United States: World Tax Advisor - July/Aug 05

After years of political deliberation, contentious debate and practical obstacles, the EU Savings Directive (Directive), adopted in 2003, finally takes effect on 1 July 2005. As from that date, the 25 EU Member States, five non-EU countries and 10 dependent and associated territories will apply "equivalent" measures on savings income. Although the legal scope of the Directive does not extend beyond EU borders, its implementation will, in fact, affect those other countries and territories that have agreed to introduce "equivalent measures."

The Directive is the culmination of efforts by EU Member States to improve transparency and find a mechanism enabling them to effectively tax the savings income of their residents that is derived from other Member States or offshore financial centers. These goals were thought to be best achieved through the automatic exchange of information between the tax authorities of the Member States (and, as noted below, between the Member States and certain other key jurisdictions), or, in some instances, the imposition of a temporary withholding tax.

Although originally scheduled to take effect 1 January 2005, implementation of the Directive was postponed to allow Switzerland and other territories cooperating with the EU adequate time to transpose the legislation into their domestic law. The European Council concluded on 7 June 2005 that all formalities and conditions necessary for the Directive to enter into effect have been satisfied.

The basic premise of the Directive is that EU Member States will automatically exchange financial information with each other about EU individual customers who earn savings income in one Member State but reside in another Member State. However, under transitional provisions, certain Member States (Austria, Belgium and Luxembourg) are permitted to operate a temporary withholding tax regime rather than information reporting. To prevent an exodus of capital from EU Member States to offshore accounts, it was agreed that certain non-EU jurisdictions and dependent and associated territories would need to adopt a system of information reporting or impose a withholding tax during the transition period for the Directive to become applicable. The third countries are Andorra, Liechtenstein, Monaco, San Marino and Switzerland. Additionally, three U.K. dependent territories (i.e. Guernsey, Jersey and Isle of Man), five British Caribbean territories (i.e. Anguilla, British Virgin Islands, Cayman Islands, Montserrat and Turks & Caicos Islands) and two Dutch Caribbean territories (i.e. Aruba and Netherlands Antilles) will apply equivalent measures.

The Directive requires Member States to introduce an information collection and sharing regime with respect to interest payments, to ensure that, as a minimum, the beneficiary of the interest will be taxed on that income by his/ her home state of residence. The Directive applies only to the savings income of individuals, not companies (although it may apply to other types of entities), and only applies in the context of cross-border payments of interest. For example, individuals resident in the U.K. will be subject to the information reporting (or withholding) rules in other Member States (or other participating jurisdictions) and individuals resident outside the U.K. will be subject to the U.K. information reporting rules. Notably, the Directive, as such, does not affect domestic regimes for taxation of such income (in other words, in internal situations, Member States may still apply domestic withholding taxes).

Savings income for purposes of the Directive comprises "debt claims," essentially interest earned on bank deposits, corporate and government bonds and income from certain types of investment funds. Grandfather provisions are included for certain types of bonds in existence when the Directive enters into effect; until 31 December 2010, interest on bonds and other negotiable debt securities issued before 1 March 2001 or on which the prospectus had been authorized before that date, will not be deemed to be a "debt claim" for purposes of the Directive.

With effect from 1 July 2005, EU Member States must require any "paying agent" (broadly defined as any economic operator that pays interest for the immediate benefit of the beneficial owner) established in their country to obtain certain information relating to the beneficial owner. The Directive specifies the minimum amount of information that must be reported by the paying agent to the tax authorities of its country of residence. That information must include, inter alia, the identity and residence (determined according to rules set forth in the Directive) of the beneficial owner and the amount of interest paid. The tax authorities will then provide this information (at least annually) to the tax authorities of the state of residence of the beneficial owner.

The Directive specifies that the country of residence is considered to be the country in which the beneficiary has his/her permanent address. An individual’s permanent address will be determined by the following rules: 

• For contractual relationships entered into before 1 January 2004, the paying agent must use the information already at the agent’s disposal, in particular, information collected under the EU Anti-Money Laundering Directive;

• For contractual relationships entered into on or after 1 January 2004, in most cases, the paying agent will use the address on the individual’s passport or official identity card, although, if this address is not the country that issued the passport/ID card or the residence state of the paying agent, the country of residence will be deemed to be the country that issued the passport unless a tax residence certificate is provided by the authorities in that country to verify the third country address.

The following EU Member States will implement an information sharing regime: Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Malta, Netherlands, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden and the U.K.

