Monday 20 June 2016 at midnight the EU Council reached political agreement on the Anti Tax Avoidance Directive (ATAD). The ATAD will be formally adopted in a forthcoming EU Council meeting. The main goal of the ATAD is to ensure a coordinated and coherent implementation at EU level of some of the OECD’s recommendations regarding base erosion and profit shifting (BEPS) and to add certain anti tax avoidance measures which are not part of the OECD BEPS project.
The Member States have to implement all measures as of 1 January 2019, except for the exit taxation provision and the interest deduction limitation provision. The exit taxation provision must be implemented per 1 January 2020. The implementation of the interest deduction limitation provision can be postponed until 1 January 2024, subject to certain conditions.
The ATAD lays down rules against tax avoidance in five specific fields:
- deductibility of interest;
- exit taxation;
- general anti-abuse rule (GAAR);
- controlled foreign company (CFC) rules; and
- hybrid mismatches.
Compared to the first proposal of the European Commission (see our Tax Flash of
28 January 2016) substantial changes were made to most of these rules. The switch-over clause, limiting tax exemptions for income from low-taxed foreign subsidiaries and permanent establishments, was eliminated.
The implementation of the ATAD will require changes to currently existing corporate income tax rules, like interest deduction limitations, but will also require the introduction of completely new sets of rules like for CFCs and hybrid mismatches in many Member States. The rules of the ATAD merely set the minimum required standards: Member States may apply additional or more stringent provisions aimed at BEPS practices.
More detailed information about the five adopted rules of the ATAD can be found here.
a) Interest deduction limitation rule
This rule limits the deduction of net borrowing costs to the higher of (i) 30% of the earnings before interest, taxes, depreciation and amortisation (EBITDA) and (ii) an amount of EUR 3 million. The net borrowing costs are defined as the balance of a taxpayer’s interest expenses and economically equivalent costs and expenses incurred in connection with the raising of finance, on the one hand, and a taxpayer’s taxable interest income and equivalent taxable income, on the other. The rule does not distinguish between third party and related party interest. The EBITDA is calculated on the basis of tax numbers and excludes tax exempt income. Member States can choose to apply the fixed rule of 30% and the EUR 3 million threshold escape at the level of a local group as defined according to national tax law. Further, Member States can choose to exclude standalone entities from the application of the interest deduction limitation.
If the taxpayer is member of a consolidated group for financial accounting purposes, the ATAD provides for two alternative worldwide group ratio escape rules, namely
(1) an equity escape rule or (2) an earnings-based worldwide group ratio rule. The Member States may choose to implement one of these two escape rules, but they are not obliged to do so. Under the equity escape rule a taxpayer is allowed to fully deduct its exceeding borrowing costs if it can demonstrate that the ratio of its equity over its total assets is not more than 2 percentage points lower than the equivalent ratio of the worldwide group. Under the earnings-based worldwide group ratio rule a taxpayer is allowed to deduct its exceeding borrowing costs up to the level of the net interest/EBITDA ratio of the worldwide group to which it belongs.
A Member State may give the taxpayer one of the following rights to ensure a balanced application of the interest deduction limitation rule over a number of years, devoid of effects of incidental fluctuations in EBITDA and net interest expense level:
- To carry forward, without time limitation, non-deductible borrowing costs to future years; or
- To carry forward, without time limitation, and back, for a maximum of 3 years, non-deductible borrowing costs; or
- To carry forward, without time limitation, non-deductible borrowing costs and, for a maximum of 5 years, unused interest capacity.
Member States are not obliged to apply the interest deduction limitation rule to financial undertakings, which are defined in the ATAD and generally comprise regulated financial institutions such as banks, insurance companies, pension funds and certain investment funds. Member States may also exclude the application of this rule with respect to loans used to fund certain long-term infrastructure projects.
The agreed text includes a grandfathering clause which excludes the application of the interest deduction limitation rule in case of loans concluded before 17 June 2016, but this exclusion shall not extend to any subsequent modification of such loans.
On the basis of a special implementation rule, Member States can postpone the implementation of the interest deduction limitation rule, provided they already have national rules preventing base erosion and profit shifting in place, which are equally effective to the interest deduction limitation rule as included in the ATAD. If so, they can postpone the implementation of the interest deduction limitation rule until the end of the year following the date of the publication of the agreement between the OECD members on a minimum standard with regard to BEPS Action 4, but no later than
1 January 2024.
b) Exit taxation
The ATAD provides for an exit tax to be assessed in the Member State of origin on the difference between the market value of the transferred assets and their tax value. Exit tax shall be triggered in the case of:
- transfer of assets from the head office to a permanent establishment (PE) located in another Member State or in a third country in so far as the Member State of the head office no longer has the right to tax the transferred assets;
- transfer of assets from a PE in a Member State to its head office or another PE located in another Member State or third country;
- transfer of tax residence to another Member State or third country (except when the assets remain connected with a PE in the Member State of origin); or
- transfer of the business carried out in a PE out of a Member State.
Members States to which assets are transferred must accept the market value of the assets transferred established by the transferor Member State as the starting value for tax purposes (i.e., a step-up).
Member States must give taxpayers the right to defer the exit tax payment by paying it in instalments spread out over five years when the transfers occur between Member States or states that are party to the European Economic Area Agreement (EEA States; Liechtenstein, Norway and Iceland). Contrarily to the initial proposal, the ATAD provides that the deferral on payment in case of EEA States can only occur in case the EEA State has concluded an agreement with the EU Member State of origin or with the European Union on mutual assistance for the recovery of claims, equivalent to the mutual assistance provided for in Directive 2010/24/EU.
