Setting up a company and benefitting from the country’s tax advantages is easy for people who are already digital nomads or are willing to leave the country. All you need to do is choose the best country to reside in, or live directly as a tourist and enjoy the life of a perpetual tourist.
If you live in a country that doesn’t have any CFC rules (controlled foreign company), or has a territorial taxation system, you can start up your companies where you want and benefit from the advantages there.
But if this isn’t the case, if you live in a country with CFC rules, you’ll have to pay special attention to certain aspects of these rules, and you won’t always be able to benefit from the tax advantages of establishing companies abroad (much less if the State in question is considered a tax haven and is on the blacklist).
This article will explain what CFC rules or international tax laws are, how they work in different countries around the world, and the effect they can have on your plans to start up a company outside the country in which you reside.
Your principal goal should be to find out if your country of residence has CFC rules, and if so, how they will affect you and how you can legally avoid them.
At the end of the article, we’ll explain the effects of CFC rules on people residing in four example countries, including the UK.
All about CFC rules
International tax laws, also known as CFC rules, are used in multiple countries. In fact, almost all the big industrial countries have them, in order to prevent their “subjects” from running away with their capital.
On the European continent, these laws exist to a greater or lesser extent in the UK, Germany, France, Spain, the Scandinavian countries, the Baltic States, Italy, Hungary, Greece, Israel, and more leniently in Turkey. Not so in Ireland.
On an international level, you can also find CFC rules in the US, Canada, Mexico, Brazil, Argentina, Peru, South Africa, China, Japan, South Korea, Australia, Indonesia, and New Zealand.
CFC rules have consequences for companies that are located outside of the country of residence. They decide whether or not the company abroad also has to pay taxes on a local level (i.e., in the partner’s country of residence).
It’s important to understand that when we talk about taxes, we’re always referring to corporate tax.
CFC rules have no regulatory effect on income tax returns for natural persons.
Of course, you still have to pay tax on your income (whether this is through salary or dividends) at the corresponding rate, and your foreign companies don’t alter this.
This has led to a situation in which there are many countries without CFC rules where you have to pay taxes on your international income, regardless of its origin.
If you want to avoid paying taxes on income earned abroad, you have to reside in a State with a territorial taxation system or where you can live as a non-dom (you can search the Tax Free Today blog for both terms if you’re unfamiliar with them).
The aim of CFC rules is to prevent or obstruct the creation of structures used by companies for tax optimisation. In other words, they’re in place to make sure you don’t transfer your profits to companies in other countries that are directly or indirectly under your control in the interests of saving on taxes.
CFC rules usually affect passive shell companies (also known as dummy corporations) that shelter profits in order to avoid paying taxes.
Your country of residence will usually want a slice of the pie, and to achieve this, they use international tax laws to reduce the profits of foreign companies, as if they were locally-owned.
CFC rules generally are triggered by resident natural persons with shares in foreign companies, but there are also instances where they apply to companies with shares in foreign corporations. This is the case in countries like Egypt and Turkey.
There are States that don’t have official CFC rules, but that have some regulation or local law in place to obstruct the management of companies abroad. This is the case in Austria, Latvia, Malta, the Netherlands, and Slovenia for instance.
What happens if your country of residence doesn’t have CFC rules?
Despite the above, the majority of the countries of the world don’t have any kind of CFC rules or international tax laws. This is the case with certain countries in the EU: Belgium, Bulgaria, Cyprus, Croatia, the Czech Republic, Ireland, Luxembourg, Poland, Romania, and Slovakia. Outside the EU, you can also find Ukraine, the Balkans, and of course Switzerland.
Outside of Europe you have other appealing places with no tax laws including Malaysia, Colombia, Chile, Mauritius, the Philippines, Singapore, Thailand, and many more (in a later section, we’ll explain what the laws specifically consist of in more depth, on a country-by-country basis).
If you reside in a country with no CFC rules, you’ll have no problem establishing and managing your international companies. In other words, you don’t have to declare that you’ve set up an offshore company, nor account for your profits.
