CFC rules may violate EU law in cases involving third countries


The German CFC rules have sharp teeth that are often overlooked or underestimated in practice. For one thing, the low-tax threshold is (too) high – currently still 25% – and, for another, the CFC rules even apply to foreign passive investment income (FPII) in mini-shareholdings – from 1% and possibly even less. In EU/EEA cases, Sec. 8(2) of the German Foreign Tax Act (GFTA) provides for the opportunity to put forward economic reasons for interposing companies abroad. But in cases involving third countries, i.e. where German persons subject to unlimited tax liability hold a stake in a corporation that is tax-resident outside the EU or the EEA and generates FPII, this opportunity does not exist. These scenarios are not uncommon in corporate groups, ranging from medium-sized family-owned businesses to large corporations. As a result, CFC rules are increasingly becoming a focal point of tax audits.


However, this restriction was questionable from the perspective of EU law. That is why scrutiny by the Court of Justice of the European Union (CJEU) was required immediately (Federal Tax Court Order for Reference of 12 October 2016, I R 80/14). In its decision on the legal matter of X GmbH, published in February of this year, the CJEU set its essential course, but referred the case back to the Federal Tax Court for final clarification. Its final decision is now available (dated 22 May 2019, I R 11/19).


The dispute relates to 2007, the year in which the declaratory judgment was rendered. X GmbH, a corporation resident in Germany, held 30% of the shares in Y AG, resident in Switzerland. Y AG had concluded a purchase of receivables and transfer agreement with Z GmbH. Y AG generated profits from this, which the tax authorities classified as FPII within the meaning of Sec. 7(6a) GFTA and which were then taxable at the level of X GmbH pursuant to Sec. 7(6) GFTA. The Federal Tax Court (Order for Reference of 12 October 2016, I R 80/14) doubted that the rules complied with EU law because the free movement of capital also protects shareholdings in companies resident in third countries.

The CJEU’s decision

A first major question was whether the application of the CFC rules on FPII (Sec. 7(6), (6a) GFTA) violates the free movement of capital. In principle, this was affirmed by the CJEU in that it recognized a restriction of the free movement of capital. But this may be justified for reasons of general interest, in particular for preventing tax avoidance and tax evasion. The CJEU’s justification test has two stages:


(1) The taxpayer must have the opportunity to prove economic reasons for its shareholding in, or interposing, a third-country company. According to the CJEU, both the shareholding and the company itself can prove to be ‘artificial’, which would justify the application of the CFC rules.


(2) The tax authorities must have the opportunity to verify the accuracy of that information in relation to (i) the company established in the third country and (ii) its activities, provided by the taxpayer as proof that there is no purely artificial form. The decisive factor here is whether international agreements on the exchange of information are in place with the third country in question. If not, it is possible to waive the opportunity mentioned under (1) because the tax authorities would be prevented from checking the accuracy of the information provided by the taxpayer.


Secondly, the CJEU essentially had to examine whether the CFC rules on FPII were protected by the standstill clause (Art. 64(1) TFEU). To put it simply, this clause provides protection for rules vis-à-vis third countries which, in terms of direct investments, restrict the free movement of capital. However, the rules are required to have been in place as of 31 December 1993 and to have remained unchanged since then. There was good reason for doubting this in the case at hand. Although the CFC rules existed before the key date, they have since been changed to such an extent that it can be assumed a new concept has in fact emerged (based on the key date for the standstill rule). The CJEU delegated the final decision to the Federal Tax Court.

The Federal Tax Court’s final decision

Standstill clause does not apply

The essential aspect of the Federal Tax Court’s ruling is that the standstill clause pursuant to Art. 64(1) TFEU has no impact in the context of the CFC rules. The Federal Tax Court rightly ascribes this to the fact that the system underlying the rules underwent several fundamental changes after 31 December 1993 and, coupled with their interventions under EU law, the rules have not continued without interruption since that date.

Limitation of the free movement of capital

On this basis, the Federal Tax Court then rightly concludes that the CFC rules applicable to FPII restrict the free movement of capital in relation to third countries. This is because the provisions did not (and do not) grant the taxpayer the opportunity, demanded by the CJEU, to present economic reasons for its shareholding in a foreign company as part of a motive test.

Exceptional justification

It was ultimately a special feature of the dispute in 2005 that the plaintiff’s request failed: The DTT between Germany and Switzerland was only supplemented by a ‘major’ exchange of information clause modelled on Art. 26 para. 1 OECD-MC (valid from 2011) in the Amendment Log of 27 October 2010. So, in the year of the dispute, the international agreements on the mutual exchange of information deemed necessary by the CJEU were not in place. As a result, the taxpayer was not automatically entitled to the motive test, which could have been granted only as an option.

Practical implications

The Federal Tax Court’s key message is that the taxpayer must be given the opportunity under EU law – specifically freedom of capital movement – to present economic reasons for interposing the company in question, even in cases involving third countries. In other words, the ‘Cadbury test’ on an interpretation of Sec. 8(2) GFTA in conformity with EU law is also permissible where third countries are involved.


However, this principle does not apply in exceptional cases where the competent tax authority is unable to verify the information provided. A legal framework must exist for this (in EU/EEA cases, the Directive for Mutual Administrative Assistance) in which the states involved exchange tax-relevant information with each other or are contractually obliged to do so (e.g. via the ‘major’ DTT exchange of information clause, Art. 26 OECD MC). Where third countries are involved, it should therefore be carefully examined whether the corresponding DTT contains a ‘major’ exchange of information clause. Practical application may not be interpreted to the detriment of the taxpayer.


In the present case, the ‘major’ exchange of information clause stipulated in Art. 27 DTT with Switzerland was not applicable because it applies only to assessment periods from 2011 on. For more recent or current disputes, the tax authorities must consider economic reasons put forward by the taxpayer.


The above principles are not restricted to FPII. In its judgment of 13 June 2018 (I R 94/15), the Federal Tax Court decided that the CFC rules must also be measured against the free movement of capital. Consequently, the substance or Cadbury test in third-country cases is generally possible and independent of the actual amount of the shareholding in the individual case.

Consequences by the Draft of ATAD Implementation Act

On 10.12.2019 the Federal Ministry of Finance (BMF) published a draft for a law to implement the requirements of the so-called Anti-Tax-Avoidance-Directive. An essential part of the draft is also the amendment of the German CFC rules.


The consequences of the present decision have already been processed by the BMF: For FDII the draft provides in Sec. 13 Para. 4 GFTA for a motive test also for third country cases. A restrictive prerequisite is, however, that the mutual exchange of information with the state in question is guaranteed. This includes all non-EU/EEA constellations in which a DTT with the ‘major’ DTT exchange of information clause is negotiated. However, an extension beyond FDII is not yet planned.