Concept and Implementation of CFC Legislation

S. 3561. Introduction

The first country in Europe to recognize the negative effects of international profit shifting was West Germany. By attributing income to low-tax foreign subsidiaries, internationally operating companies were able to shift income away from Germany and achieve deferral, meaning that the income was not subject to the domestic taxation until the profits were repatriated. In order to effectively counteract such practice, the German legislator, based on rules first introduced in the 1960s in the United States, developed a concept to prevent abuse beyond their borders, hence the first controlled foreign company (CFC) legislation was introduced in Europe. Other countries, such as France in 1980 and the United Kingdom in 1984, followed and introduced similar legislation. It is worth noting that many other EU countries such as Austria, Belgium, or the Netherlands as well as many Eastern European countries have had, until recently, no experience with CFC legislation.

In 2013, the OECD in cooperation with the G20 adopted a 15-point action plan to combat base erosion and profit shifting that included, inter alia, CFC legislation. Some of the participating countries had already implemented CFC rules in some form, and others were interested in introducing them which is why the Final Report on BEPS Action 3 sets out recommendations on how to structure CFC legislation that effectively tackles base erosion. The report was not meant to be a minimum standard for all participating countries but a set of building blocks for jurisdictions who wished to implement or update their existing legislation. The EU decided to implement the findings of the BEPS Project by introducing the Anti-Tax Avoidance Directive of 2016 (ATAD). The CFC rules included therein were largely inspired by the recommendations of the OECD. The CFC rules of the ATAD aim at calculating and taxing undistributed income of controlled subsidiaries or permanent establishments in low tax jurisdictions. The conditions that must be fulfilled in order for a subsidiary to be considered a CFC is for the parent to directly or indirectly own more than 50% of the subsidiary and that the effective tax rate of the state where the subsidiary/permanent establishment is situated is less than half of that in the parent state. In contrast to Action 3 of the BEPS S. 357Project, the EU’s CFC legislation was drafted as a minimum standard, and all EU Member States are required to implement it.

EU primary law provides the so-called four fundamental freedoms that are the essential means to form and maintain the internal market. By guaranteeing the free movement of goods, services, persons, and capital, the fundamental freedoms safeguard against restrictions on cross-border intra EU trade and thereby allow for fair competition. Although direct taxation does not fall under the competence of the EU, any legislation introduced by Member States must nevertheless conform to the fundamental freedoms in order to allow the common market to function properly. Any CFC legislation must therefore conform to the fundamental freedoms, which is why the BEPS Final Report on Action 3 also took the EU fundamental freedoms into account when suggesting how CFC legislation should be drafted.

The research aim of this thesis is to examine whether CFC legislation as drafted in the ATAD is in line with the fundamental freedoms. Chapter 1 will provide a general overview of what the fundamental freedoms exactly are and which might be relevant for the CFC rules as included in the ATAD. Chapter 2 looks at the limits imposed on the ATAD by the case law of the Court of Justice of the European Union (CJEU) related directly to CFC legislation, most notably by the Cadbury-Schweppes, and the X GmbH decisions. The last chapter, Chapter 3, concludes whether the ATAD CFC rules are in line with the fundamental freedoms and under which conditions this might not be the case.

1.1. The fundamental freedoms

At the heart of the EU legal systems lies the internal market which is an area allowing for the free movement of goods, services, persons, and capital, also S. 358called the fundamental freedoms. Besides the fundamental freedoms, it is important to also mention the general prohibition of discrimination on the grounds of nationality included in Article 18 of the Treaty on the Functioning of the European (TFEU) which is applicable “without prejudice to any special provisions contained therein [TFEU]…”. Article 18 can be viewed as a general norm, or leges generales, which is further specified in greater detail by the fundamental freedoms.

The effect of the fundamental freedoms is not unrestricted on national tax law but applies only when cross-border situations with other Member States arise, as is the case with CFC legislation which requires the undistributed income of foreign subsidiaries to be included in the tax base of the parent company. Since the purpose of the fundamental freedoms is to facilitate equal treatment for parties conducting cross-border trade within the EU, they do not apply in purely domestic settings. According to the fundamental freedoms, cross-border situations may not be treated less favourably than purely domestic situations unless a justifiable reason can be found. However, the fundamental freedoms do not cover situations when cross-border situations are treated more favourably than domestic ones. In purely domestic cases, tax sovereignty remains exclusively with the Member States.