Of course, you don’t have to pay corporate tax either. You can therefore start up companies in jurisdictions where your companies won’t pay taxes.
As we mentioned before, this doesn’t mean that you, as a natural person, won’t pay any tax if you reside in a country that assesses for it. You have to declare your income in the country in which you reside fiscally, according to the conditions of local tax laws.
Of course, you’ll generally pay less tax, since you’ll receive your income through dividends (which is usually more profitable), and you may even be exempt from all taxes and permitted to leave your money in the company. If you do so, you’ll be able to delay the moment at which you distribute the dividends until the time is right and move to a country where this type of income isn’t taxed at all, allowing you to take out all the company’s money without paying a penny.
As you can imagine, when choosing the best country to take up residence in, you don’t only have to check that the State doesn’t assess for tax (whether the system is non-dom, territorial taxation, or general tax-exemption), but also that they won’t disrupt the management of your foreign companies.
Sometimes, you don’t even need to go to a tax haven to avoid taxes; you can often find very attractive countries that assess local companies and workers for tax, but don’t require you to pay tax on income earned abroad.
The consequences of CFC rules in practice
In case you’re not lucky enough to live in a country with no international tax laws, which would be the case if you resided in Australia, Canada, or the UK (you can find a complete list below), you have to bear in mind how these international tax laws can affect your ability to establish and manage companies abroad.
The CFC rules of these countries vary wildly in character and effect.
In any case, as the owner of a foreign company, you may have to pay corporate tax in your country of residence (even on profits that haven’t been distributed) in the following cases:
- if the company is located in a State with no taxes or with a low tax burden (a country with a low tax burden is generally understood to be one where the tax rate is 20-50% lower than corporate tax in your country of residence; there are also often blacklists of tax havens)
- if the company’s income is mostly passive, i.e. over 30% (passive income is understood to be income from interest, licences, rent, patents, etc.)
- if the partner of the company has a high share in it (the definition of a high share varies between countries, sometimes from 1% to 50%)
The legal repercussions of CFC rules
It’s important to understand that CFC rules don’t prohibit the establishment of companies, and that no country can prevent a person or company of any nationality or residence from setting up companies abroad.
Of course, these rules can have an effect (a negative one) on the tax situation. Sometimes, the result is that the partner will have to pay corporate tax in their country of residence.
Generally, when the company has its residence in a country with a low tax burden, you’ll pay tax in your country of origin as if it were a domestic company. However, the worst case scenario (where there is no double tax agreement involved) is that you’ll have to pay corporate tax in both countries (which is very rare, since the only countries without these agreements generally don’t assess for tax).
Tax laws across the world: 5 kinds of CFC rules
In general, we can distinguish between 5 kinds of CFC rules, where the fifth type is the absence of any rule at all. Of course, this is a generalisation, and it’s important to examine each case in more depth to avoid nasty surprises.
The first group: most industrial States and members of the OECD have strict CFC rules that limit management of companies abroad, even those with active income. The decision whether to assess for tax in the country of origin or the partner’s country generally depends on the percentage share and the degree of taxation in the country of origin (which houses the company’s headquarters).
Second group: there are also a few States that aren’t as strict towards active companies in countries with a low tax burden. In these cases, the CFC rules only apply to shell companies, with passive income such as capital income, rent, and revenue from licences. As soon as this kind of company distributes its dividends, the partners will have to pay withholding tax or something similar.
The third group: some countries have lax CFC rules. In these cases, the laws apply when the partner has a great number of shares and the company pays little tax. The laws only affect individuals and companies up to a certain point. When only the company is affected, these laws obstruct certain practices, such as transfer of profits, for example. However, individuals are still able to house their income in a shell company.
I’ve outlined below a very general summary of the kind of CFC rules in each country. Above all, it’s based on the degree of taxation from which CFC rules begin to apply.
Group 1: Strict CFC rules against active companies
UK: the board has to reside in the country.
