Concept and Implementation of CFC Legislation

S. 601. Introduction

The principles of corporate taxation can be regarded as the separation principle and the transparency principle. In the former, the company and the shareholder are taxed separately, i.e. the profits of the company, on the one hand, and the income of the shareholder (dividends) on the other. Thus, taxation at the level of the company takes place irrespective of whether dividends are distributed. The transparency principle, unlike the separation principle, is not predominant in the taxation of corporations but in the taxation of sole proprietorships and partnerships. It considers them as non-income taxable entities which leads to the fact that profits and losses are only calculated at the level of the company but, at the same time, assumes that they would have accrued to the shareholders. As an exception to the foregoing, however, there are also countries that apply the transparency principle to corporations. This, therefore, raises the question that I address in my thesis of whether the CFC rules nevertheless apply to those countries that treat corporations as transparent or whether this is not feasible.

As it is discussable if transparent entities and permanent establishments are covered or should be seen as covered as well as to what extent by controlled foreign corporation rules (CFC rules), this master thesis focuses on the reasons for considering or not considering CFCs as fiscally transparent entities. It will give facts about Action 3 of the Base Erosion and Profit Shifting Project by the OECD (BEPS) with a focus on transparent entities and will point out limitations of the CFC rules. Furthermore, it will address solutions through the use of the tax avoidance of these entities, e.g. Anti Tax Avoidance Directive II (ATAD II). Finally, the thesis gives some information about the country specific CFC legislations from selected jurisdictions.

2. Foreign Base Company as a CFC

2.1. OECD BEPS Action 3 and its limitations

BEPS Action 3 contains recommendations on the design of the rules for controlled foreign companies (CFCs). These rules are intended to apply to companies in which a majority stake is held in a foreign company with the aim of preventing the shifting of income to a foreign subsidiary and the associated erosion of the tax base of the country of residence. In this regard, a total of six points have been defined for possible implementation in national law for the countries. These are the definition of a CFC, CFC exemptions and threshold requirements, definition of S. 61income, computation of income, attribution of income, and prevention and elimination of double taxation.

In order that the income, after its calculation, can be attributed to the respective shareholder of a CFC, the following five process steps were created by the OECD:

The measures proposed by the OECD through the BEPS Project to coordinate the application of tax treaties to transparent companies and CFCs treat CFCs and transparent entities separately in terms of their legislation. On the one hand, BEPS Action 2 (as amended by Action 6) or its scope focuses relatively little on CFCs. On the other hand, countries' CFC regulations should cover transparent entities according to the recommendation of BEPS Action 3.

A fiscally transparent entity is when the income legally earned by an entity is fiscally attributed to the underlying member/partner, aggregated to the overall income of the latter according to his personal circumstances and the relevant tax is S. 62reduced by his personal deductions and allowances; most of all, the final tax must be determined as if the partner himself earned that income.

Transparent companies and CFC rules were basically very rarely subjected to an examination in cumulo just as, for example, the Partnership Report did not intend to address CFC rules. At the time, however, there was also little concern about their application in agreement situations, presumably in part because they were not yet as widespread. The long experience of US treaty practice and the Partnership Report almost certainly significantly influenced the work on the OECD's new rules regarding transparent entities. First, several amendments were made to the OECD Model Tax Convention in this regard and, subsequently, the Multilateral Agreement Implementing the BEPS Measures (MLI) was adopted on 24 November 2016 (signed on 7 June 2017).

In order to avoid bilateral renegotiations of each individual agreement, the MLI supplements all tax treaties that are in force. This is how agreed changes are implemented in a synchronized manner (OECD, Explanatory Statement, at 3 et seq.). If two states have decided to ratify the MLI, it will be applied to the extent of the compatibility clauses and reservations of the signing parties (restrictions are possible through reservations according to Article 28) provided that it is preceded by a concluded tax treaty.