Austria, Belgium and Luxembourg instead will impose a withholding tax on interest income for a transition period during which these countries are not required to exchange information obtained from paying agents in their jurisdictions with other Member States, although they may receive such information. Further, the imposition of withholding tax in the source state will not preclude the residence state of the beneficial owner from taxing such income.

The transition provisions aim to protect the banking sectors from competitive disadvantage compared to the non-EU states and territories that will not be required to exchange information due to banking secrecy laws.

The withholding tax, which is levied in addition to any domestic withholding tax, will apply at the following rates:

• 15% for the first three years (to 30 June 2008);

• 20% for the next three years (to 30 June 2011); and

• 35% thereafter until the end of the transition period.

The transition period will terminate when Switzerland, Liechtenstein, Monaco, San Marino and Andorra all have agreed to, and the U.S. commits to, the exchange of information upon request with the EU in line with the 2002 OECD Model Agreement on Exchange of Information on Tax Matters with respect to interest payments. Once the transition period ends, Austria, Belgium and Luxembourg will be required to introduce an automatic reporting system and cease to apply withholding.

The proceeds from the withholding regime will be shared with the countries where the beneficial owners are resident: 25% will be retained by the authorities in the country of the paying agent and 75% will be provided to the authorities of the residence country of the beneficiary. Countries that use the withholding tax regime are required to offer at least one of two alternatives to withholding:

• Beneficial owners of the interest can request that the information sharing regime be used rather than withholding, so that information about their identity, residence and interest income is disclosed to the authorities in their state of residence; or

• Beneficial owners can provide the paying agent with a certificate from the state of tax residence confirming that the residence state tax authorities are aware of the individual and the debt claim that gives rise to the interest.

The withholding tax may be credited against liabilities in the state where the individual is resident. If it exceeds the tax due, it is repayable by the Member State where the individual is resident.

To inhibit capital flight from the EU, the application of the Directive depends on the five jurisdictions (i.e. Switzerland, Liechtenstein, San Marino, Monaco and Andorra), as well as the above mentioned dependent and associated territories implementing equivalent information sharing or withholding systems. After protracted negotiations, this has now taken place. Most of these jurisdictions will impose a withholding tax at the same rates and for the same time period as withholding tax imposed by Austria, Belgium and Luxembourg. Revenue will be shared in the same manner as well. 

The following jurisdictions will impose a withholding tax on interest payments: Andorra, British Virgin Islands, Guernsey, Isle of Man, Jersey, Liechtenstein, Monaco, Netherlands Antilles, San Marino, Switzerland and Turks and Caicos. Anguilla, Aruba, Cayman Islands and Montserrat, on the other hand, have opted for information sharing.

In the case of Switzerland, the savings tax agreement negotiated with the EU was accompanied by a memorandum of understanding. In addition to an analogous withholding tax regime, disclosure and revenue sharing, the agreement also provides for the application of measures equivalent to certain principles in the EC Parent-Subsidiary and Interest and Royalties Directives. Dividends, interest and royalty payments between associated limited companies resident in Switzerland and in an EU Member State, which are linked through a 25% shareholding held for at least two years, can be made free of withholding taxes. These rules also enter into effect 1 July 2005.

The application of the EC-Switzerland agreement is subject to conditions that are similar, but not equal to, the conditions in the (Savings) Directive. Interestingly, one of these conditions is that the U.S. apply measures that conform, or that are equivalent, to those in the Directive or the Swiss agreement, whereas in the Directive, only the move from the transitional withholding regime to a definitive exchange of information depends on the U.S. position. The Swiss tax authorities confirmed in late June 2005 that they would apply the EC-Switzerland agreement as from 1 July 2005.

For individuals resident in an EU Member State, the impact of the Directive is generally straightforward: information about their accounts in other Member States (or in one of the third countries or dependent territories) will be disclosed to the tax authorities in their country of residence, or a withholding tax will be imposed. Individuals resident outside the EU (e.g. residents of Switzerland or one of the other dependent territories) will not be subject to the information exchange or withholding but they will need the paying agent to confirm the beneficial owner’s residence to ensure they do not need to share information or withhold tax. Paying agents likely will have such information readily available to make this determination.

