Object exemption for foreign business profits

Transcription

1 Genoteerd December Edition 90 Object exemption for foreign business profits Corporate entrepreneurs who invest abroad can do so via a subsidiary company (a participation) or in the form of a branch of the Dutch head office (a permanent establishment). With effect from 1 January 2012 the legislator has changed the tax treatment of foreign permanent establishments by introducing a complete exemption for foreign business profits (the object exemption ). The object exemption also applies to foreign real estate and a few other categories of foreign income. As a consequence of the object exemption, entities which are subject to corporation tax can no longer deduct losses from their foreign businesses from their worldwide profits. For entrepreneurs who are subject to income tax, the tax treatment of foreign business profits and losses has remained unchanged. This issue of Genoteerd considers the rules for the object exemption in more detail. Because the change in the law was intended to reduce the difference between the tax treatment of permanent establishments and participations, it will also briefly describe the changes that still remain between permanent establishments and participations following the introduction of the object exemption. Share the Expertise

2 In this edition The object exemption General The exempt income categories Exception for low taxed foreign investment businesses Deduction of termination losses European law Transitional rules Introduction Clawback rule Stalled profits Termination losses Differences between permanent establishments and participations Summary 2

3 1. The object exemption 1.1 General Business profits are normally taxed in the country in which the business activities are carried out. For this reason the Netherlands has a rule to prevent the double taxation of business profits that are realised outside the Netherlands. Until 1 January 2012 this rule took the form of a reduction of corporation tax to the extent that this tax related to foreign business profits. This effectively meant that foreign business losses were deductible from the Dutch tax base, while foreign business profits were exempt. Incidentally, the exemption only applied to the extent that the relevant profits exceeded the foreign business losses which had previously been deducted from the Dutch basis (the clawback rule). That system has been changed by the introduction of the object exemption. The object exemption has been included in articles 15e to 15j of the Corporation Tax Act 1969 ( CTA ). As mentioned, the object exemption does not apply to entrepreneurs who are individuals. The amended system for corporation tax is as follows. First the worldwide profit of the taxpayer company is determined. For taxpayers which gain profits in other countries, the worldwide profit is then reduced by the positive and negative amounts of the profit from that other country. The exemption for foreign business profits is thus maintained, but there is no longer a deduction for foreign business losses (because the Dutch tax base is increased by the foreign losses). Although the method of preventing foreign losses has been changed, there was no intention to make any changes to the principles of profit allocation. This means that the permanent establishment profits to be exempted are determined in the local currency, so currency translation profits and losses are in principle reflected at the level of the head office. Also, a transfer of business assets with hidden reserves from the head office to the permanent establishment will not result in an immediate realisation of profit. The profit is realised gradually, because the foreign profits to be exempted in the future will be lower. The reason for this is that the foreign profit is determined on the basis of the higher market value of the business asset, which results in high depreciation, whereas the worldwide profits continue to be determined on the basis of the (lower) book value. A fiscal investment institution (FII) under article 28 CTA cannot make use of the object exemption. Excluding FIIs from the object exemption has ensured that the distribution requirement for FIIs also applies to their foreign business profits. 1.2 The exempt income categories The exempt object (the foreign profit) is separately regulated for treaty countries 1 and non-treaty countries. For profits realised in a treaty country, the object exemption applies to the total of: (i) the profit attributable to permanent establishments; (ii) net income from real estate: and (iii) other net income. For each of these categories, the object exemption only applies if and to the extent that the Netherlands is required to grant an exemption to prevent double taxation under the treaty or other applicable arrangement. If these requirements are not met, the object exemption does not apply and the profit or loss is not eliminated from the Dutch company s worldwide profit. The object exemption is applied separately for each treaty country (the per-country method). For non-treaty countries, the object exemption is applied to the total of: (i) the profit derived from a foreign business, i.e. a business/part of a business which is carried on through a permanent establishment; (ii) net income from real estate; (iii) net income from rights over shares in the profits of a company whose management is based in the other country, to the extent that these rights are not derived from holdings of securities; and (iv) activities which are carried on for a continuous period of at least 30 days in, on or above the territory of the other country. For non-treaty 1 Strictly speaking this relates not only to treaties in force, but also to other arrangements which provide for the allocation of elements of income, in particular the Tax Regulations for the Kingdom of the Netherlands and the Tax Regulations for the country of the Netherlands. 3

