Eucotax Wintercourse 2011 LUISS Guido Carli (Roma) Global Finance and Taxation (Financial and Economic Crisis and the Role of Taxation)

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1 Dipartimento di Scienze giuridiche CERADI Centro di ricerca per il diritto d impresa Eucotax Wintercourse 2011 LUISS Guido Carli (Roma) Global Finance and Taxation (Financial and Economic Crisis and the Role of Taxation) Contributi di sintesi giugno 2011 Luiss Guido Carli. La riproduzione è autorizzata con indicazione della fonte o come altrimenti specificato. Qualora sia richiesta un autorizzazione preliminare per la riproduzione o l impiego di informazioni testuali e multimediali, tale autorizzazione annulla e sostituisce quella generale di cui sopra, indicando esplicitamente ogni altra restrizione

2 Il presente lavoro nasce dallo Eucotax Wintercourse, al quale l Università Luiss Guido Carli partecipa sin dal Ha formato oggetto dell ultima edizione del Wintercourse tenutosi presso l Università LUISS Guido Carli dal 6 al 15 aprile 2011 il tema Finanza globale e fiscalità. Si presentano nel seguente documento i paper finali redatti nel corso dei lavori presso l Università LUISS Guido Carli cui hanno contribuito i docenti e gli studenti rappresentanti della Luiss secondo il seguente schema: Gruppo Chairman Co-chairman Studenti Taxation of investment income of individuals Prof. H. Jochum Prof. S. Lampert E. Cassaer E. Buysse P. Cucci Taxation of financial institutions Prof. C. Gustafson Prof. L. De Broe Prof. H. Litwińczuk Prof. W. Nykiel A. Kaznowski A. Campana Exchange of information and tax procedures, including legal protection of taxpayers Prof. P. Pistone U. Gustafsson- Myslinski S. Müller C. Mione Tax arbitrage Prof. T. Rosembuj Prof. B. Wiman M. Sek C. Lombardozzi Deductibility of interest in company taxation Prof. D. Gutmann Prof. P. J. Neau-Leduc B. Kolozs K. Simader M. Gruber G. Del Vecchio Fiscal and commercial accounting rules Prof. E. Ruggiero Prof. D. Deak J. Bjuvberg A. Zaccagna

3 ELENCO DEI CONTRIBUTI 1. Taxation of investment income of individuals (e.g. comprehensive income tax systems versus dual income tax systems, box systems); 2. Taxation of financial institutions; 3. Exchange of information and tax procedures, including legal protection of taxpayers; 4. International tax arbitrage; 5. Deductibility of interest in company taxation; 6. Fiscal and commercial accounting rules on financial instruments.

4 General Theme: GLOBAL FINANCE AND TAXATION, FINANCIAL AND ECONOMIC CRISIS AND THE ROLE OF TAXATION Subtopic 1: Taxation of investment income of individuals (e.g. comprehensive income tax systems versus dual income tax systems, box systems) Prof. Dr. Heike Jochum, Mag. rer. publ. -University of Osnabrück- Germany Maria Tumpel Vienna University of Economics and Business Austria Gertjan Verachtert KU Leuven Belgium Eric Pasveer Université Paris 1, Panthéon-Sorbonne France Heiner Rohde University of Osnabrück Germany Gábor Zachár Corvinus University of Budapest Hungary Paolo Cucci Luiss Guido Carli Italy Kim de Veer Tilburg University Netherlands Aneta Nowak Lódz University Poland Christina Pettersen Dasca University of Barcelona Spain Oscar Rosendahl Uppsala University Sweden Galina Petrova Georgetown University Law Center USA

5 EUCOTAX-wintercourse 2011 Rome Chapter 1: An overview of taxation systems; investment income Introduction Principle of Equality Efficiency Comprehensive tax system Schedular tax systems Dual income tax system Box system Conclusions... 8 Chapter 2: Taxation of capital investment income differentiation of residents and non-residents The taxable categories of investment income Investment income other than capital gains Capital gains The tax rate Withholding tax The tax base Deduction of expenses Deduction of losses Transfer of losses Allowances Tax-free amount Sub conclusion; taxation of residents Non-residents Investment income other than capital gains Double taxation treaties Capital gains Tax free amount Expense deduction Loss deduction Carry back/carry forward Tax rate: flat or progressive? Method of collection: withholding tax? Chapter 3: Flight of capital and the relation to the financial and economic crisis definition of capital flight problems with capital flight Wealth taxes various tax systems and capital flight

6 EUCOTAX-wintercourse 2011 Rome Chapter 1: Overview of taxation systems and investment income 1.1 Introduction Taxes have been present since the start of civilization. Publio Cornelio Tácito had already pointed out in the 55 B.C. the necessity of income taxes: Neither can the quiet of nations be maintained without armies, nor armies can be maintained without salaries, nor salaries without taxation. Today, taxation has an enormous role in countries economies, and it is essential to grant the economic adequacy of countries to fund the Welfare State. The expenses of the Welfare State are shared by citizens in countries according to their personal situations, and thereby making the tax system as fair as possible. Fairness is one of the main issues in every tax system and because of its significance, the principle of equality is examined below. Individuals can receive income from diverse sources. The intention of this topic is to describe and analyze the treatment of investment income in the different income tax systems. Although each country has its particular way of handling individual income taxes, the tax systems can be divided in two main groups: the comprehensive system and the schedular system. Hungary, as one of the Wintercourse participating countries has recently introduced an almost pure schedular system. 1 However, in the past years its development rather has tended to move towards the schedular subgroups of the dual income tax and box systems. In this paper, we analyze these income tax systems to identify their advantages and disadvantages. The comprehensive system is the one that most closely fulfils the principle of equality. On the other hand, the dual income tax and the box system, seek to be more efficient and neutral even though they move from the traditional frameworks of the principle of equality. Another fact that one must be bear in mind is that capital is mobile and it has a natural tendency to be reallocated to places where taxation is more favourable. 2 Furthermore, the European principle of free movement of capital and the availability of information indicate that private investors can invest their savings wherever they see fit, and in particular where taxation is most favourable. To adapt to these circumstances, numerous countries have already reformed their personal investment income tax system. In the context of tax competition, investments are encouraged, along with risk-taking and entrepreneurship. When comparing the different 1 Annex 1 2 M. Cozian & F. Deboissy, Précis de fiscalité des entreprises, éd. Litec, 2009/2010 P

7 EUCOTAX-wintercourse 2011 Rome systems of participating countries, several conclusions can be drawn that will be discussed at the end of this paper Principle of Equality One of the main questions that arise when there are changes in any country s tax system is whether the system fulfils the principle of equality. The principle of equality is specifically recognized in the constitutions of almost all modern countries. 4 Because of its constitutional significance, it is a principle that benefits from exceptional protection. In some countries, taxpayers have the opportunity to go to court on the grounds of this principle. 5 Nevertheless, this potential to litigate on equality grounds does not apply to all countries. Equity in taxation is an element of tax justice. 6 Equity was among the elements Adam Smith proposed as integral to an adequate tax system, in addition to efficiency, simplicity, certainty and fiscal responsibility. 7 Usually, a progressive tax is considered fair, and therefore equitable, tax because it takes into consideration a taxpayer s individual situation in accordance with the ability-to-pay principle. 8 However, it must be noted that there is no universally accepted agreement on the meaning of the principle of equality. Therefore, one can disagree with the concept behind this principle and decide that proportional taxation, which applies a flat tax rate, fulfils the requirements of the principle of equality just as well. The principle of equality can be interpreted as applying the same treatment to two individuals who are in the same financial situation. The principle of equity is an extension of the principle of equality. The latter aims at applying equal treatment, whereas the principle of equity determines the fair share that an individual should pay. The principle of equality has two dimensions, vertical and horizontal, and both derive from the ability-to-pay principle. Vertical equity motivates tax policies applying progressive tax rates since it holds that differently situated taxpayers should be treated differently, e.g. an individual with more income and/or capital should bear a larger tax burden. Horizontal equity dictates that individuals situated in similar economic circumstances should shoulder a comparable tax burden according to their similar ability to pay. 9 3 Wintercourse Eucotax 2010, Rome: Participating countries: Austria, Belgium, France, Poland, Spain, The Netherlands, Sweden, Hungary, Italy, United States and Germany. 4 M. Bourgeois, Constitutional framework of the different types of income, B Peeters, The concept of tax IBFD 2005, p Annex 1. 6 W. Nykiel, Zasady, p Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1970 ed) 8 N. Gajl, Teorie podatkowe w swiecie, PWN, 1992, p Tax Reform for Fairness, Simplicity and Economic Growth: The Treasury Department Report to the President, Nov /01/

8 1.4 Efficiency EUCOTAX-wintercourse 2011 Rome Governments find themselves squeezed by pressures to maintain or increase their expenditures, on the one hand, and the need to make their tax systems more competitive, on the other hand. In addition, cross-border competition among tax systems can stimulate investments that will lead to economic growth, the development of businesses, and the creation of durable jobs. To achieve the goals of being a welfare state, on the one side, and to remain a country attractive to investors and to able to prevent capital flight, on the other side, the tax system needs to be as efficient as possible. One way to achieve an efficient system is through a tax system that is simple and neutral. In a completely neutral tax system, taxation should not influence an investor s choice to invest in a particular asset. In line with this neutrality, comes the need that a broader tax base is used since all kinds of investment income should be taxable and thereby at a lower tax rate. In a neutral system, the market will optimize itself by allocating capital to assets that provide the best payoffs regardless of the tax consequences. Further, simplicity is also needed to make the tax system efficient. A general fact is that recent tax reforms in many countries have shown an effort to simplify the taxation of investment income in order to improve tax compliance. 10 Several common trends can be identified among the recent tax reforms, including introduction of an electronic filing system of tax returns, pre-filled tax returns, improvement of the availability of different tax authorities to help taxpayers in the event that they encounter difficulties when filing their tax return. In turn, such reforms will also improve the efficiency of the personal income tax and increase the attractiveness of the system. 1.5 Comprehensive tax system A comprehensive income tax system taxes all or at least most wages and income from capital according to a single progressive rate schedule. In other words, all income, regardless of origin, is aggregated to produce an overall net income to which a single tax scale is applied. The main advantages of this system is that it favours the implementation of the principle of equality and helps with the reduction of tax avoidance since a single tax rate applies to all types of income. Along with the United States, Austria, France and Italy use this tax system. 11 In practice, however, none of the above mentioned countries have fully implemented a pure 10 PwC, Paying Taxes 2011, the global picture (see 11 Annex 1. 5

9 EUCOTAX-wintercourse 2011 Rome comprehensive personal income tax system. 12 All countries have special tax treatments for certain types of income (fringe benefits, owner-occupied housing, capital gains, pensions, etc.), and many countries levy social security contributions only on certain types of income (mainly labour income). This lack of neutrality, in turn, increases compliance and administrative costs, reduces tax compliance and tax revenues, and impairs the efficiency and equity of the tax system. 13 As a result of such a semi-comprehensive tax system, tax arbitrage possibilities become available to individuals who take advantage of cross-border differences in tax rules and rates and of tax exemptions and allowances. Further, progressive-rate taxation of realized gains exacerbates the lock-in effect because the taxpayer may be pushed into a higher tax bracket in the year of realization of capital gains. 14 On the other hand, since a comprehensive tax system treats all income the same way, taxpayers would try to shift their income to be taxed under corporate rates and thereby receive more favourable tax treatment. 1.6 Schedular tax systems A schedular tax system separates income into different categories with each category being subject to its own computing rules and tax rates. 15 Two main problems are characteristic of a schedular taxation system. 16 First, tax rates and computing rules may differ between schedules, and taxpayers try to manipulate the character of their income to fit into a more favourable schedule. The complexity associated with these schedules also leads to administrative hassles in the classification of the different schedules. Second, it is challenging to implement a progressive scale based on the ability-to-pay principle since a schedular system imposes tax separately on the income under each schedule rather than on the total income. 1.7 Dual income tax system Briefly, the system splits total income into income from earnings and income from investments. Typically, the net wealth of the capital category is taxed at a proportional rate and the net wealth of the earnings category is taxed at a higher progressive rate. 12 Annex OECD Policy Brief, Reforming Personal Income Tax (2006) 14 PBS Dual Incometax System, Nordic system p Ault, p Ault, p

10 EUCOTAX-wintercourse 2011 Rome The objective of a dual tax system has been to increase efficiency through neutrality and simplicity. One of the most positive aspects of the dual income tax is its neutrality, and this neutrality transpires in different ways. For example, the system avoids the lock-in and clientele effects 17 associated with the use of progressive rates. However, if taxation of capital gains relies on the realization principle, as it usually does, the lock-in effects due to realization will hamper the reallocation of capital towards its more productive uses. 18 The lower tax rate on capital reduces incentives for capital flight, tax avoidance and tax evasion. While the system also achieves horizontal equity within each of the categories, there is a discussion in tax literature whether dual income tax is in conformity with the principle of equality. Depending on the origin of the income, whether from capital or from labour, the combinations of an individual taxpayer s income categories will change the ultimate tax liability arising from that individual s income. This arbitrage opportunity is seen as an incentive to shift labour income to the capital income category, which is taxed at lower rates, thus motivating complex special legislations to prevent such a shift. Furthermore, this difference of treatment can lead to tax arbitrage. This can be described as deliberately exploiting the taxation differences within the tax system or between different countries tax systems. Treating all investment income the same way reduces the potential for tax arbitrage within a country Box system A box system, applied only in the Netherlands, like the dual income tax system, treats investment income separately from other income apart from some exceptions. Even though the three boxes include different types of investment income, it is in box 2 and 3 where most of the investment income of individuals is being taxed. These two boxes have their own tax rates and computing rules. In box 3, investment income is taxed through a fixed assumed yield calculated each year on the actual value of the assets held. This imputed rate of return creates benefits such as absence of lock-in effects on invested capital and also removes much of the problems of figuring ways to take inflation into consideration. Although, the imputed rate of return does not refine the definition of income because it is a standard calculated return irrespective of the individuals de facto return, which will otherwise be 17 Under a progressive capital income tax, investors in high-income tax brackets may choose to specialize in holding assets whose returns accrue in tax-favoured form (e.g., in the form of capital gains benefiting from tax deferral). Since the productivity of assets may depend on who owns them, such tax distortions to ownership patterns may be undesirable. A switch to proportional taxation of income from capital will reduce such distortions. 18 PBS Dual Income Tax System, Nordic system p PBS Dual Income Tax System, Nordic system p.7. 7

11 EUCOTAX-wintercourse 2011 Rome subject to taxation. For this reason, the box system approach does not reflect the principle of equality in its entire definition. 1.9 Conclusions When comparing the different tax systems that are used in Europe, the following clear trend can be identified: The majority of the European countries initially adopt the comprehensive tax system whose underlining values are the principle of equality together with the redistribution of wealth. Since the 1990 s, with the introduction of the dual income tax system in the Nordic countries, this trend seems to go towards increased efficiency at the cost of equality. The principle of equality is recognized in the constitutions of most of the participating countries. 20 However, only in a minority of these countries the taxpayers have the option to take legal action against tax provisions on the ground that the provisions violate the principle of equality. 21 Nevertheless, the success rate of challenging the compatibility of a tax provision with the constitutional right to equality is very low. It is interesting to point out that in the Netherlands, where the principle of equality could be considered to be least respected because no such constitutional right is provided due to the taxation of investment income at an imputed rate of return of the box 3 assets. The box system, however, seems to meet the requirements to manage efficiency. Although equality is a fundamental principle of a comprehensive system, its importance is less visible in schedular tax systems. Instead, a schedular tax system favors neutrality, efficiency and simplicity. These characteristics and the use of a flat rate seem to be more attractive for investors. Being able to deal with the principle of equality and manage to be efficient at the same time, the dual tax system seems to be the intermediate one between the comprehensive tax system and the box system. This is probably the main reason for the popularity of the system. It is also interesting that Sweden, which has taken the dual income tax system the furthest, is about to implement an optional investments savings account, under which the most common securities will be taxed at a fixed notional yield much reminding of box 3 in the Dutch system. The main reasons for this new tax form are simplifying the taxation of investments and preventing lock-in effects arising from the use of the realization principle and thus ultimately increasing the efficiency of the system. 20 Annex Annex 1. 8

12 EUCOTAX-wintercourse 2011 Rome Chapter 2: Taxation of capital investment income 2.1 Differentiation of residents and non-residents Participating countries determine residency based on an individual taxpayer s domicile or place of abode, or based on presence in that country for more than 183 days. Countries tend to define non-resident taxpayers in the negative, by defining expressly residents and excluding them from all individual taxpayers. This is the case with Austria, Belgium, France, Germany, the Netherlands, Italy, Poland, Spain, and Sweden. The United States and Hungary distinguish citizenship as a third, additional category to the definition of a resident. Apart from this difference in the United States and Hungary, the definitions of residency or non-residency are uniform in the states we examined. 2.2 The taxable categories of investment income While a general definition of this term cannot be given, each country can define the categories of taxable investment income through its domestic law. Countries define their investment income categories in different ways, although most types of investment income are taxed in almost every country. Furthermore, it is possible that countries define the same categories in different ways, so that one country taxes certain income type as income from capital investment, while another does not. To expand on the causes of this problematic situation, we introduce the most common categories and how they are taxed in many European countries and in the United States. 2.3 Investment income other than capital gains The most important categories are dividends, interest, royalties, rents and capital gains. Since capital gains are so particular and important, their taxations will be described and explained separately further below. These types of income are taxed as follows: dividends interest royalties rents Austria x x x* x* Belgium x x x x* France x x x x* Germany x x x* x* Hungary x x x* x* Italy x x x x* 9

13 EUCOTAX-wintercourse 2011 Rome Netherlands x x x** x** Poland x x x x Spain x x x x* Sweden x x x* x USA x x x x * Taxed, but not as investment income. ** Taxed under certain circumstances. As it can be seen from the table above, dividends, interest, royalties and rents are all taxed in the examined countries. Differences arise in how they are treated and regulated in the countries. While dividends and interests are always taxed as investment income, royalties and rents may be taxed differently depending on the domestic law of each country. 2.4 Capital gains Capital gains are taxed in all examined countries, but Belgium, Netherlands, Germany, Poland, Hungary and Spain tax them in different ways. For this reason, it is important to distinguish between capital gains from investment income and ones from immovable property. In Belgium, income from speculative transactions is subject to tax, but generally capital gains are not. In Spain, there is no separate capital gains tax, but it can be included as part of a resident individual s income tax or a non-resident s income tax. In the Netherlands, capital gains are taxed only under the box 1 and 2, whereas they are not taxed under box 3. In Germany, capital gains out of real estate will be taxed if they are held for less than 10 years. In Poland, capital gains from immovable property are taxed when the property is held for less than 5 years. In Hungary, capital gains from disposal of immovable property are taxed depending on the length of the holding period of the immovable property. The longer it is held, the less it is taxed. 2.5 The tax rate The setting of tax rates is an issue of domestic legislation. Tax rates can be changed all the time. For example, if a country has to adapt to a new economic environment (e.g., caused by the financial crisis), the modification of the current tax rates can be a solution. Tax rates that apply to investment income in the examined countries vary on a broad scale, ranging from 15 to 50 percent. Most of the Eucotax member countries apply flat rates to investment income. The only exception to this trend is the United States, which applies both a flat rate and progressive rates within a comprehensive tax system framework. In Hungary 10

14 EUCOTAX-wintercourse 2011 Rome and Sweden, a single flat rate applies to all investment income. Belgium s flat rate can vary depending on the item, while Spain s flat rate depends on the amount. The rest of the countries can apply progressive tax rates as well for investment income. Rather the tax rate is progressive or proportional depends on the amount or the item which is taxed. 2.6 Withholding tax In countries that use withholding tax, taxpayers receive the cash proceeds from their investment income only after the deduction of taxes, and they usually do not have to pay directly or report any tax. Upon deduction of withholding tax, the tax file is usually closed. Countries can benefit from this solution because it is easier to keep the tax within the country and withholding causes less work to the tax authorities. In Spain and Sweden, there is no withholding taxation at all. In Germany, Hungary, Italy, the Netherlands, Poland, and the United States, withholding taxation is basically used, but with certain exceptions. In all other countries, the taxation of investment income is a final withholding taxation. 2.7 The tax base Next to tax rates, the tax base is the most important figure defining an individual s tax burden. The tax payable is the product of the tax base and the respective tax rate. Gross income equals total income, including the receipts and gains from all sources, without any deductions. Net income is the residual income after summing up total income and gains and subtracting all expenses and losses. According to these definitions, only in Belgium the tax base consists of gross income. In all other examined countries, the tax base consists of net income. But the allowances of certain deductions can be very different in these countries. 2.8 Deduction of expenses Deductibility of related investment expenses and costs is an important element that determines whether the tax base is taxed on gross or net basis. Related costs can be defined as costs, which are incurred to generate income. Deductibility of investment expenses interacts with the ability-to-pay principle because some taxpayers may reduce their taxable income by deducting costs related to their investments while those who pay tax on income from labour cannot. In Austria, Belgium, Italy and the United States, investment expenses generally cannot be deducted at all, while in Hungary, and Sweden, they are fully deductible. In France, investment expenses are deductible only when income is subject to taxation under a progressive rate. In Germany, the deductibility of related costs is limited to a 11

15 EUCOTAX-wintercourse 2011 Rome maximum amount of EUR 801, whereby acquisition costs can be fully taken into account. Furthermore, it is possible for German residents to deduct the EUR 801 even when they have incurred no investment expenses. Along the same lines, Germany allows for all related expenses to be taken into account if the resident taxpayer has chosen to be taxed under the progressive tax rate. In the Netherlands, expenses are deductible only in box 1 and box 2 while no deduction is allowed in box 3. In Poland, expenses may be deducted for any investments other than dividends and interests. In Spain, generally the expenses are deductible to the extent of investment income, so that the deductions would not produce a tax refund. However, the deductibility can change in the different autonomous regions. 2.9 Deduction of losses A taxpayer can incur a capital loss, and the questions arises how far this loss can be taken into account in arriving at taxable investment income. In many countries, the deduction of losses is widely used, but only in Belgium, no deduction is possible at all. A further exception is the Netherlands, where losses are deductible in only box 1 and box 2. In all other countries, capital losses are deductible. In Germany, losses can be deducted only against income from the same investment category Transfer of losses It is clear from the previous paragraph the capital losses are deductible in almost every country. In most cases, capital losses can be carried forward to other periods in compliance with different limitations. The only two countries where losses are deductible but not transferable are Austria and Sweden. In the United States, residents can carry forward capital losses indefinitely but only at the amount of USD 3,000 annually. In France, Hungary, Italy, Poland and Spain the carry forward is limited by a time period ranging between two and six years. In Germany, a loss carry forward is limited to an amount of EUR 1 million or to 60 percent in excess of EUR 1 million. In the Netherlands, the rules on transfer of losses vary according to the regimes of each box Allowances An allowance is a fixed amount that is set against a taxpayer s income under certain personal circumstances, allowing the taxpayer to receive that amount of income free of tax. It is not very common to have allowances related to investment taxation, but some examples are observable. 12

16 EUCOTAX-wintercourse 2011 Rome As described above, France generally taxes investment income at a proportional rate, but sometimes the rate can also be progressive. Allowances are available only where progressive taxation applies. In the Netherlands, allowances are given only if the investment falls in box 1. This means that no allowances are available if the investments are treated in box 2 and box 3. In Poland, allowances are generally not available although by exception, domestic law allows allowances in case of the rental income from immovable property and royalties. In the United States allowances are given but not to all forms of investment income. An allowance can be used against investment income from rents, ordinary dividends, interest, and royalties. In all other examined countries, there are no allowances related to investment income taxation Tax-free amount A tax-free amount is not considered taxable income up to a pre-determined amount, allowing the taxpayer to receive that much income free of tax. In general, governments can allow taxpayers to realize certain amounts of income without any tax charge. But these allowances are well-regulated and not considered anywhere as legislative loopholes. As usual, in France, a tax free-amount can arise but only when the investment income is taxed at progressive rates. In Hungary, if an investment is held enough long under a proper contract, it can be realised without any tax charge and gains from disposal of movable property are exempt from tax below a certain limit. In the Netherlands, a tax-free amount exists, but only in box 3. In Poland, a tax-free amount exists for rental income from immovable property and royalties, but not in the case of other types of income. In Spain, investment income can be realized without any tax burden on it, up to EUR 1,500. In the United States, a tax-free amount can reduce the tax liability of resident taxpayers in case of rentals, ordinary dividends, interest and royalties. In the other Eucotax member countries, there are no tax-free amounts at all Sub-conclusion on taxation of residents Firstly, tax rates are totally different in member countries and can be treated in entirely different ways. This demonstrates a problem of dealing with taxes within the member countries because investments in other countries are treated entirely different from each other. A common European standard would help to simplify the system. Secondly, domestic law provides many further exceptions, which make the system not easily comparable where expenses can be deducted in one country, and another country 13

17 EUCOTAX-wintercourse 2011 Rome does not even allow the deduction of losses. It is most obvious that through varying tax policies regarding deductibility of investment losses and expenses countries can stimulate investment because investors will find the most effective country to invest in. An additional observation is that throughout the current systems successful investment without any legal advice is almost impossible. These lines shall be seen as an introduction of the different tax systems within member countries and shall make it obvious that each member country has in certain points a quite different understanding of investment income. Since not all investments income is taxed under an investment income regime, it is important and obvious that the term is used differently across the countries Non-residents As a result of limitations on extraterritorial jurisdiction, all countries tax only the investment income of non-residents generated from the country s domestic sources. States tend to define non-resident individual taxpayers in the negative, by defining expressly residents and then excluding them from all individual taxpayers to arrive at the definition of non-residents. Tax treatment of non-residents should be viewed within the context of each jurisdiction s inherent tax system instead of being analyzed in isolation according to its individual elements Investment income other than capital gains Although most states tend to tax non-residents in a manner similar to the taxation of residents, some states do not allow non-residents the same benefits permitted to residents, such as refundable and non-refundable income tax credits and personal allowances. Most states tax income from capital assets, such as interest income and dividends from share holdings. States included in this majority group include Belgium, France, Germany, Italy, Hungary, the Netherlands, Poland, Spain, and the United States. In addition, France, Germany, Hungary, Italy, Poland, Spain, Sweden and the United States tax capital gains. In some states, however, both residents and non-residents are subject to the same provisions that apply to certain types of income. An example of this parallel tax treatment is Poland where identical taxation applies to all types of investment income of both residents and non-residents, other than most forms of interest income. Poland also includes income from investment funds while countries, such as France and the United States, effectively tax the same income under different categories. 14

18 EUCOTAX-wintercourse 2011 Rome Italy differentiates between capital gains from qualified shareholdings and capital gains from non-qualified shareholdings by including only 49 percent of qualified shareholdings in a non-resident s tax base, and capital gains from non-qualified shareholdings are subject to withholding tax. In Germany and Austria, taxation of capital gains from shareholdings depends on whether the non-resident taxpayer holds a substantial shareholding. Austria taxes dividends, distributions of profits from private foundations, Austrian silent partnerships and real estate investment funds. Austria also subjects to tax interest income from loans and mortgages secured by ships and real estate in Austria, but not from bank accounts, for example. Austria classifies royalties and rent from immovable property as an income category separate from investment income. True to the spirit of its box system, the Netherlands categorizes types of investment income from different sources by taxing it under its three different box regimes. The Netherlands taxes non-residents income from home-ownership, such as rent from immovable property (Box 1); dividends, other profit distributions, interest, and capital gains derived from substantial shareholdings (Box 2); interest income, royalties, and dividends from equity interests other than substantial shareholdings (Box 3). Moreover, the Netherlands allows non-residents the option to be taxed as residents Double taxation treaties Unlike residents, non-residents would qualify for reduction of their tax liabilities and even total exemption under bilateral tax conventions concluded between the non-resident s country of residence and the taxing country. Moreover, bilateral tax conventions serve to prevent double taxation of individual taxpayers income, in addition to credits for foreign income tax paid. Notably, tax treaties may fully exempt particular types of income from taxation to the benefit of non-resident taxpayers. In fact, international double taxation is one of the most challenging problems in tax law, and different solutions have been prospected to solve it. The creation of an international model, the OECD Model Tax Convention, is solution that we could qualify as an effective one. The most important element of model tax treaties is that they are neither self-executive nor compulsory. This way, countries may preserve their sovereignty but at the same time they can opt to abide by similar guidelines. Broadly speaking, most EU Member States follow the OECD-Model. Most countries use the credit method to avoid double taxation. However, the full credit method is not applied. Therefore, corrective rules should be applied, and these rules are decided by the states themselves. Some states prefer to have their own regulations, and there may be 15

19 EUCOTAX-wintercourse 2011 Rome many reasons for that. For instance, if a EU Member State that is interacting with a non- White-List country may choose to implement its own regulations Capital gains Capital gains are examined separately from other types of investment income, because several countries treat them differently from other investment income. Furthermore, the taxation of capital gains of non-residents is a topic, which is especially relevant to foreign investors. Bbecause their treatment differs in most states, capital gains have been split up into two categories: capital gains from disposal of shares and capital gains from disposal of real property. Hungary, Poland and Spain, tax capital gains from disposal of shares. Capital gains from disposal of shares are generally not taxed in France, Italy, the Netherlands, Sweden and the US, that is, except under certain conditions. The United States generally does not tax capital gains unless they derive from disposal of immovable property or are realized by a non-resident who has been present in the United States for more than 183 days during the tax year. Capital gains from disposal of shares are not taxed at all in Belgium. Interestingly, France treats royalties from patented inventions and software as long-term capital gains if received by individuals conducting a business. Specific conditions apply to the taxation of capital gains from disposal of shares in Austria and Germany. In these two countries, only capital gains from qualified shareholdings are subject to taxation. A qualified shareholding in this context is defined as a holding of at least 1 percent of the shares comprising a company s capital. This generous definition of a qualified shareholding leads to the situation that taxation of capital gains from shares in Austria and Germany for non-residents is not a factual exception, as it would be for a definition where a holding of 25 percent was required. For purposes of determining a non-resident s tax base, Italy distinguishes between capital gains from qualified shareholdings and non-qualified shareholdings. Italian tax law dictates including 100 percent of a non-resident s non-qualified shareholdings in the tax base and only 49 percent of qualified ones. This variation reflects a policy choice of exempting partially the tax base, rather than achieving th same result by imposing a different tax rate. Capital gains from disposal of real property are subject to taxation in France, Germany, Hungary, Italy, Poland, Spain, Sweden and the United States. Under certain conditions, capital gains from disposal of real property are also subject to taxation in Austria and the Netherlands. In Belgium, capital gains from disposal of real property are not taxed at all. In Germany and Austria, capital gains from disposal of real property are only subject to 16

20 EUCOTAX-wintercourse 2011 Rome taxation if they have been held under 10 years. After that period expires, they are no longer taxable since they are not considered speculative income anymore. Apart from examining whether capital gains from disposal of shares and real property are subject to taxation or not, it can be examined whether capital gains from disposal of shares and capital gains from disposal of real property are treated in the same way in respective countries. In Hungary, Poland, Spain, Austria, the Netherlands and Belgium, the two categories of capital gains are either both subject to taxation, both not taxed, or both taxed only under certain conditions. Sweden taxes rent from and capital gains from immovable property and dividends, but exempts from taxation interest income and capital gains from disposal of securities Tax free amount With the exception of Germany, most countries allow a tax-free amount only to their residents, but not to non-residents Expense deduction Although some states tax investment income on gross basis, most allow deductions for investment expenses to a varied degree. The extent of allowed deductions depends on the extent of neutrality of their regimes with respect to capital inflows from non-residents. States allow deductions for investment expenses and losses either to attract capital or to create neutrality between their residents and non-residents, both of whom choose to invest in a country s domestic economy. The extent of allowable deductions for investments also varies according to how broadly tax regimes define investment expenses to include only closely related costs or nearly any possible investment expense. Belgium, Hungary, Poland, the Netherlands, and Sweden impose tax on investment income on net basis by allowing deductions for investment expenses. In contrast, the tax bases in other states, such as Austria, France, Germany, Italy and Spain, are made up of gross investment income. Austria and Germany allow only deductions for expenses related to income from investment funds. Only the United States taxes non-residents on their gross investment income and generally does not allow non-residents to deduct investment expenses unless they earn investment income from the conduct of a trade or business in the United States. In addition, the United States does not allow deductions for investment expense while Sweden, Hungary, and the Netherlands allow such deductions only for closely related costs. 17

21 EUCOTAX-wintercourse 2011 Rome In the Netherlands, deductions under box 1 and box 2 are limited to costs related to income in those boxes, box 3 allows deduction of mortgages, investment loans, and other deductions related to investment property in box 3, but these deductions are limited to the amount of corresponding income. Unique modes of taxation characterize Belgium and Poland. In Belgium, nonresidents may deduct costs incurred to maintain their investment, such as bank fees. Poland allows deductions for the acquisition cost of shares. Poland also permits deduction of any expenses incurred to generate capital gains, rents from immovable property, and income from capital funds Loss deduction Poland and Belgium certainly allow deductions for investment losses. Other states allow mostly deductions for particular losses. For example, Sweden allows deductions only for losses connected to investment derived from Swedish sources. In Hungary, losses are deductible against income from controlled capital market transactions. In Austria, a nonresident taxpayer may take deductions for investment losses only if choosing to include his investment income in his tax return. The United States allows deductions for investment losses generated in a non-resident taxpayer s business that can be offset against business investment income but not for capital losses. The Netherlands has a combined provision for investment losses that allows their deduction in box 1 and box 2, but not in box 3. France, Germany, and Spain allow deduction only for investment losses, but not for investment expenses. Italy allows deduction only for capital gains and limits loss deductions by amount. France, Germany, and Spain allow deductions only for investment losses, but not for investment expenses. Italy allows deduction only for capital gains. In Austria and Germany, the offsetting of losses is limited to allow offset of losses from investment income only with income from investment income. The rationale behind this tax policy of Germany and Austria is that losses may not be offset against income taxed at a different tax rate. In Germany, for example, the tax rate for investment income is 25 percent. Other types of income, however, are subject to a progressive tax rate up to 45 percent. It would be possible to use losses arising under investment income to reduce the tax burden on other income, for example from businesses or labour. That would lead to a potential for tax avoidance, possible erosion of the tax base and loss of fiscal revenue Carry back/carry forward 18

22 EUCOTAX-wintercourse 2011 Rome Although the approaches of different tax systems to carryover of losses vary, no countries allow transfer of loss deduction to offset taxable income from previous tax years in the form of loss carrybacks. The Netherlands is an exception to this trend of disallowing loss carrybacks for non-residents because it permits carrybacks of 3 years for box 1 and 1 year for box 2. Carryforwards of losses are not allowed in Belgium, Sweden, the United States, and the Netherlands (box 3). Other countries, however, such as Austria and Italy, allow carryforward of losses only for specific types of income. Austria permits loss carryforward for business investment income, and Italy allows it for capital gains but only for net capital losses, and with a temporal limit of 4 years. The examined countries typically allow carryforward but with at strict temporal limit. For example, the limit extends only to 2 years in Hungary, which also requires express permission, 9 years in the Netherlands (box 1 and box 2), 5 years in Poland, and 4 years in Spain. Non-residents of France and Germany may carry forward their investment losses indefinitely into the future Tax rate: flat or progressive? Tax rates applicable to non-residents range from 15 to 50 percent. The tax rate on investment income of non-residents is flat in most of the countries we examined. For example, Austria, Belgium, France, Germany, Hungary, Spain, Sweden, and the United States impose flat tax rates. In Italy, all investment income of non-residents is subject to progressive rates. Most investment income in Poland is also taxed at a flat rate, except for rent payments, which are subject to progressive rates. Applying a single, flat rate across categories of income, regardless of type, promotes horizontal equity among non-resident recipients of different types of investment income. Furthermore, flat rates imposed on investment income are generally lower than the rates imposed on income from other categories, the rationale behind that being encouragement of foreign investment or prevention of capital flight. Taxation in the Netherlands differs from the other countries examined because the applied tax rate may be either flat or progressive and its magnitude may vary depending on which box the income belongs to. Progressive tax rates are applied, for example, to immovable property rented out to a connected person, capital gains from business activities and income from a Dutch primary home (box 1). Income from a substantial shareholding and income from a second home located in the Netherlands are taxed at flat rates (box 2 and 3). The tax rate for income from a substantial shareholding and income from a Dutch second home are 25 percent and 30 percent, respectively. 19

23 EUCOTAX-wintercourse 2011 Rome Some countries tax all categories of investment income at the same flat rate. For example Hungary applies 16 percent, Austria and Germany tax at 25 percent, and Sweden subjects nonresidents investment income to 30 percent. In the United States, the tax rate is 30 percent for all categories of investment income except for capital gains from immovable property, which are subject to a flat rate of 10 percent. Where the flat rates differ by category of investment income, a distinction is made mostly between dividends, interest, and royalties. France, Belgium and Spain are good examples of such varied tax treatment. Poland may also be associated with other countries where the flat tax rate differs by category of investment income, because it only slightly differs from France, Belgium and Spain in that rent payments are subject to a progressive rate. In France, the tax rate levied on fixed-income securities 22 generally is 18 percent although it may vary according to the securities issue date, the date of payment, holding period, and whether the subscription is anonymous or not. France taxes dividends paid to non-residents at a rate of 25 percent and to residents of the EEA at 18 percent, but exempts interest from tax. However, France imposes a tax rate of 50 percent on dividends and interest paid to non-residents who reside in tax havens. In France, royalties are taxed at percent. In Belgium, dividends are subject to a tax rate of 25 percent, which may be lowered to 15 percent if certain conditions are met while interest and royalties are generally subject to tax at 15 percent. In Spain, dividends and interest are taxed at 19 percent if they equal amounts below 6,000; above this threshold, the rate is 20 percent. Royalties and payments to artists and sportsmen are taxed at 24 percent. In Italy, the tax rates levied on investment income generally are progressive Method of collection: withholding tax? Tax systems resort to withholding of tax instead of self-assessment and selfreporting, which they may otherwise allow to their residents. The reason for implementation of a withholding mechanism is that countries have limited extraterritorial jurisdiction over nonresidents, who often are not citizens of other sovereign states and whose capital is highly mobile across borders and thus may ultimately escape taxation. Where a withholding tax is applied to investment income of residents, it is usually reasoned that a withholding tax leads to simplification. Moreover, a withholding tax is particularly important where bank confidentiality provisions prevent reporting of information about the income received to the 22 Fixed-income securities include interest income derived from private and government-issued bonds, negotiable debt instruments, bank deposits, and capitalization contracts that are combined with life insurance policies. 20

24 EUCOTAX-wintercourse 2011 Rome tax authorities. Tax on investment income of non-residents is levied through a withholding mechanism in Austria, Belgium, France, Germany, Spain, and the United States. Only some types of investment income are taxed by withholding tax in Italy, the Netherlands, Poland and Sweden. Hungary, Italy, and Poland levy a withholding tax on dividends, interest, and royalties. In Poland, non-residents report their tax liabilities arising from rents and capital gains from immovable property through self-assessment. As for Sweden and the Netherlands, only dividends are taxed through withholding in these two countries Sub-conclusion on taxation of nonresidents Tax treatment of non-residents should be viewed within the context of each jurisdiction s inherent tax system instead of being analyzed in isolation. Most states tax income from capital assets, such as interest income and dividends from share holdings. As a general trend, most countries levy tax on capital gains from disposal of shares and real property. Although some states tax investment income on gross basis, most allow deductions for investment expenses. The examined Eucotax countries allow deductions for investment expenses and losses either to attract capital or to create neutrality between their residents and non-residents, both of whom choose to invest in the country s domestic economy. While states vary in how liberally they levy tax on net basis and the extent to which they allow deductions for investment losses, they typically allow offsetting of losses from a certain investment category only against income from the same category. Hence, capital losses may be offset only against capital gains. Tax rates applicable to non-residents range from 15 to 50 percent. Most states impose tax through withholding mechanisms at flat rates to ensure collection of taxes and to simplify the assessment of non-residents tax liabilities. Tax treaties following the OECD Model Tax Convention may reduce or eliminate tax on a non-resident s income derived from a treaty partner country. States often follow the OECD Model to avoid double taxation because it provides both an inspirational form of self-government and common guidelines for treaty negotiations. Chapter 3: Flight of capital and the relation to the financial and economic crisis 3.1 Definition of capital flight 21

25 EUCOTAX-wintercourse 2011 Rome In order to examine the relationship between capital and the financial and economic crisis, it is important to start off with a clear understanding of what capital flight entails. For the purpose of this paper, we will apply a strict definition. There will always be some flight of capital in any state that cannot be attributed to the tax system, due to personal reasons or non-tax related social-economical situation. This type of capital flight will be excluded here. Capital flight should be understood as the situation where investors decide to reallocate their assets due to changes in taxation. Capital flight can be legal and illegal. Legal capital flight means a taxpayer will still comply with all his legal obligations, but will try to place his capital in a country where the tax regime is more favourable than in his country of residence. Illegal capital flight, on the other hand, arises when a taxpayer reallocates his capital to another country, but has no intention to report the income from this capital to the tax authorities of his country of residence. 3.2 Problems with capital flight Capital flight posses several problems. There is, for instance, a clear impact on the state budget. No further explanation is necessary that the disappearance of capital, and therefore income from capital, could lead to less taxation of capital income and consequently lower state revenues. Moreover, a state will have higher expenditures since remedies have to be found to fight tax evasion and to repatriate capital that has fled. Another issue to be examined are the principles behind taxation in general. Taxes are levied by governments in order to afford certain facilities. For example, such facilities include a road network or, on a higher level, a well-organized tax authority. In this respect, it makes sense that a country levies tax on the income of taxpayers who benefit from these facilities. When capital flight occurs, a taxpayer does not contribute his fair share to the government s budget. Also there is the ability-to-pay principle, which is represented in most tax systems. A wealthier taxpayer will be more able to pay his taxes, but he will also be the one to avoid taxation by placing his capital abroad. Therefore, the possibility exists that the ability-to-pay principle, although represented within a country s tax system, can turn out to be not very effective. 3.3 Wealth taxes In each country, taxes on wealth in the broad sense are in force. Wealth taxes do, however, differentiate from one country to another. It is not difficult for the taxpayer to conclude that he should better invest in a country with a more favourable tax regime. In this respect, it is necessary to do research on the various wealth tax measures in place in the 22

26 EUCOTAX-wintercourse 2011 Rome Member States of the European Union. This research might give us an answer to the question whether specific tax measures exist that may stimulate flight of capital more than others. Some topics that are often subject of serious debate are the introduction of net wealth taxes (wealth is taxed regardless of the question whether income is obtained), the taxation of capital gains and the level of tax rates. As displayed in the matrix, the inherent tax system of most countries does provide for sufficient measures to prevent capital flight. Each country is thus aware of the problem and tries to find a balance between sufficient taxation on the one hand and investment opportunities on the other hand. Regarding the taxation of net wealth tax, only two countries have this type of taxation. 23 The Netherlands levies tax on an assumed investment yield of 4 percent of the value of the assets in box 3. The introduction of this system in 2001 would probably have had an effect on capital flight because it was no longer possible to avoid taxation by not selling assets. Today, the system has probably stabilized and its negative effect is no longer a serious issue. The wealth tax in France is payable on net assets above EUR 800,000 held on the first of January. The existence of the French wealth tax is not considered as a significant reason for most taxpayers to move away from France. Moreover changes will be made to the existing wealth tax in France. Other countries do not have net wealth taxation provisions in force and legal doctrine is often convinced of the negative effects of such provisions in the end. Nonetheless, the debate is vital again due to the financial crisis and for instance in Austria, Belgium, Spain, and the United States net wealth tax became an issue again. Often these measures are subject to debate between left-wing oriented parties and the more rightwing oriented parties. 3.4 Various tax systems and capital flight Concerning the taxation of capital gains on investment income of individuals, most countries do levy a tax. Only in Belgium and the Netherlands capital gains taxation is in some circumstances absent. The Netherlands does not tax capital gains in box 3. In Belgium, there is renewed attention to this issue on the occasion of the financial crisis and it is not unthinkable that adjustments will be made in the future. Finally, it can be useful to look at the tax rates in force in the different countries. In this respect, we can already mention that many countries adopted (semi-)dual income tax systems. The evolution towards dual income tax systems took place in the Nordic countries and now Belgium, Germany, Poland, Spain and Sweden are examples of countries with a 23 C. Heckly, Wealth Tax in Europe: Why the Downturn? in M. Taly and G. Mestrallet (ed.), Estate Taxation: Ideas for Reform, Institute Reports, Paris, Institut de l entreprise,

27 EUCOTAX-wintercourse 2011 Rome (semi-)dual income tax system. 24 The main characteristic of dual income tax system is the division of a taxpayer s total income into income from capital and income from labour. These categories of income are treated separately. Progressive tax rates are levied on labour income, whereas a flat rate is imposed on capital income. By consequence, capital income is taxed less heavily than labor income. Nonetheless, differences between for instance the dual income tax systems regarding the tax rate remain. Sweden and the United States, for example, have remarkably higher tax rates than other countries, which mostly do not exceed a proportional 25 percent tax rate. It is, however, difficult to assess the influence of the level of the tax rate on the existence of capital flight, since the after-tax situation can differ a lot from the before-tax situation and not only the tax rate has to be taken into account when tax systems are compared. Nonetheless, it is often stated that dual tax systems are better suited to encounter economic troubles and capital flight than comprehensive tax systems. Firstly, it is assumed that a low proportional rate on capital reduces the negative results of inflation. The second advantage of this system, which is put forward by its proponents, is that the lower rate can reduce tax arbitrage of capital income. Taxpayers have to rely less on tax avoidance methods in order to enjoy favourable tax rates. Taxpayers decisions concerning the allocation of capital investments are not dependable on tax rates. Then, distortions in allocation of investments are reduced, which favours the economic welfare of a country. Several countries prefer to levy their taxes on investment income through a withholding tax. This is the case for Austria, Belgium, France, Germany and Poland. In Italy, Hungary and the Netherlands a withholding tax is in force for certain types of income. A final withholding tax should increase the efficiency of tax collection and can also serve as a measure that can contribute to a solution against capital flight. Another issue worth mentioning is exit taxation. 25 Exit taxation is used by countries to not lose their taxation rights when taxpayers are emigrating. This can be an extra measure in counteracting capital flight, because although a taxpayer might move away to another country, the taxpayer still needs to pay taxes in his former resident country. The United States imposes taxes on any U.S. citizen, regardless of the U.S. citizen s actual country of residence. Citizens renouncing their U.S. citizenship and permanent residents terminating their U.S. residency if their annual incomes or net worth exceed thresholds for ten years after changing their status. 26 Within the European Union, several principal freedoms are in place, and the free movement of capital is one such example. This means that no obstructions are 24 W. Eggert and B. Genser, Dual Income Taxation in EU Member Countries, CESifo DICE Report, 1/2005, p See matrix 26 USA I.R.C. 877(a)(2). 24

28 EUCOTAX-wintercourse 2011 Rome allowed when capital is transferred to another EU member state. Even more so, free movement of capital is the only EU freedom that is also applied to transfers of capital to non- EU member states. Nevertheless, there are several countries that levy some kind of exit taxes and use the coherence of their national taxation as an argument to do so. The Netherlands is an example of a country that has a type of exit taxation. 27 When a Dutch resident emigrates, he receives a preservative assessment for the amount he would have had to pay when he would have sold his shares right before the moment of emigration. If this taxpayer sells his shares within the next ten years from the moment of emigration, he needs to pay the tax amount of this preservative assessment. If this taxpayer does not sell his shares within ten years, the preservative assessment is remitted. Germany applies a similar system and Austria also taxes at the moment of alienation, but does not apply any time limit. Given the description above, it is difficult to make exact statements about the relationship between capital flight and tax provisions. As mentioned above, the wealth tax in France did not give rise to serious capital flight. Moreover, it is clear that other elements have to be taken into account than tax provisions alone. Nonetheless, capital flight remedies are still often sought in the implementation or adjustment of tax measures. The fear of capital flight is for instance often used by legislators to justify a tax system that violates the principle of equality by taxing investment income differently than other types of income. 28 The dual income tax system is assumed to be justified by the fear of capital flight. The question is whether or not this sort of blackmail is sufficiently supported by taxpayers actually emigrating or transferring their capital abroad because of features of the tax system. Unfortunately, it is almost impossible to determine how much the capital flight will increase due to, for example, an increase in taxation of capital income of 1 percent. However, what can be determined is the general opinion whether capital flight is considered to be a problem and especially at the time of the outburst of the financial and economic crisis. As the matrix shows, flight of capital is not really threatening the economy of any country at a large scale. Hungary is an exception, not really due to its tax system, but more because of its socioeconomic situation and its history of being a former communist state. Referring to the matrix again, in some countries the flight of capital has become an even more significant issue due to the financial and economic crisis, which makes sense because the governments budgets have decreased as a result of the crisis. As already noted above, to counteract flight of capital, some countries started to tax investment income in a preferential manner that is more advantageous to taxpayers than 27 The Netherlands Article 4.16 section 1 sub h PITA. 28 S.R.F. Plasschaert, schedular and global systems of income taxation; the equity dimension, Antwerpen: Centrum Derde Wereld, Universitaire faculteiten St. Ignatius,

29 EUCOTAX-wintercourse 2011 Rome other types of income, which would mean a violation of the equality principle. This might have prevented capital flight to some extent, but also in these countries capital flight still occurs. While for instance Belgium has favourable tax provisions regarding the taxation of investment income, many residents still keep their private estates in Luxemburg. There will always be countries where the tax base and tax rate will lead to less taxation for an individual taxpayer than the tax system of the taxpayer s own country. The danger exists that in the struggle to counteract capital flight and to attract foreign investments, countries will lower their tax rate on investment income continually, which can lead to a race to the bottom where the tax base is eroded and the rate is close to zero. A solution for capital flight might be found in a common European or even global system. When the tax system in another country is no different from a taxpayer s own national system, there would be no reason for taxpayers to attempt capital flight. Moreover, an investor s decision about in what and where to invest will no longer be limited by tax incentives, which will have a positive result on the economy. However, every country has its own culture with its own values and habits. Therefore, it is important for every country to be able to come up with their own tax system, which is most compatible with these values and habits. Also, sometimes it can be necessary to steer investments in a certain direction for environmental reasons, for example. When there is a European or even global system in place, this regional steering will be more difficult, due to the cultural differences. Worth mentioning here, is the European freedom of movement of capital. Even with no common system, it was obviously considered to be acceptable for taxpayers to freely transfer their capital to EU member states, including countries with a more favourable regime for taxation of investment income than their own. Until fiscal autonomy of EU Member States is no longer sacred, it is not likely that a serious change will be made on this autonomy in the future. Consequently, it will be hard to present a complete and harmonized European or global system. However, when it comes to counteracting capital flight, and illegal capital flight, in particular, a European or even global approach could provide remedies in certain areas. In this respect, it can be thought of measures that try to reduce possibilities for anonymous investment. The financial and economic crisis has shed a new light on these possibilities. By reducing the possibilities for anonymous investment, the incentives for fraudulent taxpayers to move to more lenient tax regimes will decrease and capital flight will also diminish. Worldwide measures have been taken in these areas to restructure the international financial market. 29 The introduction of these measures should then contribute to a better collection of taxes and should improve fiscal solidarity amongst taxpayers. Tax evasion by some taxpayers will indeed create pressure on tax revenues and increase the tax 29 See for example the so-called Bretton Woods II-plan and the G20-meeting in Washington, 15 november