Issues may arise, however, where EU nationals reside outside the EU; for example, assume a Dutch resident, holding an EU passport, is working and living in the U.S. and holding a "green card." If the individual has a bank account in the Netherlands Antilles, he may be affected by the Directive, even though interest income from the bank account would be taxable in the U.S. The Antilles bank would need to use the residence rules in the Directive to determine the individual’s residence for purposes of the Directive. If the contractual relationship began after 1 January 2004, residence could be presumed by default to be the Netherlands, as that is where the passport was issued. Thus, to prevent withholding in the Netherlands Antilles, the individual would need to have the U.S. Internal Revenue Service issue a tax residence certificate verifying his U.S. residence. It will, therefore, be important for EU nationals living outside the EU to be aware of this potential unexpected effect of the Directive.

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Impact of 1 July 2005 on Payments Between Associated Enterprises in Switzerland and the EU Member States

Adopted in 2003, the EU Savings Directive (Directive) originally was intended to apply as from 1 January 2005. Because this date was conditioned on the EU concluding "equivalent" agreements with five non-EU member states and a number of EU dependent or associated territories and those agreements were still under negotiation in 2004, the Council postponed application of the Directive to 1 July 2005.

One of the non-EU jurisdictions required to reach an agreement with the European Community was Switzerland, but it was only after protracted negotiations that the two signed an "equivalent measures" agreement on 26 October 2004. That agreement also enters into force on 1 July 2005. As noted below, the agreement with Switzerland has implications beyond just the Directive, as the agreement includes certain benefits granted under the EC Parent-Subsidiary and Interest and Royalty Directives to Switzerland. 

As the European Council has now secured commitments and guarantees from all the non-EU member states and the dependent and associated territories, and the (Savings) Directive applies as of 1 July 2005, it is appropriate to summarize the implications for associated enterprises within the EU and Switzerland in respect of dividends, interest and royalties.

The EC Interest and Royalty Directive allows cross-border payments of interest and royalties to be made between associated enterprises of the EU Member States without application of withholding tax in the source country. Although the Directive has been generally applicable since 1 January 2004, a number of Member States are permitted to apply transition rules that partially depend on the application of the Directive. With a 1 July 2005 date of first application for the Directive, the transition periods for interest and royalty payments can be summarized as follows:

• For Greece, Latvia, Poland and Portugal, an eight-year transition period starts on 1 July 2005 and ends on 30 June 2013; during the first four years (i.e. until 30 June 2009), interest and royalties may be subject to a 10% withholding tax, which is reduced to 5% for the last four years.

• For Lithuania, a six-year transition period starts on 1 July 2005. Lithuania may apply a 10% withholding tax on royalties for the entire six years (until 30 June 2011), but the 10% withholding tax on interest must be reduced to 5% after 30 June 2009.

• For the Czech Republic and Spain, a six-year transition period starts on 1 July 2005. The two countries must apply the Directive fully in respect of interest but they may levy a 10% withholding tax on royalty payments until 30 June 2011.

• The Slovak Republic may continue to levy withholding tax on royalties until 30 April 2006.

Withholding tax levied during the transition periods by one of the above countries must be credited at the level of the recipient. Any double tax treaties between the respective Member States that provide for more favorable tax treatment of interest and royalties in the source state will take precedence over the transition provisions in the Interest and Royalty Directive.

The agreement between Switzerland and the EU introduces measures equivalent to the (Savings) Directive; Switzerland will operate a withholding tax system applicable to interest payments made to individuals resident in EU Member States. The agreement also secures certain benefits of the Parent-Subsidiary and Interest and Royalty Directives for Switzerland, in that it abolishes withholding taxes on dividend, interest and royalty payments between affiliated enterprises resident in an EU Member State and the Swiss Confederation provided certain requirements are met. 

The agreement contains a number of transition arrangements:

• With respect to dividends, Estonia may, for as long as it charges income tax on distributed profits without taxing undistributed profits, and at the latest until 31 December 2005, continue to apply tax on distributions by Estonian subsidiaries to their Swiss parent companies;

• The EU Member States that are entitled to apply transition measures (as noted above) may continue to levy withholding tax on interest and royalties paid to associated companies in Switzerland to the same extent outlined above;

• Any existing double tax treaties between Switzerland and EU Member States that provide for more favorable tax treatment of dividends, interest and royalties are unaffected by the agreement; and

• Between Switzerland and Spain, both countries may apply withholding tax on dividend, interest and royalty payments made to companies resident in the other country until the countries amend their tax treaty to include a tax information exchange agreement relating to administrative, civil or criminal cases of tax fraud. After that date, Spain will continue to benefit from the transition period with respect to royalties.

