On 28 January 2016 the EC published a proposal for a so-called Anti-Tax Avoidance Directive. If implemented it would apply to all taxpayers who are subject to corporate tax in an EU Member State, including corporate taxpayers with a permanent establishment in the EU. Unanimous consent would be required from all Member States for this proposal to be implemented, and there may be some doubts as to whether this will be achieved. There has been no official comment from the United Kingdom Government.
On 28 January 2016 the European Commission published a proposal for a so-called Anti-Tax Avoidance Directive (Directive) (Proposal for a Council Directive laying down rules against tax avoidance practices that directly affect the functioning of the internal market, 2016/0011 (CNS)). This is the next step by the European Union (EU) in the implementation of the OECD’s anti-Base Erosion and Profit Shifting project (BEPS), although it should be noted that not all of the EU proposals are specifically contemplated in the final BEPS reports. The first BEPS related action at EU level was to include a general anti-avoidance rule and a provision against hybrid mismatches in the EU Parent Subsidiary Directive. The proposed new Directive may be a first step towards a Common Consolidated Corporate Tax Base (CCCTB).
The proposal sets out minimum standards which all EU Member States (Member States) would be required to implement. Member States would have to test their own domestic regimes against these minimum standards if the proposed Directive were implemented. This can cause issues where existing domestic regimes give particular reliefs that are not contemplated by the Directive. The Directive does not preclude provisions that offer a higher level of protection for domestic corporate tax bases. The Directive would apply to all taxpayers that are subject to corporate tax in any Member State, including corporate taxpayers resident outside the EU with a permanent establishment in the EU. The proposal, however, does not yet stipulate from when the Commission intends that the Directive should be adopted by Member States.
The proposal includes six measures: (1) a general interest limitation rule; (2) a provision on exit taxation; (3) an "exemption to credit system switch-over" clause; (4) a general anti-abuse rule; (5) controlled foreign company rules; and (6) a framework against hybrid mismatches which addresses both hybrid entities and hybrid instruments. These measures are discussed in this alert. We also give our initial view on the implications of these measures for corporate taxpayers in the United Kingdom.
2 General Interest Limitation Rule
The Directive limits the deduction of net interest expenses to an amount of 30% of the taxpayer’s earnings before net interest, tax, depreciation and amortisation (EBITDA) or up to an amount of €1,000,000, whichever is higher. This interest limitation rule is similar to the current German interest limitation rule. The aim of this measure is to mitigate the bias against equity financing. It might, therefore, result in a shift of debt financing to equity financing.
The limitation applies without distinction as to the origin of the debt. For example, it is not relevant whether the interest is related to intra-group, third party, EU or third country debt. Member States may (but are not obliged to) implement the following important exception to the interest limitation rule: taxpayers which are part of a group can fully deduct their net interest if they can demonstrate that the ratio of their equity over their total assets is equal to or higher than the equivalent ratio of the group. A ratio that is 2 percentage points lower than that of the group is still considered to be equal to the group ratio. The group consists of all entities which are included in audited consolidated statements drawn up in accordance with the accounting rules that apply in a Member State, IFRS or U.S. GAAP. The EBITDA of a tax year which is not fully absorbed by the net interest incurred by a taxpayer in that or previous tax years may be carried forward indefinitely and will increase the relevant EBITDA of the following year. Similarly, interest which cannot be deducted because of the EBITDA limitation may be carried forward to subsequent years.
The interest deduction limitation rule does not apply to financial institutions and insurance undertakings. In the view of the European Commission this exception should only be temporary. We note that based on the current wording of the proposal, the interest deduction limitation rule also applies to stand-alone taxpayers that are not part of a group.
The deductibility rate is set at the top end of the scale of 10-30% recommended by the OECD. Member States are allowed to implement stricter rules.
2.1 Implications for the United Kingdom
The United Kingdom Government launched a consultation on a general interest limitation rule in October 2015 in response to the publication of BEPS report on Action 4, so it seems likely that a rule will be introduced in the United Kingdom (although the responses to consultation were far from positive in most cases). If such a rule is introduced, we would not expect this to be before 2017, at the earliest. It was clear from the consultation document that the Government’s thinking was at an early stage and that many of the key elements of the United Kingdom rules remain to be settled. The proposed EU rule does not contemplate an exclusion for public benefit projects, which would be of concern to some infrastructure investors. The group ratio exemption also follows the asset-based approach used in Germany, whereas the UK consultation document was open to exploring different forms of group ratio test, including one based on payments rather than assets.
3 Exit Taxation
The Directive obliges Member States to apply an exit tax when a taxpayer transfers assets or its tax residence out of the tax jurisdiction of a Member State. This includes transferring assets from a head office to a permanent establishment in another Member State or a third country as well as transferring assets from a permanent establishment to the head office or a permanent establishment in another Member State. It also includes the transfer of tax residence to another Member State or to a third country except for those assets which remain effectively connected with a permanent establishment in the original Member State; and a transfer of a permanent establishment out of a Member State.
