Developments in International Taxation
01 June 2006
Let us look at trends. The EU now has 25 member states and is – next to the United States – the biggest market in the world.
Friedrich Hey, Debevoise & Plimpton LLP
The EC Treaty leaves direct taxation to each member state but the European Court of Justice has been unimpressed by this. In the past five years, the European Court has used the anti-discrimination clauses of the treaty’s basic freedoms to exert considerable influence over national tax legislation. In fact, it is fair to say that the European Court has had a more profound effect on the taxation laws of many countries, certainly Germany, than most political parties. One can safely assume that this trend will continue and probably accelerate. The reason is competition among the member states. As companies and individuals protected by liberal interpretation of the discrimination clauses can move more freely and because national obstacles are being chipped away at by court decisions, the mere threat of moving businesses across national borders – or in the case of qualified individuals their brains – will be a powerful tool to force governments with heavy tax systems to relax their legislation.
Look at Germany: not long ago tax rates stood at around 65 per cent (corporate tax on retained profits and trade income tax combined) to come down to a combined rate of around 40 per cent now. This author predicts that the next changes will be in the areas of cross-border reorganisations – in all forms (migrations, mergers, split-ups and spin-offs) – and in the area of tax accounting, ie, the determination of taxable income. At the heart of this prediction lie several landmark tax but also, no less important, corporate law decisions. The court decisions in Lankhorst-Hohorst and in Bosal stand for the proposition that a foreign parent or a foreign investment may not be treated less favourably than domestic equivalents regardless of the local tax authority being unable to tax the income in respect of which deductions are incurred, for which reason the home jurisdiction thought it could justify a different treatment of the deduction of such expense. ‘Eurowings’ stands for the additional proposition that a less favourable treatment cannot be justified on the grounds that the overall combined tax burden is still below the tax cost that would result if the recipient of the income had its seat in the same country and, so, ‘Eurowings’ is effectively the landmark decision allowing unfettered tax competition subject only to the EC Treaty prohibition of state aid. Put differently, as long as a country does not give selective tax benefits to certain industries or regions (thereby violating EU state aid rules) companies can avail themselves of favourable tax regimes and – since taxes are just another form of business expense – enjoy considerable cost advantages over competitors in high tax jurisdictions.
Against this background it comes as no surprise that tax rates have come down and for the same reason the taxable basis needs to become more uniform to ensure that the tax is imposed on a comparable basis. Yet another landmark case was Lasteyrie du Saillant which involved a French national individual who wanted to expatriate to another member state; France sought to tax him on capital appreciation although that appreciation had not yet been realised. As expected, the European Court ruled that such a departure tax violates the EU freedoms and scholars have widely if not uniformly concluded that the court’s rationale also extends to businesses, thereby effectively allowing companies to move to friendlier locations.
And this is where corporate law comes in. The tax benefits may only exist on paper if significant other disadvantages result. For example, the EU Merger Directive comes to mind, which was enacted in 1990 and which for lack of a corporate law counterpart was largely (except for contributions of qualifying assets and shares) without practical relevance. Some countries, notably Germany, resorted to the position that for want of a corporate law allowing cross-border mergers there was no need to incorporate the EU tax Merger Directive into national tax legislation and Germany took the further view that the movement of the central place of management to another country automatically triggered a liquidation of a corporation; conversely, a foreign corporation with its central place of management in Germany was not recognised but had to incorporate anew under German law. In a string of decisions, some involving Germany, some involving other member states, the European Court of Justice just swept this bulwark of corporate law protectionism away and effectively paved the way for a uniform European company law.
It is no exaggeration to say that the sequence of corporate law decisions: Centros (a UK-Danish case), Überseering (a Dutch- German case), Inspire Art (again involving a UK limited company) and finally Sevic Systems (a Luxembourg-German merger) will have a revolutionary effect. Again: because these decisions remove corporate law obstacles they make the exercise of rights established under the anti-discrimination clauses possible and therefore are of equal relevance in the area of taxation.
