How to vote in the EU Referendum if it were only about tax…
Forgive them, for they know not what they do…
Is the EU Anti Tax Avoidance Directive the last straw the UK needs to leave the EU today? And would the UK be more tax-competitive out of the EU?
At midnight, on Monday 20th June, the European Council of the European Union (ECOFIN) approved the draft Anti Tax Avoidance Directive (ATAD).
The European Commission (EC) clearly doesn’t trust Member States of the EU to implement the OECD’s BEPS 2015 recommendations. The EC claims ATAD seeks to ensure a consistent and uniform implementation of BEPS recommendations across the EU. In fact, it goes considerably further than this: under the guise of ‘restoring trust in the fairness of tax systems and allowing governments to effectively exercise their tax sovereignty’, the EC is pushing its own agenda of unified EU tax corporate tax policy: there is a strong whiff of the CCCTB (a pan-European corporate tax base) waiting in the wings. After all, if we are now to have unified anti-avoidance rules, which are very much more a matter of national tax policy, why not a common measure of accounting profit, at which point a minimum corporate tax rate becomes a very real possibility.
In fact, rather than empowering Member States, ATAD does the exact opposite, removing their ability to implement BEPS in line with their own national tax and economic policies. For example, BEPS Action 3 on CFCs recognise that a state that exempts foreign profits for companies may prefer limited CFC rules that focus on profit artificially diverted abroad. This is what the UK has chosen to do.
The UK has spent almost 10 years positioning itself as the go-to territory for multinational groups to locate their European headquarters. Starting with the reform of the taxation of foreign profits and ending with a recast CFC regime, the UK has taken on Luxembourg and the Netherlands and won. ATAD would largely remove its ability to continue to do this. It simply usurps Member States’ tax sovereignty. Subsidiarity seems to have been forgotten about here. While it’s true that ATAD ensures the BEPS recommendations are implemented by Member States, this is at the cost of a ‘one size fits all’ policy that looks suspiciously like it has may have been dictated by Germany, jealous at the effect of UK tax competition: first a challenge to the Patent Box, now to the UK’s CFC rules.
In gradually nibbling away at Member States’ tax sovereignty, the Commission seems to be creeping towards its goal of a pan-European tax system. But with 28 Member States that have vastly differing economic performance and priorities, this cannot work and is doomed to failure for the same reasons as the single currency. A uniform implementation of the BEPS recommendations must be balanced with Member States’ ability to stimulate their economies through tax policy and incentives. The ATAD takes a huge step backwards in removing this ability. For example, the UK has a comprehensive and effective CFC regime that includes an exemption for foreign group finance companies (where certain conditions are met). It is difficult to see how this can survive post ATAD. Ireland, which does not currently have a CFC regime, will have a CFC regime forced upon it (as will Malta and Cyprus). Countries will respond because they need to remain competitive – Ireland may well move from a credit method for dividends to an exemption method.
Thankfully the pernicious Switch Over clause has been dropped at the last minute – the same thing that happened when some states tried to have it included in the Parent-Subsidiary Directive in 2014. However, the ATAD is subject to review in 4 years’ time and we’re betting that it eventually finds its way back in…
One wonders why Member States haven’t objected to / rejected the ATAD, perhaps they haven’t yet woken up to how their ability to chart their own course has been taken away from them? The ATAD significantly overshoots the target harmonisation with BEPS by the including yet another GAAR and Exit Tax provisions (which are arguably contrary to EU law). This is supranational law and – unlike the BEPS project – has been forced on the UK (and every other Member State) without any coherent, analytical or reasoned opposition.
If the UK chooses to leave the EU it will have an immense competitive advantage simply by having the ability to set its own tax policy.
When does ATAD apply?
Member States must implement all measures by 1 January 2019 with the exception of the Exit Tax measure, which must be implemented by 1 January 2020 and the interest deduction limitation measure, which may not be implemented until 1 January 2024 where the Member State has sufficient existing domestic rules that broadly achieve the same result.
