On 25 November 2013, the European Commission announced a proposal (the Proposal) to amend the EU Parent Subsidiary Directive (the PSD). The objectives of the Proposal are to address perceived tax anti-avoidance through the use of cross-border hybrid loan arrangements, and to introduce a general anti-abuse rule into the PSD. If introduced, the Proposal is required to be implemented into the domestic legislation of each Member State by 31 December 2014.
The PSD, which first came into force in 1992, sets out the legal framework for the tax treatment of cross-border payments of dividends and other profit distributions within the EU, and was generally intended to prevent corporate double taxation.
In broad terms, the PSD applies where a company resident in one Member State (the parent) holds a qualifying percentage of the share capital of a company resident in another Member State (the subsidiary). Where all applicable conditions are satisfied, the PSD provides that:
- dividends paid by the subsidiary to the parent are exempt from withholding tax in each of the relevant Member States; and
- the Member State of the parent is required to either (i) exempt the dividend received from a charge to corporation tax in that Member State, or (ii) provide tax credit in respect of any corporation tax paid by the subsidiary (including lower tier subsidiaries) in respect of the dividend (the Direct Tax Exemption).
Accordingly, the general effect of the PSD is to eliminate any withholding tax on certain cross-border payments of dividends and other profit distributions within the EU and to prevent potential double taxation of such payments.
The Proposal identifies the use of hybrid loan arrangements which are being used as a mechanism to achieve, what the Proposal describes as, “double non-taxation” by exploiting asymmetries between the domestic tax regimes of the parent and subsidiary. By way of example, where the Member State of the subsidiary regards such an arrangement as a debt relationship (payments made being treated as a tax deductible interest expense), and the Member State of the parent regards such an arrangement as an equity relationship (payments received being treated as a tax exempt dividend), “double non-taxation” results under the PSD. One aspect of the Proposal would amend the PSD so that such arrangements would no longer benefit from the Direct Tax Exemption.
Further, the Proposal contemplates the inclusion of a common general anti-abuse rule in the PSD (the PSD GAAR) in order to ensure that certain arrangements which are considered to be both artificial and only put in place for the essential purpose of obtaining a tax advantage under the PSD would no longer benefit from the PSD.
The key criteria for the application of the general anti-abuse rule would likely to be whether the arrangements in question are artificial or not. Although this will ultimately turn on a factual analysis of the particular arrangements, the Proposal contains a list of specific situations which should be considered by Member States in ascertaining whether such arrangements are so artificial. One such situation is where the arrangements in place do not reflect “economic reality”, such as, for instance, by being carried out in a manner which would not ordinarily be used in a reasonable business arrangement. As a result, and by way of one example, so called “letter box” companies could come under increased scrutiny if the Proposal were to be introduced in its current form.
It should be noted, however, that certain Member States already apply a domestic anti-avoidance rule to payments under the PSD. Accordingly, the practical impact of the PSD GAAR would likely be limited to those Member States which do not currently apply such a rule.
Although the Proposal will need to be approved unanimously by the Council of the European Union to become effective and bind the Member States, given the current European and international focus on addressing corporate tax avoidance and, in particular, mismatches between tax systems and instrument characterization, it seems that there is likely to be a “fair wind” behind the Proposal.
Accordingly, in the first instance, it would be prudent for market participants (whether corporate groups or investment funds) to consider whether any existing EU arrangements could be adversely affected by such changes to the PSD.