According to an article in the Financial Times yesterday, the Netherlands and Luxembourg between them received foreign investment to the tune of $5.8 trillion by the end of 2012, more than the US, UK and Germany combined. Yet only $695 million ended up in the real economies of the two countries, the remaining approximately $5 trillion of capital funding holding, finance and licensing companies primarily involved in international business development outside of these two countries. And the reason for this is clearly utilising the benefits of double tax treaties entered into by these two countries with the rest of the world, condemned in the UK by the House of Commons Public Accounts Committee.
Are these companies a necessary stimulant to the growth of international business, or is this the unacceptable face of tax avoidance government bodies, fuelled by media attention, wish to legislate against? And what form of legislation are we to expect which would impact on the use of low tax countries, or specifically created beneficial tax regimes within high tax jurisdictions, which are used by international businesses such as Starbucks, Google and Amazon featured in my February newsletter?
In this newsletter I bring to your attention a brief overview of the latest developments in the area of anti-avoidance as developed by various international groups and organisations. The importance of the matter is shown by the magnitude of the players — the Organisation for Economic Co-operation and Development (OECD), the European Commission and governments across the world.
The European Commission is the executive body of the EU which drafts proposals for new European laws. Its Recommendations, however, are not binding for Member States, but of course they carry political weight and are instrumental in shaping national legislation. In this sense the Commission differs from the OECD, whose Reports, although hugely persuasive, carry more academic significance.
In December 2012 the Commission issued an Action plan aimed at combatting tax evasion and avoidance accompanied by two Recommendationsto Member States on aggressive tax planning (C(2012) 8806) and promotion of good governance in tax matters globally (C(2012) 8805). The Action plan describes the Commission’s steps to tackle an estimated €1 trillion in public money lost every year in the EU due to tax evasion and avoidance. However, I want to concentrate on the Recommendations, which might cause short term consequences for the EU-resident taxpayers and their foreign counterparties.
Recommendation One re Double non-taxation and GAAR
According to the first Recommendation, aggressive tax planning consists of taking advantage of the technicalities of a tax system or of mismatches between two or more tax systems for the purpose of reducing tax liability. In other words, this is achieved through strictly legal arrangements which however contradict the spirit and intention of the law. The Commission acknowledges that national provisions of Member States are often not fully effective to protect their national tax bases due to the cross-border dimension of many tax planning structures and the increased mobility of capital and persons. For example, a State may exempt a certain item of income from tax in its double taxation treaties or under its national laws without checking whether the same item is liable to tax in the other State, resulting in double non-taxation.
To address this issue, the Commission recommends that where Member States have committed not to tax a particular item of income under a double taxation treaty, they should ensure that such commitment only applies where the item is subject to tax in the other party of that convention. The suggested wording of the clause to be inserted in the double tax treaties resembles remittance clauses that many Member States already have in their conventions. For example, Article 6 Limitation of relief of the UK–Irish convention reads:
Where under any provision of this Convention income is relieved from tax in a Contracting State and, under the law in force in the other Contracting State, an individual, in respect of the said income, is subject to tax by reference to the amount thereof which is remitted to or received in that other Contracting State, and not by reference to the full amount thereof, then the relief to be allowed under this Convention in the first-mentioned Contracting State shall apply only to so much of the income as is remitted to or received in that other Contracting State.
The effect of this Article is as follows. A UK resident non-domiciled individual receives interest from Irish companies free of 20% withholding tax under the terms of the Convention, but only if the interest forms part of his UK taxable income. If the same individual claims the remittance basis of taxation and does not remit the interest to the UK, the interest exemption from Irish tax under the Convention will not apply.
Remittance clauses can be found in a few other treaties concluded by the UK and also Malta, which is another Member State that allows its non-domiciled residents to be taxed on the remittance basis. Outside the EU, Singapore offers a similar exemption, and many of its treaties (e.g. with France) also contain the limitation of relief clause.
The first Recommendation encourages all Member States to take the same general approach towards “aggressive” tax planning. The Commission concludes that national legislators are often not quick enough to pass specific anti-avoidance measures. Instead it recommends the Member States adopt a common general anti-abuse rule (GAAR), which should avoid the complexity of many different ones. Also, according to the Action plan, the Commission will review the anti-abuse provisions of the principal EU tax Directives with a view to implement the principles described in the Recommendation.
The GAAR should apply to domestic and cross-border situations, confined to the EU and situations involving third countries. The GAAR is couched in very broad terms and is only one paragraph long (compare it with UK’s GAAR in Finance Bill 2013!). It reads:
An artificial arrangement or an artificial series of arrangements which has been put into place for the essential purpose of avoiding taxation and leads to a tax benefit shall be ignored. National authorities shall treat these arrangements for tax purposes by reference to their economic substance.
The Commission elaborates on the meaning of each part of the wording of the GAAR; however, in my view the underlined terms deserve special attention:
- An arrangement is artificial where it lacks commercial substance and the Commission then goes to provide examples of various factors that signify artificiality.
- A given purpose is considered essential where any other purpose that is or could be attributed to the arrangement appears at most negligible, in view of all the circumstances of the case.
