On Saturday 21 March 2020, the Luxembourg parliament passed the law implementing the Council Directive (EU) 2018/822 of 25 May 2018 ("DAC6") regarding the mandatory exchange of information in the field of taxation in relation to reportable cross-border arrangements.
As expected, the wording of the law largely resembles the wording of DAC6 and the commentaries to the draft law provide few explanations on how it will be interpreted and applied in practice. Therefore, some of the rather vague terms and concepts used in DAC6 will continue to give rise to uncertainty and will require interpretation.
The investments and business activities of Luxembourg companies often have a cross-border dimension. In these cases, the question needs to be answered whether a particular piece of advice, or involvement in implementation, is reportable. This article provides a clear and concise overview of the new mandatory disclosure regime and the mechanism that triggers reporting obligations.
What type of arrangements will need to be reported?
Under the law, EU tax intermediaries such as tax advisers, accountants and lawyers who design and/or promote tax planning schemes will have to report potentially aggressive tax planning cross-border arrangements to the tax authorities.
The term "arrangement" may also include a series of arrangements, and an arrangement may comprise of more than one step. Hence, the understanding of the term within the meaning of the law is very broad. An arrangement is considered as cross-border if it concerns either (i) more than one EU Member State, or (ii) an EU Member State and a third country.
Cross-border arrangements may be reportable if they contain at least one of the hallmarks listed in an annex to the law. These hallmarks describe characteristics or features of cross-border arrangements that might present an indication of a potential risk of tax avoidance.
Certain hallmarks must fulfil a Main Benefit Test ("MBT"). The law provides that this test will be satisfied if "it can be established that the main benefit or one of the main benefits which a person may reasonably expect to derive from an arrangement, having regard to all relevant facts and circumstances, is the obtaining of a tax advantage."
The law shall apply to all "direct" taxes of any kind levied by or on behalf of a Member State or the Member State's territorial or administrative subdivisions, including the local authorities, but also by a third country. However, this law shall not apply to value-added tax and customs duties, nor to excise duties covered by other EU legislation on administrative cooperation between Member States. This law shall also not apply to compulsory social security contributions.
What hallmarks are used to determine reportable cross-border arrangements?
Hallmarks are divided into two categories: generic and specific. Generic hallmarks target features that are common to promoted schemes, such as the requirement for confidentiality or the payment of a premium fee. Generic hallmarks can be used to capture new and innovative tax planning arrangements as well as mass-marketed transactions that promoters may easily replicate and sell to a variety of taxpayers.
Specific hallmarks are used to target known vulnerabilities in the tax system and techniques that are commonly used in tax avoidance arrangements such as the use of loss creation, leasing and income conversion schemes.
The law follows the logic of DAC6 and sets out the following five categories of hallmarks:
- general hallmarks linked to the MBT;
- specific hallmarks linked to the MBT;
- specific hallmarks related to cross-border transactions;
- specific hallmarks concerning automatic exchange of information and beneficial ownership; and
- specific hallmarks concerning transfer pricing.
Neither the law nor the commentaries to the draft law provide much explanation on the interpretation of these hallmarks. However, given that the mandatory disclosure regime (DAC6) is inspired by the Final Report on BEPS Action 12 (Mandatory Disclosure Rules) that is also referred to in the commentaries to the draft law, the guidance provided in this Report may be a useful source of interpretation.
What is the Main Benefit Test?
Many of the hallmarks set out in the annex to the law are subject to an additional threshold test. This means that many of the hallmarks only trigger a reporting obligation when an arrangement meets the MBT, reducing the risk of excessive or defensive filings. This should enhance the usefulness of the information collected because the focus will be on arrangements that have a higher probability of truly presenting a risk of tax avoidance.
As mentioned above, the MBT is fulfilled if "it can be established that the main benefit or one of the main benefits which, having regard to all relevant facts and circumstances, a person may reasonably expect to derive from an arrangement is the obtaining of a tax advantage." Hence, this test compares the value of the expected tax advantage to any other benefits likely to be obtained from the transaction.
According to the Final Report on BEPS Action 12, the MBT sets a relatively high threshold for disclosure. In practice, arrangements may not meet the MBT if the taxpayer can demonstrate that the value of any tax benefits was incidental when viewed in light of the commercial benefits of the transaction as a whole. Moreover, cross-border arrangements are generally taxpayer and transaction specific and not widely promoted as domestically marketed schemes.
It is interesting to note that DAC 6 explicitly states that the tax treatment of a cross-border payment at the level of the recipient cannot alone be a reason for concluding that an arrangement satisfies the MBT. Thus, it does not matter per se (i) if the jurisdiction of the recipient of a payment does not impose any corporate tax or imposes corporate tax at a rate of zero or almost zero or (ii) if the payment benefits from a full exemption or (iii) a preferential tax regime. Likewise, the "converting income scheme" hallmark is subject to the MBT despite investors may benefit from a full tax exemption (suggesting that a tax exemption does not, on its own, suffice for the MBT to be met).
Taxpayers are generally free to choose the option that results in the lowest tax liability including, amongst others, the choice of financing instruments (be it equity or debt) and, in an EU context, the choice of the EU Member State in which an entity is established and managed (also referred to as freedom of establishment). On the contrary, investment managers and multinationals have a fiduciary duty towards their investors to not pay more taxes than legally due (considering all applicable tax laws). Thus, the very fact that there exists an alternative that gives rise to a higher effective tax rate cannot inform the analysis of the MBT unless it can be established that the tax advantage defeats the object or purpose of the applicable tax law.
When there is a series of arrangements, the MBT should be applied in regard to the series of arrangements rather than singling out one specific arrangement. In addition, when a new arrangement is included in a series of arrangement, it should be the series of arrangements that is tested for the purposes of the MBT.
Overall, the MBT comes down to the assessment as to whether an arrangement or a series of arrangements is tax driven (i.e. targeting a tax benefit that is not ancillary to the commercial benefit) or the tax advantage is ancillary to the main benefit of generating on-going income and benefiting from value appreciation at the end of the investment (the latter can be referred to as optimising the tax position in accordance with all applicable tax laws).
Last but not least, the EU Anti-Tax Avoidance Directives ("ATAD I & II") required EU Member States to implement a number of anti-abuse rules in their domestic tax laws as from 2019 including hybrid mismatch rules, interest limitation rules, controlled foreign company ("CFC") rules, a general anti-abuse rule ("GAAR") and exit tax rules. Thus, explicit rules exist in all the areas that have been identified as critical and taxpayers can merely comply with the applicable rules rather than taking advantage of loopholes that may otherwise meet the MBT.
How are reportable cross-border arrangements determined?
When determining whether advice on a particular arrangement is reportable under the mandatory disclosure regime, it is first necessary to analyse whether the arrangement has a cross-border dimension, and then whether one of the hallmarks is present.
When at least one of the hallmarks is fulfilled, it is necessary to verify whether the hallmark is subject to the MBT. If this is not the case, there is an automatic reporting obligation under the mandatory disclosure regime. When the hallmark is subject to the MBT, it is necessary to perform a comprehensive analysis of all relevant facts and circumstances in order to determine whether the main benefit or one of the main benefits was the obtaining of a tax advantage.
Given that many of the hallmarks and the application of the MBT require a good understanding of international tax law and some kind of judgement, the analysis of potential reporting obligations under the mandatory disclosure regime is generally not the role of a person with a risk management profile but requires the involvement of a person with a tax background.
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