Case Study – Tax Planning Under EU Law (Part 3)
Question 5
Tax Planning Under EU Law – Company also receives (arm’s length) Interest and Royalty payments from its wholly owned subsidiaries. Those payments completely erode the tax base of these subsidiaries. To counter this, Member states Y and Z want to introduce rules that limit this possibility of tax base erosion, and they feel encouraged to do so by the BEPS project of the OECD.
What rules could those Member states potentially introduce?
The OECD and the G20 in a joint effort have developed and introduced the BEPS action plan. Base Erosion and Profit Shifting (BEPS) refers to Tax Planning Under EU Law strategies that exploit these gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity, resulting in little or no overall corporate tax being paid. BEPS is of major significance for developing countries due to their heavy reliance on corporate income tax, particularly from multinational enterprises (MNEs).
In our case the host states could introduce the Action 4: Limiting Base Erosion Involving Interest Deductions and Other Financial Payments.
How will the BEPS measures be implemented?
Some of the measures may be immediately applicable such as the revised guidance on transfer pricing. Other measures require changes to bilateral tax treaties, something that can be done via the multilateral instrument under Action 15. Finally, other measures require domestic law implementation.
The use of third party and related party interest is one of the most simple of the profit-shifting techniques available in international tax planning. Added to this most countries tax debt and equity differently so that there is a tax-induced bias towards debt financing. Groups can easily multiply the level of debt in group companies via intra-group financing, as a result groups can generate intra- group interest deductions that are greatly in excess of the group’s actual third party interest expense. They can also use this debt to fund the generation of tax exempt income.
The approach includes a fixed ratio rule, which allows an entity to deduct net interest expense up to a benchmark net interest/EBITDA ratio, within a corridor of 10%-30%, and an optional group ratio rule which allows an entity to deduct net interest expense up to its group’s net interest/EBITDA ratio, where this is higher than the benchmark fixed ratio. Targeted rules to support general interest limitation rules and address specific risks are also included in the report.
A common approach on interest deductibility has been agreed to facilitate convergence of national tax practices over time, thus enabling further consideration of whether such measures should become minimum standards in the future. A country may supplement the approach in the report with other general or targeted interest limitation rules, either to address base erosion and profit shifting risks it faces or to achieve wider tax policy aims.
As far as the Royalty payments if the profit is shifted on preferential tax regime (i.e IP box regime) then Action 5 – Harmful Tax Practices should be also considered
Preferential regimes continue to be a key pressure area. Current concerns are primarily about preferential regimes which can be used for artificial profit shifting and about a lack of transparency in connection with certain rulings. The report sets out an agreed methodology to assess whether there is substantial activity. In the context of IP regimes such as patent boxes, agreement was reached on the “nexus approach” which uses expenditures as a proxy for substantial activity and ensures that taxpayers can only benefit from IP regimes where they engaged in research and development and incurred actual expenditures on such activities. The same principle can also be applied to other preferential regimes so that such regimes are found to require substantial activity where the taxpayer undertook the core income generating activities. In the area of transparency, a framework has been agreed for the compulsory spontaneous exchange of information on rulings that could give rise to BEPS concerns in the absence of such exchange. The results of the application of the existing factors applied by the FHTP, and the elaborated substantial activity and transparency factors, to a number of preferential regimes are included in this report.
Question 6
Also briefly discuss whether those rules would be in line with the direct tax directives and /or the fundamental freedoms?
There is an Intra-Union situation between the member states and therefore the Fundamental freedoms are applied. In order to determine which fundamental freedoms will might be infringe by the implementation of those provisions firstly we need to identify that the implementation of those rules will restrict the allowable interest expense. If the Member states will implement rules according to the Action 4 of BEPS which allows interest expense to be deducted from the Tax Base up to a benchmark net interest/EBITDA on the percentage that will specifically defined. Effectively this also indirectly prohibits to the group to peruse its financing activities to any member state (State X) they may choose.
Free Movement of Capital
The TFEU does not specifically define the scope of the free movement of capital. In Verkooijen (Case C-35/98), the ECJ defined capital movements as financial operations essentially concerned with the investment of funds. Even though this Directive has been superseded by the Treaty of Amsterdam and its contents have been largely absorbed into the TFEU provisions relating to the free movement of capital, the ECJ still refers to the nomenclature.
The following transactions are included in the nomenclature:
- Direct investments, such as the establishment of branches or new undertakings belonging solely to the person providing the capital.
- The acquisition in full of existing undertakings, and participation in new or existing undertakings with a view to establishing or maintaining lasting economic links.
- Operations in securities normally traded on the capital markets.
- Financial loans and credits.
- Other capital movements.
Freedom of Establishment
According to established case-law, the freedom of establishment, actually grants to nationals, companies or firms having its registered office, central administration or principal place of business within the Community, the right for them to take up and pursue activities according to the law of the other member state through a branch or agency or subsidiary Company. (Case 270/83 Commission v France [1986] ECR 273, paragraph 18, and Case C-330/91 Commerzbank [1993] ECR I-4017, paragraph 13) and Gebhard (Case C-55/94).
Free Movement of Capital Vs Freedom of Establishment
Based on ECJ the free movement of capital and the freedom of establishment, can be invoked in a wide range of circumstances. However, in Fidium Finanz (Case C-452/04), the ECJ stated that where a measure restricts both the free movement of capital and another freedom, and one freedom is more directly in point than the other, then the measure should be analysed for its compatibility with only the freedom to which it most closely relates.
