This article is produced by our European Tax team, which is part of our global Tax practice. Our series, "Understanding Tax", explores commercially relevant and recent changes to the international tax environment.
The last ten years have seen the international tax landscape shift dramatically. Growing consensus that the international taxation system is no longer fit for purpose has fuelled the Organisation for Economic Cooperation and Development ("OECD")’s Base Erosion Profit Shifting ("BEPS") initiative. As the BEPS recommendations have been implemented, developments in both national and international law indicate that existing and future cross-border structuring should be carefully examined.
One of the key outcomes of the BEPS process was the introduction of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (the "MLI"). The MLI enabled tax-treaty related BEPS measures to be introduced into existing treaties without the need for bilateral negotiations between the States to formally amend the treaties.
A key aspect of the MLI was the inclusion of an anti-abuse test which, in most treaties, takes the form of a "principal purposes test" ("PPT"). In broad terms, the aim of the PPT was to ensure that only genuine transactions benefit from the tax treaty, excluding transactions that are primarily implemented to take advantage of the tax treaty benefit.
The direct application of the PPT, and its wider impact on the approach to cross-border arrangements, has proved somewhat controversial, and created uncertainty for business.
Market uncertainty arising from recent case law
The developing reaction of local tax authorities to the issues discussed above can be evidenced through a range of recent international case law. In general terms, these cases focus on whether "intermediate" entities included in an investment or finance structure should, for reasons of beneficial ownership or substance, be entitled to benefit from a double tax treaty.
Questions over beneficial ownership
A series of cases have looked at whether an entity is the "beneficial owner" of payments it receives. As will be clear, the outcome is heavily fact dependent.
In a recent Danish case it was held that dividends paid by a Danish subsidiary to its Luxembourg parent (which then retained and reinvested those dividends in the Danish company) should be paid free of Danish withholding tax. This was due to the Luxembourg parent being treated as beneficially owning the dividends, and the mere fact that the company’s only activity was holding shares in its subsidiary, and that it did not have its own independent offices or staff, did not disqualify the parent from being the beneficial owner.
On the other hand, a Swiss case found that an intermediate Irish parent was not the beneficial owner of dividends received from a Swiss subsidiary. This was on the basis that the intermediate Irish parent shared an address and management with its own ultimate parent (also Irish). The intermediate Irish parent was seen as an effective extension of the ultimate Irish parent, with the ultimate Irish parent determining the timing and size of the dividend payments received by the intermediate Irish parent.
Questions over substance
Other cases have looked at "substance" requirements, i.e. the need for a company to have a genuine purpose and existence (e.g. sufficient human and technical resources to ensure the continuation of its own activity, etc.).
A number of Austrian cases considered the Austrian exemption from withholding tax on dividend payments, available where (among other things) a parent receiving dividends has substance in the jurisdiction in which it is established. In one such case involving a claim for the refund of withheld tax, it was decided that a Luxembourg parent with three employees, premises in Luxembourg and a number of investments both inside and outside the EU did have sufficient substance for these purposes. However, similar Austrian cases came to differing conclusions on their facts.
With respect to Germany, the Court of Justice of the EU (the "ECJ") has already ruled (in both 2017 and 2018) that the German substance rules, which can operate to restrict EU parent entities from withholding tax exemptions under the EU tax directives, violate EU law. It has been determined that such holding companies cannot be considered abusive per se on the basis of abstract criteria without having due regard to the relevant facts and circumstances. In practice, this requires the German authorities to establish that the relevant structure if both artificial and abusive.
The Danish cases
In February 2019 the ECJ handed down its judgment in the "Danish cases". These cases concerned the application of the EU tax directives, and the extent to which they could be relied upon to provide relief from withholding tax.
In each case, payments (of interest or dividends) were being routed from a Danish subsidiary, through an intermediate parent and then out to an ultimate patent. Without routing the payments through the intermediate parent, Danish withholding tax would have been suffered.
The ECJ concluded that each intermediate parent was not entitled to the benefit of the relevant EU tax directive. Important take-aways from the judgments include:
(a) to benefit from an EU tax directive, the direct recipient of the payment should have the benefit of the sums involved and should have the economic and/or legal power to freely use them;
(b) consideration should be given to the timing of onwards payments from an intermediate patent to an ultimate parent;
(c) the existing approach to understanding the application of double tax treaties is also relevant to EU tax directives;
(d) the burden of proof to show lack of beneficial ownership falls on the tax authorities; and
(e) the benefit of an EU tax directive is not necessarily lost where the ultimate parent would itself have been able to receive the payment without suffering the relevant withholding.
Practical impact of the Danish cases
The practical impact of the Danish cases can already be evidenced in recent local law developments.
For example, Spanish domestic law contains an exemption from Spanish withholding tax for payments of interest made to an EU recipient. Importantly, it has historically not been necessary for the recipient to show beneficial ownership of the interest paid to it.
In a recent domestic case, involving interest paid gross from a Spanish company to a Dutch parent, the Spanish Central Economic-Administrative Court denied the existing Spanish withholding exemption by directly applying the beneficial ownership concept discussed in the Danish cases.
In addition, it is expected that some EU member states’ domestic legislation will be amended in light of the Danish cases, including the Netherlands, Germany and Sweden.
Challenges for business
These shifting grounds leave businesses in an uncertain position as to when treaty and directive benefits can be relied upon.
Holding company, as well as cross border investment and financing, structures should each therefore be looked at with a critical eye, bearing in mind not only current uncertainties but also the direction of travel - that is, an increasing focus on beneficial ownership, operating substance, and persuasive non-tax reasons for choices of company jurisdictions.
In connection with this, it would be prudent to consider:
(f) cash flows within the relevant structure, and the arrangements by which funds will be repatriated to shareholders or investors;
(g) the extent to which a given entity has "substance" in its jurisdiction of residence;
(h) whether, an intermediate parent has a function beyond simply operating as a fiscal conduit for underlying payments;
(i) whether payments, in respect of which withholding tax may be relevant, can be replaced with alternative funds flows, whether the fund instrument underlying such interest payments is really required, and whether more reliable forms of withholding tax relief may be available (such as the UK’s quoted Eurobond exemption); and
(j) whether a greater level of comfort can be derived from: (i) establishing a more permanent investment structure, which may itself establish underlying SPVs as and when required for discrete investments; and/or (ii) ensuring that an investment platform undertakes a wider range of functions and activities (beyond simply holding the equity in question or making the loan in question).
Overall, remaining alive to the fact that structuring is now coming under ever more scrutiny (and with less certainty of result) than it has done to date, and that this broad direction of travel looks set to continue, should provide businesses with the ability to meet change half-way and be prepared.
White & Case has an extensive European tax network, and has been assisting a range of client for many years in navigating the complexities and uncertainties of the international tax regime.
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