Controlled Foreign Corporation (“CFC”) rules target profit shifting strategies, whereby easily mobile income is attributed to group companies located in low tax jurisdictions. The Action 3 of the Plan on Base Erosion and Profit Shifting (“BEPS”) directed the OECD is specifically devoted to this important issue. Spain has become one of the early adopters of most of the recommendations of this BEPS Action Plan. In the Corporation Tax reform of 2015 the Spanish CFC rules where substantially amended to comply with BEPS recommendations. The purpose of this post is comment the new rules applicable, to highlight the main differences with the previous regulations and to comment some loopholes that the new regulations still persist.
CFC rules are applicable to Spanish companies that alone or together with to other related individuals or entities control 50 % of more of the voting rights, capital, assets or profits of the CFC. Spanish approach to set the control requirements is rather broad and refers both to the legal control and to the economic control. Under the Spanish rules, the CFC must be a corporation since other legal vehicles, like partnerships and other pass through entities, are not targeted by this regime on the grounds that the full income of such entities is anyway attributable to their Spanish members.
For the CFC rules to apply, the low tax threshold must be met. This threshold means that the attributable income is deemed to be low taxed if the tax paid in the CFC jurisdiction is lower than the 75 % of the tax that would have been paid according to the Spanish Corporation Tax rules. However, the Law allows for a “the minimis” rule so that if the attributable income represents less than 15 % of the net income of the CFC no attribution is required. This rule allows circumventing CFC rules by the fragmentation and allocation of the attributable income into several group companies.
As from January 2015, Spain has completely shifted the general approach to CFC rules. Instead the former transaction based approach, the new rules are more based on the entity approach. So the first step is to look at the substance of the CFC to see if it has the necessary means, in terms of assets and employees, to perform its business. In case it fails in this first test, the full income of the CFC would be attributed to its Spanish parent company. This rule will therefore prevent the artificial allocation of, not only passive income, but also trading or services income to foreign subsidiaries. However, this CFC attribution rule based on the entity substance is not applicable to:
- Holding companies
- When the tax payer can probe that the establishment and functions of the CFC are based on valid economic criteria
- When the CFC uses the assets and employees of other group company to obtain his income
If the CFC meets the substance criteria, then no full attribution would be required, but still certain categories of passive income (dividends, interest, royalties…) could be attributed to the Spanish parent company.
Holding companies and CFC rules
As a general principle if the CFC is a holding company, dividends and capital gains on the disposal of shares are viewed as passive income and, therefore, are attributable to the Spanish parent company. However, if the CFC holds at least 5 % of the share capital of the paying company for at least one year, dividends paid to the CFC – or capital gains- will not be attributable if they are paid out of active income (that is, the subsidiary of the CFC is engaged in an actual business or trade) or the CFC itself is engaged in the trade of securities. But in any case the Law requires that the CFC has the necessary substance as to manage his interest in his subsidiaries. It is important to remark that all these requirements (participation, substance, time of ownership) are analyzed at group level, not only at CFC level.
Other important issue, frequently overlooked, is that if the subsidiary of the CFC is located in a country who has signed a Tax Treaty with Spain or subject to a nominal tax rate of at least 10 %, then the dividends paid to the CFC would never be deemed to be attributable income to the Spanish parent company, even if the dividends are not paid out of active income. Due to the participation exemption regime, said dividends would have been exempt in the hands of the Spanish parent company if they had been paid directly to it. Therefore, assuming no tax at the CFC jurisdiction, the effective tax rate of the CFC is not lower than the 75 % of the tax that would have been in Spain paid according to the Spanish Corporation Tax rules.
Interest and insurance premiums
As a general rule, interest and other finance income earned by the CFC is deemed to be passive income and therefore attributable. However, interest earned in an active financing business would not be attributable under certain conditions. It is important to remark that interest earned by the CFC from other group companies is always considered business income.
Financing business income earned by the CFC is attributable when the following conditions apply:
- Interest is earned from related companies resident in Spain
- The payer is entitled to deduct this expense
Finally there is a safe harbor rule: none of the financing income of the CFC would be attributable if more than 50 % of this income is earned from unrelated parties.
The very same rules apply to insurance income and, for that matter, income earned by the CFC for services.
This is one of the new rules which came into force in January 2015. Before the legal change, IP companies were not affected by CFC rules which allowed Spanish companies to shift IP assets to affiliated companies located low tax jurisdictions. However, with the new rules, royalties earned from IP assets, as well as other mobile income such leasing activities are attributable income unless such income is earned in the context of an active business.
To finish with the analysis of the Spanish CFC rules, we should add that losses of the CFC are never attributable to the parent company and only can be offset by the CFC. However, the rules allow offsetting passive income of the CFC and the losses resulting from an active business or from other types of passive activities. In other words, the attributable income cannot exceed the overall profit of the CFC.
Contributed by Emilio Alvarez: email@example.com