In Baars (Case C-251/98), the ECJ also has provided guidelines for determining when one freedom takes precedence over another and more specific between the freedom of establishment and the free movement of capital, the decisive criterion is whether there is “definite influence”. This criterion, has been described by the ECJ to be the holding in the capital of a company established in another member state, giving him definite influence over the company’s decisions and allowing him to determine its activities is exercising his right of establishment.
Although the concept of “definite influence” has not yet fully specified, it can be deduced that the size of shareholding is a key element. In N (Case C-470/04), the ECJ ruled that if a company holds a 100% shareholding in another company, it has definite influence in that other company. In Test Claimants in the Thin Cap Group Litigation, the ECJ ruled that a shareholding of 75% also qualifies as definite influence. However, it follows from Test Claimants in the FII Group Litigation and STEKO (Case C-377/07) that a shareholding of 10% does not qualify as definite influence.
Given that in this case none of the two freedoms is more directly in point than the other, thenthe decisive criterion is whether there is “definite influence”. In the Lasertec case the court decided that according to the purpose of the legislation – only participations which involve a dominant influence are involved the issue falls within the scope of Art. 49 and if those provisions might also have discriminatory effects under Art. 63 must be seen as unavoidable consequence of the discrimination of Art. 49 and, consequently, there is no need to apply the free Movement of Capital.
To further examine whether there is actually infringement of the Freedom of Establishment we need further to analyse the case. In Marks & Spenser Case the decision by the Special Commissioner was divided into the following sections:
- The Principles applicable to art. 49 (ex. Article 43)
- Differential Taxation by a host state of activities conducted through a Branch or Subsidiary
- Differential Tax Rules of the Home State restricting the Freedom of Establishment elsewhere in the Community
- Non-discriminatory measures liable to make less attractive the exercise of the Treaty Freedoms
- ECJ has recognised that Fundamental Freedoms also include a prohibition against non-discriminatory measures liable to hinder or make less attractive the exercise of the Treaty Freedoms. This means that a national provision may constitute a restriction on Fundamental Freedoms even if the provision applies equally to nationals of all member states and is not as such discriminatory.
- Application of Art. 49 (ex. Article 43) discrimination principles
- Justification for the hosting country provisions
If we follow the Marks and Spenser Case we need to exercise the above in order to determine if there is infringement of the Freedom of Establishment. The first exercise is the principles applicable to article 49 as we have described above.
We need to ensure if there is a differential taxation by the host countries (Member states Y and Z) on the activities conducted through a subsidiary.
Then we need to check if there are any Non-discriminatory measures makes less attractive the exercise of the Treaty Freedoms which means that even if the provision applies equally to nationals of all member states, a domestic provision may constitute a restriction on Fundamental Freedoms. The Court has confirmed in a number of judgments, such as that in Bosman (Case C-415/93) or in Gebhard (Case C-55/94), that restrictions liable to hinder or make less attractive the exercise of fundamental freedoms guaranteed by the Treaty must fulfil four conditions:
- they must be applied in a non-discriminatory manner;
- they must be justified by imperative requirements in the general interest;
- they must be suitable for securing the attainment of the objective which they pursue;
- they must not go beyond what is necessary in order to attain it
Further we need to check if there are any discriminations to the home or host states that violating the rules and therefore does not treat the subsidiary Companies in the host states in the same way as nationals of that state and the home state is hindering the establishment in another member state of one of its Companies incorporated under its legislation.
Finally the last exercise is to check if the application of those provisions in the hosting states are justified, which with the information we have we can definitely can understand that even though the interest and royalty payments are given in an arm’s length, there is a shifting of the profits from the host states.
In a recent case the European Commission has questioned the compatibility of the Swedish legislation with the freedom of establishment within the EU/EEA. Sweden has recently enacted new legislations that limit the right to interest deduction on intra-group debts. Under Swedish legislation, interest payments to affiliated companies are generally not deductible even if at arm’s length. Interest payments may, however, be deductible in the case that the recipient (the beneficial owner) is subject to an effective tax rate of at least ten percent and the loan is deemed not to have been granted primarily to obtain a significant tax benefit (“the 10 % rule”), or that the purpose of the debt is deemed mainly business motivated (“the business purpose rule”).
In its formal notice, the Commission states its opinion that the interest deduction limitation rules are in breach of the freedom of establishment. The Commission has examined the actual application of the rules so far, as well as the preparatory works to the legislation, and has concluded that the rules are unlikely to affect loans between two Swedish legal entities that are subject to normal Swedish corporate income taxation. Instead, the Commission submits that the rules are in practice aimed at cross-border situations.
The Commission also finds that the rules do not only prevent interest deductions in relation to wholly artificial arrangements. Moreover, the Commission criticizes the rules for being unclear and unpredictable, as only limited guidance is provided in relation to the assessment of “business reasons” and the concept “significant tax advantage.” On this basis, it is concluded that the rules constitute a restriction of the freedom of establishment which cannot be justified.
As a conclusion I would say that measures restricting intra-EU investment and discriminatory measures are incompatible with the Treaty provisions on the free movement of capital and the right of establishment. Non-discriminatory measures, on the other hand, are admissible if they are based on objective and if they are justified by imperative requirements in the general interest.
We need at all events, to observe the principle of proportionality, where the content and form of the action must be in keeping with the aim pursued.