Source taxation will be allowed for (i) passive income sourced in the same state where the CFC is incorporated (i.e. the home state of the CFC) and (ii) for passive income sourced in a country other than the home state of the CFC only (a) when the premises of the CFC constitute a permanent establishment and (b) to the extent that the item of income is attributable to that permanent establishment. In this case, the S. 63residence state has to credit the foreign taxes to the shareholders (Article 11(1)(d) of the MLI). On the other hand, no credit obligation exists on the residence state (of the shareholders) for taxes that are levied by the state where the CFC is incorporated solely because this state considers the CFC to be a separate taxable entity. This occurs either when the premises of the CFC do not constitute a permanent establishment to which the specific item of income is connected. In these cases, taxation is levied by the state of the CFC not in accordance with – i.e. under the protection of – the treaty distributive rules but on the basis of that state’s sovereign taxing power. Since treaties do not limit residence-based taxation by the state of incorporation of the CFC, the opt-out clause in Article 5(6) of the MLI allows the state of residence (of the shareholders) to refrain from its credit obligation.

As far as CFC rules are concerned, Action 3 in the BEPS Project contains a set of recommendations entirely dedicated to them. The interplay between CFC rules and transparent entities is scrutinized in Actions 2 and 3. Action 2 specifically considers that the CFC rules could be an efficient defensive measure to prevent double non-taxation arising out of situations where a deductible payment is made to an entity that is transparent in its home state but opaque in the investors’ state (deduction/non-inclusion outcome).

The same CFC inclusion effect is also considered to neutralize branch mismatch structures as the public discussion draft of 22 August 2016 suggests. This indicates that CFC rules are seen as a tool to include the (non-included) income stemming from a source that the taxpayer does not directly own, as BEPS Action 3 confirms.

2.2. Fiscally Transparent Entities and Permanent Establishments

Article 1 (2) of the OECD Model already refers to the term of a “fiscally transparent entity”:

S. 64With minimal changes, this term found its way into Article 3(1) of the MLI via BEPS Action 2 and replicates Article 1(2) of the OECD Model:

The purpose of this provision is to ensure that the source state grants treaty benefits in cases of different classification of the legal entity only if the condition is met that the income is considered by the other contracting state to be received by a resident of that state. This provision was already contained in the old Article 4 (1) (d) of the US Model (1996) as well as in the subsequent Article 1 (6) of the US Model (2006) – of course, with slight differences. With minor changes, it even found its way into many of the DTTs of the United States which is why the case law in this regard is of particular relevance for the interpretation of Article (3) (1) of the MLI.

Originally, the rule in the US Model (1996) was designed to address reverse hybrid situations that can result in double non-taxation. Reverse hybrid situations are those in which a US company is treated as taxable under the laws of the source state but is considered transparent in the United States. This is made possible, for example, by the US check-the-box system (see also section 5.3). The regulation in the US models of 2006 and 2016 as well as Article 3 (1) MLI go beyond reverse hybrid situations as they also explicitly address hybrid situations. These are cases in which US companies are considered non-transparent under US law but transparent under the law of the source state.

S. 65On Feb. 17, 2016, the United States Model Income Tax Convention, Models IBFD, replaced the US Model (2006). The minor changes that were made in comparison to the previous versions of Article 1 (6) of the US Model (2016) are

highlighted below:

Differences between Article 1(6) of the US Model (2016) and Article 1(2) of the OECD Model as implemented in Article 3(1) of the MLI, are minor as it is based on the USModel.

Even after the long history of the US model (2006) and its Article 1 (6), it is still disputed whether the decision of the state of residence on the attribution of income has a binding effect on the decision of the source state. Furthermore, it is unclear whether a person receiving income is also the person liable to pay tax on that income.

It is clear that the Partnership Report has influenced the additions to the commentary of Article 1 of the OECD Model with regard to the definition of a fiscally transparent entity because it is required that the final tax on the imputed income is calculated in accordance with the characteristics of the taxpayer, i.e. that person who is entitled to this income. It is not relevant how and at what level the tax base is calculated. The addition of paragraph 26.10 of the commentary to Article 1 of the OECD Model (2014) which states that “fiscally transparent” refers to those situations in which the income is taxed at the level of the shareholders (under the domestic law of a contracting state) was considered in the context of BEPS Action 2.

