On 12 July 2016, the European Council formally adopted the “Anti-Tax Avoidance Directive”. This directive obliges EU countries to implement specific measures in their tax laws aimed at combatting corporate tax-avoidance. The directive contains measures such as a limitation of interest deduction, a general anti-abuse clause, etc. The Directive should be seen in the light of the many initiatives worldwide against perceived ‘aggressive tax planning’ by corporate tax payers, the most well-known being the OECD BEPS project.
Some of the measures in the directive will also affect the tax affairs of funds investing in Europe. This Q&A will explain in brief answers what the expected impact of the directive on the European investment management industry will be.
- What is the “Anti-Tax Avoidance Directive"?
- Is it relevant for the fund industry?
- What is the key content of the Directive?
- What are the important topics for the fund industry?
- Limitation of interest deduction
- What will be the impact of this interest limitation on funds?
- What about the impact of the GAAR on fund structures?
- What about the CFC-rule?
- What other major attention points are worth while noting?
- When will the Directive enter into force
- What should be done?
1. What is the “Anti-Tax Avoidance Directive"?
It is an EU directive aimed at combatting cross-border ‘base erosion and profit shifting’ (BEPS). In other words avoiding that potentially taxable profits of companies are shifted to low tax environments. The Directive was formally adopted on 12 July and should be seen in the light of the many initiatives worldwide against perceived ‘aggressive tax advice’ by corporate tax payers.
2. Is it relevant for the fund industry?
Measures against corporate tax avoidance not only concern multinationals, but also the fund industry. Some of the proposed measures are likely to result in higher effective tax burdens and costs for funds and managers. Existing fund structures and management organisation may need to be amended in order to mitigate the potential adverse effects.
3. What is the key content of the Directive?
The main goal of the Directive is to ensure a coordinated and coherent implementation at EU level of some of the OECD’s recommendations regarding BEPS and to add certain anti-tax avoidance measures which are not part of the OECD BEPS project. It contains measures in five specific fields that must be implemented by each EU country:
- interest limitation rule;
- a general anti-abuse provision (GAAR);
- exit taxation;
- controlled foreign company (CFC) rules; and
- hybrid mismatches.
4. What are the important topics for the fund industry?
The most important rules affecting funds are the limitation of the deduction of interest and the introduction of a so-called ‘GAAR’, or ‘main purpose test’.
5. Limitation of interest deduction
This rule limits the deduction of interest costs on net borrowings to basically 30% of the EBITDA or a (higher) threshold of EUR 3 million (effectively on a ‘per country’ basis). This rule is a ‘de minimus’ rule: individual EU countries may impose additional and stricter limitations. The rule does not distinguish between third party (bank) and related party interest. Countries like Germany and Italy already have a similar system in their domestic tax laws. EU countries can choose to exclude standalone entities from the interest deduction limitation. A similar exclusion applies if a corporate tax payer can prove that its solvability on the basis of commercial accounts is equal or better than that of the consolidated group to which it belongs (allowing a 2% margin). There is also the option of a similar escape based on the group EBITDA.
EU countries may introduce a carry forward of ‘unused interest capacity’, but this is not mandatory. The agreed Directive text contains a grandfathering clause which excludes the application of the interest limitation rule in case of loans concluded before 17 June 2016, but this exclusion shall not extend to any subsequent modification of such loans.
6. What will be the impact of this interest limitation on funds?
Fund vehicles as such will normally not be affected, for two reasons:
- EU countries have the option to fully carve out those funds that qualify as ‘alternative investment funds’ in the sense of the AIFM Directive.
- But even if the ‘AIFMD carve out’ is not applicable, most investment funds are not leveraged at the level of the fund vehicle and/or are exempt / transparent and, hence, deductibility of interest is not an issue.
However, in many instances, the interest deduction limitation will apply to the investment structures underneath the fund. For example, to the local holding and target companies in the specific EU countries where the ultimate investments are located. Many EU countries already have similar interest deduction limitation in their tax laws today.
The above means that fund structuring strategies that work with third party or shareholders’ loans (external or internal leverage) to reduce the taxable basis of target companies through interest payments, may be affected by this ‘hard cap’ deduction limitation. So, in particular buy-out and real estate funds may need to revisit the tax efficient financing structures that they are using.
