This is our third article in a series of articles we are publishing regarding the proposal for a Council Directive laying down rules against tax avoidance practices as published by the European Commission on January 28, 2016. This article will focus on the switch-over clause as laid down in Article 6 of the proposed Directive.

Background

On January 28, 2016 the European Commission published its so-called Anti Tax Avoidance Package. One of the items of this Anti Tax Avoidance Package is the proposal for a Council Directive laying down rules against tax avoidance practices that according to the European Commission directly affect the functioning of the internal market.

 

The proposed Directive sets out six key anti tax avoidance measures, which all Member States should apply. These are:

·        Interest limitation rule

·        Exit taxation

·        Switch-over clause

·        General anti-abuse rule

·        Controlled foreign company legislation

·        Hybrid mismatches

 

First of all it should be noted that the proposed Directive arranges that the anti tax avoidance measures laid down in the Directive are minimal measures. In this respect Article 3 of the proposed Directive arranges that the Directive shall not preclude the application of domestic or agreement-based provisions aimed at safeguarding a higher level of protection for domestic corporate tax bases.

 

Switch-over clause

The switch-over clause is an interesting piece of legislation. During the first reading it looks like a simple straightforward piece of legislation. However after letting it sink in, the questions come. One of the questions that I have is whether the provision of Article 6, Paragraph 1 of the proposed Directive are not too general in nature and whether they do not lead to some overkill/double taxation.

 

Conditions that have to be met for the switch-over clause to apply

The switch-over clause only applies to situations in which the taxpayer is an entity resident in an EU Member State that either directly owns a subsidiary that is a resident of a third country (non-EU Member State) or has a permanent establishment in a third country (non-EU Member State).

 

Secondly the subsidiary or the permanent establishment is subject to a tax on profits in the third country at a statutory corporate tax rate that is lower than 40 percent of the statutory tax rate that would have been charged under the applicable corporate tax system in the Member State of the taxpayer.

 

Unlike CFC legislation the switch-over clause does not apply to the non-distributed income of a low-taxed subsidiary or low-taxed permanent establishment, but to the income realized by the taxpayer itself.

 

The switch-over clause applies to the following sorts of income:

·        foreign income which the taxpayer receives as a profit distribution from an entity in a third country; and

·        foreign income which the taxpayer receives as proceeds from the disposal of shares held in an entity in a third country; and

·        foreign income which the taxpayer receives as income from a permanent establishment situated in a third country.

 

What does the switch-over clause arrange?

Article 6, Paragraph 1 of the proposed Directive arranges that if the conditions described in the section above are met, Member States shall not exempt a taxpayer from tax on the sorts of foreign income mentioned above. Instead the Member State will arrange that the taxpayer shall be subject to tax on the foreign income with a deduction of the tax paid in the third country from its tax liability in its state of residence for tax purposes. Article 6, Paragraph 1 also arranges that the deduction shall not exceed the amount of tax, as computed before the deduction, which is attributable to the income that may be taxed.

 

Article 6, Paragraph 2 subsequently arranges that the switch-over clause only applies to positive income and not to losses by arranging that Paragraph 1 shall not apply to the following types of losses:

(a)   losses incurred by the permanent establishment of a resident taxpayer situated in a third country;

(b)   losses from the disposal of shares in an entity which is tax resident in a third country.

 

So far, so good. Then the sinking in starts and the questions start to pop-up.

 

‘Retrospective’ force?

The switch-over clause applies a.o. to profit distributions and the proceeds from the disposal of shares. The proposed Directive doesn’t include provisions that arrange that the shareholding in a low-taxed subsidiary is revalued at the moment the Directive and the local regulations that are based thereupon enter into force. Neither does the Directive contain provisions that arrange that the application of the switch-over clause is limited to profit distributions made out of profits that the low-taxed subsidiary realizes after the moment the Directive and the local regulations that are based thereupon  enter into force. A consequence of the absence of such provisions seems to be that also non-distributed profits and increases in value that are already existing when the proposed Directive (and local legislation) enter into force, will be taxed under the switch-over clause when the low-taxed entity makes a dividend distribution or when the shareholder sells its shareholding in the low-taxed entity.

 

An example

In this example we assume that the proposed Directive and the local legislation based thereupon as implemented by EU Member State X become effective on January 1, 2017. We also assume that Member State X implements the switch-over clause in its local legislation exactly as it is laid down in the proposed Directive.