S. 66The fact that the OECD concept of a tax transparent entity does not require that the calculation of the tax base must be made according to those rules that apply to the taxpayer to whom the income is attributed through transparency represents a slight deviation from the pattern of pure tax transparency. If the rules of calculation of the tax base differ between the levels of the company and the partner, this position seems questionable. In the end, there is a difference in the treatment of the tax base (and taxes) of the partner who earns income through a transparent entity and the partner who earns the same income directly. The former partner is thus placed in a better position. According to the principle of homogeneity in the tax base calculation, the tax base should rather be calculated according to the partner’s rules that apply to the same type of income in order to avoid such differences.

It seems that the concept of fiscal transparency is about fictitiously assuming that the taxpayer to whom the source of the income is directly attributed would have directly carried out the activity in question or would be the owner of the profitable property (fictio iuris).

“Under generally accepted principles, income attribution is in fact a consequence of the fiscal attribution of the relevant source income.” That the income retains the character that it has received defined by the source is thus a legitimate finding. From this perspective, the connection of the ownership of the interest in a transparent entity with the ownership of the assets and activities contained therein is given for legal purposes. The application of this concept can also be found in other legal paradigms. These include, for example, trusts, where the income is attributed to a taxable person other than the entity owning the profitable assets. In the latter, the term itself applies by analogy where not all of the principles of the Partnership Report apply to trusts. A more complex situation in which the income is attributed to the partner but the underlying assets and activities to the transparent entity is also conceivable. However, this is not in line with the position of the OECD for which source and income constitute a whole pattern.

In principle, this particular concept of tax transparency could be adapted to certain CFC rules. In doing so, CFC rules replicate the essential elements of the tax transparency pattern: the separation between the legal right to the income and the relevant source as well as the potential tax subjectivity of the corporation. Ultimately, whether CFC rules fall within the OECD’s definition of fiscally transparent entities depends on the characteristics of the imputation mechanism.

S. 67It is also, not least, that CFC rules could also apply to certain transparent entities and permanent establishments (PEs) if those entities earn income that raises BEPS concerns and those concerns are not addressed in another way.

2.3. Anti-Tax Avoidance Directive Solution for transparent entities

The Council Directive (EU) 2017/952 of 29 May 2017, Anti-Tax Avoidance Directive II (ATAD II), is the newest legislation on hybrid mismatches with third countries. These amendments are intended to counteract the aggressive tax planning ostensibly used by multinational corporations.

One of the introductions by the ATAD II is the concept of reverse hybrid entity mismatch. Due to the different characterization of corporations by jurisdictions in terms of their taxation, it is possible that income is subject to double non-taxation. This is possible due to the fact that one state considers the corporation to be non-transparent while the other state considers it to be transparent.

In the case of one or more related (directly or indirectly held) non-resident entities, the reverse hybrid concept applies if more than 50% of the voting rights, capital shares, or profit-sharing rights are held in such a hybrid entity and it is incorporated in a Member State. Based on the national laws of a Member State, hybrid companies may be considered fiscally transparent while, for the state in which it is not resident, it may be considered fiscally non-transparent. Under these circumstances, however, it makes sense to consider this hybrid entity as fiscally non-transparent in the Member State as it is thereby recognized as a taxable person (generating tax substrate instead of double non-taxation). However, for investment funds (and similar collective investment vehicles), the reverse hybrid rules do not take effect as they are subject to the Member State’s investor protection rules due to its diversified portfolio of securities.^,

“Reverse hybrid” is defined by the OECD Report as follows: “… any person [including any unincorporated body of persons] that is treated as transparent under the laws of the jurisdiction where it is established but as a separate entity [i.e. opaque] under the laws of the jurisdiction of the investor”.

As of 1 January 2020, EU member states must apply the anti-hybrid measures of the ATAD II, although the implementation of countermeasures regarding reverse S. 68hybrid mismatches does not have to take place until 1 January 2022. Nevertheless, adoption of measures in this regard at an earlier date is feasible.

3. Recognition of CFCs as fiscally transparent entities

First of all, we can distinguish two functionalities of CFC legislation: The piercing-the-veil approach, on the one hand, in which the controlled foreign corporation is regarded as a transparent entity. It therefore attributes the income when generated which is normally the shareholder’s fiscal year in which the entity’s financial year ends. The underlying rationale is that the shareholder is taxed on income that it would have earned directly without the interposition of the CFC. On the other hand, it is worked with the deemed-dividend approach in which a notional distribution of profits from the foreign company to its shareholders is assumed. So, it attributes the income as soon as distributions become possible since it subjects to tax a fictitious distribution.