The Member State must tax unrealised capital gains on the assets which are transferred, e.g. the difference between the market value and the book value of the assets which are transferred. If the assets, tax residence or permanent establishment are transferred to another Member State, that Member State must accept the market value established by the Member State of origin as the starting value of the assets for tax purposes. In this regard, ‘market value’ is the amount for which an asset can be exchanged or mutual obligations can be settled between willing unrelated buyers and sellers in a direct transaction.
In the case of a transfer to a Member State or to a third country that is party to the European Economic Area (EEA) Agreement, the taxpayer must have the right to either immediately pay the exit tax or to defer payment of the tax over at least five years and to settle the tax liability through staggered payments. In the view of the Commission this makes the provision compliant with case law of the Court of Justice of the EU (CJEU). In case of deferral, the Member State may impose interest. The Member State may also request a guarantee as a condition for deferral if there is a demonstrable and actual risk of non-recovery and the legislation does not provide for the possibility of recovering the tax debt through another taxpayer which is member of the same group and resident for tax purposes in that Member State. The deferral period comes to an end, and the tax becomes recoverable, if the transferred assets are disposed of, or subsequently transferred to a third country, if the taxpayer’s tax residence or its permanent establishment is subsequently transferred to a third country, or if the taxpayer is bankrupt or is wound up.
No exit tax may be levied when the transfer is of a temporary nature and the assets are intended to revert to the Member State of the transferor, for example where the transfer takes place in order to meet prudential requirements or for the purpose of liquidity management, or when it comes to securities’ financing transactions, or assets posted as collateral.
3.1 Implications for the United Kingdom
The current United Kingdom exit tax provisions are in line with the proposed provision in the Directive. This measure will, therefore, probably not have a big impact on corporate taxpayers in the United Kingdom.
4 Switch-over Clause
If the Directive is adopted Member States must apply a credit system for certain types of foreign income which originate from third countries instead of an exemption (hence the name ‘switch-over’). The foreign income from third countries to which this switch-over clause applies includes profit distributions, proceeds from the disposal of shares and profits of a permanent establishment. The switch-over clause applies if the entity or permanent establishment from which the income originates is taxed at a corporate tax rate lower than 40% of the statutory corporate tax rate that would have been charged in the Member State of the taxpayer. In that case, the foreign income must not be exempt, but must be taxed with a deduction for the tax paid in the third country (a direct credit, i.e. not a credit for the taxes paid by the entity from which the income originates). The deduction may not exceed the amount of tax attributable to the foreign income. The switch-over clause does not apply to losses incurred by a permanent establishment of a resident taxpayer situated in a third country, and losses from disposals of shares in an entity which is tax resident in a third country.
4.1 Implications for the United Kingdom
Introducing this measure would represent a significant departure from the United Kingdom’s current territorial approach to taxation. There are broad exemptions from corporation tax available in relation to the receipt of dividends from both United Kingdom and non-United Kingdom subsidiaries. If a switch-over rule were introduced, then these exemptions would need to be overridden in the case of distributions from subsidiaries in low tax jurisdictions. Although the UK’s comparatively low corporation tax rate means that these provisions would only apply in relation to subsidiaries that are subject to tax at a rate of 8% or less, of particular concern would be the impact of this rule on subsidiaries that qualify for one of the exemptions from the current United Kingdom controlled foreign companies rules.
An elective regime providing full exemption from United Kingdom corporation tax for profits of foreign permanent establishments of United Kingdom companies was introduced in 2011. A switch-over rule on the Commission’s proposed terms would require changes to these rules.
5 General Anti-Abuse Rule
The Directive includes a General Anti-Abuse Rule (GAAR) which is designed to cover gaps that may exist in a country’s specific anti-abuse rules. According to the European Commission, it is designed to reflect the ‘wholly artificial test’ of the CJEU, where ‘wholly artificial’ is being translated as ‘non-genuine’. An arrangement or series of arrangements are regarded as non-genuine to the extent that they are not put into place for valid commercial reasons which reflect economic reality. If the Directive is adopted, non-genuine arrangements or a series carried out for the essential purpose of obtaining a tax advantage that defeats the object or purpose of the relevant tax provision, must be ignored for the purpose of calculating the corporate tax liability. The tax liability must be calculated by reference to economic substance in accordance with national law.
The GAAR must be applied in the same way in domestic, intra-EU and third country situations.
5.1 Implications for the United Kingdom
The United Kingdom has had its own general anti-abuse rule in place for over two years now. As such, this proposal will probably not have a big impact in the United Kingdom.
There are differences however: this proposal would apply where a transaction has the “essential” purpose of obtaining a tax advantage, whereas the United Kingdom GAAR merely requires that one of the main purposes of a transaction is to obtain a tax advantage. The Commission’s proposal also requires that the transaction defeats the object or purpose of the relevant tax provisions, whereas the United Kingdom GAAR takes a less prescriptive approach requiring merely that the transaction cannot reasonably be regarded as a reasonable course of action in relation to the relevant tax provisions (whether or not the transaction defeats the object or purpose of the relevant tax provisions being relevant to, but not determinative of, that test). It remains to be seen whether these differences would be sufficiently material to require changes to the United Kingdom GAAR should these proposals be implemented.