In addition to having to take account of the various transition rules, the tax administrations of a number of Member States are expected to cause further delays to application of the provisions in the Switzerland-EU agreement because of uncertainties as to whether the tax authorities should follow their domestic tax law or EU law. Although agreements concluded by the European Community with third-party countries must be regarded as directly applicable when taking into account the wording, purpose and nature of the agreement, the provisions in the Switzerland-EU agreement contain a clear and precise obligation that is not subject to the adoption of any subsequent measure in its implementation or effects. Nevertheless, national tax authorities likely will seek to apply their national rules and the provisions of relevant tax treaties for dividend, interest and royalty payments made by companies resident in their country to associated companies resident in Switzerland. It is hoped, however, that, in these cases, negotiations with the tax authorities in the source state will help to prevent lengthy litigation that might otherwise ultimately be referred to the European Court of Justice.

To comply with EC law, Belgium recently introduced changes to the dividends received deduction and issued a Royal Decree to implement amendments to the EC Parent-Subsidiary Directive. The bill implementing the changes to the dividends received deduction was published in the Belgian Official Gazette on 31 May 2005.

Belgium grants a dividends received deduction for qualifying companies, under which 95% of net dividends received are exempt from tax. Previously, the dividends received deduction did not apply to the extent the recipient company incurred certain disallowed items (e.g. interest expense, nondeductible fines and all business expenses that unreasonably exceeded the professional needs of the company). According to the European Commission, this limitation on the application of the dividends received deduction infringes the EC Parent-Subsidiary Directive.

Under the new law, the dividends received deduction can be offset against all disallowed items, provided:

• The dividends are paid by subsidiaries located in the EU; and

• The distributing company is a subsidiary as defined in the Parent- Subsidiary Directive. That is, the subsidiary must have one of the legal forms listed in the Directive (see below) and the minimum participation requirement must be met.

This amendment applies retroactively from tax year 2005 (accounting years ended on 31 December 2004 or later).

The Royal Decree implementing the EC Directive of 22 December 2003, which amends the Parent-Subsidiary Directive, provides for a phased in reduction of the minimum participation in a subsidiary required for the withholding tax exemption on dividends to be applicable. The Decree provides that the minimum shareholding is reduced to 20% for dividends paid or attributed as from 1 January 2005. The holding requirement will be further reduced to 15% as from 1 January 2007 and 10% as from 1 January 2009. The minimum holding period of one year remains intact.

The amendments to the Directive expanded the list of corporate entities to which the Parent-Subsidiary Directive applies. However, as the list now basically includes all Belgian legal entities that are subject to corporate income tax, no changes were required to Belgian tax law.

The implementing measures apply retroactively as from 1 January 2005.

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Parliament Approves Bill on Notional Interest Deduction

The bill implementing the notional interest deduction for companies was adopted by the Belgian Parliament on 2 June 2005 and now awaits publication in the Belgian Official Gazette.

Under the notional interest deduction, a company will be able to take a deduction from its taxable profits that approximate the interest it would have paid in the case of debt financing. The regime will apply to all Belgian companies and to Belgian establishments of foreign companies, regardless of their size. The notional interest deduction is expected to preserve and reinforce the attractiveness of Belgium as a favorable location for treasury centers and for capital-intensive investments in general.

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Czech Republic

The Czech government recently approved amendments to the Income Tax Act (ITA) that would introduce important changes to the corporate tax rules. If approved by the Czech Parliament, the changes are expected to take effect 1 January 2006.

The proposals would introduce a binding ruling procedure for transactions with related parties, under which a taxpayer would be able to obtain certainty from the authorities regarding the method of determining prices in such transactions. To qualify for a binding ruling, the taxpayer would be required to submit certain documents with the ruling application.

Changes to the ITA in 2003 extended the thin capitalization rules (e.g. to sister companies), originally with effect from 1 January 2005. Subsequent amendments to the ITA included transition rules whereby interest from credits and loans paid under agreements concluded before 1 January 2004 would not be affected by the extensions to the thin capitalization rules. Under the proposal, an amendment to a pre-2004 agreement would bring the related interest from credits and loans within the scope of the thin capitalization rules for tax periods beginning in 2005.

The ITA currently treats derivatives for hedging and trading purposes differently, making it difficult to determine which derivatives are deemed to be for trading purposes and which are hedging for tax purposes. Under the current rules, it is possible to treat derivatives as hedging for tax purposes, even if they are treated as trading for accounting purposes. In addition, the Ministry of Finance has issued various (and inconsistent) interpretations of the ITA provisions relating to unrealized foreign exchange gains and losses from securities or derivatives. The proposed amendments would require that the tax treatment of securities and derivatives be derived solely from their accounting treatment, so that no further modifications would be made for corporate income tax purposes. Additionally, the tax base determination procedure likely would be simplified.

