Sentiment
Firstly, at the beginning of what is likely to prove a difficult year for many of us, IFS would like to wish all of our readers success in their endeavours this year, but above all a healthy and happy New Year.
Knowing that we are now deeply into a global recession, I have been wondering (yet again) why Governments are still targeting ‘the evil of tax avoidance’ (see our December Newsletter for continued initiatives from the US and UK to combat tax avoidance). Wouldn’t a tax amnesty be a better method of encouraging Investment, much needed in the current climate? For example, I have recently been informed that there is a proposal from the Israeli authorities to permit disclosure of previously hidden assets subject to a maximum tax rate of 10%. This mirrors the Italian amnesties over the past few years which have been commercially successful in meeting their objective.
Clearly, IFS does not advocate the ‘koshering’ of funds previously secreted away through tax evasion techniques. Instead, structuring investment opportunities to minimise taxation (often wrongly referred to by various authorities as tax avoidance) should be seen as a vital component in any period of recovery from our economic woes.
Employing the long accepted Keynesian theory that Savings = Investments, maximising the cash return achieved from an Investment, even perhaps through tax minimisation, must create greater Savings and therefore again create further Investments. What the US and UK Governments appear so far to consider the remedy to the global recession is is to increase public debt in order to provide what can only be a temporary stimulus to the economy. Without greater productivity, this increase in public debt may be paid for by printing money, but the history of Germany between the First and Second World Wars must serve as a warning to all politicians that this cannot be a durable strategy to avert a full scale depression.
Instead of spending money on publicly financed Investments, public debt may still increase as a result of lower tax revenues. This is in any event very likely in times of recession, but could be voluntarily created if taxation rates (or the tax base) were lowered. Since lowering of taxation creates greater Savings to the private sector, this may in turn stimulate the Investments that the global recession requires. True, it will not be the Government itself which is spending to create greater investments (and we are all aware of the wastage which is associated with Government spending), but it is the private sector which will encourage investments. If industry as a whole, and entrepreneurs in particular, are offered significant short term tax exemptions, the benefits to the economy could be far greater that relying on Government spending alone.
Again, lets take a look at history and consider how the Australian economy boomeranged into the fastest growing economy of the 60’s and 70’s when capital gains tax was abolished, and the likes of Robert Holmes a Court, Kerry Packer and Rupert Murdoch were encouraged to make their multi-millions. And what did these guys do with their millions? They invested their money in the country with which they were most familiar i.e. Australia, proving again that Savings = Investments. Eastern European countries have significantly reduced income tax rates across the board and this has certainly provided a stimulus to their economic growth. And what has the recent rhetoric of the UK and US governments been? In particular, Gordon Brown and Alistair Darling have succeeded in discouraging non-doms to remain resident in the UK, even though their initial legislation was significantly toned down during its process through Parliament. And companies were told that their low taxed foreign earnings would create significant additional domestic tax burdens, encouraging them to consider shifting their headquarters to other countries such as Ireland where tax minimisation was not considered to be a social evil.
So let’s not knock legitimate tax mitigation i.e. structuring investments properly within the laws of various jurisdictions. Let’s lobby as well for short term tax exemptions for both corporate profits and personal income, and maybe even a longer term exemption for capital gains. Since the tax payer will eventually have to foot the bill anyway, why cannot he chose the method by which his Investments (from increased Savings) can regenerate the economies with which they are most familiar.
In this IFS January issue, I have written about investing in real estate in France, with the help of my friend Patrice Lefevre-Pearon, Lara has written about the new UK draft provisions regarding the taxation of foreign profits, and also the changes in Luxembourg’s withholding tax on dividend distributions.
Happy reading – and again, a happy new year.
Roy Saunders
Foreign Investment in French Real Estate
The Luxembourg/French Treaty Changes
The traditional route for foreign investors to structure their French real estate investments has been through a Luxembourg company which acquires the real estate direct. Until recently, the Luxembourg / French double tax treaty provided that the profits from ultimate disposal of the French real estate were considered to be ‘business profits’. Such business profits were not subject to French tax if the real estate itself was not posted on the balance sheet of a permanent establishment of the Luxembourg company in France. Mere ownership of the real estate was not in itself deemed to create a permanent establishment carrying on a French business activity. Therefore, without a relevant permanent establishment in France, the business profits could only be taxable in Luxembourg (section 4 of the DTT). This was confirmed by a decision in the French tax Supreme Court on 18 March 1994 (no 79971).