30 EUCOTAX-wintercourse 2011 Rome burden, which will eventually have to be fulfilled by other non-fraudulent taxpayers. Tax fraud will also disturb the global market and fair competition. Measures that are often introduced to reduce the practice of anonymous investment abroad include reduction of banking secrecy laws, possibilities for fiscal amnesty, exchange of information and the fight against money laundering. Answers to this topic are often sought at an international and European level. The OECD takes the lead in seeking to encounter tax evasion for many years now and pleads for transparency and international cooperation between tax administrations. The European Union also took the initiative to improve the exchange of information between tax administrations. Important here are the Directive on Mutual Assistance and the Savings Directive. Probably even greater effect can be attached to these initiatives than to the work of the OECD. Firstly, these directives are more effective because of their legal value. The OECD is a politically inspired organization and strictly no legal value can be attached to the model-treaties or proposed international standards. Moreover, the proposed working method by the OECD standards provides for exchange of information on request, whilst the Savings Directive provides for automatic information exchange. The European Commission did adopt an amending proposal in 2008 with a view to closing some existing loopholes. 30 Some complex and denatured financial products should be included in the scope of the Directive after this change too. One of the direct causes of the financial and banking crisis was exactly the creation of complex, non-transparent and denatured financial products. With the new proposal on the Directive on Mutual assistance, the EU will aim to make it no longer possible for tax administrations to refuse an appeal by another tax administration on the exchange of information from financial institutions _review/com(2008)727_en.pdf. 31 Proposal of 2 februari 2009 for a new directive concerning mutual assistance within the European Union in the area of taxation, COM (2009)29. Adopted by the Commission on 1 february

31 Annex 1 EUCOTAX-wintercourse 2011 Rome Annex 2 Gábor and Heiner Annex 3 Tabel 1 Investment income subject to taxation (tax base): Type of income included in tax base? Taxed unconditionally Taxed, with qualifications Dividends Austria, Belgium, France, Germany, Hungary, Italy, the Netherlands, Poland, Spain, Sweden, the US Interest income Belgium, France, Austria, Hungary, Italy, Germany, the Poland, Spain, the Netherlands* US Not taxed Sweden 28

32 EUCOTAX-wintercourse 2011 Rome *the Netherlands: Interest income: taxed if it is from profit-sharing bonds Type of income Taxed Taxed, but not Not taxed included in tax base? regarded investment income Rent on real estate Poland, Sweden, Austria, Spain, the United Belgium, States France, Germany, Hungary, Italy Royalties Belgium, France, Austria, Italy, Poland, Spain, Germany, the United States Hungary, Sweden Type of income Taxed Not taxed, Not taxed included in tax base? except under certain conditions Capital gains from Hungary, Poland, Austria, Belgium disposal of shares Spain France, Germany, Italy, the Netherlands*, Sweden, the United States Capital gains from France, Germany, the Belgium disposal of real Hungary, Italy, Netherlands*, property Poland, Spain**, Austria*** Sweden, the United States *the Netherlands: Capital gains from disposal of shares: Not taxed in box 3, but taxed in box 2; Capital gains from disposal of real property: not taxed in box 3, but taxed in box 1. **Spain: Taxes capital gains from disposal of real property, but not as investment income. ***Austria: Taxable if the property has been under ownership of the seller not more than 10 years. 29

33 EUCOTAX-wintercourse 2011 Rome Tabel 2 Tax Rates COUNTRY TYPE OF INCOME TYPE OF RATE (Highest Marginal Rate) France Dividends Flat (50%) (residents of tax havens) France Royalties Flat (33.33%) United All investment income other than capital gains Flat (30%) States Sweden All investment income Flat (30%) Italy Royalties Flat (30%) Netherlands Box 3: interest income, royalties, and dividends from Flat (30%) equity interests other than substantial shareholdings France Dividends Flat (29%) (Residents of EEA) Italy Dividends Flat (25%) (12.5% for saving shares) France Dividends Flat (25%) (All other nonresidents) Austria All investment income Flat (25%) Germany All investment income Flat (25%) Netherlands Box 2: dividends, other profit distributions, interest, and Flat (25%) capital gains derived from substantial shareholdings Belgium Dividends and other interest Flat (25%) (exemptions 15%) Spain Royalties and payments to artist and sportsmen Flat (24%) Spain Dividends and interest over 6,000 euro Flat (20%) Poland Interest and royalties Flat (20%) Poland Capital gains, dividends, and income from capital funds Flat (19%) Spain Dividends and interest below 6,000 euro Flat (19%) Hungary All investment income Flat (16%) Belgium Interest Flat (15%) United Capital gains from immovable property Flat (10%) 30

34 EUCOTAX-wintercourse 2011 Rome States United Capital gains from disposal of shares Flat (0%) States France Interest Flat (0%) Italy Investment income other than dividends and royalties Progressive (43%) Netherlands Box 1: income from home-ownership, such as rent from Progressive (52%) immovable property Poland Rent Progressive (32%) Tabel 3 Collection Mechanism COLLECTION MECHANISM Withholding Self-assessment COUNTRY Austria Belgium France Hungary Italy the Netherlands (Box 3) Poland Sweden (dividends) United States the Netherlands (Box 1 and Box 2) Poland (rents and capital gains from immovable property) Sweden (investment income other than dividends) 31

35 EUCOTAX-wintercourse 2011 Rome Annex 4 32

36 General Theme: Global Finance and Taxation Financial and Economic Crisis and the Role of Taxation Subtopic 2: TAXATION OF FINANCIAL INSTITUTIONS Austria (Clemens Willvonseder) Belgium (Marjan Verhelst) France (Salomé Bilounga) Germany (Till Meickmann) Hungary (Eszter Molnár) Italy (Alessandra Campana) Poland (Bartosz Czerwinski) Spain (Mariona Borràs Mata) Sweden (Miklos Kovacs Kal) The Netherlands (Arian Koelewijn) United States (Brendan Sponheimer) Prof. Gustafson, Prof. Litwinczuk & Andrzej Kaznowski

37 Table of contents Table of contents Introduction Taxation of banks Introduction CIT Comparison BANK ACCOUNTING SYSTEM RATES Flat rate Progressive rate Funding of Banks BASEL II & III Cross Border Situations Deposit Guarantee Schemes Proposals of the EU and the IMF National solutions VAT Conclusions Taxation of insurance Companies Introduction The taxation of the income of insurance companies in general Insurance technical provisions Income taxation in cross-border situations Financial Stability Charge Special Taxes Guarantee Schemes Taxation on benefits from life insurances Value Added Tax Insurance Premium Tax Evaluation and conclusions Taxation of Collective Investment Funds Introduction: legal form Taxation PRINCIPLE OF TRANSPARENCY

38 TAXATION ON CORPORATE LEVEL Tax exempt CIFs / tax transparent Taxable CIFs TAXATION ON INVESTOR LEVEL Tax exempt CIFs / tax transparent Taxable CIFs Discussion Taxation of Pension Funds (PFs) Introduction The Three Pillar System Pension Fund Profits Pension Fund Contributions Pension Fund Distributions Restrictions on Pension Fund Investment Withholding on payments to Pension Funds The Residency of Pension Funds according to the criteria of Art. 4(1) Limitation of Benefit Provisions Recent Pension Fund Structural Changes The Continuing Viability of Current Pension Fund Systems Conclusion Appendix Matrix: taxation of banks Matrix: taxation of insurance companies Matrix: taxation of Collective Investment Funds (CIFs) Matrix: taxation of Pension Funds (PFs)

39 0. Introduction T he general consensus is that the recent financial crisis had its genesis in a combination of factors arising from the credit boom and housing bubble in the United States 1. While insufficient standards in evaluating the credit-worthiness of home-buyers (at the micro-level), the large-scale securitization of mortgages, and the poor assessments of such securities by rating agencies all played significant roles in the crisis, the onus for such sweeping economic failures falls mainly on large, complex financial institutions 2. These organizations allowed risk to remain concentrated in their portfolios at excessively imprudent levels which facilitated a precipitous and disastrous economic collapse when such investments failed 3. The consequence was a domino-effect, causing a global financial crisis around the world. Furthermore, this has resulted in severe challenges for public finances in the world. Tax policies might have played an important role in countering this crisis. Thus, the aim of this paper is to analyse and evaluate the role and the position of the taxation of financial institutions in the context of this financial crisis. More precisely, we investigate the role of taxation as contributor to the cause of the crisis and examine whether taxation provides remedies for this, especially focusing on the countries participating in the EUCOTAX Wintercourse In the first chapter, the income tax system of banks is analysed, focusing on the general tax system as well as international proposals and implemented practices concerning crisis measures. Further, the taxation of insurance companies is evaluated, both with regard to direct and indirect taxes. Chapter three describes the taxation of Collective Investment Funds (CIFs) on the corporate level and on the level of the investor, distinguishing between tax exempt CIFs and taxable CIFs. Afterwards the general structure and tax system of Pension Funds (PFs), as well as recent changes and their future viability is explained. Finally, a conclusion is drawn, presenting the outcomes of each chapter and examining the link between global finance and taxation. 1 Viral V. Acharya, and Matthew Richardson Causes of the Financial Crisis. Critical Review 21 (2-3): Id. at Id. at Austria, Belgium, France, Germany, Hungary, Italy, Poland, Spain, Sweden, the Netherlands, United States. 4

40 1. Taxation of banks 1.1. Introduction The financial crisis has led to renewed interest in additional taxation for financial institutions, both from governments and the general public. There have also been intensive debates, especially concerning the tax treatment of banks. This paper endeavors to evaluate the different Corporate Income Tax regimes, concentrating on accounting specificities and the various corporate tax rates. Furthermore, the funding of banks is explained in order to provide an outlook on the functioning of the Basel II and Basel III systems, focusing on the capital adequacy requirements. Afterwards, the different approaches, on a national level, to bank taxation, as well as the international proposals of the IMF and the EU, are analyzed. Crossborder situations are also examined in order to assess the tax treatment of foreign branches of banks with regard to discrimination issues. Another important aspect is the ex ante and ex post deposit guarantee schemes implemented to protect the saving depositor s accounts. To conclude, the VAT treatment of banks applied in the represented countries is considered CIT Comparison Banks, as business companies, are generally subject to the corporate income tax ( CIT ). All the countries taking part in this study are subject to this rule, though there might be some exceptions in some points of the regulations that do not follow generally applicable CIT rules. The corporate Income tax is a direct tax that is levied on corporate income. In the corporate tax regime, there must be a taxable event in order for the corporation to realize income, by whatever source. Some of the present countries do have special articles (provisions) which vary the tax treatment of banks in their respective CITAs, such as France (concerning bad debts), Poland (concerning reserves -risk reserves, bad debts, general reserves) and the United States (has specific rules to charge off bad debts and securities). 5

41 In our study of the comparison of the CIT, it is necessary to distinguish the bank accounting system and the rates applied in the different countries, to understand in a better way the different systems taking part in this Wintercourse BANK ACCOUNTING SYSTEM As with any business entity, the accounting method adopted by a banking institution will have a significant impact on its timing of income and deductions. Concerning this theme, two pertinent questions must be considered: (1) do banks have specific accounting systems or are they subject to commercial accounting rules, and (2) do banks have special tax accounting rules? France, Poland and The Netherlands maintain this distinction between commercial accounting rules and tax accounting rules. This means that two completely different sets of rules exist to determine annual profits. In the Netherlands, profit determination is based on a set of principles that evolved from case law to a full legal system RATES The tax rates that banks are subject to can be classified into two types: Flat Progressive A flat tax rate is one in which the percentage paid as tax stays the same as the amount of income rises. Italy, Austria, France, Poland, Belgium, Germany, Spain and Sweden have implemented this tax rate, each one with different withholding regimes. A progressive tax rate is one in which the tax rate increases as the amount of earned income increases. The Netherlands, Hungary and the United States have implemented this type of tax with their own withholding regimes as well 5. Below we provide two different tables distinguishing the different rates and percentages Flat rate COUNTRY PERCENTAGE AUSTRIA 25% 5 6

42 BELGIUM 33.99% GERMANY 15% + 5.5% + Local taxes 14% FRANCE 33,1/3% ITALY 27,5% POLAND 19% SPAIN 30% SWEDEN 26,3 % Progressive rate COUNTRY PERCENTAGE HUNGARY First 500 Mn HUF of profit 10%, everything more 19% THE NETHERLANDS First of profit 20%, everything more 25% UNITED STATES From 15% to 35% All these dates provided above are updated to March Funding of Banks BASEL II & III When we write of the funding of banks we will only focus on capital adequacy rules. These are basically the same for all participating Wintercourse countries. This is due to the general rules provided by the Bank for International Settlements (BIS) 6. The Basel agreement has been implemented in an EU banking directive (2006/48/EC) and the Capital Adequacy Directive (2006/49/EC). These directives, in some form, have been implemented in national laws. In this paragraph, we will only focus on Basel II and Basel III. The Basel II agreement was the result of the banking crisis in the 1990s. The agreement expanded the depth, technicality and scope of the original Basel I agreement. In Basel II, however, three different pillars can be distinguished; these are; (1) Minimum capital requirements, (2) supervisory 6 Website of BIS, 7

43 review, and (3) market discipline 7. To be more precise we will further focus on pillar 1 (about minimum capital requirements). Capital reserves can be divided into two different tiers. Capital in the first tier, known as Tier 1 Capital, consists of only two types of funds: disclosed cash reserves and other capital paid for by the sale of bank equity, i.e. stock and preferred shares. Tier 2 Capital is somewhat more ambiguously defined. This capital can include reserves created to cover potential loan losses, holdings of subordinated debt, hybrid debt/equity instrument holdings, and potential gains from the sale of assets purchased through the sale of bank stock. Tier 1 and tier 2 capital are decisive for the amount of leverage a bank can have on its balance sheet. All liabilities are formed by tier 1, tier 2 and tier 3 capital; however, tier 3 capital consists of subordinated liabilities. Assets (the active side of the balance sheet) are divided in to several categories. These different categories are weighed by certain risk percentages (a percentage of 0% means no risk; this can be applied to cash). After the corrective weighing has been done, the assets are multiplied using the following formula: Reserves =.08 * Risk Weighted Assets + Operational Risk Reserves + Market Risk Reserves. It can be concluded that tier 1 and 2 capital need to represent at least 8% of the total risk weighted assets. When Basel III is implemented, these requirements will change significantly. The proposed changes provide that tier 1 will then represent %, and tier 1 and tier 2 combined will represent %. The recent Basel III agreement raises the minimum capital requirements for common equity capital from 2% to 4.5% of risk-weighted assets and the Tier 1 ratio from 4% to 6%, effective as of Also, fully effective as of 2019, banks will be required to add a conservation buffer of 2.5 percentage points on the top of common equity and Tier 1 capital ratios 8. Nonetheless, a final proposal has not yet been solidified. Some initial thoughts about the Basel III directive and taxation can be that capital adequacy rules could probably be more effective. Only a substantial change between the treatment of debt and capital for tax purposes could result in a real incentive for banks to change their behavior concerning their amounts of leverage; meaning the ratio between debt and equity. 7 Bryan J. Balin, Basel I, Basel II, and Emerging Markets: A Nontechnical Analysis, The Johns Hopkins University School of Advanced International Studies (SAIS), Washington DC 20036, USA 8 Slovik, P. and B. Cournède (2011), Macroeconomic Impact of Basel III, OECD Economics Department Working Papers, No. 844, OECD Publishing. doi: /5kghwnhkkjs8-en hecksum=03859c388e8dd48f4a1f701bb

44 The categorizing of equity and other liabilities for prudential purposes in tier 1, 2, and 3 is completely different from the distinctions being made for tax purposes. Rules of most countries are completely different but the main features distinguishing debt from equity can be summarized in characteristics concerning: (1) the amount of subordination, (2) profit and loss participation, (3) control and (4) maturity Cross Border Situations The most important point in the perspective of cross border taxation is whether bank levies, which have been implemented in several countries, also apply to foreign branches of banks in those countries. Our initial thought was that the bank levy does not apply to foreign branches. What we found out, however, is that in the Austrian situation the bank levy does apply to foreign branches. 10 The German situation is different however, foreign branches seem prima facie not to qualify. 11 This interpretation of the law is however debatable. 12 This results in a stronger position for foreign banks operating in domestic markets. Thus, a rare situation occurs in which domestic banks are not benefiting from any national ruling, but are actually in a less competitive situation compared to their foreign counterparts. Reasoning from the ratio of a Financial Stability Contribution ( FSC ) it is, however, a logical result that only a domestic bank has to pay the levy since it will only be national banks that will be helped when a crisis occurs. The different treatment is, in our opinion, a strong argument to implement a FSC on a more international scale; e.g. EU or even larger. The problem does, however, still exist that banks will consider moving their activities to a tax friendlier jurisdiction and maintain operating in their home market using a branch. Next to the differences due to the (newly introduced) bank levies, there are no flagrant discriminations between the tax treatment of foreign branches and domestic banks. However, this goes only for as far as it concerns EU situations. For foreign branches within the US regime there are some extra demands. These concern some additional administrative burdens and thresholds. 9 See for instance (from a Dutch perspective): J.A.G. van der Geld,, Hoofdzaken vennootschapsbelasting (fed fiscale studieserie), 6e druk, Kluwer Deventer 2010, p. 77, Sec. 1, Stabilitätsabgabegesetz (Stability Charge Act). 11 Sec. 1, paragraph 1, RStruktFG; sec. 1, para. 1, KWG. 12 Holger Häuselman, Die deutsche Bankenabgabe, DStR, Becklink

45 1.5. Deposit Guarantee Schemes Most European countries have a deposit guarantee scheme. According to the European Commission, the purpose of such a scheme is to reimburse a limited amount of deposits to depositors whose bank has failed. From the depositors' point of view, this protects a part of their wealth from bank failures 13. From a financial stability perspective, this promise prevents depositors from making panic withdrawals from their bank, thereby preventing severe, negative economic consequences. All Wintercourse countries recognize the benefits of a deposit guarantee scheme and possess either en ex-post or an ex-ante deposit system. In most cases these schemes are financed afterwards (ex post) by colleague banks and the (central) government(s). Within the EU, the minimum amount that must be guaranteed for deposit holders is euro 14. Currently there are some developments within the EU to create a unified EU ex ante system concerning the deposit guarantees 15. There are several countries, within the Wintercourse conference and also non-participating countries, which already have an ex ante system. These countries are Belgium, Germany, Sweden, Cyprus and Denmark 16. The effectiveness of the general trend of an ex ante approach is doubtful in some cases. Sometimes levies for an ex ante fund are not added to a special fund, but go directly to government s budgets. In addition some funds that are currently being formed are expected to be far too small when the insolvency of a bank actually occurs. Due to these reasons, the effectiveness of these measures is questionable. The general trend of moving to a more ex ante approach is, according to us, probably due to the fact that governments do not like surprises. This means that when a bank goes bankrupt, an event that is hard to forecast, this results in unexpected costs for a government. Anticipation of these costs using a special fund is generally considered to be better for a country s budget. Forming an ex ante fund opposed to an ex post approach probably does not have a large impact on the general or real economy; from a macroeconomic perspective certain countries will not benefit. Despite of the possible weaknesses of an ex-ante system, the EU approach clearly aims to balance the ex-ante and ex-post systems to guarantee satisfactory funding in case of future 13 Accessed on: This minimum requirement has been agreed upon during the financial crisis (see news message published on the website of the Dutch prudential supervisor 10 October 2008, 15 See a Dutch letter to the Lower House of 15 March 2011 (FM/2011/7132 M). 16 See a letter of the Dutch Government to the Lower House of 3 February 2011 (FM/2011/6316 M). Additional information can be found in the matrix that has been added as an appendix. 10

46 crises. To ensure the safest possible system, a four-stage reform was proposed in the EU proposal on harmonized Deposit Guarantee Schemes 17. The first step highlighted in that proposal is to ensure that the deposit guarantee schemes have 1.5 % of eligible deposits on hand after a transition period of 10 years (this is referred to as the target level ). If these financial means turn out to be insufficient in the event of a bank failure, the second and third steps must be taken. The second level is, in other words, the ex-post system, meaning the possibility of extraordinary contributions of up to 0.5 % of eligible deposits if necessary. Thirdly, the option of a loan applies, meaning that it will be possible to borrow from all other DGSs in the EU through a mutual borrowing facility, which must, if needed, lend to the DGS a maximum of 0.5 % of its eligible deposits. The fourth and final action to be taken is the creation of alternative funding arrangements to avoid exclusive dependence on deposit guarantee schemes Proposals of the EU and the IMF Apart from the general income taxation rules it is important to examine and compare the additional regulations burdening banks. Firstly the proposals of the EU and the IMF will be analyzed in order to have a general overview; then we analyze the details concerning the individual countries. Concerning the proposals of the EU and the IMF, numerous parallels can be drawn. The focal point of discussions is how the financial sector could make a fair and substantial contribution toward paying for any burden associated with government interventions to repair the banking system 18. The proposals providing possible remedies can be divided into the subcategories of a Financial Transaction Tax (FTT), a bank levy, a Financial Stability Contribution (FSC) and a Financial Activities Tax (FAT). The FTT is an option focused on raising substantial revenues by levying a tax burden on each actor on the financial market. Therefore, the proposed FTT targets a wide range of transactions including stock, bonds and derivative transactions 19. An FTT could be an effective tool to reduce speculative and technical trading. However, both the EU Commission and the IMF raise doubts about the implementation of such a tax. One of the main 17 Accessed on: International Monetary Fund. A fair and substantial contribution by the financial sector. 2010, p ibid. p

47 weaknesses mentioned is the burden of an FTT being transferred to the final consumers rather than as often seems to be supposed, earnings in the financial sector 20. Another issue concerns open legal questions, especially with respect to the taxation of currency transactions. The tax would discriminate between all transactions involving countries with different currencies compared to countries with one currency 21. Furthermore, the problem of transactions moving to non-taxed jurisdictions should also be considered. Summarizing the position of the IMF and the EU Commission, the introduction of an FTT is not the best instrument for reaching the goal of fair burden sharing. Furthermore, the possibility of a bank levy was proposed. Unlike conventional taxes, in case of levies the proceeds are usually being used to benefit the payer, or otherwise earmarked for a designated purpose, as opposed to a tax that traditionally goes into the general coffers 22. According to this argument, it logically follows that in case of a bank levy, the funds raised through the collection of levies should be used for the benefit of the industry that is subject to these taxes 23. The option of a bank levy could be used to create a coordinated system of ex ante resolution funds 24. As Member States have already considered introducing such a levy individually, the EU has rightly found the necessity of coordinating these proposals in order to avoid double taxation issues. The central role of such a levy would be to collect funds to cover the cost of financial sector distress 25. Another possibility of levying an extra tax for banks is an FSC. According to the explanation of the IMF, it would mean a levy to pay for the fiscal cost of any future government support to the sector. This could either accumulate in a fund to facilitate the resolution of weak institutions or be paid into general revenue. The FSC would be paid by all financial institutions, initially levied at a flat rate 26. In addition, a FAT seems to be a favored option by the EU and the IMF for the following reasons. Regarding implementation, a FAT is a straightforward option levied on the sum of profits and remuneration of financial institutions 27. Another merit of a FAT would be its 20 ibid p ibid p21 22 Vinod Kalloe, Barry Larking, Richard Iferenta. Bank Levies and Taxes A New Species in the Evolution of Taxation?. Tax Analysts. 2011, p Dániel Deák. Hungary introduces special taxes. Published in European Taxation IBFD. P Vinod Kalloe, Barry Larking, Richard Iferenta. Bank Levies and Taxes A New Species in the Evolution of Taxation?. Tax Analysts. 2011, p ibid 26 International Monetary Fund. A fair and substantial contribution by the financial sector p 5 27 ibid. p

48 variable character, serving multiple purposes. By including the total of remunerations the FAT could be a tax on the value-added. Alternatively, the FAT could be a tax on excess returns in the financial sector, meaning a tax levied on above average profits. Hence, it could mitigate excessive risk-taking 28. Furthermore, in contrast to an FTT, this proposal would eliminate the problem of discrimination and would not directly alter market structures where financial institutions are active, since it taxes profits independently of how profits are earned. Thus it does not differentiate between different products or depend on the turnover. Due to the aforementioned merits, the European Commission actually considers the FAT as the first-best solution 29, if the aim is to reduce economic rents of the financial sector National solutions Yes Hungary Austria France Germany Sweden Belgium Special Bank Tax No Netherlands Italy USA Poland Spain When evaluating the different national systems, it becomes evident that the European region is split concerning the introduction of special crisis levies on the bank sector. Regarding the US, such special taxes targeting banks are included in the regulations of the general Internal Revenue Code. Furthermore, it should be emphasized that from those European countries which have not yet introduced a crisis levy, the Netherlands and Spain adopted a waiting position, therefore only planning to introduce an additional burden for banks if global trends continue in that direction. Poland and Belgium, on the other hand, are already in the phase of proposals discussing the possible introduction of a tax on the banking sector. The last group 28 ibid p European Commission. Monitoring Tax Revenues and Tax Reform in EU member States European Economy 6/2010. p 65 13

49 of the countries without a bank levy is Italy where there have not even been proposals in this respect. This section will now concentrate on the different systems of special bank taxes, analyzing the national solutions of Hungary, Austria, France and Germany. The Hungarian system places significant emphasis to the additional taxation of the financial sector. The reason is connected to the changes in the corporate income and personal income tax schemes, causing a loss in state revenues, filled by these additional burdens. Hence, in Hungary there is a so called special tax and additionally also a profit tax for credit institutions 30. According to the Act 59/2006, financial institutions are obliged to pay a special tax since The scope of this Act only includes credit institutions and insurance companies. However, in 2010, the Act 59/2006 was amended to broaden its scope and so including financial companies, investment companies, the stock market, produce exchange providers, venture capital managing companies, financial intermediaries and investment funds 31. This measure can already be classified as a response to the crisis, having the special temporary nature of a crisis tax, ceasing to be effective on January 1, Concerning banks, the basis of their tax liability is their balance sheet total. According to the amendment, the special tax in question is a progressive tax, meaning that the tax liability of credit institutions is 0.15% up to balance sheet totals of HUF 50 billion. Above this threshold the applied tax rate is 0.5% 33. In addition, the special tax under discussion may be deducted as an expense for corporate income tax purposes 34. In addition, from 2011 a profit tax is introduced by the Hungarian government burdening credit institutions. Therefore, banks will be liable to pay 30% of their profit, the amount of which shall not exceed the value of the aforementioned special tax. Moreover, credit institutions may reduce their special tax liability with the amount of the profit tax. The resulting tax liability is due after any corporate income tax has been paid 35. In contrast, the bank levy in Austria is a stability charge in effect from January 1, The levy is composed of two separate charges. In the first case, banks are taxed on their total 30 59/2006. Act on the special tax to improve the state budget 31 Balázs Bodzási. About the initial concept of the bank tax. Jogi Iránytű p Daniel Deák. Hungary introduces special taxes. Published in European Taxation IBFD. p ibid 34 ibid 35 Dániel Deák. Hungary introduces special taxes. Published in European Taxation IBFD. p See Stabilitätsabgabegesetz (Stability Charge Act) 14

50 assets minus capital stock, equity reserves, insured deposits, and other specific liabilities 37. The second part is a charge on derivatives, meaning that the banks are taxed on the volume of derivatives that were traded 38. Both taxes are calculated from the balance sheets (respectively trading books for the tax on derivatives) of 2010 for the years 2011 to From 2014 forward, they will be based on the data from the previous year 39. Therefore, these taxes are clearly a response to the financial crises, in contrast to Hungary, where an additional burden on banks existed already from Regarding the Hungarian profit tax of credit institutions, however, the parallel can be drawn to Austria and the other jurisdictions, having the purpose of crises management. Concerning the tax rate of the Austrian levies, another parallel can be drawn to Hungary. The charge on total assets is a progressive rate, whereas the charge on derivatives is a flat rate. In France, extra contributions of the banking sector already existed from Hence, like Hungary, the special tax burden on credit institutions is not a new phenomenon. However, the global financial crises made it necessary for France, as well, to impose an additional tax on banks called the Taxe systémique. This levy targets the banks sector through a flat rate of 0.25%, effective from Therefore, again it seems apparent that an additional levy was needed in order to compensate the state assistance given to the financial sector during the global credit crunch. In contrast to the French compensatory reasons, a bank levy was introduced in Germany in order to create a buffer for the future bailout of the financial sector. Thus, the proceeds of the bank levy are paid to a so called restructuring fund, imposed at a flat rate, from 2011 forward. Similarly to Austria, the additional tax is a systemic risk-adjusted levy and a new resolution arrangement for banks and banking groups. The fund and the special resolution regime will be entrusted to the Federal Agency for Financial-Market Stabilization (FMSA). The FMSA was created in 2008 to manage the recapitalization and restructuring of failing financial institutions during the financial crisis 40. In contrast, the revenues of Hungary and France are simply paid to enhance the general state budget. Hence, it can be debated whether the proceeds will be used to benefit the financial sector or just for other budgetary purposes. 37 See Sec. 2 Stabilitätsabgabegesetz (Stability Charge Act) 38 See Sec. 4(2) Stabilitätsabgabegesetz (Stability Charge Act). 39 Sec. 2(1) Stabilitätsabgabegesetz (Stability Charge Act) for the charge on total assets and Sec. 4(2) Stabilitätsabgabegesetz (Stability Charge Act) for the charge on derivatives. 40 International Monetary Fund. A fair and substantial contribution by the financial sector p

51 All in all, the analysis above indicated two major trends in the additional taxation of credit institutions. Either the levies have the purpose of generating surplus revenue for the state budget, or they are paid to a separate fund to prepare for future crises situations. Country Tax base Tax rate 1 Belgium Secured deposits 0,15% of the deposits 2 Germany 1. Liabilities without equity and secured deposits. 1. Progressive rate for the liabilities: 2. Derivatives (for their nominal 0,02% on liabilities up to value) 10 billion 0,03% on liabilities from 10 billion up to 100 billion 0,04% above 100 billion 2. Flat rate for derivatives of 0,00015% Beware that the bank levies may not exceed 15% of the annual profits after taxes. 3 France Risk weighed assets (Basel II) 0,25% of the capital adequacy ratio 4 Hungary Liabilities without loans between 0,15% up to 50 billion financial institutions HUF 0,5% above 50 billion HUF 5 Austria 1. Non-consolidated total assets, without equity, secured deposits, and certain loans between financial institutions. 2. Financial derivatives 1. 0,0% up to 1 billion 0,055% from 1 billion up to 20 billion 0,085% from 20 billion 2. 0,015% of the volume of all financial derivatives 16

52 6 Sweden Liabilities without outstanding shares, bonds, internal loans between a group of companies that form the bank, and finally the debts outstanding to the Swedish government because of stateaid the rate is 0,018% From 2011 the rate is 0,036% The above table provides a summary of the implemented taxes due to the financial crisis. The aim of these measures can be summarized as retributive and corrective taxes. In our opinion, the aim of these taxes can be categorized in three different categories: - Taxation aiming to form a stabilization fund to pay for the impact of the financial crisis. - Taxation trying to alter behavior of financial institutions and making debt financing less attractive. The aim could be summarized as reducing negative externalities of an imperfect market. The market can be considered imperfect because risks are not priced the right way. - Taxation (bluntly) aiming for higher revenues for governments. All taxes can be considered to be variations of Financial Stability Contributions. The progressive rate seems to connect to the amount of systemic risk a financial institution poses. However, the proposals differ on a few main dimensions and depend on certain functioning parts 41 : - Is the base formed by uninsured liabilities, or are insured (secured) deposits also included. The use of insured liabilities provides a disincentive for banks to fund risky lending. - Another issue we looked at is whether the rate is progressive or flat. If a rate is progressive a higher amount of leverage on a bank s balance sheet becomes less attractive. - In our opinion an additional interesting point is the interaction with mandatory regulated capital. Unnecessary accumulation of several measures, Basel III, and taxes should not occur uncoordinated. Basel negotiations or tax negotiations should include economics, tax experts and prudential regulators. One of the topics that has been mentioned, but is not emphasized, is the competitive disadvantages of regulations and taxes. Western (US and European) banks could slowly start 41 See also: Douglas A. Shackelford, Daniel Shaviro, Joel B. Slemrod, Taxation and the financial sector, June 2010, New York University of law, public law & legal theory research paper series working paper no , p

53 shifting their main activities to Asian countries that might be less regulated. One could expect that only severe exit taxes will prevent this from happening VAT VAT means Value Added Tax and is an aiming to tax consumers. This tax is based on an EU directive (2006/112/EC). Banks are liable to VAT since they are commercial companies. However banking activities have been exempted in almost all participating Wintercourse countries. It is the case in the Netherlands, Hungary, Italy, Austria, Poland, Spain, Germany, Belgium, France and Sweden. A VAT or a similar federal tax does not exist in the USA. On a state level a sales tax can be found but this tax usually does not apply on intangible good or services. Therefore the USA does not have to deal with any VAT issues. The exemption of banks could however be nuanced in certain aspects. Certain activities are VAT liable. E.g. if a merchant bank does any underwriting activities, such activities are not included in the exempted activities of banks. The same applies for non-typical banking services or goods that a bank provides. In general, however, banking activities have been exempt. Beware that an exemption also results in non-deductibility of VAT costs. This can result in complex VAT schemes where banks purchase certain goods that can be used in the whole group using a foreign subsidiary Conclusions The first issue we attended was the general taxation of banks. However Every country uses their general Corporate Income Taxation Act and none of the participating Wintercourse countries considers the specialized functions of banks to be enough reason to provide a specific system of profit determination or a special Bank Tax Act. Some countries do, however, have special provisions concerning banks which are not crisis related. Some of these provisions have been changed due to the financial crisis, e.g. the possibilities to write off bad debts have been broadened. This usually fits in more elaborate tax programs/ tax measurements that have been implemented due to the financial crisis. 18

54 The funding of banks, and more specifically the capital adequacy rules, can be found in the Basel directive for all participating Wintercourse countries. We were not able, from a tax perspective, to judge the necessity of the new Basel III directive. If, however, banks were able to circumvent or evade the requirements and scope of the Basel II directive then, we concluded, it should result in a new directive. As the analysis of the various deposit guarantee schemes has shown, there is a trend emerging among the represented Wintercourse countries, fixing the proportions of ex-ante and ex-post bank contribution. This is mainly because bank failures are unpredictable and the best future results likely if countries contribute to DGS in advance. Hence, there can be a shift observed from setting up deposit guarantee funds in advance, contrasting the previous approach of expost systems. VAT has little or no connection to the financial crisis. We did however draw the conclusion that the ratio to exempt banking activities from paying VAT is really meager. There is no real necessity for consumers not to pay VAT for banking services. On the other hand, we would not advise anyone to implement VAT for banking activities because there is already, in our opinion, a looming possibility that additional taxation costs will be directed to the consumers by charging higher fees or asking for higher interests on loans. Our final conclusion is twofold. First, due to the developments in separate (member) states of introducing a specific bank levy, it would be best, from a competitive perspective, that a levy for banks should be of systemic importance and be implemented on a global or at least EU level. The second conclusion concerns unnecessary accumulation of different measures. The implementation of Basel III should be coordinated with bank levies. In the aftermath of the economic and financial crisis banks have to deal with additional prudential demands (Basel III), bank levies, changes in the deposit guarantee schemes and finally bonus taxes. 19

55 2. Taxation of insurance Companies 2.1. Introduction Insurance companies assume an important role in our economy as they help to spread the risk of individual persons or companies among larger group. For the functioning of this system, it is necessary that sufficient funds are accumulated by the insurance companies so that all claims can be satisfied, even in the case of an exceptionally high number of insured events. However, insurance companies are not only considered to be important financial institutions because of their central function and the public trust that is necessary for the assumption of this role, but also because of the large amounts of funds collected, managed, invested, and distributed by them. It is evident that the role of banks in the recent financial crisis has been more pronounced than that of insurance companies. Nevertheless, it cannot be denied that insurance companies have also been involved and exposed to the crisis, especially in the fields of credit insurance and reinsurance, as in the case of AIG. Consequently, it is also necessary to examine the taxation of insurance companies in more detail, especially with regard to its relation to the financial crisis The taxation of the income of insurance companies in general The insurance supervision laws of all countries treated in this paper normally require insurance companies to be established in certain legal forms. Usually, they have to be incorporated as separate legal entities under corporate law, with the most prevalent forms being joint-stock companies and mutual insurance companies 42. This principle is reflected in the first Non-Life Insurance Directive 43 as amended by the third Non-Life Insurance 42 See, for example, Austria: Sec. 3 (1) Versicherungsaufsichtsgesetz (Insurance Supervision Act); Art. 9, 1 wet betreffende de controle der verzekeringsondernemingen, 9 juli 1975; Germany: sec. 7 para. 1 VAG; Hungary: 60/2003. Act on Insurance Companies and Insurance activities; Poland: Act of 22 May 2003 on Insurance Activity (JoL No. 124, item 1151, as amended) ( Insurance Activity Act ); in the United States, the states have the legislative power for insurance supervision laws. However, also the states supervision laws generally require insurance companies to be incorporated. 43 First Council Directive 73/239/EEC of 24 July 1973 on the coordination of laws, regulations and administrative provisions relating to the taking-up and pursuit of the business of direct insurance other than life assurance [Art 8.(1)]. 20

56 Directive 44, the Life Insurance Directive 45 and the Reinsurance Directive 46. Most of the legal forms prescribed by these directives are separate legal entities. As a result, insurance companies are generally subject to corporate income tax in all 11 Wintercourse countries. While, in principle, the determination of taxable income based on the same rules as for other companies, specific regulations for insurance companies exist in most nations. Foremost, there often are specific accounting rules for insurance companies which are part of insurance supervision law and become relevant for tax purposes in countries where the tax accounting is based on commercial accounting 47. In some cases, the special accounting rules are accompanied by special regulations in the CITA. Then again, in other countries, where tax accounting is independent from commercial accounting, all special rules are set down in the CITA or a special rule in the CITA provides for the relevance of a certain other law, such as in Poland 48. In particular, it is worth mentioning that in Italy, the International Financial Reporting Standards (IFRS and IAS) are used to determine the taxable income of insurance companies 49. Only in the United States, however, is there is a completely different set of rules for the determination of the corporate income tax base which is provided in the Internal Revenue Code Insurance technical provisions Arguably, the most important special accounting rules for insurance companies in most countries concern insurance technical provisions 51, which are also recognized by the 44 Council Directive 92/49/EEC of 18 June 1992 on the coordination of laws, regulations and administrative provisions relating to direct insurance other than life assurance and amending Directives 73/239/EEC and 88/357/EEC (third non-life insurance Directive)[Art. 6(1)(a)]. 45 Directive 2005/68/EC of the European Parliament and of the Council of 16 November 2005 on reinsurance and amending Council Directives 73/239/EEC, 92/49/EEC as well as Directives 98/78/EC and 2002/83/EC [Art 6(1)(a)]. 46 Directive 2005/68/EC of the European Parliament and of the Council of 16 November 2005 on reinsurance and amending Council Directives 73/239/EEC, 92/49/EEC as well as Directives 98/78/EC and 2002/83/EC [Art. 5(1) in conjunction with Annex I]. 47 E.g. Austria: Secs. 81i et seq. Insurance Supervision Act, Germany ( ), 48 Act of 15 February 1992 on Corporate Income Tax (consolidated version: Journal of Laws of 2000, No. 54 item 654, as amended). 49 In Italy, the International Financial Reporting Standards are generally relevant for the determination of the taxable income of financial institutions, but not for the taxation of other businesses. 50 United States: Subchapter L Internal Revenue Code (IRC) 51 Insurance technical provisions are also known as technical provisions, technical reserves, actuarial reserves or just reserves. The term technical provisions, as it is also used in a European context (see, for example, Art 23 et seq. Insurance Accounting Directive 91/674/EEC or Art 30(c) CCCTB-proposal.), reflects 21

57 Insurance Accounting Directive 52. These are amounts treated as liabilities which may include items that would normally be characterized as provisions, reserves, deferred income or as accounts payable. Due to the income first nature of the insurance business 53, they are set aside so that sufficient funds are retained in the company and all justified current and future insurance claims can be satisfied 54. Important technical provisions also provide for unearned premiums, life/health insurance provisions, provisions for claims outstanding and equalization reserves. Provisions for unearned premiums are established for premiums that are received for future time periods and basically constitute deferred income. Life/health insurance provisions basically provide for the increase in risk that is associated with life or health insurance policies when the insured persons become older. Provisions for claims outstanding are generally established in order to provide for uncertain insurance claims for insured events that already have occurred. Finally, equalization reserves are established to adjust unusually largely varying amounts of insurance claims caused by extraordinary events (e.g. natural disasters). Most rules regarding technical provisions simply adapt the general rules for the establishment of provisions in order to accommodate special necessities of the insurance business. The tax deductibility of the allocations to these provisions (i.e. the increase of the provisions), and therefore also the taxation of the release (i.e. the decrease) of the provisions is also generally ensured by the tax laws of all treated countries. If there are additional conditions for tax deductibility, they usually only require that the provisions have to be calculated according to actuarial methods, by a special actuary, or according to the methods as laid down in the insurance accounting or supervision laws 55. However, restrictions to the recognition of income for tax purposes may apply to equalization reserves. In Austria, for example, Sec. 15(2) CITA restricts the deductibility of allocations to these reserves to 50 percent of the actual allocation 56. A reason for this special treatment can be found in the fact that equalization reserves also provide for general business risks by giving insurance companies the possibility to lower the income in years with less insurance claims and by releasing the allocated funds in years where no or fewer profits are made due the facts that they are treated as liabilities, that they are caused by special characteristics of the insurance business, and that they are often calculated according to special methods. 52 Council Directive 91/674/EEC of 19 December 1991 on the annual accounts and consolidated accounts of insurance undertakings (Art. 6 and Art. 23 et seq.) 53 Emanuel Burstein, Federal Income Taxation of Insurance Companies, Ch This usually is further ensured by regulatory rules which require that technical provisions are covered by adequate assets. See, for example, 55 See, for example, 56 22

58 to higher amounts of claims. Outside of the insurance industry, such provisions for general business risks can normally not be deducted at all. The current legal situation in the tax treatment of technical provisions in the countries which have been examined is also reflected on a European level in the proposal for the Common Consolidated Corporate Tax Base (CCCTB). According to Art 30(c) of the CCCTB-Proposal, technical provisions of insurance undertakings established in compliance with the Insurance Accounting Directive are recognized for tax purposes. Exempt from this rule are equalization provisions, for which the decision about the recognition of the deductibility of allocations lies with the individual member states Income taxation in cross-border situations With regard to international activities, it is worth mentioning that between EEA countries, insurance companies are entitled to directly provide insurance in other member states through the freedom to provide services. Consequently, they can derive income from the conclusion of insurance contracts from other member states without being subject to taxation in these states because of the existence of a permanent establishment. While this does not constitute a difference to the treatment of other businesses in the EEA, insurance companies from third states are normally obliged to operate through a branch if they conduct business in an EEA member state. Therefore, they will generally be subject to taxation with their income from this country, as the branch will normally constitute a permanent establishment according to national tax laws and the OECD-Model Convention 57. Apart from this consideration, insurance companies generally do not face tax treatment different than other businesses operating internationally. One specific tax rule for insurance companies the United States, however, should be mentioned. It only applies when US insurance companies operate in the Canadian or the Mexican market and carry on their business in these countries through a local branch. According to this special rule, such branches will be treated as a separate legal entity for purposes of the US corporate income tax. Thus, profits of the respective branches will only be taxed in the US when they are repatriated. In contrast, other businesses operating through branches in these countries will be immediately subject to corporate income tax when the profits are earned abroad. 57 Art. 7(1)OECD-Model Convention in conjunction with Art. 5(2)(b) OECD-Model Convention. 23

59 2.5. Financial Stability Charge Only in France are insurance companies subject to the Financial Stability Charge, which was introduced as a reaction to the crisis Special Taxes Most Countries of the European Union do not have a special tax for insurance companies. Belgium has an annual special tax on insurances companies, which is similar to the annual tax for banks 59. The tax base for those insurance companies recognized by the National Council of Cooperative is the exempt dividends divided by the total distributed dividends of the preceding fiscal year. The tax base for those insurance companies offering life insurance that are linked to investment funds include the total provisions. The tax rate is 0.07 percent. In Sweden insurance companies are subject to the yield on the Pensions Means Act 60. The tax base is the amount of capital foundation multiplied with the average state loan interest. The capital foundation consists of the life insurance companies assets after deductions have been made for financial debts. The tax rate is 15 percent. These taxes have been established before the crisis and have no changes have been made during or after it Guarantee Schemes Only a few Member States of the European Union have insurance guarantee schemes. While there have been proposals for regulation on a European level, the lack of community harmonization in this area may hinder effective and equal consumer protection. This may lead to a loss of consumer confidence in the relevant markets and may ultimately put market stability at risk. It may also impede the functioning of the internal insurance market by distorting cross-border competition. 58 See Chapter Art. 2 para. 1 wet betreffende de controle der verzekeringsondernemingen, 9th of Jule 1975; See Chapter Lag (1990:661) om avkastningsskatt på pensionsmedel. 24

60 Germany and Poland have guarantee funds, which are financed by a special levy 61. In Poland the levy base is the accrued gross premium received as remuneration for certain types of compulsory insurance, while the levy rate depends on the financial needs of the fund. In Germany the levy base is the amount technical provisions of insurance companies and the rate is 0.02 percent. Since 2010, the funds are completely filled because the capitalization of the funds is 0.1 percent of the total technical provisions of all insurance companies Taxation on benefits from life insurances The taxation of benefits of life insurance companies is treated differently in the many states participating at the Wintercourse. While Belgium, Germany, Hungary, Italy, Poland and Spain, in principle, treat life insurance benefits as personal income and therefore tax such benefits, other countries do not characterize the benefits from life insurance as personal income or simply exempt them from taxation. There is no connection between the crisis and the tax treatment of benefits from life insurances Value Added Tax Generally, insurance companies are subject to Value Added Tax, but according to the European Union Directive 2006/112/EC Chapter 3, Article 135 para. 1 (a) Member States of the European Union shall exempt insurance and reinsurance transactions, including related services performed by insurance brokers and insurance agents from Value Added Tax. This exemption is included in the national law of all participating countries 62. In the United States of America there is no Value Added Tax or other federal indirect tax. 61 Germany: sec. 124 ff. Versicherungsaufsichtsgesetz; Poland: Act of 22 May 2003 on Compulsory Insurance, Insurance Guarantee Fund and Polish Bureau of Transport Insurance (JoL No. 124, item 1152 as amended). 62 E.g. Austria: sec. 6 para. 1 (9c) Umsatzsteuergesetz; Belgium: art. 44 para. 3,4 Belgian VAT Code; Germany: sec. 4 no. 8 Umsatzsteuergesetz; The Netherlands: art. 11 Wet op de omzetbelasting. 25

61 2.10. Insurance Premium Tax Currently 21 of the 27 EU member states operate Insurance Premium Tax regimes. In the participating countries, Insurance Premium Taxes are included in the tax system of Austria, Belgium, France, Germany, Hungary, Italy and the Netherlands 63. Some of the taxes (e.g. in Austria, Germany and The Netherlands) are charged directly on the premiums or contributions like a Value Added Tax. Other Insurance Premium Taxes (e.g. in Belgium and France) are charged annually. All of the Insurance Taxes have a diversified tax rate, which is used for steering and depends on the type of insurance. In the different countries, the Insurance Tax Rates vary between 0,02 and 21.5 percent depending on the type of insurance. However, some insurance types are exempted from Insurance Tax (e.g. health insurance in Germany or reinsurance agreements in Belgium). From an overall perspective, it can be said that the Insurance Premium Taxes in most countries are more diversified Value Added Tax substitutes, but they do not appear to have a connection with the financial and economic crisis Evaluation and conclusions The examination of the system of the taxation of insurance companies reveals different results depending on which taxes are considered. More extensive special regimes with regard to the taxation of insurance companies income can only be found in the United States, where the determination of taxable income is regulated separately from that of other companies, and in Italy, where it is based on IFRS/IAS. Apart from that, the most specific rules concern the recognition of insurance technical provisions for tax purposes. The recognition for the determination of taxable income, which exists in all Wintercourse countries, is necessary to ensure that the main objective of insurance technical provisions, namely to accumulate sufficient funds in the companies accounts for the satisfaction of all current and future claims. If countries did not 63 E.g. Austria: Versicherungsteuer; France: Taxe sur les contracts d assurance; Germany: Versicherungsteuer; The Netherlands: Assurantiebelasting. 26

62 provide for the deductibility of allocations to these provisions, funds that were to remain in the company to cover future insurance claims would be taxed as part of company income and partially lost. In countries where tax accounting rules are based on commercial accounting rules, the deductibility of allocations to technical provisions also ensures that these provisions are established in sufficiently high amounts. This is due to the fact that insurance companies can reduce their taxable income and subsequently their tax burden by establishing technical provisions, whereas otherwise, they would most likely try to allocate as little funds to them as possible. Thus, the recognition of insurance technical provisions for tax purposes generally helps to improve the financial situation of insurance companies and thereby supports the objectives of insurance supervision law. Consequently, this special rule may also have contributed to reduce the crisis effects on insurance companies. With regard to international tax issues, only the obligation for third-country insurance companies to establish branches and thus PEs for operations in the EEA can be mentioned. Only some countries levy special taxes directly upon insurance companies. In this regard, France stands out as the only Wintercourse country where not only banks, but also insurance companies are subject to a financial stability charge. While there clearly are differences between banks and insurance companies, they both have a very important role in the economy. Other countries could therefore consider the French example and treat banks and insurance companies equally, especially in view of the ongoing convergence of the functions of financial institutions. However, retributive taxation of insurance companies will most likely not be justified to the same extent as for banks, because insurance companies involvement in the crisis, their systemic risk and their need for financial support, have been considerably inferior. For a complete evaluation of the taxation of insurance companies, indirect taxes also have been treated in this chapter, but no connection between taxation to the crisis could be found. With regard to VAT law in Wintercourse counties, no special observations can be made. In those countries which are EU members, the VAT Directive with its exemption for insurance services is implemented, and in the US, no VAT is levied. In contrast, most EU members levy a tax on insurance premiums, which can be seen as a comparable the VAT exemption. As a conclusion of the deliberations made, it can be said that although there are several specific tax regimes and rules for insurance companies, a strong connection to the crisis cannot be established in most countries. If there were any effects at all, the special tax rules slightly helped insurance companies to endure the consequences of the crisis. Now, in the aftermath of the crisis, it could be contemplated to subject insurance companies to similar 27

63 regimes and rules that have been implemented for banks. However, when such proposals are made, it has to be taken into consideration that the role and the necessities of insurance companies before and after the crisis are substantially different than those of banks. 28

