by Professor Edoardo Traversa, Matthieu Possoz, and Elien Van Malder
The European Commission on January 28 presented, as a key part of its anti-tax avoidance package, a proposal for a directive laying down rules against tax avoidance practices. This proposal mostly draws on measures contained in the OECD/G20 base erosion profit shifting (BEPS) final reports, as well as the Commission’s 2011 proposal for a common consolidated corporate tax base (CCCTB).
The Commission aims to achieve a balance between the need for a certain degree of uniformity in the implementation of the BEPS outputs across the EU and the tax sovereignty of the EU Member States. However, the imprecision of some of the terms used in the proposal for directive could lead to an unharmonised implementation across the EU.
The proposal contains 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.
The deductibility of interest
Multinational groups appear to reduce their tax base as a whole by financing group entities in high-tax jurisdictions through debt and subsequently arranging for these companies to pay back ‘inflated’ interest to subsidiaries resident in low-tax jurisdictions.
The aim of the rule proposed by the Commission is to discourage such practices by limiting the deductibility of taxpayers’ net borrowing costs (i.e., the amount by which financial expenses exceed financial revenues). Therefore, the ratio for deductibility is limited to 30 percent of a taxpayers’ earnings before interest, tax, depreciation and amortisation (EBITDA) or to EUR 1 million, whichever is higher. Special rules are provided to calculate the ratio for companies belonging to group, while financial and insurance undertakings are excluded from this interest limitation rule.
This proposed measure is similar to regimes existing in some Member States, in particular Germany, Italy, and Spain. However, by not linking the denial of the deduction to non-taxation of the interest in the hands of the beneficiary, this measure is likely to increase international double taxation of interest, contrary to the objective of the existing EU interest and royalties directive adopted in 2003.
Exit taxation
The European Commission has included in the proposal a provision on exit taxation of companies, which is in line with the existing case-law of the Court of Justice of the European Union. The proposal allows Member States to tax unrealised capital gains on assets in case of a transfer from one Member State to another. However, to comply with the Union law, the proposal states that taxpayers subject to the exit tax should have the right to either immediately pay the amount of exit tax assessed or defer payment of the amount of tax, possibly together with interest and a guarantee, over at least 5 years and to settle their tax liability through staggered payments.
In a welcome move, the proposal aims at avoiding international double taxation by obliging the Member State of destination to accept the market value established by the Member State of origin as a basis of assessment for a possible tax on future capital gains.
Switch-over clause
The anti-tax avoidance directive proposal provides for a switch-over clause which is targeted against certain items of foreign income, for example, profit distributions, proceeds from the disposal of shares, and permanent establishment profits which are tax exempt in the Union and originate in third countries.
The switch-over clause subjects this income to tax in the EU if it has been taxed in the third country at a tax rate below 40 percent of the normally applicable statutory tax rate of the Member State of residence of the taxpayer. Since the computation of the effective tax rate can be complex, the proposal suggests that Member States use the statutory tax rate when applying the switch-over clause. To prevent double taxation, Member States that apply this clause should give a credit for the tax paid abroad.
The switch-over clause will not be applicable to the losses incurred by the permanent establishment of a resident taxpayer situated in a third country and to the losses from the disposal of shares in an entity which is tax resident in a third country. A similar measure was included in the 2011 CCCTB proposal; its compatibility with existing double taxation conventions concluded by Member States with third countries remains to be assessed.
General anti-abuse rule (GAAR)
One of the most significant measures in the proposal is the inclusion of a general anti-abuse rule applicable to cross-border and domestic situations, denying tax advantages in case of non-genuine arrangements, i.e., “arrangements that are not put into place for valid commercial reasons reflecting economic reality.”
However, such a wording leaves a very wide room for interpretation and is likely to disproportionately increase the discretionary powers of the tax authorities. An explicit reference to “artificiality” in the articles of the proposal (and not merely in the recitals) would have enhanced legal certainty. Moreover, it is questionable whether the EU has legislative competence to enact such a GAAR that would apply in domestic situations, within the Union, and vis-à-vis third countries in a uniform manner and how it can be reconciled with general principles of law, in particular legal certainty.
Controlled foreign company (CFC) legislation
A controlled foreign company rule is designed to re-attribute income of a low-taxed controlled subsidiary to its parent company. According to the proposal, the parent company becomes taxable on the income of its subsidiary in the State where it is resident for tax purposes if some conditions, are met. To comply with EU law requirements, the measure is limited to wholly artificial situations or non-genuine arrangements. The financial undertakings are excluded from the scope of the CFC legislation.
A framework to tackle hybrid mismatches
The EU already adopted modifications in 2015 to the Parent-Subsidiary Directive specifically designed to tackle hybrid arrangements by means of which companies achieve international double non-taxation.
The Commission now proposes to enact similar rules for so-called hybrid entities, i.e. entities that are simultaneously considered resident or non-resident in different Member States. Those rules aim at ensuring that the Member States involved apply their rules in a coordinated manner, to avoid mismatches resulting in double non taxation of income. Unfortunately, the proposal does not contain binding rules to address and solve cases of international double taxation resulting from different characterization of the same entity or items of income by different member states.
Final thoughts
As a conclusion, and beyond the technical aspects of the proposal, the Commission confirms a radical change in its strategy toward tax integration. The prevention of avoidance and abuse has become the main objective of its tax policy, while the removal of cross-border tax obstacles, in particular double taxation, and the coordination of tax systems has gone to second place.
Despite the European Commission’ intention to relaunch the harmonisation process of corporate taxation (CCCTB), one could wonder whether the adoption of the anti-tax avoidance proposal would not undermine the Member States’ willingness to go further in that direction. Indeed, one of the biggest advantages of the CCCTB would be to neutralize tax planning schemes based on mismatches and loopholes between domestic tax systems. If similar results are achieved through an ad-hoc instrument, it remains to be seen what could motivate Member States to transfer another piece of their tax sovereignty to the EU level.
— Edoardo Traversa is a Professor of European and International Tax Law at the University of Louvain, Belgium and coordinates the EU Tax Taskforce at Liedekerke (Brussels). Matthieu Possoz and Elien Van Malder are lawyers at Liedekerke (Brussels).
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