In the recent months, businesses like Starbucks, Amazon and Apple have ended in the eye of a media storm for avoiding paying enough taxes thanks to various schemes designed in shifting profits to low-tax jurisdictions. Tax avoidance and aggressive tax planning affect countries worldwide and have been discussed at the most recent G8 summit in Saint Petersburg (Russia). International research groups and think tanks, like the OECD (Organisation for Economic Cooperation and Development), have put forward proposals to solve these problems and protect the countries’ right to tax and tax basis without resorting to protectionism which could harm transnational trade and investment. In particular, the solutions advocated in the OECD action plan on Base Erosion and Profit Shifting (BEPS) and its potential implementation within the EU will be discussed in a second article to be published tomorrow.
In the EU, the problem is perceived as acute as well. There, the main challenge is to find the right balance between justified domestic measures aimed at preventing tax evasion and tax avoidance, and the economic freedoms which form the basis of the Single Market. Accordingly, a presentation of the current legal situation will be provided in this first article.
I/ The reason for adopting anti-tax avoidance measures
Businesses use various means to shift profits to low-tax jurisdictions in order to reduce their overall tax burden, in particular thin capitalisation, transfer pricing and controlled foreign companies (which may be shell companies, in the most extreme form of tax avoidance).
Thin capitalisation is related to the way how a multinational company finances itself: to raise money, a company can sell its shares on the market or it can borrow money. Furthermore, when a subsidiary needs money, it can look for external financing or for money coming from inside the group. Usually, the cheapest solution is to borrow money from the group’s internal finance company (usually located in a low-tax jurisdiction), which itself will borrow money in the name of the whole group. It is cheaper, because the whole group has a better reputation and is financially stronger than the single subsidiary, so lenders ask for a lower interest rate (as the risk is lower). Furthermore, borrowing money is cheaper than issuing shares for several reasons, including the possibility to deduct interest payments to the internal financing company from the subsidiary’s taxable income (while dividends paid to shareholders are taxed). Investing little capital in a subsidiary located in a (comparably) high-tax jurisdiction means that this subsidiary will have to borrow a lot of money and therefore pay huge interests, thereby reducing its corporate tax base.
Transfer pricing refers to the pricing of goods, services, material and immaterial property (an example of the latter is intellectual property) that are transferred from one entity to another one of the same multinational group. To reduce the group’s tax burden, the strategy can be to charge an unreasonable price to the subsidiary located in the high-tax jurisdiction, to reduce its taxable income and increase the income of the subsidiary located in a low-tax jurisdiction.
Finally, controlled foreign companies are sometimes artificial bodies used to shift profits in low-tax jurisdictions using means such as thin capitalisation and a transfer pricing that does not respect the internationally accepted arm’s length principle.
To avoid that multinational companies and groups unduly reduce their tax base and burden, the national tax authorities sometimes refuse to automatically apply favourable rules, such as interest deduction, and verify whether the terms are at arm’s length. Where it is not the case, they may re-characterise the interest as dividend or re-allocate the excessive transfer price to the subsidiary located in their jurisdiction. But with the development of the EU, groups have started using rules on free economic movement to challenge restrictive national measures. The Court of Justice of the European Union (CJEU, formerly ECJ) had to rule on several cases related to these topics.
II/ The conditions of validity of anti-abuse measures under EU law
Several cases deal with thin capitalisation. In Case C-324/00, Lankhorst-Hohorst , the German subsidiary ran into difficulty. The Dutch parent company of the group granted a loan and a guarantee on existing loans (to reduce interest rates). The German legislation refused to grant a tax credit for interests paid by a subsidiary (here, Lankhorst-Hohorst) to the parent company where the shareholder was non-resident or where the shareholder was exempt from corporation tax. More precisely, where the parent company was foreign, the interest was re-characterised as a dividend. This breached freedom of establishment. Germany invoked fighting tax evasion, but the measure was disproportionate, since it did not have “the specific purpose of preventing wholly artificial arrangements, designed to circumvent national tax legislation”, but applied generally to any non-resident parent company. A presumption of tax evasion cannot be accepted. Moreover, a reduction in tax revenue does not constitute an overriding reason in the public interest. The argument of the cohesion of the tax system was also rejected, since there was no direct link between the less favourable tax treatment of Lankhorst-Hohorst and any potential tax advantage to offset that unfavourable treatment.
In case C-524/04, Test Claimants in the Thin Cap Group Litigation  the interest was re-characterised as a dividend where it did not respect the arm’s length principle. The claimants were British subsidiaries who had lent money to a subsidiary located in another Member State. For some, their parent company resided in another Member State; for the others, it resided in a third country. Only the first ones could benefit from freedom of establishment, since only EU residents can benefit from this freedom. Before 1998, the whole interest was re-characterised (not simply the excess amount). In 1998, transfer pricing rules were added to apply to interest payments between companies. In 2004, after the Lankhorst-Hohorst judgment, the rules were extended to domestic situations. In addition, a further problem was that ACT (advanced corporation tax) was due on the re-characterised interest. This issue was not removed by the 1998 reform. The justifications of allocation of fiscal powers, fiscal cohesion and prevention of abusive practices were all rejected. The ECJ decided that the legislation was precluded unless it provided for “a consideration of objective and verifiable elements” making it possible to identify the existence of a “purely artificial arrangement”, “entered into for tax reasons alone”, and allowed the taxpayers to produce, “without being subject to undue administrative constraints, evidence as to the commercial justification for the transaction”, and interest was treated as distribution “only in so far as it [exceeded] what would have been agreed upon at arm’s length”.