In response to these developments, the EU and national legislatures have not been idle. From a corporate law perspective, the Societas Europaea (SE) business form has been established. And most recently a directive in the corporate law area allowing cross-border mergers has been passed, which is being implemented into national law in the various member states, both from a corporate law perspective and from a tax perspective. I am and remain skeptical about the practical prospects for the SE and have likened it to Esperanto – a great idea in theory but without much hope for practical relevance. This conclusion was based on the argument that in light of the decisions in Centros, Überseering and Inspire Art it will be permissible to use existing corporate forms, which already have tested and established jurisprudence unlike the SE. Nonetheless, Allianz, the largest German insurer, has decided to convert into SE status. The German government, for example, to implement the EU merger directive and the SE has introduced, in draft form, tax legislation which will make crossborder reorganisations possible without an immediate tax cost.
The latest proposal now calls for no taxation to the extent the assets remain within a German permanent establishment. One would think that this requirement is also met with respect to goodwill because in many cases the German customer base will continue to be served by the German permanent establishment even if the German legal corporate form disappears by virtue of a merger into a foreign EU entity. By contrast, it appears that, if no permanent establishment remains in Germany, the mere instance of moving the business to another member state would trigger taxation subject only to the alleviation that tax payments can be stretched over several years. It is doubtful whether immediate taxation without a true realisation event, simply triggered by virtue of exercising the freedom to establish the business anywhere within the EU is in compliance with European law; the ability to make the tax payments over several years alleviates the cash impact but does not alter the fact that the sole event of moving across the border causes a significant tax cost. One will have to see whether this position is upheld as the legislative deliberations begin.
As cross-border migration and reorganisation becomes easier and as national legislation is barred from protecting the national tax base by virtue of the antidiscrimination clauses in the EU freedoms, a level playing field as regards the tax costs has to be established. As discussed, tax rates have come down significantly – narrowing the gap between high- and low-tax jurisdictions. As practitioners know, the tax rate is only part of the picture. More important is probably the taxable basis. In this respect, huge discrepancies exist among the member states, making comparisons difficult on the one hand but also offering clandestine ways to offer special tax regimes to certain but not all taxpayers on the other.
For some time this author has predicted that the only way for the member states to agree on a common tax base is to adopt IAS (now IFRS) accounting as the starting point for determining taxable income. Not so much because this is a good system from a tax policy point of view, but because it is the only common accounting system around and therefore will become the system of choice by default. One can safely assume that the 25 member states will not agree on another uniform system of tax accounting rules, nor can the member states remain inactive and not have a (more) uniform system of determining taxable income in light of the developments at the European Court. Therefore, it comes as no surprise that the EU is actively exploring using IFRS as the basis for a common system of tax accounting and high-ranking German tax officials seem to have accepted this reality and provide their input. Obviously, IFRS will not be adopted for tax purposes without modifications. For example, an unmodified mark-to-market principle would lead to unjustified and erratic taxation of income which has not yet been realised. For German businesses it will be a bitter pill to swallow that IFRS rules are far more restrictive than German GAAP rules when it comes to establishing reserves for contingent liabilities, which reserves can be claimed as a tax deduction because German tax accounting follows (subject to some modifications) German GAAP accounting. It has been argued that adoption of IFRS as the basis for determining taxable income is unjustified because such measure cannot be left with a body other than the elected legislature.
This author’s cynical view is that if one takes the German legislature over the past two decades as the yardstick, the IFRS standard-setting board can hardly do any worse. As compared to a generic system of tax accounting, a system which derives the taxable basis from the income determined for commercial purposes has some balancing effects built into the system. Management, on the one hand, wants to show a high profit to present the business (and their job) in a favourable light but doing so comes at the expense of higher taxes. Put differently: overly aggressive tax positions and tax structures will hurt income and for publiclytraded companies have an unfavourable side effect and for privately-held companies will make it more difficult to obtain financing. Hence, human nature when it comes to saving taxes should be somewhat contained. On this philosophical note, my observations end leaving the readers to make their own conclusions as to what the future in international taxation holds.