Open mouthed, my Russian client stared at me incredulously. “You mean I can just pick up this or that company and transfer its residence somewhere else?” “Exactly, Boris Andreyevitch, just think. Your Swiss company and its reserves; your Spanish company owning very valuable re-zoned land; your UK inheritance tax issue with your UK company. All of these tax problems may potentially have a solution through corporate migration.”
This is a typical conversation which will be heard over and over again during the coming decade. The 60s were notable for the brain drain (changes in personal residence rather than corporate residence); the 70s were notable for the proliferation of offshore structures; the 80s predominantly for tax schemes (sometimes wholly artificial); the 90s for treaty shopping using conduit entities resident in relevant tax treaty jurisdictions. The ‘Noughties’ saw a proliferation of legislation countering these tax avoidance structures, largely effective even if their scope has not yet been fully appreciated. So how should we, as tax practitioners, face the ‘Teens’?
Clearly artificiality is a non-starter. Entities without the appropriate degree of substance should not be considered, and where they are used, they must be beneficially entitled to the relevant income and assets. But I believe there is a wider phenomenon at force: namely, the old difference between tax evasion and tax avoidance is hardly recognised anymore. We used to be able to say that tax avoidance was legal and tax evasion illegal, and clearly this is still true to a certain extent. But whilst legal, if provisions exist in domestic or international law which deny the anticipated benefits to be derived from tax avoidance structures, then the distinction has little relevance.
It is therefore necessary to look carefully at what is considered tax avoidance (examined further in this month’s article). In the absence of a clear definition of tax avoidance, I would like to propose the following: Tax avoidance is the minimisation of tax where relevant legislation does not exist to legally, intentionally and morally permit such tax minimisation. Readers may think that this is a hammer blow to the profession in which tax practitioners have honed their skills. Especially the moral bit.
But let’s go back 50 years to the brain drain. No-one thought that the doctor leaving the United Kingdom for the US was morally reprehensible; it was just that with personal tax rates of 83% plus an investment income surcharge of 15%, he was able to keep just 2% of part of his unearned income. And yet he was certainly minimising his tax burden by emigrating to the US. So what was the UK response to the brain drain? Reduce tax rates.
In the same vein, why would a corporation be considered morally wrong if it wishes to come within the tax regime of another country whose tax rates may be more beneficial, or where certain existing problems would not exist. This might be contemplated through corporate migration, and is the future of the international tax planning community.
Consider the following scenarios. A company is incorporated in country A with tax rates and legislation which is acceptable to it; but these rates then change in new legislation, or existing benefits are denied through complex legislation introduced in forthcoming Finance Acts. If the corporation were an individual, he/she might leave the country; why not a company? What if a company is located is a jurisdiction with an appropriate double tax treaty with the country where its major source of income arises, but the treaty is then terminated or the provisions changed? Why not relocate to another jurisdiction which has the original benefits of the previously acceptable double tax treaty? Or what if a tax ruling is withdrawn?
Corporate migration can be accomplished through re-domiciliation (we have re-domiciled BVI companies owning Portuguese real estate into Luxembourg); or changing the place of effective management (such as UK companies to Cyprus); or merger/fusion with another entity (we have concluded our first merger of a common law company with a civil law one – quite a complex transaction!); or share for share exchanges and subsequent transfer of assets; or the creation of a ‘transportable’ entity such as a Societas Europaea; or simply the liquidation of an existing company and starting up the business in a new company. Clearly there are many problems which need to be fully understood but along with these problems, come the opportunities. Such as uplifting the base cost of assets in the new jurisdiction, a theme which the European Commission discussed as long ago as 2006 when reviewing exit taxes for companies within the EU. I will be examining many of these issues at the ITPA Conference in Montreux on March 14-16, and anyone interested in attending could visit the ITPA website at www.itpa.org.
Since this is a complex topic which is indeed in its infancy, I will be devoting the major part of the second annual ITSAPT Conference to this topic, and the contributors to my book “International Tax Systems and Planning Techniques” will be speaking at that Conference on corporate migration issues as it affects their country. We will also devote part of the Conference to discuss personal migration issues as well. The Conference will take place at the same venue as last year, The Landmark Hotel, London on Thursday 3 November, and if anyone would like to reserve their places for this Conference (without commitment) please click here.
