February 2012 (118) – Tax Aspects of EU Merger Migration

Oil is a 3 letter word that is required for the smooth operation of a combustion engine. Tax is a 3 letter word that is required for the smooth operation of a social infrastructure. Both words are associated with the rich being the donors and the poor benefiting from the smooth operation. Unfortunately, the poor don’t benefit in the way they should, and governments need to be careful that they are not so hard on the rich that they stem the flow of oil, or tax. Too much pressure on the oil price and the producing nations will turn off the flow since the exploitation will become non-profitable; too much pressure on tax rates and the same will happen – entrepreneurs will leave one country for another, unemployment will rise and the social infrastructure will drastically suffer. That is why the IFS adopted topic of corporate migration is such an interesting one which features again in this month’s newsletter article. 

Governments should be challenged with the simple question “Is tax working?”. Capitalism isn’t the culprit, as many demonstrators would have you believe – tax is the culprit. That is not to say that tax should be abolished – far from it. Like oil, it is a fundamental resource for the functioning of a properly socially aware society. This statement has no political nuance, neither is it restricted to a particular country. Ask the public in Spain and Greece, where 50% of their youth are unemployed; or in France and Germany where taxpayers are unaware of how their tax revenue is being used. Like most culprits, tax should be made accountable for its actions. 

This is not so bizarre as it sounds – what is required to achieve this is a radical overhaul of the tax system, something which many have advocated for a long time. There should be ring fencing of revenues for specific social requirements and accountability if revenues are not used for the purposes stated. There is an old adage amongst fund raisers – there is no such thing as a person who doesn’t give, just a person who doesn’t ask. And judging from the amounts people give to specific causes, no matter how wealthy or poor they are, such as Comic Relief, Alzheimer’s Society, Cancer Research, people would be happier if they could see that the tax revenues they provide are allocated for the purposes stated. 

I have always thought the National Insurance contribution is a ‘con’ – it is a tax just like income tax, it doesn’t go specifically towards funding illness, unemployment, or other welfare benefits. In truth, employers be far happier to know that the employers’ NI contributions were allocated to youth training, and perhaps youth employment could be exempt from employers’ NI to encourage youth employment. We motorists may not be so upset with the fuel price if we knew that the government tax was utilised for new roads or other transport requirements. A specific ‘old age’ tax such as exists in the Netherlands would be accepted if the money were utilised for care homes for the elderly. 

It is not only in the field of direct tax that this should be considered. Stamp duty on house sales would be better tolerated if the government could produce evidence that the money was being used for the construction of new affordable homes. VAT could have varied rates, the highest being on the luxury items generally purchased by the wealthier members of our society, a middle rate for standard purchases and low rates for items required for normal living purposes by everyone. 

I believe that we wouldn’t mind being asked (or obligated) to give if we understood where our tax revenues were going. Unhappily, we feel that our tax revenues, 40% of GDP in the UK and even higher elsewhere, are supporting massive wastage within the public sector, and we are powerless to do anything – other than move to another country (where the system is probably the same or worse!). The remedy is not simple, I’m afraid, since accountability is complex with so many items within our social infrastructure being dependent on the public purse. But if we don’t try to change the tax system as a complete whole, we may find that, like oil, the well runs dry at some stage. 

If the above sounds very academic, it is probably because I am entering the academic season, starting with my participating in teaching the MA course of the University of London at the Institute of Advanced Legal Studies in early March, run by Philip Baker QC of Grays Inn Tax Chambers. Readers of International Tax Systems and Planning Techniques (ITSAPT) will be aware of the case study in Part A, which depicts the growth of Polycon Lens Company into a multi-national conglomerate and examines all the international corporate tax issues relating to this growth; this forms the basis of the course. It is a training course that I am replicating in other countries during the course of this year. 

After a presentation in April to hedge fund managers, my conference programmes start in May with the first being a presentation I am giving for Michael Thomas of Grays Inn Tax Chambers on the international tax structures required for investment and trading in UK real estate (May 15th); the second presentation is on 23rd May for Patrick Soares of, yes you’ve guessed, Grays Inn Tax Chambers, and reviews international corporate migration and the role of UK companies in international structures; the third is the next day in Geneva where IFS is teaming up with Memery Crystal to host a presentation entitled “Seeing London more clearly” where we will be discussing London as an ideal location to raise private and public equity finance whilst operating an advantageous corporate tax regime. We will be sending an e-flyer out later this week in respect of the Geneva presentation, but please don’t hesitate to contact us for further information on any of these conferences. 

And then comes the most important presentation of them all, in early June where I will present my daughter Lucie to her newly wed husband! 

And of course the day job keeps me quite busy too (client advisory work) so I’m afraid I may have to forego an improvement in my golf handicap for yet another year! Anyway, I will be taking a rest in South America over the next 3 weeks, but I look forward to seeing you on my return at an early opportunity. 

