In late June, the Economic and Financial Affairs Council of the European Union (ECOFIN or the Council) achieved political consensus on the content of the EU Anti-Tax-Avoidance Directive (the ATA Directive). In last month's voting, ECOFIN was unable to reach consensus. Last week's agreement is a political compromise that was achieved at the expense of some of the initially proposed measures. This article, a follow-up to our recent alert, provides more detail on the five remaining adopted anti-tax-avoidance measures as well as some practical takeaways.
It is important to note that the ATA Directive provides only for minimum standards which the EU member states are to adopt in their respective local legislation. This is a change from the initial draft ATA Directive, which allowed for less flexibility. The additional flexibility is expected to increase the likelihood of disparity in the ways the different member states implement the rules – that is, clearly the opposite of what the EU is trying to achieve with this initiative.
Another important change from earlier drafts of the ATA Directive is that the EU member states are only required to implement and put into effect these new rules in their local legislation as per January 1, 2019. An additional transition period is granted for the provision dealing with exit taxes, which is to be implemented and come into effect no later than January 1, 2020. The introduction of the new rules by the EU members in relation to interest deductibility can even be postponed until January 1, 2024 provided member states have effective interest deductibility limitation rules already in place.
We expect the ATA Directive to be formally adopted in one of the next EU Council meetings.
INTEREST DEDUCTIBILITY LIMITATION
The ATA Directive provides for a rule limiting interest deductibility based on 30 percent of EBITDA (this is similar to the proposed interest deductibility limitation rule laid down in Action 4 of the OECD BEPS). The rule is not limited to related party debt alone but also includes third-party debt. It is expected that many EU member states will introduce this limitation rule as a complement to already existing interest limitation rules.
The ATA Directive provides for a grandfathering provision under which loans concluded prior to June 17, 2016 are excluded. When companies assess their short-term response, it is also important to bear in mind that certain EU members might not introduce these rules in their local legislation until January 1, 2024, per our comment above. Hence, in particular for new long-term debt planning, companies will need to consider the interest deductibility limitation of the ATA Directive.
The interest deductibility rule would limit deductibility of net interest expense to 30 percent of EBITDA with a minimum of net interest expense exceeding €3 million. The concept of “net interest expense” also includes costs incurred in relation to obtaining the financing. The EBITDA calculation is based on the company’s tax books.
The 30 percent EBITDA rule provides for a safe harbor for companies that are part of a consolidated group. EU member states can adopt one of two escape rules, based on either (i) a group equity ratio or (ii) a group earnings ratio. Under the equity ratio, escape interest continues to be deductible if its equity to assets ratio is comparable to the consolidated group ratio (to a maximum of 2 percent lower). The group earnings ratio escape allows for a deduction of exceeding interest expenses up to the level of the net interest/EBITDA ratio of the consolidated group.
Carry-forward of exceeding borrowing costs indefinitely is allowed, whereas carry-back is restricted to three years (five years for unused interest capacity).
Further, member states can exclude certain financial institutions from these rules as well exclude specific loans used to fund long term infrastructure projects in the EU.
The exit taxation provision requires all member states to levy an exit tax on unrealized gains in cases where assets are, or the residence of a company is, transferred within the EU, including transfer of assets from a head office to a branch. The object of this clause is to prevent the risk whereby assets, expected to generate high income, are moved to low-tax jurisdictions to be sold later and realise a high capital gain which will be low-taxed.
The member states are not obligated to apply the exit taxation in case of:
- tax exempt assets and
- financial assets, provided asset transfer is temporary and the assets are due to revert to the “departing member state.”
As with previous drafts, the ATA Directive provides for deferral by means of five year instalments in case of transfers within the EU/European Economic Area , subject to interest, guarantees and recapture provisions. In order to prevent double taxation, the “destination member state” shall accept the market value as determined by the member state of the taxpayer as the starting value therein.
Example: A pharmaceutical company based in a member state develops a promising new product and deducts the costs of development from its taxable profits in that state. Just as the asset starts generating profits, it moves the product to a no-tax country and applies for the patent there. As a result, all value generated on the intellectual property of this product is now untaxed.
With the exit tax, the member state where the product was originally developed can tax the company on the value of this product before it is moved abroad. That is, taxation better reflects where the economic activity takes place.
Many EU member states already have comparable exit taxation provisions in their local legislation.
GENERAL ANTI-ABUSE RULE
The general anti-abuse rule (GAAR) aims to address any gaps that could exist in domestic anti-abuse rules. It allows member states to ignore transactions that are not based on valid business reasons. According to the preamble, member states are not prevented from applying penalties where the GAAR is applicable. The GAAR is similar (both in wording and purpose) to the GAAR included in the EU Parent-Subsidiary Directive last year.
CONTROLLED FOREIGN COMPANY RULES
In order to discourage the shifting of profits out of a highly-taxed parent company towards its subsidiaries in low-tax jurisdictions, controlled foreign company (CFC) rules have been included in the ATA Directive.
