Development in International Taxation

28 January 2008

One of the predictions was that increasing freedom to locate businesses anywhere in the EU would force the member states to lower tax rates to stay competitive. Germany is a case in point. The headline tax rate is now 16.5 per cent and including trade tax amounts to approximately 30 per cent (previously it was approximately 40 per cent). The international tax observer will not be surprised that there are numerous base broadening measures to limit the loss of tax revenue, making the calculation of the true tax burden very much a case by case analysis; a cynic could argue that these tax reductions are in large part nothing more than window dressing. In this context, one could also point to Mexico with its recent introduction of a flat tax coupled with severe limitations on the deduction of business expenses. Anyway, this author’s prediction is that the trend, including window dressing, will continue.

On the other hand, looking back over the past twelve months or so one cannot help but notice that the European Court of Justice is gradually receding from its liberal, taxpayer-friendly jurisprudence as regards what constitutes discrimination, and is moving towards a more balanced position, making its decisions less predictable. It is no secret that the local governments complained heartily about the expansive interpretation of the various discrimination articles by the Court of Justice. One can safely assume that behind the scenes more than mere complaints were voiced. The Cadbury Schweppes decision (and maybe even earlier, the Marks & Spencer case) was arguably the turning point where the court deviated from its previous position that a discrimination exists if a taxpayer is in a less favourable position as compared with the tax position it would have been in if it had been a purely domestic case.

‘Scorpio’ is another case in point where the court approved the imposition of withholding taxes in the case of non-resident artists where there would not have been any withholding obligation in case of a domestic entertainer. Of particular import to an international audience is the ECJ’s view on the interaction between the freedom of establishment and the freedom of capital movement. The distinction between these two freedoms is of great practical relevance because the freedom of capital movement extends to the entire world (subject to a stand-still clause for adverse positions in place before 1994), while the freedom of establishment and the other freedoms under the EU Treaty are only available to EU residents. ‘Fidium’, ‘Lasertec’, ‘Holboeck’ and ‘Test Claimants’ all stand for what is truly a novel view that the freedom of capital is not available if a taxpayer holds a controlling interest, typically more than 50 per cent, in a business enterprise which has the “odd” consequence that third country residents with less intensive EU investment enjoy greater protection than third country residents that have made a greater commitment to the economy of the EU. This result obviously does not make sense and can only be explained by second thoughts about the fundamental question of whether third country residents should enjoy the benefits of the EU Treaty, a question that we will revisit below in the context of tax treaties. In any event, in light of various decisions reiterating and refining the distinction between the freedom of capital movement and the freedom of establishment, one must conclude that this position is now settled and a parent–subsidiary situation involving third countries will not be able to invoke the discrimination articles of the EU Treaty.

What are the trends ahead of us? Three areas come to this author’s mind, all of which have been the subject of a recent US government-directed study by the US Treasury Department: (i) transfer pricing and shifting of business opportunities, (ii) thin-capitalisation/earnings stripping and (iii) treaty shopping.

Transfer pricing has been a hot topic for many years. The increasing focus also results from modern technologies and the decreasing relevance of where physical business operations are maintained. As increasing the value of a business is reflected in intangibles and less in “brick and mortar” facilities, and as the world becomes more economically intertwined, the movement of such intangibles becomes commonplace. It is often not the result of deliberate tax planning, but of mere business necessities. The latest area of focus is the secondment of high-level employees to a foreign country. Germany, for example, takes the view in a draft ruling that such secondments can give rise to a taxable event. That is truly a scary development and especially ill-advised in the case of Germany, where the Berlin wall was specifically designed to inhibit the brain drain that tax law now attempts to accomplish, although by other means. One other area of transfer pricing concerns permanent establishments. Several initiatives are currently going on at the level of the OECD. For a while this area was quiet but now it has become the center of focus. There are three major areas: first, expansion of the source country’s ability to tax income from the provision of services. Effectively one would move a step away from the traditional concept of a “fixed place of business” and towards a time and income-based threshold. Second, the concept of attribution of profits and expenses to a permanent establishment where one moves in the direction of treating permanent establishment and main office as though they were separate and independent businesses, with the consequence, for example, that a mark-up needs to be charged for services that are customarily rendered to clients.