64 3. Taxation of Collective Investment Funds 3.1. Introduction: legal form A Collective Investment Fund (CIF) is a collective securities portfolio controlled by an organism instead of a number of private investors 64. Those investors deposit their money into a fund or entity in order to invest their capital in joint deposits, shares, bonds or other investment products. The greatest advantage for the investor is the wide spread of risk. Investment funds, more distributive in nature, typically release revenues by means of coupons 65. However, investment funds with a capitalization focus reinvest the earned income once again. There are many different type of CIFs. Belgium, for instance, distinguishes between mutual investment funds and investment companies. At first, a mutual investment fund 66 (contractually) is a legal joint ownership, managed by a management company on behalf of the participants. It does not have legal personality and therefore, it is tax transparent. The second type includes investment companies 67 (statutory) that possess legal personality 68. This category includes many types of investment companies such as open-end investment companies (BEVEKs/SICAV 69 ) and the closed-end investment companies (e.g. BEVAK/SICAF 70 ). This distinction is not uniform in all countries; however, there are some similarities. German CIFs, for example, are also transparent, but those funds are called special purpose funds 71. In Sweden, they differ between mutual funds and special funds, which do not have a legal entity 72. In Hungary, only open-end and closed-end investment companies apply such 64 C. VAN HULLE, Bank- en financiewezen, II dln., Leuven, Acco, 2007, K.S. & L.V., Beleggen in fondsen, Also see art. 2, 2, 5 bis ITC. 67 Also see art. 2, 2, 5, f ITC. 68 Law of 4 December 1990, B.S ; especially in book III of this law: The institutions of Collective Investment, formerly called beurswet. 69 BEVEK = Beleggingsvennootschap met Veranderlijk Kapitaal = SICAV = Société d Investissement A Capital Variable; Art. 14 wet van 20 juli 2004 betreffende bepaalde vormen van collectief beheer van beleggingsportefeuilles. 70 BEVAK = Beleggingsvennootschap met Vast Kapitaal = SICAF = Société d investissement a Capital Fixe; Art. 19 wet van 20 juli 2004 betreffende bepaalde vormen van collectief beheer van beleggingsportefeuilles. 71 Sec. 1 & 11 InvStG (German Financial Investment Tax Act). 72 4:1 Swedish Investment Fund Act. 29

65 distinctions. The form of SICAV is recognized in France, Italy 73 and Spain 74. Finally, the CIFs in the United States are different as they are bank-administered trusts Taxation Collective investment funds may be divided into two different categories. The first category constitutes those funds that are tax exempt (through specific provisions in the tax act) and funds based upon the transparency, whereas the second comprises funds that are taxable, but nevertheless in practice do not pay (much) tax. Furthermore, the taxation of tax exempt funds and taxable funds may be levied on two different levels: on the level of the fund and on the level of the investor PRINCIPLE OF TRANSPARENCY Investment funds income taxation is, in many countries, based upon the principle of transparency. The content of the principle is that the investors are being subject to tax the same way as if they would invest directly, while the funds themselves are exempt from taxation. While the income is determined on the level of the fund, the tax is charged on the level of the investor. In principle, this means that the fund will not be subject to taxation; instead the investor will be exposed to tax TAXATION ON CORPORATE LEVEL Tax exempt CIFs / tax transparent As mentioned before, many countries have not exposed the CIFs to tax. Actually, it is quite common that the CIFs are tax exempt due to specific provisions within their respective tax act. Germany, for example, applies a form of taxation that is based upon the principle of transparency. First, the income is determined and pre-taxed on the level of the fund according to the rules of the InvG 76 and the InvStG 77. Then the investment funds, themselves, are 73 Article 1, letter m) of the Legistlative Decree n. 58, 1998 (TUF, Consolidated Law on Financial intermediation). 74 Law 35/2003 and RD 1309/ Collective Investment Funds, Comptroller s Handbook (October 2005) p. 1; 12 CFR Investmentgesetz; German Financial Investment Law. 30

66 subject to taxation. However, at a later stage, the investment funds are actually exempt from tax 78. A similar tax regime is applicable in Poland. Investment funds are considered to constitute legal persons, and they are therefore subject to the Corporate Income Tax Act 79. However, due to a specific provision within the CIT Act they are exempted from income tax 80. Similarly, Austria has exempted the fund itself from taxation by treating it as transparent, and the Netherlands have different types of CIFs, but some follow the same pattern to tax exemption. Even the United States have exempted their CIFs from taxation. Now that it is established that many countries actually exempt the CIFs from taxation, the question arises- what justifies this tax exemption? In Poland, the exemption has been justified by the limitation of activity. The reason is that the fund is a way of making a profit for individuals on capital. An alternative approach would be if the individual would acquire securities on the capital market on his own. From an economic perspective it could be said that the fund does not make the investment or the profit for the fund itself, but for the investors. Taxation of the fund, which shall be shared between the investors, occurs at the level of the investors. If the income of the fund would not be exempted, there would exist some form of double taxation on the income earned by investors, which would result in a situation where the same income would be subject to tax twice with the same tax subjects (in practice). This would hinder investment activity Taxable CIFs In some countries Collective Investment Funds are theoretically exposed to taxation. However, in practice they either do not pay any tax at all tax due to a zero tax base, profit or tax rate; or they only pay tax on a very limited tax base. Different countries have chosen different approaches to achieve this aim. At first, Belgian recognized that investment companies 81 are subject to corporate taxation 82. Nevertheless, to remain competitive against similar foreign investment companies, the Belgian legislature decided to reduce the tax base of CIF profits significantly and to 77 Investmentsteuergesetz, German Financial Investment Tax Law. 78 (KSt and the GewSt). Ssec. 11 para. 1 (2) InvStG (Investmentsteuergesetz, Investment Taxation Code). 79 Art of the CIT Act and 4. 1 of the OECD. 80 Art of the CIT Act 81 In accordance with the wet van 20 juli 2004 betreffende bepaalde vormen van collectief beheer van beleggingsportefeuilles. 82 Art. 179 ITC. 31

67 implement a special tax regime 83 in art. 185bis ITC. Investment companies are, therefore, only taxable on two elements. Firstly, they are taxable on their received abnormal and favourable advantages 84, e.g. fines 85 and restaurant expenses 86. Secondly, the disallowed expenses are a part of the limited tax base as well: expenses and costs, other than devaluation and losses on shares 87, which are not deductible as professional expenses 88. So, investment companies are not taxed on the company profit they distribute or reserve. In Sweden, collective investment funds are subject to some special forms of taxation. First and foremost, capital gains are not subject to taxation and capital loss is not deductible when it is assignable to a partnership authority described in 48:2 ITA 89. Instead of accounting for the capital gains, the fund shall report a template amount corresponding to 1,5 percent of the value on the assets maintained in the beginning of the fiscal year (market value) 90. In addition, the dividends and interest that the fund receives during the year is also added to the profit calculation. This profit is then subject to a tax rate of 30 percent. However, the fund can deduct the amount that the shareholders receive from the fund as dividend 91. The main purpose of the applicable tax rules is to avoid taxation on income assignable to dividends and interest if the income is in turn handed out to the shareholders. Therefore, Swedish CIFs will not be subject to taxation since they will simply redistribute their profit to the shareholder; thereby, they can deduct the dividend that has been distributed and their profit will be zero. Consequently, no taxation will occur within the fund and this way double taxation is avoided. A CIF simply passes the tax burden to the shareholders. Furthermore, the Netherlands apply two different regimes. As discussed previously, one is a total exemption regime. The second does not apply an exemption but instead the tax rate is 0% if the profits are distributed. Thereby, the same aim is achieved. In Spain, the CIFs are semi-transparent, meaning that they will not pay any tax but are still subject to similar 83 K. SCHELLEKENS, Beleggingsvennootschappen naar Belgisch en Luxemburgs recht (BEVEK, BEVAK, SICAV en SICAF), Gent, Larcier, 2002, 11-13; L. TAILLEU, D. GEERTS, Practicum Inkomstenbelasting: Vennootschapsbelasting, Antwerpen, Standaard Uitgeverij, 2009, See art. 26, art. 79 and art. 207 ITC. 85 Art. 53, 6 ITC. 86 Art. 53, 8 bis ITC. 87 This exclusion is inserted by art. 32, 2 wet 28 december 1992 houdende fiscale, financiële en diverse bepalingen (B.S. 31 December 1992), and is entered into force as from fiscal year For investment companies that do the accounting per calendar year, this operation has converged with art. 3 law 23 October 1991, that has implemented the non-deduction of decreases in value and devaluation on shares. 88 According to the Minister of Finance, the corporate taxation also belongs to those expenses: Parl. Vr. nr. 631, 31 Januari 2005, Vr. en Antw., Kamer, , nr , 21889, discussed by M. De Munter, in Fiscoloog, ed. 1025, 3 May 2006, :14 dot 1 ITA :14 dot 2 ITA :14 dot 1 ITA. 32

68 provisions. The taxation of SICAVs, for example, depends on its number of shareholders. If there are less than 100 shareholders, they are subject to 30%. If there are more than 100 shareholders, they are subject to 1% TAXATION ON INVESTOR LEVEL The topic whether the investors should be subject to tax is closely connected to the taxation of the fund itself. Therefore, the determination of how CIFs are taxed in the different countries is essential for the taxation of CIF investors. In order to provide an overview of the international system, the taxation schemes will be divided into two different categories. Since the taxation of the investors depends upon the taxation of the fund, the categories will be divided into the taxation of the shareholders in countries where the CIF is tax-exempt, and also into the taxation of shareholders where the CIF is taxable Tax exempt CIFs / tax transparent Since a number of CIFs are tax-exempt, the question arises who should then be subject to taxation. Should the investors be exposed to taxation or should the CIFs and its subjects be completely exempted from tax? As a natural consequence of fund tax exemption in some countries, the tax burden is simply passed over to the investors when the shareholders receive payment from the fund. In Germany, for instance, the investment funds income taxation is based upon the principle of transparency. Therefore the investors are to be taxed as if they would invest directly, while the funds themselves are exempt from taxation. The income is taxed on the level of the investor according to the tax rules for private investors, professional investors (Private Income Tax) or institutional investors (Corporate Income Tax and Trade Tax). Consequently, the tax is charged on the level of the investor and the funds themselves are not subject to a withholding tax on capital income. A similar tax regime exists in Poland. Just as in Germany, the fund constitutes a legal entity and is tax exempt. Revenues gained by legal persons from the investment funds are taxed in accordance with the basic rules of the Polish corporate income tax system. Revenues gained by natural persons from the investment funds are defined as the revenues from money 33

69 capital 92. Tax deductible costs are regulated in the same way as in the Corporate Income Tax Act 93. The incomes earned are subject to the lump-sum tax with a tax rate of 19%. 94 Also, in Austria the fund is tax transparent leaving the investors subject to regular capital taxation. Similarly, the funds in Hungary follow the same principle of transparency. Consequently the investors are subject to taxation. If the investor is a legal entity, the normal corporate taxation will be applicable, whereas if the shareholder is a physical person, the normal personal income tax will apply. Basically, what is worth mentioning is that investors are generally subject to ordinary taxation according to the different countries tax schemes Taxable CIFs However, not all CIFs are tax exempt. In some countries they are taxable, even though in practice they mostly do not have to pay tax. It is interesting to examine how the taxation is carried out on the investor level in such cases. In Sweden, for instance, the shareholders are subject to regular taxation concerning dividends and capital gains. For physical entities, this means that they will be taxed on capital income according to the Income Tax Act. Capital income is subject to a tax rate on 30 percent. There are some minor differences when the shareholder is considered a legal entity. First and foremost, all income within a legal entity is considered as income from business activity 95. Also, they are exposed to tax rate of 26,3 percent 96. The capital gain is considered to have been realized when the share is disposed of, and the share is considered disposed of when it is sold, traded etc 97. If a CIF is dissolved, then all shares are considered to be disposed of from a fiscal perspective. In Italy, the taxation of the investors is carried out a bit differently. Investors in open-funds and closed-funds are exempted from the taxable income under the condition that the profit received is not considered as being part of an exercised business activity. If such income is from a business activity, the profit of the investment will be part of the taxable income. Investors are also subject to withholding tax, which is deducted at source for every investor. 92 Art of the Personal Income Tax Act (Poland). 93 Art and art e of the Personal IncomeTax Act (Poland). 94 Art. 30a. 1 of the PIT Act. 95 1:3 par 2 Income Tax Act (Sweden) :7 Income Tax Act (Sweden) :3 ITA (Sweden). 34

70 However, there exists an exemption for individual entrepreneurs who are connected to the commercial business. In Spain the tax regime is built upon the same way of reasoning. The tax system that exists can be called semi-transparent, and as a consequence, the investors will be subject to regular income taxation when they receive money from the fund. The Netherlands have a quite complex structure where the funds are divided into different categories resulting in different types of taxes. What basically can be said is that the investors are subject to withholding tax due to the income received from some types of funds; however they may also be subject to income tax. Nevertheless, if the fund is subject to both types of taxes, the investors can deduct the tax paid for withholding when paying the income tax Discussion There are many differences between the regulations concerning CIFs. One interesting aspect is that CIFs in some countries are divided into a fund and a management company. The fund may then be tax transparent contrary to the management company that is subject to taxation. That is the case in Poland, where 19% tax is paid upon the profits. Also, the tax regime in Hungary follows similar regulations. In Hungary, the management companies are taxed at the normal Hungarian corporate income tax rate on received contributions. An exception to those countries is Italy, as not only are mutual funds taxable but the management company as well. That is to say, the Italian mutual funds pay 12,50% tax on their income. The management company applies 20% WHT from the profits of the fund or from the profits earned after its surrender or liquidation. Another finding is that many countries apply special tax regimes in order to achieve neutrality between direct and indirect investment. That is, for example, the case in Sweden, the Netherlands, and Germany. Due to the importance of the principle of neutrality and equality, these regulations may be considered quite reasonable. Some countries also have the purpose of being competitive on the investment market in order to attract investors. Different examples of countries that apply these set of rules are Hungary, United States, and Belgium. Furthermore, Belgian investment companies are more favorable to invest in than the funds are. 35

71 Finally, in what countries have CIFs contributed to the cause of the financial crisis? And in what countries have the financial crisis affected the taxation of the CIFs? Firstly, in almost all countries the Collective Investment Funds have not contributed significantly to the financial crisis. However, concerning the taxation as a consequence of the crisis, Hungary is the only country that is introducing a crisis tax for CIFs 98. It will be effective on January 1, The rate is a progressive rate, meaning that the tax liability of credit institutions is 0.15% up to balance sheet totals of HUF 50 billion. Above this threshold the applied tax rate is 0.5% 100. In addition, the special tax under discussion may be deducted as an expense for corporate income tax purposes 101. What should also be pointed out is that the crisis might have affected the CIFs in the United States in terms of the value of their assets. 98 Act on Credit institutions and Financial institutions. 59/ Daniel Deák. Hungary introduces special taxes. Published in European Taxation IBFD. p Ibid. 101 Ibid. 36

72 4. Taxation of Pension Funds (PFs) 4.1. Introduction Pension funds assume an important social role; they accumulate contributions and invest in financial markets in order to provide retirees with fiscal security when they are limited by age or disability. Countries have structured the taxation of pension plans differently; however, the respective regimes do have noteworthy similarities. This paper endeavors to broadly examine individual countries tax regimes, in particular the tax treatment of contributions, pension profits, and distributions. Investment limitations or restrictions will also be surveyed. Finally, the continued viability of individual pension systems will be analyzed. Some countries afford pension funds substantial tax benefits in order to aid their functions. Conversely, other countries tax pension funds as general business entities without any material tax advantages. Nonetheless, the objective of all pension plans is for the participants and their employers to habitually contribute to the funds with the resulting contributions being invested in sound and worthwhile investments. Pension funds in Germany are corporations or pension fund associations on mutuality (Pensionsfondsvereine auf Gegenseitigkeit) and subject to unlimited tax liability according to sec. 1 para. 1 KStG. The tax liability of corporate pension is regulated in sec. 1 para. 1 no. 1 KStG. According to that regulation, those pension funds which are managed or settled in Germany are subject to unlimited tax liability. Furthermore, sec. 7 para. 1a requires a corporate pension fund s management or settlement must be in Germany. Pension funds organized as pension fund associations on mutuality, are subject to unlimited tax liability under sec. 1 para. 1 no. 3 KStG. In Hungary, it is necessary to distinguish between the pension fund and the pension management entity. The pension fund, itself, is a non-taxable flow-through entity which collects and redistributes assets. The fund manager, however, is subject to the general Hungarian rules of company taxation after profits are received. Therefore, no special regime applies to pension funds, and they are simply treated under common tax rules. In the Netherlands, pension funds are, theoretically, liable to pay corporate income tax, but have been specifically exempted from paying such taxes in the Dutch CIT Act. In France, pension fund taxation is governed by article and They enjoy a specific, beneficial tax regime; however, to qualify under this regime, the pension fund must 37

73 obtain a certificate from government administration by ensuring that the fund does not exercise a lucrative activity. Furthermore, the pension funds must provide a fixed ceiling on managerial income. In Belgium, Belgian institutions for the occupational retirement provision (pension funds) operate as separate legal entities under the form of an Organism for Financing Pensions (OFP) 102. In order to encourage foreign companies to build up additional retirement income for employees, Belgian institutions for the occupational retirement provision receive beneficial tax treatment 103. The specific fiscal statute of an OFP 104 is included in art. 185bis ITC. The fiscal regime is founded on the EET-principle (Exempt-Exempt-Taxed). This means that the contributions and accumulation of pension income is exempt. Only the pension distributions are taxed. Pension funds in the United States are governed by provisions in the Internal Revenue Code as well as rules promulgated under the Employee Retirement Income Security Act of 1974 (ERISA). These rules provide special and beneficial tax treatment for pension funds with the purpose of facilitating the accumulation of retirement savings for beneficiaries. Swedish pension funds are not subject to tax or considered legal entities; however, the company administrating the fund is exposed to tax. There are three different pension funds in Sweden: 1. national pension insurance funds which are not subject to tax, 2: pension funds administered by insurance companies or pension foundations which are subject to tax on returns (the managing company not the fund), and 3. individual pension savings, which can be placed in different funds and are also subject to tax on returns. In Poland, in accordance with art. 2 of the Pension Fund Act, a pension is a legal person with the sole aim to collect and invest cash in order to provide payment of retirement pensions for fund members when they reach the retirement age. The body of a pension fund is a pension agency which manages and represents the fund in its relations with third parties, art. 3 of the Pension Funds Act. In Spain, pension funds are legal, corporate entities and are subject to corporate income taxation. In Austria, A pension company has to be incorporated as a joint stock company (Aktiengesellschaft) 105 and is consequently subject to the Corporate Income Tax Act. 102 Art. 8 wet betreffende het toezicht op de instellingen voor bedrijfspensioenvoorziening, 27 oktober L. TAILLEU, D. GEERTS, Practicum inkomstenbelasting: vennootschapsbelasting, Antwerpen, Standaard Uitgeverij, 2009, Sec. 6(1) Pensionskassengesetz (Pension Companies Act) 38

74 In Italy, the tax regime of pension funds was introduced by the Legislative Decree n.47/2000 and the Legislative Decree n. 124/1993. This law introduced the application of an income tax, in the measure of the 11% on the net operating profits accrued in each tax period The Three Pillar System Many countries have established a three pillar pension system which is aimed at providing broad retirement coverage. The first pillar is a social trust, typically funded by mandatory employer or employee contributions. The second pillar is an employer-created trust for their employees. The final pillar is an individually-created trust, which is usually voluntary and provides supplemental retirement coverage for those able to afford the extra contributions. Germany, France, Poland, Spain, Austria, Italy and Sweden expressly provide for such a system. Other countries have varied the three pillar system to a certain extent, and the United States has indirectly created a similar pension structure. In Hungary, The Act on Private Pensions and Private Pension Funds 106 founded the concept of state and private pension funds operating in a parallel manner. Later, the possibility of voluntary pension funds was added to the system, thus creating a three pillar pension system. However, due to the global economic and financial crisis, the Hungarian government has introduced extreme changes from the existing pension scheme in an effort to use pension assets as an extra source of revenue to ease the burden of governmental budget deficits. The Netherlands similarly provide for a three pillar system. Current employees taxes directly pay for the public aspect of the system. Due to the increase in the retired population, the system has become more expensive and the entitlement age has been raised from 65 to 67. Private pension funds are organized in different sectors, by separate companies, or for civil servants. (e.g. organized by sectors, separate companies, civil servants). The third pillar of the pension system includes funds organized by entrepreneurs themselves. In Belgium, the 1st pillar contains the statutory social security pension schemes that mandatory under State s SS-Law offering minimum social protection to population. The 2nd pillar, or occupational pension schemes set up by the employer to the benefit of the employees (extra-legal pension schemes), is obligatory; every employer and every employee /1997. Act on Private Pensions and Private Pension Funds 39

75 is subject to mandatory contributions. When the employee is 65, he/she begins to receive payments from the pension fund. The 3 rd pillar includes individual retirement schemes that are wholly individually and voluntary. While not specifically labeled the three pillar system, American law facilitates a retirement savings structure similar to the three pillar system. America s public retirement and disability mechanism, the social security system, is a massive, legislatively created, government-managed trust 107 which is funded by employee and employer taxes. 108 Employercreated trusts are regulated by the Internal Revenue Code and the Employee Retirement Income Security Act of Employees are also encouraged to create individual retirement plans to ensure they are adequately prepared for the fiscal needs associated with prolonged retirement Pension Fund Profits Countries vary in their tax treatment of pension fund profits. Some countries tax pension funds as if they were normal business entities. For instance, pension funds in Germany are fully taxable corporate entities. Italy taxes the returns on the investments of private pension schemes at a reduced rate. In Hungary, the profits of the fund manager are taxed under the CIT rules. Similarly, in Sweden, the company administrating the pension fund is subject to tax on returns from pension funds. In Poland, funds have legal personality, however under art and art a of CIT Act 109 they are exempted. France also taxes pension fund profits to a certain extent. However, some countries choose not to tax pension fund profits. This considerable government subsidy allows for the accretion of wealth in pension funds, which, in turn, facilitates investment flexibility. The Netherlands specifically provides that pension funds are tax exempt. In Belgium, the pension funds actual profit is disregarded. Their tax base consists solely of disallowed expenses and received abnormal and favourable advantages. By exclusively being involved in arm s length transactions and by avoiding abnormal and favourable advantages, pension funds can obtain a zero tax base. While pension funds in Spain are subject to corporate taxation they are taxed at a 0% rate because of certain 107 USC See, Federal Insurance Contributions Act- Chapter 21 of Title 26 of the United States Code 109 Act of 15 February 1992 on Corporate Income Tax (consolidated version: Journal of Laws of 2000, No. 54 item 654, as amended). 40

76 transparency principles. In the United States, Qualified pension plans, under 401 of the Code, including defined benefit and defined contribution plans, are exempt from taxation. 110 This allows for significant tax-deferral. Earnings on the assets of the plan are permitted to accumulate for decades. IRA s and Roth IRA s not considered tax-exempt entities under 501 of the Code. However, both individual retirement accounts are afforded similar tax exempt treatment under All pension plans are subject to the unrelated business taxable income provisions of the Code 112. These provisions, with some exceptions, require pension plans to recognize income from the active, regular conduct of a trade or business unrelated to their trust activity 113. The income of pension companies in Austria is exempt insofar as it is attributable to IRGs 114, and as long as certain requirements are met. 115 The income that is not attributable to IRGs, especially management fees, is not exempt and normally taxed under the CITA Pension Fund Contributions Unlike the taxation of pension fund profits, there appears to be a more unified approach to the deduction of contributions to pension funds. In Germany, contributions are deductible up to 4 percent of the base for statutory pension insurance. Austria, Hungary, Poland, Sweden, Spain, Italy (under the ETE model) and The Netherlands similarly allow deductions for such contributions. In Belgium, contributions to pension funds are deductible for the employer under several conditions (artt. 52, 3, b ITC, 59 ITC and artt. 34 and 35 RD/ ITC). American employers are allowed deductions, subject to amount limitations, for certain contributions to both qualified and non-qualified employee pension plans. Contributions may be deducted only to the extent that they are ordinary and necessary business expenses during the taxable year 116 or for the production of income 117 and are compensation for personal services actually rendered 118. Furthermore, deductible contributions must be (a) (e)(1); 408A(a) 112 see generally Id. 114 The capital invested by pension companies is held in so-called investment and risk sharing groups (IRGs), which basically just are separately managed accounts in the books of a pension company. 115 Sec. 5(7) in conjunction with Sec. 6 CITA 116 see generally see generally CFR 1.404(a)-1(b) 41

77 reasonable when examined collectively with the employee s entire compensation package in the given taxable year 119. What exactly constitutes a reasonable contribution depends upon the facts and circumstances in the particular case 120. Contributions to traditional, noninherited IRA s 121 are deductible, subject to amount limitations, to the extent they are paid in cash by or on behalf of an individual 122, and the individual is under the age of 70 ½ Pension Fund Distributions Pension fund distributions are almost uniformly taxable to the recipient. The Netherlands, France, Belgium, Spain, Poland (in application of art of PIT Act.) and Germany (according to the provisions sec. 22 para. 5 EStG) all provide that beneficiaries are taxed when they receive pension fund proceeds. In Sweden, as well, the beneficiaries of pension funds are taxed on distributions and the payment is regarded as payment from employment. Similarly, in Austria, distributions are taxable under the normal progressive tax rate 124 as income from employment 125. Contributions that were made by the employee or by selfemployed persons are only taxed at 25% 126. Amounts distributed by American qualified trusts and IRA s to an employee or his beneficiary are taxable in the taxable year when distributed under the rules of Internal Revenue Code section Notably, however, in Hungary, pension distributions are not taxable to the recipient. Similarly, in Italy, the component of the pension distribution corresponding to the pension investment (which has already been taxed at a reduced rate) is exempt from further taxation. The remainder of the distribution, however, is taxed at the beneficiaries personal income tax rate. 119 Id. 120 Id (d)(4) (e)(1) (d)(1); 219(a) 124 Sec. 33 IITA 125 Sec. 25(2) IITA 126 Sec. 25(1)(2) IITA (a), 72 42

78 4.6. Restrictions on Pension Fund Investment Pension funds maintain substantial holdings of wealth that many future retirees depend on for post-retirement income. Not surprisingly, some countries have placed limitations on pension fund investment in order to protect the beneficiaries expectations. Spanish law provides, in the form of percentages, restrictions on certain types of investments pension funds may pursue. In Poland, there are several investment restrictions. In fact, pension funds may invest only certain amounts in shares and they are also not authorized to invest abroad. Such investment regulation is set forth in the Act of organization and functioning of PF. In Germany, pension funds must be approved by the Federal Financial Supervisory Authority (pursuant to sec. 112 para. 2 VAG). Pension funds can be approved for cross-border activities only with prior special approval by the regulatory authority. There are even more investment limitations determined in the VAG (German Insurance Supervision Act). The Netherlands law provides that pension fund portfolios must be diversified and include investments in stable instruments, such as treasury bonds. In Belgium, pension fund assets must be invested prudently and in a way that is consistent with the investment policy stipulated in the declaration concerning investment principles (SIP Statement of Investment Principles) and with the hypotheses that are used in the financing plan. Investments in derivatives are accepted if they contribute to the reduction of the investment risks and if they facilitate an efficient portfolio management. In Italy, limits to pension fund investments are defined in the Treasury Minister Decree n. 703/1996, which restricts investment in unlisted securities and other risky assets. In Austria, The Pensionskassengesetz (pension companies act) regulates which investments can be made by pension companies for funds invested in IRGs. This act includes rules about the type of stocks, the maximum investment in one company, or, for example, the acquisition of derivatives. In the United States the main source of investment regulation for such pension funds rests in fiduciary rules promulgated under the Employee Retirement Income Security Act of 1974 (ERISA). Section 404 of ERISA compels such pension fund fiduciaries to discharge their duties solely in the interest of the participants and beneficiaries of the plan and (A) for the exclusive purpose of providing benefits for such participants and beneficiaries; and defraying reasonable expenses of administering the plan 128, (B) with the care, skill, and diligence that a 128 ERISA 404(a)(1)(A) 43

79 prudent man acting in like capacity and familiar with such matters would use 129, (C) by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is imprudent to do so 130, and (D) in accordance with the documents and instruments of the plan 131. Furthermore, ERISA supplements these fiduciary duties by generally proscribing self-dealing transactions and transactions with interested parties 132. Nonetheless, some countries do not limit pension fund investment and apparently feel that unconstructed asset growth outweighs the possibility of misguided or manipulative investment. Such countries include Hungary, France, and Sweden Withholding on payments to Pension Funds In an effort to ensure that taxes are immediately collected on items of income distributed to a pension fund, some countries have created a withholding regime. German law provides that payments to pension funds are subject to withholding tax on capital income. Similarly, Spain applies a withholding regime to pension funds. In Belgium, an OFP is not liable to any tax on investment income 133. No withholding tax is paid on movable income, though it is deducted at source. Then, the withholding tax that is deducted at source is credited against corporate tax. This system results in favourable tax treatment in which gross income is often equal to net income and allows OFPs greater flexibility and choices with regard to investment decisions. Polish law applies a withholding tax; however, the significance of the withholding regime is limited for pension funds because such funds cannot invest abroad. In Austria, the payer of the dividend or interest to pension companies normally does not have to withhold if the income is attributable to an IRG 134 (dividends received by pension companies generally are tax exempt 135 ). Withholding has to be levied by the dividend paying company if the pension company does not own more than 10% of the company and the income is not attributable to an IRG ERISA 404(a)(1)(B) 130 ERISA 404(a)(1)(C) 131 ERISA 404(a)(1)(D) 132 see ERISA Voorafgaande beslissing nr dd ; Sec. 94(6)(c) IITA 135 Sec. 10 (1) CITA 136 Sec. 93 (1) and (2) IITA in conjunction with Sec. 94 (2) IITA 44

80 Other countries allow pension funds to assume any withholding function when funds are distributed to beneficiaries. In Hungary, similar to investment funds, the pension fund, on its own, is not a taxable person. The pension fund manager, however, is liable for withholding tax at source at the time of paying the client. The withholding taxes are deducted and documented. In the United States, payments to pension funds are not subject to the withholding requirements of The pension funds, themselves, are required to assume any withholding functions upon distribution to beneficiaries. Also, a few countries simply do not provide for a withholding regime. Such countries include The Netherlands, France, Italy and Sweden The Residency of Pension Funds according to the criteria of Art. 4(1) In order to claim treaty benefits, an individual or entity must usually be a resident of a contracting state. While some countries do not recognize pension funds as legal entities (i.e, France, Belgium, Sweden, and Hungary) others label a pension fund as a business entity, in turn allowing the fund to be recognized as a resident of such country. For instance, German pension funds are legal entities in the form of insurance institutions. Therefore, domestic pension funds have access to the treaty network if the entity is managed or settled in Germany. Similarly, Polish, Italian, Spanish and Austrian pension funds are considered legal entities, and therefore domestic funds in such countries have access to a treaty network. The Netherlands pension funds are residents of the state; however The Netherlands attempt to negotiate treaty access for certain residents during treaty discussions. American pension plans are considered residents of their state of establishment 138. Nonetheless, a resident pension plan will only be entitled to the benefits of a Treaty if it is a qualified person under the limitation of benefits provisions of Article (b)(1) 138 US Model Income Tax Convention (2006). Art. 4(2) 139 US Model Income Tax Convention (2006). Art. 22(1) 45

81 4.9. Limitation of Benefit Provisions Limitation of benefit provisions are placed in tax treaties in an attempt to limit the ability of certain entities to engage in organizational manipulation to take advantage of treaty benefits. Some countries do not require such provisions in their treaties (i.e, Hungary, Spain and France); however, there is a growing trend of placing such provisions in bi-lateral treaties. German tax treaties typically do not include LOB-clauses. However, they are included in some treaties including those with Switzerland and the United States. Nonetheless, these clauses do not include provisions for pension funds. The Netherlands and Austria also do not generally include limitation of benefits in their treaties; however, they both have included such provisions with the United States. Poland uses limitation of benefit provisions in double tax conventions with Israel and Sweden, however Poland itself generally do not include limitation of benefit provisions in most conventions. Recently, Belgium renewed its double tax treaty with the United States and included such provisions 140, and generally, the OFPs should meet limitation of benefits conditions 141. Italy typically includes limitation of benefit provisions. For example, the new Italy-USA treaty against double taxation implemented with the Law n.20, 2009 included and LOB provision. The United States has also insisted on including limitation of benefit provisions in their tax treaties. A resident pension plan will only be entitled to the benefits of the Treaty if it is a qualified person under the limitation of benefits provisions of Article A pension fund is a qualified person if more than fifty percent of the beneficiaries, members or participants of the organization are individuals resident in either Contracting State 143. For purposes of this provision, the term "beneficiaries" is understood to refer to the persons receiving benefits from the organization 144. Swedish tax treaties also usually contain limitation of benefit provisions november See art. 21 overeenkomst tussen de Regering van het Koninkrijk België en de Regering van de Verenigde Staten van Amerika tot het vermijden van dubbele belasting en van het ontgaan van belasting inzake belastingen naar het inkomen, 27 november US Model Income Tax Convention (2006). Art. 22(1) 143 US Model Technical Explanation Accompanying the US Model Income Tax Convention (2006) Art. 22 2, Tax Exempt Organizations -- Subparagraph 2(d) 144 Id. 46

82 4.10. Recent Pension Fund Structural Changes The worldwide financial crisis certainly impacted pension funds to a significant degree. With a renewed understanding of the interconnectedness of the worldwide financial system, some countries have made changes to their pension structures in an effort to lessen the scale of another possible future financial meltdown. Some states have used the pension system as a means to cover budgetary deficits. However, most countries have not reacted with any noteworthy changes to their pension system (i.e, Poland 145, Spain, Austria, Italy, Germany, Sweden, France, and The Netherlands). Hungary s former regulations declared that all individuals employed since the year 1998 [were] obliged to be members of private pension funds 146. Thus, it was obligatory to choose a private pension fund, to which 8% of employee s pension contributions were paid. Moreover, 1.5% of contributions were added to the state pension funds and there was the option to be a member of a voluntary pension fund as well. With the exception of voluntary pension funds, the operation of which is unchanged, the oldage pension scheme was transformed in 2010 in the following manner. The obligatory membership of private pension funds was ceased by adopting the Act on Pension Reform and the Deficit Reduction Fund 147 according to the new regulations, the whole sum of pension contributions due between the 1st of November 2010 and the 31st of December 2011, have to be disbursed exclusively to the state pension fund. This means that the payment of 9.5% of contributions will go to the government instead of the former 1.5%. Moreover, from January this amount will further be raised to 10% of employee contributions. Another implication of the pension reforms, independent from the one year period mentioned above, is an amendment that requires those who have formerly belonged to the multi-pillar system to either move to the state pension fund as an automatic option or to sign a separate declaration to stay in the previous private fund. For those choosing to stay in the private fund, the following implications came into effect after 1 st December 2011: 10% of their pension contributions were nonetheless transferred to their private accounts. However, the pension contributions of employers, which constitute 24%, will still be paid to the state pension fund. Additionally, the ones staying in the private funds accept that their time in employment will 145 However significant modifications regarding the amount of money transferred to private pension funds are to be introduced due to the budgetary problems. 146 ibid /2010. Act on Pension Reform and the Deficit Reduction Fund. 47

83 not rise after 1 st December This also means that the earnings after this time will not be taken into account when calculating the amount of old age pensions 148. The new system also contains implications for the operation of private pension fund managers. In contrast to the former maximum of 4,5%, private fund managers will from 2011 on only be allowed to have a maximum of 0,9% operational costs and wealth management charges will be cut to a maximum of 0.2%, as opposed to the earlier 0.7% 149. If a member of a private pension fund refrains from declaring an intention to stay in the private fund, the contract ceases to exist on 1 st March 2011, and the individual will be moved into the state pension scheme. The assets accumulated so far in the private pension funds will be transferred to the Deficit Reduction Fund, meaning that at the time of retirement the person will only receive an old age pension from the state pension fund going forward. In Belgium, before 1 January 2007, occupational pensions were exclusively managed by insurers and welfare funds, pension funds and social security funds. Pension funds exclusively operated as non-profit organisations or mutual insurance association 150. However, changes in law on the supervision of institutions for the occupational retirement provision 151, including implementing orders 152, have converted the European Directive 2003/41/E.C. on the activities and supervision of institutions for occupational retirement provision 153 into Belgian law 154. As a consequence, institutions for the occupational retirement provision should operate as separate legal entities under the form of an Organism for Financing Pensions (OFP) 155. By 31 December 2011, the above mentioned non-profit organisations or mutual insurance associations must be transformed into an OFP. The American pension system has not changed as a result the recent economic crisis. However, the growing number of retirees and their lack of sufficient retirement funds may necessitate a systemic change in American pension plans in the coming years Accessed on: ibid 150 D. VAN GERVEN, Een nieuwe rechtspersoon: het organisme voor de financiering van pensioenen (OFP), T.F.R., 2007, ; J. DEROEY, H. HUANG, A. VERLINDEN & P. LOGGHE, Nieuwe controlewetgeving voor pensioenfondsen, Mechelen, Wolters Kluwer, 2007, Mechelen, B.S. 10 november B.S. 23 januari Directive 2003/41/E.C. of the European parliament and of the council of 3 June 2003 on the activities and supervision of institutions for occupational retirement provision. 154 D. VAN GERVEN, Een nieuwe rechtspersoon: het organisme voor de financiering van pensioenen (OFP), T.F.R., 2007, ; J. DEROEY, H. HUANG, A. VERLINDEN & P. LOGGHE, Nieuwe controlewetgeving voor pensioenfondsen, Mechelen, Wolters Kluwer, 2007, Mechelen, Art. 8 wet betreffende het toezicht op de instellingen voor bedrijfspensioenvoorziening, 27 oktober

84 4.11. The Continuing Viability of Current Pension Fund Systems Pension fund investments remain in a precarious state. The investment goal of most pension funds is to receive considerable returns while safeguarding assets already held. This places fund managers in the tenuous position of being both risk-averse and aggressive at the same time. Also, finding a moderate investment plan in the current economic climate is not easy as financial markets continue to recover and economic forecasts are of questionable reliability. The continuing viability of current pension fund systems appears dubious at best: - The German pension fund system appears stable at present; however, it is difficult to assess the German pension systems future security. - Hungarian pension reform has focused on raising significant extra revenues for the state budget. However, it is arguable whether these severe changes can be considered constitutional. Furthermore, they pose serious questions concerning discrimination and have seriously burdened private (employee) pension funds. Viewing the trends in other EU countries, it is questionable whether these reforms have continuing viability regarding the possible violations of central EU principles. - In The Netherlands, it appears that the pension system, as a whole, remains viable. However, there might be small cutbacks in distribution amounts in the coming years. - In France, the pension fund system will likely require alteration within the coming years - In Belgium, it appears that the crisis has not significantly affected pension funds such funds remain viable. - Pension plans in America are subject to a growing number of retirees and a dearth of sound investment strategies. Coupled with an inadequate social security regime, retirement funding is at the precipice of disaster. State pension funds, which were not discussed in this paper, are also in a crisis state. Hopefully, as global markets recover, pension funds may again regain sound financial footing. Nonetheless, it appears the entire United States pension system will continue to struggle to provide sufficient income to retirees in the near future. - Sweden has not been strongly affected by the financial crisis, and therefore, their pension system appears to be stable. - In Poland, the private pillar may be weakened by a planned reform of pension system (the amount of money transferred to pension funds will be decreased more money will 49

85 go to public pillar which distributes the money it receives. It does not invest like private pension funds). Therefore, it is unlikely to be significantly altered. - Spain survived the financial crisis relatively unshaken so it will unlikely change its pension system. - It is evident that the Austrian social security pension system is not sustainably financed at the moment because people are retiring at early ages. The lower retirement age has been raised and its consequences alleviated gradually but it is very questionable that this will be enough. Pension companies will therefore likely play a more important rule in the future in order to compensate for the problems with social security pensions. - Italian pension funds suffered because of the financial crisis; however, the harmful effects to pension funds were limited because pension funds in Italy were unable to invest in excessively risky securities. It appears, therefore, that the pension system in Italy is stable and does not need to be amended. 50

86 5. Conclusion In this paper, the taxation of banks, insurance companies, Collective Investment Funds and Pension Funds of the countries that participate in the EUCOTAX Wintercourse 2011 are compared. Moreover, the role of taxation of these financial institutions as a contributor to the causes of the financial crisis and the remedies taxation can provide are discussed. First of all, the analysis of the banking sector has shown that a levy for banks should be of systemic importance and should be implemented on a global or at least EU level. In addition, it is necessary that Basel III is introduced and is connected with these bank levies. There is also the trend of ex post deposit guarantee schemes shifting to ex ante systems. In the second chapter, the examination of the tax system of insurance companies revealed the following main conclusions. Most importantly, it is found that, although there are several specific tax regimes and rules for insurance companies, it appears that no strong connection to the crisis in most countries. If there were any effects at all, the special tax rules slightly helped insurance companies to endure the consequences of the crisis. Thirdly, the comparison of the various Collective Investment Funds has shown that there are many differences between the regulations of the countries; no single legal form could be identified. Nevertheless, there are some similarities. The different tax regimes, additionally, want to either achieve neutrality or attract investment. At last, no significant contribution to the financial crisis is found. In the chapter on pension funds, the taxation and the three pillar system are described. The tax regime of contributions, profits and distribution has shown many similarities among states. Also pension funds registered consequences after the crisis but countries did not react with noteworthy changes to their systems. 51

87 6. Appendix 6.1. Matrix: taxation of banks 6.2. Matrix: taxation of insurance companies 6.3. Matrix: taxation of Collective Investment Funds (CIFs) 6.4. Matrix: taxation of Pension Funds (PFs)

88 Bank questions / Countries CIT regime? Progressive rate? Special provisions in CITA? Changes in profit determination < crisis? Commercial accounting rules separate from profit determination for tax purposes? Special acts CITA? Special tax < crisis? Special tax? Plans to make a special tax? Deposit guarante e scheme? VAT? Discriminat ion? Austria Yes No, 25% No N.a. No, unless explicitly stipulated in the CIT Financial Yes, FSC Stability Contribution, levy on debts & levy on amount of derivatives traded. Progressive levy on debts + levy on derivatives. There already is. Yes, ex post up to euro Exempt No Belgium Yes No 33.99% No No No Diverse Taxes. France Yes No, 33,1/3 % Germany Yes No 15% + 5.5% + local taxes 14% Yes, for bad debts. No yes There are special Taxes for Banks. No. No. Yes. Profit determination based on tax accounting; tax accounting based on commercial accounting. Bank levy in addition to CIT. Rate increased to 0.15% + access rights. In the future. Spahntax Ex ante. Yes; exemption s No. n.a yes, the Tax is called "Taxe systémique" Yes. Flat rate paid to restructuring fund. Already is. Yes, ex ante. Yes, ex ante. Exempt Yes; most financial & banking services are exempt. n.a. no Yes. Foreign branches are not subjects of the bank levy.

89 Hungary Yes Yes, first 500 mln HUF 10%, everything more 19%. No N.a. No Yes, special tax and profit tax on banks (extra profit tax on banks of 30%, looks like a financial activities tax). Yes. Tax base, Already is balance sheet total, 0,15% first 50 bln HUF, the rest 0,5% (Financial stability contribution) Yes, ex post. Exempt No, but there is a dominance of foreign banks Italy Yes No, 27,5% No Credit impairment, from 0,3% to 0,5% Poland Yes No, 19% Yes, No concerning reserves (risk reserves, bad debts, general reserves) No, IASB. No n.a. n.a. No Yes, ex ante No; profit determined by tax law provisions, without a connection with accounting regulations. No. No. No. Proposals on a bank levy. Spain Yes No, 30% no n.a. No No n.a. n.a. Dependent from international development Sweden Yes No, 26,3% No n.a. No, but small alterations for tax purposes Netherlands Yes Yes, first of profit 20%, everything more 25% Yes, ex post Yes, ex post Exempt Exempt Exempt No No n.a. ex post Exempt No No n.a. Yes No n.a. n.a. Not independent, dependent from international development Yes, ex post Exempt No No. No No

90 USA Yes Yes, 15% - 35% Yes, concerning bad debts, securities, and participations Troubled Asset Relief Program (TARP) Banks are usually limited to the accrual method No, rules are incorporated in the general act (Internal Revenue code) Proposals; nothing codified yet n.a. Only proposals Yes, ex ante n.a. Yes, some additional thresholds.

91 CIF questions / Countries Different forms? Legal personality? Tax regime, tax base, tax rate? Purpose special tax regime? Investor taxed? Remarkable Treaty access? difference between direct investment or investment by the fund? Crisis effect? Austria Belgium Kapitalanlagefonds (domestic CIFs) generally are open-ended. They can be divided into public funds and special funds. No legal personality. Mutual investment funds (no legal personality); Investment companies: open-end (BEVEKs) & closed-end (e.g. BEVAKs) (legal personality). Tax transparent. Mutual investment funds: tax transparent; investment companies: taxable on (abnormal and favourable advantages + disallowed expenses) at 33,99%. Equality between investing through investment funds & direct investments; strengthening capital market. Being fiscally flexible and competitive on the European investment market; adequate protection of investing public. Yes: on the distributions Not really. to him, not when the fund receives money (unless when deemed distributions). Yes: mutual investment funds 25% on dividends; investment companies 15% on dividends/exempt on purchasing bonus/exempt if investor is subject to personal taxation. Yes: 25% when directly investing or via mutual investment fund; 15% or exemption when investing in investment companies. No < no taxable entities. Yes. Not significantly. Not significantly. France SCR (Companies of Venture - legal SCR: not tax transparent personality); FCP (Mutual funds - but exempt; FCP: tax no legal personality) and FCPR transparent; SICAV: (Mutual funds in Risk - no legal favourably taxed at 15%. personality); SICAV (open investment trust - legal personality). No. Yes. No. No. Not significantly. Germany Special properties: no legal personality. Tax transparent. Equality between investing through investment funds & direct investments. Yes. Some differences concerning deductibility of expenses, but no remarkable effect on taxation. Yes. Not significantly.

92 Hungary Italy Open-end or closed-end funds. Both have legal personality. CIFs + SICAV = part of general category of collective investment undertakings OICR. Legal personalities: trust or corporation. Fund: tax transparent; management company: taxable at normal corporate income tax rate on received contributions. Italian mutual funds: 12,50% tax on income; Real estate investment funds: tax transparent. Management company applies 20% WHT from the profits of the participation at the fund or from the profits earned after its surrender or liquidation. Attract investors by having a clear and understandable tax regime and a favourable tax rate, considering the comparably low personal and corporate income tax rates. No. Person: normal personal income tax; company: normal corporate income tax. Investors in open-funds and closed-funds: exemption from taxable income, unless result of the investment is not earned exercising business activities; investors in real estate investment funds: WHT deducted at source for every investor, except for individual entrepreneurs if the participations are related to the commercial business, for commercial partnerships, companies, resident commercial entities, Italian permanent establishment. No. Yes, there might be differences. No < no taxable entities. It depends, if they are considered 'persons' under the treaty. Crisis tax. Not significantly.

93 Poland Spain Sweden Investment fund; foreign investment fund (open-end investment fund or investment company); National Investment Funds (joint-stock companies): all have legal personality. Fund: exempt; managing bodies: 19% tax on profits. Investment companies Investment funds: with variable capital (SICAV) generally: 19% up to (Limited Corporation); Investment 6.000, 21% over funds (no legal personality); Real Guipuzcoa, Alava and Estate Investment Funds (no legal Vizcaya: 20% - Navarra: personality); Real Estate investment 18% up to 6.000, 21% Societies (Limited Corporation); over 6.000; Mortgage Certification mortgage funds (no funds: CIT exempt; Real legal personality). estate investment fund: tax transparent; SICAVs: subject to the number of shareholders: less than 100 shareholders subject to 30%, more than 100 shareholders subject to 1%. Mutual funds (UCITS directive) & Income tax at 30% on Special funds ( UCITS directive) - profits (= dividend + No legal personality but tax subject. template amount of 1,5% of the value of the fund). Not relevant. No. Equality between investing through investment funds & direct investments; strengthening capital market. Yes. Revenues gained by legal persons from a participation in the investment fund are taxed in accordance with basic rules of the Polish corporate income tax system. Yes, when dealing with funds (not for societies): taxed for the difference between what is invested and what is earned from that investment. Personal income tax on capital gains. No. Yes. No. No. Yes. Not significantly. No. Yes. Not significantly.

94 Netherlands Investment funds (no legal personality itself, but management companies have legal personality) and investment companies (legal personality). Two regimes: Total exemption; No exemption but a 0% rate (but obligation to distribute profits). Equality between investing through investment funds & direct investments. Yes, taxed in Box 3 (when their participation is less than 5%) at 30% on a fictional yield of 4% of capital. You could say that there is a 1,2% capital tax. No. Two regimes: Not Total exemption: significantly. often no treaty access possible but there is no obligation to distribute investment results; No exemption but a 0% rate: generally treaty access. United States CIFs = bank-administered trusts that hold commingled assets and meet specific criteria < structured as trusts. Funds & banks that manage the fund: tax transparent. Enhance pooling assets and investment management. Yes on income of the fund realised each year. Somewhat: time difference. No < no residents in the Contracting State. The crisis has affected the CIFs in terms of the value of their assets, but no significant changes as a consequence.

95

96 Insurance companies questions / Countries Austria Legal forms? CITC? Special accounting rules? Aktiengesellsch aft (Joint-Stock Company); Versicherungsve rein auf Gegenseitigkeit (Mutual Insurance Company); Societas Europea Technical provision deduction? Yes No Yes if establishes according to Insurance Supervision Act, Additional regulations and restrictions in the CITA Special Income Tax rules? Discrimination? Special Income Tax rules in cross border (foreign companies)? Special Income Tax rules in cross border (domestic companies)? Discrimination? Special Tax? VAT? Insurance Premium Tax? Financial Stability Charge? No - No No No - No No No Yes No No Benefits taxed? Belgium Cooperative Corporation; partnership on shares and mutual insurance associations Yes Yes Covered by assets; extra add on equity and liability side of the balance; exemption of equalisation provisions and provisions for unearned premiums. No - No No No - No Annual special tax. No Yes Yes No France Corporation Yes Code of Insurances Regulated in Tax Code No - No No No - No No No Yes No Yes

97 Germany Capital Companies Yes Additional rules in the Commercial Code Yes: Commercial Code, Corporate Income Tax Act and Regulation on Accounting of Insurance Companies No - No No No - No No No Yes No Yes Hungary Companies limited by shares or associations Yes Regarding deductable expenses laid down in the act on corporate tax and divident tax No No - No No No - No No No No Yes Italy Corporation; limited cooperative or mutual insurance Yes IAS used for Restricted No - No No No - No No No Yes No Yes tax purposes for insurance companies Poland Spain Joint Stock Company, mutual insurance society Capital Companies Yes No Requirement s in Insurance Activity Act Yes No Regulated in Tax Code No - No No No - No No No No No Yes No - No Taxed with 18 percent Taxed with 24 percent - Yes, if there is no tax treaty. No No No No Yes

98 Sweden Limited liability companies or mutual insurance companies Yes Yes, special accounting act. Similar to rules for banks and based on normal commercial accounting. Regulated in Tax Code No - No No No - No Yield on Pension s Means Act. No No No Yes Netherlands United States Public or private limited companies Often required to be corporations by state law Yes No Additional rules Yes Special rules according to the Internal Revenue Code, that are not applicable to any other companies; they are based on industry standards No - No No No - No No No Yes Yes No Deductable Yes - No Yes, if operate in Mexico or Canada through branches: treated as serperate legal entities + income is tax exempt. Only in case of repatriation of income it's taxed. No; It's favour to domestic insurance companies with branches abroad No No VAT No No No

99 Pension funds questions / Countries Special tax regime? "Three pillar system"? Profits taxable? Contributions deductable? Distributions taxable to the recipient? Restricted investment? WHT on dividends and interest? Resident according to art. 4(1)? Tax treaties + LOB provisions? New recent structural changes? Continuing viability? AUSTRIA Joint stock company; subject to Corporate Income Tax. YES Generally exempt. Yes Yes Investments can be made by pension companies for funds invested in IRGs. There are rules about the type of stocks, the maximum investment in one company, or, for example, about the acquisition of derivatives. Generally, no WHT. WHT levied by the dividend paying company if the pension company does not own more than 10% of the company and the income is not attributable to an IRG. Yes - No. No Pension companies will play a more important rule in the future. BELGIUM FRANCE Organism for YES Financing Pensions (OFP); EETprinciple (Exempt- Exempt- Taxed); special tax regime. Specific, beneficial tax regime YES Actual profit disregarded. Tax base: favourable advantages + disallowed expenses. Profits taxed to a certain extent. Deductible for the employer under several conditions. Yes Assets must be invested prudently, in a way that is consistent with the investment policy stipulated in the declaration concerning investment principles and with the hypotheses that are used in the financing plan. n.a. Yes No limits to investments. No tax on investment income; WHT on movable income & deducted at source. Yes - Yes. 1 January 2007: new legal form: 'Organism for Financing Pensions'. Yes No WHT. No - No. No Alteration needed.