The free movement of goods put an end to any tariff barriers such as customs or other duties or non-tariff barriers such as quantitative restrictions to trade between EU Member States. The free movement of services puts service providers within the EU on an equal footing and allows for their cross-border provision as well as their receival without restrictions. The freedom protects the right to provide, among others, insurance, banking, tourism, and broadcasting services along with digital services like software, films, and music. The free movement of persons can be dissected into three specific categories which are the free movement S. 359of workers, the freedom of establishment, and the right to stay in any Member State without the aim of conducting business activities. The free movement of workers constrains both the home and host Member State to treat foreign workers worse than their own nationals. With respect to CFC legislation, all three of those freedoms have little relevance since they do not limit investments in other Member States and will therefore not be further discussed.

The freedom of establishment allows both individuals and companies from EU Member States to freely conduct business in any other Member State. The implication for an individual is that he can perform any activity as a self-employed person across the EU. Companies, on the other hand, are allowed to freely establish agencies, branches, or subsidiaries within the community. The free movement of capital, as the name suggests, prohibits any restrictions on the movement of capital and payments not just between Member States but also between Member States and third countries. This is important to stress since the free movement of capital is the only freedom that is applicable beyond the borders of the EU. In the realm of direct taxation, the freedom is mostly linked to real property and dividend payments.

Within its jurisprudence, the CJEU decided already in the 1960s that EU law takes precedence over national provisions. Since any national law, as well as the ATAD as secondary EU law, are subject to primary EU law, the fundamental freedoms must be taken into account when considering conformity with primary EU law. CFC legislation can potentially limit the freedom of establishment since part of the tax base of foreign subsidiaries or permanent establishments will be added to the tax base of the resident parent entity, in effect treating a foreign subsidiary less favourably than a purely domestic situation. As was mentioned before, in purely domestic settings, CFC rules would typically not apply. At the same time, the free movement of capital may also be limited because establishing a foreign subsidiary or permanent establishment is nothing more than a cross boarder investment that, due to CFC legislation, will be treated worse than a domestic investment. For this reason, both fundamental freedoms may potentially be affected by CFC legislation depending on the circumstances; it is therefore necessary to define the boundaries between those two freedoms or assess if, potentially, even both freedoms could be applicable at the same time, which will be further discussed in Chapter 1.3.

S. 3601.2. Secondary EU legislation

Although this book’s chapter is, in principle, concerned with the interplay of primary EU legislation and CFC legislation, it is important to stress that secondary EU legislation might also influence the application of CFC legislation. Due to a lack of political consensus, the area of direct taxation has been harmonized to a very little extent by secondary legislation despite the fact that it was recognized already in the 1960s that different corporate income tax systems of EU Member States have an adverse effect on the common market. The commission proposed the adoption of legislation in 1975 in order to introduce a range of acceptable tax rates from 42% to 52% and on domestic loss-carry forward and cross-border loss relief in 1984 and 1990, respectively, but all efforts failed due a lack of political consensus. A similar path seems to lie ahead for the proposal regarding a common consolidated corporate tax base that is a uniform way of calculating the tax base of taxpayers belonging to a group that operates across the EU. Such legislation was first proposed in 2011 and again with slight amendments in 2016 but, due to the lack of political support, has so far failed to become EU law.

On the other hand, there are also positive examples of integration in the area of taxation. Examples include the Parent-Subsidiary Directive, the Merger Directive and the Arbitration Convention, which were all adopted on the same day in 1990. Worth considering in respect to CFC legislation is certainly the aforementioned Parent-Subsidiary Directive in today’s form, which is also dealing with the taxation, or rather non-taxation, of dividend income between parent companies and their subsidiaries situated in different EU Member States. The directive’s objective is to exempt dividends from withholding taxes if those are paid by subsidiaries to their parent companies as well as eliminating double taxation.S. 361A company needs to hold at least 10% of the capital of its subsidiary to be considered the parent company. If this is the case, the source state is bound not to tax dividend distributions within the EU while the resident state has to either exempt such income or, in the case that it decides to tax, allow for a deduction for all levied lower tier corporate taxes.

