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International tax laws or CFC rules and their effect on your foreign companies

Private Island

Setting up a company and taking advantage of tax benefits is easy for those who are already digital nomads or for those who are willing to leave their country. They only have to choose the best country to reside in or, directly, they can live as tourists, enjoying the life of the permanent traveler

If you live in a country that does not have CFC rules or with a territorial tax system you can set up your business wherever you want and take advantage of the place.

However, if this is not the case, if you live in a country with CFC rules, you will have to pay special attention to certain aspects of these laws and you will not always be able to take advantage of the tax benefits of setting up companies abroad (even less so if the State in question is considered a tax haven and is on the black list).

Your main objective should be to find out if the country you reside in has international tax laws and, if so, how they affect you and how you can legally avoid them.

At the end of the article we explain the effects of the CFC rules from the example of partners residing in various countries

About international tax laws

International tax laws or CFC rules (controlled foreign companies), which could be translated by SEC rules (controlled foreign company rules), exist in multiple countries. In fact, almost all large developed countries have them to prevent “subjects” from fleeing with their capital.

On the European continent you will find these laws to a greater or lesser extent in Germany, France, the United Kingdom, the Scandinavian and Baltic countries, in Italy, Hungary, Greece, Israel and more gently in Turkey.

Worldwide we find CFC rules in the United States, Canada, Mexico, Brazil, Argentina, Peru, South Africa, China, Japan, Korea, Australia, Indonesia and New Zealand.

And where do we find the toughest CFC rules worldwide? We find them in Germany and in the United States.

CFC rules have their effect on companies outside the country of residence. It depends on them that the company abroad has to pay taxes also locally (i.e. in the partner’s country of residence).

It is important to be clear that when we talk about taxes we always mean corporate taxes.

The CFC rules do not in any way regulate the filing of personal income tax returns.

Of course, you will have to pay taxes on your income (either via salary or dividends) at the tax rate that applies to you and the foreign companies you own will not change this.

This leads to the situation that there are many countries without international tax laws where you have to pay taxes on your income worldwide, no matter where it originated.

If you want to avoid paying taxes on income originating abroad, you will have to reside in a state with a territorial tax system or where you can live as a non-dom

The aim of the CFC rules is to avoid or hinder the creation of business structures to optimize taxes. That is, they exist to control that you cannot transfer your profits to companies in other countries that are under your control (directly or indirectly) in order to save taxes.

CFC rules usually affect passive shell companies (also called shell companies) where profits are kept to avoid paying taxes.

It is not uncommon for the country where you reside to want to have a piece of the pie, in these cases they use CFC rules to achieve this goal and tax the profits of foreign companies as if they were local companies.

There are states that officially do not have CFC rules, but have created some kind of local regulations or laws that make it difficult to manage companies abroad. This is the case in Austria, Latvia, Malta, Netherlands and Slovenia.

What if the country where you live does not have international tax laws?

However, most countries in the world do not have CFC rules of any kind. This is also the case in certain EU countries (although common rules will soon make it compulsory to introduce them): Belgium, Bulgaria, Cyprus, Croatia, Czech Republic, Ireland, Luxembourg, Poland, Romania, Slovakia. And also outside, in Ukraine, the Balkans and, of course, Switzerland.

Worldwide, other interesting places without CFC rules are Malaysia, Colombia, Chile, Mauritius, Philippines, Singapore, Thailand and many more

If you live in one of the countries without CFC rules you will have no problem setting up and managing your international business. That is, you do not have to declare that you have incorporated an offshore company, nor do you have to account for its benefits in your tax returns.

Of course, you do not have to pay corporate taxes either. You can therefore set up companies in jurisdictions where your companies do not pay taxes.

As we said, this does not mean that you, as a natural person, do not pay taxes if you reside in a country where taxes are paid. You will have to declare your income in the country where you reside for tax purposes as stipulated by local tax laws.

However, you will generally pay less tax, as you will receive the income via dividends (which is usually advantageous) or you may pay nothing and leave the money with the company. By doing so, you can delay the time of distribution of dividends until it is worth moving to a country where you do not pay any taxes on this type of income and can take all the money out of the company without paying anything.

As you can see, when choosing the best country to reside in, you should not only pay no taxes (non-dom, territorial, or no taxes in general), but also let you manage foreign companies without problems.

Sometimes you don’t even need to go to a tax-free country in order not to be taxed, often you can find very attractive countries that even though they have taxes for local companies and workers, they don’t force you to tax your income abroad

The effects of international tax laws in practice

In case you are not lucky enough to be in a country without international tax laws, you will have to consider how these laws affect your ability to incorporate and manage companies abroad.

The CFC rules of these countries vary greatly in form and effect.