 

Company A is a resident of EU Member State X. EU Member State X taxes profits against a statutory corporate tax rate of 25%. In 2013 Company A obtained a 100% shareholding in Company LT against a purchase price of EUR 100 mio. Company LT is a production facility. LT is a resident of State Y. State Y taxes profits against a statutory corporate tax rate of 8%. Therefore LT is considered to be a low-taxed entity to which the switch-over clause applies as per January 1, 2017. The market value of LT as per December 31, 2016 at 23.59 PM amounts to EUR 175 mio. On March 1, 2017 Company A sells its shareholding to an unrelated third party for EUR 180 mio.

 

Since the Directive contains no provisions arranging for a ‘step-up’ in value applying as per January 1, 2017 in my view the proceeds that are taxed at the level of Company A at the moment of the sale (March 1, 2017) amount to EUR 80 mio. Whereas, if the shareholding would be revalued to market value at the moment the switch-over clause enters into force, the proceeds that Member State X would be allowed to tax at the moment of the sale would be only EUR 10 mio (EUR 180 mio (sales price) -/- EUR 170 mio (market value as per December 31, 2016)). Therefore in my view the switch-over clause has retrospective force.

 

In my view the same problem arises with respect to undistributed profits that are available in a low-taxed subsidiary at the moment the provisions of the proposed Directive come into effect and the low-taxed subsidiary distributes these profits after the switch-over clause comes into effect.

 

It looks that by introducing a switch-over clause that is drafted as it is drafted right now, the European Commission seems to have found a way to arrange that undistributed profits of entities residing in low-taxed third countries at the moment the switch-over clause comes into effect, will be subjected to taxation in Europe. Therefore in my view it is very important for groups that have EU (sub-)holdings, which on their turn have direct shareholdings in non-EU resident entities review whether based on the conditions mentioned in the proposed Directive the non-EU subsidiaries will qualify as low-taxed entities. If a non-EU subsidiary (owned by a EU resident shareholder) qualifies as a low-taxed entity and it either has undistributed profits on its balance sheet or if its market value has increased since the moment the shareholding in that low-taxed non-EU subsidiary was obtained by the EU resident shareholder, it is important to investigate if and what exit strategies are available in order to minimize taxation.

 

Change in status

The switch-over clause applies to certain transactions (dividend distributions, disposal of shares or receiving income from a permanent establishment). In my view based on the way the provision of Article 6, Paragraph 1 is drafted, it is purely the status of the subsidiary/permanent establishment at the moment that such a transaction takes place that determines whether or not the switch-over clause applies.

 

The switch-over clause does not seem to contain a provision that softens the pain if at some point in time the status from a subsidiary changes from not low-taxed to low-taxed. This can for example be the case when the country of which the subsidiary is a resident lowers its statutory corporate tax rate for taxing profits. Or when the EU Member State of which the shareholder is a resident increases its statutory corporate tax rate for taxing profits.

 

In my view in such a case later dividend distributions made by the subsidiary or the proceeds made by the shareholder on the sale of the shares in the subsidiary are fully taxed by the EU Member State of which the shareholder is a resident. In my view even the distribution profits or increase in  market value of the shareholding stemming from the time the subsidiary was NOT considered to be low-taxed entity are going to be taxed by the EU Member State of which the shareholder is a resident.

 

An example

In this example we again assume that the proposed Directive and the local legislation based thereupon as implemented by EU Member State X became effective on January 1, 2017. We also assume that Member State X implemented the switch-over clause in its local legislation exactly as it is laid down in the proposed Directive.

 

Company B is a resident of EU Member State X which taxes profits against a statutory corporate tax rate of 25%. In 2006 B incorporated Company NLT which is a research facility. Since that date B owns 100% of the shares in NLT. At incorporation B made a capital contribution of EUR 10 mio into NLT. NLT is a resident of State Z. Until December 31, 2017 State Z taxed profits against a statutory corporate tax rate of 12% (48% of the statutory corporate tax rate of State X). Therefore for the period up to and including December 31, 2017 NLT is not considered a to be low-taxed entity. Therefore the switch-over clause will not apply to dividend distributions that NLT makes in the period up to and including December 31, 2017. As per January 1, 2018 State Z lowers the statutory corporate tax rate to 9%. The statutory corporate tax rate in Member State X does not change and remains 25%. Therefore as per January 1, 2018 the switch-over clause will apply to any dividend distributions made by NLT (or to proceeds Company B realizes on a disposal of shares in NLT).