100 GERMANY Corporations or pension fund associations on mutuality ; subject to unlimited tax liability. YES PFs are fully taxable corporate entities. Contributions deductible up to 4% of the base for statutory pension insurance. Yes Cross-border WHT on capital activities only with income. prior special approval by the regulatory authority. There are even more investment limitations determined in the VAG (German Insurance Supervision Act). Yes - No. No Yes < stable but difficult to assess. HUNGARY Pension fund: Yes, but non-taxable recent flow-through changes entity; fund manager: general rules of company taxation after profits are received. Profits of the fund manager: taxed under CIT rules. Yes No No limits to investments. PF manager: WHT at the time of paying the client. WHT is deducted and documented. Yes, but discussions. - No. All Questionable. employed individuals were obliged to be members of private pension funds. 2010: significant changes.

101 ITALY NETHERLANDS Legislative Decree n.47/2000 and the Legislative Decree n. 124/1993 Liable to corporate income tax but specifically exempted from paying tax. YES YES Returns on Yes investments of private pension schemes: taxed at a reduced rate. Pension Funds are exempt. Exemption: component of pension distribution corresponding pension investment; taxation at beneficiaries personal income tax rate: remainder of distribution. Limits to pension fund investments are defined in the Treasury Minister Decree n. 703/1996, which restricts investment in unlisted securities and other risky assets. Yes Yes that pension fund portfolios must be diversified and include investments in stable instruments, such as treasury bonds No WHT. Yes - Yes. No. Yes. No WHT. No - No. No. Yes. POLAND Legal person. YES Funds have legal personality but are exempt. Yes Yes Several investment restrictions. In fact, pension funds may invest only certain amounts in shares and they are also not authorized to invest abroad. law applies a withholding tax Yes - Yes: tax convention s with Israel & Sweden; however generally no LOBprovisions in most No. The private pillar may be weakened by any planned reform of pension system.theref ore, it is unlikely to be significantly altered.

102 SPAIN Corporate income taxation. YES Subject to corporate taxation but taxed at a 0% rate. Yes Yes Spanish law provides, in the form of percentages, restrictions on certain types of investments pension funds may pursue applies a withholding regime to pension funds Yes - No. No Yes. SWEDEN PF: not subject to tax or considered legal entities; company administrating the fund: exposed to tax. YES Company administrating pension fund: tax on returns from the fund. yes yes No limits to the investments not provide for a withholding regime No - Yes. No Yes. USA Provisions in the Internal Revenue Code + rules promulgated under Employee Retirement Income Security Act of 1974 (ERISA). YES, indirectly Pension plans: exempt from taxation employers are allowed deductions, subject to amount limitations, for certain contributions to both qualified and nonqualified employee pension plans Yes the main source of investment regulation for such pension funds rests in fiduciary rules promulgated under the Employee Retirement Income Security Act of 1974 (ERISA). payments to pension funds are not subject to the withholding requirements.the pension funds, themselves, are required to assume any withholding functions upon distribution to beneficiaries. Yes, it is a qualified person under the LOBprovisions of Article 22 - Yes. No The pension system might continue to struggle to provide sufficient income to retirees in the near future.

103 INTRODUCTION This paper is a part of the Wintercourse project of The topic of this year is Finance and Economic Crisis and the Role of Taxation in general and Exchange of Information in Tax Matters in particular. The focus of this paper is to best practice regarding this issue. It is subsequently divided into to three groups. INTERNATIONAL INSTRUMENTS 1. Introduction This sections concerns international instruments for exchange of information in tax matters and will be divided into three parts. First, the international standard of transparency and exchange of information for tax purposes will be discussed. The second part is called five critical aspects and the third and last part regards the so-called fishing expeditions. In the following something will be said about each of these three parts. The Global Forum has designed an international standard for exchange of information for the purpose of combating tax avoidance and tax evasion and the goal is to ensure that all jurisdictions fully implement the standards. Global Forum has for the moment 97 members, including all G20 members, all OECD countries and all major financial centres. The standard requires: - Existence of mechanisms for exchange of information upon request - Availability of reliable information (in particular bank, ownership, identity and accounting information) and powers to obtain and provide such information in response to a specific request in a timely manner - Respect for safeguards and limitations and strict confidentiality rules for information exchanged. Since these standards are internationally accepted, most of the international instruments regulating exchange of information have been updated in order to follow the development within this area. There are several different kinds of international instruments that could be used for exchange of information in tax matters: first there are double taxation treaty models: the OECD, UN and US MTCs. These instruments are not binding but serve as models for 1

104 double taxation treaties. All of them contain an article on exchange of information. Instruments can also be based on EU law - for instance directives regulating exchange of information. Moreover, countries can ratify conventions as well as sign TIEAs. The latter are agreements intended to be used with countries for which double tax treaties are not considered appropriate due to the fact that these countries either have no or low taxes. A TIEA is also more detailed than the article on exchange of information in the MTCs. In order to find out the best practice concerning international instruments for exchanging tax information, the instruments will be compared and discussed in relation to five critical aspects: taxes covered, methods covered, possibilities of denying a request for information, secrecy aspects and taxpayer protection. Even though international instruments in this field suggest that exchange of tax information takes place to a wide extent, states are not allowed to engage in so called fishing expeditions. This prohibition can be found in all the articles on exchange of information in the MTCs. For instance, according to the OECD MTC article 26, only foreseeable relevant information can be exchanged. Fishing expeditions are prohibited in order to protect the taxpayer and due to the principle of subsidiarity, i.e. a country should pursue all domestic means before asking another state for help. 2. The Global standard on Transparency and Exchange of Information for Tax purposes Better transparency and information exchange for tax purposes are a key to ensuring that taxpayers have no place to hide their income and assets and that they pay the right amount of tax in the right place. 1 Transparency is included in de bases of good governance. Good governance is still a developing process. The principles of good governance are all connected to each other. They have to be in balance to work in the most optimal way. Good governance is depended on the social, political and economic situation 2. Good governance is a term which give space of interpretation. Because of the fact that good is not a concrete term. 3 For good governance it is important that there is 111 information of the OECD website

105 participation, legalisation, transparency, consensus, responsibility, equality, effectively an accountability. All these safeguard are made to take care of improper use of power of the governance. 4 After the Commonwealth Business Forum in 2009 concluded prof. dr. Van Kommer that unsatisfactory governance and lack of integrity have a negative influence on a country's economic growth and social welfare. The problem is that the fundamentals of good governance and integrity Van are of western (often Anglo-Saxon) origin but are presented as universal principles, thus denying the importance of domestic values and failing to acknowledge cultural characteristics. Fighting corruption and non-integrity is ineffective if the focus is on foreign standards that cannot be implemented in an environment that is (almost) hostile to non-practical and non-executable advice. He advised to first investigate the reasons behind unwanted behaviour, and the conditions that facilitate it. In this sense, he said that every case of corruption is an example of the failing conditions of a system that is unable to protect its participants against vulnerable situations. 5 In the Netherlands for example, there is a codification of good governance in the General Act of Administration. The principles of carefulness, care for balance of interests, proportion and detournement de pouvoir are laid down. 6 The first principle, i.e. carefulness is part of the principles of fair play. Because of the reason that the decision of tax matters are regulated there is a little space of making a balance of interest. Detournement de pouvoir will say that the government is not able to use their power for other perspectives than what the power is given for. Proportionality is important for making a decision which is in balance with the situation. The measure of the governance has to be in proportion into the situation which is created. This is also the case with exchange of information. 4 Manon Hornesch (VBT) en René van Eijk Kader Primair 6 - Februari Good Governance and Integrity: presentation given by Prof. Dr van Kommer during the Commonwealth Business Forum article 3:2, 3:3, 3:4 General Act of Administration, The Netherlands. 3

106 The Global Forum on Transparency and Exchange of Information for Tax Purposes is goaled to implement the international standards on transparency and exchange of information. It is because of the number of tax advoidance and tax evasion that countries will lose vital revenue of taxation. The increase in cross-border flows that come with a global financial system require more effective tax cooperation. For that reason the OECD developed a tax transparency standard based on the OECD MTC and the TIEA model. The global forum on transparency and exchange of information for tax purposes has listed a few criteria to check the transparency of the several conventions of countries. Below a list of these criteria. Exchange of information on request where it is foreseeably relevant to the administration and enforcement of the domestic laws of the treaty partner. No restrictions on exchange caused by bank secrecy or domestic tax interest requirements. Availability of reliable information and powers to obtain it. Respect for taxpayers rights. Strict confidentiality of information exchanged. The peer review group of the global forum will control these criteria by reviewing the countries. 3. Five critical aspects 3.1 Taxes covered First a distinction must be made between direct and indirect taxes. These types of taxes serve different needs and are therefore usually dealt with separately. Also, rules regarding value added tax (VAT) are, in contrast to direct taxes, to a large extent harmonized within the EU. With that, it may not always be desirable to try to regulate these two types of taxes in the same international instruments. Many of the international instruments are wide to their scopes when it comes to taxes covered. For instance, the OECD MTC article 26 states that exchange of information is applicable to taxes of every kind and description 7. In contrast, the Directive 2003/48/EC on taxation of savings 7 Article

107 income in the form of interest payments (Savings Directive) only covers income from interest on capital. In order to be able to exchange as much information as possible under an international instrument, the best practice would of course be to include all taxes imposed in all states. It is however important to remember that even though a certain tax is covered by an instrument, relevant information may still not be exchanged between countries due to other reasons. An example could be the inheritance tax that is imposed in many countries, but not in Sweden. Since Sweden does not have this kind of tax, related information is neither collected for domestic purposes nor subject to transmission to another country. 3.2 Methods covered There are three main methods for exchanging information: upon request, spontaneously and automatically. From the OECD MTC article 26 and its Commentary it becomes clear that exchange of information should take place upon request and that other methods are voluntary and not mandatory. Also according to the TIEA model, the only method required is the exchange upon request. Nevertheless, both the Council of Europe/OECD Convention on Mutual Assistance in Tax Matters and the Nordic Convention on Mutual Assistance in Tax Matters explicitly suggest all the three methods as well as some additional. Automatic exchanges of tax information tend to be used increasingly (for instance the Savings Directive). Even though automatic exchange could be preferred in some situations, there are disadvantages. For example, automatic exchange may not always be efficient, since all the information then must be filtered. This, in turn, could be both time-consuming and expensive. Also, automatic exchange may not be needed in all cases. Thus, an instrument allowing for many different methods does not necessarily has to be more efficient than one only suggesting exchanges upon request. The best practice would be to, in the international instrument, allow for, and require as many methods as possible as long as the advantages outweigh the possible efficiency disadvantages. In addition, a computer system sorting incoming information (in case of automatic exchange of information) is to be desired. 3.3 Possibilities of denying a request 5

108 The international instruments contain similar grounds for denying a request. In the OECD MTC article 26.3 stipulates that a state does not have the obligation to supply information which is not obtainable under the laws or in the normal course of the administration of that or of the other contracting state. Furthermore, there is a possibility of denying a request if the supply of information would disclose any trade, business, industrial, commercial or professional secret or trade process, or information the disclosure of which would be contrary to public policy (ordre public). In addition, reciprocity could, according to some instruments, constitute a ground for denying a request. With reciprocity means that a requested state does not have to go further in collecting information than the requesting state would be able to do in a similar situation. The underlying idea of the concept of reciprocity is that a state should not be able to take advantage of the information system of the other state if it is wider than its own system. It has been recognized that too rigorous of an application of the principle of reciprocity could frustrate effective exchange of information and that reciprocity should be interpreted in a broad and pragmatic manner. 8 In fact, the principle of reciprocity has been abandoned to some extent in recent developments. When the TIEA model was drafted by the OECD in 2002, it was decided that there would be no reciprocity ground, due to the fact that the so called tax havens usually do not have any functional tax systems. Since 2005, the OECD model article 26.5 stipulates that a requested state cannot deny a request solely because the information is held by a bank, other financial institution, nominee or person acting in an agency or a fiduciary capacity or because it relates to ownership interests in a person. A similar provision is found in the new assistance Directive, amending the Directive 77/799/EEC. Actually, this rule is now also a part of the internationally agreed tax standard that has been developed by the Global Forum. Consequently, the best practice is to follow the internationally agreed standard and be aware of the issues that may rise from having reciprocity as a ground for denying a request for information. 3.4 Secrecy aspects 8 OECD Manual on the implementation of exchange of information provisions for tax purposes: Approved by the OECD Committee on Fiscal Affairs on 23 January 2006, p

109 When it comes to secrecy, three aspects will be mentioned. First, according to the OECD, UN and US MTCs, information received may be disclosed only to persons or authorities (including courts and administrative bodies) concerned with the assessment or collection of, the enforcement or prosecution in respect of, the determination of appeals in relation to the taxes, or the oversight of the above. A similar provision is found in the TIEA model as well in article 9. However, the Commentary to the article 26 of the OECD MTC stipulates that information received by a contracting state may be used also for other purposes if the laws of both states allow it and if the supplying state authorizes such use. A best practice would be to continue allowing for this kind of extra use of information since it is more efficient to exchange information under one instrument instead of many. A second issue regards legal privilege. If a requested state has information to transmit may depend on whether or not secrecy applies on that information. It becomes clear from the TIEA model that a contracting party does not have the obligation to obtain or provide information, which would reveal confidential communications between a client and an attorney, solicitor or other admitted legal representative where such communications are either produced for the purposes of seeking or providing legal advice or produced for the purposes of use in existing or contemplated legal proceedings. 9 The best practice should be to allow states to have some secrecy rules as long as they do not, to an increased extent, prevent exchange of information to take place. Third, one interesting secrecy aspect is whether or not a receiving state can forward obtained information also to a third country. The OECD MTC article 26 does not allow for such transactions. According to article 23.4 of the new EU Assistance directive however, a transmission to a third member state is possible. Naturally, as far as exchange of information is concerned, such exchange would be desirable, but is not likely that countries outside the EU would be willing to accept it. 3.5 Taxpayer protection Concerning taxpayer protection, a controversy may appear between international instruments and states domestic laws. The international instruments serve to facilitate the 9 Article

110 exchange of information, and in order to do so, a certain level efficiency is required. This efficiency aspect has been taken into consideration in the TIEA model which in article 1 states that the rights and safeguards secured to persons by the laws or administrative practice of the requested party should remain applicable to the extent that they do not unduly prevent or delay effective exchange of information. So, to some extent, the efficiency will prevail the rights of the taxpayer concerned. In contrast, the OECD model states that in no case shall the contracting state be obliged to carry out administrative measures at variance with the laws and administrative practice of that or of the other contracting state. Rules that may delay or even prevent exchange of information to take place could be notification- and hearing rules. Best practice would be to include rules on taxpayer protection in the MTCs and the TIEAs. Nevertheless, the more common rules on human rights (taxpayer included), for instance the ECHR, the less controversy in this aspect. 4. Fishing expeditions 4.1 Definition Based on the OECD Model Tax Convention 10, exchange of information take place only if it is foreseeable relevant. This means that it wants to provide exchange of information in the widest possible extent and to clarify that the Contracting Parties are not at liberty to engage in fishing expeditions. However, there is no specific definition of the term. Moreover there are some linguistic problems concerning the term foreseeable relevant. 11 For the reason that the double tax agreements and the tax information exchange agreements are instruments to tackle tax dispute and fishing expedition is one of them, one can find in these international tools that concrete indications for a relevant connection concerning tax matters between the taxpayer and the requested state are 10 The OECD Model Tax Convention 2010, condensed version, 11 There is differences between the OECD MTC in English and French: foreseeable relevant and vraisemblablement pertinents. Vraisemeblablement means likely and is less sure and pertinent means accurate and it is true; so there is something contradicting about it. 8

111 required. 12 Fishing expeditions are prohibited by the principle of subsidiarity which dictates a country should pursue all domestic means, and there should be a link between the requested information and the taxpayer, who is investigated. Relevancy is the crucial point of this story: The relevance of the information should be showed in order to avoid fishing expeditions; allowing the foreign countries to scan through bank accounts in hope of finding something of their interest is impermissible. We can state that in this manner, the taxpayer is protected for the reason that not all information can be exchanged. The topic of fishing expedition can be connected to the domestic auditing because it leads to a lower level of fishing expeditions as the country knows already the information it wants to request. Another principle that can be linked to the fishing expedition is the MFN clause for the reason that MS can achieve Level Playing Field in order to get the same type of information. As these topics are interesting, we will explain it more in detail in the following paragraphs. 4.2 The result of most-favorable-nation clauses. In this paragraph we discuss the result of the MFN 13 clauses in the DTT 14 as it is a very important issue within the exchange of information because it can lead to a Level Playing Field. Recently, this kind of clause is incorporated in the new mutual assistance Directive. The European MS 15 agreed to install MFN clauses in the new Directive for the reason to find an agreement so that every MS can get the same level of information. However, it took a long time to agree because it was difficult for some countries, like for example Austria and Luxembourg to agree this clause as it was one step too far for them. 16 At the time countries such as Luxembourg and Belgium had to renegotiate their article 26 of DTT, Switzerland also started to re-negotiate but they had already a MFN clause with Spain. Two special treaties are the Switzerland-France and Switzerland- U.S.A. treaties, with additional MFN clause with Spain. These DTTs are mentioned 12 art. 26, 5 OECD and TIEA art. 5, 5 13 MNF: Most- Favorable-Nation 14 DTT: Double Tax Treaty 15 MS: Member State 16 Austria and Luxembourg have the bank secrecy and wanted to agree what they already had. 9

112 because they are very detailed and existed before the new Directive. Due to the special most-favorable-national clause with some countries, like Spain, one can state that Spain would get the same information on the same level, i.e. Spanish tax authority can ask information about their own Spanish residents. 17 But can the received information be useful for Spain if it covers, in this example, the taxes in France and Switzerland? Therefore, the Joe Doe summons can form a solution as it is a general request for information 18. Although it also can be refused due to the fact that there is no clear nexus between requested information and the person that is investigated. Finally, it important to observe that this kind of clause is of great significance because the MS should achieve a tax co-operation through a Level Playing Field in order to improve transparency and establish effective exchange of information, cfr. new mutual assistance directive 19. Consequently, same type of information should be exchanged. For example, if Luxembourg and Austria have the right to have the withholding system and to exchange bank information due the Saving Directive. But, due to the MFN clause this kind of information can be exchanged, if Luxembourg transmit bank information with one other MS Domestic auditing Next is the twofold question. First, should there be a domestic auditing in advance or should the foreign tax authority be asked first? Second, will it be more efficient for a foreign tax authority to ask the taxpayer before asking the domestic tax administration? First, domestic measures based on the international instruments should be all pursued, unless the measures are disproportionate. This is a valid reason for not 17 Protocol 29 June 2009 to the Switzerland-Spain contains a special provision concerning the most favoured nation, art. 5 (11): A consequence of this provision is that the taxes that are covered within this tax treaty has a limited scope of taxes, which are covered and the scope of application with regard to Spain does not extend to the other taxes that are included by other tax treaties, like for example the tax treaty between Switzerland and France. 18 The US case law has blessed the use of summons authority to investigate tax liabilities for foreign governments with whom the US shares a tax treaty or a TIEA. : In the USA the tax administration, so the IRS, can obtain information by the taxpayer s voluntary disclosure and if the taxpayer doesn t cooperate, the IRS can use the summons in order to push the taxpayer to exchange its information. Note that the summons has to need four criteria in order to be used, i.e. the Powell requirements; there should be a legitimate purpose, information that is sought should be relevant to the purpose, the information may not be yet in possession of the tax administration ( IRS) and the administrative steps should be satisfied. 19 This new mutual assistance Directive is signed by the Council on 1 February

113 exchanging information. But what about the question of proportionality? Maybe the domestic auditing has disproportional administrative burden 20. Therefore, perhaps, the domestic tax authorities will say that the measures are disproportionate 21 without trying their best and go directly to the other state and ask the information. However, this is just an issue of transferring costs and administrative burden to another MS. But from the other side, the requesting party can refuse in accordance to article 19 of the EU Council Directive of Moreover, if there is no domestic auditing there is a higher level of fishing expeditions and this is not allowed, so we need to have domestic auditing, especially if there is a high cost and administrative burden. The second question is whether it is efficient to request directly information from the taxpayer or the tax administration. The answer to this question is dependent on the situation; on the one hand you have the efficient way of gather information by the administration and on the other way you have the possible voluntary cooperation of the taxpayer, if there is a trust-relationship. In our opinion, it is important to have trust between the tax administration and the taxpayer in order to gather quickly the relevant information. However, if there is no voluntary cooperation, the best practice is that foreign tax authority should ask the national administration. As a conclusion we can detect that the fishing expeditions have some consequences that we need to research. First, has the most favoured nation clause had important consequences for the fishing expedition? Second, is it efficient to request directly a foreign tax administration without domestic auditing and should it be more optimal if foreign countries ask immediately the taxpayer instead of the tax administration? In our opinion, based on the principle of subsidiarity it is a good idea to start with the domestic auditing in order to find out which information can be relevant. Otherwise without an auditing, there is the possible chance that the requested Party will transmit irrelevant information. In the case of the taxpayer versus tax administration, it depends on the situation. If there is voluntary cooperation from the taxpayer, it could be efficient to gather information. Although, it could be less reliable as it is the taxpayer 20 Art. 19, Council Directive of Europe/OECD convention on mutual administrative assistance in tax matters, As the administrative burden takes too much time, and they noticed that a foreign tax system is faster in collecting the relevant information. 11

114 himself and therefore gathering tax information by the tax administration might be more optimal. Domestic law This subsection focuses on how the different states implement the basis for the international exchange of information within their domestic law. First, there will be an introduction on domestic regulations, a description of the differences to the international legal frameworks and a decision for best practice. Second, there will be a discussion on special issues, such as FATCA, use of summons, and the distinguishing between personal, and confidential data. Third, taxpayer protection will be evaluated and recommendations for a minimum standard for protection will be made. Finally, the highly debated issue of banking secrecy will be addressed. I. Domestic Regulations Concerning the Exchange of Information, the Exchange of Information in the Absence of a Treaty, and the Influence of Different Tax Procedures 1. Regulation in national law There are different approaches concerning the regulations concerning the exchange of information within the EUCOTAX countries. Countries such as Germany 22, the Netherlands, 23 and Sweden 24 have regulations linking international commitments to the internal law of the countries. Other countries do not have such regulations. However, all of the EUCOTAX countries (except for the US) are Member States of the European Union, and have transposed the EU Council Directive 77/799 into national law. In the US, case law has stated that IRS can use its summons authority to collect tax information for foreign authorities Exchange of information based on a treaty or in the absence of a treaty s. 117 (1) and (2) AO. art. 13 para. 1 a WIB. Law on mutual assistance in tax matters. Banquero v. United States, 18 F. 3d 1311, 1316 (194). 12

115 There are different approaches to the possibility of an exchange of information in the absence of a treaty. The majority of the EUCOTAX countries do not exchange information in the absence of a treaty. Most countries either need a European or an international instrument. 26 Generally, the exchange of information is based on reciprocity. In international law, reciprocity is defined as the right to equality and mutual respect between states. Bilateral agreements and treaties are the most common way of expressing the commitment of states to the principle of reciprocity. These instruments assure more than any other that in similar conditions the other party will act in a similar way 27. However some countries exchange information on the basis of reciprocity even in the absence of a treaty. In Germany, domestic regulations allow the exchange of information in the absence of a treaty at the discretion of a tax authority 28. Other countries such as Hungary and Spain 29 do not have special domestic regulations concerning the exchange of information. However, these countries do at the discretion of a tax authority - exchange information in the absence of a treaty on the basis of reciprocity 30. Reciprocity is also required in Germany when it comes to an exchange of information in the absence of a treaty or European law. 31 German authorities exchange information upon request in the absence of a treaty 32. Hungarian authorities exchange information in the absence of a treaty mainly upon request. But, due to the fact that there is no regulation which excludes a spontaneous exchange of information, such an exchange in the absence of a treaty is also thinkable. Spanish authorities are allowed to exchange information in the absence of a treaty only spontaneously. 26 This is the situation in: Austria, Belgium, France, Italy, Netherland, Poland, Sweden, USA S. 117 (3) AO. 29 In Spain the possibility of an exchange of information in the absence of a treaty is controversial. 30 D. Deak, Hungary in: R. Seer and I. Gabert (eds.) Mutual Assistance and Information Exchange, EATLP International Tax Law Series Vol pp S. 117 (3) no. 1 AO. 32 Loy, Pump/Leibner, 117 para

116 In Germany and Hungary, international law is not even the last resort 33. If the scope of an international instrument is not wide enough, e.g. only taxes which are mentioned in a treaty are covered, there is still the possibility of course only on the basis of reciprocity which ensures that information will only be exchanged if the other state would exchange the same information 34 to extend the international instrument by exchanging the information according to national law. This situation prevents many countries from exchanging information 35. A system with concrete laws and regulations will be more effective in increasing the exchange of information. Furthermore, precise regulations may create more legal certainty concerning taxpayers rights than when the rights are merely based on soft law. Nevertheless a detailed regulation by treaty can not be replaced by a national regulation. 3. Influence of different tax procedures There is a strong link between domestic procedural regulations and the ability to exchange information. The principle of reciprocity is universally relevant for the exchange of information. As a result, countries exchange only the information which is available under the administrative procedures of the applicant and the requested state. 36 This leads to a situation in which the lowest common dominator in the national law of the involved countries is the basis for an international exchange of information. A regulation to circumvent the influence of national law can be found in the OECD model TIEA. Art. 7 (1) model TIEA 37 states that: The requested Party shall not be required to obtain or provide information that the applicant Party would not be able to obtain under its own laws for purposes of the administration or enforcement of its own tax laws. The competent authority of the requested Party may decline to assist where the request is not made in conformity with this Agreement Schwarz, Praxis Kommentar AO, 117 para. 51. Schwarz, Praxis Kommentar AO, 117 para. 51. All those countries which do not have an international instrument with the requested state. Amongst others: Söhn, HHsp Abgabenordnung, 117 para

117 This regulation contains on the one hand a limitation on the law of the applicant state so that the applicant state cannot extend its rights by requesting a state wider possibilities of obtaining information. On the other hand, in contrast to art. 26 (3) lit. a OECD MTC 38, the requested state can not decline a request for information only because the state can not provide the information under its national law. This regulation has the advantage that much more information may be exchanged according to this regulation. Its disadvantage is the massive influence it will have on the sovereignty of the affected states. Due to the conflict between the applicant state s interests in acquiring information needed to maintain an adequate tax base with requested state s reduction of sovereignty, it is uncertain whether a regulation which implements the applicant state s national standards in the requested state can be seen as best practice. Nevertheless it is impossible to implement an adequate exchange of information in the absence of a regulation similar to that one mentioned above without the voluntary acceptance of the other state. Thus, there is unlikely to be an effective alternative to countries voluntarily accepting a common standard. II. Selected issues: The use of summons to obtain tax information. If the United States tax authorities cannot obtain information through voluntary disclosure, IRS agents and officers may issue and serve a summons that will order a taxpayer to produce the information. IRS may use its summons authority for any of the following purposes: 1) To ascertain the correctness of any return; 2) To make a return where none has been filed; 3) To determine the liability of any person for any internal revenue tax; 4) To determine the liability at law or in equity of any transferee or fiduciary or any person for any internal revenue tax; and 5) To collect any internal revenue tax liability. 39 But the question is: are there sporting chances of using a John Doe summons for fishing expedition? No. It seems that this instrument is not linked with seeking information without having real expectation of receiving or uncovering relevant data. The Banquero v. United States, 18 F. 3d 1311, 1316 (194). 15

118 broadness of the summons authority is arguably limited by the procedural requirements of enforcing (not only the Powell standards but also tree additional requirements: 1) the summons relates to the investigation of a particular person or group; 2) there is reasonable basis for believing that this person or group has failed (or may fail in the case of a current transaction) to comply with the internal revenue laws; 3) the information sought under the summons is not readily available from other sources and information concerning the identity is not also not readily available. US case law has blessed the use of summons authority to investigate tax liabilities for foreign governments with whom the US shares a tax treaty or a TIEA. When issuing a summons pursuant to a TIEA, a court has held that the IRS may issue summons as if the IRS was requesting documents for its own investigation. The IRS summons authority can be larger when it is used to investigate foreign tax liabilities. In the domestic context, the IRS summons authority is essentially limited to investigating for civil liabilities. The IRS investigation is voluntarily stalled once a criminal procedure begins. IRS summons authority is statutorily restricted once a case is referred to the Department of Justice. This limitation does not apply to investigations for foreign criminal prosecutions. To conclude, the IRS summons power is broad and far reaching. The IRS is entitled to disclose information to other agencies for the purpose of law enforcement. Hence, once the IRS gains a foreign persons information pursuant to a treaty or TIEA, it is possible that information will be used by other entities and government bodies for both additional civil punishments and criminal prosecution. What is more, a U.S. court can order a non-u.s. corporation (e.g. a bank based in Liechtenstein) with a U.S. branch to produce its records based abroad. On the other hand, foreign entities and persons become affected by the US attempts to collect tax information, it can be expected that privacy and protection of information will become a pressing issue in the future. III. Selected Topics: The Foreign Account Tax Compliance Act The Foreign Account Tax Compliance Act (FATCA) was enacted in 2010 and marks an increased aggression in the US government s attempt to close the tax gap by 16

119 combating tax evasion of US persons concealing funds in foreign bank accounts. The law requires US taxpayers holding funds in foreign bank accounts to report them in tax return. What makes this law particularly aggressive, however, is its requirement that foreign financial institutions report directly to the IRS information regarding accounts held by US tax payers. This foreign reporting requirement will begin on January 1, Furthermore, foreign financial institutions will be required to withhold a 30% tax on any payments of US source income made to the following parties: non-participating Foreign Financial Institutions, individual accountholders failing to provide sufficient information to determine whether or not they are a U.S. person, foreign entity accountholders failing to provide sufficient information about the identity of its substantial U.S. owners. Essentially, FATCA will require US taxpayers to choose between voluntarily giving up information regarding their foreign bank accounts, and taking the risk that the foreign bank report their accounts to the IRS and paying a 30% tax. 41 Taking into consideration new withholding regime seems to have far-reaching impact on other jurisdictions. Foreign financial institution (such as banks brokerages and investments funds) must consider potential changes to functionality of their systems, their technology and internal governance and start to bring alterations into effect as soon as possible. Otherwise they will not be compliant with new U. S. standards and will be required to withhold the 30 percent tax. This could result in the loss of clients. IV. Personal and sensitive personal data Definition of personal data is a highly complex and broadly issue. The directive of July defined personal data as any information relating to an identified or identifiable natural person ('data subject'); an identifiable person is one who can be identified, directly or indirectly, in particular by reference to an identification number or 40 Summary of Key FATCA Provisions available at 41 Id. 17

120 to one or more factors specific to their/its physical, physiological, mental, economic, cultural or social identity (art. 2 indent a) 42. Some examples of personal data are bank statements and credit card numbers. Personal data may only be transferred to third countries if that country provides an adequate level of protection. What is more, according to Article 9 of 95/46/EC Directive some personal data is classified as a sensitive personal information: religious belief, political opinions, health, sexual orientation, and race. When such sensitive information is being processed additional restrictions apply. France maintains a distinction between personal information and sensitive information which allows direct or indirect identification of a natural person (e.g. information about a living). This distinction is blessed by both the domestic law of 1978 and the directive 95/46. In Spain also, personal data are protected in varying degrees. Sensitive data (e.g. information about a religion) is protected more than data referring to the identity of a particular taxpayer. Italian Legislative Decree 196 of 30 June 2003 (Personal Data Protection Code) has establish of a new category of personal data called sensitive data, which, due to their nature, specifically mandates protection. Polish Act of 29 August 1997 on the Protection on Personal Data 43 does not clearly distinguish between personal and sensitive personal information. Nonetheless, this Act is compatible with general policy of European states, which respects human rights, fundamental values of the respect for privacy and the free flow of information 44, pluralistic democracy and open market economies. It also fallows the considerable rules introduced by the Directive 95/46/EC of the European Parliament and of the Council Council and European Parliament Directive 95/46/EC on the protection of individuals with regard to the processing of personal data and on the free movement of such data, OJ L 281 of 24 October Act of 29 August 1997 on the Protection on Personal Data, Journal of Laws 2002, No. 101, heading 926, amended. 44 Preamble to Convention for the Protection of Individuals with regard to Automatic Processing of Personal Data of 28 January 1981, available at: 45 Council and European Parliament Directive 95/46/EC on the protection of individuals with regard to the processing of personal data and on the free movement of such data, OJ L 281 of 24 October 1995, p

121 Finally, in the United States, there are two types of information in the context of taxpayer information. First, there is information protected by the Privacy Act of This law protects information, collected by any US government agency, that is retrievable by name of the individual or by some identifying number, symbol, or other identifying particular. The second type of information is protected by IRC section This law specifically protects Return Information. This is a broad type of information that includes any tax information the taxpayer files. US law does not distinguish between confidential and personal data. These two types of information are simply divided by the laws that protect them, not by their sensitivity. Undoubtedly, the best practice is making distinction between personal data and sensitive personal data. Both kinds of information can be used according to the general principles of protecting taxpayer s privacy rights, However, sensitive data requires stronger protection. Derogation from the general rule was introduced by the Court of Justice of the European Communities in the Case C-73/07. V. Case C-73/07 Tietosujvaltuutettu v Satakunnan Markkinopörssi Oy and Others The Court of Justice of the European Communities (ECJ) established the rule that the transfer of personal information by the tax authorities (in Finland) for the purposes of putting into place a text-messaging service permitting telephone users to receive tax information relating to other individuals may be the subject of a exception (or derogation) from the data protection rules introduced by the Directive 95/46/EC. This exception is carried out only for journalistic purposes or for artistic or literary expression. Moreover, the scope of application of aforementioned Directive is extended to the processing of personal data which consists in transferring onward on CD-ROM (to be used for commercial purposes), data on the earned and unearned income and the assets of natural persons which has been collected from documents in the public domain held by the tax authorities and processed for publication and which has already been published in 19

122 the media 46. Undoubtedly, this interpretation has a great impact on the processing of personal data rules and need to be applicable in all EU jurisdictions and gives green light for revealing personal data. Nonetheless, Article 9 of the aforementioned Directive is an exemption from general data protection rule that must be interpreted narrowly. Extensive interpretation may leads to infringement of taxpayer s rights and easily disturb the balance between freedom of speech and taxpayer s right to privacy. Transparency is very important but it cannot abuse the general principles on taxpayer s privacy rights when their data is processed. Only such an interpretation (and only for the purposes covered by this derogation clause) can be considered as the best practice. VI. Taxpayer protection Even though taxpayer protection is an important issue in domestic as well as foreign proceedings, it is often neglected. This subsection should emphasize the different degree of protection in the EUCOTAX countries and provide a basis for our recommendation concerning the development of a minimal standard which should be achieved in each country. Generally the taxpayer may be protected by the following rights: the right to notification, the right to be heard and the right to appeal. The right to notification refers to the obligation of the tax authority to inform the taxpayer before the exchange of information that a foreign request of information was received. The right of consideration includes the hearing of the taxpayer in the proceeding, meaning that he is given the opportunity to comment on the information which should be exchanged or on the exchange procedure. Finally the right to appeal provides the taxpayer the possibility to let the legitimacy of the exchange of information checked by court. Moreover the right to 46 Case C-73/07 Tietosujvaltuutettu v Satakunnan Markkinopörssi Oy and Others, The Court of Justice of the European Communities. 20

123 appeal includes the right of objection therefore the taxpayer may also block the transfer of information until the court s decision, insofar a suspense effect is granted. The following matrix outlines the differences in protection between the EUCOTAX countries: Right to notification Right to consideration Right to appeal Austria NO NO NO Belgium NO NO NO France NO NO NO Germany YES YES YES Hungary NO NO NO Italy NO NO NO Netherlands NO NO YES Poland NO NO YES Spain YES NO NO Sweden YES NO NO USA NO NO NO Except bank information The exchange of information is executing even if the parties affected raise an objection, however information is not exchanged if confidentiality is not ensured In Sweden the taxpayer is notified after the exchange of information took place In general the EUCOTAX countries do not provide any of the rights mentioned above to protect to the taxpayer before the information is exchanged. 47 However, some countries put it in the discretion of the authority to inform the taxpayer when it receives a foreign request, while in other countries it is only obligatory to notify the taxpayer after the transmission of the information. Nevertheless these methods cannot be seen as best practice. The former is creating legal uncertainty since it is up to the authority to decide in each case. Without the existence of objective criteria for the notification of the taxpayer the decision is not traceable and therefore not transparent. In addition it has to 47 See chart above 21

124 be considered that under both approaches effective measures are lacking which enable the taxpayer to influence what kind of information is used. This may cause problems if tax officials do not have expert knowledge in certain fields of business, which would enable them to identify for example trade and business secrets, etc. A unique notification rule can be found in Dutch law. The law requires that the information provider has to be notified about the exchange of information and gives him the right to appeal against an exchange of information. 48 Such a requirement is far reaching especially considering that other countries do not provide the taxpayer which such possibilities. In addition, under Dutch law the right to appeal is granted for the automatic exchange of information, but it can only be claimed after the transmission of the information. There is no right of the information provider to be notified directly in such a case, but exchanges based on bilateral treaties must be published in the newspaper. 49 As mentioned above, the EUOCTAX countries generally do not provide for the right to appeal the authority s decision to exchange information. Nevertheless, some countries are exempted from this general rule. For example, in Austrian regulation enables the taxpayer to appeal the transfer of information within two weeks after notification. However, this rule is only valid for the exchange of bank information to foreign authorities but not generally for requests concerning other information relevant for tax assessment. 50 This provision is noteworthy as a special rule concerning taxpayer protection only for a certain sector of a country s economy. A different approach is applied by the Polish tax authority, which publishes its decision whether a foreign request is executed every time, regardless of the kind of information exchanged, and grants the taxpayer a right to appeal the decision. 51 Another question appeals rights raise is the suspense effect of the appeal. In general such an effect is only obtained if the taxpayer applies for it, that means information is exchanged unless the taxpayer request that the exchange proceeding is halted till courts have decided about the legitimacy. 48 Art. 5 para. 3 WIB 49 A.C.M Schenk-Geers, Internationale gegevensuitwisseling en de rechtsbescherming van belastingplichtige, FM nr. 120, paragraph 2-4; Article 6 paragraph 2 WIB 50 Art. 4 ADG 51 Art. 220 of the General Tax Law of 29 August 1997, Journal of Laws 2005, No. 8 heading 60, amended 22

125 In short, taxpayer protection is generally is very weak in most of the EUCOTAX countries. The exchange of information is a critical topic since the interests of the authorities exchanging the information, and the interest of the taxpayer s right to privacy and notice clash. Nevertheless countries should try to find minimum standards that satisfy the interest of both parties to a certain extent. A minimum standard for taxpayer protection during an exchange of information procedure must include the obligation of the authority to notify the taxpayer about a foreign request for information. However, when deciding whether to grant the taxpayer an appeal, the time consumption of such procedures should be considered. As there may be cases which require immediate actions, a special rule for such situations should be adopted in the minimum standard. The problem of time-efficiency in all other cases can be solved by granting a suspense effect only by request of the taxpayer. In addition, a time limit should be laid down for dealing with such requests (for example 6 weeks). However, the time or costs of a proceeding should not hamper the effective protection of a taxpayer. Therefore a right to appeal a decision should be granted. Nevertheless it can be required from the taxpayer that he decides for example within 10 days after his notification whether to appeal a decision or not. As it concerns the protection of the taxpayer after the information is exchanged, i taxpayers can generally base their claims on the Union Data Protection Directive 95/46/EC. This was mandatorily adopted into the national laws of every Member State of the European Union. However, in this subpart the focus should be put on specific national regulations. It has to be pointed out that most countries rely on the obligation to confidentiality when it comes to the protection of the taxpayer after having transmitted the information. Nevertheless, it is questionable whether the provisions in the international legal framework are sufficient; especially, since the international legal framework itself does not include any legal consequences for the infringement of these provisions. Consequently, it makes sense to include a minimum standard of protection into every national law to increase legal certainty. As it regards the secrecy provisions contained in the national law of the EUCOTAX countries, it can be concluded that the majority of these countries provide secrecy rules which are generally in line with those 23

126 covered in the international legal frameworks, meaning that they provide a special rule for tax secrecy. Sweden provides an even more far-reaching secrecy rule by declaring restrictions to the use of information in the requested state also binding for the Swedish authorities, irrespective of the Swedish law. 52 However, some countries rely only on the protection of personal data and do not provide a special provision concerning tax secrecy under their domestic law. 53 Another question is the handling of information by the requesting authority if the exchange procedure was unlawful. In general, unlawfully exchanged information must not be used in the receiving country. However, France does allow the use of information if it was obtained lawfully. 54 This situation actually causes legal uncertainty from the taxpayer s point of view, since his tax liability or depends on the country which takes part in the exchange of information. The determination of a common practice concerning the dealing with unlawful exchange procedures will definitely increase transparency. As it concerns best practices the use of information obtained in an unlawful exchange procedure should be prohibited, as otherwise it would not be necessary to conclude international legal frameworks on which an exchange may be based. However, if an authority receives a request which violates national law or an exchange procedure, it should inform the requesting authority immediately about the decline of the request and provide the reasons for its decision. Finally, there is a special case which needs to be dealt with, the use of unlawfully obtained information. This issue was coming up due to the Liechtenstein-CD which included stolen information about account holders of a bank in Liechtenstein. Actually this CD was bought by the German tax authority and was used for investigation against potential tax evaders. Later on the information on the CD was offered to tax authorities in other countries. The EUCOTAX countries are dealing differently with that matter. While in some countries, information must not be used, in other countries there are no unanimously results or it is at least not prohibited to use such information and therefore 52 The Swedish Tax Agency s guidelines of international taxation 2009 p 743 (SKVs handledning) 53 For example: Italy 54 Framework of the Franco-British Convention, TA Dijon 14 May 1996 Oldham 24

127 left to the discretion of the authority to decide in each individual case. Usually the authority s decision depends on the importance of the information exchanged and for what purpose the information is used, meaning for criminal or tax purposes. France additionally focuses on the exchange procedure which has to be lawful in case of unlawfully obtained information. 55 In Spain, on the other hand, the dealing with such issues is alarming, since administrative practice violates Spanish law by using such information even though it is prohibited. 56 The handling of unlawfully obtained information is obviously a delicate problem. However, it must be settled whether to solve that problem either by prohibiting, allowing or putting it in the discretion of the authority to use the information, or by other measures, such as the improvement to the access to bank information, which would mean that the actual cause is tackled and not the effect. However, this may only be achieved in the long run, and therefore solutions for the short run are desirable too. Deciding about the best practice in dealing with unlawfully obtained information is complex. On the hand it has to be considered that if authorities buy such information, they give incentives to those stealing information to go on with such actions. On the other hand if information is not used, taxpayers who are trying to evade taxes are protected, which may encourage in their behavior. Consequently the best practice in this case would be to put it in the discretion of the authority whether to use the information or not. This enables the authority to decide case by case and to consider the kind of information, the degree of misbehavior, etc. VII. Banking secrecy There has been an on-going debate between countries about bank secrecy for years, especially since the global financial and economic crisis has placed great pressure on countries to increase revenues to counteract the growing budget deficits. One group of countries, such as Austria and Belgium, allows banks to keep the identity and information of their clients secret even to tax authorities, but the rest of the world demands transparency to be able tax the income earned and deposited on those 55 Cass. crim., 28 October 1991; CE, 8 et 9 ss., 3 déc. 1990, n , SA Antipolia. 56 Art. 11 Ley Organica 6/1985, de 1 de Julio, del poder Judicial 25

128 accounts. The U.S. and the vast majority of Europe wants more information on bank account holders who are evading taxation by taking advantage of a countrys tax secrecy law to hide their taxable income. In 1998, the OECD's Committee on Fiscal Affairs released a report that drew attention to a dangerous trend: more and more countries were lowering tax rates and providing other fiscal incentives to attract investments and residents. The danger of this trend toward the so called harmful tax competition had the potential to deprive nations that refuse to engage in tax competition from high amounts of tax revenues. In order to fight this phenomenon, the OECD proposed that low tax countries should be required to abolish bank secrecy at least to an extent that applied to tax investigations initiated by foreign authorities. It also proposed sanctions against countries that engaged in harmful tax practices, such as the termination of tax treaties or ending tax credits. The fight became even fiercer in 2000, when the OECD identified 35 so-called "uncooperative tax havens" and set forth a variety of sanctions to be imposed on them unless they agreed to cooperate to revise their tax and financial privacy policies as set forth by the OECD specifications. These tax havens were given one year to sign an agreement with the OECD that obliged each of them to bring its tax regime in line with the OECD International standards In 2009, the OECD issued a "grey list" of countries that committed themselves to, but failed to comply in full with international tax cooperation rules set by the OECD. This list included Austria, Belgium, and Luxembourg as well. 57 In Austria, banking secrecy could have been lifted only in case a criminal procedure was initiated, and providing information in tax administration procedures was prohibited. According to the requirements of the internationally agreed tax standard grey listed countries shall release information on accounts held by foreign investors in financial institutions upon the request of foreign tax authorities acting in their official course of dealings. The request must be complied with regardless of the type of tax

129 inquiry, so it may be in connection with civil, criminal, or administrative proceedings, as well. A requested state shall not refer to the domestic bank secrecy laws to refuse the provision of information. Further, grey listed countries were required to sign at least 12 tax information exchange agreements (TIEA) with other countries. Only after meeting all these demand can a country be removed from the grey-list. The OECD Model Tax Convention was also updated, in 2005, by adding a new bank anti-bank secrecy paragraph to Article 26, Exchange of information. As a result of the growing international pressure during the financial crisis, in March 2009, Austria, Belgium, Luxembourg, and Switzerland withdrew their reservations to Article 26. Since then, they have been actively renegotiating their treaties to comply with the new standards. Bank secrecy plays a legitimate role to protect the confidentiality of the financial dealings between financial institutions and individuals. Confidentiality is crucial regarding the relationship between the banker and the individual in order not to deprive the account holder of the right of privacy and not to jeopardize its financial well-being. It also strengthens the trust in a country s banking system which stimulates the development of financial activities, and therefore contributes to the well being of the society. Banking secrecy in Austria, Belgium, and Switzerland has deep historical and cultural roots. This secrecy towards government authorities, such as tax authorities provides an opportunity for taxpayers to hide illegal activities and income to escape taxation. To effectively carry out provisions regarding taxation, tax administrations must analyze the records of financial transactions of the taxpayer, which requires access to banking information. Conditions that allow the concealment of financial records and transactions, and allow denying access to such information to law enforcement authorities, must therefore be abolished. Allowing the tax authorities to access bank information for tax administration purposes is not contradictory to the confidentiality of the information. All OECD (and therefore all EUCOTAX) countries tax administrations are bound by very strict secrecy rules on how to use taxpayer and banking information. Article 26 of the OECD Model 27

130 also provides fort he confidentiality of information exchanged by authorities on the basis of tax treaties. Prohibiting tax authorities to access bank information, however, can have adverse effects both domestically and internationally. Domestically it might prevent the tax authority to exercise its right to assess and collect the due amount of tax. Furthermore, it contradicts the equality principle of taxation. Because of information inequality, some taxpayers might not have the knowledge or resources to be able to take advantage of the bank secrecy rules in foreign countries by transferring their income there. This creates a distortion in the distribution of the tax burden and may jeopardize the fairness of the tax system. It might also support the inequity of taxation between highly mobile capital and income earned from income. Furthermore, by not being able to access bank information, tax authorities are forced to use more inefficient and time consuming ways to investigate, which results in higher costs and higher government spending, which is a burden on the honest taxpayers. Internationally, it might hinder he cooperation of tax administrations and might distort cross border capital and financial flows by directing them to bank secrecy promoting jurisdictions. Because of the aforementioned reasons, it is clear that banking secrecy is a large burden on tax authorities which prevents them carrying out their obligations efficiently, and it has many adverse effects, therefore the best practice would be to abolish banking secrecy not just in cross border but also in domestic matters, too. TAX CRIMES Introduction This section discusses the application and significance of information exchange specifically to tax crimes. The first part explores how countries separate tax crimes from general civil tax offenses, and how the differences can eventually affect the prevention of cross-border tax evasion and fraud. This negative effect gives rise to the suggestion that a universal standard be adopted for tax crimes. The second part discusses how the OECD standard for good governance can be applied to tax crimes. Because the OECD standard can be effectuated through several types of treaties, the third part explores the advantages and disadvantages of each type of treaty regarding the exchange of information. This 28

131 section will then go on to explore the connection between tax crimes and money laundering, and use this connection to explain the need for allowing information held by FIU s to be exchanged for tax purposes. I. The Need for a Universal Standard for Tax Crimes While their exact definitions and punishments vary amongst countries, tax crimes are universally marked by how they are separately identified from the civil tax offense. Tax crimes and civil tax offenses both involve the violation of a country s tax law. Tax crimes, however, are distinguished from civil tax offenses by the degree of taxpayer s wrongdoing. One common marker of wrongdoing that transforms a civil tax offense into a tax crime are the amount of tax underpayment. For example, an underpayment of taxes in Spain is an administrative offense if the total unpaid amount is less than euros. If the amount is more than euros, then the non-payment of taxes becomes a crime. 58 The intent of the taxpayer is a more common marker of criminal wrongdoing. In Italy, the intent to deceive the government will likely mean the infringement of tax law will be punished as a crime. 59 The willfulness of the taxpayer to is also the key element of a criminal tax offense in France and the United States. 60 In the United States, no statute provides a definition of the key willfulness element of a tax crime. However, case law states that willfulness may be inferred by certain circumstances that include: a pattern of understatement, keeping a double set of books, destruction of books and records, concealment of assets or covering up sources of income, or generally Conduct the likely effect of which would be to mislead or conceal. 61 In short, the taxpayer must have committed an act very wrong, and done it very purposefully to be convicted of a tax crime. How countries differ in their prosecution of tax crimes is exactly how offensive the taxpayer s behavior needs to be to constitute a tax crime. Even if tax crimes are 58 Article 305 Criminal Code (Spain) 59 Italian law. 60 French paper page 73 and IRC section Spies v. United States, 348 US 147 (1954). 29