BEPS v. ATAD
|BEPS recommendations||ATAD measure|
|Interest limitation rule||Recommendation by BEPS to cap interest deductions at 10-30%||The ATAD introduces the BEPS minimum standard as a binding measure Member States are free to restrict this further under their domestic law Cap interest deductions at the higher of 30% or EUR3m Interest on any loans in existence at 17 June 2016 not subject to restriction – provided no modification|
|Exit Tax||Not recommended by BEPS||ATAD goes beyond BEPS recommendations and arguably infringes fundamental freedoms of establishment and capital|
|GAAR||More limited recommendation in BEPS Action 6 of ‘principal purpose test’||A general anti-abuse law to apply where domestic law cannot find against a taxpayer in a perceived abusive arrangement. This seems to apply not just to cases of ‘egregious’ abuse targeted by the UK’s GAAR.|
|Controlled foreign companies||Recommendations by BEPS to permit a territorial approach to implementing CFC rules or a wider approach||ATAD forces Member States to adopt CFC rules with a ‘one size fits all’ approach that extends to arrangements with third countries|
|Hybrid mismatch||Recommendation by BEPS to remove the ability for groups to secure double non taxation through mismatches in domestic tax systems||Binding measure that tackles mismatches between Member States broadly in line with the BEPS recommendations, but is not extended to third countries. Meaning US ‘tower’ and other structures not affected.|
|Switch Over clause||Not recommended by BEPS||Thankfully dropped at the eleventh hour, a measure that would have forced Member States to apply a credit method on the receipt of dividends or gains on disposal of shares where the income or gain is not taxable in the original company at a rate of at least 40% of the corporate tax rate of the recipient country.|
A closer look at the five ATAD measures
1. General interest limitation rule
Many groups will fund their overseas subsidiaries with a combination of debt and equity. It is common to fund primarily with debt as it is cheaper and easier to extract than equity. Most importantly, interest charged on the debt may be deductible against income thus reducing an entity’s taxable profits (subject to the local territories tax rules that may already exist to restrict interest deductions, such as transfer pricing, thin capitalisation etc).The measure included within the Directive is consistent with the recommendations and fixes a ratio for deductibility. Deduction of net interest expenses is restricted to 30% of the taxpayer’s earnings before net interest, tax, depreciation and amortisation (EBITDA) or up to €3,000,000, whichever is higher. The deductibility rate is set at the top end of the scale of 10-30% recommended by the OECD and Member States may decide to restrict this to the lower end.Where the taxpayer is part of a group which files statutory consolidated accounts, the indebtedness of the overall group at worldwide level may be considered.After push-back from certain Member States, a grandfathering provision means that loans concluded before 17 June 2016 will not be subject to this restriction provided no amendments are made to the loan.
How will it affect Member States?
States will need to repeal or restrict existing rules that are more generous than the proposed measures. As the ATAD introduces the minimum recommended OECD standard, Member States may well already be prepared to make such changes. The UK announced in its 2016 Budget that it would introduce a 30% restriction and cap at EUR 2m from 1 April 2017, albeit subject to a detailed consultation. The UK will remove its similar Worldwide Debt Cap legislation, but will still have transfer pricing, thin capitalisation and the unallowable purpose rules to further restrict interest deductibility. It is not clear as to why the consultation process will be necessary in light of the ATAD measures, as aside from increasing the cap to EUR 3m, there is very little the UK can do differently.
2. Exit taxation
An area not considered by the OECD as part of the BEPS project, this measure seeks to tax any unrealised gains on assets, business of a permanent establishment or residence of a company transferred out of their Member State of origin (an ‘exit tax’). The unrealised gain being determined by reference to the market value at the date of transfer and the base cost in the asset.
The taxpayer may either immediately pay the exit tax or defer payment of the tax over five years and settle the tax liability through instalments. The deferral period ceases when the gain is realised and tax becomes recoverable such as on a sale. Where the tax liability is deferred, interest may be charged by the Member State and where there is a demonstrable and actual risk of non-recovery a guarantee may be required.
It is stated that this measure is in line with EU law, but it is highly questionable whether these rules are compatible with the Treaty on the Functioning of the European Union (TFEU), in particular the Free Movement of capital and Freedom of Establishment principles. It is clear from the CJEU N Case (Case 470-04) that to tax a person on unrealised gains when transferring an asset, company residence or business to another Member States would be discriminatory. In the more recent National Grid case (Case 371-10) it was held that exit tax provisions would be compataible with EU law where they granted the following options to the taxpayer:
- pay the tax due at the time of emigration;
- to request a tax deferral until the moment that the capital gains on assets are realized; or
- to pay the tax in equal instalments over 10 years.
It would seem the EC has leveraged off the third limb and disregarded any option for the taxpayer to defer the tax until the gain is actually realised. It is very difficult to see how this can be compatible with EU law since it imposes a tax liability merely by virtue of corporate or asset migration even though no gain is realised.
How will it affect Member States?
