New EU directive against tax evasion immature
At the end of January, the European Commission published the anti-BEPS directive against tax evasion. It is an historic document: if the directive is adopted, key areas of corporation tax will have been harmonized. The current proposal deserves support but is not yet mature, argues Stan Stevens.
The objective of the anti-BEPS directive is to combat tax evasion by businesses. So there is really nothing wrong with the directive's intentions. Sovereign states create their own tax systems and, because fiscal rules differ from country to country, this creates possibilities for tax arbitration. Over the past years, a number of multinationals have made use of tax structures in order to minimize their tax burden. These structures are legal. The relevant rules and regulations are complied with in all countries.
Nevertheless, multinationals are being called to account for their fiscal behavior: it is asserted that they are not paying their fair share of tax. Of course anyone may present someone else with his own ethical standard, but it is also the task of politicians to ensure that the required standards are laid down in rules and regulations, certainly if the contents of the standard are a little ambiguous and/or politically contentious. It is the function of a democracy to find a reasonable balance between conflicting interests and standards.
Disturbance of competitive conditions
In this respect, the fact that the European Commission has picked up the gauntlet by proposing European regulations in the field of direct taxes is to be praised. However, in my opinion the proposal is not yet mature. In some points, the contents conflict with the principles of the European Union, such as the open market, and moreover they lead to a disturbance of the competitive conditions between the Member States. What is the problem?
One of the most important tax benefits is participation exemption. The objective of this is to avoid double taxation on profits paid out by a subsidiary to its parent company. This principle is also endorsed in Europe. On grounds of the Parent-Subsidiary Directive, Member States are obliged to grant exemption on corporation tax for dividends received by a parent company from a subsidiary. The alternative is that settlement of corporation tax is granted.
The difference between an exemption and settlement may be simply illustrated by means of an example:
BV A is established in country A with a tax rate of 25%. BV A has a subsidiary, B Ltd, in country B with a tax rate of 15%. The profit made by B Ltd amounts to 100 and so is fully paid out as dividend. BV A has a profit (excluding the dividend) of 200. The tax burden under an exemption regime is 65 (Country A 50 and Country B 15). After all, the dividend is not taxed in country A. With settlement, the tax burden becomes 75 (25% of 300). Country B still has 15 and in country A, 75 is levied and 15 may be settled, resulting in a tax levy of 60 in country A.
The financial difference between the systems is clear. In an exemption regime, the tax burden on the profit of B Ltd is equal to the effective rate of the country in which the company operates. In a settlement regime, additional levies are made up to the parent company's rate. It is assumed that an exemption regime is economically more efficient, because companies operating in the same market are confronted with equal tax burdens. That is why the Netherlands has always favored an exemption regime.
Tax concessions eliminated
Included in the BEPS directive is the proposal that the exemption method be compulsorily replaced by a settlement method (switch over) if the statutory tax rate in the subsidiary's country is less than 40% of the statutory rate of the parent company. So in the Netherlands, the exemption will be replaced by a settlement, if the rate is less than 10%.
It is quite remarkable that this obligatory switch over also applies if the subsidiary has genuine economic activities, such as production and/or sales activities. In this case there is no question of misuse and the subsidiary's country is in effect limited in its tax sovereignty. Tax concessions (a low rate to attract investments) are eliminated by the Member States of the European Union. The settlement method will solely apply to subsidiaries established outside the EU.
The reference to the statutory rate of the country in which the parent company is established also produces strange effects. In Ireland the rate is 12.5%. That means that Ireland need only grant a settlement if the tax rate of the subsidiary is 5%. So this stipulation stimulates holdings to establish themselves in Ireland instead of in the Netherlands. If the Netherlands wants to remain competitive as a host country for holdings, then the overall corporate tax rate will have to drop. So the switch over is an incentive for small countries to lower the rate. To prevent that, it would be more logical to stipulate that exemption is canceled if the subsidiary's rate amounts to less than 10%.