CFCs should be considered as transparent units for different reasons, both theoretical and practical. The theoretical one concerns DTTs in particular. It refers to the imbalance created by the CFC rules (meaning the DTA law and the uneven distribution of taxation right) and is akin to that created by the approach of fiscal transparency. It has been mentioned by Lang that, as much as one has to acknowledge that the contracting state taxes the partnership while the other taxes the shareholders according to their national laws, one has to acknowledge that the former state taxes the CFC while the latter taxes the income of the shareholders of the CFC which is attributed to them under the CFC laws. Irrespective of the national legislation, treaties are not taking an allocation decision; they just accept the allocated amount as determined by national law. Since the rules of distribution, regardless of the laws of the two countries, do not necessarily require the income to be allocated to the same beneficiary, the treaties will still be applicable even if the income is allocated to different beneficiaries. The absence of global tax coordination therefore leads to circumstances where both contracting states levy taxes on the identical income in the possession of differing persons. However, only the common issues already encountered with respect to partnerships are raised by the CFC rules.

S. 69To reach the common target of combating tax avoidance, the need to ensure the coordination of both domestic and non-domestic tax laws was evident after the BEPS Project. This provides the systematic justification. A clearly welcomed outcome is the fact that the application of the partnership approach to CFCs can promote the coherent application of CFC rules in treaty scenarios.

The structure of the CFC rules constitutes another argument in favour of considering CFCs as fiscally transparent entities. Consequently, an analysis of the core elements of each type of CFC rule has to be carried out. CFC legislation that follows the piercing-the-veil approach can be consistent with tax treaty law if applied in accordance with the principles of the Partnership Report because it essentially replicates the features of the partnership approach, Rust explained. Moreover, he argues that shareholders are treated similarly to partners in a partnership as they generate income directly through the company. For treaty purposes, he subsequently explains why certain CFC rules can shape fiscally transparent entities.

3.1. The structure of CFC rules versus the fiscal transparency pattern

Elements indirectly and directly affecting the final tax calculation are the basic features of a tax transparency approach with the former group referring to the attribution, qualification, and calculation of taxable income. A partial or complete attribution of income based on a ratio is pursued within the framework of the tax transparency principle of the OECD approach which is why even a merely partial attribution of income (e.g. implementation of a “deemed dividend” approach) through the CFC regulations can fulfill the requirements in principle. In the following, it will be explained in more detail that, although within the CFC rules, in principle, no consolidation of the tax bases – namely, that of the company and that of the (controlling) shareholder – is permitted, both the tax transparency approach and the CFC rules allow the inclusion of these bases. In addition, the imputation under the fiscal transparency approach should neither affect the taxation date nor the source and nature of the income.

Since chargeable income is viewed as if it were domestic business income, the CFC rules based on the piercing-the-veil approach respect these requirements. Minimal variations from normally being considered and calculated as operating income under the rules applicable to the shareholder may be provided, but this does not change the substance. Normally, imputed income attributed to the shareholder on a pro rata basis would be calculated separately but, for OECD purposes, there is no difference at which level it is calculated.

S. 70The direct impact on the final tax is found in the second group where the correspondence of the final tax with the personal characteristics of the taxable entity is required in the definition of tax transparent entity in Article 3 (1) of the MLI. Since a tax incurred in a foreign country affects the final tax under both the piercing-the-veil and the transparency approaches, these taxes are credited against the taxes incurred in the domestic country. In this case, it is fictitiously assumed that the shareholder would have realized income directly and that this would also be taxed accordingly. This is not the case under the deemed dividend CFC regime where the deduction of foreign taxes from attributed income is generally prohibited.

Additional rules for the avoidance of double taxation do not appear to be material for the classification of a CFC as fiscally transparent and are not explicitly addressed by the OECD:

Dividends distributed by the CFC may either not be recognized by the shareholder or may be deducted from the actual distributions up to the amount of the previously imputed income; dividends exceeding the imputed income are generally tax-exempt or fully taxable – depending on the level of taxation of the CFC in its home country.