US: rules apply if the share owned by US citizens is more than 50%.
Germany: rules apply if corporate tax is below 25%, if income is passive, or if the board doesn’t reside in the country.
Brazil: taxes are deducted at source up to 34%.
China: rules apply if corporate tax is below 12.5%.
South Korea: rules apply if corporate tax is below 15%.
Egypt: rules apply if the board doesn’t reside in the country, or if the company has over 70% passive income.
Spain: rules apply if the foreign country assesses for tax at less than 75% of the sum demanded in Spain.
Estonia: rules apply if corporate tax is below 7%.
Finland: rules apply if corporate tax is below 12%.
France: rules apply if the foreign country assesses for tax at less than 50% of the sum demanded in France.
Greece: rules apply if corporate tax is below 13%, or if the board doesn’t reside in the country.
Hungary: rules apply if corporate tax is below 10%.
Iceland: rules apply if corporate tax is below 3.3%, or if the board doesn’t reside in the country.
Israel: rules apply if corporate tax is below 15%, if income is passive, or if the board doesn’t reside in the country.
Italy: rules apply if the foreign country assesses for tax at less than 50% of the sum demanded in Italy.
Japan: rules apply if corporate tax is below 20%.
Norway: if the share is over 50%, rules apply if corporate tax is below 2/3.
Portugal: rules apply if the foreign country assesses for tax at less than 60% of the sum demanded in Portugal.
Russia: the board has to reside in the country (but only over 10m roubles).
South Africa: rules apply if the share is over 50%, bearing tax at source in mind.
Sweden: rules apply if corporate tax is below 12.1%.
Group 2: Strict CFC rules against passive companies
Australia: rules apply if passive income corresponds to more than 5% of total income.
Canada: rules apply if income is passive and if the share is over 10% or a majority.
New Zealand: rules apply if passive income corresponds to more than 5% of the total.
Denmark: rules apply if passive income corresponds to more than 50% of total income.
Lithuania: rules apply for passive income if the foreign country assesses for tax at less than 75% of the sum demanded in Lithuania.
Mexico: rules apply if passive income corresponds to more than 20% of the total, and if the foreign country assesses for tax at less than 75% of the sum demanded in Mexico.
Peru: rules apply if the foreign country assesses for tax at less than 75% of the sum demanded in Peru.
Venezuela: rules apply if corporate tax is below 20%.
Group 3: Lax CFC rules against passive companies
Argentina: rules apply if passive income corresponds to 50% of the total.
Indonesia: rules apply if the share is over 50%.
Poland: rules apply if passive income corresponds to 50% of the total, if the taxed sum is 25% lower than that in Poland, and if turnover is over €250,000.
Turkey: rules apply if passive income corresponds to 25% of the total and if the taxed sum is 10% lower than that in Turkey, and only companies are affected.
Uruguay: rules apply if corporate tax is below 12%, and only individuals are affected.
Group 4: No international tax laws, but certain general rules that impede tax avoidance
Austria: the company has to be active and show a certain substance.
Latvia: 15% tax is paid on transactions with countries with a low tax burden.
Netherlands: 15% tax is paid at source if the company is in a country on the blacklist or has taxes under 12.5%.
Malta: there are restrictions if passive income corresponds to more than 50% of the total and if taxes are below 15%.
Group 5: No international tax laws
The rest of the world
Special mention should be given to: Ireland, Switzerland, Belgium, the Czech Republic, Slovakia, Luxembourg, and Chile.
Depending on the case, some States decide whether CFC rules apply according to the country in question. They have blacklists of countries where international tax laws automatically apply.
Every country on this list is automatically subject to corporate tax in the partner’s country of residence, no matter the rules in that of the company. There are often additional conditions involved, and sometimes certain company expenses cannot be deducted.
Some States work in the opposite way, using whitelists instead of blacklists. These lists group together countries whose residents can establish and manage companies unhindered, while paying tax at source. Countries on these lists often have a high tax burden and good commercial relations worldwide.
