How to facilitate foreign investment in developing countries.
Poor countries need jobs and knowledge from abroad in order to develop. To attract foreign investors, many developing countries offer reduced tax rates for a limited amount of time. This is what is referred to as a tax holiday.
Laws aimed at deterring tax havens counteract this incentive. CFC rules (Controlled Foreign Taxation) allow for example Norway to capture the difference between tax rates in Norway and another country, if these differences are large enough.
Say a Norwegian investor (Amina) wants to put her money into a company in a poor country. Normally, the corporate tax rate for the country is 15 percent, but in order to attract investors they offer a tax holiday of 10 percent for five years. In this case Amina would pay 10 percent tax to the country she invests in, and 10 percent to Norway.
This is because the tax rate in Norway is 20 percent, and CFC regulation requires Amina to pay tax to her home country (Norway) if the country she is invested in has a tax rate of less than two thirds that of Norway. The result is that Norway captures money that Amina could otherwise use invest in the poor country.
When is a tax holiday reasonable?
A solution to this problem is to reconsider the period evaluated for determining the tax level in a country. If the period is short (e.g. 2-3 years), a tax holiday for, say, 5 years, could mean that the developing country is classified a low tax jurisdiction and therefore becomes subject to CFC regulation.
If the period taken into consideration is longer (e.g. 5-7 years), the developing country granting the tax holiday should not be considered a low tax jurisdiction. Therefore, the solution to the CFC problem above may be to redraft CFC legislation to ensure that the evaluation period is sufficiently long enough to level out the tax holiday.
Secondly, investment in a developing country subject to CFC taxation should be restructured to avoid the scope of CFC legislation in the developed country. This solution depends on the domestic CFC legislation in various countries.
In general, many countries exempt investors from CFC taxation if the company activity in the low tax jurisdiction involves mostly active income. There is rarely a clear cut definition of active income. Examples of passive investments are interest income, royalty income and dividend income to pure holding companies are examples of income that is usually considered passive.
Contrarily, if an investor for example establishes a factory in the low tax jurisdiction, the income from the factory is considered active income. However some countries, including Norway, only grant CFC exemptions for active business if there is a tax treaty in place between Norway and the developing country.
Finally, if the investor is a tax resident in an EU state or an EEA state, the right of establishment in the EU treaty and the EEA Agreement, means that including an intermediate holding company between the investor and the developing country may allow CFC taxation to be avoided.
However, this way of restructuring the holding of the investment in the developing country will only work if the intermediate holding company in an EEA state or EU state without CFC legislation is not a wholly artificial arrangement aimed at avoiding taxes. Based on case law from the EU law, the threshold for not being a wholly artificial arrangement is not that high and is relatively easy to fulfill.