A so-called switchover rule is applied in Italy, for example, if a foreign company is subject to a nominal tax rate of less than 50% of the Italian standard tax rate and dividends distributed by the CFC are fully taxable. However, an indirect tax credit is granted in those cases where an effective business activity is carried out by the CFC. If the dividends along the repatriation chain are subject to effective taxation of more than 50% of the Italian nominal or effective tax rate, the switchover rule does not apply. For purposes of the participation exemption rule, the same requirement of effective taxation applies. This requirement must be met from the first year of ownership of an interest in the CFC in order to qualify for the capital gains exemption and, if not met, will result in fully taxable gains. However, provided that the CFC actually conducts business, there is the indirect tax credit of the taxes borne by the CFC. In essence, economic double taxation is imposed only when the CFC earns active income.

The relief from economic double taxation on the sale of the shareholding in the CFC may likewise be provided by an increase in the tax base of the shareholding by a reduction in the sale price and by a deduction from the tax paid on the sale. Since losses can be offset against the partner’s liability, the second element affecting the tax calculation is that of loss pass-through. Income and losses should thus pass through in equal measure in the case of pure fiscal transparency and be S. 71added to the shareholder’s total income. Trusts, however, are an example of the fact that, in practice, there are cases in the context of tax transparency where no losses are allowed through, but only income since losses are not taken into account by the OECD. Undoubtedly, this is what the OECD intended to address and, consequently, should be included in the definition of a fiscally transparent entity. Furthermore, treaties address income rather than losses, so Canè does not consider loss pass-through as crucial to characterize a CFC as fiscally transparent. Besides, the separate calculation of the final taxation of a taxable person is possible on the basis of his personal allowances and deductions according to the OECD. “Separate taxation of imputed income – namely, whether it is aggregated to the shareholder’s overall income or taxed in a separate basket – undoubtedly represents a distinctive characteristic of many CFC rules, which does not normally feature a fiscally transparent entity.”

In fact, by consolidating imputed income with the shareholder’s income from other sources and offsetting it against losses and personal deductions would, in fact, result in such a pure transparency pattern directly affecting the tax to be paid. From CFC rules such as those in Germany that have implemented a deemed dividend approach and allow imputed income to be added to the total income of the shareholder (other CFC rules provide for separate taxation and are based on a piercing-the-veil approach), it is apparent in practice that hardly any rules allow for loss pass-through. Politically, there is a trend toward making separate taxation a necessary formality for the defensive function of CFC rules. Finally, a defensive function of CFC rules would become obsolete if a surrogate fiscal consolidation effect with the low-taxed subsidiary takes place due to the fact that foreign losses are allowed to reduce domestic taxable income.

S. 72For shareholders of a corporation, separate taxation under the CFC rules essentially replicates the tax system to which the income would also be subject if it had been earned directly. This income, which is imputed to the shareholder, is considered business income as in Italy and in many other countries, for example, and is calculated in the same way and is subject to the tax rate that applies to corporate shares. Accordingly, separate taxation does not necessarily result in a different tax regime than that applicable to the shareholder. The shareholder is subject to personal tax on the income fictitiously assumed for him even in periods in which he has not reported any income. Likewise, he may be subject to personal tax if the CFC has suffered losses during this period. However, since this is in line with the basic ideas of the CFC rules, separate taxation is, in principle, not to be regarded as a decisive counter-argument.

Finally, the OECD requires that the final tax on imputed income must be subject to the shareholder’s personal allowances in order for a corporation to qualify as fiscally transparent. Since subjective allowances should theoretically hinder the operation of CFC rules, this requirement appears to be met because certain non-profit organizations, for example, that, by their nature, are exempt from income tax, will also be exempt for this imputed income.

The fact that a piercing-the-veil CFC generally does not allow personal imputations and deductions by shareholders to offset separately computed tax on imputed income represents the only difference from the OECD's fiscal transparency approach. This characterizes the imputed income tax more as a real tax that is nevertheless consistent with the underlying rationale of the CFC legislation and the policy option.

4. No recognition of CFCs as fiscally transparent entities

There are several political and legal reasons why CFCs should not be considered fiscally transparent entities.

