On 28 January 2016, the European Commission published the proposal for a so-called Anti-Tax Avoidance Directive. The Directive applies to all taxpayers which are subject to corporate tax in an EU Member State, including corporate taxpayers resident outside the EU with a permanent establishment in the EU. The Directive sets out minimum standards which all Member States must implement. The Directive includes six measures which are discussed in this alert, including the impact each measure may potentially have on Luxembourg.
1. Introduction
On 28 January 2016, the European Commission published the 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 outcome of the OECD’s anti-Base Erosion and Profit Shifting project (BEPS). The first action following the BEPS project was the inclusion of a general anti-avoidance rule and a provision against hybrid mismatches in the EU Parent Subsidiary Directive. This new Directive may be a first step towards a Common Consolidated Corporate Tax Base (CCCTB).
The Directive sets out minimum standards which all EU Member States (Member States) must implement. The preamble explicitly states that the implementation of the Directive should not affect the taxpayer’s obligation to comply with the arm’s length principle or the Member State’s right to adjust a tax liability upwards in accordance with the arm’s length principle. Furthermore, the Directive does not preclude the application of domestic or agreement-based provisions aimed at safeguarding a higher level of protection for domestic corporate tax bases. The Directive applies to all taxpayers which are subject to corporate tax in a Member State, including corporate taxpayers resident outside the EU with a permanent establishment in the EU. The Directive, however, does not yet stipulate as per which date it should be adopted by the Member States.
The Directive 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 will also give our view on the potential implications of these measures for corporate taxpayers in Luxembourg.
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 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 one proposed by the OECD in the BEPS action plan. The aim of this measure is to mitigate the bias against equity financing. It might, therefore, result in a shift of debt financing to more equity financing.
The limitation applies without distinction of 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 two percentage points lower than that of the group is still considered to be equal to 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 limitation rule does not apply to certain financial undertakings (Financial Undertakings), including credit institutions, insurance undertakings, alternative investment funds and UCITS, as the Member States could not come to an agreement on specific rules for these sectors. In the view of the European Commission this exception should only be temporary.
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. We would, however, not expect that Luxembourg would opt for a lower rate than 30% of EBITDA.
2.1 Implications for Luxembourg
In Luxembourg, interest deductibility is currently limited based on thin capitalisation and transfer pricing rules. The thin capitalisation rules are not embodied in a piece of legislation or regulation, but flow from administrative practice confirmed by case law, according to which the debt/equity ratio applicable to a holding company stands at 85/15. This ratio represents a safe harbour which applies to debt financing obtained from related parties. A taxpayer can however use a higher leverage, if it is in a position to demonstrate that it could have borrowed from an independent third party in excess of the safe harbour ratio. Interest rates on debt financing provided by a related party need also to be at arm’s length to be fully tax deductible, in accordance with Luxembourg transfer pricing rules and OECD transfer pricing guidelines.
If the Directive is adopted, the EBITDA rule will probably be implemented alongside the current Luxembourg transfer pricing rules, but the currently existing thin capitalisation rules are likely to be abolished.
3. Exit Taxation
The Directive obliges Member States to apply an exit tax when a taxpayer moves 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 in compliance 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 of that Member State. The deferral must immediately be discontinued 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 goes bankrupt or is wound up.
No exit tax may be levied when the transfer is temporal and the assets are intended to revert to the Member State of the transferor, for instance 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 Luxembourg
The current Luxembourg exit tax provisions, which were adjusted in 2014 to comply with the freedom of establishment in light of the CJEU’s case law on exit taxation, are similar to the proposed provisions in the Directive. This measure will, therefore, probably not have a big impact on corporate taxpayers in Luxembourg, although it should be noted that Luxembourg currently does not charge interest in the case the taxpayer opts for the deferral of the Luxembourg exit taxes.
4. Switch-over Clause
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 permanent establishment profits. 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 may not be exempt, but must be taxed with a deduction (credit) of the tax paid in the third country. 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.
41. Implications for Luxembourg
Under the Luxembourg participation exemption regime, income derived from a participation held in a subsidiary established in a third country can be exempt from corporate income tax, if the subsidiary is subject to corporate income tax corresponding to Luxembourg corporate income tax, i.e., it must be subject to a statutory corporate tax rate equal to at least 50% of the Luxembourg corporate income tax rate, applied to a tax base computed pursuant to rules similar to Luxembourg rules. Regarding profits derived from a permanent establishment in a third country, Luxembourg companies are subject to corporate income tax based on their worldwide profits, including the profits derived from a permanent establishment, unless an exemption is available under a double tax treaty. A tax credit is already available under current law with respect to income derived from a non-treaty country, if such income is subject to a tax similar to Luxembourg income tax. Although the Luxembourg rules partially meet the requirements of the Directive, some adjustments will be required to fully implement the switch-over clause.
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 to be 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 thereof carried out for the essential purpose of obtaining a tax advantage that defeats the object or purpose of the otherwise applicable 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 Luxembourg
As the requirements to apply the GAAR are similar to the Luxembourg GAAR (Gestaltungsmissbrauch under Steueranpassungsgesetz Paragraph 6), this provision will probably not have a big impact on taxpayers in Luxembourg.
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 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. Where the CFC engages in non-genuine arrangements, the income to be included in the controlling company’s tax base is limited to amounts generated through assets and risks attributable to significant people’s functions carried out at the level of the controlling company.
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 Luxembourg
Luxembourg will have to design new legislation to implement this provision.
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 affected. The preamble of the Directive states that hybrid mismatches between Member States and third countries need to be examined further.
7.1 Implications for Luxembourg
Luxembourg will have to design new legislation to implement this provision. With respect to the proposed rule regarding hybrid entities, we would expect that its implementation into Luxembourg will have limited effects. Under current Luxembourg rules, EU entities that fall within the scope of the EU Parent-Subsidiary Directive or the EU Merger Directive, which should cover most, if not all, EU entities that are subject to corporate taxes, are treated as tax opaque for Luxembourg tax purposes. Accordingly, the situations where an EU entity gives rise to a hybrid mismatch situations in Luxembourg are extremely rare.
8. Timing
The measures which are included in the Directive have been discussed over the past few years in the framework of the proposed CCCTB Directive. Furthermore, these measures were part of the discussions in the OECD BEPS project. Member States have committed themselves to implementing the outcomes of the 15 BEPS Action Items. We have the impression that the European Commission expects that these measures will be acceptable to all Member States. An indication of this expectation is that supposedly more controversial elements, such as an interest limitation rule for financial undertakings and the extension of the framework for hybrid mismatches to third countries, have been left out. It seems, therefore, that the European Commission expects that the Directive can be adopted within a relatively short timeframe. Nevertheless, the Directive, in its current form, does not yet stipulate a specific date as per which it should be implemented by Member States.
Unanimity will be necessary to adopt the Directive.
We will, of course, keep you informed of all new developments, but please do not hesitate to contact us in the meantime if you would like to discuss the Directive and its impact on your business.
