By Robert Jean Kloprogge, partner, and Olivier Elsenburg, associate, Simmons & Simmons LLP, Amsterdam
On 15 December, the prospect Dutch coalition government published its 2021–2025 coalition agreement, which includes tax plans. Among the proposals is a plan to adopt some specific recommendations regarding the Dutch controlled foreign company (CFC) rules from the 2020 report of the Dutch Advisory Committee on the Taxation of Multinationals.
According to the report, the CFC rules should be strengthened by, inter alia, applying the rules to distributed profits and omitting downward transfer pricing adjustments to qualifying CFC income.
An important additional factor in strengthening the CFC rules is that the tax plan also confirms that the OECD’s Pillar II income inclusion and undertaxed payment rules will be implemented.
This article discusses the expected amendments to the CFC rules based on the proposals included in the coalition’s tax plans.
Current Dutch CFC rules
The Netherlands has implemented its (additional) CFC rules following the Anti Tax Avoidance Directive. Under these rules, a specific step plan should be followed to determine the impact of the CFC rules on a Dutch resident taxpayer. The Netherlands could choose between option A (inclusion of undistributed profits) and option B (transfer pricing approach) for implementing the CFC rules. Although the legislator considered that the Netherlands already de facto implemented option B, it chose nonetheless to also implement option A. This option A, the additional CFC rule, is in effect as of 2019.
Step 1: Does the Dutch taxpayer hold an interest in a CFC?
Under the additional CFC rule, it should first be determined whether the taxpayer holds an interest in a CFC. A foreign entity or permanent establishment is considered a CFC if the Dutch taxpayer has a(n) (in)direct interest of at least 50% in the nominal paid-up shares, statutory voting rights, or profit rights in the CFC and if it is established in a low-tax or black-listed non-cooperative jurisdiction. A low-tax jurisdiction is a jurisdiction with a statutory profit tax rate of less than 9%, whereas the “black list” of non-cooperative jurisdiction is maintained at the EU level.
Step 2: What is the amount of passive income?
If the Dutch taxpayer indeed holds an interest in a CFC, it should be assessed what amount qualifies as so-called passive income. Passive income most notably includes interest, royalties, and dividend income. For purposes of the CFC rules, passive income also includes income from financial leasing, insurance, banking, or other financial activities and income from invoicing companies that earn sales and services income from goods and services purchased from and sold to associated enterprises while adding no or little economic value.
Under the rules, the Dutch taxpayer includes the passive income of the CFC in its taxable income. The amount of passive income is calculated on the basis of Dutch tax standards and includes each (in)direct CFC, to the extent applicable on a pro rata basis. For calculating the amount of passive income, it should be determined what the taxable amount of this income would be if the CFC were a Dutch resident taxpayer. This also means, for example, that if a CFC receives dividend income that would be exempt under the participation exemption were the CFC a Dutch-resident taxpayer, this dividend income should not qualify as passive income.
An important additional rule stipulates that if a CFC distributes any amount of passive income within the same financial year to its (non-CFC) shareholder, this amount does not have to be included in the taxable income of the Dutch-resident taxpayer.
Step 3: Does any exception apply?
Lastly, it should be verified whether an inclusion exception applies. An exception applies – meaning that the foreign entity or permanent establishment is not considered a CFC – if either 30% or less of its net income is passive income, or if the foreign entity is a financial undertaking in the form of a legal entity and less than 30% of the entity’s passive income is derived from related party transactions. Furthermore, the exception applies if the CFC carries on genuine economic activities in its home jurisdiction.
Committee recommendations to amend Dutch CFC rules
The Dutch Advisory Committee on the Taxation of Multinationals published their report on 15 April 2020. The report aimed to find a more balanced Dutch corporate income tax system for multinationals and to provide the legislator with underlying analyses and recommendations to do so. Part of the report’s recommendations relates to the CFC rules.
The committee starts by mentioning that the Dutch CFC rules have a limited scope due to the fact that passive income is calculated based on Dutch tax standards and by virtue of the economic activity exception (substance/ economic nexus escape). Under standard Dutch transfer pricing rules, only a very limited profit allocation takes place to entities performing limited (key) functions. Therefore, applying the CFC rules will not result in a substantial levy in the Netherlands as either no profit is allocated to the CFC or the substance escape will generally apply. The committee, therefore, proposes a series of recommendations to strengthen the effectiveness of the Dutch CFC rules, which essentially means that the amount of CFC income will increase.