That states suffer negative budgetary consequences as a result if the tax substrate is partially or entirely reduced by the shifting of taxing rights can be cited as a policy reason. When classifying a CFC as transparent, it is assumed that the income is received directly by the shareholder through the premises of the intermediary CFC (this also applies to permanent establishments). As a result, if there is an applicable treaty (that provides for the exemption of business income from a permanent establishment in that country) between the country of residence and the S. 73source country, the income of the shareholder must be exempted by its country of residence. Apart from the exemption method, any tax levied on the CFC would have to be credited by the residence state in terms of the imputation method.

Other reasons are based on the assumption that a piercing-the-veil approach cannot be reconciled with international tax rules. The prohibition of taxation of foreign entrepreneurs who do not carry on business in the home country that arises from the primary distribution rule of Article 7(1) of the OECD Model is the basis of the objections to the compatibility of a CFC regime with tax treaties. Belgium's comments on Article 1 of the OECD Model can be particularly emphasized at this stage:

However, it has also been argued that neither the attribution of passive and low-taxed income of a CFC instead of its total profit nor taxation based on the residence of the controlling shareholder is prevented by Article 7 (1) of the OECD Model. This corresponds exactly to the way some CFC rules work. The French CFC rules were adapted in 2006 to include a deemed dividend approach, and they now overcome the business profit characterization. France now refrains from violating tax treaty law and considers foreign income as deemed dividends.

The question of who is understood by the term “enterprise” in the sense of Article 7 (1) of the OECD Model seems fundamental: While the CFC state will consider the CFC as an enterprise, the state of the shareholder may consider this shareholder as an enterprise. For this reason, by assuming that a “piercing-the-veil” CFC rule refers to the profits of the CFC and that these are also taxed as those of the CFC, there is a contradiction between Article 7 (1) of the OECD Model and this CFC S. 74rule. The result of the interpretation of the words “profits of a company” by the French Conseil d'Etat in 2002 in the Schneider case was that France had no possibility to tax these profits. This arose from the fact that the taxed profits (according to Article 209 B of the Code général des impôts) were, from the French point of view, profits of a company resident in Switzerland which fall under Article 7 (1) of the treaty.

It is also claimed that the piercing-the-veil approach would invalidate Article 5 (7) with its anti-single-entity clause that respects the separate legal identity of a sub-subsidiary and Article 10 (5) which prohibits extraterritorial taxation. However, the taxation rights of the controlling shareholder's country of residence are not affected as Article 10 (5) only concerns the withholding taxation of the CFC. Moreover, the original purpose of this paragraph was not to prevent the application of the CFC rules but to counteract the extraterritorial taxation of dividends as imposed by the United States, among others.

CFC rules are fundamentally different from a pure transparency rule, according to another reason why they should not be treated as a fiscally transparent entity. That “CFC rules based on the notional sum approach and the diverted imputation approach” differ significantly from the tax transparency rule, according to the case law, is because it considers the resident shareholder as the person to whom income earned domestically is attributed but not as the one who receives the income earned abroad. Accordingly, it is not Article 7 of the OECD Model Tax Convention that should be applied but Article 21.

The UK CFC regime, based on the notional amount approach, did not violate Article 11 of the Income and Capital Tax Treaty between the Netherlands and the United Kingdom (2008), according to the UK Court of Appeal in Bricom Holdings Limited v. IRC. This was based on the fact that a notional amount was assumed to be income that was taxed in the case of a person deemed to be resident in the United Kingdom. The notional amount attributed to the resident shareS. 75holder for transparency reasons did not correspond to the income of the CFC in this case, according to the court’s finding.

In 2014, a similar result was reached in the Vale case by the Brazilian Superior Court of Justice that affected a diverted attribution rule for CFC. What is particular about this is that it created a difference between CFC rules that follow the piercing the veil pattern and those written under the diverted attribution approach. At the same time as changing the application of the rule to align it with a purely fictitious totals approach, the scope of application was massively narrowed in its entirety which was ultimately owed to Law 12, 973/2014 after a series of rulings. “Profits earned by foreign controlled companies” are no longer “added to the profits of the parents” under Brazilian law. Rather, an “adjustment to the investment account equivalent to the profits earned by the directly or indirectly controlled foreign companies” must now be made by the resident taxpayer in its financial statements.