But, in Luxembourg, the profits were deemed to be derived from property, and consequently taxable only in the State (France) where such a property was situated (section 3 of the DTT) confirmed in the Luxembourg Administrative Court of Appeal case held on 23 April 2002 ‘Lacosta Sarl’. The fact that each State treated the profits in a different manner did not cause the relevant courts to vary the way their local laws are interpreted.
The French authorities have now decided that such profits are subject to tax domestically. A new Section 3 of the Luxembourg / French double tax treaty provides that as from 1 January 2008, income or capital gains derived from the transfer of (French) real estate is subject to tax in the State where it is located (France). This is irrespective of the status of the owner (individual, corporation or partnership), and regardless of the fact that the real estate may not be reflected on the balance sheet of a permanent establishment in that state.
Thus France will now invoke Section 244 bis A of the French tax code which permits the French tax administration to impose a withholding tax on any relevant capital gain at a rate equal to 16% with respect to individuals living in another EU country (including Iceland and Norway) and 33.33% in other cases. The tax basis of the levy is decreased by 10% a year after the 5th ownership year with respect to individuals and increased by 2% a year (deemed as depreciation) for taxpayers subject to the corporate income tax. This is then offset against the direct French corporate income tax charge on such sale, with any excess withholding tax being repayable upon final assessment. Should the real estate owner be deemed as conducting a real estate dealer or developer business in France, then the relevant withholding tax rate is 50%.
Continuing Benefits of the Existing Treaty
However, there remain three potential exemptions from French taxation which still seem to be possible. The first is if the shares of the Luxembourg owning company itself are sold. French and Luxembourg Governments stopped short of amending the Luxembourg / France double tax treaty to enable capital gains derived from the sale of shares in such a Luxembourg company to be subject to capital gains tax in France, even if the only assets of the Luxembourg company are directly or indirectly more than 50% French real estate assets. Clearly, any prospective buyer may wish to discount the value of the Luxembourg company shares for the potential capital gain if the underlying property were sold subsequent to the transaction. However, bearing in mind the annual exemptions allowed under French law, if the intention of the acquiring entity is to retain the underlying real estate for many years, the discount negotiated may be limited.
The second possibility is if the property is owned by a French SCI (Societé Civile Immobiliere) which in turn is owned by a Luxembourg company. Again, the changes to the French / Luxembourg double tax treaty did not extend to the sale of shares by a Luxembourg company in a French SCI, and therefore capital gains on the sale of the shares in the French SCI will not be subject to French capital gains tax, nor indeed withholding tax in advance of any assessment. Moreover, in Luxembourg, the participation exemption will apply so that there will be no further Luxembourg tax on the capital gain obtained.
In order to avoid any potential discounts on the value of the shares in the Luxembourg company (for the potential capital gains tax on sale of the underlying property), one could consider re-domiciling the Luxembourg company to a country where similar exemptions as under the old French / Luxembourg double tax treaty exist i.e. where business profits are only subject to tax in the event of a permanent establishment in France. This is with the knowledge as upheld in the above-mentioned court case that mere ownership of real estate in France does not create such a permanent establishment. From a practical point of view, two treaties that come to mind are the Lebanese and Danish treaties with France (although the latter is to be amended soon and is more likely to include the same provision as the revised Luxembourg / French double tax treaty, enabling the French tax authorities to tax capital gains on a direct sale of the underlying property).
One could consider changing the domicile of the Luxembourg company to Lebanon, if that is permitted under both Luxembourg and Lebanese company law legislation. The French tax administration cannot then assess the foreign company to tax in France on any potential capital gains, based on the fact that the Lebanese / French double tax treaty provides that business profits cannot be taxed in France in the absence of a French permanent establishment and the assumption that such includes real estate gain realised by a corporate taxpayer. The issue would then be whether the transfer of domicile of the Luxembourg company to Lebanon creates a French tax charge as if it were a constructive liquidation of the Luxembourg domiciled company. This would involve the disposal of its assets and their re-acquisition once a new domicile has been obtained. Technically, the re-domiciliation does not result in a constructive liquidation of the Luxembourg company, but this must be considered the possible approach of the French tax administration, even if such an approach appears challengeable.