The Parent-Subsidiary Directive, therefore, either exempts or credits profits against the tax already paid at the level of the parent company as opposed to CFC rules that shift the retained profits of the subsidiary to be taxed at the level of the parent company. This may lead to conflicts in situations in which the Parent-Subsidiary Directive and CFC legislation are applicable simultaneously, e.g. CFC rules require undistributed income to be taxed at the level of the parent whereby the conditions for exempting such income (if it were really distributed) would be met under the Parent-Subsidiary Directive. According to Orlet, it is worth noting that, since the Parent-Subsidiary Directive and the ATAD are equivalent in strength, the CFC resident state must follow the former and grant relief for the taxes levied since the Parent-Subsidiary Directive is, despite its wording, also applicable to fictitious dividend distributions.

1.3. The freedom of establishment vs the free movement of capital

At first glance, one might suspect that only the freedom of establishment is possibly at stake, since CFC legislations in general aims at curbing the transfer of profits to subsidiaries located in states with more favourable taxation. In contrast to purely domestic situations, CFC rules may restrict the freedom of establishment because retained profits of establishment or subsidiaries in low-taxed Member States are added to the parent company which leads to a worse treatment of a foreign subsidiary compared to a purely domestic situation. The ATAD itself specifically states a 50% control threshold which is a strong indicator for the application of the freedom of establishment, but it is important to point out that this legislation shall be viewed as only a minimum level of protection for Member States S. 362meaning that they are free to implement a lower control threshold if they see the need. This is expressed in the explanatory notes of the ATAD reading “In order to ensure a higher level of protection, Member States could reduce the control threshold…”. Therefore, it is not only the freedom of establishment that needs to be considered but also the free movement of capital. The latter freedom extends to all shareholdings regardless of the level of influence, hence also portfolio investments which do not fall within the scope of the freedom of establishment. Therefore, smaller investors could also rely on the protection of the free movement of capital if their foreign investments are treated worse than their domestic investments.

The CJEU in its earlier decisions took the position that more than one of the freedoms can be applied to a particular situation, but more recent case law suggests that the court tends to apply the “center of gravity” view which says that, despite that more fundamental freedoms could be applicable simultaneously, freedoms that are only ancillary will not be further inspected, meaning that only one freedom is being considered by the court. To determine which of the two freedoms is applicable, it is necessary to determine if the legislation was intended to apply to all shareholders or only shareholders with substantive influence on the decisions of the other company. Whenever the legislation requires substantive influence, the freedom of establishment needs to be considered; if the opposite is true, it is the free movement of capital. If this distinction is not expressly made by the legislation in question, two situations must be contrasted which are (i) intra-EU and (ii) third countries. In intra-EU scenarios, the logic is the same as if the legislation specifically stated what kind of shareholding is required, meaning that, as long as the shareholder has substantive influence over the company in the individual case at hand, the freedom of establishment is at stake except if the legislation is more closely connected to the free movement of capital. In third country scenarios in which the disputed legislation not only applies exclusively to shareholders with substantive influence, one can rely on the free movement on capital also in situations where a substantive influence is given. In spite of that, the previously mentioned steps should never lead to a disguised expansion of the freedom of establishment to third country scenarios where the purpose of the legislation is closely linked to market access. To sum up, the CJEU is distinguishing between simple S. 363“capital movements” and full “market access” which is crucial regarding CFC legislation since the free movement of capital extends to third countries while the freedom of establishment does not. In the end, the purpose of the legislation is the decisive factor for determining which fundamental freedom is relevant.

It is important to note that some scholars also have contrasting views and that, whenever a third country scenario is being considered and the taxpayer can, for obvious reasons, not rely on the freedom of establishment, it should be possible to rely on the free movement of capital despite the purpose of the legislation. Pistone considers capital liberalization extending beyond EU boarders to be justifiable since the free movement of capital protects the capital itself and not the investee/investor or any person disposing over the capital. Other scholars, such as Stahl, consider that such a wide interpretation of the free movement of capital would inevitably extend the other freedoms to third states “through the back door” which was supposedly not their original purpose.

1.3.1. Substantive influence

To distinguish between mere capital movements and market access, it is necessary to determine what constitutes a substantive influence of a shareholder. Settled case law of the CJEU confirms that shareholdings of more than 50% are sufficient to constitute a substantive influence. In addition, the CJEU confirmed the applicability of the freedom of establishment even to shareholdings of 34% in SGI and 25%,, respectively in the decisions Lasertec and Scheunemann. It is unclear if a lower shareholding is sufficient to trigger the freedom of establishment, but the CJEU took the position in the cases Test Claimants in theFII Group Litigation, Kronos, and Itelcar that a 10% shareholding is too low to be regarded as substantive and therefore the freedom of establishment is not applicable in such cases.