I have suggested above that tax avoidance, according to my definition, should no longer be part of the tax practitioner’s armoury in the coming decade. This month’s Newsletter article attempts to describe the existing approach taken by tax authorities, Courts and the European Commission to tax avoidance structures in an attempt to understand why I have defined the term as above.
What is clearly required is a thorough understanding of the corporate tax legislation of the relevant country to which a company may migrate, and moreover what these countries intended to provide, so that there can be no claim to ‘immorality’ as a result of corporate migration.
I would be delighted to hear from you if you would like to discuss the above.
International Approach to Tax Avoidance
In the context of a cross-border transaction anti-avoidance provisions may apply at more than a single level. Thus each relevant jurisdiction’s laws must be considered, complemented by the terms of any relevant applicable double tax convention. If it is a transaction involving EU law, one must also consider anti-abuse provisions of relevant Directives together with ECJ legislation. Both in their turn can disapply terms of the tax treaty or find domestic anti-abuse provisions incompatible with the EU fundamental freedoms. Therefore even the most carefully considered structure may be deemed abusive unless all three are taken into account.
Anti-abuse provisions of EU Directives
The notable EU Directives that prevent international double taxation and which are usually invoked in international tax planning are Parent-Subsidiary, Interest and Royalty, and Merger Directives. The Directives either authorise the Member States to adopt anti-abuse measures, whether by domestic law or by treaty, or contain their own anti-abuse measures.
The Parent-Subsidiary Directive eliminates double taxation on dividends paid by subsidiaries to their parent companies. The relief is only available to certain companies described in the Directive and this is subject to the existence of a parent-subsidiary relationship as evidenced by the qualifying holding. The Directive gives Members States discretion in Article 3(2) to stipulate a holding period of at least two years in respect of the qualifying holding in the subsidiary. More importantly, Article 1 of the Directive permits the Member States to apply domestic or agreement-based provisions required for the prevention of fraud and abuse.
The practical effect of these provisions is best considered vis-à-vis a non-EU corporate entity, resident in say Canada, which wants to save the relevant 5% withholding tax on dividends from its French subsidiary by interposing a Maltese company. First of all, the minimum holding period necessary for the Directive to apply excludes any “on the spot” tax planning but requires establishment of a bona fide holding structure with substance and necessary capitalisation. Furthermore, although Malta does not withhold tax on dividends payable to non-residents, France may demand proof that the Maltese company is not incorporated solely for the purposes of obtaining withholding tax exemption. France may also invoke the limitation of benefits provision under the double tax treaty (although this may be found contrary to EU law).
Case No. 59/2005 decided by Spanish National Court on 22 January 2009 also demonstrates the relationship between the Directive and domestic anti-abuse provisions. A Spanish subsidiary paid dividends to its US parent via two Netherlands intermediaries. The US company received the distribution subject to the 5 percent withholding tax under US-Netherlands double tax treaty. The Spanish tax authorities applied domestic tax regulations implementing the Parent-Subsidiary Directive, under which the withholding tax exemption was subject to the following conditions:
1. the EU parent company is effectively conducting a business directly linked with the activity carried out by the Spanish company;
2. the EU parent company’s purpose is the management of the Spanish subsidiary through reasonable human and material means; or
3. evidence is provided that the EU parent company is incorporated for sound economic reasons and not merely to benefit from the parent-subsidiary withholding tax/participation exemption.
Neither of the Netherlands holding companies satisfied these conditions, and the Directive therefore failed to exempt the distribution. Instead, the Spanish-Netherlands double tax treaty imposed a 10 percent dividend withholding tax in Spain. The Spanish courts found that the domestic anti-avoidance provisions apply, mainly because the Netherlands parent was a mere conduit company, which did not add any value to the production process and lacked substance and business purposes.