For new acquisitions, it would seem possible to structure these investments through a company in Lebanon, with the ability to sell the underlying real estate without French taxation (assuming the French do not amend the Lebanese treaty in the near future). Alternatively, the ownership of French real estate through an SCI owned by either a Luxembourg or Lebanese company would still appear to be the most beneficial route, assuming that the shares of the SCI are to be sold rather than the underlying real estate.
Grateful thanks go to Patrice Lefevre-Pearon at Morgan Lewis & Bockius in Paris for his assistance with the preparation of this article.
UK Tax Changes for Foreign Income
Unlike other European jurisdictions, the UK does not currently have a full participation exemption in respect of dividends paid to UK companies from overseas subsidiaries. Under the current rules, the UK taxes overseas dividends received by UK companies and provides a credit for overseas tax paid.
However, the UK’s 2008 Pre-Budget Report announced a package of reforms to the taxation of foreign profits and draft legislation was issued on 9 December 2008. These reforms will be included in the 2009 Finance Bill. The central measure is to introduce an exemption from tax for dividends received by large and medium groups regardless of the source and the level of shareholding. The new provisions also include a proposed worldwide debt cap which would see interest that is deductible in the UK capped by reference to the net external finance costs of the worldwide group.
These new rules may make the UK holding company more attractive a proposition in many cases and certainly represent a significant change in the field of corporate taxation.
In respect of capital gains on a disposal by a UK company of shares in a trading company, the UK is already an attractive jurisdiction because of its ‘Substantial Shareholdings Exemption’. This provides that a gain on a disposal by a UK company of shares (in a UK or non-UK company) is exempt where, throughout a continuous twelve-month period beginning not more than two years before the disposal, the company (the ‘investing company‘) held a ‘substantial shareholding’ (broadly, at least a 10% interest) in the company (the ‘investee company‘) whose shares are the subject of the disposal. The investing company must be a trading company or a member of a trading group (the UK company would be the holding company of a trading group and therefore a ‘member’ according to the legislation) and the investee company must be a trading company or the holding company of a trading group (or subgroup).
It remains to be seen to what extent the new dividend exemption will strengthen the UK’s international competitiveness, particularly in light of the uncertainty surrounding the UK’s CFC regime (on which consultation will continue through 2009). However, the new rules seem to represent a positive move to encourage investment in the UK and boost the economy at a time when this is sorely needed.
Luxembourg – Changes to Dividend Withholding Tax Regime
Further to a law adopted on 16 December 2008 (effective 1 January 2009), dividends paid by a normally taxable Luxembourg company to a foreign parent company which is subject in its home jurisdiction to a tax comparable to Luxembourg corporate tax will be exempt from Luxembourg withholding tax if a tax treaty exists between Luxembourg and that foreign jurisdiction. Up until now, this exemption was limited to parent companies which have their seat in another EU/EEA Member State or Switzerland and to Luxembourg permanent establishments of foreign companies resident in a treaty jurisdiction.
The benefit of the exemption is subject to the recipient company holding (or committing to hold) a minimum investment of 10% (or shares with an acquisition price of at least EUR 1.2mn) for an uninterrupted period of at least 12 months in the dividend paying company.
As another development, the Luxembourg Parliament has also recently ratified the double tax treaty with Hong Kong which has a similar effect as regards dividend payments – dividends paid from Luxembourg to Hong Kong will not be subject to Luxembourg withholding tax, subject to the same conditions for the recipient company as outlined above.
It is expected that the effect of these changes will be to simplify the use of the Luxembourg company in international structures. Whereas the Luxembourg company has always been widely used, largely because one can liquidate a Luxembourg company with the liquidation proceeds paid out from Luxembourg without any withholding tax, and also because of Luxembourg’s flexible tax ruling procedures, extra steps often needed to be taken to mitigate the Luxembourg withholding tax in respect of outbound dividend payments. Often this involved complex structures such as the use of convertible preferred equity certificates (CPECs) which allow for distributions of income to be made from a Luxembourg company without Luxembourg withholding tax (subject to obtaining the relevant tax ruling).
Indeed, we understand that there has been some lobbying going on in Luxembourg to abolish its dividend withholding tax in its entirety, although so far nothing concrete has been announced. In the meantime, the above changes represent a positive step by Luxembourg to increase its international competitiveness.