU / EEA company carrying out a genuine economic activity may be exempted from CFC rules. In addition to Europe, the US, Canada, Australia and many other countries have implemented very strict CFC rules as well. It’s worthwhile mentioning that Switzerland has not enacted CFC rules. There are also some exceptions based on certain economic activities and some countries use blacklists and whitelists to determine whether CFC rules apply to a company located in a particular jurisdiction doing a certain economic activity.
Example 2: Company A in Finland owns 100% of an Estonian company — Estonian company is genuinely doing business and carrying its activities in Estonia.
Because of the EU/EEU subsidiary exception, and because Estonian company is genuinely carrying business in Estonia, the Estonian company is not considered a CFC in Finland.
What is a permanent establishment?
The term “permanent establishment” is usually defined in double taxation tax treaties. Permanent establishment means a fixed place of business, through which the business of a company is wholly or partly carried out.
For example, if a person living in Germany sets up a business in Estonia and manages that business by himself from Germany, the German tax authorities might say that the Estonian company has a permanent establishment in Germany based on the location of the management — and thus the German permanent establishment should be taxed in Germany instead of Estonia, while the Estonian permanent establishment would be taxed in Estonia. OECD has released guidance on how the profits should be attributed to a permanent establishment. In general, the profits to be attributed to a PE are those that the PE would have derived if it were a separate and independent company performing the activities that cause it to be a PE.
All in all, which companies in which jurisdictions qualify as a CFC is individual to each country. Permanent establishment matters may also affect your situation. In general, in terms of all-around tax optimization, the best solutions are usually possible in situations where not just the assets — but the owner as well is able relocate. If you have any doubts about CFC rules or permanent establishment matters, contact us at info@comistar.com.