What is perhaps a more interesting question is how the GAAR proposed by the Commission would apply in intra-EU situations – for example, will it be possible or indeed necessary for a transaction that avoids tax in one jurisdiction to be recharacterised under the tax laws of another?
6 Controlled Foreign Company Legislation
The Directive obliges Member States to apply controlled foreign company (CFC) rules to taxpayers with controlled subsidiaries in low-tax jurisdictions with a certain amount of mobile passive income. The CFC rules attribute non-distributed income of the low-taxed controlled foreign subsidiary to its parent company by including it in the tax base of the parent. A subsidiary is ‘controlled’ if the taxpayer, together with its associated enterprises as defined under the applicable corporate tax system, holds a direct or indirect participation of at least 50% of the voting rights or owns more than 50% of capital or is entitled to receive more than 50% of the profits of that entity. The subsidiary is located in a low-tax jurisdiction if under the general regime profits are subject to an effective corporate tax rate lower than 40% of the effective tax rate that would have been charged under the applicable corporate tax system in the Member State of the taxpayer. Furthermore, the CFC rules only apply if more than 50% of the income accruing to the entity falls within any of the following categories: (1) interest; (2) royalties; (3) dividends and income from disposal of shares; (4) income from financial leasing; (5) income from immovable property unless the Member State of the parent would not be entitled to tax the income because of a tax treaty; (6) income from insurance, banking and other financial activities; or (7) income from services rendered to the taxpayer or its associated enterprises. This provision only applies to financial undertakings if more than 50% of the income in these categories comes from transactions with the taxpayer or its associated enterprises. The CFC rules do not apply if the subsidiary’s principal class of shares is regularly traded on one or more recognised stock exchanges.
The foreign income to be included in the tax base must be calculated in accordance with the rules of the corporate tax law of the resident state of the taxpayer and in proportion to the entitlement of the taxpayer to receive profits of the subsidiary. The income must be included in the tax year in which the tax year of the subsidiary ends. Losses of the subsidiary are not included in the tax base, but are carried forward. To avoid double taxation, the amount which was previously taxed under the CFC rules must be deducted from the tax base when calculating tax due on distributed profits or upon the disposal of the participation.
The proposed CFC rules apply to both third country and EU CFCs. However, for CFCs in the EU and EEA countries these rules only apply if the establishment of the entity is wholly artificial or to the extent that the entity engages, in the course of its activity, in non-genuine arrangements which have been put in place for the essential purpose of obtaining a tax advantage. The attribution of controlled company income must be calculated in accordance with the arm’s length principle.
Financial undertakings which are tax resident in the EU or the EEA and EU and EEA permanent establishments of financial undertakings are excluded from the scope of the CFC rules.
6.1 Implications for the United Kingdom
The United Kingdom has only recently reformed its controlled foreign companies rules; this was as part of the package of measures by which the United Kingdom moved towards a territorial approach to taxation. As such the United Kingdom CFC rules are primarily designed to prevent companies artificially diverting United Kingdom profits to controlled companies in overseas jurisdictions.
The CFC rules that have been proposed by the Commission would not appear to permit such a territorial approach. This seems logical, the intention here being to prevent the erosion of the tax bases of all of the Member States of the EU. A domestic CFC regime, such as the United Kingdom’s, that only protects the domestic tax base but permits the erosion of the tax base of other jurisdictions does not seem consistent with this.
7 Framework against hybrid mismatches in EU situations
The final measure provides that when two Member States give a different legal characterisation to the same taxpayer (hybrid entity) or payment (hybrid instrument) and this leads to a either a situation where a deduction of the same payment, expenses or losses occurs in both Member States, or to a deduction in one Member State but not an inclusion in the tax base of the other Member State, the legal characterisation given to the hybrid entity or to the hybrid instrument by the source state in which the payment is made, or the expenses are incurred or losses are suffered, must be followed by the other Member State.
It is important to note that this measure only applies in intra-EU situations and not in third country situations. This means that, for example, U.S. check-the-box situations are not targeted. The preamble of the Directive states that hybrid mismatches between Member States and third countries need to be examined further.
7.1 Implications for the United Kingdom
The United Kingdom government has already published draft “hybrids” legislation to be enacted in next year’s Finance Act and to take effect from 1 January 2017 which is broadly consistent with the BEPS recommendations. There are some differences between the BEPS recommendation and the Commission’s proposal: for example, in the case of hybrid instruments the BEPS recommendation is to deny the deduction, whereas this proposal is for the holder to include the income as taxable profit.
This Directive will not be adopted without the unanimous consent of all Member States. It remains to be seen whether this will be achievable. There are a number of Member States for whom these proposals would represent a significant change in tax policy. While some of these proposals are consistent with United Kingdom tax policy (for example, hybrids rules, a GAAR and exit taxation), others are contrary to the principle of territorial taxation which has only recently been introduced: in particular, the proposals for a switch-over clause and relating to controlled foreign company rules. There may be other smaller Member States that could have some reservations about these proposals.
The concept of passing control of these aspects of tax policy to Brussels at the same time as the United Kingdom is renegotiating its relationship with the EU before a referendum, now expected later this year, may raise some difficulties for the United Kingdom Government.