S. 364In addition to simple percentages, the CJEU stated, e.g. in the decision SGI, that “Such holdings [more than 34%] are, in principle, capable of giving SGI “definite influence”…”. Spies highlights that percentages as such are therefore only an indication of which freedom might be applicable but are, by themselves, not sufficient. The CJEU continues by stating that “Moreover … there are links between those companies at management level”, which suggests that dependencies on the management level can also influence whether a definitive influence is given or not. This could also be observed in the case Columbus Container for which the court decided that, despite the fact that only a 10% shareholding existed, family ties between shareholders were strong enough to substantiate the application of the freedom of establishment. Such tests of factual control were performed by the court only in cases of rather low shareholdings; in cases of higher shareholdings, the court automatically assumed that the control is sufficient to constitute substantial influence and thereby applied the freedom of establishment without turning to such a test.

The ATAD, by default, requires a 50% shareholding which means that, primarily, the freedom of establishment is to be considered. Only under certain circumstances, such as when Member States decide to lower this threshold, might the free movement of capital become relevant. For the purposes of further analysis, there is no difference between the freedom of establishment and the free movement of capital, i.e. the assessment of the violation of the freedoms is the same; the only difference lies in third-country aspects. The following chapters will therefore refer to both freedoms, but any peculiarities concerning third-country situations will be addressed when appropriate.

1.3.2. Exchange of Information

Another aspect that needs to be considered is that, in third country situations without a framework for the exchange of information, one cannot rely on the protection of the free movement of capital. The reason is that tax authorities cannot request necessary information in order to access whether a business is genuine. A lack of information exchange can therefore limit the protection of the free movement of capital.

S. 365This does not concern the freedom of establishment which is only applicable within the EU since Member States can rely on the Mutual Assistance Directive that was introduced already in 1977 and gave them the possibility to request information on tax matters from each other. The directive was meanwhile repealed in 2011 with the introduction of the currently in force Directive on Administrative Cooperation that went even beyond the mere exchange of information on request by allowing for an automatic exchange of information with respect to certain tax and financial information. The aim of those directives was always to tackle tax evasion in the EU which is why the CJEU never accepted a lack of information as a sufficient reason to limit the fundamental freedoms in a pure EU context despite difficulties that arise in practice. In a third country scenario, the directive cannot be relied on, but one must keep in mind the numerous agreements of exchange of information that have been signed by individual Member States with third states to facilitate such an exchange as well as the automatic exchange of information framework of the OECD. Due to the large information exchange network, it will become increasingly difficult in the future to limit the free movement of capital towards third states since it is the only freedom applicable outside the EU.

1.4. Income attribution by the ATAD CFC rules

Since the aim of the thesis is to analyze whether CFC rules, particularly as included in the ATAD, conform to the fundamental freedoms, it is necessary to have a closer look at the conditions under which the ATAD requires income to be attributed to the parent company. When implementing the directive, tax administrations can choose either of two options, i.e. the categorical approach and the non-genuine arrangement approach. Both include taxable income of the conS. 366trolled entity or permanent establishment in the low tax jurisdiction and add it to the tax base of the controlling company whereby the tax base is calculated based on the tax law of the controlling entity’s state.

The categorical approach lists specific types of passive income such as interest, royalties, dividends etc. that are subject to the rule provided that the controlled entity does not have enough substance (staff, equipment, assets, and premises) to support its business activity. In third country situations, Member States may refrain from applying the substance requirement, i.e. substance carve-out, and always subject the passive income listed to CFC legislation. In addition, this approach excludes losses of the controlled entity or permanent establishment and requires that those shall be taken into account in subsequent periods by the controlled company/permanent establishment.

By contrast, the non-genuine arrangement approach requires that non-distributed income that arises from non-genuine arrangements that were set up in order to obtain a tax advantage shall be included in the tax base of the controlling company. The amount that is considered to be non-genuine depends on the actual functions performed and risks assumed by the controlling entity and must correspond to its scope of duties.

Comparing the two options, it appears that only the categorical approach has a substance carve out but, since the non-genuine arrangement approach applies by definition only to situations that are “not genuine” and lacking in substance, such a carve out is unnecessary.

