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ATAD Transposition Act – Part II – The new CFC rules

After the Federal Ministry of Finance (Bundesministerium der Finanzen, BMF) had initially put forward two drafts for an ‘Act to Transpose the Anti-Tax Avoidance Directive’ (Gesetz zur Umsetzung der Anti-Steuervermeidungsrichtlinie, ATADUmsG), the German government passed the ATADUmsG on 24.3.2021. A key element of the draft is the much-needed reform of the German CFC rules under Section 7 ff. of the Foreign Transactions Tax Act (Außensteuergesetz, AStG).

The principles of CFC rules

The CFC rules aim to prevent a company’s profits in a country with low taxes from evading taxation in Germany. The rules cover profits of a foreign company that is based in a low tax country and in which German resident taxpayers have a majority stake.  

For the underlying supply relationships, a distinction is made between ‘passive’ and ‘active’ operations. Only the profits generated from passive operations will be added back to a taxpayer’s taxable income and taxed in Germany. Therefore, the CFC rules break through the shielding effect of corporations abroad.

At this point, we would already like to point out that, in the course of amending the CFC rules, the reduction in the low tax threshold that had been called for by academics and practitioners did not happen. The 25% threshold still applies. From a German perspective, in global terms, a majority of states have to be classified as low tax countries accordingly in this respect. 

Change to the conditions for application

The draft legislation of 24.3.2021 – like both of the BMF’s drafts prior to it – provides for a fundamental reform of the concept of control. Under the prevailing law, the CFC rules apply if German resident taxpayers with unlimited tax liability effectively control a foreign company and it generates low-taxed passive income. From now on, however, there will no longer be a requirement for one – potentially purely random – situation where German resident taxpayers have control but, instead, actual control in the sense of coordinated use by related parties. The aim is for shareholders who are German resident taxpayers with unlimited tax liability to no longer be ‘part of the calculation’. As a result, on the one hand, some constellations will no longer be covered by the CFC rules and, on the other hand, existing structures will now fall under the rules for the first time. To determine whether or not a German resident taxpayer with unlimited tax liability controls a foreign corporation, now, the indirect shares held by him/her will also have to be taken into account.

Please note: It should also be taken into account that the draft legislation provides for ‘direct access’ to ‘downstream’ intermediary companies. As a consequence, the concept of ‘transferring add-backs’ in accordance with Section 14 AStG, will fully cease to apply.

Income from intermediary companies

In terms of harmful ‘passive’ income, Section 8(1) AStG currently includes a ‘catalogue of active income’ that is explicitly deemed not to be ‘detrimental’. While the ATAD provisions for ‘harmful’ income provide for a so-called ‘catalogue of passive income’, nevertheless, the draft legislation of 24.3.2021 has also retained its ‘catalogue of active income’. In this respect, there has been a modest number of specific changes. The plans for the tightening of requirements with respect to activities in the areas of trading and services and those of financial institutions – which were contained in the first draft bill of 10.12.2019 and had already partially disappeared in the second draft bill of 24.3.2020 – have now not been carried over into the governmental draft either.

Receiving profit distributions will continue to be generally considered as active income. However, this is the correlating preferential treatment for the system established under Section 8b of the Corporation Tax Act [Körperschaftsteuergesetz, KStG]; consequently, the exceptions relating to the correspondence principle for holdings in shares that are freely traded and for shareholdings in a trading portfolio will now also be established in the CFC rules. 

In this respect, the BMF’s first draft was problematic because only certain types of distributions were covered by the provision. By contrast, the second draft bill as well as the draft legislation that was recently passed now cover all the payments under Section 8b(1) KStG, as a result of which the scope of application of this rule now also includes liquidation payments and payments under Section 20(1) no. 9 of the Income Tax Act (Einkommenssteuergesetz, EStG) that, as such, are not passive.

Substance Test

When compared already with the first of the BMF’s drafts, there were no changes to the requirements of the substance test in terms of content, which is why, in the area of normal CFC rules, it is still envisaged that the use of the substance test will be restricted to EU/EEA companies. The residency of a foreign company is irrelevant solely in relation to income that is derived from investment-like capital. The reason for this is that the ATAD provisions include a corresponding option and, moreover, the new ‘control’ criteria would only affect the freedom of establishment. 

The add-back amount

When compared with the first draft, the rules on the calculation, accrual and treatment of the add-back amount have only been supplemented in one point. It has now been clarified that the add-back amount may not be reduced for trade tax purposes. Therefore, it remains the case that, when compared with the current regulations, a considerable number of the rules will also have to be applied for the first time in the area of CFC rules and it will only be possible to determine income in accordance with Section 4(1) EStG. The recognition of the add-back amount in the same reporting period is likewise still planned in the ATADUmsG.

For the treatment of actual distributions from a foreign (intermediary) company the current Section 3 no. 41 EStG will be replaced by a reformed procedure (“amount of reduction for profit distributions” in accordance with Section 11 AStG-E [draft]) that will no longer include, in particular, the seven-year deadline under Section 3 no. 41 EStG, which had been open to criticism.

Conclusion: The concept for reforming the CFC rules presented by the German government in the ATAD-UmsG is largely unconvincing. The main problem areas in relation to CFC rules will not be resolved by implementing the proposed legislation unaltered. In particular, a reduction in the low tax threshold to 15% as well as the implementation of an appropriate de minimis rule would be desirable. Moreover, consideration should be given to expanding the scope of application of the current counter-exception under Section 8(2) AStG to include third-country companies.

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