Even the OECD confirms with references of the OECD commentary to Article 7 and Article 10 of the CFC rules that there are clear distinctions between CFC rules due to the notional sum approach and the piercing-the-veil approach. Paragraph 10.1 of the OECD Commentary on Article 7 of the OECD Model Tax Convention (2003), which remains unchanged to this day, states that the CFC rules are aimed at taxing the profits of residents and are not restricted by treaties. Additions to Article 1 (3) of the OECD Model Tax Convention, which were implemented in Article 11 (1) of the MLI based on the recommendation of Action 6 of the BEPS Project, reaffirm the view that provisions of a treaty do not affect a state's right to tax its own residents. This is precisely the case when the partnership approach or certain CFC rules are applied by a state. The commentary on Article 10 further confirms the structural differences between CFC rules (such as under the “deemed dividend” approach versus the ones following the “piercing the veil” approach) as fictitious dividends can be subsumed under Article 10 (1) of the OECD Model.

S. 765. Country specific CFC legislation

CFC regimes differ across countries. A large number of them are targeting passive income although active income is also targeted frequently. Low taxation is a common requirement as well. Though CFC rules would appear, based on their name, only to apply to corporate entities, many countries include trusts, partnerships, and PEs in limited circumstances to ensure that companies in the parent jurisdiction cannot circumvent CFC rules just by changing the legal form of their subsidiaries.

6. Austria

Austrian legislators introduced key aspects of the ATAD within the framework of the Annual Tax Act 2018 (Jahressteuergesetz 2018). What is more, Austria introduced the first CFC regulations with the adoption of Articles 7 and 8 of the ATAD. Low-taxed passive income generated through a controlled company is attributed to the controlling entity according to Section 10a of the CITA. As a matter of fact, it is often debated that Austria finally introduced a CFC regime because Austria did not adopt one for quite a long time. This is obvious when having a look at the years of implementations of CFC rules in other European countries such as Germany (1972), France (1980), Spain (1995), or Italy (2000). In Austria, the CFC legislation requires that a CFC obtains passive income in a low-taxed country as defined in Section 10a paragraph 2 CITA. Austria has decided in favour of the “categorical approach” when implementing the ATAD. It implies that only specific passive income of a company abroad is subject to CFC taxation. Non-distributed passive income of the CFC is attributed to the controlling company in accordance with Section 10a paragraph 1. no 1 CITA. However, the CFC legislation in Austria is applicable only if the three criteria set out in Section 10a paragraph 4 CITA are met simultaneously:^,

• no. 1: Passive income amounts to more than one third of the total income of the foreign corporation (de minimis limit).

• no. 2: The foreign corporation is controlled by the domestic corporation (controlling event).

• S. 77no. 3: The foreign corporation does not exercise any significant economic activity (proof of substance).

The provisions of CITA Section 10a paragraph 6 broadens the scope of coverage of the CFC legislation to cover dual residency of No. 1 and non-resident permanent establishments of No. 2. However, Section 10a paragraph 7 CITA is not affected by this paragraph. A consequence of the fact that the scope is extended to cover national companies based in Austria and whose place of effective management is located in a foreign country is that, because of the “tie-breaker rule”, national companies with dual residency are not liable to worldwide taxation when a double taxation agreement is applicable. Consequently, they are similar to CFCs (Section 10a paragraph 6 no. 1 CITA). According to Section 10a paragraph 6 no. 2 CITA, even if the double taxation agreement foresees the exemption method, the CFC rules are applicable to non-resident permanent establishments. Marchgraber/Zöchling found that, as a consequence of the situation that companies that are subjected to unlimited tax liability can have no further reliance on the exemption method, there is a treaty override.

According to the Austrian addition tax, foreign corporations can be considered as controlled intermediate companies. This refers to “foreign legal entities without owners that are comparable to a domestic corporation on the basis of a comparison of types and whose registered office is abroad”.

Due to the neutrality of the legal form, foreign permanent establishments are also included. With regard to permanent establishments, Section 10a (6) 2 KStG S. 78adds “even if the double taxation agreement provides for an exemption”. This standardizes a so-called “treaty override”. As a result, the additional taxation is applicable to foreign permanent establishments irrespective of a DTA. By including permanent establishments, controlled foreign partnerships can also be subject to the additional taxation.