An important question will be if fund vehicles are seen as the ‘top entity’ of a consolidated group. If the answer is yes, then the group ratio escape (see above under 5) will normally not help (the consolidated group will often have a high equity). If the fund is not included in the consolidation (which may well be the case in many countries), there may be more possibilities to increase the ‘interest deduction ceiling’.
It is still unclear what the interaction will be of the interest deduction limitation and certain specific fund regimes like the REITS or certain ‘private exempt fund regimes’ in Europe. This is an important point of attention for those managers who are using special tax exempt regimes.
7. What about the impact of the GAAR on fund structures?
To mitigate the tax burden on cross-border private equity investments, funds often rely on Luxembourg and Dutch investment holding and finance structures underneath the fund vehicle that may benefit from reductions of tax on the basis of tax treaties and/or EU directives (e.g., P/S Directive). The GAAR can be used by EU source countries (where the invested assets are located) to deny the tax benefits to the fund’s investment vehicle. For instance, deny a reduction of withholding tax or a capital gains exemption to a Luxembourg or Dutch holding company wholly owned by an offshore fund.
It can be expected that local tax authorities shall increasingly challenge structures that – in their view – lack economic reality and business rationale. As a result, legal entities (like “SPVs”) with little physical presence and minimal personnel may no longer produce the desired effects and need to be revisited.
Fund managers and associations representing the fund industry should put an effort in explaining that investment fund set ups are by definition not ‘abusive’ as they are playing a genuine and critical role in society and pool the money of institutional investors, generally entitled to tax (treaty) benefits had they invested directly in the underlying assets / targets.
8. What about the CFC-rule?
The so-called ‘CFC-rule’ is aimed at structures with low taxed entities without substantive activities. If the CFC-rule kicks in, the non-distributed profits of certain low taxed EU or third country subsidiaries will immediately become subject to tax in the hands of the (ultimate) EU parent company. This may, for instance, be an issue if a fund – directly or indirectly - uses certain special tax regimes (e.g., the Spanish Socimi, or the Italian ‘Fondi’). The CFC-rules may not only impact the effective tax rate of fund structures, but may also change investor preferences for certain fund vehicles.
9. What other major attention points are worth while noting?
Fund managers should take a look at their structures to see if these contain so-called ‘hybrid structures’ or ‘mismatch structures’. For example, financing structures where the interest is deductible on one side, but not taxed on the other side. There are also elaborate ‘exit tax’ provisions, aimed at securing the taxation rights of EU countries for in case businesses or assets are being transferred out of the country.
Two other important and related topics are reporting/exchange of information and transfer pricing. Although not included in the text of the Directive, other EU measures and actions (CbC, exchange of rulings, etc.) will mean that much more information on tax structures and positions will be exchanged between the authorities of EU countries (and third countries!). A system of automatic exchange of rulings is put into place, not only within the EU, but in essence also with many third countries. Moreover, the transfer pricing used by fund and management structures are also likely to become more vulnerable to scrutiny.
10. When will the Directive enter into force
EU countries must implement the anti-tax avoidance provisions into their domestic tax laws by 1 January 2019. On the basis of a special implementation rule, EU countries could postpone the introduction of the interest deduction limitation until no later than 1 January 2024.
11. What should be done?
The Directive is part of a large body of international changes in the field of the fight against international perceived “aggressive tax advice”. The potential impact of all measures is simply too large to ‘wait and see’ Even if it is too early to implement fundamental changes, it is recommendable to establish the priorities and define potential actions to improve:
- review and improve the existing substance and rationale of investment and finance structures and ascertain that they are at the required level;
- realise that tax structuring is becoming an increasingly important topic in the discussions with investors (fiduciary duty);
- review tax rulings and advance pricing agreements to see if they contain sensitive elements;
- restructure certain tax advice schemes that are too risky (like the use of certain hybrids) and improve the quality of the implementation (close the ‘implementation gap’);
- review and bolster the transfer pricing analysis and documentation underlying both the related party financings of a fund and the management services structure cross border. Improve the intra-group finance structure of investment vehicles, following the transfer pricing review.