 

In the years 2007 through 2017 NLT patented a few great inventions. NLT licensed rights to make use of these inventions to unrelated third parties. In the period 2007 - 2017 NLT has made a fortune on these patents. These profits were taxed against the statutory corporate tax of 12% in State Z. At the end of 2017 NLT has EUR 400 mio of undistributed income on its balance sheet. In 2018 the shareholders of Company B want to receive dividends. In order to enable Company B to make this dividend distribution, NLT makes a dividend distribution of EUR 250 mio in March 2018. This dividend distribution is fully made out of the undistributed income that was already available in NLT on December 31, 2017. In my view the way in which the text of Article 6, Paragraph 1 of the proposed Directive is drafted means that the switch-over clause applies to the full amount of this dividend distribution. Therefore Member State X has to tax the dividend distribution at the level of Company B in line with the provisions of the switch-over clause.

 

Deduction of the tax paid in the third country

Article 6, Paragraph 1 of the proposed Directive arranges that when the switch-over clause applies a the taxpayer (the shareholder residing in a EU Member State) shall be subject to tax on the foreign income with a deduction of the tax paid in the third country from its tax liability in its state of residence for tax purposes. The question is how the term ‘tax paid in the third country’ should be interpreted.

 

As I described above I see the switch-over clause as a sort of transaction tax that is levied via a tax on profits at the level of the shareholder. Therefore in my view one can question whether the term ‘tax paid in the third country’ should be interpreted as only the foreign tax due over the transaction itself (e.g. capital gains tax and withholding tax). Or whether perhaps a wider interpretation can be applied. The latter being an interpretation in which next to the foreign tax due over the transaction itself, also the tax that the third country has levied on the non-distributed income that is still available at the moment of the dividend distribution.

 

Since I expect that in many cases also the CFC legislation of the proposed Directive will apply to a shareholding to which the switch-over clause applies, perhaps the system of the CFC legislation gives an indication how the term ‘tax paid in the third country’ is to be interpreted. In the general CFC article of the proposed Directive (Article 8) it is arranged that a taxpayer shall include the non-distributed income of an entity in its own tax base if certain conditions are met. The CFC legislation does not seem to provide for a credit of a foreign tax on profits that is levied by the third country at the level of the CFC subsidiary. Therefore I tend to come to the conclusion that the term ‘tax paid in the third country’ as used in Article 6 of the Directive, should be interpreted in a narrow way. Consequently I feel that only foreign taxes that become due because of the transaction taking place (capital gains tax and withholding tax) are deductible from the tax due at the level of the shareholder because of the switch-over clause applying.

 

On the other hand the Explanatory Memorandum to the proposed Directive states a.o. the following with respect to the switch-over clause: “Furthermore, by applying the switch-over clause, income of a third-country origin that flows into the Union would be taxed by the Member State of the taxpayer at the same level as income of a domestic origin, which would ensure equal treatment between Union and third-country origin payments.” Since a narrow interpretation of the term ‘tax paid in the third country’ leads to double taxation, one might argue that a wider interpretation of the term ‘tax paid in the third country’ is to be used. Still I feel that the narrow interpretation the one that applies. In my view it would however be desirable if the legislator would come with some additional explanation and examples on how the term ‘tax paid in the third country’ should be interpreted.

 

Example

Back to our example of NLT as described above. NLT makes the dividend distribution of EUR 250 mio to its EU shareholder. Based on the local legislation of State Z the dividend withholding tax to be withheld over the dividend distribution amounts to 10% of the gross amount of the dividend. Company B’s profits are taxed against 25% in EU Member State X. At the moment of the dividend distribution the statutory corporate tax rate in State Y is 9%. Therefore the switch-over clause applies to the dividend distribution. The income was however realized by NLT in the period that the statutory corporate tax rate in State Y still was 12%. So for NLT being able to make a dividend distribution of EUR 250 mio the income of NLT before tax amounted to the equivalent of approximately EUR 284 mio. Assuming that the narrow interpretation of the term ‘tax paid in the third country’ is to be applied how would this dividend distribution then be taxed?

 

 

Calculation of total ETR in case of switch-over clause

 

 

 

 

 

 

 

 

 

At the level of NLT

 

 

 

 

Income before tax

       284.000.000

 

 

 

Corporate income tax

       (34.000.000)

        34.000.000

 

 

Income after tax

       250.000.000

 

 

 

 

 

 

 

 

At the level of Company B

 

 

 

 

Gross Dividend

       250.000.000

 

 

 

Dividend withholding tax (State Z)

       (25.000.000)

        25.000.000

 

 

Gross amount of Switch-over clause (MS X)

       (62.500.000)

        62.500.000

 

 

Deduction of tax paid in State Z

        25.000.000

      (25.000.000)

 

 

On the bank account of Company B

       187.500.000

 

 

 

 

 

 

 

 

Total Tax

 

        96.500.000

 

 

 

 

 

 

 

Total effective tax rate (=96.5/284)

 

33,98%

 

 

 

 

 

 

 

The calculation above shows that this system is not in line with the statement made in the explanatory memorandum that the income will be taxed by the Member State of the taxpayer at the same level as income of a domestic origin,. If the profits were made directly in Company B the income would have effectively been taxed against 25%, where now it is taxed against 33,98%.