Blacklists often include tax havens. Each State defines tax havens according to its own criteria. Countries without corporate tax are often automatically included in this group. States with agreements to exchange fiscal data are usually excluded from these lists. This is why some countries without corporate tax can’t be found on the blacklist.
The EU intends to sanction countries that don’t assess for tax. However, there’s still no general EU blacklist. You can find the blacklist for each country in the European Union here.
Below is an example of a blacklist, in this case that of Lithuania (chosen because it’s a fairly complete list that includes all the “usual suspects”):
- Antigua and Barbuda
- Ascension Island, St. Helena, and Tristan da Cunha
- British Virgin Islands
- Cayman Islands
- Cook Islands
- Costa Rica
- Curacao and Sint Maarten
- French Polynesia
- Hong Kong
- Isle of Man
- Marshall Islands
- New Caledonia
- San Marino
- St. Kitts and Nevis
- St. Pierre and Miquelon
- St. Vincent and the Grenadines
- Turks and Caicos Islands
- United Arab Emirates
- US Virgin Islands
Exceptions to the CFC rules
OK, so you’ve found out that your country of residence has CFC rules, and what’s more, they’re strict: they don’t let you set up a company in the way you wanted in the State you had your eye on.
But don’t lose hope: things aren’t over yet.
In general, there are two important exceptions to CFC rules. One is due to the law of freedom of establishment inside the European Union, and the other concerns companies that can demonstrate a certain level of “substance” in the foreign country.
Below, you can read about what these exceptions consist of and how they can help you circumvent CFC rules in your country of residence.
Exception 1: Freedom of establishment in the EU
Within the European Union, there are different options of optimising your taxes in a totally legal way, but only if you’re willing to set up your company in the right place (or transfer it there).
These options are due to freedom of establishment in the EU, a law that guarantees the free establishment of people or companies in any country within the common space.
In principal, European law outranks national laws and rules, although this hasn’t prevented Germany, for example, from hindering the establishment of companies in certain countries within the European Union (Malta, Cyprus, Ireland, Estonia, and Bulgaria) by classifying them as having a low tax burden.
Of course, the ability to optimise your taxes by taking advantage of the different tax systems across the EU could disappear if Brussels gets its way.
The EU is planning to force all member States to impede tax optimisation through international tax laws. What’s more, there’s even talk of a common corporate tax.
Obviously, given the current situation in the European Union, it’s not likely that this will succeed, since every State would have to agree, and such a measure would be damaging to at least a quarter of them.
Exception 2: Permanent establishment with foundation or substance
The concept of substance refers to how credible a company is, to the real economic interest the company has in the country in which it was created.
Substance is a question of degree. To show that a company has substance, it can have its own office, workers, a manager in the foreign country, etc.
If your permanent establishment or company abroad meets these requirements, there should be no restriction to your State recognising the foreign corporation, no matter how strict its rules.
Substance plays an important role in double taxation agreements. The degree of substance required to prevent the involvement of international tax laws varies wildly between the countries that have one.
Even in cases where there is a double taxation agreement between a State with a high tax burden and a State with a low one, companies (and their potential tax advantages) are still recognised when they have enough substance. Where there is no agreement, the process is more complicated, but not necessarily impossible; everything depends on the countries concerned.
The example of residents in Germany
To get an idea of the problems that can arise due to international tax laws, let me introduce one of the most restrictive countries when it comes to letting its residents set up companies abroad: Germany.
If you live in Germany, in order to establish a company abroad without triggering CFC rules, you have to demonstrate that your company has “substance” in the foreign country. In other words, it has to have an office, employees, and contracts there. This is even the case with other countries in the European Union (which is against this community law and has already given a warning to Germany, who ignored it besides a few tiny modifications to the rules).
Moreover, the manager of the company has to spend certain periods of time in the foreign country, and mustn’t own over a 50% share.
