On June 21, 2016, the Economic and Financial Affairs Council (ECOFIN) of the European Union (EU) reached final agreement on the EU’s anti-tax avoidance directive (the Directive). The Directive targets certain arrangements that have the effect of shifting profits among taxing jurisdictions to reduce the total amount of taxes paid. The Directive builds on global standards developed by the Organisation for Economic Co-operation and Development (OECD) last year as part of the Base Erosion and Profit Shifting (BEPS) initiative.
The political agreement on the Directive is expected to be submitted to ECOFIN on July 12 and will likely be formally adopted without further discussion.
The Directive will apply to any taxpayer that is subject to corporate tax in one or more EU member states, including permanent establishments or subsidiaries based in a “third country.” A third country, in EU parlance, refers to any country outside the EU.
The Directive is intended to harmonize the EU member states’ approach to limiting tax avoidance strategies. The Directive strives to accomplish this goal by establishing minimum standards with respect to the following five areas:
Interest deductibility limitation rules
An interest deductibility limitation to discourage companies from creating debt arrangements to minimize taxes through earnings stripping (described below)
A general anti-abuse rule (GAAR) to counteract aggressive tax planning whereby one of the main purposes is obtaining a tax advantage by avoiding otherwise applicable tax provisions
A controlled foreign company (CFC) rule to discourage artificial profit shifting to low- or no-tax countries
Hybrid mismatch rules to prevent companies from exploiting differences in legal characterization to reduce taxation
An exit tax on assets moved from a member state's jurisdiction under certain circumstances.
Multinational groups may finance group entities in high-tax jurisdictions through debt and arrange that interest is paid to entities that reside in low-tax jurisdictions. This practice is often referred to as “earnings stripping.” The Directive targets earnings stripping by limiting the deduction of “exceeding borrowing costs” to 30% of taxable income before interest, taxes, depreciation and amortization (the fixed ratio rule). Exceeding borrowing costs means the amount by which a taxpayer’s borrowing costs (including interest expense) exceed taxable interest revenues and other economically equivalent revenues.
The rules also include exemptions, a de minimis
threshold, equity escape rules, group ratio rules and grandfather provisions. In general, the rules are similar in nature to those recommended by the OECD under BEPS Action 4.
General anti-abuse rule
The GAAR, which is designed to cover gaps in a country's specific anti-abuse rules, allows tax authorities to deny taxpayers the benefit of “non-genuine arrangements” or a series of arrangements carried out by which one of the main purposes is obtaining a tax advantage that defeats the object or purpose of the otherwise applicable tax provisions. The GAAR rules were drafted to generally reflect existing EU case law. Arrangements are considered non-genuine if they have not been put in place for valid commercial reasons reflecting economic reality.
Companies sometimes shift profits from their parent company (or home jurisdiction) in a high-tax country to controlled subsidiaries, or permanent establishments, in low- or no-tax countries to reduce the group's tax liability. To prevent this form of tax avoidance, the Directive included CFC rules.
The rules require member states of a taxpayer to treat entities that meet certain thresholds as CFCs. An entity is treated as a CFC if the taxpayer has more than 50% ownership (by vote, capital or profit allocation) and the corporate tax paid by the CFC is lower than the difference of tax that would have been charged in the EU member state of the taxpayer and the actual tax paid under the applicable corporate tax system. The rules apply to EU entities, permanent establishments (PEs) and third-country entities that satisfy the threshold requirements.
If the entity or PE is treated as a CFC, the member state of the taxpayer should include in its tax base the nondistributed income of the CFC generated from certain categories of income. The rules also include certain exceptions and de minimis
Member states may treat the same income or entities differently for tax and/or legal purposes, which may give rise to double deductions or a deduction in one jurisdiction but without a corresponding income inclusion in another. This is often referred to as a “hybrid mismatch.”
The Directive provides specific rules limiting deductions when a hybrid mismatch occurs. These rules generally apply in cases of double deductions by limiting the deductions only to the member state where the payment has its source. The rules also apply when a deduction does not include a corresponding income inclusion in another jurisdiction and acts to deny the deduction taken in the member state of the payer.
It should be noted that the scope of these rules is limited to hybrid mismatches between member states. Although currently not included in the scope of these rules, hybrid mismatches between member states and third countries may be subject to a European Commission proposal anticipated for October 2016.
Currently, certain assets are not always taxed when expatriated from a member state. The Directive introduces an exit taxation rule whereby a taxpayer shall be subject to tax at an amount equal to the market value of the transferred assets at the time of exit, less tax basis under certain circumstances.
The Directive further sets out that a taxpayer may defer the payment of an exit tax by paying it in installments over at least five years if certain conditions are satisfied.
In principle, the Directive does not carry the weight of law. Rather, it will have an implementation period during which member states are required to implement the Directive in their local laws.
Member states will generally have until Dec. 31, 2018, to implement the Directive provisions covering hybrid mismatches, interest limitations, CFCs and GAAR in their local laws to be effective as of Jan. 1, 2019. Member states have until Dec. 31, 2019, to implement the exit taxation rules in their local laws to be effective as of Jan. 1, 2020. Member states that have targeted rules that are equally effective to the interest limitation rules included in the Directive may apply their rules until the end of the first full fiscal year following the publication of an agreement between the OECD members on a minimum standard, but no later than Jan. 1, 2024.
The Directive is a profound step toward EU tax reform and synchronization of member state taxation. The rules apply broadly and may impede many cross-border transactions by U.S. multinationals with EU operations. As drafted, the Directive would dramatically affect existing structures and arrangements such as EU holding companies, structured financing arrangements, intellectual property structures and supply chain operations. Taxpayers potentially subject to the Directive should evaluate the effect of the measures. The provision could have a significant impact on a company's global effective tax rate, tax benefits obtained from pre-existing arrangements, movement of assets both within and outside the EU and many other common transactions. Given the breadth and complexity of the changes, an in-depth evaluation of existing arrangements and structures is recommended to fully appreciate the ramifications.
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