In any case, you may have to pay corporate taxes in your country of residence (even on undistributed profits) as the owner of a foreign company in the following cases:

  • The company is located in a tax-free or low-tax state. Generally speaking, a low tax burden country is one which, in relation to the corporate tax in the country where you reside, has a 20 to 50% lower tax rate. There are often also blacklists of tax havens.
  • The company’s income is mostly passive (more than 30%). Passive income is understood to be that which comes from interest, licenses, rents, patents, …
  • The partner of the company has high participation in the company (the definition of what is high participation varies a lot according to the country, and goes from 1% to 50%)

Legal consequences of the CFC rules

It is important to understand that the CFC rules do not prohibit the incorporation of companies, nor does any other country oppose a person or company of the nationality and residence to incorporate companies abroad.

However, this type of international law has an effect (often quite negative) on the tax aspect. Sometimes, the consequence is that the partner has to pay corporate tax in his country of residence.

Generally, when the company resides in a low tax country you can deduct the taxes paid at source from those of your country of residence, but in the worst case (that there is no double taxation agreement), you may have to pay the corporate taxes of both countries (which is very rare, since, in general, the only countries without agreements are those that do not impose taxes).

Tax laws in the world: 5 types of CFC rules

In general we can differentiate between 5 types of international tax laws, the 5th type consisting of no laws. Of course, we are generalizing and it is important to study each specific case to avoid surprises.

First group: Most of the industrial states have strict CFC rules that limit the administration of companies abroad even when they are considered active. The decision whether they pay taxes in the home country or in the partner’s country depends in general on the percentage of shares and the degree of taxes in the home country (company headquarters).

Second group: There are also some states that are not so strict with companies active in low tax countries. In these cases the CFC rules are only activated when it comes to shell companies, companies with passive income such as capital income, rent, and license income. As soon as such companies pay out dividends, the partners will have to pay offsetting or similar taxes.

Third group: There are countries with lax international tax laws. In these cases, the laws are activated when the partner has a large number of shares, and additionally the company pays few taxes. In part, the laws only affect individuals or companies. When they only affect companies, what they do is prevent certain practices, such as the transfer of profits, for example. However, individuals can keep their income in the shell company.

Below is a very general summary of the type of CFC rules in each country. I refer here mainly to the tax amount from which the CFC rules are activated.

Group 1: Strict CFC rules against active companies

Europe

Norway: in case of a participation of more than 50%, they are activated if the corporate taxes are below 2/3.

Germany: activated if the corporate taxes are below 25%, also in case of passive income or if the management is not present in the country.

Sweden: activated if the corporate taxes are below 12.1%.

United Kingdom: the address must be present in the country.

Iceland: activated if corporate taxes are below 3.3% or if the address is not present in the country.

Finland: activated if the corporate taxes are below 12%.

Estonia: activated if the corporate taxes are below 7%.

Hungary: activated if corporate taxes are below 10%.

France: they are activated if you pay less than 50% tax in the foreign country than you would in France.

Portugal: activated if you pay less than 60% of the taxes that you would pay in Portugal.

Italy: activated if you pay less than 50% of the tax that you would pay in Italy.

Greece: activated if corporate taxes are below 13% or if the address is not present in the country.

Russia: the address must be present in the country, if more than 10,000,000 rubles.

Spain: activated if the foreign country pays less than 75% of the taxes that would be paid in Spain.

Asia

China: activated if corporate taxes are below 12.5%.

South Korea: activated if corporate taxes are below 15%.

Japan: activated if corporate taxes are below 20%.

Israel: activated if corporate taxes are below 15%, in case of passive income or if the address is not in the country.

America

USA: activated in case the participation of US citizens is more than 10% 50%.

Brazil: taxes are deducted at source up to 34%.

Africa

Egypt: activated if the management is not present in the country or the company has more than 70% of passive income.

South Africa: the management must be present in the country if more than 50%, taxes are taken into account at origin.

Group 2: Strict CFC rules against passive companies

Europe

Denmark: they are activated if the passive income corresponds to more than 50% of the total income.

Lithuania: activated in case of passive income, if less than 75% of tax is paid in the foreign country than would be paid in Lithuania.

America

Canada: activated in case of passive income, in case the participation exceeds 10% or is majority.

Mexico: activated in case of passive income comprising more than 20% of the total, if in the foreign country less than 75% of taxes would be paid in Mexico.

Peru: activated if the foreign country pays less than 75% of the taxes that would be paid in Peru.

Venezuela: they are activated if the corporate taxes are below 20%.

Oceania

Australia: they are activated if the passive income corresponds to more than 5% of the total income.

New Zealand: activated if the passive income is more than 5% of the total.