Finally, the decreasing relevance of the location of physical business operations has resulted in a great many “limited risk” and commissionaire distribution arrangements, which the authorities attempt to attack on the grounds of shifting of business opportunities (transfer of goodwill and customer base) and on the argument that the local distributor constitutes a dependent agent giving rise to a permanent establishment of the principal, coupled with the further position that any such local PE would have to be attributed a profit greater than the commission/low risk margin agreed to under the relevant contract with the local “agent”.

With respect to this third issue, Germany is at the forefront of countries that attack these situations at the OECD level and in real life, as the author knows from practical experience.

The second area of increasing international focus will be thin-capitalisation/earnings stripping. It is interesting and probably indicative to note that the US Treasury Department in its study did not find conclusive evidence of earnings stripping by foreign-controlled US corporations. However, it did not state that there was no problem, but rather concluded that additional information is needed to determine whether there should be reason for concern. A cynic could argue that agencies will continue to study the area until they arrive at the desired result that there is an inappropriate erosion of the US tax base through interest deductions. A case in point is Germany, which tightened its thin-capitalisation rules effective from 2008, moving entirely away from the concept of tainted shareholder and shareholder guaranteed debt. Under the new law, any and all debt is subject to the new rule that restricts the ability to deduct finance charges (after a de minimis hurdle of e1 million is exceeded) up to 30 per cent of the EBITDA determined under tax accounting rules; no longer will debt-equity safe harbours play a role. In terms of trends one can point to Italy, which will take a similar approach, and to Denmark, whose system is slightly different in that it limits the interest deductions to 6.5 per cent of the tax basis of certain assets and to 80 per cent of the EBIT. France has recently tightened its shareholder debt financing rules and so has the Czech Republic (narrowing the debt equity safe harbour); Finland is actively looking at anti-thin-capitalisation rules and the Netherlands has also recently tightened its regime in the context of acquisitions. Other countries have no formal rules, but one can safely assume that it will only be a matter of time before measures to protect the local tax base will be enacted.

Another area where one can observe a trend is the entitlement to treaty benefits (including in the EU the entitlement to certain benefits under the EU Parent Subsidiary Directive). It was mentioned above that recent decisions from the European Court of Justice limit the ability of third country taxpayers to invoke the freedom of capital. At the treaty level, the US has been the trendsetter with its declared position that it will not negotiate a (revised) treaty without a comprehensive limitation on benefits (LOB) article. In fact, the recent study undertaken by the US Treasury Department on how to reduce the abuse of US tax treaties highlighted the continued concern about the improper use of US treaties with insufficient limitation on benefits clauses. Clearly, from a US perspective, the issue is of greater relevance because, unlike several other industrialised nations, the US imposes a significant withholding tax under its domestic law on interest payments across borders. The treasury study concludes that the US will press to revise existing treaties with insufficient LOB clauses. In the same vein, Germany has recently enacted much stricter anti-treaty shopping provisions that, among other things, require that the relevant person claiming treaty benefits derives at least 10 per cent of its income from its own business activities (other than collecting dividends and interest, unless it is a true controlling and active supervisory holding company with an organisation appropriate to perform such functions). Activities of affiliates in the same country will not be imputed to the relevant person seeking the treaty benefit. Thus, in many cases treaty (and EU directive) benefits will no longer be available, even if some substance is present and even in situations where fully-fledged business operations with many employees are maintained “under the same roof” for a different legal person, but the person that invokes the treaty merely holds the shares. Germany is not alone in its endeavours to combat treaty shopping; other countries too have stepped up their efforts, be it by way of legislative action or administrative practice. In the European Union Luxembourg is at the forefront of those countries providing a favourable environment for “stepping stones”. Cyprus and Mauritius are other locations that come to mind with respect to investments in certain other areas of the world and it will only be a matter of time before the governments of those countries respond.

As always, there will be no calm on the legislative and administrative tax front. International tax planning will remain fruitful, murky, frustrating and breathtaking as one tries to keep up with and stay ahead of more aggressive and alert taxing authorities around the world.

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