- The purpose of an arrangement consists in avoiding taxation where, regardless of any subjective intention of the taxpayer, it defeats the object, spirit and purpose of the tax provisions that would otherwise apply.
The rule is largely reminiscent of various forms of GAARs (statutory or case law-based) already existing in many Member States, such as Austria, France, Ireland and recently the UK to mention a few. It would also put on a statutory footing, if implemented nationally, the beneficial ownership concept —presently existing mostly through international tax case law — which determines the availability of benefits under double taxation conventions.
The OECD Commentary to Article 10(2) of the model double tax treaty reads:
The term “beneficial owner” is not used in a narrow technical sense, rather it should be understood in its context and in light of the object and purposes of the Convention, including avoiding double taxation and the prevention of fiscal evasion and avoidance (para. 12).
Commercial substance, proportionate to the risks and functions undertaken by the taxpayer’s entity, is the key requirement that needs to be satisfied in order to be able to achieve tax benefits otherwise denied under the GAAR. However, the same has always been required in order to satisfy the beneficial ownership concept and hence the GAAR should bring nothing new to law-abiding international tax advisors and their clients.
Recommendation Two re Low Tax Countries
The second Recommendation seeks to limit the role that tax havens play in tax planning strategies. The Commission does not per se disapprove of countries attracting foreign investments through the imposition of low income taxes, as long as they allow other States to enforce their tax policy. However, low tax regimes often combine a lack of transparency with little or no exchange of information with other States, essentially sheltering some types of mobile income or capital of non-residents from the tax administration of their State of residence.
There are various international initiatives that address the shortcomings in transparency and exchange of information. However, considering the freedom of economic operators to conduct business anywhere in the EU and the broad availability of low tax jurisdictions, the Member States are not adequately protected against base erosion caused by such practices. The Commission therefore proposes a set of measures to be applied in relation to third countries that do not meet the minimum standards of good governance in tax matters both in regard to transparency and exchange of information.
The criteria used in the Recommendation effectively single out most of the widely known offshore States. These include the States that provide for zero taxation to non-residents, do not require any real economic activity and substantial economic presence in their territories or whose tax measures lack transparency. Members States are expected to take measures discouraging the use of such jurisdictions by the taxpayers, including blacklisting them and renegotiating any relevant double taxation treaties. Conversely, any indicators of the foreign State’s willingness to comply with minimum standards should allow it to develop a mutually beneficial relationship with the EU Member States.
Many States in the EU already have black lists, which they use to limit the use of offshore entities. For example, France, Spain and Portugal all discourage ownership of their domestic real estate by blacklisted entities through disallowing the deduction of rental payments, imposing annual property taxes or higher rates of stamp duty.
The Commission ends both Recommendations by requesting Member States to inform the Commission on the measures taken in order to comply with their terms. I find the wording of the requests conveying a strong sense of persuasion rather than a mere suggestion, although, as I mention above there is no legal requirement for Member States to comply.
OECD Report on Base Erosion and Profit Shifting (BEPS)
The Recommendations highlight the issues identified in a recent OECD Report on base erosion and profit shifting (BEPS). OECD describes BEPS as tax planning strategies that exploit loopholes in tax rules to make profits disappear for tax purposes, or to shift profits to locations where there is little or no real activity but where they are lightly taxed, resulting in little or no overall corporate tax being paid. The Report calls for the action plan to include proposals in a numbers of areas, such as hybrid entities, preferential regimes, transfer pricing and anti-avoidance measures, with an eye on the issues posed by the increased digitalisation of the economy.
There have been mostly positive responses to the measures outlined in the Action plan and the BEPS report. In his recent letter to the President of the European Council, David Cameron expressed his ambition that the May European Council will inject the political will to tackle the problem and restore confidence in the fairness and effectiveness of our tax system, and called for action in four key areas:
- a new global standard for multilateral information exchange;
- action plans to increase transparency in beneficial ownership;
- reform of global tax rules through the G20 and OECD, including where we could go further, e.g. greater country-by-country company reporting on the tax paid in their countries of operation; and
- improving the ability of developing countries to collect tax, building on the example of the government’s new joint unit.
The Netherlands acquiescence is somewhat surprising given the use of Dutch companies in international business structuring as suggested by the FT figures at the beginning of this newsletter. In general, the initiatives of the European Commission and the OECD reflect the ever-growing concern that governments have expressed worldwide in their fight against tax avoidance, but as I stated in my February newsletter, there is sufficient legislation in existence already to combat the issues raised in the Recommendations if implemented correctly by tax administrations. Certainly, tax evasion is illegal so there is no need to issue Recommendations in this respect. Aggressive tax planning doesn’t need a GAAR if case law and legislation adequately requires concepts such as substance, beneficial ownership, transfer pricing etc to be appropriately considered by tax administrations before acceptance of submitted tax computations.
Appropriate tax advice nowadays relies on non-aggressive but nevertheless effective tax planning for longer term results which will not create conflicts between clients and tax administrations. On the basis that existing laws developed over decades of disputes between taxpayers and administrations are properly implemented by both sides, the constant barrage of Recommendations and Reports fuel only the attention given to legitimate tax planning by the general media. Knowledge of existing legislation and its implementation will secure the maximum tax revenue in developed countries to which the EU and OECD are addressing their views.