Interest may be charged on deferred exit tax and the deferral of payment of exit tax may be subject to security arrangements to ensure proper collection. The deferral of exit tax must be terminated if the transferred assets are disposed of, are transferred to a third country or if the taxpayer transfers its residence for tax purposes to a third country or goes bankrupt. The deferral is also terminated in case the taxpayer fails to fulfill its obligations in relation to the installments and does not correct its situation over a reasonable period of time (which shall not exceed 12 months).
Under the GAAR, non-genuine arrangements or series thereof that are put in place for the main purpose or one of the main purposes of obtaining a tax advantage that defeats the object or purpose of the applicable law should be ignored for the purposes of determining the corporate tax liability. The wording of the GAAR corresponds to the wording of the general anti-abuse rule of the 2015 amendment to the EU Parent Subsidiary Directive, except that the GAAR in the ATAD should be applied to the entire domestic corporate tax laws of the Member States.
Arrangements or series thereof shall be regarded as non-genuine to the extent that they are not put into place for valid commercial reasons, which reflect economic reality. If the GAAR applies, the tax liability should be determined in accordance with the respective national law. In addition, according to the preamble, Member States may apply penalties whenever the GAAR is applied.
d) CFC legislation
The ATAD prescribes Member States to implement CFC legislation in their national laws. Under the ATAD, a CFC refers to an entity or a PE that meets the following conditions:
- a taxpayer holds (alone or together with associated enterprises) a (direct or indirect) participation of more than 50% of the voting rights, more than 50% in the capital or the entitlement to more than 50% of the profits of that entity; and
- the actual tax paid by the entity or PE in the CFC jurisdiction is lower than the difference between the corporate tax that would have been charged on the entity or PE under the applicable corporate tax system in the Member State of the taxpayer and the actual tax paid on profits in the CFC jurisdiction. The final wording reflects the concerns raised by some Member States as to the use of the concept of “effective tax rate” in previous draft versions of the ATAD. Still, the approved version leads in fact to the same result: a CFC will be any entity or PE that is subject to an effective tax rate of less than 50% of the effective tax rate in the country of the Member State of the taxpayer.
The non-distributed income of such a CFC needs to be included in the taxable income of a taxpayer in case additional requirements are met. Member States may opt for two alternative approaches:
- Inclusion of non-distributed specific types of income as defined in the ATAD (i.e., interest, dividends, income from the disposal of shares, royalties, income from financial leasing, income from banking, insurance and other financial activities, income from invoicing associated enterprises as regards goods and services where there is no or little economic value added). In this case, an exception is provided for situations where the CFC carries on a substantive economic activity supported by staff, equipment, assets and premises, as evidenced by relevant facts and circumstances. If the CFC is not a resident of or situated in a Member State or an EEA State, Member States may decide to refrain from applying this ‘substantive economic activity’-exception. Exceptions may be applied if the income of the CFC consists for one third or less out of the specific types of listed income and for financial undertakings when certain conditions are met.
- Inclusion of non-distributed income arising from non-genuine arrangements which have been put in place for the essential purpose of obtaining a tax advantage. An arrangement shall be regarded as non-genuine to the extent that the CFC would not own assets or would not have undertaken risks if it were not controlled by a company where the significant people functions, which are relevant to those assets and risks, are carried out and are instrumental in generating the controlled company's income. The attribution of income is then limited to the income attributable to the significant people functions carried out by the controlling company. In this case, an exception may be provided by an Member State for CFC entities or PEs with accounting profits of no more than EUR 750.000 and non-trading income of no more than EUR 75.000 or of which accounting profits account to no more than 10 percent of its operating costs for the tax period.
The provisions on CFC legislation in the ATAD provide rules with respect to the computation of the income to be included under the CFC rules (calculated in accordance with the rules of the Member State where the taxpayer resides) and the amount of income to be included under the CFC rules (proportion of entitlement to profits of the entity). The provisions also provides for relief of double taxation through a credit for the underlying corporate tax paid by the CFC.
e) Hybrid mismatches
Hybrid mismatches are situations in which an entity is qualified differently in two Member States and this difference in qualification results in:
- a double deduction of certain costs or losses (“double deduction” or “DD”); or
- a deduction of certain costs without taxation of the corresponding income (“deduction/no inclusion” or “D/NI”).
The most common types of these structures can be depicted as follows:
Click here to view the table.
- B Co. is transparent in Country A
- B Co. is non transparent in Country B
- Interest expenses of B co. can therefore be deducted in Country A and Country B
Click here to view the table.
- B Co. is transparent in Country A
- B Co. is non transparent in Country B
- Interest expenses of B co. paid to A co.
Can therefore be deducted in Country B, but is not visible or taxable in Country A.
In the first draft of the ATAD, these mismatches were solved by prescribing a full requalification of the hybrid entity in one of the Member States involved. This Member State had to follow the qualification of the other Member State and in that way the mismatch was taken away. This mechanism had lots of other tax consequences than only solving the hybrid mismatch and was replaced by a simpler set of rules.
Under the new rules, the general qualification of the hybrid entity is left unchanged. The rules are limited to a denial of the deduction of the payment that leads to a double deduction or deduction/no inclusion in one of the Member States.
- In case of a double deduction, only the Member State where the payment has its source shall give a deduction (in the first example above: country B). This means that the other Member State involved (in the first example above: country A) has to deny the deduction of the payment.
- In case of a deduction/no inclusion, the Member State of the payer shall deny the deduction (in the second example above: country B).
The rules also apply to hybrid mismatches caused by a structured arrangement with a different legal characterization of a financial instrument.
The scope of the rules is limited to hybrid mismatches between Member States. In the Annex to the ATAD the EU Council requests the European Commission to put forward a proposal for hybrid mismatches with non-EU countries by October 2016.