The Interest and Royalty Directive aims to alleviate taxation of interest and royalty payments between associated companies established in different Member States. The Directive removes any withholding tax at a source state while extending taxation rights to the state of the recipient’s residence. The Directive contains extensive anti-abuse rules, including “limitation of benefits” and “subject to tax” articles. That is, only the person who receives interest and royalty for its own benefit and not as an intermediary for some other person can benefit from the Directive. Further, exemption from withholding tax is applicable only if the recipient company is effectively subject to tax on the interest or royalty received. This removes from the ambit of the Directive hybrid instruments, such as where payments are considered interest in the payor country but income from equity participation in the recipient country (e.g. participating loans).
A more elaborate Article 5 of the Directive copies word-for-word Article 1 of the Parent-Subsidiary Directive described above. It also contains an “anti-Directive” shopping provision, similar to domestic anti-treaty shopping provisions. It states that the Directive may not apply where one of the main purposes behind arranging transactions in a certain way was to gain the benefit of the Directive. For example, an Italian company borrows money from an associated UK company, with the UK company itself borrowing funds from a company in Russia. Had the Italian company borrowed from a Russian company directly it would have paid 10% withholding tax on interest, absent under the UK-Russia double tax treaty. In light of Article 5 of the Directive, the Italian payor may have to withhold 10% tax on interest payable to the UK recipient.
The Merger Directive aims to provide tax neutrality for cross-border restructurings by ensuring that any increases in the value of assets are not taxed until their actual disposal. Article 15 of the Directive (the new numbering) features a wide anti-avoidance provision. It allows Member States to withdraw the benefits of the Directive where it appears that the restructuring has as its principal or one of the principal objectives tax evasion or tax avoidance. The latter may also be presumed if the transaction is not carried out for valid commercial reason. The Directive does not define “evasion” or “avoidance”, leaving it up to each Member State to pass anti-abuse legislation under reservation of competence. Often the extent of these provisions is challenged by taxpayers. It is therefore useful to refer to the ECJ case-law to establish what constitutes acceptable and unacceptable tax avoidance under the Directive and to see the limits of domestic anti-avoidance regulations.
ECJ case law
Proceedings in Leur-Bloem concerned a share-for-share exchange, one of whose main purposes was to attain a horizontal offsetting of tax losses between the participants of the fiscal unit. The Court held that a restructuring performed in order to attain a pure fiscal advantage, based on a tax technicality, does not constitute a valid commercial reason. At the same time, the Court elaborated on the conditions under which a Member State can refuse to apply the rules of the Directive. Member States cannot adopt general anti-abuse measures but must consider each case on its own merits observing the principles of proportionality, looking at individual motives of each transaction. Shareholders must be given an opportunity to demonstrate that there are bona fide commercial reasons for disposing of the assets or for the lack of substance in the transaction companies.
Kofoed considered another share-for-share exchange, following which the shareholders received substantial dividends that the tax authorities regarded as an illegal cash consideration for the acquisition. The Court decided that merely because the dividend was akin to the cash payment, the two must be interpreted strictly and cannot be arbitrarily reclassified. Nevertheless, the Court accepted that there were indications that the transaction was aimed at attaining unfair fiscal advantages.
In Kofoed, the ECJ followed on from the Leur-Bloem case and considered the issue of tax avoidance under the Directive. It held that persons must not improperly or fraudulently take advantage of provisions of Community law. The application of community legislation cannot be extended to cover abusive practices, i.e. transactions carried out not in the context of normal commercial operations, but solely for the purpose of wrongfully obtaining advantages provided for by Community law.
It can be further inferred from the judgment that the Directive alone cannot be relied on by Member States to deny its benefits to the taxpayers, unless there are comprehensive domestic anti-avoidance measures, which meet the purposes of the Directive. This approach is often contrasted with that adopted by the ECJ in the VAT abuse case Halifax. It held that Community law cannot be relied on for abusive practices, even in the absence of specific anti-avoidance provisions in the Sixth VAT Directive.
