Last January, the European Commission (COM (2016) 26 final)(2016/011 (CNS)) proposed for Council action rules against tax avoidance practices to fight against tax avoidance and aggressive tax planning, both at the global and EU levels. This fight has been ongoing for several years now and is reflected in part by the BEPS project of the OECD which was recently finalized and adopted by the G20. The schemes targeted by this Directive involve situations where taxpayers act against the actual purpose of the law, taking advantage of disparities between national tax systems, to reduce their tax bill.
Taxpayers may benefit from low tax rates or double deductions or ensure that their income remains untaxed by making it deductible in one jurisdiction whilst this is not included in the tax base across the border either. The outcome of such situations distorts business decisions in the internal market and unless it is effectively tackled, could create an environment of unfair tax competition. Having the aim of combating tax avoidance practices which directly affect the functioning of the internal market, this Directive lays down anti- tax avoidance rules in six specific fields: deductibility of interest; exit taxation; a switch-over clause; a general anti-abuse rule (GAAR); controlled foreign company (CFC) rules; and a framework to tackle hybrid mismatches. As to the last item, hybrid mismatches achieve tax avoidance objectives by taxpayers based on differences in the legal characterization of payments (financial instruments) or entities when two legal systems interact. Such mismatches may often lead to double deductions (i.e. deduction on both sides of the border) or a deduction of the income on one side of the border without its inclusion on the other side. Taxpayers, especially those engaged in cross-border structures, often take advantage of such disparities amongst national tax systems and reduce their overall tax liability in the EU. The Directive of last January prescribes that the legal characterization given to a hybrid instrument or entity by the member states where a payment, expense or loss as the case may be, originates, shall be followed by the other member state involved in the mismatch.
There were other items identified in the Directive that are base erosion strategies and further present tax administration problems among the member jursidictions of the EU and G20 as a whole. This would include the application of controlled foreign company rules which re-attribute the income of a low-tax controlled subsidiary from its parent corporation in a high tax jurisdiction or vica-versa. Another area is the use of general anti-abuse rules or GAARs to take on abusive tax practices have not been utilized to the degree that was anticipated. Another controversional item is the difficulty in given credit relief for taxes paid abroad in light of the fact that member states tend to exempt from taxation foreign income in the state of residence. Yet another item under discussion is the topic of exist taxes which have the purpose of ensuring that where a taxpayer moves assets or its tax residence out of the tax jurisdiction of a member state, that state taxes the economic value of any capital gain created in its territory even if yet unrealized.
This ultimately led to six resolutions under the proposed anti-Tax Avoidance Directive by the European Commission.
Interest limitation rule (article 4): The proposed rule generally states that borrowing costs are always deductible to the extent interest or other taxable revenues are generated from financial assets. Accordingly, an interest deduction limitation based on an earnings before interest, tax, depreciation and amortization (EBITDA) is proposed. For this purpose, net borrowing costs, like interest expenses, will only be deductible up to a fixed ratio based on the taxpayer’s gross operating profit. It is envisaged to cap the interest deduction at 30% of the EBITDA or, if higher, EUR 1 million. The proposal contains a group ratio test based on an “equity/total assets”-ratio for the purpose of granting taxpayers entitlement to deduct higher amounts of net interest expenses.
Exit taxation (article 5): An exit tax is proposed upon specified transfers of assets or the transfer of residence, requiring an EU Member State of origin to levy tax over the fair market value minus tax book value. An option is introduced to defer taxation in annual instalments of at least five years for transfers from an EU Member State to another EU Member State. Interest may be charged and, in case of the risk of non-recovery, guarantees can be required. The receiving EU Member State should provide for a step-up to fair market value as established by the EU Member State of origin as the starting value of the assets for tax purposes. Lastly, exit tax should not be charged if, in short, a transfer of assets is of a temporary nature.
Switch-over clause (article 6): A proposed switch-over clause would shift from the exemption method to the credit method to ensure that profits are subject to a minimum level of taxation, either in the source state or in the state of the parent company. The switch-over clause applies to income from subsidiaries and to income from permanent establishments. The switch-over clause only applies in relation to non-EU source states. If the statutory corporate tax rate in that source state is less than 40% of the statutory corporate tax rate in the EU Member State of the parent company, the credit method should be applied. As the switch-over clause does not require control of the subsidiary or permanent establishment, it is proposed to use the statutory tax rate of the third country, i.e. non-EU member state, involved.
General anti-abuse rule (GAAR) (article 7): A GAAR is proposed to cover gaps that may exist in a country’s anti-abuse rules. The GAAR should reflect the condition that in case of non genuine arrangements (i.e. (series of) arrangements not put in place for valid commercial reasons which reflect economic reality) carried out for the essential purpose of obtaining a tax advantage that defeats the object or purpose of the otherwise applicable tax provisions, tax authorities can deny tax benefits to the taxpayers concerned.
