M&A Vocabulary – Understanding the Experts: “CFC rules”

Controlled Foreign Corporation rules, known in German as “Hinzurechnungsbesteuerung” and in English as “CFC rules,” are provisions in the German Foreign Tax Act (AStG). These rules ensure that profits generated by a controlled foreign company (a so-called “intermediate company”) in a low-tax foreign jurisdiction are taxed at the level of the parent company. They serve as an anti-abuse measure. Without such regulations, it would be possible to let profits accrue in a low-tax intermediate company, thereby reducing the overall tax burden. If the distribution of such profits were also tax-privileged, a final tax effect—rather than just a temporary one—could occur in the absence of these rules.

The following requirements must be met for CFC taxation to apply:

1. It must be a “foreign company,” i.e., a corporation, association of persons, or estate within the meaning of the Corporate Income Tax Act that has neither its registered office nor its management in Germany. Transparent partnerships are therefore excluded.
2. The foreign company must be controlled by German residents; i.e., the person with unlimited tax liability in Germany must, alone or together with related parties, hold more than half of the voting rights or shares in the nominal capital, or be entitled to more than half of the profits or liquidation proceeds. Related parties may also be resident abroad, meaning they do not necessarily have to be subject to unlimited tax liability in Germany. Note that the rules on domestic control changed as of January 1, 2022. Before this date, for example, it was not required for related parties to exercise control. However, controlling persons had to be subject to unlimited tax liability in Germany. It should also be noted that for interests in foreign companies that generate at least 10% or EUR 80,000 in investment-type income and do not have a business operation with the necessary material and personnel resources—such as foreign holding or financing companies without substance—the criterion of domestic control does not need to be met for CFC taxation to apply.
3. The foreign company must generate passive income, and this income must be subject to low taxation. To distinguish this, Section 8 (1) AStG contains a catalog of active income (e.g., production, independently rendered services, or trade, provided an established business operation exists). If the foreign company carries out both active and passive activities, a functional allocation of income is performed. Note that for companies in non-cooperative jurisdictions (e.g., Russia), stricter CFC taxation applies under the Tax Haven Defense Act. This means that in such jurisdictions, even active income is subject to CFC taxation if it is taxed at a low rate. Until December 31, 2023, low taxation was defined as an income tax burden of less than 25%. Income must be determined according to German tax law. In connection with the Pillar II implementation in Germany, this tax rate was reduced to 15%, so many states that were considered low-tax countries for CFC purposes until the end of 2023 no longer fall under this category.
4. The foreign company must not be a company in the EU or the EEA that has a business operation with the necessary material and personnel resources.
5. If the foreign company generates both active and passive income and it is not a case of stricter CFC taxation under the Tax Haven Defense Act, an exemption limit applies. Gross income from passive sources that amounts to less than 10% of the foreign company’s total gross income and does not exceed EUR 80,000 per year is then not subject to CFC taxation.

If CFC taxation is applicable, the low-taxed profits of the subsidiary are added—proportionately, if applicable—to the parent company as a CFC addition. The taxes paid in the subsidiary’s country are credited against the income or corporate tax due on the CFC addition.

CFC rules are particularly relevant in M&A practice when acquiring foreign (holding) companies and should be examined in advance to avoid unpleasant surprises. However, the reduction of the tax rate for the “low taxation” criterion to 15% now means that significantly fewer cases fall under CFC taxation.

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