Under the CFC rules, EU resident companies will be required to include non-distributed income from qualifying CFCs in its taxable income on an annual basis. In brief, a subsidiary will qualify as a CFC in cases where an EU resident entity has direct or indirect controlling interest of more than 50 percent (e.g., holding more than 50 percent of the voting, capital and/or profit rights) and the corporate tax paid by the CFC is lower than the difference between the corporate tax that would have been charged in the member state of the EU parent company and the actual tax paid under the applicable corporate tax system.
In earlier versions of the ATA Directive, the latter CFC condition referred to an effective tax rate of the income less than 50 percent of the effective tax rate of the EU parent company. Furthermore, the definition of “effective tax rate” has been removed from the ATA Directive, providing the member states with more flexibility. However, member states with lower domestic statutory tax rates will be less vulnerable to the application of the CFC rules.
Member states may choose to attribute to the EU parent company:
- the entire revenues of a low-taxed subsidiary or
- predefined categories of non-distributed (passive or “tainted”) income (specified below) or
- non-distributed income from non-genuine arrangements (i.e., income artificially diverted to a subsidiary).
Under the second option, the following categories are deemed to be “tainted” income:
- interest or any other income generated by financial assets
- royalties or any other income generated from intellectual property
- dividends and income from the disposal of shares
- income from financial leasing
- income from insurance, banking and other financial activities and
- income from invoicing companies that earn sales and services income from goods and services purchased from and sold to associated enterprises, and add no or little economic value.
Furthermore, this option provides for an escape clause, under which a taxpayer will have to prove that the CFC carries on a substantive economic activity supported by staff, equipment, assets and premises. In addition, the second option also contains a throw-out clause, under which member states may not treat anentity or permanent establishment as a CFC if:
- not more than one-third of its income falls within one or more of the aforementioned listed types of tainted income or
- its financial undertakings earn not more than 1/3 of their income through associated enterprises.
The third option essentially re-attributes to the EU parent company income generated in the subsidiary from assets and risks which are effectively managed through significant people functions in the parent's member state. In this regard, amounts beyond arm's length are deemed wholly artificial. The third option provides exemptions for low accounting profits (no more than €750,000, and non-trading income of no more than €75,000) and low profit margins (no more than 10 percent).
Example:A company has its headquarters in an EU member state. It sets up a re-insurance company as a subsidiary in a no tax third country. This subsidiary does not carry out substantive activities relating to this income. The insurance company makes inflated royalty payments to the offshore company, thereby reducing its taxable profits in the EU member state. The payments received by the subsidiary are not taxed either, because of the third country's zero rate.
With the proposed CFC rule, the EU member state can tax the subsidiary's profits as though they had not been shifted to the no-tax country, thereby ensuring effective taxation at the tax rate of the member state concerned.
A rough example of the CFC rules in action:A parent company is resident in an EU member state and is subject to corporate tax at a rate of 40 percent. The EU parent company holds a CFC subject to corporate tax at a rate of 25 percent and has profits of 1000. The tax paid in the CFC state is 250 (25 percent of 1,000). For the purposes of this example, it is assumed that the computation of the taxable base in both jurisdictions is similar. If the profits had been subject to tax in the EU member state in which the parent company is based, the total tax due would have been 400 (40 percent of 1,000). There is thus a difference of 150 (400-250=150). In this case, the CFC rules would not apply, as the difference (150) is lower than the total tax paid in the CFC jurisdiction (250).
Within the context of the OECD BEPS initiative, both BEPS Action 4 (interest deductibility) and BEPS Action 3 (CFCs) are so-called recommendations, as a result of which short-term consensus on these items is not expected within the OECD. Adoption of the ATA Directive, on the other hand, subjects all EU member states to these binding CFC rules.
HYBRID MISMATCH RULES
The anti-hybrid rule requires member states to follow the classification of the instrument or the entity of the source member state (claiming the initial deduction). This would result in an inclusion of the corresponding income at the level of the recipient. An anti-hybrid rule is also part of the OECD BEPS initiative. It is important to note, however, that the proposed EC anti-hybrid rule is contrary to Action 2 of the OECD BEPS plan, which provides for a primary rule requiring the source state to disallow a deduction.
Mismatches with non-associated enterprises and individuals are out of scope of the adopted anti-hybrid rule. Furthermore, the rule only covers mismatches within the EU. The Council has requested the European Commission to put forward a proposal by October 2016 on hybrid mismatches involving third countries in order to provide for rules consistent with (and no less effective than) the rules recommended by the OECD BEPS report on Action 2, with a view to reaching agreement by the end of 2016.
Example:A group with operations in two member states sets up a new entity in one of the states. The two states view this hybrid entity differently for tax purposes (mismatch). The entity borrows money on behalf of the group and pays interest on the loan. Because of the mismatch, both member states allow a tax deduction for this interest payment. With the hybrid measures proposed in the Directive, the mismatch is eliminated and the tax deduction will be allowed in the member state where the payment was made. Therefore, the income is effectively taxed within the EU.