132 comparatively more difficult to charge than other tax offenses within each set of domestic laws, countries still differ with each other in their ease of charging a taxpayer with a crime. This difference causes problems in two aspects in the realm of the international exchange of tax information. First, the exact definition of a tax crime amongst countries affects the choice of instruments that may be used to exchange information. Governments have two types of instruments they can use to gather information for investigating a tax crime: criminal treaties with tax clause within them, and pure tax agreements such as double tax treaties and TIEAs. A country where it is easier to convict a taxpayer may be more prone to use criminal treaties. This, in turn, can affect the rights of taxpayers whose information is being exchanged, and the governmental parties who can access the information. Second, the willingness of governments can differ according to how tax crimes are defined. The most infamous example is Switzerland. Switzerland traditionally did not consider tax evasion (as criminalized by the US) a crime, and this difference in defining tax crimes was the basis of Switzerland s refusal to provide tax information requested by US tax authorities. 62 What is needed for an effective, widespread, and fair system of exchanging tax information is a common standard that guides the dividing line countries place between general tax offenses and tax crimes. One place to begin the search for a common standard is the principle of proportionality practiced by the European Union. The principle of proportionality prohibits a governmental body from instituting a law that provides a punishment more harsh than needed to achieve the goal of the law. For example, an ECJ case involved the Dutch interpretation of Article 11(1)(a) of Council Directive 90/434/EEC of 23 July 1990 on the common system of taxation applicable to mergers, divisions, transfers of assets and exchanges of shares concerning companies of different Member State. 63 This article addressed mergers through the exchange of shares, and the eligibility of such transactions for tax benefits. The court held here that the aim of this article was to prevent tax evasion or tax avoidance. The Dutch law in question, however, laid down a rule that automatically excluded certain 62 Lynnlwy Browning, Switzerland Agrees to Aid in Pursuit of Tax Cheats, The New York Times, March 13, 2009 available at 63 Leur-Bloem, Case C-28/95 (17 July 1997(1)). 30

133 transactions whether or not tax avoidance or evasion had actually occurred. This Dutch interpretation violated the principle of proportionality by imposing consequences too harsh than was necessary to achieve the goal of preventing tax evasion and avoidance. A limiting standard such as the principle of proportionality should be used to define a clear universal standard for dividing tax crimes from civil tax offenses. A universal standard would ease the exchange of information amongst countries by generally clarifying what information countries such as Switzerland can provide according to their domestic banking secrecy law. Establishing this universal standard as a limiting one as possible would mean that fewer offenses would be categorized as being egregious enough to constitute a crime. A universal standard that requires governments to categorize as many offenses as possible as civil offenses would set a clear goal to adhere to. Instituting criminal punishments only just harsh enough to the extent of deterring the most egregious tax offenses is a simple requirement compared to the activity of considering a multitude of subjective factors. A universal and limiting standard would also aid the exchange of information using treaty instruments. More tax investigations would fall into the realm of tax treaties, as opposed to criminal treaties. As discussed below, this would mean that tax investigations would more likely be handled by tax experts and administrators, as opposed to generalist prosecutors. It would also mean that more investigated taxpayers would have the notice and appeal rights associated with tax treaties. More importantly, the use of a limiting standard would mean that exchange of information will be encouraged without the risk of violating a fundamental human right: the right not to self-incriminate oneself. 64 If less tax offenses are categorized as crime, less taxpayers would risk criminal penalties by providing tax authorities with their information. Adhering to a limiting standard such as the principle of proportionality would thus help to assure that fundamental rights would be protected in the quest to improve tax transparency. Besides the principle of proportionality, other international policies and standards can be looked to as inspirations for a universal standard in defining tax crimes. Possible candidates would be the European Commission s Communication on promoting Good 64 Article 6 of the ECHR and article 8 of the ACHR (American). 31

134 Governance in Tax Matters, and the OECD standard on global governance. II. Tax crimes and money laundering. Money laundering may be generally defined as the practice of disguising the origins of illegally-obtained money. It is worth emphasizing its place in the field of serious taxpayer misbehavior when dealing with exchange of information. The field covered by the incrimination differs according to the States. The common idea is the concealment of the origin of money and goods, but the predicate offences may be defined with a list (Spain, US) or by a punishment threshold (France, Poland) and acts which constitute the laundering may be more or less precisely aimed 65. Even if the offence of money laundering is not strictly speaking a tax crime, these two kinds of crime are very often related. They either support each other (for instance when a tax crime is the predicate offence of money laundering), or share substantial similarities in the techniques used by the offendors. In this regard the OECD's Committee on Fiscal Affairs and the Financial Action Task Force 66 are now interacting. What is at stake is the use of the information obtained in the framework of the struggle against money laundering for tax crimes purposes. It is actually a big issue for the exchange of information in tax crimes matter because the arsenal available to the financial authorities to obtain information is very efficient and quite well implemented in a many countries. The most important provisions in this matter are the FATF recommendations 67. They served as a pattern for others provisions such as the article 7 of the 2003 United Nations Convention against Transnational Organized Crime 68 or the European directive 2005/60/EC. Thanks to the directive, the recommendations, which are, generally non prescriptive, became almost 69 binding for EU Member States. The key devices in terms 65 By any means (French art of the penal Code), conversion, transfer, acquisition or use of money or assets (Belgian article 3 of the law of 11 January 1993). 66 Inter-governmental body founded by the G7 in 1989, which purpose is to struggle money laundering and since 2001 the terrorism financing. Hungary and Poland are not directly members of the FATF, but indirectly through the European Commission recommendations against Money Laundering and 9 special recommendations against Terrorism Financing recommendations against Money Laundering and 9 special recommendations against Terrorism Financing of the directive provides that the Community action should be in line with the Recommendations of the Financial Action Task Force. 32

135 of obtaining information are recommendations 5 to 13. They provide for financial institutions and some other professions the obligations to realize Customer Due Diligence and to report suspicious transactions to a special Financial Intelligence Unit (FIU). Thus FIUs hold information highly likely to interest tax authorities. And the system really works. This success of FATF recommendations is partly based on the mutual evaluation process. In this process, the effectiveness of the implementation is regularly assessed. The States have to provide information on the measures that have been implemented to deal with the deficiencies identified in the report:. The States are thus kept under pressure. As a result, many improvements have been made in this context (Sweden). Some emphatic shortcomings are present: neglect to monitor certain categories of people or places (France), insufficiency of the penalties (Austria), and high threshold for reporting which creates the need for investigation (Germany). However, the reports do show that the domestic laws have been largely compliant with the recommendations. The advantages of FATF recommendations are numerous concerning the information exchange. The implementation of these recommendations leads to the identification of fund and asset wners. Collection of information is not restricted by bank secrecy. The reports are spontaneous. The FIU need only process and evaluate the information, but does not need to actually investigate to acquire the information. The reporters filter the information acquired by the FIU and provide a focus on foreseeably criminal acts. As a consequence, the FIU may have a larger mass of information, but also accurate information than the tax authorities themselves. This may be true especially in countries which are reluctant to disclose information to tax authorities (e.g. Austria). Considering all these elements, the best practice could be to increase the access to the information held by FIUs and facilitating the exchange of such information. First, a great improvement could be made by the decompartmentalization between the different national authorities. This development would be in compliance with the principle of subsidiarity provided by the Models of Tax Conventions. Thus, a tax authority should request information from another one only if it has exhausted all the means at its disposal to obtain information. From this point of view, the access to information held by FIU can provide as an additional source of information available for 33

136 international exchange. The legislative bodies of countries can regulate the disclosure of financial information to tax authorities by regulating the access tax authorities have and the transmission of information regarding tax crimes. Currently, the interpretative note on recommendation no 13 provides that suspicion reports must take place even when tax matters are involved, even if money laundering is involved. Several countries have already established rules facilitating and regulating internal transmissions of financial information (Germany 70, France 71, Belgium 72 ). The exchange of information between the different FIUs is much needed. If all tax authorities can access information held by the financial unit of its country and if financial units can exchange information, a joint struggle against financial crimes (including tax crimes) will be possible. Such exchanges already exist between the members of the Egmont Group. The Edgmont Group has even developed a computer system for transmitting information between FIUs. The challenge is now to further this exchange processes to all FATF members and eventually to all members of FATF-style regional bodies. 73 The articulation between decompartmentalization within each state and exchange of information collected under the FATF is particularly important in respect of relationships with countries with privileged tax regimes. Nowadays we can consider that the former distinction between tax havens 74 and regulation havens 75 is less relevant than 70 Section 11(6) GWG. 71 The persons subject to statements of suspicion obligations must inform TRACFIN of operations which they know, suspect or have reasonable grounds to suspect from tax evasion when there are at least one of the criteria laid down in Article D of the Monetary and Financial Code. These criteria include inter alia "the use of shell companies which have their headquarters in one state or territory which has not concluded with France a tax treaty providing access to banking information, identified from a list published by the tax authorities "or" some international financial transactions to or from abroad destinations especially when performed with these same states or territories". As a consequence, tax authorities have an indirect but real access to information obtained in the framework of the fight against money laundering. 72 Article 22 of law 11th January 1993: FIU must ensure cooperation between the national authorities. 73 Eight FATF-style regional bodies (FSRBs) have been established for the purpose of disseminating international standards (40+9 FATF Recommendations) throughout the world. (Asia, Eurasia, Caribbean ) 74 Countries with non significant income tax; obstacles to effective exchange of information; lack of transparency of tax law; no obligation of substantial activity nor real presence. 75 Countries which ensure an easy registration for corporations, an excessive confidentiality of transactions and very little supervision and monitoring of the market operators. 34

137 the distinction between cooperative and non-cooperative countries 76. Indeed if a country has a very light tax pressure but is cooperative, it is simply partaking in fair competition. Being attractive for tax purposes is not a harmful practice as long as their is transparency within the regime. However, the tax authorities in a country with little taxes cannot be expected to have a lot of information at its disposal. Consequently, the exchanges of information with such tax authorities is not likely to be very profitable regardless the number of conventions signed. Indeed, article 26 of the OECD MTC allows a country to deny a request for information when the exchange requires the requested country to exceed its own administrative practices to provide the requested information. However, if countries implement the FATF recommendations, the relevant information will be collected by at least a financial authority, if not by the tax authorities. It will then become crucial that this country end internal partitioning and allow disclosure of financial information to foreign tax authorities. An incentive for implementing this practice would be to label countries as non-cooperative if they attempt to profit by refusing to exchange information and attracting tax evaders from other countries. In other words, if retaliation policies are no longer based on low tax rates of countries, they may be based on the refusal of the country to exchanges information. A last step might be to insert a clause into tax treaties that allows the access of foreign tax authorities to information detained by the national financial unit. It would be an optimization of the current system and save an immense amount time and money by preventin overlapping investigations. III. The OECD Standard for Good Governance and Tax Crimes With the financial and economic crisis, the need for international tax cooperation and common standards has become a priority. Fair and efficient tax systems ensure a level playing field for economic relations, trade and investment, and also provide the basis for public spending. On 28 th April 2009, the European Commission issued a Communication on Promoting Good Governance in Tax Matters, to present concrete actions that could be taken to better promote the principles of good governance in the tax 76 April 2009: OECD classification depending on the implementation of the internationally agreed standard for exchange of information. 35

138 area (transparency, exchange of information and fair tax competition), both within the EU and third countries. Good governance in the tax area is essential to combat cross-border tax fraud and evasion, money laundering, and the financing of terrorism. The Global Forum of the OECD also responded to the financial and economic crisis by strengthening its pressure on states. In its September 2009 meeting in Mexico, the Global Forum established an in-depth peer review process towards effective exchange of information to the internationally agreed standards. This peer review process will ultimately ensure that there is no safe place to hide assets and income from a jurisdiction s tax authorities. The peer reviews will examine each jurisdiction s legal framework (phase 1) and its practical implementation of the standard (phase 2). In September 2010, the Global Forum published the first phase 1 peer reviews of the legal framework. In the cases of Botswana and Panama, the deficiencies were considered sufficiently serious to prevent these countries from proceeding to phase 2. To be considered to have substantially implemented the standard, a jurisdiction needs to have agreements which meet the international standard with 12 OECD jurisdictions. As many smaller jurisdictions lack the resources required to conclude large number of agreements, the Global Forum has started the multilateral negotiation project. The standards are aimed at transparent information exchange for countering specific cases of tax fraud. As a result of this aim, bank secrecy has been removed in countries where it had still existed (e.g. Austria, Luxembourg and Switzerland). Jurisdictions should ensure that ownership and identity information for all relevant entities and arrangements is available to the competent authorities, and should also keep reliable accounting records in relation to those entities and arrangements. Since most of tax crimes are committed by fabricating or destroying accounting records, the implementation of these standards has resulted in changes of the domestic law in many countries. The ultimate effect of these changes will be to reduce tax crimes. ********** It is now necessary address the issue of a standard having several international treaties. The good governance standards of the EU and the OECD are more helpful for multilateral treaties than bilateral treaties in achieving a common purpose. On other hand, 36

139 bilateral treaties may be a more suitable to responding to the specific needs of each country. If a countries choice is to keep several instruments, it is important to discuss the advantages and disadvantages of each type of instrument for the exchange of information. IV. Tax crimes treaties and tax treaties. When the exchange of information concerns tax crimes, the issue that arises is the choice of instrument. The choices available are regular tax treaties, used to solving tax problems, and conventions for assistance in criminal matters, which contain tax clauses. Both of them provide some kind of exchange of information. Thus, each investigative situation there is an accurate instrument because another one may not allow exactly the same result. The general instruments in crime tax matters used by the States are: the European Convention on Mutual Assistance in Crime Matters (1959) and its additional Protocol (2001); the UN Convention against Transnational Organized Crime (2000); bilateral agreements on mutual assistance in criminal matters concluded by the States. Regarding information exchange, the guiding principle contained in each of these states is the effective cooperation between police authorities, realized through a continuous and constant exchange of information. Using this method, police authorities obtain reports about the origin and the development of financial interests of transnational organized criminal groups. Each State Party shall designate a central authority that shall have the responsibility and power to receive requests for mutual legal assistance and either to execute them or to transmit them to the competent authorities for execution. The favored form provided by all these instruments is the spontaneous exchange. 77 In a spontaneous exchange, the competent authorities of a State Party forward to the competent authorities of the other State Party information relating to criminal matters obtained during own investigations. The information is forwarded without prejudice to 77 Article 11 of ECMACM and article 18, paragraph 4 of UN CTOC 37

140 their own investigations or proceedings. It may be useful to compare the prerequisites of the cooperation in this specific category of cases with the provisions of the two European Directive on the exchange of information. According to the European law, the competent authorities of each Member State shall communicate to another Member State the foreseeably relevant information in a series of cases. The content of these communications aim to enable the correct assessment of taxes in the receiver State, and can include an information of which they are aware and which may be useful to the competent authorities of another Member State. Thus, the scope of the exchange is undoubtedly wider. In contrast, the cooperation in criminal matters, starts only when it is believed that: such information could assist the authorities in undertaking or successfully concluding inquiries and criminal proceedings or in accordance to a request formulated by a Sate Party pursuant to the conventions. The providing State may, under its national law, impose conditions on the use of such information by the receiving State, which shall be bound by those conditions. The protection of information presents a fundamental problem. Art. 26 of the Protocol to European Convention on Mutual Assistance in Criminal Matters states that the personal information transferred from a State Party to another may be used only for: proceedings to which the Convention or its Protocol apply judicial and administrative proceedings directly related to it, preventing an immediate and serious threat to public security. Furthermore, the providing State Party has the right to be informed about the use made with the information transferred. Both regular tax treaties and the conventions on criminal matters present advantages and disadvantages. Without doubt, tax treaties are more efficient because they put authorities interested in the exchanged information into direct contact. However, conventions on mutual assistance in criminal matters provide for a more complex system involving the Ministry of Justice. In some urgent cases, however, the request for mutual assistance may be 38

141 forwarded directly by the administrative or judicial authorities of the requested Party and returned through the same channels. Another basic point of this comparison regards the purposes of the exchange of information. The goals of mutual legal assistance are strictly delineated 78 : (a) Taking evidence or statements from persons; (b) Effecting service of judicial documents; (c) Executing searches and seizures, and freezing; (d) Examining objects and sites; (e) Providing information, evidentiary items and expert evaluations; (f) Providing originals or certified copies of relevant documents and records, including government, bank, financial, corporate or business records; (g) Identifying or tracing proceeds of crime, property, instrumentalities or other things for evidentiary purposes; (h) Facilitating the voluntary appearance of persons in the requesting State Party; (i) Any other type of assistance that is not contrary to the domestic law of the requested State Party. In contrast, Art. 26 of the OECD MTC, the basis of the regular tax treaties, specify that the exchange of information shall be realized for carrying out the provisions of the Convention and also for the administration and the enforcement of the domestic tax laws. On the basis of this, we may conclude that tax treaties are more suitable to tax matters and ensure more celerity and efficiency, while crime treaties are usually drafted to fight criminality in all of its forms. Still the conventions for the assistance in criminal matters are arguably more reliable for taxpayer s right. The reason for this is the requirement that the exchange of information be narrowly related to judiciary control. Another issue to consider at this point is: if there s an international crime treaty can the tax administrators use the information exchanged for its own purposes? 78 Art. 18 par. 3 UN CTOC. 39

142 At the international level, the border dividing assistance based on regular tax treaties and treaties concerning assistance in criminal matters is not clear. This vagueness may create a problem may arise when a state suspects a tax crime offense, and requires the assistance of another state with whom the tax treaty does not provide for cooperation in criminal matters. In such a situation, the best solution would be stop the cooperation under the administrative agreement and instead continue the operation under a crime treaties, even if with a disadvantage in terms of celerity. It is worthwhile here to take note the commentary (12.3) to the OECD MTC article 26, which represents an international standard. The commentary states that information that appears to be of value to the receiving state for other purposes than the initials can be used if both countries have agreed on such a rule in their bilateral treaty. If this has not been agreed on and information is used for wrong purposes, it may constitute an abuse of the international law and will also probably lead to deteriorated relations and cooperation with other countries. Therefore, the best practice may be to create specialized units for the exchange of tax criminal information. This will result in the double advantage of the instrument of exchange being specialized in tax matters and providing the taxpayer adequate procedural guarantees at the same time. But such a practice may be difficult to implement since it requires an amendment of all domestic laws. Another solution could be to draft protocols to crime treaties providing a specific cooperation in tax crimes. This would produces advantages in terms of both accuracy and protection. Last but not least, a protocol should be added to crime treaties drawing the line between the cases where the tax authorities should use a regular tax treaty and cases where it should use a crime treaty. Conclusion The exchange of information contains different aspects which have to be considered when talking about exchanging information either in a tax procedure or in a criminal procedure. There is a need to take international as well as national regulations into account. The exchange of information may be an exchange of information on the basis of tax treaties or on an exchange of information on the basis of criminal assistance. 40

143 Even if the exchange of information may be divided into international regulations, national regulations and criminal aspects there are links between the different subparts. The main aim of this paper was to point out best practices for the exchange of information procedure. It turned out that in some areas there can be found best practices but in other areas there is not only one solution which can be seen as best practice. However it seems like a common system amongst the states concerning the exchange of information would be really a best practice and would improve the amount of exchanging information. Conclusion The exchange of information contains different aspects which have to be considered when discussing exchanging information either in a tax or criminal procedure. There is a need to take international as well as national regulations into account. The exchange of information may be based of tax treaties or an agreement on criminal assistance. Even if the exchange of information may be divided into international regulations, national regulations, and criminal aspects there are links between all of these subparts. The main aim of this paper was to point out best practices for the exchange of information. A range of best practices could be found depending on the sub-issue involved. However it seems that common system amongst the states concerning the exchange of information would be the truly best practice and would improve the global capability to fight tax evasion. 41

144 EUCOTAX WINTERCOURSE : GLOBAL FINANCE AND TAXATION Subtopic 4 International Tax Arbitrage Chair: Prof. Dr. T. ROSEMBUJ; Prof. Dr. B. WIMAN Co-chair: E. CASSAER, E. BUYSSE

145 Students Austria; Helen Baier Belgium; Joris Luts France; Laura Bavoux Germany; Hendrik Greinert Italy; Carolina Lombardozzi The Netherlands; Iris Musters Poland; Alicja Łusiewicz Spain; Sergio Puig Ruiz Sweden; Kristin Bernhardtson United States; Katie Marcusse

146 Table of Contents General introduction... 5 Part 1: Tax Avoidance Introduction Difference between permissible and non-permissible tax burden reduction Tax avoidance and GAAR s or substitute concept... 7 Requirements Legal consequence Tax avoidance and International tax arbitrage Part 2: Cross-Border Tax Arbitrage Definition of the concept of cross-border tax arbitrage Unilateral measures to counter cross border tax arbitrage: SAAR Introduction Rules regarding Controlled Foreign Companies Examples of other specific anti-avoidance rules Multilateral measures to counter cross border tax arbitrage Part 3: Hybrid entities Introduction Comparative analysis of the criteria Response to tax arbitrage Solutions Part 4: Financial Instruments Introduction Hybrid Instruments Classification of Debt and Equity Regulation of Hybrid Instruments Repos States regulations Foreign Tax Credit Generators Hybrid Financial Instruments Repurchase Agreements (Repos) Anti-avoidance measures Part 5: Treaty Shopping

147 5.1 Treaty Shopping and Tax Avoidance Introduction GAAR and Treaty Shopping SAAR and treaty shopping Conclusion Beneficial ownership in treaties and domestic law Introduction Domestic law referring to the term of beneficial ownership Relevant cases Anti-abusive clauses in treaties Specific clauses Conclusion General conclusion

148 General introduction As long as countries are free in determining their tax jurisdictions and making rules of law, tax regimes will differ. Taxpayers want to minimize their tax burden, so they will use these differences to search for tax advantages and profit maximization. This search is also known as tax arbitrage in which tax advantages are obtained on the basis of differences in tax jurisdictions, usually differences in addressing a common tax question. The preferable result of tax arbitrage is the situation of non-taxation. However, in times of a weak economy this situation collides with the purposes of governments. Governments try to conserve their state funds and want to recover from the financial and economic crisis. Tax avoidance has a negative influence on the recovery of the crisis. 5

149 Part 1: Tax Avoidance 1.1 Introduction Tax avoidance is a highly subjective and political term and covers an enormous range of actions. It is no longer sufficient to distinguish between avoidance (a legal action) and evasion (an illegal action). The terminology has been complicated by the use of terms such as tax savings and tax avoidance, begging the question: What is acceptable tax avoidance? This problem has become more interesting after the global financial crisis as the domestic problem of tax avoidance has assumed a bigger size and has involved cross-border situations. During recent years, the issue of tax avoidance has become the issue of international tax arbitrage that had before been usually accepted by countries. Now, this debate takes place in a general context of fiscal consolidation in the EU and elsewhere, when the world faces urgent global policy challenges with significant budgetary implications. 1 The EU has made substantial pledges to development and to meet the commitments that new revenue sources should be explored further. EU Member States are starting to put in place national tax instruments to respond to these challenges. It is important that such developments take place in a coordinated framework. If not, different national systems levied on diverging tax bases could create incentives for tax arbitrage and result in allocation distortions between financial markets in the EU. The emergence of uncoordinated national solutions could also lead to double taxation and fragmentation of the European economy, hampering the proper functioning of the Single Market. In order to approach the new ideas of fiscal consolidation in the EU and challenging crossborder tax arbitrage, the main purpose of this paper is to describe the development of the concept of tax avoidance and its relationship with international tax arbitrage. The first part of this paper will be focused on the domestic anti-avoidance concepts; the second part will discuss cross-border tax arbitrage concepts; the third and fourth sections will deal with hybrid entities and hybrid financial instruments representing some of the most important tools to realize avoidance in an international contest; and finally, in the last section, this work will analyse the use and abuse of bilateral tax treaties. 1 European Commission, Brussels 7/10/2010, COM (2010) 549 final. 6

150 1.2 Difference between permissible and non-permissible tax burden reduction The European Union and the single member countries use several terms differently a uniform terminology cannot be recognized. 2 However, every country distinguishes permissible and non-permissible tax burden reductions. Generally, a tax burden reduction can be considered as a permissible one (tax planning or tax saving) if the tax burden reduction is not considered as tax evasion (tax fraud) or tax avoidance (tax abuse or tax circumvention). What is considered as tax evasion or tax avoidance is a material question and needs to be answered according to every single national tax system. 3 In this part, the focus will lie on the difference between tax planning and tax avoidance. 1.3 Tax avoidance and GAAR s or substitute concept The principle for tackling tax avoidance and its dogmatic background differs from country to country. Therefore, the term General anti-avoidance rule (GAAR) must be interpreted broadly: sometimes it can be used for codified rules and sometimes for case law regarding the problem of tax avoidance. So a general rule can be deemed as a general principle or technique to counter tax avoidance. 1. Austria Austria adopted the general anti-avoidance rule of sec. 22 FFC. In paragraph 1, it states that abuse of legal constructions arrangements will not circumvent tax liability. Requirements: For section 22 of the FFC to be applicable, it requires the tax planning structure or series of transactions to be unusual, inadequate and solely aimed at tax avoidance. Legal consequence: 2 Bergmann, Evasion and Abuse Terminology in European Tax Law, SWI 2010, Cf. Bergmann, Evasion and Abuse Terminology in European Tax Law, SWI 2010, 477 (481). 7

151 As legal result, the Austrian GAAR provides for the recharacterization of the relevant transaction for tax matters. According to paragraph 2, taxes must be levied in accordance with an appropriate structure for the respective economic transaction, facts and circumstances. 2. Belgium Belgium s GAAR is set forth in Article 344, 1 of the Belgian Tax Code. Requirements: The tax authorities determine, by means of presumptions or other proof, that the legal characterization given by the parties to an act, or to separate acts which together realize the same operation, is aimed at avoiding taxes, unless the taxpayer proves that his characterization is justified by legitimate needs of a financial or economic nature. Belgium also uses the step-transaction doctrine, which is described below in the U.S. section. Legal consequence: That legal characterization given by the parties may not be opposed to the tax authorities; hence a requalification will be conducted. Dogmatic approach: The idea that, in giving legal categorizations to (a series of) acts with the sole purpose of avoiding taxes, a situation of abuse of rights exists, is not explicitly expressed in the statute itself, however. Moreover, the abuse of rights principle as it exists in private law, is not effective in income tax matters, as such. On one hand, some legal scholars argue that the legal characterization is embedded in the legal act itself; the non-opposability of the legal characterization thus inevitably affects the legal act itself. Consequently, those scholars assume that the GAAR allows the tax authorities to requalify the legal act itself, without altering the legal facts, with the intention to reconcile the actual taxation to the object and purpose of the tax provision. Such assertion is clearly linked with the fraus legis doctrine. Other scholars think that only the legal label of an act, or successive acts which constitute a single transaction, can be set aside and recharacterized with the view of a higher tax burden. 8

152 3. France In France, there are three general anti-avoidance clauses. First, the abuse of law procedure permits, under certain circumstances, a transaction to be disregarded. Second, the abnormal act of management allows the FTA to challenge the deductibility of expenses which are not made in the interest of the taxpayer company. Third, there exists a general right of authorities to classify contracts or arrangements. The last clause applies even when there is no intention by the taxpayer to avoid taxation while under the abuse of law procedure, generally, the taxpayer is seeking such avoidance. The abuse of law theory was implemented in the Supplementary Finance Act in Requirements: The abuse of law concept covers contracts, conventions or any other arrangements which are either fictitious or real, if the transaction 1) had no other purpose than to avoid tax, and 2) leads to a tax advantage contrary to the purpose of the French regulation. Legal consequence: As a result, many tax benefits may be caught by the abuse of law under French law. It triggers an 80 percent penalty unless the taxpayer did not initiate the abuse of law. In that case, penalties are reduced by half. All parties involved in an abuse of law procedure may be held jointly liable. Dogmatic / practical approach: Historically, the abuse of law theory was created in civil law and then, codified in the French Tax Code in Although, for many years, abuse of law has been mainly used by the French authorities to sanction fictitious arrangements or transactions designed solely to avoid tax, the last decade revealed its interest with respect to international investments and financial transactions. This approach of the abuse of law theory includes fraus legis. 4. Italy Italian law regulates tax avoidance through the application of Art. 37bis, Presidential Decree n. 600 of 29 September Requirements: According to Article 37bis, transactions that lack a valid economic purpose and are aimed at circumventing obligations or prohibitions, or unduly obtaining tax reductions or reimbursements 9

153 constitute tax avoidance. Despite its wide application, this provision is not a general anti-avoidance rule, since its application is limited to the specific list of transactions contained in paragraph 3 of Art. 37bis. Legal consequence: The tax authorities can disregard transactions involving tax avoidance. Dogmatic approach: In recent years, the Italian Supreme Court has increased the number of tools that may be used by the tax authorities to fight tax avoidance more efficiently, which affirms the existence of a general abuse of law principle in the Italian tax system. In 2008, the Supreme Court has clearly stated that it considers the principle that a taxpayer cannot unduly benefit, for tax purposes, from the distorted use of legal structures, i.e. those which, although not in violation of a specific rule, lack any economically sound reason, except for that of the tax saving, to be direct and essential consequences of Article 53 of the Constitution. 5. Germany Germany s general statutory anti-avoidance rule is Section 42 Abgabenordnung (GFC). Section 42 GFC was slightly changed by the Finance Act of Requirements: Section 42, para. 1, s. 1 AO contains a merely pragmatic statement that a tax law cannot be circumvented. Sec. 42, para. 1 states: An abuse shall be deemed to exist where an inappropriate legal option is selected which, in comparison with an appropriate option, leads to tax advantages unintended by law for the taxpayer or a third party. This shall not apply where the taxpayer provides evidence of nontax reasons for the selected option which is relevant when viewed from an overall perspective. Generally, a selected legal option is inappropriate, if a reasonable person, against the background of the economic facts (particularly the pursued economic aim), would not choose this option because he considers it as inappropriate (too much effort, too complicated, etc.). A tax advantage is not intended by law if the legal arrangement is inappropriate. The taxpayer carries the burden of proof with respect to his non-tax reasons. 10

154 Legal consequence: The legal consequence of tax circumvention in the sense of 42, para. 2 AO can be seen as a fiction: the appropriate options or facts replace the inappropriate option or facts. Then, the claim will arise only according to that relevant tax provision. Dogmatic approach: Tax avoidance which is not consistent with the German term Steuervermeidung is considered as a sub-case of law circumvention, rather than the abuse of law; the German GAAR speaks about the abuse of legal arrangements. 6. Netherlands For many years, the Dutch domestic law contained a general anti-avoidance concept which was incorporated into article 31 of the General Taxes Act. Requirements: The above mentioned article provides the correct tax imposition with respect to direct taxes. It is directed at those transactions which would not be undertaken except to make the future levy of taxes wholly or partly impossible. Legal consequence: Abusive transactions are ignored by the Tax Administration. Dogmatic approach: Since the Dutch Supreme Court judicially developed the doctrine of fraus legis, Article 31 is considered to be obsolete. To counteract abusive behaviour, several specific methods can be used: 1) give a different interpretation of the facts presented by the taxpayer applying a sham doctrine or fiscal conversion; 2) stretch or restrict the statutory provisions using legal interpretation or substance over form; 3) apply the doctrine of fraus legis, which is the Dutch abuse of law concept. 7. Poland Polish tax law does not include a GAAR. It is believes, however, that the article 199a of the General Tax Act can be construed as a GAAR. The preliminary ruling of a civil court is essential 11

155 when considering whether a legal action exists. In fact, article 199a is a procedural provision, but can be treated as a GAAR, even though this is substantive. Moreover, it has thus far not been applied by tax administration. Requirements: Only administrative courts try to use article 199a in order to point out tax avoidance. Courts sometimes refer to general rules when they want to avoid using the term tax avoidance (which does not exist in Polish tax law). There is no legal justification for using the term of tax avoidance. However, courts sometimes refer to it, which raises a lot of legal uncertainty. Legal consequence: The Polish tax administration applies the substance over form rule. 8. Spain Spanish Law contains general anti-abuse clauses, such as a substance-over-form rule (Art.16 GTL) and the fraus legis doctrine (Art. 15 GTL). Requirements: The transaction must be inadequate and artificial and must not produce any relevant legal or economic effects. Furthermore, there has to be an essential aim of the taxpayer to circumvent tax law. Legal consequence: In Spain, the legal effects of applying the GAAR can also be found in article 15. This article establishes the method used to recharacterize the legal action in accordance with tax law and in a way which corresponds to the appropriate transaction. Dogmatic approach: i) Substance-over-form. It can be found not only in the EU jurisprudence references to the economic reality but also in its incorporation in the new General Accounting Plan and in the amendments of the Commercial Code of 2007 in several of its assumptions (e.g. leasing, drafting of financial statements, accounting police). This projects the principle not only in the accounting and the mercantile arena but also in the tax arena. Art. 16 of the GTL provides the substance-over-form rule. 12

156 ii) Economic substance. TEAC has recently published two important decisions which reiterate the view that valid economic motives in transactions are a fundamental element of tax fraud. iii) Abuse of law. General Tax Law (LGT) contains arts. 13, 15 and 16 of the LGT, where we can find various forms of abuse of law with different content and scope. These are: the qualification, the conflict in the application of tax rule (fraud of law in the strict sense), and the simulation. iv) Fraus legis. According to the Spanish courts, such kinds of acts are not just fraudulent but contrary to law and therefore, they must suffer the penalty created for the violation. According to the modern concept, the fraus legis regime applies to those acts which are covered under a rule that protects or tolerates them, and pursues a result prohibited or contrary to the legislation considered as a whole, i.e., a result contrary to any rules that form the system. In the view of the Court itself, this distinction is reflected in Article 15 of the LGT to regulate the conflict on the implementation of the rule. v) Presumptions. Spanish legislation recognizes that art. 108 of the Securities Exchange Act is a legislative rule that aims "to try to neutralize the circumvention of ITPAJD in the transmission of real estate through the interposition of corporate figures." Spanish legislation makes assumptions for the neutralization of various transactions with avoidance tendencies. 9. Sweden Requirements: According to the preparatory works of the Tax Avoidance Act, an activity constitutes tax avoidance only if it is used to, or with a main purpose to, reach a certain tax advantage. If it was not for the tax advantage, the avoidance transaction would not have been undertaken since it would have been useless. If these arrangements are taken only to reach the tax advantage, they can be regarded as avoidance transactions. There are four necessary conditions which have to be fulfilled to consider a transaction a tax avoidance activity. The first condition to be fulfilled is that the transaction, separately or collectively with other transactions, shall create an essential tax advantage for the taxpayer. The second condition requires the taxpayer to take part, directly or indirectly, in the transaction(s). Under the third condition, the tax advantage is the prevailing reason for the transaction. The fourth and last condition is the most controversial and hardest to apply. It requires the activity to be contrary to the purpose of the law of taxation. The purpose in this context is the 13

157 purpose which emerges from the tax legislation in general and from the specific rules which can be applied on the case or the rule which has been avoided through the transaction. Legal consequence: If the conditions are fulfilled, the avoidance activity is ignored in the assessment and hence, the tax is levied as if the avoidance activity had never been done. 10. U.S.A. Because the United States relies on the collection of tax to meet its budget, the law, as found in the Code and as applied by the courts, attempts to discourage tax avoidance. The U.S. courts use a variety of doctrines to prevent taxpayers from benefiting from the tax law when they strictly follow regulatory requirements, but do not engage in the type of transaction that was intended to be advantaged. In fact, several of these doctrines overlap, but ultimately, the focus is on the economic substance of the transaction rather than the form. However, depending on the circuit, the actual application of the doctrines can vary. i) Economic Substance Doctrine: Requirements: In most federal courts, applying the economic substance doctrine, it was a disjunctive, two-step process. A court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of a profit exists. However, as codified in IRC 7701(o), a taxpayer needs to show both a subjective business purpose and an objective pre-tax profit potential to satisfy the test. In this last respect the taxpayer carries the burden of proof. Legal consequence: When it is determined that a transaction should not be recognized for federal income tax purposes, either the relevant tax transaction is disregarded or requalified. ii) Step Transaction Doctrine: Another method used by the courts to determine the underlying economics of a transaction is the use of the step transaction doctrine. Under this doctrine, courts will step together two or more purportedly independent transactions and look at the final result to determine the tax implications of the transaction. 14

158 Requirements Almost every examined country refers, in its definition of tax avoidance, to the purpose of the relevant tax provision that is proposed to grant a tax advantage or to hinder a tax advantage. But the problem is raised to determine where the tax liability starts and where it finally ends. Therefore, the majority of the countries use an economic concept to determine what facts, besides the explicit facts covered by the wording of the rules, should be addressed or, alternatively, which situations should be not addressed even though covered by the wording of the relevant tax law. Consequently, the definitions adopted by the states drew the line between tax saving and tax avoidance where arrangements are chosen only because of tax reasons and where no significant economic motives exist. Additionally, the burden of proof to provide non-tax reasons is most dominantly carried by the tax payer. In this context especially Austria, Germany and Italy, as well as the US and Belgium with their Step Transaction Doctrine, emphasize that the economic substance or the abusive arrangement respectively needs to be determined according not only to the single transaction(s) but to the whole context surrounding a particular transaction. Legal consequence Usually, the abusive arrangements will be requalified by the taxing authority to a non-abusive (appropriate) one and the legal consequence will be determined correspondingly, so that the tax burden may be higher in the end. In contrast and as an exception, the French concept abuse of law provides not only a requalification but also penalty for the intention to avoid tax which depends on the amount of the tax that was or tried to be avoided. U.S. law also imposes such a penalty for violation of the economic substance doctrine. 1.4 Tax avoidance and International tax arbitrage Based on the above definitions of tax avoidance used in each Country and just (or mainly) based on domestic approaches, it could be very difficult to say when a cross-border tax arbitrage is 15

159 abusive or non-permissible and constitutes a tax avoidance matter. Furthermore, no European country has so far adopted a clear definition of abusive tax arbitrage, except than the United Kingdom. 4 Therefore, the first problem to solve should regard the understanding of which tax arbitrage is acceptable and which not. In this respect, the US context could be helpful, in that it provides insight into transactions that, while clearly arbitrage, are not considered tax avoidance from the U.S. perspective. 5 Cross-border tax arbitrage has been defined as: taking advantage of inconsistencies between different countries tax rules to achieve a more favourable result than that which would have resulted from investing in a single jurisdiction. 6 International tax arbitrage can occur even where two countries operate rigorous and comprehensive systems of taxation. It is the differences or inconsistencies between the two systems that give scope for arbitrage, independent of any more traditional understanding of competition between strong and weak, or strict and permissive, tax regimes. Tax shelter abuses, on the other hand, are typically concerned with the ambiguous margins of tax rules, sometimes flirting with legality by engaging in transactions with little or no economic substance. While it is certainly possible that a cross-border arbitrage may have no true economic substance, this is not essential to such transactions, which seek a more solid tax benefit derived from inconsistencies between different countries tax rules. 7 One could say there should be no limitations on the use of arbitrage opportunities. Certainly there is a strong argument that governments should leave taxpayers alone to seek out and exploit differences and inconsistencies 4 Many scholars have discussed the UK government idea to introduce specific rules addressing abusive tax arbitrage involving tax avoidance based on the U.S. experience. However this kind of legislation was introduced in the UK Legislation in March 2005 to counter contrived arrangements intended to avoid UK tax. This legislation applies to schemes involving both deductions and receipts. The deductions rules apply only where a scheme involving a hybrid entity or hybrid instrument increases a UK tax deduction or deductions to more than they would otherwise have been in the absence of the scheme. The legislation does not apply in a case where, although there is such a scheme, it has no effect on UK taxation. Where the legislation does apply, the effect will be to limit tax deductions as far as is necessary to cancel the increase in UK tax deductions attributable to the scheme. The deductions rules are designed to disallow UK tax deductions which are: a) not matched by a taxable receipt; or b) where there is another deduction allowed for the same item of expenditure. The receipts rules apply in relatively narrow circumstances where an amount that represents a contribution to capital is received by a UK resident company in a non-taxable form while it creates a tax deduction for the payer. 5 See, e.g. Tech. Adv. Mem (Nov. 28, 1997), where the IRS has also indicated that it will not be concerned with deductions taken by two different taxpayers in a double dip leasing transaction (further discussed in later sections) where the fact of dual-tax ownership derives merely from differences in the laws of the involved countries. 6 H. D. Rosenbloom, International Tax Arbitrage and the International Tax System, David R. Tillinghast Lecture on International Taxation, (2000) 53 Tax Law Review M. Boyle, Cross-border tax arbitrage Policy choices and political motivation (2005) 5 Brtish Tax Review

160 between national tax regimes, so long as in doing so the domestic laws of each of the countries involved are not offended. It appears that the key question for domestic tax authorities is whether they should regard their competencies as being limited simply to protecting their own jurisdiction with an eye to ensuring that cross-border structures are not used to erode their own tax base, or whether they should be concerned to act more widely (whether unilaterally or multilaterally) against any transaction which produces the wrong result in global taxation collection terms. The difficulty with the latter approach, which appears to be the one currently being pursued by Governments, is that there is often no clear answer, either in policy or practical terms, as to what is right or wrong. For any authority to move beyond the scope of its natural jurisdiction and its own domestic policy and legislative framework and seek to impose its rules on a wider international audience leads to a lack of certainty and a great deal of subjectivity in the application of those rules. In conclusion, the GAARs or similar concepts can be seen as an assistance device to determine the limits of tax liability. Nevertheless, the question of who and what is considered liable to tax, and who is not, is a matter of the single (domestic) tax regulations in the countries. Hence, tax arbitrage cases can be considered as tax avoidance only when the inconsistencies on one side are not within the purpose of existing tax laws. In other words, as soon as one State establishes regulations against certain tax arbitrage arrangements, it is not within the purpose of the law, thus, it is not consistent with one tax system. Hence, it cannot be called cross border tax arbitrage anymore, according to the definition of H. D. Rosenbloom. 17

161 Part 2: Cross-Border Tax Arbitrage 2.1 Definition of the concept of cross-border tax arbitrage As mentioned above, the concept of cross-border tax arbitrage refers to tax planning strategies using the differences in two or more countries systems of taxation. It is, according to Rosenzweig, one particular form of double non-taxation. 8 Taxpayers engaged in cross-border business achieve double (or even multiple) tax benefits by exploiting the conflicting rules and gaps between national tax systems. Additionally, the presence of intent is required in order to talk about crossborder tax arbitrage. 9 A good example of international tax arbitrage are cases where a tax deduction for the same expense is given by both countries involved. 10 The taxpayer complies in a technical sense fully with the laws of both jurisdictions but incurs a lower total net tax liability than if the transaction had been subject solely to the laws of either jurisdiction. 11 The following double-dip lease case will explain the concept of cross border tax arbitrage. Country X Country Z Lessee = economic owner Lease The idea behind this cross-border tax arbitrage transaction is that the two jurisdictions each respect their taxpayer as the owner of a leased asset at the same time, but in fact one taxpayer is the lessee (economic owner), located in country X and the other one is the lessor (legal owner), located in country Z respectively. In both countries, the owner can take accelerated depreciation deductions and is entitled to investment tax credits. Lessor = legal owner 8 Rosenzweig, A.H., Harnessing the costs of international tax arbitrage, Virginia Tax Review, 2007, p Ring, D.M., One nation among many: Policy implications of cross-border tax arbitrage, Boston College Law Review, 2002, p Rosenbloom, H.D., The David R. Tillinghast lecture, International tax arbitrage and the international tax system, Tax Law Review, 2000, p Rosenzweig, A.H., Harnessing the costs of international tax arbitrage, Virginia Tax Review, 2007, p

162 This is the result of the conflicting rules of X and Z regarding the definition of asset ownership. 12 This construction of cross border tax arbitrage only works successfully because the two owners of the asset are located in two different countries. If this leasing transaction had occurred in X only, there would have been only one taxpayer identified as the owner and hence only one taxpayer would have been entitled to accelerated depreciation deductions. Such tax planning strategies resulting in tax advantages for the taxpayers cause states, both developed and developing, to lose large amounts of revenue every year. 13 Nevertheless, states have different approaches to tax arbitrage. In some states, tax arbitrage is seen as a logical effect of the inconsistencies in states tax regulations which need not be prevented any more than necessary. In other states, tax arbitrage is regarded as a great source of loss of the state s revenue, which much be prevented as much as possible. The American, Austrian, Dutch, French, German, Italian, Polish and Swedish approaches to cross-border tax arbitrage have one great similarity. All the enumerated states want to prevent tax arbitrage. However, the prevention can be done in several ways and be taken on unilateral, bilateral and multilateral levels. Responses on the unilateral and bilateral levels are the most common, due the difficulties in creating multilateral tax treaties. Belgium, however, has a relatively positive stance toward international tax arbitrage. A few anti-avoidance rules have been adopted, but they are to a large extent inapplicable in an international context. The Belgian policy is rather aimed at attracting foreign financing activities. 2.2 Unilateral measures to counter cross border tax arbitrage: SAAR Introduction Specific anti-avoidance rules (SAARs) are rules aimed at preventing cross-border tax arbitrage. The SAARs limit the advantages derived from the use of inconsistencies in different states tax regulations. The rules basically mean that an exception from a general principle is made in crossborder situations where a tax advantage can occur. 12 C. Staffan Andersson et al., Cross-Border Leasing Provides Major Tax (and Other) Benefits, LEXIS 91 TNI OECD, The Global Forum on Transparency and Exchange of Information for tax purposes, page 4, viewed on

163 Controlled Foreign Company (CFC) rules are a common sort of SAAR. Several states use CFC rules, or rules similar to the CFC rules for preventing tax avoidance. There are also many other SAARs used by states. The most important ones will be exemplified below, like the foreign tax credit limitations Rules regarding Controlled Foreign Companies CFC rules A company group can reduce the amount of tax to be paid by locating the profit in a state with a lower tax rate. For example, if a parent company situated in Germany contributes shares to her subsidiary in a foreign state with low profit taxation rates, such as the Bahamas, the income of the shares cannot be taxed in Germany unless the foreign subsidiary distributes dividends attribution or sells the shares profitably. The reason is that both corporations are two different tax subjects. If the foreign subsidiary never distributes any dividends but instead reinvests the profits, Germany will have lost the competition with tax havens and other jurisdictions with low tax rates. To prevent this kind of avoidance activity, several states use CFC rules, which are designed in a way so that shareholders in companies located in low tax countries do not get a tax deferral. Instead, the shareholders are liable to tax for the company s profits annually. Thus, the provision extends the tax liability for the shareholders. Several states have implemented the CFC rules from the OECD, for instance France, Germany, Italy, Spain and Sweden. 14 Other states have chosen not to implement the CFC rules established by the OECD, but use similar rules instead, like the Subpart F rules in the U.S. Some states, like Poland, have not implemented any such rules. Thus, in these states it is possible for shareholders to avoid taxes by locating profits of subsidiaries in a low-taxed state. The fundamental conditions for implementing the CFC rules of the OECD are that a taxable person is a partner in a foreign legal entity and that the foreign company has a low-taxed income. There are two definitions of what constitutes a low-taxed income. 15 It can either be a state with a minimum tax rate, or a state especially enumerated in a list The CFC rules in the enumerated states basically correspond to the CFC rules established by the OECD, but with some deviations. 15 Chapter 39a, section 5, Income Tax Act. 16 The list can be reversed, meaning that the list enumerates states which do not constitute low-taxed states. 20

164 Regulations similar to the CFC rules Some states do not use traditional CFC rules. Instead, similar rules leading to the same result as the CFC rules are used for preventing the kind of tax avoidance the CFC rules are intended to prevent. Such rules can be found in Austria, Belgium and the Netherlands. For example, the Belgian Income Tax Code contains a rule which authorizes the Belgian tax administration to disregard a transfer (sale or contribution) of assets by Belgian taxpayers to residents of low-tax jurisdictions. The effect of this provision is that the assets are deemed not to have left the Belgian transferor s estate and income produced by these assets is still attributed to him and therefore taxable in his hands. 17 Although Belgium does not have CFC-legislation as such, 18 the effects of this rule are, to a certain extent, comparable to those of a CFC rule. 19 The Austrian legal system has no pass through legislation in place, except for sec. 42 Investment funds Act (IFA), which would be comparable to the American CFC-Legislation. 20 Sec. 42 IFA provides for foreign investment funds the taxation directly at the level of the Austrian shareholder. Subpart F Subpart F is the rule used in the U.S. for preventing the activities that CFC rules aim to prevent. The Subpart F rules require certain types of income acquired by certain foreign corporate subsidiaries of U.S. persons to be included immediately in the taxable income of the U.S. person, as if it had been distributed as a dividend by the foreign corporation. 21 The Subpart F rules apply to controlled foreign corporations of U.S. shareholders. A CFC is a foreign corporation, more than 50 percent of the voting power or value of whose stock is owned by U.S. shareholders. 22 A U.S. shareholder is a U.S. person that owns, directly, indirectly or constructively, 10 percent or more of 17 M. BOURGEOIS and E. TRAVERSA, C.D.F.I. 2010, ; L. DE BROE, Summary, 8; in cases of non- at arm s length -transactions, a clash between Art and Art. 26 ITC can occur. Where art ITC disregards the transfer, Art. 26 ITC accepts the transfer but adjusts the profits of the transferor. The tax authorities cannot apply both simultaneously. Legal doctrine is not consensual about which article precedes (L. DE BROE, Prevention, ). 18 Although a Bill of 12 December 2008 proposed to insert CFC-rules in Belgian tax law. Our Council of State has however shown some major problems in adopting such rules in Advice no /1 of 3 December L. DE BROE, Summary, 8,22; P. MINNE and S. DOUÉNIAS, Planification, Bendlinger, in Hammerschmied (ed.) Steuerberatung und Wirtschaftsprüfung in Europa - FS Brogyanyi (2008) p. 525 et seq. 21 IRC IRC

165 the voting power of the foreign corporation. 23 Once a CFC is determined to exist, the Subpart F rules generally apply to require current recognition of only some income, called Subpart F income. 24 Foreign personal holding company income is one type of Subpart F income and includes most types of passive income, including interest, dividends, rents, and royalties as well as gains from the sale of property producing such income, such as stock or securities. 25 There are some exceptions to this definition, but the ones most commonly used in the arbitrage transactions are the same country exception and the look-through rules Examples of other specific anti-avoidance rules Foreign tax credit limitation in Belgium, the Netherlands and the US In order to prevent abusive behavior, countries like Belgium, the Netherlands and the US are limiting the scope of tax credits allowed for foreign withholding taxes. 27 Belgium approaches the foreign tax credit limitation in three ways: (1) an anti-channelling provision has been inserted in Art. 289 ITC, (2) the FTC itself is limited (to a percentage of the FTC) to the extent the interest income received is eroded by onwards-paid interest charges, (3) a pro rata calculation of the FTC is made, dependent on the duration of the ownership of the loan (i.e. an anti-stripping rule). 28 The Swedish limitation of deductibility of interest expenses Inconsistencies regarding chargeability and deductibility of interest can be used for obtaining a more favorable tax result than would have occurred if only one state was involved. For that reason, Sweden has adopted rules which limit the deductibility of interest expenses. 23 IRC 951(b). 24 IRC 952(a). However, once Subpart F income is enough to make up more than 70% of the gross income of the CFC, all of the CFC s gross income will be considered Subpart F income. IRC 954(b)(3)(B). 25 IRC 954(c)(1)(A), (B)(i). 26 The same country exception applies to exempt from foreign personal holding company income dividends or interest that are received from a related party corporation that is incorporated in the same country as the CFC and also has a substantial part of its assets in that country.171 The look-through rule exempts dividends, interest, rents and royalties received from a related CFC that is attributable to non-subpart F income. 27 See for examples of FTC-structures (with Italian State bonds) where the tax administration is put in the wrong: Court of First Instance Mons 20 June 2003, F.J.F 2004, no. 8, 748; Court of First Instance Brussels 26 June 2003, F.J.F. 2005, no. 5, 490; Court of First Instance Brussels, 18 December 2009, note C. BUYSSE, Fiscoloog 2010, no. 1217, 12; 28 S. VAN CROMBRUGGE, Beginselen van de vennootschapsbelasting, Kalmthout, Biblo, 2010, ; M. BOURGEOIS and E. TRAVERSA, C.D.F.I. 2010,