If that’s not enough, the company also has to contribute to the country’s economy (or at least try to), and has to demonstrate that it has an economic interest in establishing the company abroad. This is often the hurdle people fall at when setting up companies in tax havens (because it’s difficult to get clients in these countries).
If you can’t demonstrate that your foreign company has substance, you have to pay withholding tax in Germany.
This means that the company pays both German corporate tax and trade tax (depending on the partner’s place of residence).
Even if the foreign company doesn’t distribute its dividends, it won’t escape the German treasury. German tax law explicitly cites this case and also taxes profits that haven’t been shared out among partners.
The withholding tax (Hinzurechnungsbesteuerung in German) usually has a very negative effect on individual tax returns. What’s more, the basis is often not the company’s balance sheet, but a fictitious sum estimated by the German tax office (and rarely in the company’s favour).
The result of this is that residing in Germany makes it very difficult to optimise taxes through international taxation strategies. You have to establish a company with substance in another country in the European Union, which is a fairly expensive solution that’s only worthwhile when income is high.
In spite of this, if you do it right, you can manage to pay only 5% tax in, for example, Malta.
The example of residents in Austria
We’ve already studied the case of Germany, but if we head a little southwards, things are fairly different. Austria is a country that has no international tax laws, but does include certain general rules that impede tax avoidance when creating companies abroad (while still respecting the laws of the European common space).
Austrian residents generally can’t receive profits from abroad without paying taxes there. Of course, this is limited to passive income, such as interest, capital income, and revenue from licences.
CFC rules in Austria don’t impede residents from leaving their profits in the foreign company. Unlike in other countries, they don’t have to pay taxes on profits that haven’t been distributed.
There is also no obstacle to making investments (before taxes) through the foreign company. Of course, taxes must be paid when distributing dividends to the person who is physically residing in Austria.
In general, we can say that you can manage most online businesses from Austria with no problems at all, even if this is through foreign companies.
Of course, there are regulations that require you to justify the existence of the foreign company beyond “so I can optimise my taxes”; maybe you want direct access to the market in a specific region, contact with suppliers, etc.
The example of residents in the Czech Republic
Unlike these other examples, there are no international tax laws in the Czech Republic that obstruct the management of companies abroad.
This is the case even though, as with the other countries in the European Union, the Czech Republic taxes the person’s income worldwide (residence-based taxation).
The absence of CFC Rules allows a resident of the Czech Republic to create companies anywhere in the world and transfer the profits or leave them in the company, all while paying little to no tax.
This company would pay tax on its global earnings in the State in which it was established and according to the rules of the country of residence. It would also be subject to tax law, labour law, commercial law, criminal law, etc., in the country of establishment.
In other words, if you reside in the Czech Republic, you can leave your profits in the company or invest them in the stock market, for example, so that you wouldn’t have to pay tax in your place of residence and your money can grow more quickly.
On the other hand, you can also include personal expenses as company expenses. This wouldn’t be difficult if your foreign company was in the UK or especially Cyprus.
Again, the important thing here is not to distribute dividends, and instead to keep the money in the company. Nevertheless, you’ll have to declare this income on your annual tax return.
The example of residents in the UK
Finally, let’s analyse the situation in the UK, and more generally, how English people can set up a company abroad.
As we mentioned, the UK has CFC rules. Generally, they apply if the companies abroad pay less than 75% of the tax they would pay in the UK and the shareholder owns 40% or more of voting interests.
There are different ways to escape CFC rules as a resident in the UK:
- The level of accounting profits is less than 50,000 pounds.
- You create substance in order to meet an active business test.
If you are not able to escape the CFC rules in the UK, you will have to pay taxes on the undistributed company income. To know exactly how this is regulated, you have to examine the double tax agreements between the UK and the foreign country where the company is established.
As you can see, the topic of CFC rules isn’t simple, and totally varies depending on your country of residence and the site of your foreign company.
If you want to know if your plans for tax optimisation would work, you can use Tax Free Today’s data verification service. And if you need us to help you find a better solution, you can book a consultation.