EU Member States recently reached an agreement on the EU Anti Tax Avoidance Directive 2016/0011(the “Directive”). The Directive is aimed at tax planning practices currently widely used by multinational companies and builds on the OECD's Base Erosion and Profit Shifting (“BEPS”) project. The Directive is not only important for multinational companies like Starbucks and Apple, but may also have significant consequences for the structuring of funds.
The Directive contains five mandatory rules which must be implemented by each Member State. Member States are of course allowed to implement stricter rules as they deem appropriate. We anticipate the following four rules may be relevant for investment funds:
Interest Limitation Rule
This rule aims to discourage artificial debt arrangements in group structures to minimise tax liabilities. It limits the deductibility of what is termed 'exceeding borrowing costs' (i.e. net finance expenses) from both related and third party loans to 30% of the taxpayer's earnings before net interest, tax, depreciation and amortisation (“EBITDA”) or optionally a de minimis threshold of EUR 3 million.
The Directive provides for the harshness of this interest limitation rule to be mitigated through a number of reliefs and exclusions.
First, where the taxpayer is a member of a consolidated group for financial accounting purposes, the taxpayer may deduct its ‘exceeding borrowing costs’ calculated by applying either (i) a ratio of its equity over its total assets compared with the equivalent ratio of the group, or (ii) a group ratio based on the group’s EBITDA.
Second, Member States have the option of excluding taxpayers that are not part of a multinational group (i.e. standalone entities), financial institutions and alternative investment funds as defined in the Alternative Investment Fund Managers Directive (2011/61/EU) from the interest limitation rule.
Third, interest which is non-deductible because of the EBITDA limitation can be carried forward.
Fourth, the Directive includes an optional grandfathering clause excluding loans from the scope of the interest limitation rule which were concluded before 17 June 2016, provided they are not subsequently modified.
We anticipate that fund vehicles themselves will generally not be affected by the interest limitation rule because:
- Member States can opt not to apply the rule to alternative investments funds;
- investment funds are generally not leveraged at the level of the fund vehicle;
- the fund vehicle is often a tax exempt or tax transparent entity; and
- even if the fund vehicle is affected, the de minimis threshold of EUR 3 million is often sufficient.
The interest limitation rule will, however, likely affect structures beneath the fund vehicle, i.e. in the country where the fund’s assets are located or held.
General Anti-Abuse Rule (“GAAR”)
This rule gives Member States the power to tackle artificial tax arrangements when other specific rules fail to counteract them. Member States should deny tax advantages resulting from commercially non-genuine arrangements, or series of arrangements, that have been put in place for the main purpose of obtaining that tax advantage.
The GAAR could, for instance, affect special purpose vehicles that have been included in the fund's structure for tax related reasons and that have limited physical and economic substance. If, for example, a Spanish PropCo is held via a Dutch HoldCo which has been set up beneath a Luxembourg fund vehicle, Spain could deny certain tax advantages (e.g. favourable withholding tax rates) if the Dutch HoldCo lacks sufficient substance.
Controlled Foreign Company (“CFC”) Rules
These rules are aimed at multinational groups that use controlled subsidiaries, including permanent establishments, without substantive economic activities to shift profits from high to low taxed jurisdictions. If the CFC rules apply, non-distributed financial profit (e.g. interest, dividends, income from the disposal of shares) of the low taxed entities is attributed to and taxed at the top holding/fund vehicle.
Member States can choose to allocate to the parent company non-distributed income of CFC's, which arises from commercially non-genuine arrangements which have been put in place solely for the purpose of obtaining a tax advantage.
The CFC rules could affect fund structures that utilise favourable tax regimes or low taxed entities. This may have an impact on funds and holding vehicles located in offshore low tax jurisdictions such as the Cayman Islands.
Rules on Hybrid Mismatches
These rules provide that where (i) a deduction of the same payment occurs in two Member States or (ii) a deduction occurs in one Member State without an addition to the taxable income in the other Member State, the legal characterisation given to the hybrid instrument or entity by the state in which the payment is made must be followed by the other Member State.
The hybrid mismatch rules also cover mismatches that are caused by different characterisations of financial instruments by Member States. Contrary to the hybrid mismatch rule of the EU Parent Subsidiary Directive (2011/96/EU), these rules apply to all taxpayers in Member States.
As a consequence of these rules, it is likely that hybrids utilised by complex funding structures will become less tax efficient.
Implementation of the Directive
The Directive must be implemented by Member States by 1 January 2019. Member States that have existing interest limitation rules in place equivalent to those provided for in the Directive are permitted to postpone the introduction of the interest limitation rule until 1 January 2024.
We expect that Member States will implement the Directive in different ways, leading to discussions with local tax authorities and uncertainty for taxpayers.