Key issues for Member States to consider are how to deal with losses arising on later realisations or currency gains or losses, whether the Host State should give a credit for tax paid to the State of Origin or whether a claim can be brought by the taxpayer for a refund of tax from the State of Origin when the asset is subsequently disposed of at a lower value. In the absence of clear guidance or instruction within the ATAD, there is a risk of incompatible national rules and double taxation.
3. EU General Anti Abuse Rule (EU GAAR)
Many countries have invested time to develop an appropriate general anti abuse provision within their domestic law. No GAAR is easy to apply and in the UK there is a ‘GAAR advisory panel’ to ensure it is used correctly by the tax administration. This was to reassure companies that the GAAR would not turn into open hunting season for HMRC. There is no such requirement in the EU GAAR.
The ATAD seeks to cover gaps not covered by a domestic GAAR (or where no domestic GAAR exists) and will apply to artificial arrangements or a series of arrangements that have been designed to obtain a tax advantage that defeats the main or one of the main objects or purposes of the relevant tax provision. Where the EU GAAR applies, the arrangement or arrangements must be ignored and reconstructed by reference to economic substance and in line with the Member State’s domestic law.
Almost all Member States have targeted anti-avoidance rules (TAARs) such as CFC, interest expense restriction, etc and many now have GAARs. So why introduce a GAAR within ATAD, without proper consultation? The answer starts with the CJEU Halifax case (C 255-02). This case concluded that the particular tax avoidance arrangements in place were so extreme that they constituted ‘abuse’ of rights granted by EU law and where this was the case they should be reconstructed in the context of ‘normal commercial operations’. The proposed EU GAAR follows the principles of the Halifax case, which now must form part of domestic law.
How does it affect Member States?
Whilst the GAAR provisions recognise and acknowledge the right of a taxpayer to choose the most efficient tax structure for its commercial affairs, it means that the taxpayer must consider TAARs, a domestic GAAR and an EU GAAR. It’s possible the UK’s GAAR will be found to be compliant with ATAD and no additional layer of complexity is introduced into UK domestic law. However, when UK taxpayers are engaging in cross-border transactions, they are now at the mercy of potentially less scrupulous tax authorities in other Member States, who may see the new EU GAAR as a useful tax-raising measure and without the protection of the UK’s GAAR panel. So not only is there an erosion of a Member State’s tax sovereignty in that states are being forced to introduce a uniform GAAR when have their own domestic mechanisms to deal with the issue (e.g. §42 AO in Germany, the concept of abus de droit in France etc), but the EU GAAR could also become a Trojan horse, a stick with which Member States (such as Germany and France) can beat one another where they do not like the outcome of the application of domestic law TAARs and GAARs. It remains to be seen whether the EU GAAR will be a rarely invoked mechanism to restrain the most aggressive corporate tax planning, or whether it marks a further descent into discretionary taxation.
4. Controlled foreign company (CFC) rules
This measure is broadly consistent with the BEPS recommendations. It seeks to prevent companies in one Member State artificially diverting profits to a subsidiary or exempted permanent establishment (PE) in a low tax jurisdiction without proportionate economic substance in the subsidiary or PE.
Broadly, an entity or exempt PE will be treated as a CFC where:
- it is not subject to tax, or is exempt from tax in its territory of residence;
- the taxpayer and any associated entities hold directly or indirectly 50% of the voting rights, capital or profits of the subsidiary / exempted PE; and
- the actual corporate tax (if any) paid by the subsidiary or exempted PE is lower than that would have been paid had the parent earned those profits.
The control test is in line with most CFC regimes although an associated company for the purposes of the Directive means an entity in which the CFC’s parent holds at least 25% of the voting power, equity or profits. By contrast, most countries’ associated companies test requires a 50% control of voting power, equity or profits.
The lower level of tax test is very wide and means a controlled subsidiary will be subject to these rules just because it is subject to a lower corporate tax rate – there is no minimum threshold as to how much lower meaning that more subsidiaries will by definition be CFCs and will need to consider whether there is an exemption or whether they have substantive economic activities supported by appropriate staff, equipment, assets and premises. This seems to be more restrictive than the test in the Cadbury Schweppes case (C-196/04) where CJEU would only allow CFC rules between Member States where there is a ‘wholly artificial arrangement’. Instead, the substantive economic activity test seems to be moving more in the direction of the BEPS Action 3 requirements for IP holding companies of appropriate levels of expertise, staff and activity commensurate with the level of profit in the subsidiary. In proposing these Action 3 tests, the OECD was only too well aware that they may be in breach of EU law. Here, the EC seems to be ‘trying it on’, to push the boundaries out further than the CJEU would allow.
