What is new?
Law 11/20211, which implements Council Directive (EU) 2016/1164 of 12 July 2016 (so-called “ATAD”)2 in Spain, introduces several amendments to the Spanish Controlled3 Foreign Company (“CFC”) rules with effects as of 1 January 2021 that will have an impact not only on foreign operating subsidiaries or permanent establishments generating “passive income” but also on non-resident holding companies, and particularly holding companies that are resident in a country outside the European Union (“EU”) and the European Economic Area (“EEA”).
Until Law 11/2021, the Spanish CFC rules did not have a major impact on Spanish companies holding a majority stake in foreign holding companies because the CFC regime expressly excluded dividends and capital gains obtained by foreign holding companies from ≥5% shareholdings in second-tier subsidiaries from the “passive income” imputation rule, if the (first-tier) foreign holding company had (at a corporate group level) the corresponding “substance” (i.e. human and material means) to manage the participation.
However, the removal of this exception, along with the reduction from 100% to 95% (i.e. this implying a 1.25% effective tax in Spain) of the Spanish participation exemption applicable on dividends and capital gains from non-Spanish subsidiaries, will imply that Spanish companies may be obliged to recognise, under CFC rules, an amount of 5% of the dividends and gains obtained by foreign holding companies if these dividends or gains have been subject to tax at a rate lower than 75% of the Spanish Corporate Income Tax (“CIT”) (i.e. 1.25%)4.
In addition, the (in our view, incorrect) implementation of the ATAD Directive in Spain has given rise to a number of technical doubts (see next Section) regarding the interpretation and application of the Spanish CFC rules. This could imply that, apart from recognizing income obtained by foreign holding companies, the Spanish tax authorities may understand that:
- Spanish companies (including those applying the Spanish ETVE5 regime) may be subject to an additional 5% taxation in Spain on foreign source dividends previously included in the CIT taxable base of the Spanish shareholder (even if the distributed within the same year as interim dividends); and
- The capital gain arising upon the disposal of the shares in a foreign holding company which has been subject to the CFC rules in previous tax periods may not (partially or totally) qualify for the Spanish participation exemption.
Main controversial aspects of the amended Spanish CFC rules
CFC rules are intended to prevent taxpayers to defer taxation of profits in low or no-tax territories. Subject to a minimum tax calculation test, these rules have the effect of re-attributing the income of a low-taxed CFC subsidiary to its parent company, who becomes taxable in its country of tax residence.
We include below some of the main controversial issues arising from the changes introduced by Law 11/2011 to the Spanish CFC rules:
Do Spanish CFC rules always apply to dividends and capital gains received by foreign holding companies that have been fully exempt in their jurisdiction of tax residence?
The Spanish CFC rules are triggered if the income received by foreign subsidiaries has not been taxed at least to a 75% of what it would have been taxed in Spain (i.e. minimum tax test). Therefore, if these dividends or capital gains have been taxed below 1.25% (or fully exempt or not subject to taxation due to the existence of a territorial tax system) in that jurisdiction, Spanish shareholders are in principle obliged to include in their CIT taxable base under CFC rules an amount of 5% of the dividends or capital gains obtained by foreign subsidiary, even if these dividends or capital gains have not yet been distributed to the Spanish shareholder.
However, subject to a detailed review of each scenario, there are situations in which this inclusion may not be required, for instance:
- Technically, the Spanish participation exemption has been construed as a full exemption which in certain cases must be reduced by a 5% flat rate corresponding to management costs relating to the holding in such a case are fixed as a flat rate. If the jurisdiction of the foreign holding company had a similar exemption (i.e. full exemption reduced by a ≥5% flat rate due to management costs), the Spanish CFC rules would not apply;
- If the Spanish company actually generates management costs (to be further analysed what should be considered “management costs” for this purpose) exceeding 5% of the dividends/capital gains received in a given tax period, the Spanish CFC rules would not apply;
- If the foreign holding company is tax resident in the same jurisdiction than the relevant second-tier operating subsidiaries, the literal wording of the Spanish CFC rules may lead to conclude that dividends/gains obtained by the foreign holding company are affected by the CFC rules, but this conclusion would be totally contrary to the purpose of the CFC rules because in these cases it is clear that there is no artificial relocation of income to a low or no-tax territory. We expect further guidance of the Spanish General Directorate of Taxes to apply CFC rules in this kind of situations.
Will dividends/gains subject to CFC in Spain be taxed again upon the distribution of the said dividends in the current or subsequent fiscal years?
Following the literal wording of the Spanish CIT Law, even if the dividends distributed by the foreign subsidiary have already been subject to Spanish CIT in the hands of the Spanish shareholder due to the application of the Spanish CFC rules, the distribution of the said dividends by the foreign holding company to the Spanish shareholder would trigger an additional 1.25% effective taxation in Spain (even if the distributed within the same year as interim dividends).
In our view, there are very good grounds to defend that any taxation applicable to dividends distributed when the income previously included in the taxable base is distributed to the shareholder would be against the ATAD Directive, because:
- The ATAD Directive states that the income to be included under CFC rules is “non-distributed income”, and therefore the CFC rules should exclude the taxation on dividends distributed within the same year as interim dividends; and
- The ATAD Directive requires that the CFC rules ensure there is no double taxation when the amounts of income previously included in the taxable base are distributed to the shareholder, so there should not be any additional taxation on dividends distributed in subsequent tax periods, as it happened with the previous wording of the CFC rules.
Is the Spanish participation exemption on capital gains at risk when selling the participation in a foreign holding company?
The combined effects of the new Spanish CFC rules and the elimination of the exception applicable to foreign holding entities may endanger the application of the Spanish participation exemption to capital gains arising from the sale of shares in a foreign holding company. This is because the Spanish participation exemption is not applicable to capital gains derived from shares in CFC entities where 15% or more of its income qualifies as passive income for CFC purposes6.
The literal application of the exclusion established in the Spanish participation exemption for CFC entities does not fit in with the remaining provisions and requirements of the Spanish participating exemption, since it is designed to “look-through” the direct holding companies7 and focus on the second-tier (or lower) operating subsidiaries in order to determine if the requirements to apply the exemption are met.
Therefore, in our view the Spanish lawmaker should include an escape clause in the CFC exclusion from the participation exemption when the CFC entity is a foreign holding company. In the meantime, we expect that the Spanish General Directorate of Taxes confirms that foreign holding companies should be eligible for the Spanish participation exemption.
Spanish multinational groups investing abroad or foreign multinational groups investing through Spanish holding companies need to analyse the changes introduced in the Spanish CFC rules in order to correctly assess the impact of these new tax measures in their corporate structure, and particularly if the investments are structured through foreign holding companies.
Hogan Lovells can provide practical guidance and assistance on this matter. Please contact us for more information on how we can help.
1. Law 11/2021, of 9 July, on measures to prevent and fight against tax fraud.
2. Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market.
3. A foreign company is deemed to be controlled for CFC purposes if the Spanish taxpayer, by itself or jointly with related parties, holds a direct or indirect participation of at least 50% in the share capital, equity, results or voting rights in the foreign entity.
4. We note that withholding taxes suffered by the foreign holding company on those dividends shall be computed for this minimum tax.
5. Entidades de Tenencia de Valores Extranjeros.
6. If the foreign holding company does not receive passive income (or it is lower than 15% of its total income) in some holding periods, the participation exemption is not applicable to the portion of the capital gain that corresponds to the proportion of tax periods in which the 15% was exceeded.
7. Unless they are located in a non-cooperative jurisdiction for Spanish tax purposes.
Authored by Alejandro Moscoso del Prado and María Santana.