166 The limitation means that expenses are not deductible if the interest is paid to a company in the same community of interest 29 and if the interest expenses derive from an acquisition of shares from another company in the same community of interest. 30 The limitation does not apply, if the income corresponding to the interest expense had been subject to a minimum tax rate of 10 percent. The company originally entitled to the interest would receive the income. 31 Another exception is that the limitation does not apply if the acquisition and the debt, from which the interest derives, can be justified by a commercial interest. 32 The Austrian switch-over clause In Austrian tax law, a switch-over clause from the exemption to the credit method can be found in sec. 10, para. 4 CITA in order to prevent secondary sheltering. This provision is an exception of the international affiliation privilege and regulates the legal prerequisites for the withholding of the tax exemption of dividends and capital gains from international affiliation participations if the company operates in a low tax country and in passive activities. The Italian rules limiting tax deductibility of expenses paid to foreign suppliers Pursuant to the Italian Income Tax Act, costs and other negative elements of income are not tax deductible when they derive from transactions between enterprises that are resident in Italy and enterprises that are resident in countries or internal jurisdictions regarded as having a privileged tax regime. 2.3 Multilateral measures to counter cross border tax arbitrage As stated above, states try to counter international tax arbitrage primarily on unilateral and bilateral levels. The problem with the unilateral approach is that it may be contrary to EC law. Treating foreign entities differently from domestic ones does not comply with the freedom of establishment, and it is questionable if is there are any justifying reasons for doing so. The optimal solution to international tax arbitrage would be to remove all inconsistencies in the domestic 29 Community of interest is defined in Chapter 24, section 10a, Swedish Income Tax Act. 30 Chapter 24, section 10b, item 1, Swedish Income Tax Act. Complementary rules can be found in paragraph 2 and in Chapter 24, section 10c Swedish Income Tax Act. 31 Chapter 24, section 10d, Swedish Income Tax Act. This rule shows that these limitation rules only aim to prevent tax avoidance and not bona fide situations. Complementary rules can be found in Chapter 24, section 10d paragraph 2 and in Chapter 24, section 10e, Swedish Income Tax Act. 32 Chapter 24, section 10 d, item 2, Swedish Income Tax Act. 23

167 regulations and adopt a worldwide tax jurisdiction. Since such a solution probably is utopic, the starting point to deal with tax avoidance on an international level is the use of multilateral tax treaties. The main obstacle with creating an agreement with several contracting states is that there are great differences in the tax systems in the world and states have different approaches and attitudes to tax. States can also be reluctant to sign treaties with several other countries because a high number of contracting states makes a treaty more difficult to amend than a bilateral treaty. 33 Additionally, multilateral agreements require amendments more often than bilateral treaties due to the changes in contracting states domestic laws. 34 Due to the difficulties involved in setting up a binding multilateral agreement, such agreements are mainly used as soft law instruments. The EU and the OECD released codes of conduct, aimed at harmonizing states anti-avoidance rules. The European Union Code of Conduct for Business Taxation was created by the Council of the European Union. 35 Through the Code of Conduct, the member states consent not to adopt legislation which makes the tax rate substantially low, and consent to phase out such existing legislation. 36 Despite the fact that the member states have consented to the Code of Conduct, breaching the Code of Conduct is free from sanctions. The purpose of the Code of Conduct is to ensure that the EU will be free from tax havens and from harmful preferential tax regimes. The Code of Conduct encourages the member states to cooperate in the fight against tax avoidance and tax evasion. 37 The Code of Conduct is a part of a future cooperation within the EU for preventing disloyal tax competition. An additional attempt to fight international tax avoidance is the OECD s report regarding harmful tax competition. 38 The report contains recommendations for the member states regarding the framing of domestic legislation, bilateral agreements and international cooperation. The recommendations are more detailed than the Code of Conduct. For instance, it recommends that 33 Lodin, Den svenska bolagsbeskattningen I internationellt perspektiv. Fördelar, nackdelar och behov av förbättringar (Underlag till Globaliseringsrådets skattegrupp) , p Lodin, Den svenska bolagsbeskattningen I internationellt perspektiv. Fördelar, nackdelar och behov av förbättringar (Underlag till Globaliseringsrådets skattegrupp) , p Lodin, Den svenska bolagsbeskattningen I internationellt perspektiv. Fördelar, nackdelar och behov av förbättringar (Underlag till Globaliseringsrådets skattegrupp) , p Lodin, Den svenska bolagsbeskattningen I internationellt perspektiv. Fördelar, nackdelar och behov av förbättringar (Underlag till Globaliseringsrådets skattegrupp) , p Item k), European Union Code of Conduct for Business Taxation. 38 Harmful Tax Competition; An emerging global issue from the OECD. 24

168 states implement CFC rules and to use the OECD Guidelines on Transfer Pricing. The report is not legally binding for the member states and hence, breaching the recommendations does not lead to any sanctions. Additionally, the Global Forum on Transparency and Exchange of Information for Tax Purposes, 39 as part of the OECD, is in charge of promoting tax cooperation and information exchange among tax administrations. Its ultimate goal is to achieve full transparency regarding tax havens and to ensure that all members implement the recommended standard on information exchange, to which they have made a commitment. To be more effective, it was mandated that a strong in-depth peer review mechanism be established and that the members of the Global Forum, as well as jurisdictions identified by the Global Forum, undergo reviews of the implementation of their systems for the exchange of information in tax matters. In December 2010, the Peer Review Group broke the former recommendations down into ten essential elements against which jurisdictions are reviewed. They were split in three categories: availability of information, access to information and exchanging information. - Availability of information: The Forum wants jurisdictions to ensure that ownership and identity information for all relevant entities is available to their authorities and that reliable accounting records for all relevant arrangements and entities are stored. - Access to information: Appropriate authorities should have the power to obtain the information they need and to provide this information to others. The rights concerning data privacy should be compatible with effective information exchange. - Exchanging Information: The network of information exchange should cover all relevant partners and should have appropriate provisions to guarantee the confidentiality of the information received. Further, the information exchange mechanisms should respect the rights and safeguards of taxpayers and third parties. 39 The Global Forum on Transparency and Exchange of Information for Tax Purposes is available at 25

169 Part 3: Hybrid entities In this chapter the relation between hybrid entities and tax arbitrage is further examined. The first part will visualize the concept of hybrid entities using the Enron case of The Enron case is of vital interest when discussing the financial and economic crisis. According to the Enron report, the tax motivation of Enron s financial transactions functioned as a source for financial earnings. The tax department was not considered as a cost, but rather as a generator of profit. Permanent differences in book taxation were used for tax shelters, while at the same time generating artificial losses. After the Enron case is explored, the link with the EUCOTAX countries will be made on the basis of a comparative analysis. This analysis assesses the criteria applied to differentiate between corporations and partnerships. This analysis will focus especially on classifying foreign entities, since this creates tax arbitrage opportunities. In the third section, the Enron case will be explored further in light of the current situation. What was the response to tax arbitrage using hybrid entities? Could there be an Enron case in 2011? In the last part, some recommendations with respect to hybrid entities and tax arbitrage will be made. 3.1 Introduction The 2003 Enron case may be considered the origin of the actual systemic crisis. It appears that Enron had applied a leading financial and tax operation that ended up being an anticipation of the current crisis, as it is still today an important part of the harmful routine of banking, financial, insurance system and of any transnational corporation. Enron s more than 3,000 subsidiaries and partnerships were the pathway for structured financial transactions through financial and synthetic entities. Particularly important for the international tax arbitrage in relation with partnerships is the Project Valhalla, a financial transaction structured to provide tax benefits to Deutsche Bank under foreign legislation. The state actors in that transaction were Germany and the USA. According to a report, 40 Enron created a German entity treated as a corporation under German Law, but which chose to be treated as a disregarded entity for U.S. tax purposes, using the check-the-box rules. Project Valhalla was organized to provide tax benefits to Deutsche Bank by 40 REPORT OF INVESTIGATION OF ENRON CORPORATION AND RELATED ENTITIES REGARDING FEDERAL TAX AND COMPENSATION ISSUES, AND POLICY RECOMMENDATIONS. VOLUME I: the implementation of the Project Valhalla. 26

170 allowing Deutsche Bank to use deductible payments to finance a stream of income that was taxexempt under German Law. Enron and Enron Diversified Investments Corporation ( EDIC ), a domestic affiliate of Enron, formed Enron Valkyrie, a Delaware limited liability company that elected to be classified as a partnership for U.S. federal income tax purposes. Enron invested in an exchange to receive a 95% membership interest in Valkyrie, and EDIC accessed a 5% interest in Valkyrie through contribution. Under Valkyrie s company agreement, income, gain, loss, deduction, and credit were distributed according to the members respective interests, meaning that Enron, through Enron and the Enron s affiliate, had total control of the operational and subsequent investments of Valkyrie. Shortly thereafter, Valkyrie formed Valhalla GmbH, a German limited liability company. Valkyrie contributed capital to Valhalla, in exchange for all of the common shares of Valhalla. Valhalla, in turn, contributed capital to Rheingold GmbH, a German limited liability company, in exchange for all of the common shares of Rheingold. Rheingold obtained financing through a loan from Enron and issued a note to Enron evidencing the loan with interest at a rate of 7.7 percent. Valhalla and Rheingold both chose to be treated as disregarded entities for U.S. federal income tax purposes, using the check-the-box rules. Following this, Valhalla and Rheingold entered into a subscription and procurement agreement, according to which Valhalla agreed to procure a subscriber for certain participating debt rights in Rheingold. The subscription price for the participation rights was $2 billion. Then Rheingold, Valhalla, and Deutsche Bank entered into an agreement on the participation rights, Valhalla waived its right to subscribe for such rights and Rheingold issued the participation rights to Deutsche Bank in exchange for $2 billion. Risk Management and Trading Corporation business ( RMT ), a domestic affiliate of Enron, was hedging and trading financial instruments and commodities. Rheingold used the funds received from Deutsche Bank s purchase of the participation rights along with the funds it received from Valhalla s capital contribution and the loan from Enron, to purchase two classes of RMT preferred stock. The first class ( Series 1 ) was non-voting, nonparticipating (except to the extent of a fixed percent dividend), and not convertible into any other class of RMT stock. The second class ( Series 2 ) included voting rights, but was non-participating (except to the extent of a fixed percent dividend). Valkyrie granted Rheingold the right to put the RMT preferred 27

171 stock to Valkyrie at a price that was the greater of (1) the original issue price of the preferred stock or (2) the U.S. dollar equivalent of the original Deutsche mark price on the date the put was exercised. After that, Enron loaned $1.95 billion to Deutsche Bank s New York branch. Later in 2000, Deutsche Bank s London branch took the place of the New York branch as obligor on the note. The note was due and payable on May 2, 2005 (or earlier if a payment event occurred) and required Deutsche Bank to make annual coupon payments at a fixed rate of 8.74 percent. The spread between the 8.74 percent interest rate on the note and the 7.7-percent rate on the participation right served as Enron s accommodation fee on the transaction. The $1.95 billion promissory note largely offset Enron s $2 billion liability to Deutsche Bank with respect to the participation rights. Enron personnel interviewed by the Joint Committee staff could not fully explain why Enron made a net $50 million borrowing from Deutsche Bank on the transaction, but recalled that Deutsche Bank requested that the two instruments not completely offset each other. The parties intended for the financing arrangement to remain outstanding for a period of up to five years, until May As President Barack Obama pointed out in May 2009, the American tax code is full of corporate loopholes that makes it perfectly legal for companies to avoid paying their fair share. The importance of his words are easy to understand when one considers the net amount of $86.5 billion in revenue that could be collected between 2011 and 2019 by overhauling regulations. The part of the plan affecting tax rules that President Obama is considering amending is known as the check-the-box rules. 41 The need for a change in the check-the-box rules is seen as crucial to solve the problem of tax base erosion. This American executive branch position seems to be prevented by the conservative legislature. The diagram on the following page depicts the Project Valhalla structure. 41 Bloomberg, May

172 3.2 Comparative analysis of the criteria In this part, the criteria of classification of the EUCOTAX countries are analyzed on the basis of the domestic laws. The starting point will be the liability to tax principle, since this is the basis to differentiate between entities. As aforementioned, the classification with respect to foreign entities might create double taxation and tax arbitrage issues. In this respect, the problem of hybrid entities is further explored. 29

173 The liability to tax is mainly based on the principle of residence. The classification of domestic entities is also based on a common criterion, although some EUCOTAX countries established some complementary criteria. Belgium introduced three cumulative requirements: (i) being a Belgian, (ii) the possession of legal personality and (iii) taking on economic activities. As a general rule, the classification of a corporate or non-corporate entity follows equivalent rules in all EUCOTAX countries. The main criterion to classify the entity as a corporation is whether or not legal personality exists. Legal personality implies that the company is considered to have its own rights and it treated on an autonomous level compared to its shareholders. Another criterion which is found in the Netherlands, Germany, and Sweden is the level of liability with respect to the capital of the entity. Sweden restricted the opportunities to achieve a tax benefit by locating a limited liability company or a partnership abroad. By locating a limited liability company or a company abroad, Swedish corporate taxation could be avoided. To restrict this method of avoidance, the Swedish legislature introduced CFC legislation, which will be further elaborated in the next chapters. All the EUCOTAX countries recognize a difference between entities classified as opaque or transparent. Transparency refers to the attribution of profits of an entity to the partners. However, the consequence of this recognition might be different since different laws and criteria are applied. Discussing the differences, the area of hybrid entities becomes valid. A hybrid entity is defined as a situation in which one tax jurisdiction considers the entity as a taxable subject, while the other jurisdiction views the entity as non-taxable. The result of this conflict between transparent or opaque entities might be a double taxation or even a double non-taxation. Based on literature and the comparative analysis of EUCOTAX countries, three approaches with respect to the qualification of foreign entities can be divided: The similarity approach in which (i) the features of a foreign entity are compared to the legal characteristics of a domestic entity or (ii) when the classification in the foreign country is used to qualify the entity for domestic tax purposes. The starting point of this classification is a resemblance test and the search for an equivalent entity. The advantage of applying this method is that it will contribute to the neutrality and the level of adaptability to foreign legislation. The main disadvantage which is inherent to the similarity approach is when no domestic entity will correspond to the foreign entity. 30

174 The fixed approach in which the classification of all foreign entities is the same. It does enhance the predictability. However, some discrimination problems with respect to the classification might occur. The elective approach in which the classification decision is handed over to the involved taxpayer. The taxpayer can choose whether the foreign entity is classified as opaque or transparent for tax purposes. A main advantage is that determination process is made much simpler. However, it also elicits tax-planning opportunities. 42 Based on the comparative analysis of the criteria in the EUCOTAX countries, the following conclusions can be given. The common method is known as the similarity approach, which is applied in Austria, Belgium, Germany, The Netherlands, Poland, Spain and Sweden. Belgium treats entities as opaque, due to their legal personality according to the lex societatis doctrine while the other jurisdiction treats the entity as transparent. If lex societatis is not applicable, the Belgian legal theory will refer to the laws of the residence state of the partners known as lex fori. According to the order of the national tax law, Germany introduced the concept of type comparison. This comparison is used to examine whether or not the structure formed by the foreign law and its economic function is similar to equivalent Germany structures. In the Polish tax law there is a provision referring to hybrid entities. The Polish Corporate Income Tax Act covers partnerships, if three requirements are fulfilled: (i) their seats or head offices are located in another state, (ii) in accordance with the tax laws of that state, they are treated as legal persons and (iii) their worldwide income is subject to tax in that state. Although it is still a partnership, for the purpose of tax classification, its tax status is equal to a company based on the legal personality. Under the Spanish law, the hybrid or corporate nature of an entity depends on its legal nature. The "attribution of income regime" generally applies within Spain and in certain cases as well to any foreign entity of identical or analogous nature (e.g. trusts and French partnerships). With respect to the similarity approach, France integrated the similarity method in the opposite way. The French tax authorities ruled in the Diebold case, 43 that the classification of the foreign entity should be based on its state of residence. The most convenient means of classification, known as the fixed approach, is found in Italy. According to Italian tax law, all foreign entities are classified as opaque and shall be liable for 42 A.J.A. Stevens, Hybride entiteiten en belastingverdragen, Maandblad belasting beschouwingen 2010/ CE, 8e & 9 s.-s., October 13, 1999, n , SA Diebold Courtage (Concl.), Dr. fisc. n 52, 1999, comm.. 948, note Acard, concl. Bachelier. 31

175 corporate taxation. It can be questioned whether or not this is classification conforms to EU law. According to EU law, member states have a high level of sovereignty with respect to the design of their tax jurisdiction. This sovereignty is also applied to the development of classification criteria. A relating case with respect to this sovereignty is Columbus Container Services case. This case involved the compatibility of the German legislation with the freedom of establishment. Based on this ruling, each member is free in designing their jurisdiction if and insofar as the classification is not indicated to be discrimination. 44 Referring to the Italian classification, the actual features are not taken into account. This approach might result in discrimination between non-resident partnerships and resident partnerships. With reference to the Enron case from the introduction, the United States can be indicated as a country in which hybrid entities are born. The United States implemented the elective approach with respect to the classification of foreign entities known as the check-the-box rules. The main reason to introduce those rules was based on administrative purposes, since examining the previous criteria of the Supreme Court was time-consuming. The rules allow the taxpayer to choose which tax treatment to apply through an option method. This election allows for the use of entities like the limited liability company ( LLC ). An LLC can be taxed as a partnership, while maintaining most of the advantageous corporate characteristics. For tax purposes, despite the corporate characteristics, LLCs are treated as partnerships, unless they elect another classification. Moreover, the United States applies its own domestic law and will not take foreign tax law into account. It is also questioned whether or not the EUCOTAX countries implemented legislation with respect to hybrid entities. According to the comparative analysis of the EUCOTAX countries, it can be concluded that no country specifically introduced legislation on hybrid entities. However, in May 2005, the UK published the Finance Act (number 2), which clearly saw international tax arbitrage as tax avoidance. The wide purpose of the law was aimed at denying deductions pursued in the country when part of the plan used hybrid entities or hybrid instruments, and whose purpose was to obtain a tax advantage. This British Act is the only legislation known so far relating to hybrids. 45 Taking this comparative analysis into account, it can be concluded that there is still no consensus on the classification of entities. However, a common criteria known as legal personality is 44 ECJ 6 December 2007, Columbus Container Services, C-298/ T. Rosembuj, International Tax Arbitrage, the financial hybrids

176 recognized by the majority of countries. With respect to tax arbitrage, the classification of foreign entities showed that there is no consensus between the EUCOTAX countries. Hybrid entities and tax arbitrage are still an important combination used to gain tax advantages. 3.3 Response to tax arbitrage In order to restrict tax arbitrage opportunities with hybrid entities, more consensus on a European level is needed. The OECD recognized that in the international taxation area, the risks of double taxation or non-taxation with respect to partnerships might occur. The conflict is caused by the different classification or by the different treatment of partnerships. Under this conflict, the Committee discussed how the liable to tax principle should be interpreted in case of partnerships. In 1999, the OECD published the partnership report. In general, partnerships, although they are persons within the meaning of the OECD model, are treated as transparent for income tax purposes. The liable to tax determination should be based on the amount of tax payable on the partnership income as determined in relation to the personal characteristics of the partners (whether the partners are taxable or not, what other income they have, what are the personal allowances to which they are entitled and what is the tax rate applicable to them). If there is an affirmative answer to this question, the partnership should not itself be considered as liable to tax. 46 Even though the member states of the OECD often implemented the commentary of the OECD, it is not obligatory to do so. With respect to the OECD partnership report, several countries made some reservations. A reservation is a statement by a country that it does not accept the recommendation in the OECD Model convention. The following EUCOTAX countries made reservations to the application of the OECD Model with respect to partnerships: the Netherlands, France and Germany. The Netherlands made a reservation stating that the recommendation of the OECD is only followed in case of unilateral agreements, specific provisions or on the basis of mutual agreements. The Netherlands will pursue other options to solve the negative consequence of a qualification conflict with respect to hybrid entities. France also made a reservation on article 4 of the OECD Model Convention. Stating that partnerships are not resident for the double tax treaties purposes but that partners shall be entitled to benefit from the treaty provisions, pro rata to their partnership shares, in their own state of residence. On the opposite, under French law, partnerships are always treated as liable to tax even if the taxation of the partnership s profits occurred at the 46 The Application of the OECD Model Tax Convention to Partnerships, OECD Publishing 1999, paragraph 40 33

177 partners level. As a result France does not agree that in the case where a partnership is exempt from the benefits of a tax treaty, partners shall be entitled to those benefits. Finally, Germany reserves the right to include a provision under which a partnership that is not a resident of a member state is deemed to be a resident of the member state where the place of its effective management is situated there. It is only considered to be a resident to the extent that the income derived from the other member state or capital situated in the other state is liable to tax in the contracting member state. 47 On the basis of the current financial and economic crisis, it is arguable that the OECD report on partnerships solved the problem with respect to the treatment of partnerships. Since the OECD is not binding law, the possibility of taking advantage of the classification conflict is still feasible. 3.4 Solutions The EUCOTAX theme of 2011 focuses on Global finance and taxation; the financial and economic crisis and the role of taxation. After comparing the different tax jurisdictions of the EUCOTAX countries and examining scholars, it is concluded that tax arbitrage and tax avoidance are the vital actors in the current systemic crisis. The first thing that comes to mind, after analyzing the timeline from its origin with the Enron case in 2003, is to experience a dejà-vu. If the facts and circumstances of the Enron case were allocated to the current times, it cannot be arguable but that the situation would be the same as it was in Even though there has been some progression, because of the tax regimes deficiencies regarding hybrid entities, it is still possible to create tax arbitrage and tax avoidance opportunities through hybrid and financial entities. The lack of tax consensus on a European level and even more on an international level regarding legislation creates uncertainty in the Tax Administrations and might result in avoidance by the taxpayer circumventing the tax rules. Tax arbitrage is a main problem in the European Union. Countries have to cope with the tension between fiscal sovereignty and, at the same time, the freedoms of the European Court of Justice. The adoption of provisions could be raised from three perspectives, each one of them depending on the scope of the norm. 47 OECD commentary article 4 paragraph 32 34

178 If one uses implementation of provisions through the local legislation, it can result in the same problem of characterization and harmonization from the concepts and the rules found today. Each state has their own definition based on tax literature, traditions and previous influences in their legislation, making impossible to attempt to harmonize the terminology by simply updating and amending local tax law. Bilaterally, there is the same problem if the same standards are not used. Dual Tax Treaties can help when defining corporate and non-corporate entities, but that definition should be clear and there should be no exceptions. For that reason, the implementation of annexes at the end of the treaties defining specifically through equivalence both entities would help the Tax Administration when taxing the foreign entity. This proposition, even though it sounds good, is far from being feasible since a new Dual Tax Treaty would be needed to be implemented and that task would be too long to become reality. To attempt to tackle this time consuming task, the preferable option would be to accept the terms of the entities on directive level (like the Parent-Subsidiary Directive) Following a global scope might be the best option since the introduction of international principles is already part of the routine of several countries when talking about International Private Law. Terms like the ability-to-pay Principle, single tax Principle, and Principle of origin should be understood and implemented in the local systems by the adoption of multilateral treaties. Dual Tax Treaties cover both signatory states, and therefore harmonize the concept between two parties. The idea of a multilateral agreement would give more scope to conceptions and at least tax terms would be clearer and easier to relate with a global principle of certainty. A question arises when attempting to adopt a comparable provision through hard-law, by the implementation of the conceptuality through directives like in the case in the European Union or through soft-law by simply creating a special body that creates, arbitrates and monitors the right substance of the rule or by using the ones already existing by upgrading their duties for control and monitoring, although this one would not be binding. The option of the hard-law is presented as the best option when trying to achieve the solution of this specific topic, the financial crisis, because of the need for a binding rule in order to avoid the circumvention of the tax rule through abuse. 35

179 Part 4: Financial Instruments 4.1 Introduction A hybrid situation generally implies that something is treated differently in two different countries. In this case, a financial instrument is treated as debt in one country, and as equity in the other country. Since corporate financing is increasingly done by means of hybrid financial instruments, it is imperative to know where the fiscal line lies between debt and equity in each jurisdiction. 4.2 Hybrid Instruments Classification of Debt and Equity Although there are limited exceptions in every country concerned, interest is generally deductible by the payor while payments on equity instruments, i.e. dividends, are not. This tax effect, however, is tempered between parents and subsidiaries in EU countries by adoption of the participation exemption directive, 48 and in the U.S., through the use of a dividends received deduction. 49 Still, the distinction in tax effect creates incentives to use one type of instrument rather than the other. This is important because of the ability to use differences in classification for arbitrage opportunities. For example, assume two corporations are located in two countries, Country A and Country B. The Country A corporation (ACo) gives cash to the Country B corporation (BCo) in exchange for an instrument. Assume that Country A views this instrument as debt. Payments with respect to the instrument will then be classified as interest and will be generally deductible. Additionally, if a treaty applies, the interest payments may be subject to only limited or even no withholding. If Country B views the instrument as equity, then BCo s income will be dividend income. 50 Under the regimes of the following countries, it could result in an exemption (or dividends received deduction) or a credit, which reduces the tax paid on the income to Country B. As a result, ACo will realize a deduction in Country A, while BCo does not recognize corresponding income in the same amount. 48 Council Directive 90/435/EEC, amended by Council Directive 2003/123/EC. 49 IRC In some countries, this will create a timing differential, where interest income and dividend income are differently taxed. For example, interest may create a deduction when it is accrued, while dividends will not be taxable until paid. Because of the time value of money, this advantage itself could be considerable. 36

180 Below, this section examines the determination made by each of the countries considered to determine whether arbitrage opportunities could arise in instrument exchanges between corporations located there. Although they can generally be divided into countries which look to the form of the instrument and those that look to the substance, the following will explore the differences more particularly. In Austria, instruments must meet two requirements to be classified as equity under the Corporate Income Tax Act (CITA). First, they must give the holder participation-alike or beneficial participation rights (aktienähnliche Genussrechte). Second, the instruments must give the holder the right to participate in the profits of the issuer, including liquidation proceeds. 51 Case law from the Austrian Supreme Administrative Court provides additional criteria for instruments to be treated as equity, namely, unlimited maturity, profit-related remuneration, subordination and no provision of security. If these criteria are not fulfilled, a debenture participation right (obligationenähnliches Genussrecht) exists, which is viewed as debt. 52 Moreover, if the remuneration of an instrument is not profit-related and the instrument holder is not participating in company decisions, the instrument is debt. Other characterizations of debt are a nominal redemption claim, short time horizon, and easy termination. 53 In Belgium, the general law classification of an instrument governs its tax classification and treatment. The Belgian corporate income tax system can be generally described as a form over substance approach. 54 The Belgian tax classification model is not a weigh all the circumstances - approach, but a one decisive element -approach. 55 A basic requirement of a loan relationship according to Belgian general contract law is the repayment at maturity of the amount loaned. 56 In fact, the one decisive benchmark principle for a financial instrument to be classified as debt is the right of the lender to be repaid the initial inlay at least and possibly only in case of a concursus creditorum. 57 This means that instruments will not be characterized as equity despite the following features: perpetual, redeemable, 58 profit-participating compensation, 59 interest-free, 60 convertibility (whether 51 Sec. 8 para. 1 no. 1 indent 2 CITA. 52 VwGH December, ; 92/16/0025. Haslehner, taxlex 2006, p Ruppe, in Doralt/Hassler/Kranich/Nolz/Quantschnigg (eds.) Die Besteuerung der Kapitalgesellschaft, p P. SMET and S. MARTIN, TFR 2009, 774; S. VANOPPEN, Deductible equity, 2; H. LAMON, Buy-outs, 61-62, see also Supreme Court 29 January 1988, Pas. 1988, I, 633 (dismissal of substance over form principle). 55 S. VANOPPEN, Deductible equity, 6; contra: see H. LAMON, Buy-outs, P. SMET and S. MARTIN, TFR 2009, 765; S. VANOPPEN, Deductible equity, S. VANOPPEN, Deductible equity, 62; see also A. HAELTERMAN, Réflexions, S. VANOPPEN, Deductible equity, Explicitly stated in Comm. ITC 19/3. 60 J. VAN GOMPEL, Onderscheid,

181 automatically or not) into shares of the debtor, 61 payment of interest in kind (issuer s shares), subordination, 62 even when combined with thin capitalization, 63 insufficient capital to realize corporate purpose 64 and rights of control. 65 In France, although there are many different types of debts, they share a common legal nature where money borrowed must be repaid. 66 This legal nature is also the criteria to distinguish debt from equity. Indeed, the holder of a debt instrument is usually not exposed to the uncertain results of a business. He is entitled to get a fixed payment regardless of the profits of the debtorcorporation whereas the payment of the equity 67 holder is directly linked to profits. There are also two additional criteria for debt. First, while a creditor has the right of a repayment at the end of a fixed term, a shareholder is not entitled to a refund of the payment he made until the winding up of the corporation. Second, creditors never have the right to participate in the corporation s decisions while the shareholders have the right to be informed, to vote and to preferential acquiring abilities of new shares issued by the corporation. 68 In Germany, the tax system follows the HGB (commercial and company law) in the classification of debt and equity instruments. The HGB law is characterized by its stringency and consistency. 69 The crucial characteristics for equity are subordination, sustainability, loss participation, and profit dependency of equity remunerations. For tax matters the German Superior Court (BFH) follows the material equity term, similar to the HGB law. 70 There is only one instance where tax law is not derived directly from the HGB. Namely, there is a stand-alone tax regulation for the characterization of equity, 71 which states that an instrument is not properly characterized as debt if distributions lead to a participation in the profit as well as in proceeds of a liquidation. Alternatively, if the does not lead to a participation in hidden reserves, for example, the tax law will 61 Comm. ITC 19/ J. VAN GOMPEL, Onderscheid, Supreme Court 11 January 1966, Pas. 1966, I, Supreme Court 11 January 1966, Pas. 1966, I, 611; Supreme Court 5 September 1961, Pas. 1962, I, 32; Supreme Court 15 April 1969, Pas. 1969, I, Supreme Court 11 January 1966, Pas. 1966, I, 611; Supreme Court 15 April 1969, Pas. 1969, I, Cyril David, Tax treatment of financial instruments, Kluwer, 1996, p Note that the expression equity is not used by the French Tax Code, which refers to the term actions, which are shares of a corporation, or parts sociales, which are interests in the partnerships. 68 Cyril David, Tax treatment of financial instruments, Kluwer, Dorenkamp, Eigen- und Fremdkapitalfinanzierung im Steuerrecht, Cf. BGH at II ZR 238/87, DB 1998, 1262; Priester, DB 1991, 1917 (1918) para. 3 s.2 hs.2 KStG 38

182 negate its qualification as equity. 72 This can sometimes lead to different results than the application of the HGB, but is limited in scope. In Italy, classification of instruments depends on case-by-case analysis which takes into account the specific characteristics of the relevant instrument. Art. 44, Paragraph 2, letter a) of the Italian Income Tax Act states that the instruments are treated as equity if the remuneration payable in respect of such instruments is:... completely linked to the economic results of the issuer or of other entities which are members of the same group or the economic result 73 of the transaction in relation to which they have been issued.... Accordingly, although such payments may not be classified as dividends under Italian corporate law, it is treated as dividend income for tax purposes. In contrast, the instruments cannot be classified as equity if the remuneration is only partially linked to the economic results of the issuer. Interestingly, even if the remuneration is not classified as a dividend, the portion linked to the economic result of the issuer, if any, would not be deductible in the hands of the payer, but would be fully subject to tax in the hands of the recipient. In the Netherlands, the ground for the classification of debt and equity is found in article 8, sub 1 CITA. The difference between the two types of instruments is determined by reference to four civil characteristics, as follows: 1) To be considered equity, an instrument must reflect a certain degree of ownership and control. Issuing debt will not lead to ownership or control, because it is defined as an account receivable. 2) The duration of the transfer of equity is normally undefined, which signals its permanency, and the receiving entity has no repayment obligation. In contrast, a creditor ensures that his loan is repaid in a pre-arranged time. 3) The amount of a dividend depends on the total profit of the instrument issuer while the amount of interest paid to creditors is based on mutual agreement. 4) Generally, equity has a higher level of risk compared to debt due to bankruptcy provisions. Moreover, dividend distributions depend on the total profit which might fluctuate on a random basis, creating a higher level of risk.74 The general rules for the classification of debt and equity for Dutch purposes were introduced in a case before the Dutch Supreme Court. In that case, a transaction between a parent and subsidiary was examined to determine whether it should be defined as a loan with interest or an informal capital contribution. The Court determined that the real facts and circumstances reflected the existence of an informal capital contribution instead of a loan agreement. 72 Id. 73 Economic result has not been defined by the Italian law and thus leaves much uncertainty in its application. 74 J. van Strien 2006, p

183 Under economic principles, Poland s law recognizes the typical characteristics of debt and equity. For example, debt is characterized as a fund that has to be repaid within a certain term, its amount of return is strictly determined, and it does not entail the possibility to control the issuing company. Payments made to acquire equity, on the other hand, are paid back only when the initial capital of a company is diminished or a company is liquidated, the repayment depends on the company s profits, and it carries control possibilities. However, Polish law also recognizes that there are some instruments which have features of both debt and equity and which may have a majority of characteristics which are inconsistent with the instrument s legal form. In one case, a company was going to get a loan from a shareholder, but the Court determined that, because the amounts paid to the lender/shareholders were independent of the total amount of the loan and loan duration, the payments were not deductible. 75 In Spain, the characterization of an instrument is determined with reference to the Market Financial Act. Specifically, three aspects are considered to determine whether an instrument is properly characterized, as follows: 1) the existence of a present obligation against one or more persons or entities, 2) the ability to pay off the obligation either through transfer of assets or by exchange for shares, and 3) if the settlement of the obligation is the issue of shares, whether the holder assumes the risks and benefits associated with the investment value of the issuer. Under Swedish law, the distinction between debt and equity is made by reference to the income derived from the instruments held. There is no explicit definition of what constitutes interest in Swedish law, 76 but case law uses an economic definition. 77 This method distinguishes between foreseeable and non-foreseeable increases in value at the time of investment. 78 Foreseeable increases derive from the agreement regarding the loan and constitute interest. Financial instruments which have been regarded as debt securities in case law are for instance financial derivatives, 79 participating loans, 80 subordinated debts, 81 futures contract and warrants where the incomes derive from the agreement. 82 On the other hand, the income from equity securities is unforeseeable and does not depend on agreement. The tax regulation regarding shares is, to a large extent, applicable on all 75 The judgment of the Voivodship Administrative Court in Szczecin from 23th September 2010 (I SA/Sz 392/10). 76 RÅ 1999 ref Among others, RÅ 1988 ref Lodin, Lindencrona, Melz, Silverberg, Inkomstskatt en lärobok I skatterätt, p RÅ 2008 ref Chapter 24, sections 5-10 Income Tax Act. The part of the income which can be regarded as interest is limited. 81 Document from the Swedish Tax Agency, , case number /1152 (Skatteverkets skrivelse, , målnummer /1152). 82 Futures contract and warrants are regulated in Chapter 48, section 3 Income Tax Act. 40

184 equity securities. 83 These rules apply if the main part of the instrument has the characteristics of an equity security. 84 redeemable shares. 85 For instance, these rules can apply to equity swaps, synthetic options and In the United States, the classic type of debt is defined as an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor s income or the lack thereof. 86 On the opposite side of the spectrum is the common equity holder, whose intention is to embark upon the corporate adventure, taking the risks of loss attendant upon it, so that he may enjoy the chances of profit. 87 However, there are several instruments falling between these extremes. Congress did make some attempt to distinguish stock and debt, 88 but ultimately passed authority to the Treasury to do so via regulations under This section lists five factors to be considered in determining the type of instrument: 1) whether there is a written unconditional promise to pay a sum certain plus a fixed rate of interest, 2) whether there is subordination to or preference to other corporate indebtedness, 3) the ratio of debt to equity in the corporation, 4) whether the instrument is convertible into stock, and 5) the relationship between the corporation s stock holdings and the holdings of the instrument considered. 90 However, although final regulations were issued, they never became effective and have since been withdrawn. 91 Instead, it is left to the courts to determine whether an instrument is properly classified as debt or equity. The courts will generally compare the characteristics of the instrument against a list of relevant items. 92 Ultimately, this determination looks at the substance of the relationship between the parties involved, rather than simply the form of the instrument Regulation of Hybrid Instruments When speaking of hybrid instruments, this paper refers to instruments which are treated as debt in one country, but as equity investments in another. The example in the section above described one way in which taxpayers can use this difference in classification to create arbitrage 83 Tivéus, Skatt på kapital, p Tivéus, Skatt på kapital, p Tivéus, Skatt på kapital, p 110. It is important to notice that the classification of financial instruments, especially hybrid instruments, can differ depending on the specific agreement. 86 Gilbert v. Comm r, 248 F.2d 399, 402 (2d Cir. 1957). 87 U.S. v. Title Guarantee & Trust Co., 133 F.2d 990, 993 (6th Cir. 1943). 88 HR Rep. No. 1337, 83d Cong., 2d Sess. A-98-A-99 (1954). 89 IRC IRC 385(b). 91 T.D. 7920, C.B Fin Hay Realty Co. v. U.S., 398 F.2d 694 (3d Cir. 1968), citing other cases with like lists. 93 Id. 41

185 opportunities. However, despite this arbitrage, most of the countries considered do not regulate hybrid instruments any differently than any other instrument similarly classified under its domestic rules. Germany partially regulates hybrid instruments by preventing use of the parent-subsidiary dividend exemption when a parent receives deemed dividends. For example, where a parent receives a payment that is treated as interest in the subsidiary s country, German law will deny application of the dividend exemption to that payment. Hybrid instruments are also addressed in the United States. 94 Specifically, although not prevented particularly by any law or regulation, hybrid instruments are often challenged upon examination by the Taxing Authority (IRS). However, these challenges do not mention arbitrage, but, instead, rely on the debt-equity characteristics described above, even though this creates an inconsistency between domestic and international application of the tests. Additionally, the U.S.-Germany Tax Convention provides for a resolution to the classification conflicts in domestic laws. Namely, the convention stipulates that where a payment is treated as a dividend in the source country, it will be consistently treated in the country of residence. 95 However, where the payment is treated as interest in the source country, it can still be recharacterized in the other country (although this is unlikely to occur since interest treatment will result in higher revenues in the state of residence). 4.4 Repos A repo or repurchase agreement is, by form, a sale of securities along with an obligation to repurchase the security at a later date. A repo can also be seen as a hybrid transaction used as a cross-border tax arbitrage technique since it can be characterized as a loan or a (double) sale in different jurisdictions. Indeed, from a purely legal (contractual) point of view, a (double) transfer of ownership occurs, while from an economic perspective, the proceeds received in turn for the sale constitutes a loan, with the securities acting as collateral for that loan. For an arbitrage opportunity to arise, the seller tries to take on the position that the transaction constitutes a financing transaction 94 Interestingly, while the United States looks only to U.S. classifications in applying other provisions of the tax law, the U.S. taxing authority does refer to foreign country classifications of instruments in order to prevent arbitrage. See, Biddle v. Comm r, 302 U.S. 573 (1938)(U.S. only looks to U.S. law to determine classification of entity). 95 Convention Between the United States of America and the Federal Republic of Germany, 1 January 1990, Art. 10, 3. 42

186 (loan), while the recipient tries to take on the position that the transaction is a sale. A simplified example can be very explanatory in this respect. YCo sells its shares in SubCo to Xco, and contemporaneously agrees to buy them back at a predetermined price. The tax benefits that follow from a discordance in domestic tax law are the following. In state X, the securities are regarded as property of XCo for the duration of the transaction, so exemptions or credits are available for distributions on the security (e.g. for dividends) leading to an absence of tax liability in state X. In state Y, although the distributions on the sold securities are regarded as owned by YCo, they are in fact paid to XCo and the payments are considered to be (deductible) interest on the loan from XCo to YCo. Again, no tax liability arises. In the following paragraphs, the characterization of repo transactions in the participating countries of the EUCOTAX WINTERCOURSE is discussed, by means of a dichotomy of states considering repos as double sales and that which assimilate repos to loan agreements States regulations The sale countries In Italy, a repo is also to be seen as a double sale contract. Italian recipients of the transferred securities are generally speaking to be seen as the legal owners of those securities and the distributions attached. In a recent court judgment 96 however, the tax credit claim of an Italian bank was, in a tax arbitrage transaction, rejected under the general anti abuse of law doctrine. 96 CTP Emilia Romagna, Sez. I, n. 242, 15 novembre For more comments, see F. Dezzani and L. Dezzani, CTP Reggio Emilia, n. 242/01/10 del 15 novembre 2010 Prodotti fiscali (o tax product ) utilizzati dalle banche: illeciti per abuso del diritto, cit. pag. 9; M. Mastromattei, CTP Reggio Emilia, n. 242/01/10 Utilizzo indebito dei crediti d imposta figurativi in Il Fisco, 5, 2011, pag

187 In Poland, there is no consensus about the legal qualification of a repo transaction. Polish civil law does not contain a regulation of a loan with securities as collateral and treats repos as a sale with a right of redemption (sale and repurchase). Polish tax law neither contains a repo regulation, but by an interpretation of tax acts, it is generally assumed that taxable repo income is the difference between the sale and repurchase price, taxed at the moment of contract execution. 97 The loan countries In France, according to commercial law, a repo transaction is considered as a sale and repurchase of securities. 98 However, in French tax law, repo transactions are treated as tax neutral which implies that the securities are deemed to have never been sold (Art. 38bis-0 A CGI). Accounting-wise, the cedent keeps carrying the assets in his balance sheet, along with a liability (purchase price), which corresponds with a receivable in the accounts of the cessionaris. 99 Tax-wise, the general rules remain applicable in respect of the cedent. The cedent remains the taxable person and the normal tax regime on that type of income remains applicable (e.g. DRD), although the distributions are actually received by the cessionaris, who is obliged to transfer the income. At maturity, the cessionaris repurchases the securities and the difference between the purchase and repurchase price is considered to be loan income, deductible for the cedent, taxable for the cessionaris. In Germany, repo transactions are generally speaking not to be seen as (double) sale agreements. 100 In the balance sheet, the cedent has to carry the amount he has received in exchange for the sale of the securities as a liability. 101 transactions with loans. Both Sweden and Austria also assimilate repo In the Netherlands, specific tax provisions regarding repo transactions are inexistent. However, doctrine has discussed greatly about this way of financing and two main doctrines have been developed in Dutch tax law, i.e. (1) a civil law approach and (2) an economic approach. From a civil law perspective, a repo transaction results in a transfer of legal title (ownership) ( sale and repurchase transaction). From an economic perspective, on the other hand, based on an assessment of the level of risks and ownership, one can conclude that the transferor may still be the 97 The individual interpretation of tax provisions of Drugi Mazowiecki Urząd Skarbowy w Warszawie, (sygn. 1472/ROP3/423-4/05/BB) 24 maja Mémento Pratique Francis Lefebvre, Fiscal 2010, p Haisch, in: Herrmann/Heuer/Raupach, EStG-com., 5 n Weber-Grellet, in: Schmidt, EStG-com., 5 n. 270 Pensionsgeschäfte ; Hoffmann, in: Littmann/Bitz/Pust, EStGcom., 5 n

188 economic owner, who is in the Netherlands to be regarded as the owner for tax purposes. Consequently, the securities transfer is ignored and the transaction qualifies as a loan. 102 This view was upheld in a court judgment of 8 June For the dividend stripping schemes, specific antiabuse provisions exist in Dutch tax law (a beneficial ownership requirement). In Spain, the ownership of the securities transferred remains with the cedent. For the cessionaris, the taxable income of that loan is a yield between the purchase and the repurchase price which constitutes interest (Art c) TRLIRNR jo. Art of Royal-Legislative Decree 3/2004). For the cessionaris and the cedent, the interest is taxable and deductible, respectively, on accrual basis for the non-optional repurchase and on a cash basis for the optional repurchase. Profits derived from the underlying assets will be taxable in the hands of the cedent and the tax regime and withholding will be the same as the one of the underlying asset. In the U.S.A., the courts have consistently held that the underlying economics of repos are such that they should be treated as loans, rather than sales. 104 Furthermore, the IRS has, in several revenue rulings, made the same determination. 105 This is simply another example of the focus on the underlying economic substance of a transaction in the application of U.S. tax law. Repo transactions are aggressively challenged by the IRS on examination 106, an attack which is still ongoing. 107 In Belgium, a complex system was introduced in 2005 (specifically for repos of financial instruments). As opposed to its civil law qualification, the new law introduced a non-transfer fiction, however, only in respect of the cedent (XCo), not the cessionaris (Art. 2 2 ITC). This implies that in respect of the cedent (1) there is no realization for tax purposes when transferring the assets and (2) there is also no effect on several conditions to be granted certain tax benefits (e.g. participation exemption, DRD). The non-transfer is however only partial, in the sense that it only applies to ownership, not the consequences of that ownership, i.e. the cedent is not the owner of the income of the underlying asset but the manufactured payment he may receive is taxable as miscellaneous income. Instead, the cessionaris is to be regarded as the income receiver (no tax benefits) and the manufactured payment is to be seen as a damages payment (deductible). The compensation for a 102 S.M.H. Dusarduijn, Het gebruik van repotransacties door een fiscale beleggingsinstelling, WFR 1998/ Hof Amsterdam 8 June 2005, VN 2005/ See Nebraska Dept. of Revenue v. Loewenstein, 513 U.S. 123, 134 (1994); Union Planters Nat. Bank of Memphis v. U.S., 426 F.2d 115, 118 (6th Cir. 1970); American Nat l Bank of Austin v. U.S., 421 F.2d 442 (5th Cir. 1970). 105 See Rev. Rul , C.B. 24; Rev. Rul , C.B. 196; Rev. Rul , C.B. 75; Rev. Rul , C.B Greenaway at Id. 45

189 repo is to be regarded as interest income. Moreover, a regulation exists regarding coupon stripping schemes. 4.5 Foreign Tax Credit Generators The differences in the characterization of repo transactions or financial instruments can be exploited by some taxpayers to generate tax credits. Examples of such are found below, along with existing regimes to limit this type of arbitrage Hybrid Financial Instruments Assume that, in Country A, the following structure exists. Parent company, ACo, owns all of another company, AI, which owns all of ASub. Each of these entities is a corporation under Country A law. Assume that an unrelated Country B Corporation (BCo) offers cash to AI in exchange for securities of AI. Under Country B law, the economic substance of these securities causes them to be treated as equity, whereas in Country A, they are treated as debt. AI then loans the cash to its subsidiary, ASub, which loans the money to ACo, the Country A parent. This structure creates several interest payments under Country A law. Each of these interest payments creates losses that are shared among the entire Country A group and each payment is subject to Country A withholding tax. Assume also that AI and ASub are hybrid entities and are treated as pass-throughs by Country B. Then, when Country A withholds tax on the interest payments paid by ACo and received by ASub, BCo becomes entitled to claim a part of the amount withheld as a foreign tax credit. Note that the amount of interest paid and thus, the amount of tax credits to which BCo is entitled will be determined by the agreement of the partners of AI. This type of structure is not typically prevented in any of the considered countries, aside from some general foreign tax credit limits. However, the U.S. does prevent this transaction directly. Specifically, temporary regulations deny the use of foreign tax credits deriving from this type of transaction, called a structured passive investment arrangement. 108 Effectively, this regime is designed to prevent structuring transactions to create foreign tax credits which would otherwise generate little or no foreign tax Repurchase Agreements (Repos) Repos are often used to generate foreign tax credits (e.g. generating double tax credits with a 108 Treas. Reg T(e)(5)(iv). 46

190 single withholding tax, double dip ). Tax administrations increasingly (and sometimes successfully) combat such cases of tax avoidance by means of general anti-avoidance doctrines (e.g. Italy, the Netherlands) or an extensive interpretation of anti-avoidance provisions (e.g. Belgium). In Italy, a recent case of an Italian bank (cessionaris) involved inter alia a repo transaction of UK bonds. Those bonds were subject to a withholding tax of 10% in the UK, for which the Italian bank as legal owner claimed a tax credit. At the same time, the cedent received a FTC for the same withholding tax under the laws of its residence state, which treated the seller as the economic owner of the bonds (loan). The contract itself minimized any risk or profit opportunity but for a double tax credit claimed in two different states for the same WHT ( double dip ). That tax credit was rejected based on the abuse of law doctrine. However, for this doctrine to apply, mere tax advantages are not sufficient; there has to be a clear abusive tax advantage, i.e. obtained clearly by going against the ratio legis. 4.6 Anti-avoidance measures Since domestic law discordances lie at the root of the hybrid situation problems, unilateral responses by means of regulating repos and other hybrid instruments as such can probably not offer a solution. Abusive transactions can however be countered by means of domestic anti-avoidance provisions and doctrines, as was demonstrated supra for Italy. However, many anti-avoidance rules are under extensive scrutiny and subsequently, their applicability is sometimes unsure. Assuming that multilateral responses will be possible is also rather naïve. Therefore, bilateral responses by means of double tax conventions come into play. Article 24(4), c of the UK/USA DTC is a good example of such an approach. It tries to combat repo structures by stating that: United States tax shall not be taken into account ( ) for purposes of allowing a credit against United Kingdom tax in the case of a dividend paid by a company which is resident of the United States if and to the extent that: (1) the UK treats the dividend as beneficially owned by a resident of the UK; and (2) the USA treats the dividend as beneficially owned by a resident of the USA; and (3) the USA has allowed a deduction to a resident of the USA in respect of an amount determined by reference to that dividend. Such an anti-avoidance treaty provision could provide for a reduction of aggressive tax avoidance repo schemes. The rule however only deals with situations in which a(n) (interest) deduction is granted based on the dividends paid in respect of a stock and not based on a completely different measure. Indeed, the rule (intentionally) does not deal with most repo transactions taking place on public markets. 47

191 This is important to note, however, since a too extensive repo tax regulation might have a spillover to non-tax areas and disrupt basic domestic repo agreements widely used for cash management. 48