Kind regards 

Roy Saunders


Regular readers of our newsletters will know that IFS is at the forefront of cross-border corporate migration techniques. The October 2010 newsletter talks about several available options to re-domicile a group’s UK holding company to a jurisdiction with a more agreeable tax regime. Within the EU, in the absence of the specific legislation such as 14th Company Law Directive on cross-border transfer of the registered office, the only procedure that achieves a clean break of a corporation with its home jurisdiction after it migrates to another Member State is the cross-border merger method.

The EU Merger Directive (Council Directive 2009/133/EC) applies to mergers of EU-resident companies, and basically requires there to be no tax on deemed disposals as a result of a company leaving one EU jurisdiction for another, provided that a permanent establishment in the originating country is maintained. The assets transferred to the acquiring company have a base cost of their original cost in the transferring company. However, as a result of our experience with a few cross-border migrations, we are happy to share with you a couple of important observations. The first is that it may not be relevant to leave a permanent establishment in the originating country, in which case the Merger Directive is irrelevant; and this may enable the recipient entity to step-up the basis of transferred assets, even though no capital gains tax is payable on the increase in value at the date of transfer. The second is that UK ‘exit tax’ provisions don’t have the mechanism to impose a tax liability when a company migrates from the UK to another EU country, even though the National Grid Indus case described in our December 2011 newsletter permits a liability to be computed if not immediately payable.

UK Exit Tax

The UK imposes an “exit” charge on an emigrating company that loses its UK residency. The company will be treated as if it has disposed of its assets at the date of changing its residence, and to have reacquired them at their market value, crystallising any unrealised gains for corporation tax purposes (s185 TCGA 1972). Such a charge may be postponed only where the exiting company is itself a 75 per cent subsidiary of a UK parent, and will only crystallise if either the assets are actually disposed of within the following six years or if the exiting company ceases to be a 75 per cent subsidiary. That is the only situation where the exit tax can be computed and is payable at a later date.

The UK is not unique in imposing the exit tax; many EU Member States impose similar charges on individuals and companies that cease fiscal residence in their home jurisdictions. Not surprisingly, on numerous occasions the ECJ has been asked to decide on compatibility of such domestic measures with Articles 49 and 54 of the TFEU. These guarantee freedom of establishment to nationals of EU Member States, including companies formed in accordance with their laws, within other EU Member States.

The situation has been resolved in favour of individuals; the ECJ found exit charges imposed on natural persons as restricting the freedom of establishment (cases Hughes de Lasteyrie du Saillant (C-9/02) and N (C-470/04). Only recently, however, in National Grid Indus the ECJ has ruled on the compatibility of domestic exit charges with EU freedoms. Readers may wish to refer to our December 2011 newsletter that explains the background to the case and summarises the findings of the Court. Very briefly, in National Grid Indus the ECJ found public interest justifications for the imposition of national exit charges on companies, but refused to sanction an immediate tax liability but only one that would be payable when the asset is eventually disposed of (when it is the ownership of the entity now resident in another EU country). Quite how this is tracked is unclear, and requiring a guarantee that the tax so computed will be payable in the future would seem to be, in itself, a restriction on the freedom of establishment principle.

In response to this judgment, the Netherlands adopted Decree No. BLKB 2011/2477M of 14 December 2011 that changed the way an emigrating company is liable to pay Dutch exit tax. The Decree provides that a Dutch corporation, which is migrating to another EEA State by transferring its place of effective management, can defer its exit tax liability on unrealised gains until their realisation in the future. The company must pay interest on deferred tax and must provide a guarantee sufficient to cover its amount (possibly this is something that may lead to further court decisions). It is also under a continual duty to inform the Dutch tax authorities of its operations with assets on which the gains are deferred. Depending on the number and value of assets on which the emigrating company is deferring taxation of gains, these conditions may impose substantial administrative and financial burden. Nevertheless, the Decree provides a sound alternative to the cash-flow interruption when faced with a large exit tax bill.

The UK, whose s185 exit tax regime does not envisage a mechanism to defer payment of tax until gains are actually realised or to track changes in asset value, seems to be the prime candidate to be referred to the ECJ by the EU Commission, as it has already done in respect of the Netherlands, Denmark, Portugal and Spain. No one, however, has formally challenged the rule and therefore technically there are grounds for HMRC to impose the s185 exit tax on a UK company that emigrates to another Member State by transferring its central management and control.

However, on the basis that any challenge will be successful, it seems that HMRC will have to accept that they can only compute the capital gains tax liability on the increase in value of assets at the time of migration over their original cost, but will have to defer collection of the tax until the asset is actually sold. But this is not what s185 provides, the only exception to immediate tax liability being when the exiting company is a 75% subsidiary of a UK parent company. Without a change in the law, a cross border migration through a change in the place of effective management to another EU country would appear to be untaxable in the UK when one imposes the National Grid Indus decision on s185.