2. Limitations imposed on CFC legislation

In general, the CJEU follows a four-step approach in order to arrive at its decision of whether a certain provision of national law or, in the case of the ATAD EU secondary law, is limiting the fundamental freedoms. First, it must be established if the provision in question is within the scope of the fundamental freedoms which is only the case if there is an entitled person (natural or legal) and a cross boarder S. 367element. The second step is to assess whether the fundamental freedoms are restricted by looking at the treatment of the same situation in a purely domestic setting and whether the treatment of the cross-border situation would be equal or worse. Thirdly, if the cross-border situation is treated worse, it must be determined whether such treatment can be justified. The CJEU accepts only a few justifications that aim at protecting higher goals of public interest; in the realm of direct taxation, this can be, e.g. measures that limit tax avoidance or protect the cohesion of the tax system. Lastly, the measure must conform to the requirement of proportionality meaning that the legislation shall not exceed what is necessary to achieve the objective.

The fundamental freedoms are limited whenever a domestic situation is treated differently from a cross-border situation which holds true for both the transactional and the non-genuine approach since the ATAD CFC legislation does not apply in purely domestic settings. Local investment is treated differently from an investment in another EU Member State because holding a decisive influence in a domestic entity is treated differently from holding a decisive influence in an entity established in another Member State. For CFC legislation to fall under the scope of the fundamental freedoms, it is necessary that the treatment is not only different from a purely domestic situation but to the disadvantage of the shareholder in cross boarder situations. In a purely domestic investment case, the shareholder can take advantage of deferral, i.e. the income will be taxed only once it is distributed whereby, in a cross boarder situation when CFC rules apply, the income will be taxed immediately leading to a cash flow disadvantage. In addition, in cross boarder situations, the shareholder also bears a greater administrative burden as the income calculated by foreign tax law must be converted based on domestic rules in order to determine which proportion of the income is subject to taxation in the shareholder’s state. Shareholders investing domestically suffer none of those consequences which means that the fundamental freedoms are clearly being limited by CFC legislation.

S. 368After it has been established that the fundamental freedoms are limited by the CFC legislation included in the ATAD and by CFC rules, in general, it is necessary to have a closer look at whether such a restriction is justified. The preamble of the ATAD states that “the current political priorities in international taxation highlight the need for ensuring that tax is paid where profits and value are generated”. This underscores the already mentioned purpose of the introduced CFC legislation which is primarily combating tax evasion. This is not a surprise since the ATAD was drafted after the reports on BEPS Action 3 which dealt with countering offshore structures that shift income to low tax jurisdictions.

If national legislation or secondary EU legislation implemented into national law was designed to prevent the abuse of the tax systems, a restriction of the fundamental freedoms may be warranted under certain circumstances according to case law of the CJEU. Although the ATAD is rather recent legislation that was only enacted 12 July 2016, the CJEU dealt with CFC legislation already in the past since some Member States had CFC legislation already before the ATAD was introduced. This chapter examines the presumably most influential decision in this respect, namely, the judgment on the Cadbury-Schweppes case, and the more recent X GmbH decisions of the CJEU that offer isight into what CFC legislation needs to fulfil in order to comply with EU primary law.

2.1. Cadbury-Schweppes

Facts and subject matter of the dispute

Under UK foreign tax law, the profits of a subsidiary are added to the profits of a UK company holding more than 50% of the shares of the subsidiary and taxed at the level of the parent company if the foreign tax rate is less than 75% of the rate applicable in the United Kingdom. The tax paid abroad by the subsidiary is credited against this. The addition is waived if it can be shown that the main aim of this arrangement is not to avoid UK taxation (so-called motive test). The British parent company (CSO) of the Cadbury-Schweppes Group set up two subsidiaries in Ireland whose task was to raise funds for the entire group. As both companies are based in the particularly low-taxed International Financial Services Centre S. 369(IFSC) in Dublin, their profits were taxed at only 10%. The British tax authorities considered the above-mentioned conditions for supplementary taxation to be fulfilled and increased the corporation tax payable by the parent company accordingly. Cadbury Schweppes brought an action against this decision and claimed that the British rules on supplementary taxation violated the freedom of establishment. The competent British court therefore referred the question of whether the fundamental freedoms preclude the British CFC legislation to the ECJ for a decision.

The decision of the CJEU

The substantive scope of the freedom of establishment was met since CSO, a resident of the United Kingdom, owned two subsidiaries in Ireland, meaning that a cross-border element was present which is a prerequisite for any freedom to be applicable. Companies having their seat within the community are to be treated in the same way as domestic companies with respect to the freedom of establishment.