The main recommendation (numbered A5) proposes to make the CFC rules more effective by (i) also applying the rules to distributed profits, (ii) abolishing downward transfer pricing adjustments on CFC income, (iii) working towards an effective tax rate test rather than a statutory tax rate test, (iv) amending the genuine economic activities exception, and (v) broadening the possibilities to prevent double taxation. The other recommendation (numbered B5) would apply the CFC rules also on active income and further elaborates on the relation of this, and the other (A5) measures, with Pillar II.
Recommendation (i): applying the rules on distributed profits
The CFC rules only apply to non-distributed profits. By also applying the rules to distributed profits, however, a multinational should no longer be able to circumvent taxation by distributing an interim dividend before the end of the tax year in jurisdictions where this is possible to its direct shareholder, at which level potentially no tax would be levied on the dividend income received.
Recommendation (ii): abolishing downward transfer pricing adjustments
Abolishing transfer pricing adjustments when determining the CFC income effectively results in alignment with the CFC income as commercially reported in the CFC jurisdiction, thus preventing any mismatches and reducing the risk of artificial allocation of profits to low tax jurisdictions.
Recommendation (iii): the effective tax rate
Instead of assessing the statutory rate of a jurisdiction, the effective tax rate in that jurisdiction should be assessed. The Netherlands is the only jurisdiction assessing the (mere) statutory rate, apparently due to implementation difficulties. By assessing the effective tax rate, however, any low-taxed entity, including those situated in “high” tax jurisdictions, could be affected by the CFC rules. In this respect, it is noted that this test is already applied for purposes of the Dutch participation exemption regime. Note however that the committee stipulates that this effective tax rate proposal is a spot on the horizon.
Recommendation (iv): the economic activities exception
Meeting the substance requirements is relatively easy to achieve, especially for (financially strong) multinationals, partially due to the fact that the tax inspector will have to demonstrate the plausibility that using the economic activities exception is one of the main goals of the taxpayer. Furthermore, the committee concludes that it is not an internationally accepted approach to fill in the requirement of economic activities (by, e.g., substance requirements). The committee, therefore, recommends abolishing the evidentiary presumption of meeting the substance requirements.
In addition, the committee refers to international initiatives aiming to achieve measures ensuring a minimum level of taxation. Such measures are likely to be implemented in a CFC-like fashion. The goal of the CFC rules will then no longer merely be anti-abusive, but also organising a minimum level of taxation. Implementation hereof means moving towards a more neutral capital export approach, reducing the tax competition incentive between jurisdictions, especially if this is implemented by multiple jurisdictions. The committee notes the international developments and recommends bringing this further in an international forum.
If, however, there will be no agreements at the international level on measures to ensure a minimum level of taxation, the committee advises that the Netherlands should unilaterally abolish the economic activities exception, as a result of which the CFC rules would apply to all tainted benefits (passive income) derived from a CFC. When doing so, it could be considered to raise the threshold to 50% (i.e., a CFC is assumed if 50%, instead of 30%, or more of its income is passive income), thus creating sufficient margin for taxpayers with genuine business activities. If the exception is unilaterally abolished and the goal of the CFC rules is broadened to include organising a minimum level of taxation, it could be considered when applying the CFC rules to no longer levy up to the Dutch statutory rate, but rather up to a certain minimum rate. This would also fit within the current international discussions and should be less harmful to the Dutch business climate than levying up to the national rate.
Recommendation (v): preventing double taxation
The CFC rules do not have much regard for eliminating double taxation due to the prohibitive nature of these rules. However, a wider and more effective scope of application of the rules as proposed in the previous recommendations also widens the possibility of taxpayers being affected by the CFC rules and, thus, the risk of double taxation. Therefore, the committee deems it appropriate if the legislator would acknowledge this risk and would take additional measures to prevent such double taxation.