The Merger Directive and s185

Will the s185 exit tax apply to a company that is leaving the UK by merging with an overseas legal entity, removing its assets and liabilities from the UK tax net? This is an interesting question, reflecting the novelty of cross-border merger arrangements and their effect on taxation of participating companies. The answer to this question depends on the interpretation of UK legislation and the Merger Directive, as well as on the circumstances of a particular merger.

First, on its strict interpretation, s185 should not apply since the transferring company is not migrating from the UK but instead being dissolved with the transfer of its assets to the receiving legal entity. There is no disposal of the assets at the date of dissolution, merely the transfer by virtue of the merger arrangements. In fact, this is the answer that HMRC gave us when asked to opine on a recent migration by merger transaction that we executed for our client.

If the main assets of the emigrating company are shares in subsidiaries, it may in any event have another line of defence against the exit tax — the substantial shareholdings exemption (SSE). The SSE exempts from UK corporation tax the gains and losses arising on the deemed disposal of eligible assets held as at migration. In other words, it removes the s185 exit tax liability altogether.

The exemption was introduced in 2002 in respect of gains arising from the disposal of “substantial shareholdings”. A shareholding is “substantial” if the UK holding company (investing company) holds at least 10 per cent of the ordinary shares of the subsidiary (company invested in), and has held them for a period of at least 12 months in the two years before the sale of the shares. The main condition of the exemption, other than the 10 per cent and the holding period requirements, is that the investing company has been a sole trading company or a member of a “qualifying group” prior to the sale of the shares, as well as immediately afterwards. It is also necessary for the company invested in to be a trading company. Subject to these and other conditions, any gain will be exempt from corporation tax.

The Merger Directive and requirement for an ongoing permanent establishment.

In the event of a merger falling within the provisions of the Merger Directive, assets and liabilities transferred during the merger shall not give rise to any deemed taxation of capital gains in the emigrating UK company, thus barring the s185 tax liability. However, if the acquiring company that absorbed the emigrated UK company’s assets does not have a permanent establishment in the UK, the capital gains tax exemption is not applicable under the Merger Directive. This is perfectly understandable where there is a continuing business in the UK or where assets such as real estate within the UK are transferred to the acquiring company. However, the situation is different if the only assets that the emigrating company is transferring are shares in foreign subsidiaries, and there is no effective connection to any permanent establishment in the UK after the date of merger. In this situation the Merger Directive will not apply since there cannot exist a permanent establishment, even under unilateral UK law, nor as a result of double tax treaty interpretation. A treaty typically defines a “permanent establishment” to be a fixed place of business through which the business of an enterprise is wholly or partly carried out. In the scenario above, the company, which never traded in the UK and whose main assets are foreign company shares will never be able to meet this test short of creating artificial trade operations.

The rationale behind the permanent establishment requirement is sound — to safeguard the taxing rights of the Member State of the transferring company (much as the National Grid Indus case has decided. However, it is not necessary for the Merger Directive to be applicable in order to effect a cross-border merger from the UK. The Companies (Cross-Border Mergers) Regulations of 2007 has no requirement for a permanent establishment to remain in the UK. Depending upon the nature of the company and its assets, one could envisage a UK holding company of a trading group merging with another EU company, falling within the provisions of the SSE so that no tax is payable on the transfer of assets, and thereby permitting a step-up in basis to be achieved within the acquiring company, something not envisaged by the Merger Directive.

Step-up in basis possibility

In the case of shares held by a UK company in foreign subsidiaries, the base value of the shares can be stepped-up to their current value on a corporate migration through merger, or indeed through the transfer of its place of effective management. Cash in the form of retained profits of the transferring company will effectively be stepped-up in value to the transferred company as incoming capital from the merger arrangements, as opposed to retaining its current form and, on distribution, becoming taxable rather than a return of capital.

One would always have to consider anti-avoidance measures designed to prevent an artificial step-up in basis, and it may be that one has to consider intermediary merging companies in say Luxembourg or Malta whose legislation will permit such a step-up in basis, and which entity may then become a subsidiary of the ultimate owning company.

As I have said many times when lecturing on cross-border migration, this type of tax planning will become more and more prevalent in this decade. Provided there is the proper degree of substance in the relevant entity acquiring assets, companies no longer have to remain within a tax regime which is perceived as harsh or which is no longer relevant to their management structure. In fact, I would dispute with anyone that the UK tax system is harsh, far from it; I believe it to be perhaps one of the most interesting regimes from a tax perspective in which to incorporate a group holding company, and with reductions in corporate tax rates, UK trading companies are becoming more competitive. However, there are many instances where owners or management need to move their companies from one jurisdiction to another, and the technical difficulties (but also opportunities) make this type of tax planning an important issue to get it right!