Controlled foreign company (CFC) rules (articles 8 and 9): CFC rules are proposed that attribute income of a more than 50% controlled, low-taxed, direct or indirect foreign subsidiary to its parent company. This only applies if more than 50% of the income of the subsidiary falls within certain categories of income, which includes interest, royalties, as well as dividends and capital gains from shares, irrespective whether this type of income is generated from third parties or associated companies. A subsidiary is considered low-taxed if the effective tax rate at subsidiary level is lower than 40% of that of the parent company (note that under the switch-over clause, the statutory corporate tax rate is relevant instead of the effective tax rate). CFC rules cannot be applied to subsidiaries in the EU or European Economic Area (EEA), unless the establishment of the entity is wholly artificial or to the extent that the entity engages in non-genuine arrangements which have been put in place for the essential purpose of obtaining a tax advantage. The CFC rules do not apply to subsidiaries whose shares are, in short, listed on a recognized stock exchange. The CFC rules do not apply to EU/EEA financial undertakings.
Hybrid mismatches (article 10): An anti-hybrid rule would account differences in the legal characterization of payments or entities between EU Member States. This means that this anti-Tax Avoidance Directive does not cover hybrid mismatches with non-EU countries and it is mentioned that these mismatches need to be further examined. Under the Directive, where the mismatch results in a double deduction (DD) outcome (for hybrid entities) or a deduction/no inclusion (D/NI) outcome (for hybrid entities and hybrid instruments), the legal characterization given to a hybrid instrument or entity by the EU Member State where a payment, expense or loss originates (i.e. source state) shall be followed by the other EU Member State involved in the mismatch (i.e. residence state). See BEPS action Plan 2—Hybrid mismatch arrangements.
Recent Action By The European Commission: Preliminary Decision on Rulings Granted by Luxembourg to French Utility
As reported last month by Tax Notes International, the European Commission's released its preliminary decision on work (investigation) it announced last Fall. It announced it would open a “state aid” investigation on whether a series of tax rulings granted by Luxembourg to French energy company Engie, f/k/a GDF Suez, constituted illegal State aid. The investigation is centered on the inconsistent tax treatment issued with respect to a financial instrument issued from one Luxembourg group entity to another. EU Competition Commissioner Margrethe Vestager stated in the announcement, that "while “financial transactions can be taxed differently depending on the type of transaction, equity or debt -- but a single company cannot have the best of two worlds for one and the same transaction," .
The transactions at issue involved a transfer of assets and liabilities from one group entity to a group treasury management company in Luxembourg. At the same time, the treasury management entity took an interest-free loan from a sister company -- also a tax resident in Luxembourg -- that was convertible into equity. According to the ruling request, the instrument would then circulate among the parties such that the note would cancel out and no actual payments would take place. Under a series of rulings issued and amended from 2008 to 2012, Luxembourg's tax authority agreed to allow the borrower to deduct interest expense for payments it did not make and that did not result in corresponding interest income for the lender. Could this be correct?
The Commission has proposed the correct answer is indeed “no” and stated that if the payment of interest is deductible by the borrower…it seems to require the taxation of that income once realized at the level of the lender. The Treaty on the Functioning of the European Union prohibits selective aid -- including individual rulings -- that distorts competition by favoring one entity or a subset of entities over others.
Luxembourg argued that accounting rules required that the instrument be treated as interest-bearing debt and Luxembourg's corporate tax rules require that tax treatment follow accounting treatment. According to the opening decision, the Commission was firm in stating that it would not follow this line of thought. More particularly, it stated:
"The Commission does not understand how the rule according to which the tax treatment must follow the accounting treatment could justify a derogation from the general rule on tax-deductible expenses…:
The Commission added that because there should never have been any deductible expense in the first place, the interest rate on the debt is moot.
"There is therefore, in principle, no reason to determine the price for an intragroup debt financing transaction between associated group companies and therefore no reason to resort to transfer pricing in the context of the ZORA transactions, since no such group transaction in need of transfer pricing could be said to exist," the decision says. However, it did note that unrelated parties would be unlikely to engage in a similar transaction.
So, a full investigation of the suspected state aid will be forthcoming while Luxembourg will have the opportunity to counter the Commissioner’s argument before a full decision is published.
"An economic operator in a factual and legal position similar to the GDF Suez Group companies should have been taxed on the expenses related to an instrument . . . or at the level of the lender which receives the corresponding income," the decision says.
Opening decisions inform the member state concerned that the commission will begin a full investigation of the suspected aid and state its basis for doing so. Luxembourg will now have the opportunity to counter the commission's arguments on the presence of State aid and that taxes would be due and owing for the omitted income before a full decision is reached.
The Commission investigation is the third EU investigation into tax rulings granted by Luxembourg to multinationals. The Commission has already determined that a Luxembourg tax ruling granted to Fiat was State aid because the ruling sanctioned profit allocations that were not arm’s length. That decision is now being challenged in court. Tax rulings granted by Luxembourg to Amazon and McDonald’s are also under EU investigation.
"Disclaimer of Use and Reliance: The information contained in this blog is intended solely for informational purposes and the benefit of the readers of this blog. Accordingly, the information does not constitute the rendering of legal advice and may not be relied upon by the reader in addressing or otherwise taking a position on one or more specific tax issues or related legal matter for his or her own benefit or the for the benefit of a client or other person.” ©Jerald David August for Kostelanetz & Fink, LLP”