192 Part 5: Treaty Shopping Since DTCs are considered as the emanation of international tax law 109, it should be identified what values they represent. Therefore, it is necessary to identify the aim of double treaty conventions. Unfortunately, the preamble of the OECD MC does not provide us with any explanation. Nevertheless, some guidelines may be found in the 1963 Draft Convention and the 1977 OECD Convention. In both acts, their titles include the reference to the elimination of double taxation. Even though the title was shortened in 1992, the former title has been retained in many DTCs concluded. For instance, the DTC signed by Poland and Israel is entitled: Agreement between the government of the Republic of Poland and the government of the State of Israel for the avoidance of double taxation and for the prevention of fiscal evasion with respect to taxes on income. 110 Moreover, it may happen that general provisions to some treaties determine an aim of DTCs as well. An example may be found in the DTC concluded by Netherlands with the Poland from 2002 where is stipulated: Desiring to conclude a new convention for the avoidance of double taxation and the prevention of fiscal evasion ( ) 111. Hereinabove presented statements are the proof that the main and initial purpose of concluding DTCs was avoiding double taxation. The OECD sustained that the prevention of double nontaxation is although a purpose of tax treaty. Even if double non-taxation might be a positive element to encourage regional trade and investment in one of the contracting states, we have to claim that in practice, companies do not reinvest in the local area but instead, transfer and export to a third jurisdictions thus saving money through other tax planning schemes. In addition, such a double nontaxation may negatively affect the competition since the enterprises are able to benefit from double non-taxation will be in a more favorable situation than a domestic enterprises 112. In the aftermath of the economic and financial crisis, questions can be raised to determine if prevention of double non-taxation is an emerging function of the DTCs. Double non-taxation refers to the single tax principle which means that an income from cross-border transaction should be 109 According to Rosenbloom tax treaty network is a triumph of international law, H. D. Rosenbloom, op. cit., p Umowa między Rządem Rzeczypospolitej Polskiej a Rządem Państwa Izrael w sprawie unikania podwójnego opodatkowania i zapobiegania uchylaniu się od opodatkowania w zakresie podatków od dochodu, podpisana w Jerozolimie r. z dnia 22 maja 1991 r. (Dz.U Nr 28, poz. 124). 111 Umowa w formie wymiany listów o opodatkowaniu dochodów z oszczędności i o jej tymczasowym stosowaniu między Rzecząpospolitą Polską a Królestwem Niderlandów w odniesieniu do Antyli Niderlandzkichz dnia 7 lipca 2004 r. (Dz.U Nr 30, poz. 194). 112 T. Balco, Double Taxation Agreement Workshop, Saint Lucia, 24 July 2006, IBDF. 49

193 subject to tax once at the rates determined by the benefits principle 113. Or, some scholars, such as De Broe stressed that the function of a DTC is to distribute the rights to tax an income or a transaction between the state of residence and the state of source rather than to ensure taxation. The state of source is obliged to give relief, not knowing for certain that the beneficiary is effectively taxed. One can assume that when States do not preserve their taxing rights in the treaty, they have unconditionally forgiven them, even if the other State does not effectively tax, since States have a duty to examine each other s tax laws when allocating taxing rights amongst each other. 114 As a result, taxpayers who structure their transactions in such a way to claim double exemption cannot be regarded as acting against the object and purpose of the treaty (i.e. no treaty abuse) 115 unless a specific provision states otherwise. In the opposite, there is a trend since a decade, and in particular in the OECD Partnership reports, that a goal of DTCs is to prevent double non-taxation. This view is emphasized by article 23(A)(4) of the OECD Model Convention, which states that the state of residence is able to deny the exemption if the states of source has exempted the income under the provisions of the treaty. In other words, a taxpayer shall be taxed at least once. Also, courts may consider treaty shopping as a tax avoidance practice. Some entities use this tool to reduce or avoid their tax obligations and to erode their taxable base. This practice involves tax-planning strategies for arbitrage with the intention of avoiding double taxation through the double non-taxation technique. This concern is growing up, especially in the aftermath of budgetary crisis. Finally, it must be stressed that one of the first purposes of the DTCs is to prevent tax avoidance. Indeed, the tax treaties often open up for a disclosure co-operation between the tax authorities in the contracting states. They allow tax authorities to assess the tax base and therefore to both prevent and fight against tax avoidance 116. Following the financial and economic crisis, this function of the DTC has been emphasized and developed. For instance, in 2009, France amended the DTCs between France and Luxembourg and France and Switzerland in order to strengthen the exchange of information clause included in the treaties in force by lifting bank secrecy. 113 R. S. Avi-Yonah, Tax competition, Tax arbitrage and the International tax regime, University of Michigan, Public Law Working paper n 73, January 2007, p E.g. when States include Art. 13 (5) OECD MC in treaties with Belgium, they must know that Belgium normally does not tax capital gains on shares realized by companies (L. DE BROE, Prevention, 359). 115 L. DE BROE, Prevention, B. Gouthière, Les impôts dans les affaires internationales, 7 Ed., 2007, p

194 5.1 Treaty Shopping and Tax Avoidance Introduction As a principle, DTC benefits are only available to residents from each contracting state. However, it may happen that residents from third states who are not within the personal scope of the tax treaty, might seek to obtain treaty benefits by creating a legal entity in one of the contracting states. This technique is referred to treaty shopping 117. Again, Rosenbloom described this phenomenon as the practice of some investors of borrowing a tax treaty by forming an entity (usually a corporation) in a country having a favorable tax treaty with the country of source that is the country where the investment is to be made and the income in question is to be earned 118. Treaty shopping is an example of international tax arbitrage since using provisions granting by different tax treaties a taxpayer is going to draft a scheme in order to reduce or remove its tax liability. Also, treaty shopping is a form of tax avoidance either when a fictitious transaction is taken with a foreign country just to make a tax treaty applicable and to get a tax advantage though the treaty s applicability 119 or when a legal entity is established in a country only to obtain treaty benefits GAAR and Treaty Shopping States use different methods for preventing treaty benefits derived from treaty shopping. One of them is to let domestic general anti-avoidance rules apply to treaty shopping. For instance, in the USA, the IRS has sought to challenge treaty shopping in U.S. courts with the argument that the intermediate corporation in this situation is merely a conduit, which should not be granted treaty benefits. This argument prevailed in Aiken Industries, where a Bahamian company loaned money to a U.S. subsidiary and then assigned the obligation to a Honduran subsidiary. 121 The intermediary also had no other business assets and was obligated to immediately pass the money up to its parent. 122 The Court determined that the interest payment through the Honduran conduit had no valid economic 117 P. Plansky, H. Schneeweiss, Limitation on benefits : From the US Model 2006 to the ACT Group Litigation, Intertax, Volume 3 5,issue 8/9, p David Rosenbloom, Derivative Benefits : Emerging US Treaty Policy, Intertax, 1994, p Dahlberg, Internationell beskattning, p OECD Model Tax Convention on Income and Capital with commentaries (2010), p T.C. 925, 926 (1971). 122 Id. 51

195 or business purpose, but that the only purpose was to obtain treaty benefits. 123 As such, the Court found that the Honduran subsidiary did not actually receive the interest, as required under article IX of the U.S.-Honduras Tax Treaty. 124 The German tax system includes the general anti-abuse rule of 42 AO which is applicable in national as well as in international tax law. However, the law provided special anti-abuse rules domestically (especially 50d para. 3 EStG) and internationally (partly in the single DTCs). Those special anti-abuse rules have precedence over 42 AO. Thus, 50d para. 3 EStG is supposed to prevent legal constructions in which a person links a company (regularly a capital corporation) in between himself and a domestic income source to gain tax benefits in case of cross-border-relations which the person would not have gained if he obtained the earnings directly. Because this provision only concerns the limited tax liability it shall secure the taxation in Germany as state of source 125. Typically, 50d para. 3 EStG aims at cases in which a domestic resident makes certain payments (dividends, interest, royalties, payments to professional sportsmen and artistes) and the party receiving the payment is subject to the limited tax liability. Next, in Italy some of the applicable tax treaties include provisions that explicitly allow the application of domestic anti-abuse rules. Examples of these provisions can be found in several Italian tax treaties 126. In Poland most of treaties do not include any provisions allowing application of domestic GAAR. There is however one treaty allowing that. It is the DTC concluded with Germany. Pursuant to art. 30, the DTC shall not be interpreted as precluding the application of domestic anti-abusive clauses by both contracting states. Finally, the French Supreme Court applies the domestic abuse of law theory to interpret the term beneficial owner under the French-UK DTC Id. 124 Id. 125 Frotscher, Internationales Steuerrecht, n G. Maisto, Italian anti-avoidance rules and tax treaties, cit., pag CE, December 29, 2006, Bank of Scotland, n

196 5.1.3 SAAR and treaty shopping There is no country whose domestic tax system would provide in any provision targeting solely treaty shopping activity. Therefore, it is worth mentioning that in 1962, Switzerland enacted special domestic regulation of which the only rationale was to prevent treaty shopping transactions (Abuse Decree). That is why the DTCs which were concluded in this time did not incorporate antitreaty shopping rules or limitation of benefits articles. The Abuse Decree contains a number of tests that must be fulfilled by every Swiss resident company in order to be eligible for treaty benefits. Basically, these rules are still in force. However, the regulation is not so strict any more. Some new legislation was enacted so far. Currently, there are more and more anti-treaty shopping rules incorporated into DTCs. These provisions very often originate from the Abuse Decree (e.g. Italy, Belgium and France). The anti-abuse rules in these treaties basically aim at excluding persons who are not fully subject to taxation in Switzerland (i.e. holding and domiciliary companies as well as individuals taxed on the basis of a so-called lump-sum arrangement) from the benefits of the respective treaties. It has to be taken into account that the anti-abuse rules of the above treaties are considered lex specialis as compared to the general anti-abuse rules of the Abuse Decree and the new legislation. Generally speaking, treaties rank before Swiss domestic law in the Swiss legal system. Hence, as a principle, treaties are not overridden by any domestic law, whether existing when the treaty took effect or introduced subsequently. However, it is said that some domestic law, such as the Abuse Decree, has treaty-overriding power to a certain extent. Therefore, it is very remarkable legislation Conclusion Even if states use these methods for preventing treaty shopping, most states have specific treaty shopping clauses in the tax treaties as well. 53

197 5.2 Beneficial ownership in treaties and domestic law Introduction The term of beneficial ownership is one of common clauses adopted in order to curb treaty shopping. It was introduced to the OECD Model Convention in 1977 to prevent interposition of conduit companies by non-residents. Until today the Commentary has refrained from giving a positive definition of this term. That is why it is considered as a vague and undefined treaty concept. Nevertheless, it is perhaps the most widely used anti-treaty shopping mechanism. It plays a crucial role in allocation of tax rights in respect of dividends, interest and royalties. It is also vital in determining whether a resident of a contracting state qualifies for treaty relief in a source state of income. There is an impressive significance attached to this term so that it is used in the Model Convention of the United Nations and in conventions concluded by the USA 128. The Commentary gives only a negative definition of the beneficial owner term. It explains that ( ) it is not used in a narrow technical sense; rather, it should be understood in its context and in light of the object and purpose of the Convention, including avoiding double taxation and the prevention of fiscal evasion and avoidance. 129 The Conduit Companies Report adds that conduits are not to be seen as beneficial owners if they have such narrow powers that render them a mere fiduciary or an administrator Domestic law referring to the term of beneficial ownership There is almost no state among Eucotax participators which would define the beneficial ownership. Most countries try to follow the OECD Commentary. There are only two exceptions. Regarding domestic law provisions, Austria and the Netherlands have their special concepts. In Austria the beneficial owner is interpreted as "Nutzungsberechtiger". It deviates from the OECD interpretation. In the Dutch Dividend Tax Act there is included the concept of beneficial ownership which is legally based. The provision determines when a taxpayer is qualified as being not the beneficial 128 Umowa między Rządem Polskiej Rzeczypospolitej Ludowej a Rządem Stanów Zjednoczonych Ameryki o uniknięciu podwójnego opodatkowania i zapobieżeniu uchylaniu się od opodatkowania w zakresie podatków od dochodu, podpisana w Waszyngtonie dnia 8 października 1974 r z dnia 8 października 1974 r. (Dz.U Nr 31, poz. 178). 129 The Commentary, op. cit., p F. DIERCKX, Artikel 10: Dividenden in B. PEETERS, Het Belgisch-Nederlands dubbelbelastingverdrag Een artikelgewijze bespreking, Brussel, Larcier, 2008, 205 (hereafter F. DIERCKX, Dividenden). 54

198 owner. A taxpayer is not the beneficial owner if he or she performed something in return which corresponds with the derived benefit and that return is also part of the composition of transactions. In the USA there is no unified definition which would be foreseen to all states. The term is not defined by the Convention or the Technical Explanation as well. Instead, the definition is determined by reference to local law in the source country. Therefore, it may vary greatly. Most often it is interpreted as looking for the economic substance. Although most of countries do not provide any legal definition of beneficial ownership, it seems that the term is understood similarly. Some disparities may be found only in specific cases. Therefore, they are described hereinafter Relevant cases International case law shows the highly ambiguous nature of the term beneficial ownership. Hereinafter are described some the most significant for the different countries. Canada/the Netherlands In Canada, the concept of beneficial ownership was interpreted in the Prévost judgment(s) 131. The Canadian court judged on the basis of the Canada Netherlands DTC. The Dutch company was owned by a UK company (Henlys) and by a Swedish one (Volvo). Volvo had acquired all the shares of the Canadian company Prevost Car Inc. Later on, the shares had been transferred to the Dutch company (Prevost Holding). In this way, Canadian authorities levied withholding tax at a rate of 5%, whereas Prevost Holding was not subject to tax on dividends from Prevost in the Netherlands, because of the Netherlands participation exemption. The question was, however, whether the Prevost Holding could be qualified as a beneficial owner of the dividends acquired from the Canadian company. 131 Prévost Car Inc. v. The Queen, 2008 TCJ 231 (TCC) and The Queen v. Prévost Car Inc., 2009 FCA 57; see A.M. JIMÉNEZ, Trends, 47-49; C. DU TOIT, Evolution, ; L. VERDONER, R. OFFERMANNS and S. HUIBREGTSE, Perspective Part. 1,

199 Figure 1. The scheme of Prevost case. Volvo dividends the Prevost Holding dividends Henlys dividends Prevost Car Inc. According to this judgment, the beneficial owner is the person who enjoys and assumes all the attributes of ownership. It rejects an interpretation as to defining the beneficial owner as the person who can, in fact, ultimately benefit from the dividend. The decision thus adopted a legal approach, and what was decisive was whether the intermediary had all attributes of ownership of the income (i.c. dividends), defined as possession, use, risk and control (usus, fructus, abusus). A beneficial owner thus enjoys the fruits of the ownership and can dispose of the income for its own benefit. 132 Important in reaching its decision were: (1) the fact that the shareholders did not have the possibility to directly intervene in the management of the intermediary, (2) there was no automatic flow of funds to the shareholders, (3) there was no legal obligation the pay onwards the dividends received. 133 France In France, the most significant case regarding the interpretation of beneficial ownership is the Royal Bank of Scotland case 134. In the case a US parent (Merrel Dow Inc.) concluded a usufruct agreement with a UK bank (Bank of Scotland). The UK bank acquired fixed dividend coupons 132 L. VERDONER, R. OFFERMANNS and S. HUIBREGTSE, Perspective Part. 1, L. VERDONER, R. OFFERMANNS and S. HUIBREGTSE, Perspective Part. 1, 422; A.M. JIMÉNEZ, Trends, Supreme Administrative Court (Conseil d État) 20 December 2006, no ; see L. VERDONER, R. OFFERMANNS and S. HUIBREGTSE, Perspective Part. 1, ; A.M. JIMÉNEZ, Trends,

200 attached to the (non-voting) preferred shares of the French subsidiary of the US parent company for a three-year period. The contract contained an acceleration clause entitling the UK bank to sell shares back to the US parent on a change in the applicable tax law. The aim of the structure was to use the article 9 of the France UK DTC. Under the provision, the maximum withholding tax rate was 15%, whereas dividends distributed by the French subsidiary to the bank were the subject to a 25% withholding tax. The tax treaty provided for a transfer of the avoir fiscal tax credit. The UK bank was entitled to request a refund of the French withholding tax levied in excess of the maximum rate of 15% and the avoir fiscal tax credit. Figure 2. The scheme of Bank of Scotland case. the US parent the usufruct of shares 100% the UK bank the French subsidiary dividends and avoir fiscal francais The Conseil d État, adopting an economic approach, ruled that a usufruct holder of shares was not considered to be the beneficial owner of the dividends, although the intermediary was not merely a nominee, fiduciary or mere conduit. According to the Court, the purchase of the usufruct was to be seen as a loan, redeemed through dividend payments. Important in reaching the conclusion was the fact that the intermediary had so many guarantees that his shareholder risk was quasi nihil. Italy There is also a strongly discussed case in Italy regarding the beneficial ownership. The case refers to the application of the reduced withholding tax of 10 % provided by the DTC (instead of the domestic rate of 30%) on the royalties paid by an Italian company to a Luxembourg company, totally owned by a third company resident in Bermuda, for the use of a trademark. According to the Tax Court, the Luxembourg company was just the formal owner of the trademark and the formal 57

201 recipient (and not the beneficial owner) of the royalties payments carried out by the Italian company based on the following circumstances: It had a very small organization in Luxembourg; It had no entrepreneurial risk for the acquisition of the trademark; and It was totally owned by a third company. There was stipulated that the term of beneficial owner is designed to exclude from such a notion all other persons that, in practice, have very limited decisional powers so as to make them a mere fiduciary or administrator acting on behalf of others, in relation to income earned. Furthermore, in order to identify the effective beneficial owner of an item of income, just the mere legal disposal of income received it is not enough, but it is also necessary the real and effective availability of such income, i.e. the power to decide on its economic use. The Netherlands In the Netherlands, the Dutch Supreme Court, in its landmark Royal Dutch judgment 135, adopted a legal interpretation of the concept beneficial ownership. A taxpayer, although not effectively owning the underlying asset (i.e. shares), was considered the beneficial owner of the dividends thereof. 136 The Court focused on the taxpayer s rights on the income (i.e. dividends), stating that the taxpayer became the owner of the dividend coupons (and) could freely avail of the distribution. The treaty does not contain the condition that the beneficial owner of the dividend must also be the owner of the shares. 137 There is thus quite some similarity with the Prévost case. United Kingdom In the UK, the term of beneficial ownership was concerned in the so-called Indofood case. In the Indofood case, an Indonesian trading group (Indofood) wanted to raise finance by issuing internationally marketed interest-bearing notes to the public. This was attained through a Mauritian special purpose vehicle (Indofood Mauritius) in order to benefit from the reduced withholding tax 135 Supreme Court (Hoge Raad) 6 April 1994, no , BNB 1994/217; see L. VERDONER, R. OFFERMANNS and S. HUIBREGTSE, Perspective Part. 1, ; C. DU TOIT, Evolution, P. BAKER, Possible extension, no. 16, p. 10; C. DU TOIT, Evolution, A.M. JIMÉNEZ, Trends, 504; L. VERDONER, R. OFFERMANNS and S. HUIBREGTSE, Perspective Part. 1, ; C. DU TOIT, Evolution,

202 rate of the Indonesia Mauritius tax treaty. Two years after the issue of the notes, the Indonesian government decided to terminate the tax treaty with Mauritius. Following this, JP Morgan (who was a trustee in the transaction) proposed to set up a Dutch special purpose vehicle (SPV) to receive the reduced withholding tax rate, but by using the tax treaty with the Netherlands. Figure 3. The scheme of Indofood case. the termination of the treaty Indonesia-Mauritius before after Indofood interests Indofood interests SPV Indofood Mauritius interests JP Morgan interests JP Morgan interests Indofood Mauritius The English Court of Appeal, using an economic approach, made clear that an interposed conduit is not to be considered as the beneficial owner, not only in the case of a contractual obligation, but also when it is de facto bound to pay onwards the same payment. 138 ( ) The concept of beneficial ownership is incompatible with that of the formal owner who does not have the full privilege to directly benefit from the income. 139 Relevant in reaching its decision were (1) the fact that the (hypothetical) intermediary did not retain a spread on the back-to-back interest payments and (2) interests were paid out the day after the day of receipt; both loans where thus tied. 138 C. DU TOIT, Evolution, ; P. BAKER, Possible extension, no. 19, p ; F.P.G. PÖTGENS, Uiteindelijk gerechtigde onder Nederlandse belastingverdragen; nationaal recht of context? in K. BRAUN et al. (Eds.), 40 jaar cursus belastingrecht, Deventer, Kluwer, 2010, 173 (hereafter F.P.G. PÖTGENS, 40 jaar). 139 Indofood International Finance Ltd. v. JP Morgan Chase Bank NA, London Branch 2006, EWCA Civ. 158 (2 March 2006), Para

203 Spain Another very important case concerns Spanish football club Real Madrid. Therefore, it is called Real Madrid case 140. Real Madrid is a taxpayer. It made payments to a Hungarian company for the use or the right to use image rights for one of its players. The Hungarian company immediately transferred 99 percent of the amounts received to a Netherlands company. The Spanish tax authorities denied the zero withholding tax on royalties provided under Art.12(1) of the Hungary-Spain tax treaty on the ground that the Hungarian company was interposed for the sole purpose of benefiting from this treaty, and was thus, not a beneficial owner. Figure 4. The scheme of Real Madrid case. Royalties the Hungarian company 99% of income the Dutch company In that case, the Spanish National Court concluded, based on the Commentary on the OECD MC, that the beneficial owner is the real owner of the income, disregarding the legal owner. 141 JIMÉNEZ states that in doing so, beneficial ownership is assimilated to a business purpose test. 142 Indeed, the Court did not even check what legal powers the intermediary had over the income (i.c. royalties), thus adopting a very broad economic approach. The ownership of the income-generating asset is irrelevant, as opposed to the tied nature of the income and the recipient 140 National Court (Audiencia Nacional), decision of 18 July 2006 (JUR/2006/204307), see A.M. JIMÉNEZ, Trends, and A.M. JIMÉNEZ, Trends, Ibid. 60

204 thereof. 143 In the judgment it was stipulated that "after the interpretation of the amendments introduced in 2003 in the comments to OECD it must be understood who not only is the formal owner of the return but we also have to consider who is the person from a financial point of view disposes effectively of the same. 5.3 Anti-abusive clauses in treaties Specific clauses A carve-out provision The Netherlands have a carve-out provision which purpose is to prevent stepping stone schemes. A stepping stone case occurs when treaty partners have a domestic preferential tax regime in which included income is either not taxed at all or very advantageously taxed. An example of a Dutch carve-out provision was included in the treaties with Barbados and Portugal. The Netherlands and Barbados agreed in article 31 that the benefits are not applicable to companies which are exempted from tax by a special tax regime known as the carve-out provision. The tax administration of both states should decide whether or not a tax regime is qualified as special. It is explicitly mentioned that the benefits are also not applicable if a specific regime is enacted after the date of entry into force of the treaty. Subject to tax clause The provision was introduced by the Netherlands. The remittance provisions concern that a relief is granted only if the income or gain is subject to tax. It is introduced to restrict the situation where non-domiciled residents of Barbados could benefit from the tax treaty while at the same time they are not subject to tax in Barbados. The income of these non-domiciled residents is only subject to tax if the income is realized or received in Barbados. Switch over clause In accordance with a switch over clause, if, after application of treaties, an income is not subject to tax or it is taxed at a lower rate, the exemption method has to be changed to credit method. An example may be found in the treaty concluded by Poland and Germany. 143 See A.M. JIMÉNEZ s discussion of the REAL MADRID case on 61

205 Limitation of benefits (LOB) The provision may be characterized as the restriction of treaty benefits which indicates that the access is regulated by the contracting states. LOB is included in treaties concluded by the Netherlands (DTC with the USA), Austria (DTC with the USA), France (DTC with Japan, the USA and Switzerland), Italy (DTC with the USA), Sweden (with the USA and Barbados), Germany (with the USA), Spain (with with USA, Malta, Estonia, Ireland, Latvia, Lithuania, Portugal and Slovenia), Poland (with Israel, Sweden) and the USA. Sportmans and artists Austria applies specific regulations regarding the activity of sportsman and artists. Concerning the possible taxable income of artists, Austria has different regulations depending on the artists country of origin. If the artist is a US resident, for example, Austria only taxes income if it exceeds US $20,000 gross annually, including all expenses. If the artist does not act on his own behalf but for a third person, he may not be taxed if it is proven that neither the artist, nor persons close to the artist will benefit from the treaty relief. Exit taxation The DTC concluded by Austria and Switzerland claims that profits which are created in one country are not taxed, if they leave that country. The DTC clarifies that the country in which the profits will finally end is the one to levy taxes. Substance over form provisions In accordance with these provisions benefits of a treaty do not apply if it is proved that the formal appearance is not consistent with the economic substance of the transaction and that such appearance is adopted for the sole or main purpose of taking advantage of benefits which may be obtained under the treaty. It was concluded in DTC of Italy (with the USA, the UK, France). 62

206 Exclusion provision This kind of provision means that entities which are subject to an especially privileged tax in the other state are excluded from the tax treaty. 140 This kind of exclusion provision can be found in treaty concluded by Sweden with Jamaica, Malta and Mauritius. 141 The general exclusion provision is also an effective mean for preventing the abuse of future legislation which makes certain foreign entities privileged. Such a provision can be found in Sweden s tax treaties with Estonia, Kazakhstan and Macedonia. Activity clause A common clause to prevent tax abuse is the so called activity clause (or activity reservation). Most of the German DTCs contain activity-clauses which provide the credit method for permanent establishments, moveable and not moveable assets of those permanent establishments, profits from their disposal, for intercompany dividends, and intercompany shares, if the income (partly earnings) does not derive from active activities in the minimum dimension of 90 percent (= exclusively or almost exclusively). Delocalization clause Recently, French authorities have negotiated a new type of provision with the United Arab Emirates in order to avoid profits relocation there. It provides that subsidiaries held up to 50 percent by a French company are taxable on their worldwide income in France notwithstanding all other provisions Conclusion To put it in a nutshell, the double non-taxation and the prevention of tax avoidance are two growing functions of the DTCs following the 2008 crisis. 63

207 General conclusion Tax arbitrage in respect to entities and financial instruments is still an issue. The classification of domestic entities is based on a common criterion, although that same classification for foreign entities might result in a conflict since states agree on different treatment of companies considering their transparency or opacity. The diverse interpretation of that particular definition it is the core tax arbitrage through hybrid entities. Because of the lacking consensus in the criteria and legislation states cannot counteract efficiently the erosion of their tax base concluding in a financial and economic crisis. The inconsistencies in definition regarding hybrid financial instruments cannot be tackled merely on a unilateral level. The best response to international tax arbitrage by means of hybrid instruments would be a multilateral solution, however bilateral solutions seem to be the second-best, but more practical response. States are still facing the problem of treaty shopping activity. The term of beneficial ownership with its imprecise boundaries seems to be the most efficient and the most effective antiabusive clause. Regarding there is no clear definition of beneficial owner so far, taxpayers still face problems how to avoid the application of the clause by states. Therefore, it has to be stated, it is the only anti-treaty shopping clause which may be used to reveal the greatest number of complicated tax driven transactions. Countering cross-border tax arbitrage solely on unilateral level will never succeed, because inconsistencies will still be used for obtaining a tax benefit. The only way of solving it on a unilateral level would be the implementation of a uniform global tax code. Such a solution seems to be an utopia for the moment since states are generally unwilling to give up their sovereignty and domestic policy on tax matters. Therefore, cross-border tax arbitrage needs to be countered at a multilateral level. Efforts have already been made by the EU as well as the OECD, but since these instruments are only soft law they are not effective enough to fight cross-border tax arbitrage. 64

208 Paper EUCOTAX-Wintercourse 2011, hosted by: General Theme: Global finance and taxation, financial and economic crisis and the role of taxation Subtopic 5: Deductibility of interest in company taxation Made by: Bettina Dorfer (Austria) Dieter Dilliën (Belgium) Audrey Pessot (France) Jan Niklas Bittermann (Germany) Giuseppina Del Vecchio (Italy) Maikel Verhoeven (The Netherlands) Łukasz Pikus (Poland) Chrispin Materneau (Spain) Anna Lewander (Sweden) Adam Hauptman (USA) Supervised by: Prof. D. Gutmann Prof. P.J. Neau-Leduc B. Kolozs K. Simader M. Gruber

209 Table of contents I. Introduction... 4 II. General rules as regard to interest deductibility A. Internal Transfer Pricing Principle (Sweden) B. Hidden Equity (Austria) III. Specific regulations A. Description a. Thin Capitalization Rules (Poland, France, Spain, United States, Belgium, Netherlands) b. Interest Barrier (Italy, Germany) c. Debt push down rule (Sweden) B. Purposes and Intentions C. Anti-Tax Haven D. Anti-Excessive Interest Rate (arm s length) IV. Specific rules A. Interest barrier a. The nature of Interest b. Persons concerned c. The triggering element d. The extent of deduction Limitation as to the amount of the deduction Escape and group clauses B. Thin capitalization a. Different approaches to deciding the indebtedness of an entity b. Definition of debt c. Definition of equity C. Notional Interest Deduction (NID) a. Applicable scope b. Risk-Bearing Capital c. Risk-Bearing Capital Adjustments D. The Earnings-Stripping Limitation E. Special regulations regarding interest deductibility in the Netherlands F. Specific rules regarding debt-push down in Sweden V. Effects A. Disallowance of interest deduction B. Re-characterization of interest as a hidden payout: C. Carry forward EU and international issues A The compatibility of domestic legislation with the EU principle of non discrimination a. The Principle of non discrimination in the EU law: general remarks b. ECJ Lankhorst-Hohorst GmbH case and the involvement of domestic legislations

210 c. Council Directive 2003/49/EC on interest and royalty payments made between associate companies of different Member States: general remarks B.- Current domestic regimes and the recommendations of the Council June 8, 2010 Resolution C. Harmonization of rules on interests deductibility in the EU a. Desirability of harmonization in this field b. Difficulties and obstacles towards harmonization

211 I. Introduction The financial crisis extensively affected the taxation of companies in several countries. Inter alia, many domestic legislators responded to the crisis by introducing new provisions in the field of company taxation. This paper, written as part of the EUCOTAX Wintercourse 2011, analyses the interest deductibility regulations of nine European countries (Austria, Belgium, France, Germany, Italy, the Netherlands, Poland, Sweden, and Spain), as well as the United States regarding the impact of the 2008 financial crisis. This paper is divided into five parts. First, the general structure of the domestic interest deduction provisions of the ten countries will be described and compared. Next, the purposes and intentions underlying the different regulations will be outlined. The third part covers the analysis and classification of the specific domestic regulations. After outlining the salient characteristics of the different rules, their compatibility with European and international law has been considered. Based on these descriptions and comparisons, the last part of this paper covers the conclusions of the Topic Five members. This includes the most significant aspects of the domestic provisions and whether a harmonization of the differing interest deduction provisions would be desirable in Europe. A quick comparison of the countries participating in the EUCOTAX Wintercourse shows a wide range of methods used to tackle the problem of interest deductibility. Broadly, each countries approach can be classified as either relying on general or specific rules. The general rules i.e., rules that have a very broad scope apply to all types of expenses rather than only addressing the deductibility of interest. Contrarily, the second category the specific rules are specifically tailored to addressing the deductibility of interest expenses. Most countries (Belgium, France, Germany, Italy, the Netherlands, Poland, Spain, and the United States) tackle the abuse of interest deductions with a mixture of both general and specific rules. Other countries, such as Austria and Sweden, only or almost only rely on general provisions to tackle these problems. The advantage of relying on general rules is that the tax administrators of those countries have greater flexibility in tackling new issues and tax planning strategies without having to introduce new specific rules. The primary disadvantage of relying on general provisions, 4

212 however, is that the tax administrators may not have sufficient tools to sufficiently address aggressive new tax planning strategies. Sweden, for example, had for a long time relied only on their general provisions, but had to add new rules in When certain debt-push down tax schemes were used by Swedish companies, the courts rejected the use of the general rules to defeat them. In response, the Swedish legislature passed a special debt-push down rule for the tax administration to prevent earnings from being pushed offshore. Every country has certain rules (either in legislation, case-law, or both) which limit the deductibility of expenses. Two of the main general rules that limit the deductibility of interest in all countries are (1) preconditions for interest deductions, and (2) general anti-abuse rules. Preconditions for the Deductibility of Interest Each participating country taxes companies on their net income i.e., their income after the deduction of the business expenses, including interest. On the other hand, countries only allow the deductibility of an expense if it first meets certain criteria. Comparing the criteria used in the different countries, there are three common conditions for any business expense to be deductible: (1) Costs must be deducted during the taxable year incurred (accrual principle); (2) Amount must be substantiated (e.g., by written document, by implementation on the annual account, etc.); (3) Costs must be incurred in the pursuit of business income. This test usually includes both an objective element (e.g., a link with a professional business activity) and a subjective element (e.g., an intent to create business income). Although interest generally has to meet these three criteria in all of these countries, the practical relevance of it differs from country to country. In some countries these conditions are not very strict and are only used to ensure that companies cannot deduct private expenses (e.g., interest paid by a company on a loan associated with a private residence of one of its shareholders). In other countries, however, these conditions have been used more extensively by tax authorities to deny the deductibility of an expense. This is primarily the case in countries that rely more on general rules to limit the deductibility of interest. Austria, for example, has developed case-law to apply these general criteria on interest deductions. There, interest paid by a company to one of its shareholders is only deductible to the extent that it is at arm s lengthi.e., 5

213 when there terms are comparable to the market interest rates in similar circumstances. This is not based on an explicit provision, but instead on the general rule that expenses are only deductible to the extent that they are linked with the business activity. As a point of comparison, Belgian law explicitly states that interest is only deductible if it is in accordance with market interest rates. 1 Austria reaches the same result, but without using a specific rule, instead using general provisions developed in its case law specifically for interest deductibility. This section compares the general anti-abuse principles among the participating Wintercourse countries. France, Italy and Poland and Germany have no general anti-abuse rules, while Austria, Belgium, France, Italy, the Netherlands, Spain, Sweden and the U.S. do use such general rules. Austria Austria uses two principles to deal with tax avoidance: (1) a general anti-abuse principle and (2) a sham-transaction principle. Both of these principles are based on an economicsubstance rationale, meaning that transactions must be supported by economic motives and not just tax avoidance reasons. The general anti-abuse principle looks at the economic result of the transaction rather than its legal form. The sham-transaction principle, on the other hand, tests the labels assigned by the parties e.g., the contracting parties intended to make a capital contribution, but called it a loan for tax reasons. Belgium Belgium also applies two principles to deal with tax avoidance: (1) a sham-transaction (also known as simulation ) rule and (2) a general anti-abuse principle. The simulation principle means that contracting parties have two contracts. The first contract is a façade, presented to the tax authorities. The second contract is the real, private agreement among the parties which modifies or even nullifies the first contract. If the tax authorities can prove that a transaction is a sham such as this, it will be disregarded when determining the parties tax liabilities. 1 Art. 55 BITC. 6

214 The general anti-abuse principle does not allow the parties to challenge the tax authorities characterization of a juridical qualification of a document, or of multiple documents that together creates a certain transaction, if the tax authorities can prove that the goal of this qualification is to avoid taxes, unless the tax payer can prove that the initial characterization meets legitimate financial or economic needs. If this principle applies the transaction will be re-characterized. France France has several general anti-abuse rules; however, the courts have restricted their application in the context of the deductibility of interest. First, there is the transfer-pricing rule. It applies when the amounts transferred between related parties had the effect of transferring profits outside of France. When assessing the income tax due by companies that either control or are controlled by other companies located outside of France, profits indirectly transferred to another country, either through artificially increasing or decreasing prices, or any other means, are added back into the company s income. Second, France has an abnormal act of management concept that enables the authorities to disallow the deduction of expenses that are judged excessive by the authority. The key question that triggers this rule is whether the expense is made in the company s interest. Third, under the fraus legis principle an abuse of law principle the French Tax Authority (FTA) is empowered to disregard for tax purposes any structure that is either fictitious or is motivated exclusively by a tax avoidance motive. In this situation, the sole purpose of the transaction is to comply with the literal application of a legal provision, but not with the objectives pursued by the legislator in order. Using this principle, the FTA can disregard or recharacterize a transaction, perfect in form, but solely intended to procure a tax advantage. For example, the FTA can argue that a loan is not genuine, but rather a disguised capital contribution regarding its terms and conditions. Finally, France has CFC rules. Unlike the transfer-pricing rules that focus on the price between related companies, the CFC rules focuses on amounts transfer to a company established in a country that has a tax rate less than half of that in France. This provision, however, does not apply within the EU. Italy 7

215 Italy has recently adopted an anti-avoidance rule. 2 According to this rule, tax authorities may disallow the tax advantages obtained through any act or transaction carried out without a valid economic reason, for the purposes of circumventing obligations or prohibitions contained in Italian law, and of obtaining a tax savings. It applies only if the tax advantage results from specified transactions (e.g., mergers, divisions, payments of interest and royalties eligible for the exemption under the EU directive). Because of its limited scope, it is considered a semi antiavoidance rule. In 2008, the Italian Supreme Court confirmed the existence of a general anti-avoidance principle, which supplanted the previous positions of the Supreme Court in affirming that, as far as the non-harmonized taxes are concerned, the source of the anti-abuse principle has to be found in the defining tax principles of the Italian Constitution i.e., the principles of ability to pay and progressivity. The Netherlands The Netherlands use the fraus legis principle to limit the deductibility of costs. Fraus legis applies if a court decides that a taxpayer has engaged in tax evasion. Two conditions have to be met for fraus legis to apply: (1) The only, or controlling motive for the transaction was to achieve a significant tax savings or to eliminate any tax liability; (2) The desired effect/result stands in contrast to the purpose and intent of the legislation. Spain Spain has three principles that combat tax abuse: (1) The general anti-abuse rule a taxpayer cannot use the law to gain a tax advantage which is in conflict with the intentions of the legislature. (2) The substance over form principle the form of the transaction has to match the underlying substance of the transaction. 2 Article 37 bis, of Presidential decree n 600/

216 (3) The economic substance principle, which applies to wholly artificial transactions i.e., transactions that are meant to circumvent taxes and that do not achieve any other real economic purpose. Sweden Sweden has an General Tax Avoidance Clause. 3 Under this act, a transaction will be ignored if: (1) the legal transaction alone, or together with another legal transaction, is part of a structure bringing a significant tax benefit for the taxpayer; (2) the taxpayer has directly or indirectly participated in the transaction; (3) considering all circumstances, the tax benefit appears to be the main reason for the transaction, and (4) the tax liability resulting from this transaction would be inconsistent with the aim of the tax legislation. As of the time this paper was written, it has not been established whether the act is applicable to the deductibility of interest after the introduction of the debt-push-down rules. One Swedish court stated that the act was not applicable to such a situation because it did not fulfill the fourth criteria. United States The U.S. has five different general principles: (1) the sham-transaction doctrine; (2) the economic-substance doctrine, (3) the business-purpose doctrine, (4) the substance-over-form doctrine; and (5) the step-transaction doctrine. Taxpayers, however, are entitled to try to reduce their taxes: The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted. The objective of the individual principles is to assign tax consequences to the overall result of a transaction rather than the individual steps a taxpayer makes along the way. These five principles frequently overlap. First, the sham-transaction doctrine states that if the economic activity that is purported to give rise to the desired tax benefits does not actually occur, the court will disregard the 3 Swedish tax avoidance act (1995:575) 9

217 transaction for tax purposes. The economic-substance states that if the taxpayer has no economic purpose other than to reduce his taxes and Congress did not intend that the benefits of the relevant provision to inure to this type of transaction, then courts can deny the taxpayer the benefits sought. Third, the business-purpose test is a subjective inquiry into the motives of the taxpayer that is, whether the taxpayer intended the transaction to serve some useful non-tax purpose. The fourth principle is the substance-over-form doctrine, which notes that a taxpayer is bound by the form of the transaction he chooses, while the IRS is free to challenge the form as not matching the underlying substance of the transaction. The last principle is the steptransaction doctrine. It disregards an intermediate step taken by a taxpayer on the way to an endresult. In summary, all countries use general principles of law to address the abuse of the deductibility of business expenses except Germany and Poland. All of these principles generally require that the actions of the taxpayer should be supported by a non-tax economic motive, rather than solely motivated by a desire to avoid taxes. In addition, Belgium and the U.S. have apply principles to combat shams and frauds e.g., where a taxpayer says one thing, but does something else. However, the sham/fraud principle applies is some way in every country because it is not acceptable anywhere to simply lie to the tax authorities. These rules are needed to combat schemes that erode the domestic tax bases, but also to provide for legal certainty to companies in their business-planning processes. 10

218 II. General rules as regard to interest deductibility Apart from the rules above, certain countries use other general provisions in their laws to limit the deductibility of interest in company taxation. This paper discusses two examples of such cases in Sweden and Austria. Because of the lack of a set of more specific rules, they have developed case law based on their general provisions. A. Internal Transfer Pricing Principle (Sweden) In Sweden, there is no broad legislation about the deductibility of interest. Therefore, the main limitation on the deductibility of interest is based on the national transfer pricing principle. A specific application of this general internal transfer-pricing principle implies that all interest payments between two related parties should be equal to the interest that two independent parties under similar conditions would have charged. Therefore, according to Swedish literature, interest is only deductible if, and to the extent that, it is within the arm s length interest rate (i.e., the market interest rate). Compared with Belgium, the Swedish tax system reaches the same interest deductibility limitation (i.e., market rate conformity) as a general provision that the other countries achieve with a specific provision. 4 [BREAK] Interestingly, legal commentators suggested introducing a thin capitalization rule in Sweden to go along with the general transfer pricing rule. They argued that when a company grants a loan to a thinly capitalised related company, this is not at arm s length because an independent company would never have given a loan to an already thin capitalised company. Therefore the loan should be re-characterized as a capital contribution, and thus the interest as a dividend, based on the internal transfer pricing principle. The Swedish court rejected this theory as financing between independent companies will not be done through risk capital but through loans in market orientated conditions. Therefore a loan cannot be re-characterized into equity 4 Article 55 BITC. 11

219 based on the transfer pricing principle. Even if the legal literature and tax administrations did not succeed in their efforts, this example nevertheless shows how, due to a lack of specific provisions, Sweden tried to implement a thin capitalization rule by interpreting their general provisions in an extensive manner. B. Hidden Equity (Austria) Unlike Sweden, Austrian case-law did accept a thin capitalization rule solely based on general provisions. The Austrian thin capitalization rule is based on the doctrine about hidden equity, which on its turn is based on the combination of certain general principles in Austrian tax law (e.g., the arm s length, the substance over form, and causation principles). Austrian case-law states that funds contributed by a shareholder only seeming to have the form of a loan, but economically equivalent to equity, shall not be acknowledged as a liability at the level of the company as in such cases the loan is deemed to be hidden equity. Case-law further states that this is the case when a shareholder grants a loan to his company, even though the company does not have the necessary equity (i.e., when there is an imbalance between debt and equity in). This conclusions is based on the idea that a shareholder is economically obligated to provide the company with enough capital. Conclusively, we can state that in the Austrian tax system, interest on a loan between a company and its shareholder can be re-qualified as a dividend (and thus rejected as a deductible expense) if the company is thinly capitalized. Lacking a specific debt/equity ratio, Austrian case-law uses industry averages to determine whether or not a company is thin capitalized. Austria reaches the same goal as, for example, Poland or Spain, which have an explicit thin capitalization rule in their legislation, by using general provisions. Interesting, because it is developed in case-law, the Austrian thin capitalization rule has more flexibility. For example, a fixed debt/equity ratio can be avoided much more easily than a more general description like not having the necessary equity interpreted case by case by Austrian courts. 12

220 III. Specific regulations As already mentioned, Italy, Germany, the Netherlands, Belgium, Spain, France, the United States, and Poland have implemented several specific regulations that regulate interest deductions in company taxation. In this context, the countries use a high number of different procedures to deal with this issue. At this point, only a short overview referring to the main structural issues will be given that serves as basis for the following more detailed descriptions of the domestic provisions. A. Description a. Thin Capitalization Rules (Poland, France, Spain, United States, Belgium, Netherlands) The limitation on interest deductions in the United States, Poland, France, Spain, Belgium, and the Netherlands occurs, among other ways, by using thin capitalization rules. The thin capitalization rules mainly consist of a comparison of the debt-equity ratio. This is the most common method to restrict interest deductions, particularly among the European countries. The manner in which each country implements these rules, however, differs in fundamental ways. Two aspects distinguish the thin capitalization rules: (1) the ratio itself, and (2) the method used to determine the ratio. The debt-equity ratio model, also known as a safe-harbor model, is based on an adequate proportion between debt and equity. In general, the deduction of interest is limited by the ratio. If a company exceeds the ratio, the excess is disallowed. Each country defines the ratio differently. 13

221 b. Interest Barrier (Italy, Germany) Italy and Germany have introduced an interest barrier in recent years. In this context, the deductibility of interest is not restricted with regard to a debt equity ratio in the meaning of thin capitalization rules. Rather, the interest barrier links the amount of deductible interest with a company s EBITDA. This accounting measurement equals the amount of earnings before interest, taxes, depreciation, and amortization. The determination of EBITDA, however, differs among the countries. Moreover, the applicable scope of the interest barrier provisions differ by country too. c. Debt push down rule (Sweden) In 2009, Sweden introduced specific rules restricting the deductibility of interest in debtpush down situations. The reason for the new statute was that the Swedish tax agency identified several problems with the Swedish unregulated system of interest deductions, but also the fact that the Swedish Supreme Administrative Court in 2007 stated that the Swedish Tax Avoidance Act was not applicable in debt-push down situations. These rules concern interest payments on loans between companies in a specified relationship. The restrictions relate to the payee s tax rate and whether the transaction was commercially motivated. B. Purposes and Intentions The legislative intents and purposes of the differing techniques can be grouped into the following categories: Specific Anti-Abuse Rules The primary aim of these rules is to prevent the use of abusive company financing constructions. In many cases, companies try to reduce their tax liabilities by decreasing their taxable incomes in high-tax countries by using such cross-border constructions. The legislative responses to four of the most popular methods are below: 14

222 Back-to-Back Financings One of the most popular financing constructions is the back-to-back financing. Such a financing construction is an arrangement in which two companies in different countries borrow each other s currency for a specific time period. Thus it is a kind of intercompany loan channeled through a bank. Companies use this construction in order to reduce foreign exchange risk. Although most countries have provisions that restrict this type of financing construction, the procedures to prevent abuse differ. For instance, Belgium adopted back-to-back financing rules that take loans with related parties located in tax havens into account. 5 Germany, Italy and France, on the other hand, included this type of financing in the scope of their regulations referring to interest deductions. 6 The Dutch interest deduction restrictions only contain this type of financing within their thin capitalization rules. 7 Nevertheless, there are additional specific rules in the Netherlands. In Spain, back-to-financings are covered as part of the regulations referring to indirect financings that fall into the scope of the thin capitalization provisions. Sweden has implemented similar rules within their debt-push-down financing regulations. 8 Austria, however, does not have a provision that deals with back-to-back financing. Still, the Austrian tax authorities addressed these financings in another way. The United States has a specific provision, called the anti-conduit regulations, that specifically refer to back-to-back financings. Only Poland does not have any regulations that refer to this issue. 9 Down-Stream-Inbound-Financing The second scenario involves down-stream-inbound-financing. This construction aims to decrease the tax liability of a subsidiary in a high-tax country by transferring profits to a parent company located in a tax haven. In the case of a down-stream-inbound financing, the parent company loans money to the subsidiary. As a result, the interest payments from the subsidiary to 5 E.g. Article 54 of the Income Tax Code refers to interest paid directly or indirectly 6 For Germany see: Förster, in: Breithecker/the same/förster/klapdor, Kommentar zum Unternehmensteuerreformgesetz; for France see: article 12 of the Financial Bill for , section 8a KStG recital 47 f.; 7 Dr. J. van Strien, renteaftrekbeperkingen in de vennootschapsbelasting, page See Ch. 24 sec. 10c ITA 9 W. Nykiel, Z. Kukulski, M. Wilk, Polish equity and debt financing op. cit., p. 9 15

223 the parent company reduce the subsidiary s profit and thus also the tax base of the high-tax country. In particular, the interest barrier provisions in Italy and Germany, the thin capitalization regulations of France, Poland, the Netherlands and Spain, as well as the earnings-stripping rules of the United States try to at least limit the amount of displaced profits in such constructions to secure their tax revenue. Up-Stream-Inbound-Financing This construction reverses the previous construction. Here, the subsidiary is located in a tax haven and loans money to a domestic parent company that is located in a high-tax country. Here, the interest payments are usually deductible as operating expenses at the level of the parent company which again leads to a reduction of the tax base. This construction may also be captured by the provisions in the above mentioned countries. C. Anti-Tax Haven There are specific anti-tax haven rules in Belgium, France and Italy. Belgium has three rules that try to prevent the use of interest deductions to shift profits. 10 The first of these rules describes a tax haven broadly, 11 but then lets the case law fill in the details. 12 The second rule list locations determined to be tax havens. 13 Furthermore, the Belgian system also uses a rebuttable presumption 14 for two of its provisions, 15 while another uses a 7:1 debt/equity ratio. 16 France uses a specific provision based on the CFC rules that attempts to prevent tax avoidance, particularly when the money is shifted to a tax haven (defined as a country that applies a tax rate less than 50% of the French corporate tax, namely 33 1/3-percent ). However, this provision becomes ineffective when the amount is shifted within the EU. 10 Art. 54, art. 198, 10 and art. 198, E.g. a country with a substantial more favorable tax regime 12 Art. 54 and 198, 11 ITC. 13 Art. 198, 10 ITC. 14 This implies that the interest is in principle not deductible, unless the tax payer can prove otherwise. 15 Art. 54 and 198, Art. 198,

224 Using a different approach, Italy did not set up a general principle, but instead made a white list (Albania, Belgium, Brazil, et. al.). This list applies when the tax applied in these countries is less than 50% of that applied in Italy and the income of the subsidiary is mainly composed of passive income. In addition, anti-tax haven legislation applies to prevent the use of tax havens (e.g., particular costs and expenses are not deductible if they arise from transactions with companies resident in a non-eu countries with a preferential tax regime). If the resident company can prove that the non resident company actually carries out a substantial business activity, or that the transactions have a business purpose and have in fact occurred, then the deduction will be allowed. In Sweden, the 10-percent rule states that between related parties, interest can only be deducted if the payor has an effective tax rate equal to at least 10-percent. Further there is also evidence in rebuttal regulation in the Netherlands and Sweden for certain interest deduction rules, which says that the tax rate should be at least 10% according to the tax base from its own country and in a number of countries is legislation (anti-conduit provisions) to combat detours which are made to avoid taxes. And in these detours are also (mostly) tax havens included. Anti Hybrid Instruments The Netherlands is the only country that has anti-hybrid instruments that are specified on loans. The other countries also have anti-hybrid instruments, but they are not specified on loans because it are general rules that can also be used to combat anti-hybrid instruments. D. Anti-Excessive Interest Rate (arm s length) Every country has an anti-excessive interest rate provision. Basically, every country uses the arm s length principle and except for France and Belgium the general transfer pricing rules are used to combat excessive interest rates. In Belgium there is a special provision that says that the interest rate has to be at arm s length. Secondly, France has a special anti-excessive interest rate, which uses two tests. The first test uses an interest rate quarterly published. If the interest rate is the same or lower than this published interest rate, the test is passed. If it is higher than has to be looked at the second test, which says that the interest rate has to be at arm s length. 17

