Tax Avoidance Directive

1. Introduction

On 28 January 2016, the European Commission launched its proposal for a Directive laying down rules against tax avoidance practices that directly affect the functioning of the internal market (the ‘Tax-avoidance Directive’).

Here, we look at a few of the most sensational proposals put forward by the Commission.
 

​2. Limit on the deduction of interest

The Commission’s proposed Tax-avoidance Directive would limit the deduction of a financial cost surplus (i.e. the difference between interest and similar income received and the cost of finance) to the higher of 30% of profit and EUR 1 million. Profit would be fixed on an EBITDA basis, i.e. profit before interest, tax, depreciation and amortisation, though the rule would not apply where the taxpayer could show that the ratio between its equity and the balance sheet total was equal to or greater than the ratio within the consolidated ratio at group level.

If EBITDA-based profit were not fully utilised in a given tax year to cover the cost of finance, the excess could be carried forward. 

Finance costs that could not be deducted in a given tax year could be deducted to the extent of 30% in the following tax years.

The deduction restriction would not (yet) apply to a range of financial undertakings (like credit institutions, investment companies, insurance companies, company pension funds, UCITS, etc.).

3. Exit levies

The proposal names four cases where a levy should be charged where assets are transferred by a taxpayer:

1. transfer of assets from a head office to a permanent establishment in another member state or third country;

2. transfer of assets from a permanent establishment to a head office or another permanent establishment in another member state or third country;

3. transfer of tax residence to another member state or third country except for assets that actually remained linked to the original member state;

4. moving a permanent establishment outside a member state.

The amount in respect of which the levy would be made would equal the fair value of the transferred assets at the time of departure after deduction of the fiscal carrying value.

Taxpayers could spread payment of the exit levy over a period time of at least five years if:

• assets were transferred from the head office to a permanent establishment in another member state or a third country that belonged to the EEA, and vice versa;

• tax residence or the permanent establishment were transferred to another member state or a third country that belonged to the EEA.

The directive would let member states themselves decide whether to charge interest on spread payments or demand security from the taxpayer.

4. Switch-over provision

The Tax-avoidance Directive would also create a so called “switch-over provision”, obliging member states to no longer exempt certain foreign income received by taxpayers. Intended are:

• profit distributions by entities in third countries;

• proceeds from the disposal of shares in an entity in a third country;

• the income of a permanent establishment in a third country.

Where the tax burden in these third countries was less than 40% of the statutory corporation tax rate in the taxpayer’s country, the foreign tax would be credited against the tax charge.

5. Controlled foreign companies

The Commission’s proposal also targets income from “foreign controlled companies” (CFCs) that are subject to lower, or zero, corporation tax.

A CFC exists where the taxpayer alone or with related undertakings:

• directly or indirectly holds 50% of the voting rights;

• owns over 50% of the share capital; or

• has a right to more than 50% of the foreign entity’s profits.

The undistributed income of CFCs would have to be included in the tax base of the (controlling) taxpayer where:

• those entities are subject in the country where they are situated to an effective corporation tax rate that is less than 40% of the effective tax rate that would be charged in the taxpayer’s country; and

• over half the foreign entity’s income comprises:

  • interest generated by financial assets;

  • royalties or other intellectual property rights;

  • dividends and income from share disposals;

  • financial lease income;

  • income from immovables except where a double taxation treaty excludes taxation rights for the taxpayer’s state of residence;

  • income from insurance, banking and other financial operations;

  • income from the provision of services to the taxpayer;

• the foreign entity is not a listed company.

Income from CFCs that required to be included in the tax base would be calculated according to the corporation tax rules of the taxpayer’s country.

Undistributed income would not be included where the CFC was tax-resident in an EU or EEA member state (unless the entity was set up “artificially” or formed part of an “artificial construction”).

6. Anti-abuse provision

1. An artificial construction or series of constructions with the essential aim of procuring a tax advantage that undermines the purpose or intention of the tax provisions otherwise of application would be disregarded in calculating the corporation tax due. A construction could comprise several steps or components.

2. For the purposes of (1), a construction or series of constructions would be deemed artificial where it was not set up on the basis of valid business grounds that reflect economic reality.

3. Where a construction or series of constructions was disregarded under (1), the tax charge would be calculated on the basis of the economic substance under national law.

7. Hybrid mismatches

Finally, the Commission’s proposal aims to put a stop to situations resulting from varying classifications given by different member states and that lead either to “double deductions” or to a deduction in one country without taxation of the deducted amount in the other country (“hybrid mismatches”).

The proposal draws a distinction between:

• hybrid entities: where two member states apply different legal classifications to one and the same taxpayer; and

• hybrid instruments: where two member states apply different legal classifications to one and the same payment.
   

The Tax-avoidance Directive targets future improper use of such situations by making one classification decisive.

In the case of both hybrid entities and hybrid instruments, the legal classification given by the member state where the payment originated, the charges arose or the losses were sustained should prevail.