Introduction of the CFC rules
A switch over is understandable within the framework of combating tax evasion if the subsidiary has no genuine or mobile economic activities. However, in the BEPS directive, a so-called CFC regulation has been suggested for this specific situation. CFC stands for Controlled Foreign Corporation. There is a question of control if a parent company together with an affiliated body directly or indirectly possesses more than half of the controlling rights or capital or is entitled to more than half of the profits. The profits of a CFC are – insofar as these are not paid out as dividend – allocated to the subsidiaries and levied in the country where the parent company is established. This allocation applies if two conditions are met:
- more than half of the income of the CFC must consist of mobile income such as interest, royalties, dividend, leasing, sales profits, certain income from real estate, income from bank or insurance activities and income from the provision of services within the group (e.g. a purchasing office);
- the income from the CFC must be taxed at a low rate. A CFC is taxed at a low rate if the effective tax rate for the CFC is less than 40% of the effective rate for the parent company.
The CFC rules apply primarily to third countries. Those are countries which are not Member States of the European Union, such as recognized tax havens like the British Virgin Islands, but also the United States, Brazil, etc. In the case of misuse, the CFC rules may also be applied to a subsidiary established in the European Union. Establishment abroad must then be "wholly artificial'. Essentially: the CFC company is a letterbox entity with virtually no own economic activities and insufficient qualified personnel to carry out the (pretended) activities.
There are no real fundamental objections against the CFC rules, other than they are complicated to apply in practice and result in double taxation. The proposed regulation also suffers from this defect.
The introduction of earning stripping rules
The third measure being proposed is the introduction of so-called earning stripping rules. The objective of this regulation is to avoid companies from receiving excessive financing with outside capital. The proposed regulation means that the net interest payable (to banks or group companies) may only be deducted to a maximum of 30% of the EBITDA. Two exceptions have been suggested:
- the SME exemption: the net interest payable which is less than EUR 1 million is always deductible;
- the group exemption: the ratio equity capital / total assets of the taxpayer does not deviate substantially (a maximum of 2%) from the same ratio for the group to which the taxpayer belongs. The idea behind this compensation is that the taxpayer is not excessively financed with outside capital, because the entire group has a lot of outside capital and apparently that is economically rational because third parties are prepared to provide the loan.
The Netherlands now already has a number of anti-misuse stipulations which can limit the deduction of interest. Moreover, case-law must also be taken into consideration. If the proposed regulation is implemented, then it will be high time to make cuts in the existing regulations.
Another important measure for preventing tax evasion is the rule that for the fiscal qualification of legal entities and financial instruments, adjustments are made with respect to qualification in the source country. Now it is possible for a financial instrument to be considered as capital in one country and as a loan in the other country. This may result in the interest being deductible as interest in one country, but that it is not taxed in the other country because it is considered as dividend. The proposed regulation defines that if the interest is deductible, it must in principle be taxed.
Moreover, an exit levy is prescribed if a company is moved abroad. However, the Netherlands already has such a stipulation.
Finally, all countries are obliged to include a general anti-misuse stipulation in their legislation. In the Netherlands, the tax authority may combat fiscal structures that conflict with the objective and scope of the law and whereby the taxpayer wants to save tax (and so has no other business objectives for the arrangement) with a claim on fraude à la loi (legal fraud). The general misuse assessment adds little to this.
In my opinion, the anti-BEPS directive is not yet mature. The initiative does however deserve support. An approach at a European and OECD level will offer the most possibilities for tackling tax evasion, while at the same time preventing double taxation. However, the current proposal still leads to a disturbance of the competitive conditions and also affects situations in which there is no question of misuse.
Prof. Dr. Stan Stevens is extraordinary professor of Fiscal Economy at the TIAS School for Business and Society. He is also a partner at HVK Stevens, where he gives advice on fiscal issues surrounding investments, financing, business succession and tax planning.
Executive Master of Finance & Control / Register Controller
Give your role as Register Controller substance and increase your insights with the most recent scientific knowledge and theoretical conceptual frameworks from the Executive Master of Finance and Control.