The Austrian legislator additionally stipulates that dual-resident corporations with their place of management abroad (domiciled in Austria, therefore, a domestic corporation) can be the object of addition taxation. The place of management under treaty law is decisive. The initiative proposal for the Tax Reform Act 2020 provides, as an editorial change, that only those (dual-resident) domestic companies are covered “that are domiciled abroad under a double taxation treaty”

The reverse case of a dual-resident corporation (place of management in Austria, registered office abroad) is already covered by the term “foreign corporation”. However, such corporations are, in any case, subject to unlimited tax liability in S. 79Austria, and the right of taxation is usually not restricted by a DTA. However, income that is to be exempted by Austria may have to be recorded in Austria through the addition taxation.

Section 10a (8) KStG provides for a special exception for foreign finance companies. As proposed by the ATAD as an exemption option, these can be exempted from the addition provided that no more than one third of the liability income is generated within the group. Group-internal financing companies are therefore not exempted.

7. United States

The conceptual application of CFCs in the United States treats a foreign corporation as a CFC for US tax purposes if it is owned by at least one US person. In the most common cases, a CFC will result in taxable income under Foreign Base Company Incomes. In cases where residents, green card holders, or citizens of the United States own more than 50% of the company, a company with such income is considered to be owned by “U.S. persons.” For purposes of IRC § 951, “U.S. persons” also include those persons classified as trusts, certain estates, and domestic partnerships and corporations.

This category of Foreign Base Company Incomes can be broken down into the subcategories of Foreign Personal Holding Company Income, Foreign Base Company Sales Income, Foreign Base Company Service Income, and Foreign Base Company Oil-Related Income. Taxable income then consists of the sum of these.

While the Subpart-F rules were fundamentally created to capture passive or mobile income, they also aggregate certain incomes

8. Resumé

Firstly, it has been shown that, in some cases, CFCs can be treated as transparent entities. Indeed, CFC rules produce effects and involve problems comparable to the partnership approach that are relatively unexplored for states that have historically considered foreign partnerships as opaque for fiscal purposes.

Secondly, the legal framework of tax treaties has been tested to assess whether it supports such an interconnected application of CFC rules. It has been found that the new provisions for transparent entities, only recently implemented in the Multilateral Convention, can be consistently applied even in CFC situations.

The additions to Articles 1(2)-(3) and 23(1) of the OECD Model, as transposed in Articles 3, 5(6)-(7) and 11(1)(d) of the MLI, allow a balanced application of treaties to CFCs whereby distributive rules are not applied unilaterally, and income allocation conflicts can be solved without resorting to the attribution rule of the source state.

S. 81It seems that the dividing line between fiscally transparent entities and CFCs lies in the technical details of the concerned CFC legislation. From this perspective, the piercing-the-veil approach seems to meet the OECD concept of fiscal transparency in the taxable event (i.e. the generation of income); in the way the CFC’s income is imputed to the shareholder and determined; in the timing of the attribution; as well as in the way economic double taxation is relieved. Even the very end result is the same: current taxation of foreign-sourced undistributed profits in the hand of a resident taxable person.

Separate taxation of imputed income impedes loss pass-through and the ability to compensate between the liability on imputed income and the personal deductions of the shareholder. However, separate taxation conforms to the rationale of CFC rules and is also a common effect of schedular tax systems that do not always allow compensation between income and losses from different sources of income (at least for individual shareholders). Therefore, it should not be seen as a decisive difference between CFCs and fiscally transparent entities.

This thesis advocates that the normative and interpretative materials concerning transparent entities and CFCs can support a coordinated application of CFC legislation at the tax treaty level in order to tackle base erosion and profit shifting. Such coordination is possible by applying the principles set out for partnerships to CFC rules that adopt a fiscal transparency approach.

Attribution of income under these CFC rules obtains the same result, in fact, as under the transparency approach, i.e. the inclusion in the parent jurisdiction of an item of income derived by a non-resident entity (or arrangement). Application, by analogy, of the same rules therefore appears legitimate and useful for solving the problems that (hybrid) transparent entities normally pose at treaty level.

To conclude, it is the need to coordinate tax legislation to counteract BEPS that mostly suggests extending the rules for transparent entities to CFCs based on the piercing-the-veil approach.