 

However if the corporate tax that NLT paid in the past in State Z over the non-distributed income can also be deducted from the tax to be paid in the EU Member State the total effective tax rate with respect to this income would drop below 25%. In the example described above the total tax would go down to EUR 62.5 mio. Consequently the total effective tax rate on the income realized and distributed by NLT would be only 22%. So neither of the systems of deduction I could come up with would result in a total effective tax rate of 25%.

 

No fixed threshold

The provision does not provide for a fixed minimum statutory tax rate that will ensure that the switch-over clause does not apply to a shareholding or to a permanent establishment. Now whether or not the switch-over clause applies depends on both the statutory corporate tax rate of the member state of which the shareholder/head office is a resident and the statutory corporate tax rate of which the subsidiary is a resident/in which the permanent establishment is established.

 

Based on the current statutory corporate income tax rates of EU member states the system chosen in the proposed Directive leads to the situation that a subsidiary of a Maltese shareholder seems to qualify as a low taxed entity for the switch-over clause if it is a resident of a third (non-EU) country with a statutory corporate tax rate that is lower than 14%. Whereas a subsidiary of a Bulgarian shareholder only qualifies as a low taxed entity to which the switch-over clause applies if the subsidiary is a resident of a non-EU country with a statutory corporate tax rate that is lower than 10%.

 

The way the conditions of the switch-over clause are drafted also means that in case of a joint venture it is possible that for one participant in the joint venture the switch-over clause applies, whereas for another participant in the same joint venture the switch-over clause doesn’t apply to its participation in the joint venture.

In the example given above the subsidiary X, a fully operational production facility, is a resident of country X which has a statutory corporate tax rate for profits of 9%. Subsidiary X is considered a low-taxed entity for its Dutch, French and Belgian shareholders, whereas it doesn’t qualify as a low-taxed entity for its UK shareholder. Consequently if subsidiary X makes a dividend distribution to its shareholders at the level of the Dutch, Belgian and French shareholders the switch-over clause comes into play causing an additional tax burden. At the same time the switch-over clause does not come into play for the UK shareholder, therefore no additional tax burden arises at the level of the UK shareholder. Therefore the net profits that the UK entity will realize on its participation in the Joint Venture are higher than those realized by its joint venture partners.

 

I hope the above shows that if the proposed Directive is going to be adopted without any changes and when it is going to implemented in local legislation it will be important to review which holding structures exist within the Group in which an EU resident holding company is having shareholdings in entities that are residents of countries with low statutory corporate tax rate for taxing profits. Certainly if the subsidiary has significantly increased in value since it was obtained, or when it has large amount of non-distributed income on its balance sheet it might be necessary to act before the proposed Directive and the piece of local legislation come into effect.

 

But the Directive also makes it necessary that all holding structures within a Group in which EU entities have shareholdings in non-EU subsidiaries should be constantly monitored. This a.o. means that it is very important to monitor developments with respect to the statutory corporate tax rates for taxing profits of all non- EU countries in which the Group has subsidiaries that are held via an EU (sub-)holding. The same goes for the statutory corporate tax rates of the EU countries of which the holding companies are residents. As I tried to describe above a change in statutory corporate tax rate can cause a huge additional tax burden. In situations in which a non-EU county lowers its statutory corporate tax rate only a timely response can avoid the switch-over clause coming into play when making dividend distributions or disposing the shares in the subsidiaries. NB please note that also an increase of the statutory corporate tax rate in the EU Member State of which the shareholder is a resident can cause the switch-over clause to come into play. Also in that case it can be necessary that immediate action is undertaken to avoid that the switch-over clause comes into play and causes an additional tax burden.

 

Above I refer to holding structures involving subsidiaries. However, also structures in which EU entities have permanent establishments in third (non-EU) countries will need careful monitoring, since changes in statutory corporate tax rates for taxing profits at head office level or at the level of the permanent establishment can lead to the switch-over clause coming into play if the head office receives foreign income as income from a permanent establishment situated in a third (non-EU) country.

 

 

 

Alain Thielemans

 

 

Articles previously published in this series are:

 

Copyright – internationaltaxplaza.info

 

 

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