As discussed before in Chapter 1.3.1, a 50% shareholding is considered enough by case law to be regarded as a substantive influence for the freedom of establishment to be applicable which is why the court only examined the application of the freedom of establishment. According to the court, any restriction of the free movement of services or the free movement of capital are only unavoidable consequence of the restriction of the freedom of establishment which therefore does not warrant a separate examination of those freedoms.

The CJEU ruled that the freedom of establishment is restricted if the addition of foreign profits is differentiated according to the tax rate in the country where the subsidiary is domiciled. This could discourage companies from establishing subsidiaries in countries with low taxation levels. However, the restriction is justified only when “the specific objective of such a restriction must be to prevent conduct involving the creation of wholly artificial arrangements which do not reflect economic reality, with a view to escaping the tax normally due on the profits generated by activities carried out on national territory”.

The mere aim of the company to minimize its tax burden by taking advantage of the different rates of corporate income tax existing in other Member States does S. 370not in itself justify the presumption that the arrangement is abusive. In addition to this subjective element, objectively verifiable criteria must be added. Only if the controlled foreign company is a fictitious establishment that is “not carrying out any genuine economic activity in the territory of the host Member State, the creation of that CFC must be regarded as having the characteristics of a wholly artificial arrangement”. This applies in the case of subsidiaries that are "letterbox" or "front” subsidiaries. In addition, the court states that general, irrefutable presumptions of abuse are disproportionate as opposed to rebuttable presumptions that allow for an individual review.

The CJEU leaves it to the national court to decide whether the exception to the "motive test" provided for in UK foreign tax law can be interpreted as meeting those requirements. If necessary, the information necessary for the authorities to examine the objective criteria can rely on the information exchange possible through the Mutual Assistance Directive.

2.2. X GmbH

Facts and subject matter of the dispute

In the dispute, the German limited liability company X GmbH held a 30% stake in the Swiss joint stock company Y AG. Y AG concluded so called debt assignment contracts with Z GmbH, a company managing sports rights in Germany, for which it received profit participation rights. Under the German Foreign Tax Act, such income from profit participation was considered to be passive and falling under German CFC rules which is why the German tax administration included it in the taxable income of X GmbH (in proportion to the company’s stake in the Swiss Y AG). German CFC legislation usually requires a holding of at least 50% in a foreign company in order for that company to be considered to be controlled but, in the case that foreign subsidiaries generate passive income, a 1% shareholding is already sufficient to trigger CFC rules.

S. 371Since X GmbH disagreed with this decision, the competent German court decided to refer three question to the CJEU. In its first and second question, the CJEU was asked whether CFC legislation restricting the free movement of capital with respect to third states can be justified by Article 64(1) of the TFEU (stand-still clause), taking into account that the legislation was substantially amended, but the changes were never implemented. The third question referred to whether Article 63 of the TFEU (free movement of capital) is prohibiting CFC legislation that subjects income of a company in a third state owned by only 1%.

The decision of the CJEU

The first two questions referred to the stand-still clause that allows Member States to restrict the free movement of capital toward third states if they had legislation in place limiting direct investment before 1993, i.e. before the introduction of the single market. The situation was specific since Germany already had CFC rules at that time, but the threshold was lowered in subsequent years from 10% to 1% which is why the court was asked whether the stand-still clause is still applicable. The court decided that the German CFC legislation had not changed, in essence, despite being widened to also include portfolio investments which is why the stand-still clause may be applied in this regard. The second question referred to a substantial change in German CFC legislation that occurred in 2000 but, before taxpayers had to apply the amended legislation, it was retroactively repealed and legislation in the spirit of the one before 1993 was reintroduced. The court held that, unless the applicability of the law was only deferred which is for the German national court to determine, the restriction of the stand-still clause is applicable.

The third question related to whether the company could take advantage of the protection of the free movement of capital. Since German CFC legislation was applicable to both portfolio investments and direct investments due to its low threshold of only 1%, the legislation was, besides the freedom of establishment, also potentially subject to the free movement of capital. Considering that Y AG was a resident of Switzerland, the freedom of establishment was not an option but, as was already confirmed by previous case law, X GmbH could rely on the free movement of capital.

S. 372The German Government argued that there was no restriction on the free movement of capital since holding a share in a German company and holding a share in a company established in a third state with a low level of taxation, where Germany has no taxing right, are not comparable situations. The CJEU pointed out that the free movement of capital would be deprived of all meaning “if it were accepted that situations are not comparable solely because the investor in question holds shares in a company established in a third country, when that provision specifically prohibits restrictions on cross-border movements of capital”.