The only permitted exemptions appear to be a low profit and low profit margin exemption. A CFC will be exempt where:
- accounting profits are less than or equal to EUR 750,000 and non-trading income is less than or equal to EUR 75,000; or
- accounting profits are less than or equal to 10% of operating costs.
How will it affect Member States?
Member States with an existing CFC regime will most likely need to revise their basic definition of a CFC. Where there are exemptions from the CFC regime not included within the ATAD then these will need to be repealed.
The UK includes within its CFC regime a partial exemption from the CFC charge for foreign group finance or treasury companies. It is difficult to see how this can survive the introduction of ATAD. It also exempts most companies in EU Member States with the excluded territories Gateway. This exemption has now been removed, so a Maltese subsidiary of a UK parent will be subject to the new ATAD CFC test.
Interestingly, the ATAD permits Member States when dealing with CFCs in third countries to choose between the ‘substantive economic activity’ test (as described above) or a ‘purpose’ test whereby a CFC charge will not arise if the arrangement is genuine and not put in place for the essential purpose of obtaining a tax advantage. This is potentially more far-reaching, in that substantive economic activity is no longer a grounds for exemption. High-tax Member States may therefore choose the ‘purpose’ test for third countries. However, the purpose test is also more subjective. So it is very likely that countries such as Malta, Cyprus, Ireland etc that do not currently have CFC regimes will either apply the ‘substantive economic activity’ test generously, or opt for the ‘purpose’ test for third countries and put their telescopes to their blind eye when it comes to judging the taxpayer’s purpose. In either case, groups may establish an entity a Member State such as Malta or Cyprus which and ensure that it has substantive economic activity there so as not to have a CFC charge from a higher-tax Member State. The Maltese or Cyprus subsidiary entity in turn establishes subsidiary companies in third low-tax non-Member State countries and successfully invokes the more subjective purpose test.
This measure is likely to create the most complexity, uncertainty and administrative burden for taxpayers.
5. Hybrid mismatch framework
This measure is broadly in line with the BEPS recommendations to counter taxpayers exploiting differences between domestic tax systems to achieve a double deduction for related party expenses or a deduction for the expense but no inclusion of the income in taxable income (i.e. double non-taxation).
In order for the BEPS recommendation on hybrid mismatches to have any effect a solidarity of states is required and this is the one provision that is actually welcomed and is acknowledged as a necessity.
How does it affect Member States?
Many Member States will already be considering draft legislation implementing the BEPS recommendations and repeal any existing anti-arbitrage legislation. As such, there should not be a major unexpected impact to Member States.
That said, there appears to be a clear method in which to circumvent these rules. For example, a UK headquartered group establishes a CFC in a state that has opted to apply the CFC purpose test in third country scenarios (potentially Malta, Cyprus, Ireland amongst others). Assuming a CFC charge does not arise because there is sufficient economic substance in that state proportionate to the activities of that entity, it may in turn enter into hybrid arrangements with third countries such as the US. The ATAD mismatch framework ought not to apply. This means that Member States will need to introduce stricter mismatch rules within their domestic law to counter this potential abuse.
Scope creep and the Switch Over clause
Thankfully the EC conceded to remove the proposed ‘Switch Over’ clause that would require a country to depart from its dividend exemption and apply a credit method where the income is taxed in the country of origin at less than 40% of the recipient country’s corporate tax rate.
However, the ATAD is set for a review after 4 years and this would present an opportunity to reconsider the Switch Over clause – Germany already includes such a clause in all of its new double tax treaties and is clearly championing this. The effect of such a clause is extra territorial taxation and effectively produces an EU wide minimum corporate tax rate through the back door.
The key objective of the ATAD is to improve the resilience of the internal market as a whole against cross-border tax avoidance practices which it is argued cannot be sufficiently be achieved by the Member States acting individually. As regards Hybrid Mismatches, we are in agreement.
However, ATAD is heralded as a method to implement the minimum standard recommended by the OECD, with a view to simply creating a framework within which a Member State can still include its own tax legislation. This is just not true. The measures go beyond providing a mere framework and significantly restrict a Member State’s ability to set its own tax policy.
What is patently clear is that Member States will have to make extensive changes to their corporate tax laws and that taxpayers will incur large costs of administration or require changes in behaviour that sacrifice growth. The EC talks of restoring trust in the fairness of the tax systems through the introduction of the ATAD, but consideration now needs to be given to repairing the taxpayers’ trust in the administrators.