The latest in the string of the Merger Directive cases is Zwijnenburg. The ECJ decided on whether the Directive’s benefits could be denied with respect to a merger between two domestic companies to avoid real estate transaction tax. The Court found that the tax advantages under the Directive apply regardless of the motive of the merger and these are not dependent on financial, economic or fiscal considerations. While Member States may deny these benefits where a transaction is considered abusive, they must do so subject to strict interpretation and examine each transaction on its own merits. Additionally, since the Directive defers levy of specific taxes on income and capital of companies and individuals, benefits can be denied only in respect of these particular taxes. Although the merger addressed deferral of real estate transfer tax, it was not within the ambit of the Directive and therefore its deferral could not be excluded by domestic anti-abuse laws.
Leur-Bloem and Kofoed demonstrate the approach that the ECJ takes regarding what constitutes tax avoidance. It also shows how far Member States can go to develop their domestic anti-avoidance legislation in pursuance of their obligations under the Merger Directive. The relevant case-law, however, is scarce and almost non-existent in respect of the Parent-Subsidiary Directive. Cadbury Schweppes sets the general standard with which domestic laws passed to counteract an abuse of Directives must comply. The specific object of any such restriction must not go beyond what is necessary to prevent conduct involving the creation of wholly artificial arrangements, which do not reflect the economic reality and lack business substance.
UK anti-avoidance laws
In Cadbury Schweppes it was found that the UK CFC legislation that applied to a UK company setting up foreign subsidiaries in a low tax EU jurisdiction was a restriction on freedom of establishment in the absence of a tax avoidance motive. By contrast, in Marks & Spencer the measure aiming at preventing abuse by shifting losses to a high tax jurisdiction was not considered to be discriminatory.
In this light it is interesting to note that very recently the European Commission has formally asked the UK to alter two aspects of its anti-abuse tax regimes. These are felt to be discriminatory and disproportionate, in the sense that they go beyond what is reasonably necessary in order to prevent abuse or tax avoidance and any other requirements of public interest.
The first infringement relates to the UK’s “transfer of assets abroad” legislation. Under this legislation, if a UK resident individual transfers assets to a company which is incorporated and managed in another Member State, then the individual may be subject to tax on the income generated by the company to which he/she contributed the assets. However, if the same individual invested the same assets in a UK company, only the company itself would be liable for tax.
The second infringement relates to the attribution of gains whereby if a UK-resident person acquires more than a 10% share of a company in another Member State, and the latter company realises capital gains from the sale of an asset, the gains are immediately attributed to the UK individual or company, which becomes liable for capital gains tax or corporation tax on these capital gains. If, on the other hand, the UK company had invested in another UK resident company, only the latter would be taxable on its capital gains.
Thus, it is a requirement to respect the tax legislation of another EU Member State even if domestic anti-avoidance legislation may otherwise apply, except in cases of abuse. Lord Nolan’s comments in IRC v Willoughbyexplain the respect that should be given to legislation (and this applies to that of other countries as well as the UK), and why tax avoidance motives should not be assumed merely because taxpayers utilise such legislative provisions. He states the following:
My Lords, I am content for my part to adopt these propositions as a generally helpful approach to the elusive concept of ‘tax avoidance’, the more so since they owe much to the speeches of Lord Templeman and Lord Goff of Chieveley in Ensign Tankers (Leasing) Ltd v Stokes (Inspector of Taxes) [1992] STC 226 at 240-241 and 244-145, [1992] 1 AC 655 at 675-676 and 681 respectively. One of the traditional functions of the tax system is to promote socially desirable objectives by providing a favourable tax regime for those who pursue them. Individuals who make provision for their retirement or for greater financial security are a familiar example of those who have received such fiscal encouragement in various forms over the years. This, no doubt, is why the holders of qualifying policies, even those issued by non-resident companies, were granted exemption from tax on the benefits received. In a broad colloquial sense tax avoidance might be said to have been one of the main purposes of those who took out such policies, because plainly freedom from tax was one of the main attractions. But it would be absurd in the context of s 741 to describe as tax avoidance the acceptance of an offer of freedom from tax which Parliament has deliberately made. Tax avoidance within the meaning of s 741 is a course of action designed to conflict with or defeat the evident intention of Parliament. In saying this I am attempting to summarise, I hope accurately, the essence of Mr Henderson’s submissions, which I accept.
Thus the use of the words ‘where relevant legislation does not exist to legally, intentionally and morally permit such tax minimisation’ in my definition of tax avoidance.