German CFC legislation for passive income was triggered after the conditions for it were met with no option for the taxpayer to provide proof that the arrangement was genuine. This was seen by the court as going beyond what is necessary to attain the objective.

The court therefore decided that the German CFC legislation was limiting the free movement of capital. It is important to highlight that the court granted the protection of the free movement of capital in third country situations (the option to prove that the arrangement is genuine) only in cases when a legal framework of information exchange is in place;, see here also Chapter 1.3.2. In other words, if there was no double tax treaty or another agreement on exchange of information relating to tax matters between Germany and Switzerland, the court would not have granted the protection of the free movement of capital.

3. Conclusion

The decision on the Cadbury Schweppes case highlighted that it is important to distinguish between situations with economic substance, e.g. a subsidiary performing real business activities in a EU Member State with a lower tax burden, from situations with no economic substance for which the arrangement was only put in place to formally comply with legislation. In its ruling, the CJEU laid down the conditions under which Member States may add profits of controlled foreign corporations to the tax base of their residents from low-tax jurisdictions in line with primary EU law. Based on this decision, whenever the freedom of establishment is applicable, i.e. in an intra EU situation, CFC legislation may only be applied if no “genuine economic activity” is carried out. This is reflected in S. 373the substance carve out of Article 7 section 2 of the ATAD reading that CFC legislation “shall not apply where the controlled foreign company carries on a substantive economic activity supported by staff, equipment, assets and premises, as evidenced by relevant facts and circumstances”. It is interesting to point out the wording of the ATAD’s substance carve-out is referring to “substantive economic activity” as opposed to “genuine economic activity” which is the wording used in the Cadbury Schweppes decision. According to scientific literature, despite the slight deviation, the meaning should be considered identical and therefore, in this respect, in line with primary EU law.

The ATAD provides that Member States may refrain from applying the substantive economic activity carve-out when the controlled company is located in a third (non-EEA) state. The disadvantageous treatment of third countries does not infringe the freedom of establishment because the freedom of establishment does not extend towards third states and is therefore in line with primary EU law.

As was discussed in Chapter 1.3., the decisive factor for determining whether the freedom of establishment or also the free movement of capital is applicable depends on the objective of the legislation. The free movement of capital might therefore become relevant in the case that the threshold for the applicability of CFC legislation would be lowered to also apply to portfolio investments. This is possible because the ATAD is drafted as a minimum standard, and Member States are free to lower the threshold if they see the need. In addition, in third country situations, the substance carve-out can be omitted. In theory, Member States could therefore opt for implementing CFC legislation in such a way that (i) the threshold for the application would be lowered and also become applicable to portfolio investments while, at the same time, (ii) refraining from applying the substance carve out to third countries whereby (iii) an information exchange mechanism for tax matters through a double tax treaty or other means would be in place with third countries. Not applying the substance carve-out to third countries under such circumstances would be a de-facto irrebuttable presumption that any activity performed in those third states is considered non-genuine. As was confirmed in the X-GmbH decision, this would be prohibited by the free movement of capital.

S. 374It can therefore be concluded that, in general, CFC legislation as included in the ATAD is in line with the fundamental freedoms but, in specific circumstances as described in the previous paragraph (i.e. third country scenario, CFC rules applicable not just to direct investments but also portfolio investments, no substance carve-out, exchange of information for tax matters in place), the free movement of capital could be breached. If a Member State was to implement the ATAD in such a way, the fundamental freedoms as primary EU law take precedence over national legislation. The CJEU clearly stated that “the law stemming from the treaty, an independent source of law, could not because of its special and original nature, be overridden by domestic legal provisions” and courts are obligated not to apply national provisions that conflict with EU law. The fact that the ATAD allows Member States to lower the default control threshold of 50% should not be mistaken to mean that the directive itself is not in line with primary EU law; only a far-reaching implementation of the directive into national legislation could constitute a breach of the free movement of capital. In order to avoid such situations, the ATAD could be amended by making the substance carve-out also mandatory for third country situations. Another option would be to disallow Member States from introducing a holding threshold of less than 25% since, based on Chapter 1.3.1, such a holding is still considered to be substantive, and the ATAD’s CFC rules would therefore always be subject only to the freedom of establishment.