Tax Partner at Kreston Mexico City Office, Kreston FLS
Guillermo Narvaez is a Tax Partner at Kreston FLS Mexico City Office and the Technical Tax Director, Global Tax Group, Kreston Global and member of the International Fiscal Association (IFA). Guillermo is a tax expert on international taxation, corporate taxes, transfer pricing, mergers and acquisitions, corporate reorganisations and litigation.
Within international taxation, Guillermo specialises in the analysis and interpretation of treaties to avoid double taxation applied to international transactions.
Economic substance exemption
December 20, 2023
Economic substance exemption rules ensure that companies conducting business in a particular jurisdiction have a genuine economic presence and conduct real economic activities, rather than simply establishing shell companies for tax avoidance purposes.
A Controlled Foreign Company (CFC)
A Controlled Foreign Company (CFC) is a term used in international taxation to describe a company that is controlled by a resident of another State and is subject to certain anti-tax avoidance rules. The primary purpose of CFC rules is to prevent taxpayers from shifting their income to low-tax or no-tax jurisdictions by controlling foreign companies.
Under these rules, certain companies must meet economic substance tests, and failure to do so may result in penalties and consequences.
Finland: Case study
A company in Finland mostly owned a private limited liability company (“SARL”) in Luxembourg. SARL was established to manage family assets. The balance sheet’s assets exceeded the company’s liabilities. The company received current income from its strategic investment to finance its active investment activities.
SARL has an office, employees, and sufficient office equipment to perform the necessary activities to manage the assets. There were only a few employees however they effectively managed the operation of SARL including an investment director who was responsible for the investments of the business but always following the investment policy of SARL.
Economic substance exemption
The tax Agency of Finland, after considering the background of SARL, its investment activity, and being located in a State of the EEA, granted a ruling to the Finish owner of SARL disregarding the latter as a CFC (Controlled-Foreign Company) for tax purposes in Finland based on the economic substance exemption. The tax administration regarded SARL as an investment company based on the nature of its operations, which partly had characteristics of a holding company. In short, in the view of the tax authority, SARL was an active business with activity of economic substance, thus should not be taxed by the CFC regime in force in Finland.
Accruing in resident state
Broadly, the impact of the CFC rules is that a taxpayer must accrue in its residence State the income generated by a wholly or partially owned business located in a different State. On the contrary, if the foreign business does not meet the features to be regarded as a CFC, its financial results shall not be recognized in the residence State of the equity’s owner. Huge difference.
In the Finish case, the ruling was granted based on a specific exemption local rule – the economic substance exemption. The taxpayer proved SARL had sufficient business activity (ie investment operation) carried out in Luxembourg mainly with its own resources – employees, assets, and direction.
Why did the Finish taxpayer successfully prove that SARL shall not be regarded as a controlled foreign company? Because the taxpayer provided assets and other elements to SARL to give it an independent status with an active operation and, most importantly, with real business activity.
It is most likely to avoid a CFC regime when the business unit effectively carries out an active and substantial activity.
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