225 Neutralization of the discrimination between debts and equity Companies have two general options for financing their activities: either equity investment (contribution of extern share-capital or auto-financing) or debt investment (loans, bonds, etc.). Both types imply remuneration for the granted investment. The remuneration for debt investment is interest which is in principal fully deductible as a business expense. The remuneration for equity investment (dividends) on the other hand is fully taxable at the general corporate tax rate. This implies an unjustified discrimination between these two types of investment. The EU High Level Group noted in their November 2004 report that company financing in Europe is focused too much on lending at the expense of risk capital. This is especially at a disadvantage for smaller companies, who cannot meet the guaranties demanded by financial institutions. The European Commission has ventilated two possible opposing measures that might eliminate the distortion between debt and equity: an Allowance for Corporate Equity (ACE) or a Comprehensive Business Income Tax (CBIT). An ACE would grant a deduction for the return on equity as it is the case for interest. A CBIT on the other hand seeks to eliminate the favorable fiscal discrimination of debt financed investment by disallowing a deduction for interest payments. Both systems will neutralize the discrimination between debt and equity investment. Nevertheless, both systems have disadvantages. Typical systems that can be described as CBIT systems are thin-capitalization rules and interest barriers, as these rules try to limit the deductibility of interest and thus the amount of debt investments. Countries that use that kind of system are Poland, Spain, the Netherlands (thin cap rules), Germany, Italy (interest barriers) and France (mixture of both). By limiting the deductibility of interest, these countries limit the tax incentive to use debt investment and thereby neutralize the debt/equity discrimination. A typical example of an ACE system is the Notional Interest Deduction in Belgium. By providing a deduction of a percentage of the equity of every company, Belgium does not abolish the incentive for debt investment, but just creates a similar incentive for equity investment thus neutralizing the discrimination between debt and equity. 18

226 IV. Specific rules A. Interest barrier Italy and Germany have introduced an interest barrier rule in the recent past. In this context, the deductibility of interest is not restricted with regard to a debt to equity ratio contrary to Poland, Netherlands, Spain, USA and partially France. Indeed, in order to determine whether a company is over-indebted or not, the German and the Italian legislators decided to refer to the amount of interest expenses compared to the amount of interest gains. The French legislator also refers to this balance of interest but not solely. Indeed, it also refers to the debt to equity ratio. a. The nature of Interest It appears that neither France, nor Germany, nor Italy has a clear and strict definition of the nature of interests that are covered by the legislations. Even if Italy has a definition, the legislator uses large definition without giving too many details. The lack of a strict definition can be explained by the constant move of the financial engineering left at the imagination of inventive practitioners. The authorities seem to generally apply a kind of substance over form theory and attempt to determine on a case by case analysis whether the amount at stake is interest or not. This situation leads to legal uncertainties. The downside of it is that companies can still attempt to argue that it is interest and not dividend. Going further into the details, the German Income Tax Act does not define debt but according to the German jurisdiction, debt is all expenses that are derived by generating or securing credit. As regards to Italy, the interest barrier entails several types of interest expenses and interest incomes arising from loans, leasing contracts, bonds, similar securities and from any other financial contracts. The Revenue Agency enumerated specific contracts, typical and atypical, which can lead to the implementation of the mechanism provided for Article 96 of ICTA: any and all interest related to the use of money, securities or other fungible assets, for which there is an obligation to repay and for which there is a specific remuneration. Therefore, the provision 19

227 in question includes all income items from operations of loans, of carry and repurchase, of securities different from shares and similar contracts. Even though there is a this enumeration, the Italian tax authorities can still use the substance over form mechanism as a last resort. For instance, they will analyze each item in the tax return, taking into account the economic function of the asset considered in order to determine whether it is interest or dividend. In respect to France, there is an accounting definition of debt and equity but it is not very helpful. For tax purposes, the authorities will have to refer to the General Accounting Standard. Indeed, when French tax authorities need to deal with financial hybrid instruments such as bonds convertible in shares, they adopt a case by case approach that requires to analyze the features of the relevant instrument and to determine which features of debt or equity prevail. Furthermore, the Italian legislation also prescribed some exclusions, most of them concerns the situation where interest is not considered as a genuine financial cost. In such a case of intragroup loans, the non-deductibility of interest expenses results from the application of the transfer pricing rules using the arm s length principle whereas the French Supreme Administrative Court expressly refused to use the transfer pricing rule. Eventually, the Italian legislator is preoccupied by groups of companies and more specifically companies located in countries with a lower tax rate. It requires to refer to the white list that enumerates a various number of States. For instance, if the lending company is located in Brazil, the borrowing company is allowed to fully deduct interest must demonstrate that the interest is guided by economic reasons. This recent provision raises lot of practical problem in Italy and was highly criticised. Since it entails lots of country, there is no doubt that it will damage the scope of the Italian interest barrier. b. Persons concerned Taking into account the relationship between the borrowing and the lending company? The scope of the Italian and German legislation seems to be prima facie quite similar since they indistinctly apply to all companies without even taking into account the link between the 20

228 borrowing and the lending companies as in France. Indeed, German and Italian legislations indistinctly apply to independent and related parties while the French legislation applies to related parties i.e. the lending company holds directly or indirectly the majority of the share capital or the voting rights of the borrowing company, the lending company exercises the decisional power, or when the lending companies and borrowing companies are held by a third party. The lender and borrower can be sisters or cousins. Even though, the German legislator did not refer to this notion of related companies, the German interest barrier definitively cover related companies since it requires a triggering balance equal or over 3 million Euros. In summary, even if in theory, Italian and German legislations have a similar scope, the impact is very different. Taking into account the form of the companies? Furthermore, the German, the Italian and the French legislations pay attention to the form of the companies, for instance the partnerships are not fully covered by the deduction limitation rule and the implementation of the mechanism will depend on the nature of the owner of the partnership, whether he is a natural person or he is a corporate company. This difference in the treatment can be explained by the fact that partnerships are considered as transparent. Taking into account the nature of the legal entity of the lending company? In addition, France and Italy exclude the financial sector from the scope of the mechanism contrary to Germany, specifying that the French legislator recently introduced a back to back financing mechanism as it already exists in Germany. The requirements are though still different since the French legislator requires the loan to be guaranteed by related parties while the German legislation applies to all types of loans that are guaranteed by any companies. In respect to Italian legislation, there is a specific rule applicable to the financial and insurance sectors. The relevant provision allows the deduction of interest expense from the tax base of Italian corporate income tax within the limit of 96% of their amount. In this specific system positive and negative margins achieved from the core business are irrelevant and the deductibility of interest expenses is not reported on, in subsequent tax years. This scheme is particularly inappropriate, having regard to the specific activity performed by banks and 21

229 financial institutions. This unfavorable special tax regime applicable to financial institutions and insurance companies is aimed to punish the financial sector. Taking into account the nature of the activities performed? To a certain extent, the Italian legislator took into account the nature of some activities similarly to the French legislator. Indeed, in Italy, the Project Company, consortium, companies managing the supply of water, energy and other public utilities are excluded with the scope of the Italian rule. In France, when the loan is granted in order to purchase equipment goods or tools materials that are eventually subject to a leasing operation, the cost of this loan will be fully deductible except if it infringes the general French principles such as the abnormal act of management. Furthermore, the French legislator decided not to penalize the cash pooling centers since these companies are solely pivot companies. c. The triggering element Even if both of the German and the Italian legislators decided to use the net amount of interest in order to decide whether the deduction limitation mechanism applies or not, the impact of them are opposite. When the interest received by the borrowing company exceeds the interest paid by it to a certain extent, then the legislators agree to relief it by not applying the interest barrier mechanism. The German legislation takes into account the interest balance that is to say the interest expenses less interest gains. The interest barrier is applicable when the balance is equal or exceeds 3 million Euros. Thus, if the balance amounts to 2,999,999 Euros, the legislator allows full deduction of interest expenses without any limitation. Conversely, if the balance amounts to 3,000,000 Euros, the interest barriers applies and the deduction is granted to a certain extent. Interest expenses Interest gains = or > 3 Million Euros The restriction of the interest barrier have to be considered. 22

230 The Italian legislation has a stricter condition since it is sufficient that the interest expenses exceed the interest gain to trigger the interest barrier. Interest expenses > Interest gains Implementing the interest barrier mechanism As regards to the French legislation, there are three triggering elements. The borrowing company is deemed thin capitalized provided the three thresholds are simultaneously exceeded. -Interest paid X (1.5 of equity / the average amount of the amounts put at the disposal by the related companies) -EBITDA -Interest received > Interest paid d. The extent of deduction Limitation as to the amount of the deduction When the triggering element is fulfilled, it is necessary to determine the extent of the deduction since not the full amount of interest can be deducted. What is the excessive amount to be reintegrated? For this purpose, the German and Italian legislators refer to the amount of EBITDA (Earnings before Interest, Taxes, and Depreciation/Amortization) during the relevant current financial year. The reference to EBITDA is used not to penalize companies which have higher depreciation and not to deter investment in new equipment. France refers to it but to a limited extent since the borrowing company can also refer to debt to equity ratio or to the net amount of interest depending on the circumstances. Indeed, the French borrowing company will undoubtedly take the highest amount in order to reintegrate the lowest amount. French legislation is to this extent very flexible and this flexibility raised criticisms from some authors. In addition, EBITDA is not solely used to determine the extent of deduction but also as a triggering element. 23

231 Italy and Germany use the same rate of 30% of EBITDA. In Germany, the interest balance needs to be compared to 30% of EBITDA and not solely the amount exceeding 3 million Euros. For example: Interest expense (5 Million Euros) interest gains (1 million Euros) = 4 million as interest balance. The whole amount i.e. 4 million Euros need to be assessed with the EBITDA. In Italy, the excessive interest is deductible up to 30% of EBITDA of the borrowing company. When the borrowing company is part of a fictitious consolidation, the Italian legislator prescribes a preferential treatment by referring to the EBITDA of non-resident companies provided that (i) the Italian consolidating company owns directly or indirectly more than 50% of the capital, voting rights and profit participation rights of the non-resident company starting from the beginning of the relevant tax period; (ii) the tax period of the non-resident company coincides with that of the Italian consolidating company; and (iii) the financial statements of the non-resident company are audited. Example: A (Belgium) 100 of interest B (Italy) C (Poland) As regards to B Interest expenses > Interest gains <=>100 > 70 Excessive interest = 30 Knowing that EBITDA: 30, deduction allowed up to 30% X 30 = 9 Thus, 21 need to be reintegrated except if the Italian company is part of a fictitious consolidation. As regards to EBITDA of C 24

232 Interest expense > Interest gains <=> 80 > 70 EBITDA : 100 (80-70) 30% x 100 = - 20 The borrowing company can use the 20 not used in order to reduce the amount that the borrowing company need to reintegrate within its tax base. Similarly, France does take into account the existence of tax integration in order to favour the companies within a group. Indeed, when the amount of interest cannot be fully deductible at the level of the borrowing company, the excess can still be deducted at the level of the head of the group. Thus, even though the mechanisms of the French and Italian legislations are different, the intention of the legislators was also to allow the deduction as far as possible. However differences can be observed since the requirement for tax integration are stricter and apply solely to French group. Thus, the Italian legislation is willing to attract multinationals by granting this favour. The concrete determination of EBITDA differs in the countries. While Germany refers to the taxable EBITDA, Italy bases the limitation on the EBITDA of commercial law. Next to this, the application scope of the Interest Barrier provisions differ in further ways. Generally said, the Italian Interest Barrier concretes the extent of application scope to capital companies with a domestic seat in Italy and in addition by excluding the financial sector (banks, insurances, other financial institutes) from the restrictions. In this respect, the German regulation is more widespread. Nevertheless the German Interest Barrier limits the amount of affected companies by a threshold that demands a value of net-interest expenses of three million Euro. If this threshold is not exceeded, the restrictions do not have to be taken into account. 25

233 To sum up, relating to thin capitalization rules as well as the Interest Barrier, even if the countries have a similar procedure to a certain extent referring to interest deduction, the design of the regulations extremely differ in several ways. Escape and group clauses 26

234 There is no escape clause in the Italian legislation contrary to Germany and France. Thus, when the amount of interest paid exceeds the amount of interest gained, the companies cannot escape from the interest barrier rule in Italy. Both France and Germany prescribed two important mechanisms more or less complicated. There is an important converging similarity since both legislations pays attention to the existence of a group even though the term has not the same substance. In France, although deemed thin capitalized under the deduction limitation rule, the borrowing company can demonstrate that either the excess of interest is inferior or equal to Euros or that the debt to equity ratio of the group to which the borrowing company belongs is superior to that of the company. It is quite important to stress that point since in France it is even more difficult to be deemed thin capitalized because of the requirement of simultaneously exceeding three thresholds and not solely the balance of interest paid and interest received. The German legislator prescribed the group clause and the escape clause. The group clause has an effect provided the settlement of loan capital to a certain participant (=shareholder) of the company who is able to dispose over more than 25% of the share capital does not exceed 10% of the passive interests which surpass the aforementioned required balance. If the equity ratio of the business is at least as high as the one of the group, the interest deductibility restrictions have not to be considered. The business is not defined by law and must be understood within a common sense. Thus, groups have to compute all the amount of equity of the different companies part of the concern in order to proceed to the comparative approach. Nevertheless, the implementation of those two clauses can be paralyzed by a harmful participation, having the effect of coming back to the interest barrier rule. Indeed, when shareholders receive more than 10% of the interest balance and the shareholder directly or indirectly participated with an extent of more than 25% of the capital assets, the amount of interest balance will be not fully deductible but solely to the extent of 30% of EBITDA. 27

235 B. Thin capitalization The limitation of interest deduction in the United States, Poland, the Netherlands, Spain and Belgium takes place by thin capitalization rules. Also France applies thin capitalization rules in their mix system. The taxpayer must have excessive debt to trigger for the thin capitalization rules, e.g. it has to be over-indebted compared to the equity. The issue of thin capitalization rules is important because of the fact that equity and debt triggers different consequences, which will be discussed below. The Debt-to-equity ratio is a benchmark that can be used to evaluate the level of indebtedness of an entity. It is a value resulting from comparison of a certain amount considered to be a debt to the amount considered to be equity. In different jurisdictions, the exact meaning of the debt-to-equity ratio may differ depending on the choices made by the legislator. It is used to determine whether an entity is over-indebted or not. a. Different approaches to deciding the indebtedness of an entity Although the debt-equity ratios of the countries seem to be similar and easy comparable, in fact the determination of the ratios differs extremely in the countries. In this respect, two groups of ratios can be distinguished. First, like in the Netherlands, Belgium, France, the United States and Poland, there is a global ratio that refers to the whole amount of debt and equity capital. That means that the whole amount of debt and equity on the level of the company will be taken into account to determine the debt equity ratio. The second possibility, which is solely used in Spain, consists in an individual ratio that refers individually to the proportion of debts and equity of each participated shareholder. Thus, only the amount of participation referring to debt as well as equity of the shareholder will be taken into account. Spain, the Netherlands and Poland all apply a debt-to equity ratio of 3:1. Belgium has two different ratios. On the one hand, there is a ratio of 7:1 which is only applicable for affairs that 28

236 relate to tax havens. On the other hand, a ratio of 1:1 has to be applied in the case of interests paid on loans granted by individual shareholders or directors. The ratio provides a safe harbor provision meaning that if the company does exceed the threshold, the thin capitalization rules will never apply. The Polish CITA governs that part of the interest is not deductible if the ratio is exceeded at the day when the interest is being paid and the loan is granted by shareholders that are considered to be qualified lenders. If the ratio is not exceeded, the interest is automatically non-deductible. In the Netherlands two tests apply in order to establish whether a company has excessive debt, namely the fixed ratio test and the group ratio test. The fixed ratio test uses the figures of the fiscal balance and tests whether there is excessive debt. This is the case if the debt-equity ratio is higher than 3:1. However an exemption applies: up to a debt excess of EUR there is no limitation. The group ratio test compares the debt-equity ratio of the group where the taxpayer belongs to with the debt-equity ratio of the taxpayer (tax unity). In order to establish the debtequity ratios the commercial accounts are used of both the group and the taxpayer. As long as the debt-equity ratio of the tax payer (tax unity) is not lower than the debt-equity ratio of the group which the taxpayer is a part of, the group ratio test is passed and there is no excessive debt. The taxpayer may choose if it wants to use the fixed test or the group ratio test to establish the excessive debt because the debt has to be excessive according to both tests at the same time in order to trigger the consequences. Thus the interest attributable to the excessive debt is not deductible. This includes interest and costs made for the loans, but currency results are not included. However, the maximum amount of interest that is not deductible is the interest paid to an affiliated company minus the interest received. 17 France also applies, besides an interest rate test, a thin capitalization test to decide whether an entity is over-indebted or not. 18 A borrowing entity will be deemed to be thin capitalized if it exceeds simultaneously three limits, i.e. the debt-equity ratio, the interest cover ratio and the amount of net interest. Like the rules of the Netherlands the borrowing entity is only considered thin capitalized if all the limits are exceeded. If any of the three limits is not exceeded, the borrowing entity may deduct the entire amount of interest. 17 Dr. J. van Strien, renteaftrekbeperkingen in de vennootschapsbelasting, page Article 212 II CGI. 29

237 However, France does not apply any certain debt-equity ratio like Spain, the Netherlands and Poland. The rule requires a complex computation that requires taking into account not solely the debt to equity ratio, the average of the amount put at the disposal of the borrowing company by related parties and the interest paid. For the first threshold, excessive interest is computed like follows: [Interest paid X (1.5 of equity / the average amount of the amounts put at the disposal by the related companies)] The second ratio is determined on the basis of the EBITDA in the following way: 19 [Earnings before tax + interests+ deducted amortization + portion of leasing rent] The third ratio refers to the net interest of the borrowing company. Indeed, a company will not be deemed thin capitalized when interest received is superior to interest paid by it, as the company has to be in a situation of net lending within the group. Likewise in France, the U.S. does not apply a statutory debt-ratio but it is instead determined on the basis of requirements created by case law using a case by case approach and all facts and circumstances-analysis. There are regulatory guidelines to set forth factors to be taken into account in determining, with respect to a particular factual situation, whether a debtor-creditor relationship exists or whether a corporation-shareholder relationship exists. The specifically listed factors for this purpose are for example: (1) The existence of a written unconditional promise to pay a sum in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest; (2) The ratio of debt to equity of the corporation; (3) Whether there is convertibility into the stock of the corporation. 19 Article 212-II 1 b CGI. 30

238 Country Debt-Equity Ratio Austria / Belgium 1:1 / 7:1 France 1.5:1 Germany / Italy / Netherlands 03:01 Poland 03:01 Spain 03:01 Sweden / United States 1.5:1 b. Definition of debt The definition of debt is widely differing between the different countries applying a debt-equity ratio. In the Dutch system debt contains only loans while the Spanish system and the Polish system apply a broader definition of debt. The Spanish definition includes all kind of debtsituations as loan, interest leasing commercial credits, bonds, obligations, promissory notes or any other forms of financing regardless of the fact that such financial or commercial instruments contain an explicit interest clause. Thus, Spain actually applies a substance over form approach but not in a specific manner. Also the Netherlands and the U.S. apply a kind of substance over form to decide whether there is debt or equity. The Dutch Supreme Court has made it clear where the boundaries of what is still a loan are passed. These cases are the sham-loan, the participation-loan, the down-thedrain-loan and possibly the unbusinesslike-loan. According to case law the following aspects are in general relevant for the question whether a fiscal requalification is necessary: (1) the seniority of the loan with regard to sharing in the losses, (2) the dependence of the interest on the profits, (3) the duration of the loan and (4) the degree of control in the company is of importance. The first three criteria have to be present in some way to be able reclassify a debt into capital according to case law Supreme Court of the United States 27 January 1988 BNB 1988/217, Supreme Court 11 March 1998 BNB 1998/208, Supreme Court 15 September 1999 BNB 1999/176 and Supreme Court 3 February 2006 BNB 2006/82. 31

239 In respect to France, in order to determine whether it is debt or equity, the French tax authorities refer to the traditional features of classical debt that are (1) periodically paying fixed interests to the creditor, (2) reimbursing the borrowed amount and (3) no participation in the management of the company. Poland does not use the expression debt-equity and the definition is therefore broader. It rather mentions indebtedness against a certain group of shareholders which is being described in the literature as substantial shareholders, (1) shareholders that hold at least 25% of the equity capital of the company, (2) entities that hold not less than 25% of the equity capital of the shareholder just mentioned above or (3) a loan granted by a sister company being a qualified shareholder. 21 There exists a serious controversy related to the proper interpretation of the term indebtedness. Since there is no definition of the expression in the Polish CITA, which is considered to be one of the major flaws of these provisions. 22 In the U.S there is no definition for equity and debt, due to the fact that, like mentioned before, the US applies the all facts and circumstances analysis to distinguish between debt and equity. This means that it is based on a case by case decision. c. Definition of equity One of the problems is that there are a lot of different definitions of equity not only in the different countries but also sometimes within the domestic tax acts of some countries. In addition, equity and debt are difficult to distinguish because of the financial engineering: bonds convertible in shares; non-voting preference share; bonds with bond subscription warrant. For example, Poland is providing much more specific rules in reference to equity then it does in case of a debt. Two important issues need to be taken into consideration in reference to equity. The first one is the elements that equity is composed of. The second is the moment when the equity should be calculated for the purpose of the Polish TCR. 23 Equity capital is not defined in the Polish CITA, but it is actually a general commercial law definition. It is 21 Art. 16(1)(60 and 61)Polish CITA. 22 A. Gomułowicz [in:] S. Babiarz, L. Błystak, B. Dauter, A. Gomułowicz, R. Pęk, K. Winiarski, Podatek dochodowy od osób prawnych. Komentarz 2010 (2010), p Z. Kukulski, Niedostateczna kapitalizacja, op. cit., (2006), p

240 equal to the sum of the nominal value of all the shares that represent membership rights in the company. It also determines the minimal obligation of shareholders contribution to the company. The fact that the company has a certain equity capital does not mean that the contributions towards the equity capital have been made by all shareholders in full, 24 because it is reduced in the amount of the contributions that have not been made in reality. 25 This ensures that only the capital that has been contributed, not just the registered capital, will be taken into account. However, there are also two other exclusions which are far more controversial. These include parts of the equity capital, toward which contributions have been made in a form of a claim under a loan granted to the company and under interest on that loan. Furthermore, intangibles and legal values that cannot be depreciated are also excluded. 26 For the assessment of the debt-equity ratio in France, it is agreed that the definition of equity to hold on is the one stated in the French General Accounting Standards. 27 The features of equity are the following ones: the right to participate to the shareholders meetings, the reimbursement of the capital contribution at the end of the life of the company or upon the transfer of the titles and the hazardous character of the dividends distribution. It is admitted that the amount of equity to be taken into account when assessing the first threshold, i.e. interest paid x (1.5 of equity/the average amount of the amounts put at the disposal by the related companies), can be increased by amounts arising from hybrid financial instruments, i.e. when these hybrid instruments are registered in the account of a company under other funds and cannot be fiscally classified as debt regarding their features. As a result, the financial hybrid instruments will have the effect to increase equity in favor of the borrowing company. In Spain, equity is defined as capital minus the loss of the current year. Thus, in contrary to Poland and France the Spanish definition of equity is quite clear and much narrower. However, in the U.S. there is no definition for equity and debt at all, due to the fact that, like mentioned before, the U.S. applies the all facts and circumstances analysis to distinguish 24 A. Herbert [in:] S. Sołtysiński (ed.), Prawo spółek kapitałowych. System Prawa Prywatnego. Tom 17A (2010), p Art. 16(7) Polish CITA. 26 Articles 16a-16m Polish CITA. 27 Article French GAS. 33

241 between debt and equity, which means that it is based on a case by case decision. Also the Netherlands do not apply an explicit definition for equity. In Belgium the situation is totally different in so far as there are a number of different definitions for specific sections. Therefore, for example the definition of equity for the purpose of determining thin capitalization differs from the one of notional interest deduction. d. Persons concerned The characteristic feature of the debt-to-equity ratio mechanism is that it affects only the interest payments made to a certain group of lenders. Therefore, it is important to examine how is the personal scope of the debt-to-equity ratio based rules is regulated. Most of the countries indicate very clearly what kind of relationship between the borrower and a lender falls within the scope of the provision. As an exception to the rule, the US uses a case-bycase analysis in order to determine whether the deduction of a payment between certain entities is going to be allowed. Nature of the relationship between a borrower and a lender Where a debt-to-equity ratio is employed by the legislator, it is usually used for denial of deduction of interest paid to a party that is in some kind of relationship with the taxpayer. Nevertheless, the Belgian rules on loans granted by a suspicious lenders constitute an exception, as their application do not require the borrower to have any other relationship with the lender, other than the loan agreement. Other provisions using the debt-to-equity ratio are usually applied with reference to some other kind of relationship between the borrower and a lender. The Dutch legislation makes the interest in the company a factor constituting the relevant link. Both French and Spanish law stipulates that holding shares in the company s share capital has to be taken into account. The same is true for the Belgian restriction on deductibility of interest paid to individual shareholders. Voting power needs to be taken into account in order to determine the application of TCR in Poland, and exercising certain mandate or function in the company (e.g. directors or board members) is another determining factor in Belgium. 34

242 Even though being different, all determining factors are somehow related to possibility to control the company, entitlement to participate in its profits or both. Intensity of the relationship The scope of the TCR is also determined by what can be called an intensity of the relationship. E.g. for the purpose of Belgian provisions on deductibility of interest paid to individual shareholders, holding a single share in the company is sufficient to constitute a relationship which is relevant in the context of the TCR. This makes the rule quite strict in this regard. On the other hand, according to French rules the company can be considered to be an associated company for the purposes of limiting the deductibility of interest, if the share amounts to more than 50% of the share capital. The Netherlands with an indicator of 33,33% as well as Poland and Spain with the requirement amounting to 25% are all somewhere in the middle. While in most of the countries (France, Netherlands, Spain) the indirect share/interest/etc. is sufficient to determine that the parties are related, Polish legislation does not cover situations when the relation is indirect in nature, which makes the scope of application of the provision quiet narrow. Residence of a lender Important differences between the regulations across the jurisdictions can be seen in how the criterion of a residency of the lender is used. Some of the countries, i.e. France, Netherlands and Poland, extend the application of the TCR to interest paid to related companies without any reference to the residency of the lender. It means, that the rules are applicable both in domestic and cross-border situations. Belgian provisions limiting the deductibility of interest on loans granted by individual shareholders follow the same path. On the other hand Spain never applies the thin capitalisation rules to domestic situations. As a rule, the restriction on deductibility of interest can be applied to interest payments made to non- EU/EEA entities. Additionally, the restriction can be applied also when the entity receiving interest is a resident of an EU/EEA member state, when it is considered to be a tax heaven according to the Spanish tax legislation. 35

243 An example of a restriction on deductibility of interest which is applied only to interest payments to non-eu/eea entities is constituted by Belgian rules related to loans granted by companies exercising mandates or functions explicitly mentioned in the statute (e.g. board directors). It is in fact designed as applicable to all cross-border situations but is interpreted as non-applicable to payments made to EU/EEA entities. Such practice has been employed in order to assure compliance with the EU law. Due to the nature of the Belgian suspicious lender provision it is also never applicable to domestic situations in practice. C. Notional Interest Deduction (NID) a. Applicable scope The NID applies to all Belgian resident companies who are subject to the Belgian corporate tax. The NID also applies to foreign companies who are subject to taxation as non-residents regarding their Belgian Permanent Establishment (PE) or which have immovable property located in Belgium. The fact that the NID also applies to Belgian PE s is necessary for the NID to be in line with EU law (freedom of establishment) and Belgium s double tax treaties. Five types of companies are excluded from the scope of the NID because they are already subject to different favorable tax regimes and can therefore not benefit from the NID e.g., recognized coordination centres or reconversion companies. b. Risk-Bearing Capital The NID is calculated based on a company s equity capital. That amount can be found on the previous taxable year s non-consolidated balance sheet. The amount of equity capital may also be subject to certain correction to prevent misuse of the NID. Belgian law dictates the how the the balance sheet is calculated. Belgian law requires most Belgian companies to create and publish an annual accounting statement. A similar obligation applies for foreign companies who are subject to Belgian 36

244 taxation. Ordinarily, PEs are not obliged to draw up a separate accounting statement. These companies, however, must publish such statements to benefit from the NID. This obligation is not contrary to EU law. c. Risk-Bearing Capital Adjustments Related-Party Shares The net value of a company s shares which such company itself owns (i.e., treasury shares) must be deducted from the amount of equity in order to prevent misuse of the NID. The equity related to subsidiaries not covered by this directive are not deducted from the risk-bearing capital. Permanent Establishments If a Belgian company has a permanent establishment (PE) the amount of risk-bearing capital must be reduced by the PE s net equity i.e., the PE s net asset value (own shares excluded) minus the PE s total liabilities. A PE is of course not a separate legal entity but is a part of the Belgian company. To determine which assets and debts have to be allocated to the PE, the same principles are used that are applied to determine the profit from the PE, that is tax exempted by a bilateral tax treaty. These rules and their application are based on the OECD Model Convention (in particular Art. 7 OECD MC), the OECD commentaries and OECD Report on the Attribution of Profits. Non-Belgian Real Property If a company owns non-belgian real property or has a similar legal interest in other non-belgian real property which is not connected with a Belgian PE, and the income generated by such real property is tax exempt under a bilateral tax treaty, then the risk-capital amount is reduced by the company s net equity in the real property. Anti-abuse corrections To prevent artificial constructions from inflating the amount of risk-bearing capital, Belgian law excludes three asset classifications from the NID calculations: (1) the net value of tangible 37

245 assets (or part thereof) that unreasonably exceeds professional needs; (2) the net asset value of passive investments; (3) the net value of real estate held for use by a company s managerial employees privately used by individual persons who pursuit a function listed in, or their relatives. Technical Corrections Belgian law also excludes from the computation the reserves held for the revaluation of assets. The mere revaluation of an asset in Belgium is not a taxable event on the condition that a special reserve has been created on the balance sheet. This results in an increase of the company s net equity. Since this increase is not taxed and also to prevent artificial revaluations of assets, the reserve is excluded from the computation base of the NID. Furthermore, equity subsidies are excluded if they are fully tax exempt. If a company changes its risk capital during the taxable year e.g., through receipt of a capital contribution, or by delaying a property distribution this could result in an artificial increase of the risk-capital amount. To prevent manipulation, changes in the risk-capital during the taxable year are taken in account pro rata. For example, if during the last month of the taxable year the risk-bearing capital is increased, then only 1/12 of that amount will be taken into account for purposes of the NID. Applicable rate The NID is computed by multiplying the corrected risk capital amount by an interest rate. This rate equals the average of the interest rates on applicable ten-year government bonds for the prior taxable year. For example, the reference rate for 2009 was 4,3%, for 2010 it was 4,5%, and for 2011 it is 3.8%. If a company can not use all of its NID in a taxable year because it does not have sufficient income, it may carry-forward the unused portion to the following seven years. If the NID carry-forward is not used after seven years, it is lost. D. The Earnings-Stripping Limitation Earnings stripping usually refers to the payment of excessive deductible interest by a U.S. corporation to a related person when such interest is tax exempt (or partially tax exempt) in 38

246 the hands of the related person. 28 Companies use this technique to strip their earnings out of the U.S. and into a more favorable tax jurisdiction, hence the name earnings-stripping. This phenomenon occurs more frequently with foreign-controlled domestic corporations because the subpart F provisions 29 capture the interest payments made by domestically controlled foreign corporations as current income when they engage in the same pattern. 30 The U.S. Congress has continually grappled with and legislated to prevent the use of interest payments to erode the federal tax base. Its primary tool has been IRC 163(j); a.k.a., the earning-stripping limitation. The earnings-stripping limitation operates by denying a deduction to a corporation but not to non-corporate companies for disqualified interest. 31 [T]he term disqualified interest means any interest paid or accrued by the taxpayer... to a related person if no [U.S.] tax is imposed... with respect to such interest Related persons include (1) members of a family; (2) [a]n individual and a corporation more than 50 percent in value of the outstanding stock of which is owned... by or for such individual; [t]wo corporations which are members of the same controlled group, and other statutorily defined relationships. 33 The earnings-stripping provision does not deny all interest expenses. It only applies to a corporation if during the taxable year it has (1) excess interest expense and (2) a debt-to-equity ratio that exceeds 1.5:1. 34 Excess interest expense means a corporation's net interest expense, reduced by 50 percent of the adjusted taxable income of the corporation Together, these provisions reduce the number of corporations subject to the limitation substantially. Only corporations which are leveraged so that their capital structure contains at least 50-percent more debt than equity are covered. Plus, a corporation must be paying out more interest than it earns in an amount equal to half of its earnings before interest, taxes, depreciation, amortization, and 28 DEPARTMENT OF THE TREASURY, REPORT TO THE CONGRESS ON EARNINGS STRIPPING, TRANSFER PRICING AND U.S. INCOME TAX TREATIES, 7 (2007). 29 Subpart F refers to the portion of the United States income tax code designed to eliminate the tax benefits of deferral to U.S. taxpayers investing abroad. The effect of these provisions is that for certain types of income e.g., passive income U.S. persons must pay income tax in the year that their related foreign corporations earn that income. 30 DEPARTMENT OF THE TREASURY, REPORT TO THE CONGRESS ON EARNINGS STRIPPING, TRANSFER PRICING AND U.S. INCOME TAX TREATIES, 8 (2007). 31 I.R.C. 163(j)(1)(A). 32 I.R.C. 163(j)(3). 33 I.R.C. 163(j)(4)(A). 34 I.R.C. 163(j)(2)(A). 35 I.R.C. 163(j)(2)(B)(i). 39

247 other expenses. 36 Moreover, the amount of non-deductible interest may not exceed the amount of a corporation s excess interest expense. 37 When the earnings-stripping provision does deny a corporation an interest deduction, the deduction is not lost, but carried over to the succeeding taxable year. 38 No time limit applies and the amount carried over is added to adjustable taxable income in the succeeding taxable year when calculating a corporation s net interest expense. 39 For example, U.S. corporation M is owned by individual A, a resident of country Z, a low-tax country with which the U.S. does not have an income tax treaty. M has no debt capital and therefore does not get to deduct any interest from its income. M s taxable income is subject to the U.S. corporate income tax and its dividend payments to A are subject to the 30-percent withholding tax. If M earns $100x during the taxable year and its marginal tax rate is 35-percent, it pays $35x to the U.S. and has $65x left to distribute as a dividend to A. M must withhold and pay to the U.S. 30-percent of the dividend, or $19.50x. This leaves A with after-u.s. income tax earnings of $45.50x, representing a 54.5-percent effective tax rate. If, however, a loans money to M ignoring the application of the earnings-stripping provision M could potentially offset all $100x of its income with interest deductions. As mentioned above, the U.S. sources interest income to the location of the debtor. As a result, the interest payments flowing from M in the U.S. to A in country Z would be taxable to A as FDAP 40 income and M must withhold 30-percent of the dividend, reducing the amount to $70x. From A s tax perspective, by stripping M s earnings out of the U.S. he has received more than 40-percent more income by capitalizing M with debt than he did with all equity. 36 I.R.C. 163(j)(6)(A). 37 I.R.C. 163(j)(1)(A). 38 I.R.C. 163(j)(1)(B). 39 I.R.C. 163(j)(2)(B)(i). 40 I.e. Fixed determinable annual periodical (For further information please refer to: 40

248 E. Special regulations regarding interest deductibility in the Netherlands There are two special regulations regarding interest deductibility in the Netherlands, these are Art. 10a, which contains certain contaminated transactions, and art. 10b which deals with lowinterest loans. Art. 10a applies to certain contaminated transactions, which are briefly a refund of paid up capital, a capital contribution and an acquisition or increase of the share capital. The article actually combats these three tax avoiding schemes and if the tax rate on the received interest is at least 10% according to a Dutch tax base the article doesn t apply. Secondly art. 10b is a special regulation in the Netherlands. This art. applies to the situation that an affiliated company enters into a loan with an un-businesslike interest rate and without a fixed maturity or a redemption date of more than 10 years after the loan commitment. F. Specific rules regarding debt-push down in Sweden Sweden applies specific restrictions regarding debt push down-situations. 41 The rules concerns interest payments on internal loans between companies in an economic relationship and deductibility of interest is only allowed if the corresponding income would have been taxed with a tax rate of at least 10% if the company would only have had that income or if both the acquisition and the interest payment are principally commercially motivated. There are also two additional rules containing specific anti-abuse provisions, one concerning back-to-back loan. as mentioned above. The reason for the new statutes was that the Swedish tax agency identified several problems with the Swedish unregulated system and that the Supreme Administrative Court stated that the Swedish Tax Avoidance Act was not applicable to such tax structures Ch. 24 sec 10a-d Swedish ITA. 42 RÅ 2007 ref

249 V. Effects This section deals with the effects of the specific limitation rules, such as the interest barrier or thin capitalization rules. Either of these rules can result in re-characterization of the interest paid into a constructive dividend or in the disallowance of the interest deduction. A. Disallowance of interest deduction In some countries, interest that is considered excessive results in the tax authorities disallowing the deduction of these interest payments. This increases a company s taxable income, but does not trigger any other consequences. For example, this is true in Poland, Germany and the Netherlands. 43 In the Swedish system deductibility of interest is also denied if the 10% threshold is not reached 44 or if the transaction is not principally commercially motivated. In Belgium the same system is employed for payments to tax havens. Additionally, however, the latter also recharacterizes interest payments as a hidden dividend in certain cases, which is discussed separately below. 45 B. Re-characterization of interest as a hidden payout: The other possibility of punishing excessive interest payments consists in the re-characterization of such payments as a constructive dividend. Countries that employ this measure are: the U.S., France, Italy, Spain and Belgium. Belgium, however, only re-characterizes allowances paid to shareholders or directors. 46 This in turn triggers other consequences such as the levy of withholding taxes at the level of the distributing company. The tax rate of the withholding tax is 25% in France, 47 while the U.S. applies a 30% withholding tax on cross-border dividend distributions. 48 In Belgium, on the other hand, the rate is only 15%. 49 These rates may be reduced if double tax treaties apply. Furthermore, many of the countries that employ a specific rule on the 43 Advanced tax ruling IPPB3/ /09-2/ER, 26 August 2009 (Tax Chamber in Warsaw); Sec. 8a German CITA; Sec. 4h para 1. German ITA; Art. 10d Dutch CITA. 44 Please refer to the former sub-chapter for the explanation. 45 Art. 18, indent 4 Belgian ITC. 46 Art. 54; Art. 198, indent 10: Art. 198, indent 11 Belgian ITC; 47 Art. 119 bis 2 CGI 48 IRC 1441, Ci.RH. 233/ , 18 February 1997, Bull. Bel 1997., nr. 770, 734 and Read reference number

250 deductibility of interest also have certain regulations providing for exemption of withholding tax for dividend payments from a subsidiary to a parent company in domestic situations, such as Italy and the United States. Also, no withholding tax is levied for dividend payments to companies within the European Union if the requirements of the Parent-Subsidiary directive are met. C. Carry forward Since the consequences of non-deductibility of interest can be quite harsh, some countries allow carry forwards of the disallowed amount. With respect to specific provisions on the deductibility of interest this can only be found in Germany, Italy, and the U.S., where the interest payments not deductible in recent years can be carried forward without limitation Art. 96 Italian CITA; IRC 163. Sec. 4h para 1. German ITA; Art. 5 Dutch law on dividend tax. 43

251 EU and international issues A The compatibility of domestic legislation with the EU principle of non discrimination a. The Principle of non discrimination in the EU law: general remarks European Treaties in a series of different provisions -and ECJ case law 51 accept the existence of a principle of non discrimination in EU Law. A number of provisions in the Treaties manifest the principle of equality. Articles TFEU generally prohibit discrimination, while other Treaty articles provide for non discrimination in particular fields 52. Article 49 TFEU explicitly provides for non-discrimination based on nationality regarding establishment, while Article 55 TFEU (former Art. 294 TEC) prohibits discrimination based on nationality regarding the participation in companies capital 53. ECJ traditionally accepts that non- discrimination belongs to a series of general principles of EU Law, inspired by Member States constitutional traditions 54. The protection of art. 49 TFEU is explicitly expanded on companies according to Art. 54 TFEU (former art. 48 TEC) 55. It is well established case law that the general non-discrimination principle is among these general principles of EU law. According to this principle, similar situations shall not be treated differently unless differentiation is objectively justified and different situations shall not be treated in the same way Look for example to Second Skimmed-Milk Powder Case (ECJ HNL v Council and Commission 83/76,94/76, 4/77,15/77,40/77 [1978]) and T. Hartley, European Union law in a global context: text, cases and materials (Cambridge: CUP, 2004), 383 (discrimination between different categories of farmers); ECJ, 130/75, Prais v. Council [1976] (minority discrimination); ECJ, 21/74 Airola v Commission [1975] (sexual discrimination); ECJ, joint Cases 124/76 and 20/77,Moulins Pont à Mousson and others, [1977] (trade discrimination); ECJ, 212/97, Centros [1999] (discrimination due to the national law of establishment) 52 Look for example to art and 45.2 TFEU 53 Member States shall accord nationals of the other Member States the same treatment as their own nationals as regards participation in the capital of companies or firms within the meaning of Article 54, without prejudice to the application of the other provisions of the Treaties. 54 ECJ, Judgement of 17 December 1970, Case 11/70, Internationale Handelsgesellschaft, [1970]. 55 Companies or firms formed in accordance with the law of a Member State and having their registered office, central administration or principal place of business within the Union shall, for the purposes of this Chapter, be treated in the same way as natural persons who are nationals of Member States. "Companies or firms" means companies or firms constituted under civil or commercial law, including cooperative societies, and other legal persons governed by public or private law, save for those which are non-profit-making. 44

252 b. ECJ Lankhorst-Hohorst GmbH case and the involvement of domestic legislations The European Union Court of Justice (EUCJ) published its decision in the Lankhorst- Hohorst (C-324/00) case on 12 December The case concerned a German taxpayer, Lankhorst-Hohorst GmbH, that incurred interest expenses to a Dutch related party (grandparent) on debt in excess of the German safe haven debt-to-equity ratios. Following the disallowance of the expenses by the tax authorities, the case was referred to the ECJ to determine whether the German thin capitalization provision (KStG 8a) discriminated against foreign (EU)-owned companies in violation of the EC Treaty. The ECJ confirmed the taxpayer s position, concluding that the German thin capitalization provision indeed infringed on the EU parent entities freedom of establishment, as it was mainly targeted at foreign-owned companies. In particular, the Court stated that Article 43 EC is to be interpreted as precluding tax legislation of a Member State, which provides that repayments in respect of loan capital which a company has obtained from a shareholder, such as its parent company, with a substantial holding in its capital must, in certain cases, be regarded as a covert distribution of profits, and which applies only to repayments in respect of capital obtained from a shareholder not entitled to tax credit, where, in the large majority of cases, resident parent companies received a tax credit, whereas, as a general rule, non-resident parent companies do not. 57 Therefore, most of the Countries affected directly or indirectly by the judgment, chose either to extend their thin capitalization rules to domestic situations. Not only Germany but also other Member States, with a similar discrimination, have been obliged to change their own provisions in order to avoid an ECJ censorship. 56 (C-279/93 Schumacker, C-307/97 Saint-Gobain). 57 Such a difference in treatment between resident subsidiary companies according to the seat of their parent company makes it less attractive for companies established in other Member States to exercise freedom of establishment and they may, in consequence, refrain from acquiring, creating or maintaining a subsidiary in the State which adopts that measure and constitutes an obstacle to freedom of establishment which is, in principle, prohibited by Article 43 EC. That legislation cannot be justified by reasons linked to the risk of tax evasion, where it does not have the specific purpose of preventing wholly artificial arrangements, designed to circumvent national tax legislation, but applies generally to any situation in which the parent company has its seat, for whatever reason, outside the Member State, since such a situation does not, of itself, entail a risk of tax evasion; nor can it be justified by the need to ensure the coherence of a tax system, there being no direct link between the less favourable tax treatment suffered by the subsidiary of a non-resident parent company and any tax advantage to offset such treatment. 45

253 Germany, France and Poland, since their thin capitalization rules had a discriminatory feature, were enforced to enacted their own provision and extend the subjective scope also to resident companies. Germany and UK were directly affected by EUCJ ruling and they were obliged to repeal immediately their provisions. With regard to France, following Lankhorst-Hohorst GmbH case, the Supreme Administrative Court convicted the French thin capitalization rules on the ground of freedom of establishment. Instead of waiving the mechanism of thin capitalization, the legislator decided to treat resident companies as non resident ones. In addition, reviewed the tools to determine whether a company is over-indebted or not. As regard to Italian domestic framework, the law maker extended the subjective scope of its thin capitalization rule before its introduction in the previous regime, repealed in 2007, applied also to resident companies. Also Polish Art. 16 (7a) CITA 58 provided for a similar discriminatory treatment. Taking into consideration, that Polish TCR did not use the entitlement to tax credit as a criterion but rather a more direct one, i.e. residency of a taxpayer s parent company, the discrimination found in CITA was even more evident than the one found in its German counterpart. Thus, since the beginning of the year of Poland s accession to the European Community, i.e. 2005, Article 16(7a) has been deleted. Nevertheless, the transitional provisions found in the same statute that deleted discriminatory art. 16(7a). Art. 9 of the Act of 18 November 2004 on the Amendment of the Corporate Income Tax Act and Some Other Acts, provides that old TCR are to be applied to interest on loans granted before 1 January 2005 by the lenders who are residents of Poland. Since other Member States, as Austria, Belgium, Netherlands and Sweden, which did not have a similar interest deductibility discipline, were not affected by the ECJ ruling in question. In addition, with regard to Spanish thin capitalization rules, they were already compatible with EU principles of non discrimination and they did not introduced a form of restriction of the freedom of establishment. 46

254 c. Council Directive 2003/49/EC on interest and royalty payments made between associate companies of different Member States: general remarks The Directive was adopted on 3 June The deadline for implementation was 1 January The purpose of the directive is to put cross-border interest and royalty payments on an equal footing with domestic payments, by eliminating juridical double taxation and cash-flow disadvantages. The scheme consists of exempting interest and royalty payments from taxation at source, whether by assessment or by withholding tax, while attempting to ensure that the beneficial owner of the payments is taxed in its MS of residence or, in the case of permanent establishments (PEs), in the MS where they are situated. By taxing the beneficial owner 59 in the MS of residence in the case of PEs, in the MS where they are located it is guaranteed that such income is taxed in the same jurisdiction where the related expenditure is deductable (i.e., the cost of raising capital in the case of interest income, and research and development expenditure in the case of royalties). The compatibility of domestic framework with the Council Directive 2003/49/EC The implementation of the Directive by MS had not been same for all of them, also why the provisions of the secondary law allows MS to chose among different implementation ways. For instance, having regard to Article 5, concerning fraud and abuse, several MS appear to interpret Article 5 as authorizing the denial of relief in cases where the receiving company is controlled by a third-country resident. Moreover, Article 5 must be interpreted in the light of the relevant EUCJ anti-abuse caselaw, which requires anti-abuse measures to be appropriate and proportionate. 59 Articles 1(1), 1(4) and 1(5) of the Directive provide a definition of beneficial owner. The beneficial ownership condition aims at ensuring that relief under the Directive is not wrongfully obtained through the artificial interposition of an intermediary. While there are differences of wording between the beneficial ownership criteria for companies and PEs, respectively, the key difference lies in the reference to " income in respect of which that permanent establishment is subject to one of the taxes ". The Directive here makes explicit that the payments as such must be taxed in the hands of the beneficial owner. The MS covered by the survey have adopted different approaches in respect of the beneficial ownership criteria.(look at following paragraph). 47

255 Domestic legislation or a DTC 60 provision that denies relief on the sole grounds that the parent company is controlled by a third-country resident or by one of its own residents is unlikely to meet the proportionality test, as it does not "have the specific purpose of preventing wholly artificial arrangements". It should be recalled that the beneficial owner condition of Article 1 is specifically designed to tackle artificial conduit arrangements. It may therefore be doubted whether a company that satisfied the beneficial owner test, could be considered an artificial conduit when applying Article 5. German tax system provided for an Interest Barrier which could be considered in contrast with the context of the Article 5 (1) As mentioned above, the interest Barrier does not only intend to prevent abuses but also tends to fiscally purpose. Nevertheless the provisions of the Interest Barrier are not in proportion. Thus, the exemption clause of Article 5 (1) is not applicable relating to regulation of the Interest barrier. In the case that interest expenses (or a certain amount of them) are not deductible per se in the source State, the intended tax liberation of the Directive does not eventuate. Consequently, in particular the restrictions of interest deductibility pursuant to the Interest Barrier lead to an evasion of these regulations. The Interest barriers causes an increase of the assessment basis of companies which paid interests and thus had interest expenses what finally leads to an indirect burden for the interests Corporate Income Tax and also with DTC. In this context this mechanism does not work as a chargeable withholding tax but rather than causes a definite taxation in the course of assessment. It leads to an economical double taxation and thus counteracts the intentions of the Interest and Royalties Directive to warrant a one-time taxation within the European Union. In France the excessive interest is re-characterized as a dividend which triggers the effect of 25%withholding taxes. According to the opinion of the European Commission, however, in this case the dividend should be exempt at source due to the Dividend directive. In Belgium interest on loans paid to individual shareholders and directors are recharacterized as a dividend under certain conditions. Similar to France the resulting 60 Double Taxation Conventions 48

256 dividend is subject to a 15% withholding tax, as the tax authorities do not apply any reduced rate, such as would be the case if a participation exemption would occur. This is not a problem in the light of the Parent-Subsidiary Directive, as this article is only applicable to individual shareholders and not to legal persons. Italian and all other domestic frameworks which do not provide for a thin capitalization rules had not the interest re characterization as trouble. For instance Italian legislation allows the carrying forward of excess interest (and EDIBTDA). B.- Current domestic regimes and the recommendations of the Council June 8, 2010 Resolution Due to the great variety of legislation in the area of limitations on the deductibility of interest and because of the different treatment of debt and equity, companies might use these discrepancies. This resolution clearly expresses the interest of the European Council of showing the path to the state by proposing minimum coordination within the European Union and is willing to intervene upstream in order to restrict the possibilities of aggressive tax planning. The Council attempts to raise a form of non-binding good behavior code to be followed by the states but also by the single taxpayers. The Council recognized difficulty to strike a proper balance between the public interest of combating abuse and protecting the tax bases of Member-States and the need to avoid disproportionate restrictions on cross-border activity within the European Union. 61 The resolution deals with the enforcement of anti-abuse devices, one relating to the CFC and one relating to thin capitalization on which we focus our attention. The domestic legal frameworks dealing with interest deductibility within the EU are not all in the same position with regard to the recommendations made by the Council in this resolution. Some of them already comply with one or all of the recommendations. Others need to take further steps and make more efforts to reach this level of coordination, recommended by the Council. It provides the following three indicators in order to assess the over-indebtedness 61 Council resolution, June 8,

257 1. the level of debt to equity is excessive; 2. 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 amortization (EBITDA); 3. a comparison between the equity percentage of the company to that of the group worldwide appears to prove that the debt is excessive. 62 The above matrix shows that the determination of excessive debt between related parties for the purposes of limitation of interest deductibility in the countries studied is not always based on the criteria proposed by the resolution. While Austrian legislation does apply the arm s length principle, it does not use any debt-toequity ratio or a threshold of interest compared to EBIT or EBITDA to determine excessive debt, which does not either take into account the level of debt of the group to provide for an exception or escape clause. This system thus contains none of the three criteria recommended by the resolution for excessive interest calculation. The Belgian system does apply the arm s length principle and uses a debt-to-equity ratio as a device for the calculation of excessive interest. However, it does not use any threshold related to EBIT or EBITDA nor does it take into consideration the level of the group indebtedness. So only 62 Council resolution, June 8,