4 countries, a definition of permanent establishment has been included in article 15f CTA. This definition is based on article 5 of the OECD Model Treaty. In contrast to the pre-2012 rules, it is no longer a requirement in non-treaty situations that the taxpayer must be subject to a tax on its profits in the other country. Article 15e CTA makes one exception to this, i.e. for income from the operation of ships or aircraft in international traffic. Such income only falls under the object exemption if the profits are subject to tax in the country of the permanent establishment. 1.3 Exception for low-taxed foreign investment businesses The object exemption does not apply to low-taxed foreign investment businesses (LFIBs) unless the Netherlands is required to grant an exemption from tax under the applicable tax treaty. An LFIB will exist if: (i) the activities of the foreign business consist mainly of portfolio investing, group financing or putting business assets at the disposal of the group (passive activities); and (ii) the profit from the foreign business is not subject to a tax on profits which is reasonable by Dutch standards (low taxed). For the purpose of determining whether activities are passive, the activities of participations of 5% or more which are attributable to the foreign business must be included on a pro rata basis. The following are not regarded as passive activities: (i) active financing or actively putting business assets at the disposal of the group; and (ii) holding real estate. Whether or not these activities are active has to be established in accordance with the rules in articles 2a and 2b of the Corporation Tax Implementation Decree 1971, which have been declared to be of corresponding application to LFIBs. A foreign investment business is low-taxed if a low nominal tax rate, whether or not in combination with significant differences from the Dutch tax base, results in an effective foreign tax on profits of less than 10%. Where the object exemption does not apply to an LFIB, then a fixed credit is given. For the purposes of the fixed credit, a distinction has to be drawn between positive and negative permanent establishment profits. If the foreign profit is a positive amount, a fixed credit is given of 5% of the total foreign passive business profits. The credit is therefore applied on an overall basis. If the foreign tax actually due is more than 5%, the higher amount can be credited. The credit is limited to the attributable Dutch corporation tax and can never be more than the corporation tax due. If the foreign business profit is a negative amount, the taxpayer s profit is reduced by an amount equal to 5/25ths of the total foreign business losses. This effectively means that a passive foreign business loss can be deducted at a rate of 20%. 1.4 Deduction of termination losses Unlike normal annual losses, a loss arising on the termination of a permanent establishment is in certain circumstances deductible. The rule for termination losses applies if the taxpayer ceases to earn profits in another country. A termination loss will arise if the net exempt amounts under the object exemption from a particular country total a negative amount. It is therefore not only losses realised at the time of the termination that are relevant; losses from earlier years can also qualify to be offset against the worldwide profit. This negative amount is reduced by the following two amounts: (i) amounts for which relief has been granted in the other country to the taxpayer or an affiliated entity; and (ii) amounts for which a person other than the taxpayer or an affiliated entity has received relief in the other country. Examples of such reliefs mentioned by the legislator 2 are a credit for the net losses against the profits of a sister company in the other country and a transfer of the losses of the permanent establishment on the sale of that permanent establishment to a third party, respectively. 2 Parliamentary documents II 2011/12, , no 3, pp (Explanatory Memorandum). 4

5 The termination loss is deductible at the date on which the taxpayer ceases to earn profits in the other country, provided that the taxpayer s activities in the other country have not been/are not continued to a significant extent within the group. If the activities are/have been continued within the group, then the net positive and negative amounts of profit from the other country which have been exempted under the object exemption are transferred to the entity affiliated with the taxpayer. In order to prevent taxpayers from transferring a foreign business to an affiliated entity with sufficient profit capacity with a termination in view, an anti-avoidance rule has been included to the effect that net termination losses will not be transferred where there is a continuation with a termination of the foreign business in view. A continuation with a termination in view is deemed to occur where the continued activities are terminated within three years after the start of the continuation, unless the affiliated entity shows that the termination was motivated by business reasons which arose after the start of the continuation. A termination loss which has been deducted will be clawed back if the taxpayer starts receiving profits from the relevant country again within three years. The object exemption is applied to the net balance of positive and negative business profits from a particular country. This balancing can have a negative effect on the termination loss rule. This is because losses from a foreign business cannot be deducted under the termination loss rule if they have already been balanced with positive foreign profits from other businesses in the same country. This balancing can be avoided either by not having separate permanent establishments held by the same taxpayer or by partly transferring profitable foreign activities to subsidiary companies. In the latter case it will of course be necessary to take into account the possibility that a tax charge will be triggered in the country where the permanent establishment is situated. 1.5 European law The object exemption does not appear to give rise to any conflict with European law. It can be inferred from case law of the European Court of Justice (ECJ) that importing losses from a permanent establishment does not have to be allowed as long as the losses can still be used at the level of the permanent establishment. The inability to offset losses that have become permanent could in principle give rise to a conflict with European law. Since the rules also provide that losses which are permanently not deductible in the country where the permanent establishment is situated can indeed be deducted, the rules however appear to be EU-proof on this point. Currency translation losses which are not reflected in the country of the permanent establishment also continue to be deductible at the level of the head office. In addition, business assets can be transferred from the head office to the permanent establishment without triggering an immediate tax charge on any hidden reserves. The new rules appear to be EU-proof on these points as well Transitional rules 2.1 Introduction The new rules for the object exemption include some detailed transitional rules. These transitional rules relate in particular to the clawback of losses, stalled profits and termination losses. These elements of the transitional rules are covered in this section. 2.2 Clawback rule Until 2012 there was a clawback rule for foreign business losses that had been deducted against Dutch profits. Foreign business profits were only exempt to the extent that they exceeded these deducted losses. In the absence of a transitional rule, earlier losses would have been deducted from the Dutch tax base, but later foreign profits would be unconditionally exempt under the object exemption. In order to counteract 3 See in particular the judgements ECJ 15 May 2008, nr C-414/06 (Lidl Belgium), ECJ 28 February 2008, no C-293/06 (Deutsche Shell) and ECJ 29 November 2011, no C-737/10 (National Grid Indus). 5