Recommendation B5: active income and Pillar II
In the A5 recommendations, the committee advises strengthening the CFC rules. A further-reaching step would be to also apply the CFC rules on active income. This would effectively entail that all low-taxed profits of direct and indirect subsidiaries would be included in the taxable base in the Netherlands. The scope of the CFC rules would be broadened considerably as the rules would no longer just be aimed at relocating mobile profits. This would boil down to an effective minimum taxation on all profits derived from activities performed under the Dutch level. The advantage would be that the importance of determining the transfer pricing between Dutch parent companies and its (in)direct subsidiaries would decrease, as would, by doing so, the manipulation possibilities.
Applying the CFC rules on active income, however, would significantly affect the competitiveness of Dutch multinationals as they would no longer be subject to the local tax rates for activities abroad, but to the Dutch tax rate. The Netherlands would also part with its principle of capital import neutrality for business profits. Therefore, and again, it could also be considered to not have the CFC rules levying up to the domestic rates, but to a certain minimum rate. This more limited additional taxation would mitigate (but not entirely remove) the mismatch of rates. The importance for multinationals in determining their transfer pricing policy would continue to exist, and with it also the possibility of a strategic application of the arm’s length principle. At the time that the committee’s report was published, international agreements on minimum taxation lay at the horizon with Pillar II. The committee advised committing to international consensus on generic measures mitigating and/or preventing mismatches in rates.
Pillar II, an initiative by the OECD to be adopted by the European Union Member States through the implementation of the European Commission directive, proposes to introduce a minimum effective tax rate for multinationals. Pillar II introduces two domestic rules (collectively these rules form the global anti-base erosion rules) and a treaty-based rule. The domestic rules are the income inclusion rule (imposing a top-up tax on a parent entity in respect of low-taxed income of group entities) and the undertaxed payment rule (allocating a top-up tax to a jurisdiction to the extent the low-tax income of an entity is not subject to tax under the primary rule – a backstop rule). The treaty-based rule is the subject to tax rule allowing source jurisdictions to impose limited source taxation on certain related-party payments which are subject to tax below a certain minimum rate. This rule will be implemented through a new multilateral instrument.
On 22 December, the European Commission proposed its Council Directive on ensuring a global minimum level of taxation for multinational groups in the EU, containing the Pillar II rules described above. The European Commission acknowledges that the implementation of its proposed global anti-base erosion rules could specifically affect a member states’ CFC rules as these could interact with the income inclusion rule. According to the Commission, it is not necessary to amend the CFC rules. The Commission deems it appropriate to continue the application of the CFC rules in parallel to the proposed global anti-base erosion rules. In practice, the CFC rules would apply first and any additional taxes paid by a parent company under the CFC rules will be taken into consideration in the global anti-base erosion rules by attributing those to the relevant low-taxed entity / CFC for the purpose of computing its effective tax rate in the specific jurisdiction.
Tax plans of the coalition based on committee’s recommendations
As mentioned, the prospect Dutch coalition government stated that it is contemplating implementing the CFC recommendations of the committee. More specifically, the coalition stated that “the CFC measure from the committee’s report will be introduced, as will OECD’s Pillar II”. It is unclear whether this means that all recommendations of the committee will be implemented, including recommendation B5. This is especially questionable as the coalition merely refers to “the CFC measure” (singular), whereas A5 and B5 are, at least, two separate measures. However, in light of Pillar II, at this point, we would assume the coalition intends to implement the A5 measures but not, also, B5.
Conclusions
The prospect coalition government commits to further strengthen the Dutch CFC rules by, probably, introducing application of the rules also on distributed profits, abolishing downward transfer pricing adjustments, and increasing focus on the elimination of double taxation.
Furthermore, as Pillar II will be introduced, it is likely that the recommendation to work towards an effective tax rate test rather than a statutory tax rate test will also be met. Following the committee’s recommendations on the economic activities exception and the active income inclusion proposal is more questionable, as the prospect coalition government, as well as the committee itself, appears to consider this to be under the primacy of the EU and European Commission (i.e., the ultimate outcome of Pillar II), rather than that of the Dutch government.
As it is expected that the Pillar II rules should be implemented and in effect from 1 January 2023 (for the income inclusion rules, the undertaxed payment rule would apply from 1 January 2024), we would also expect the discussed amendments to the Dutch CFC rules to be introduced from the same date.
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