As to transfer pricing, in case C-231/05, Oy AA , the Finnish company had done a transfer in favour of its UK parent company which was making losses. Finland refused to deduct the amount of the transfer from Oy AA’s taxable income because the parent company was not Finnish. Freedom of establishment was restricted. However, the ECJ accepted that the Finnish legislation was justified by the need to maintain the balanced allocation of the power to tax between MS and to prevent tax avoidance, taken together. It pursued “legitimate objectives”, was justified by “overriding reasons of public interest” and was “appropriate for ensuring the attainment of these objectives”.
Finally, there is the case C-311/08, SGI . Two elements were problematic: SGI, a Belgian company, granted a loan free of interest to its French subsidiary and paid a disproportionate director’s fee to a Luxembourgish company. The Belgian authorities added to SGI’s taxable income the interest that it should have charged on the loan and refused to count the excess of director’s fee as deductible business expenses. Such an adjustment of the company’s accounts took place only if the related company was not residing in Belgium (this is logic; if the other company is in Belgium there is no tax avoidance). Therefore, there was a restriction on freedom of establishment. The justification successfully argued by Belgium was the same as Finland in case Oy AA: the balanced allocation of taxing power and the prevention of tax avoidance, taken together.
As regards CFCs (Controlled Foreign Companies), the main problem with national fiscal measures is that they aim at taxing profits that arose in another (lower-tax) jurisdiction because they believe that profits should have arisen in their own (higher-tax) jurisdiction. A first important judgment is case C-196/04, Cadburry Schweppes . The British legislation on CFCs created an exception to the general regime by setting that, where the tax paid by the CFC in its State of residence is inferior to 75% of the tax it would have had to pay in the UK, the profits of that CFC (i.e., a foreign company in which a UK resident company owns a holding of more than 50%) are attributed to the UK resident company and taxed in its hands. Cadburry Schweppes had created in Ireland a company responsible for handling the group’s treasury. There were three purposes but tax motives played the biggest role. The UK authorities considered that the main purpose of the Irish establishment (the CFC) and of the transactions giving rise to the CFC’s profits was tax avoidance. Freedom of establishment was restricted. The ECJ reminded that a general presumption of tax avoidance was not acceptable. Furthermore, as stated in other judgments, the ECJ also said that preventing a reduction of tax revenue was not a justification, and neither was the fact that the subsidiary benefited from a lower taxation. Preventing tax evasion can justify a restriction to freedom of establishment, but the British legislation was disproportionate, because it applied even to cases where “despite the existence of tax motives [the] controlled company is actually established in the host Member State and carries on genuine economic activities there.”
This solution was reasserted in case C-201/05, Test Claimants in the CFC and Dividend Litigation Group . The ECJ also added that national authorities can impose some compliance requirements aimed at verifying the actual establishment of the CFC and the genuineness of its activities without creating undue administrative constraints.
III/ The 2010 Council resolution on the coordination of CFC and thin capitalisation rules
The original text of the Council resolution of 8 June 2010 can be found here.
“For the application of CFC rules, a non-exhaustive list of indicators suggesting that profits may have been artificially diverted to a CFC includes in particular the following:
(a) there are insufficiently valid economic or commercial reasons for the profit attribution, which therefore does not reflect economic reality;
(b) incorporation does not essentially correspond with an actual establishment intended to carry on genuine economic activities;
(c) there is no proportionate correlation between the activities apparently carried on by the CFC and the extent to which it physically exists in terms of premises, staff and equipment;
(d) the non-resident company is overcapitalised, it has significantly more capital than it needs to carry on its activity;
(e) the taxpayer has entered into arrangements which are devoid of economic reality, serve little or no business purpose or which might be contrary to general business interests, if not entered into for the purpose of avoiding tax.”
“With respect to thin capitalisation rules, which will respect the arm’s-length principle, the assessment will be on a case-by-case basis. A non-exhaustive list of indicators suggesting an artificial transfer of profits includes in particular the following:
(a) the level of debt to equity is excessive;
(b) the amount of net interest paid by the company goes beyond a certain threshold of the earnings before interest and taxes (EBIT) or of the earnings before interest, taxes, depreciation and amortisation (EBITDA);
(c) a comparison between the equity percentage of the company to that of the group worldwide appears to prove that the debt is excessive.”
To conclude, what must be remembered is that the challenged domestic rules are usually discriminatory vis-à-vis multinational groups, because “anti-abuse” legislation is targeted at them (NB: it makes no sense to apply it to domestic groups, since in that case all taxes are still paid within the same country). But these rules can nevertheless be compatible with EU law, provided that they are “specifically aimed and closely targeted at tax avoidance and the prevention of abuse” and proportionate to their aim. The 2010 Council resolution and the case law provide indices regarding the validity of CFC and thin capitalisation rules.