Group 3: Lax international tax laws against passive companies

Europe and Asia

Poland: they are activated if the passive income reaches 50% of the total, if the taxes are below 25% of what it would be in Poland if the turnover exceeds 250,000 euros.

Turkey: they are activated if the passive income reaches 25%, if the taxes are below 10% of what it would have in Turkey, it only has an effect on companies.

Indonesia: they are activated if the participation exceeds 50%.

America

Argentina: they are activated if the passive income reaches 50% of the total.

Uruguay: they are activated if the taxes of societies are below 12%, it only has effect on persons.

Group 4: Without international tax laws, they do have certain general rules to prevent tax evasion

Austria: you must take into account the substantive criterion (prove you have a business substrate) and it has to be an active business.

Latvia: you are obliged to pay 15% tax at source in the case of transactions with low tax countries.

Holland: you are obliged to pay 15% tax at source if the company is in countries on its blacklist or with taxes below 12.5%.

Malta: subject to restrictions if the passive income is more than 50% of the total, if the taxes are below 15%.

Group 5: No international tax laws

Rest of the world

Among them, of special interest: Switzerland, Ireland, Belgium, Czech Republic, Slovakia, Luxembourg, Chile, Georgia…

Non-participating countries/black lists

Depending on the case, some States decide when the CFC rules are activated according to the country. They maintain blacklists of countries with which international tax laws are automatically activated.

All countries on these lists are automatically subject to corporation tax in the partner’s country of residence, regardless of what the partner’s country of residence does. Often we encounter additional conditions or conditions that do not allow certain business expenses to be deducted.

There are also states that do the opposite, instead of black lists they use white lists. These lists group the countries in which their residents can create and manage companies without problems, paying taxes at origin. In these lists usually appear the countries with high tax burden and with good international trade relations.

Black lists usually contain tax havens. Each State defines tax havens according to its own criteria. Countries without corporate taxes usually fall directly into this group. States with agreements for the exchange of tax data are usually outside these lists. This is what makes some countries without corporate taxes are not on the blacklist.

The EU intends to sanction countries without taxes. However, there is no EU blacklist yet. You can find the blacklist of the country in the European Union you are interested in here.

Here is an example of a blacklist, in this case that of Lithuania (I choose it because it is a fairly complete list that includes all the “usual suspects”):

  • Andorra
  • Anguilla
  • Antigua and Barbuda
  • Aruba
  • Ascension, St. Helena, and Tristan da Cunha
  • Bahamas
  • Bahrain
  • Barbados
  • Belize
  • Bermuda
  • Brunei
  • United Arab Emirates
  • Costa Rica
  • Curacao and Sant Maarten
  • Dschibuti
  • Dominica
  • Ecuador
  • French Polynesia
  • Gibraltar
  • Grenada
  • Guatemala
  • Guernsey
  • Hong Kong
  • Cayman Islands
  • Cook Islands
  • Isle of Man
  • Marshall Islands
  • Turks and Caicos Islands
  • The British Virgin Islands
  • US Virgin Islands
  • Jamaica
  • Jersey
  • Kenya
  • Kuwait
  • Lebanon
  • Liberia
  • Liechtenstein
  • Macau
  • Maldives
  • Mauritius
  • Monaco
  • Montserrat
  • Nauru
  • New Caledonia
  • Niue
  • Panama
  • St. Kitts and Nevis
  • St. Pierre and Miquelon
  • St. Vincent and the Grenadines
  • Samoa
  • San Marino
  • Sark
  • Seychelles
  • Tonga
  • Uruguay
  • Vanuatu
  • Venezuela

Exceptions to the CFC rules

Okay, now you’ve discovered that the country you live in has CFC rules and they’re strict and don’t allow you to incorporate the way you wanted to in the state you had your eye on.

Don’t despair yet, it doesn’t end there.

In general there are two important exceptions to international tax laws, one is motivated by the law of freedom of establishment within the European Union and the other affects companies that can demonstrate a certain business substrate in the foreign country.

Below you can read what they are and how they can help you if you are affected by the CFC rules of the country where you reside.

Exception 1: freedom of establishment in the EU

Within the European Union you have different options to optimize taxes in a totally legal way if you are willing to set up or move your company to the appropriate place.

These options are given by the freedom of establishment of the EU, a law that guarantees the free establishment of persons and companies in any country within the common space.

In principle, European law has a higher status than national laws and regulations, although this has not managed to prevent Germany, for example, from placing obstacles to the incorporation of companies in certain countries within the European Union (Malta, Cyprus, Ireland, Estonia and Bulgaria) because they are considered low tax countries.

However, the option of optimizing taxes by taking advantage of the tax differences in the EU may no longer be available if Brussels goes ahead with its plans.

