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Jaroslav Foltýn | May 18, 2021

The ATAD directive: The rules for taxation of controlled foreign companies according to the ITA – part 1

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The rules for taxation of controlled foreign companies (the so-called CFC rules) have been incorporated into the Czech income tax act (hereinafter the “ITA”) into the stipulation of article 38fa with effect from 1 April 2019 by act no. 80/2019 Coll. (hereinafter also as “ITA Amendment”).

CFC (controlled foreign company) rules are intended to prevent artificial diversion of assets that generate passive income to foreign companies that are tax residents in countries with a low level of taxation. If the conditions of CFC rules are met, the activity of the controlled foreign company and the handling of its assets, from which the included income arises, are viewed as if they were realised by the controlling company on the territory of the Czech Republic as of the end of the taxable period of the controlled foreign company. The controlling company is then obliged to adjust its tax base for this included income of the controlled foreign company.

According to the transitional provision of the given amendment, this stipulation will first apply for the taxable period of taxpayers (legal entities) that began after the ITA Amendment took effect. This means that corporate income tax payers, who are connected to foreign companies and whose taxable period is the calendar year, will need to apply the CFC rules for the first time now, i.e. when compiling the corporate income tax return for the taxable period of the year 2020.

CFC rules have been amended by act no. 608/2020 Coll. with effect from 1 January 2021, when the procedure for taxation of controlled foreign companies was amended in the case of controlled foreign companies listed in the EU list of so-called non-cooperative jurisdictions (you can find more detailed information below). The General Financial Directorate also published the Information on application of act no. 586/1992 Coll., on income taxes, as amended, in January 2021, relating to the ATAD issue (hereinafter the “Information of the GFD”).

For the purposes of correct application of CFC rules, it is necessary to evaluate the following basic facts, individually for each foreign company:

  1. If the respective foreign company is considered a controlled foreign company?
  2. If the Czech taxpayer (legal entity) is in the position of a controlling Czech company to this foreign entity?
  3. If the controlled foreign company achieves so-called included income?

Controlled foreign company

For the purposes of the ITA, a controlled foreign company is understood to mean a corporate income tax payer, which is a Czech non-resident, while the both of the two following conditions are met:

  • the controlled foreign company performs no substantial commercial activity (i.e. it only reaches passive income), and
  • the controlled foreign company is a tax resident in a jurisdiction, where the corporate income tax or a similar tax is one half lower than would have been assessed for the company according to the Czech ITA, if it were a tax resident of the Czech Republic (the so-called hypothetical Czech tax liability).

Substantial commercial activity

The purpose of the condition is to reduce the application of the rules on taxation of controlled foreign companies only to the so-called empty shells, that is entities that only serve for placement of assets, from which income arises, such as intellectual property rights or securities, which would be subject to taxation in the country of this empty shell, and not in the Czech Republic, there their real economic source is.

Neither the ITA, nor the explanatory memorandum or the Information of the GFD define the term “substantial commercial activity”, though. According to the explanatory memorandum, it is necessary to assess, if the controlled foreign company performs actual (real) economic activity, i.e. an activity reflecting the actual economic reality. This can be discerned for example from the fact that the given company uses staff, premises, equipment and other assets for its activity. If the foreign company performs real activity, it is also necessary to assess if the income from this active operation (for example the sale of good and services) represents a significant part with regard to the achieved so-called passive income (e.g. dividends, interests or royalties), which can be detected for example from the proportion of active and passive income. If it turns out from such a comparison that the economic activity of the foreign company is only a marginal matter and most income consists in so-called passive income not directly related to the active operation, or the performing of economic activity is only a way to conceal the actual situation, then this activity cannot be considered substantial commercial activity. For the assessment, if the case is a substantial commercial activity, it is also possible to use the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, which use the term “substantial commercial activity” and define it for the purposes of determining transfer prices by the proportion of accounting profit to operating costs.

Effective tax rate

  • This condition ensures, for a change, that CFC rules will only apply in case the effective tax rate of the foreign company is significantly lower (less than 50%) than what would have been effective taxation of the same income in the Czech Republic. So this is not a matter of comparing statutory tax rates used abroad and in the Czech Republic, although a great difference between these rates, of course, indicates a risks of application of CFC rules in the given case (e.g. Bosnia and Herzegovina – 9 % vs. 19 % in the Czech Republic).
  • If we leave aside foreign companies that have their seat in the so-called tax havens (e.g. the British Virgin Islands), which apply practically no corporate income tax, it is primarily necessary to examine this condition in jurisdictions, which apply various tax discounts that lower the effective tax rate compared to the rules applicable in the Czech Republic. These include for example:
  • Cyprus and its deemed deductions applied for intangible assets or contribution of shares,
  • Luxembourg and its exemption of the income from sale of securities from corporate income tax in Luxembourg, or the collective investment schemes in Luxembourg, which are not subject to corporate income tax there.

The Information of the GFD now gives instructions for how to determine the amount of the hypothetical Czech tax liability of a foreign company accounting to Czech accounting rules and subsequently adjust the profit/loss of the Czech taxpayer according to the ITA. The hypothetical Czech tax liability will be determined from all income of the foreign company, i.e. not only from the so-called included income. From such a determined hypothetical tax liability, its half will be calculated and will be compared to a tax corresponding to the corporate income tax of the controlled foreign company in the country, of which it is a tax resident.[1]

  • Example: A foreign company reports tax liability reaching 5 in the country of residence, while a hypothetical Czech liability would be set at 20. In the given case, one half of the hypothetical Czech tax liability equals 10, which is more than the tax liability reported by the foreign company. In the given case, the condition of one half of the tax would thereby be met.

If, then, a foreign company fulfils both of the above-mentioned conditions (at the same time), it will, for the purposes of the ITA, be considered a controlled foreign company, whose included income is subject to CFC rules on the level of the Czech controlling party.

In the next part, we will take a look at when the Czech taxpayer (legal entity) is in the position of a controlling Czech company to the controlled foreign entity and when the controlled foreign company achieves the so-called included income. We will also discuss, how to report the potential adjustment in the tax return.

[1] If for the purposes of evaluating the condition, tax loss is posted, both from the perspective of the hypothetical Czech liability and the corresponding corporate income tax of the controlled foreign company in the country, of which it is a tax resident, then the tax liability considered will be 0.