M&A Vocabulary – Experts explain: CFC rules

published on 20 December 2024 | reading time approx. 2 minutes

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner present an important term from the specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give or refresh a basic understanding of a term and provide some useful tips from our consultancy practice.

The regulations of the “Hinzurechnungsbesteuerung,” known in English as “CFC rules” or “controlled foreign corporation rules,” are provisions in the German Foreign Tax Act (AStG). These rules ensure that profits generated by a controlled foreign corporation (CFC) in a low-tax jurisdiction are taxed at the level of the parent company. They aim to prevent tax abuse. Without such regulations, it would be possible to shift profits to a low-tax CFC, thereby reducing the overall tax burden. If the distribution of such profits is also tax-advantaged, this could result in not only a temporary but also a final tax effect.

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

The entity must be a “foreign corporation,” i.e., a corporation, association of persons, or asset pool under the German Corporation Tax Act (KStG), which neither has its registered office nor its management in Germany. Transparent partnerships are excluded.
The foreign corporation must be controlled by residents, meaning that a person subject to unlimited tax liability in Germany must hold, alone or together with related persons, 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 persons can also reside abroad and do not necessarily have to be subject to unlimited tax liability in Germany. Please note that the rules on resident control changed on January 1, 2022. Before this date, it was not required that related persons exercise control, but controlling persons had to be subject to unlimited tax liability in Germany. For foreign corporations that earn at least 10% or EUR 80,000 in income from capital investments 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 resident control does not need to be met for CFC taxation to apply.
The foreign corporation must earn passive income, and this income must be subject to low taxation. Section 8 para. 1 of the German Foreign Tax Act (AStG) provides a list of active income (e.g., production, independently provided services, or trade, provided there is an established business operation). If the foreign corporation engages in both active and passive activities, a functional separation of income is made. It should be noted that for companies in non-cooperative jurisdictions (e.g., Russia), stricter CFC taxation applies under the German Tax Haven Defense Act (StAbwG). In such jurisdictions, active income is also subject to CFC taxation if it is low-taxed. Until December 31, 2023, low taxation was defined as an effective tax burden of less than 25%. This income must be determined according to German tax law. With the implementation of Pillar II in Germany, this tax rate was reduced to 15%, so many countries that were considered low-tax jurisdictions until the end of 2023 no longer fall under this definition.
The foreign corporation must not be an entity in the EU or EEA that has a business operation with the necessary material and personnel resources.
If the foreign corporation earns both active and passive income and it is not a case of stricter CFC taxation under the German Tax Haven Defense Act (StAbwG), a threshold applies. Gross income from passive income that accounts for less than 10% of the total gross income of the foreign corporation and does not exceed EUR 80,000 per year is not subject to CFC taxation.

If CFC taxation applies, the low-taxed profits of the subsidiary are added to the parent company’s income as a CFC amount, possibly proportionally. Taxes paid in the subsidiary’s country are credited against the income or corporation tax due on the CFC amount.

The 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 criterion of “low taxation” to 15% has significantly reduced the number of cases subject to CFC taxation.

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