There is an intention on the part of the EU to oblige all member states to prevent tax optimisation through international tax laws. Moreover, there is even talk of a common corporate tax.

Of course, as things stand in the European Union this is not expected to happen, as all states would have to agree and such a measure would harm at least a quarter of them.

Exception 2: Permanent establishment with a business foundation or substrate

The substantive criterion or business substrate refers to how credible a company is, to the real economic interests that the company has in the country where it has been created.

The substrate is a matter of degree. To demonstrate that the company has “substance” it can have its own office, workers, a director in the foreign country, etc.

If your permanent establishment or company abroad meets these requirements, you should have no problem getting your state, no matter how strict, to recognize the foreign company.

The substantive criterion plays an important role in double taxation agreements. The degree to which international tax laws are not triggered varies greatly from country to country.

Even in cases where there is a double taxation agreement between a high and a low tax burden State, when there is sufficient business substrate the companies are recognized (and their tax advantages). Without an agreement the process is more complicated, but not always impossible (it depends on the countries involved).

The example of the residents in Germany

To give you an idea of how problematic international tax laws can be, here is one of the most restrictive countries when it comes to letting residents incorporate abroad: Germany.

If you are resident in Germany, to set up a company abroad without the CFC rules being activated, you will have to prove that the company has a business substrate in the foreign country. That is to say, that it has an office, employees and contracts in the other country. This would be the case even if the other country was within the European Union (which is against EU law, Germany has already received notices about this, which it has ignored after some small changes in its laws).

In addition, the director of the company will have to spend certain periods of time in the foreign country and must not hold more than 50% of the shares in the company.

As if this were not enough, the company has to participate in the economy of the country (or at least try to), it has to be able to demonstrate that it has economic interests to open the company in the foreign country. This is often the part that fails to open companies in tax havens (you rarely get clients in these countries).

If you could not prove that your foreign company has a business substrate, you would have to pay a so-called clearing tax (a form of withholding tax) in Germany.

This means that the company would pay German corporation tax in addition to business tax (depending on the partner’s place of residence).

Even if the foreign company does not distribute dividends, you cannot escape the tax authorities in Germany. The German tax law explicitly mentions this case and obliges to tax also the profits which have not been distributed to the partners.

The compensation tax (Hinzurechnungsbesteuerung) usually has a very negative effect on the individual income tax return. Moreover, it is often not even based on the company’s balance sheet, but results from a fictitious amount that the German tax authorities estimate (rarely for the better).

All this results in the fact that residing in Germany it is very difficult to optimize taxes through international tax strategies. You have to set up a company with a business substrate in another EU country, which makes it a rather expensive solution that is only worthwhile when the income is high.

However, if you do it right, you can pay only 5% tax in, for example, Malta.

The example of the residents in Austria

We have already seen the case of the Germans, however, if we go a little further south, things change quite a bit. We find a country that, although it has no international tax laws, does include certain general rules to prevent tax evasion by creating companies abroad (although respecting the laws of the common European space).

In general, Austrian residents cannot receive benefits from abroad without paying taxes there. However, this is limited to passive income such as interest, capital gains and license income.

The CFC rules in Austria do not prevent Austrian residents from leaving their profits in the foreign company. Unlike in other countries, they do not have to pay taxes on undistributed profits.

Nor do they have any problem making (pre-tax) investments through the foreign company. Of course, when dividends are distributed to the individual resident in Austria, he will have to pay tax.

In general we could say that from Austria you can manage most of your online business without any problem, even if it is through foreign companies.

However, there is a regulation according to which you must be able to justify the existence of the foreign company beyond “tax optimization”, maybe you want to have direct access to the market of a particular region, to your suppliers…

The example of residents in the Czech Republic

Unlike the other examples, there are no international tax laws in the Czech Republic that make it difficult to manage companies abroad.

This is despite the fact that, as in other European Union countries, the Czech Republic does levy taxes on a person’s universal income (residence taxation).

The absence of CFC rules allows a resident of the Czech Republic to set up companies anywhere in the world and transfer profits or leave them in companies that pay no or only little tax.

The company would be taxed in the state in which it is incorporated on its overall profits and according to the rules of the country of residence. It would also be subject to the tax, labor, mercantile and criminal legislation of the country in which it has been incorporated.

That is, if you reside in the Czech Republic, you could leave the profits in the company and invest them in the stock market, for example, so that you would not pay taxes in your place of residence and your money would grow faster.

On the other hand, you can also include personal expenses as business expenses. If you have the foreign company in the UK or especially in Cyprus this will not be difficult.

Again, the important thing here is that you do not pay dividends, that the money stays in the company. Otherwise, you would have to declare such income in your annual income.

As you can see, the issue of international tax laws is not simple and changes completely according to the country where you reside and the country where you want to incorporate your company.