6 this imbalance, the clawback rule has been continued from 2012 under the transitional rules. These rules provide that the object exemption does not apply until any losses deducted in the past have been clawed back. There will not be a clawback: (i) to the extent that the relevant loss has already been taken into account as a consequence of the conversion of a permanent establishment into a participation; (ii) the taxpayer shows that the relevant loss is part of an offsettable loss which have expired because the loss compensation term has been exceeded; or (iii) if the foreign business has since been terminated and the taxpayer could have taken a termination loss under the new rules, taking into account the three-year clawback period. The following should be noted in relation to point (i) above. Under the pre-2012 regime there was an anti-avoidance rule under which losses also had to be clawed back if the foreign business had been converted into a participation to which the participation exemption applied. This anti-avoidance rule has also been continued under the transitional rules. If a foreign business has been transferred to a participation, then the participation exemption does not apply to positive income from that participation up to the amount of the losses from that foreign business which have been deducted from the Dutch profits of the taxpayer or an entity affiliated with the taxpayer. For LFIBs, any offsettable amounts carried forward before the end of 2011 are offset immediately so far as possible and losses are clawed back before any credit is given for new profits. Here again a clawback is no longer necessary if the clawback has effectively already occurred or if the losses are part of the offsettable losses which have expired because the loss compensation term has been exceeded. 2.3 Stalled profits Under the pre-2012 rules, foreign profits which could not be exempted before the end of 2011 because no attributable Dutch corporation tax was due against which the foreign profit could be offset, were stalled to be used in a later year. These stalled foreign profits can still be used for the elimination of double taxation via the exemption method in 2012 and subsequent years. 2.4 Termination losses The calculation of a termination loss as described in section 1.4 only relates to foreign profits and losses which have been generated from the year 2012 onwards. The transitional rules deviate from this in relation to positive profits that have been generated in the last five years before the object exemption came into force. These profits must be taken into account in determining the termination loss, unless they have already been offset against a loss from the same country in another year. 3. Differences between permanent establishments and participations The introduction of the object exemption has removed the most important difference in tax treatment between permanent establishments and participations. Under the pre-2012 rules losses of a foreign permanent establishment could be deducted against Dutch profits immediately, whereas losses of a participation were eligible for a deduction only on the liquidation of a participation and subject to strict conditions. The object exemption ensures that losses of foreign businesses can no longer be deducted immediately, but only on the termination of the relevant business (see section 2.4). The rules for termination losses are modelled on the rules for liquidation losses under the participation exemption, except that the rules for termination losses are linked to the losses of the permanent establishment that have not been offset, whereas the rules for liquidation losses are linked to the loss suffered by the investing parent company. In addition, the object exemption in principle does not apply to low-taxed passive income, while the participation exemption in principle also does not apply to low-taxed passive subsidiaries. 6

7 Nevertheless, there are still a few important differences between the tax treatment of permanent establishments and the tax treatment of participations. The main differences are listed below. A termination loss still has to be added to the profit if the taxpayer starts earning profits from the other country again within three years after the termination loss has been deducted. The rules for liquidation losses for participations do not include such a recapture. Profits from another country have to be determined in the local currency, so that currency translation gains and losses are in principle enjoyed/suffered by the Dutch head office. However, currency gains and losses which relate to participations are exempt/nondeductible under the participation exemption. 4 Transfers of business assets from the head office to the permanent establishment do not trigger an immediate tax charge on any surplus value in the transferred assets. A transfer between a parent company and a participation in principle results in a tax charge on any surplus value realised on the transfer. 4. Summary The introduction of the object exemption has created convergence between the tax treatment of permanent establishments and participations. Its introduction effectively means that foreign losses can no longer be deducted against worldwide profits, but that currency translation profits and losses still have an impact on worldwide profits and that assets can still be transferred between a head office and a permanent establishment without an immediate tax charge. If the foreign business is terminated, the net losses that have been exempted in the past can still be deducted from worldwide profits. 4 In Genoteerd no 72 (September/October 2009) section 4, we discussed the possibility that currency losses on participations might nevertheless be eligible to be offset against profits on the basis of European law. In order to restrict this, the legislator introduced the Currency results on participations interim rules (article 28b CTA) with effect from 8 April These rules provide that currency profits on participations are taxable for taxpayers who have deducted a currency loss on participations from their profits. 7

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