The proposal would implement amendments to the EC Merger and the Parent-Subsidiary Directives. With respect to the Merger Directive, the changes relating to the transfer of the registered office of a European company and a European cooperative society, among others, would be implemented into Czech law. For the Parent-Subsidiary Directive, prior amendments to Czech law reduced the minimum holding in a subsidiary to benefit from the qualified participation rules (to 20% as of 1 January 2005, 15% as of 1 January 2007 and 10% as of 1 January 2009). Under the current proposal, the threshold will fall to 10% as from 1 January 2006 and the minimum holding period will be reduced from 24 to 12 months.

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Denmark

Recent changes to Danish corporate tax rules have been harshly criticized for a lack of conformity with EC tax law. Specifically, critics argue that the new rules on tax consolidation and the move to a territorial system of taxation for companies violate the freedom of establishment, free movement of capital and free movement of goods principles in the EC Treaty. These infringements can be challenged on the basis of European Court of Justice case law.

Various aspects of the mandatory national tax consolidation regime appear to infringe EC law:

• The mandatory national tax consolidation deems a permanent establishment (PE) or subsidiary in Denmark of a foreign group to be an establishment subject to Danish tax consolidation. A deemed tax consolidation constitutes a restriction of the fundamental freedoms of the EC Treaty.

• The different treatment of intercompany transfers (requiring new entry values only if it is a transfer between a foreign PE/foreign head office to a Danish head office/PE) constitutes indirect discrimination and a restriction incompatible with the fundamental freedoms of the EC Treaty. A claim also may be made that the different treatment conflicts with the antidiscrimination provisions in several of Denmark’s tax treaties.

• Exit taxation will be triggered if an intercompany transfer of assets and liabilities is carried out between a Danish company and a foreign PE or a foreign head office of a nonresident company but not where the same intercompany transfer is carried out between domestic entities or if international tax consolidation is elected. This disparity in treatment conflicts with the EC freedoms.

The new rules on international tax consolidation are economically and administratively burdensome with a view to effectively abolishing crossborder group consolidation and encouraging investment in Denmark rather than in another EU Member State. These rules can be challenged in general with reference to EU Member States’ obligation to refrain from introducing measures that could jeopardize the attainment of the objectives of the EC Treaty.

• The full recapture of foreign losses set off against Danish taxable profits upon the ultimate parent’s termination of the election gives rise to different treatment of domestic and foreign losses and may be challenged as indirect discrimination and a restriction in conflict with the fundamental freedoms of the EC Treaty.

• If international tax consolidation terminates, and assets and liabilities are no longer subject to Danish taxation, an intercompany transfer of assets and liabilities between foreign PEs or head offices will trigger Danish exit taxation. The transferred assets and liabilities will be deemed to be sold at fair market value at the time international tax consolidation terminates. The deemed sale gives rise to different treatment of intercompany transfers and may be challenged as indirect discrimination and a restriction in conflict with the fundamental freedoms of the EC Treaty as well as the antidiscrimination provisions in several other Danish tax treaties.

A Danish company will be fully exempt from tax on profits and losses of a foreign PE and/or foreign real estate, but cannot deduct related losses unless an election has been made for international tax consolidation. The lack of possibilities to deduct such losses incurred constitutes indirect discrimination and a restriction inconsistent with the fundamental freedoms of the EC Treaty.

Both the Danish Ministry of Taxation and the Ministry of Justice are of the opinion that any potential conflict created by the new rules is justified by the need to protect infringement of national measures, including the need to ensure coherence of the tax system.

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European Union

In an opinion issued 30 June 2005, European Court of Justice (ECJ) Advocate General (AG) Léger concluded that the deemed residence rule under the Dutch Inheritance Tax Law is compatible with the free movement of capital principle in article 56 (former article 73B) of the EC Treaty (Van Hilten-van der Heijden, Case C-513/03).

According to the 1956 Inheritance Tax Law, an inheritance is taxed in the Netherlands if the deceased lived in the Netherlands at the time of his death. If a Dutch national moves abroad but dies within 10 years of having left the Netherlands (while retaining Dutch nationality), he will be deemed to have retained his residence in the Netherlands for Dutch tax purposes. This deemed residence rule does not apply in the case of non-Dutch nationals. Inheritance tax is levied on the value of all assets acquired by inheritance from a Dutch resident.

Dutch national law also provides rules to mitigate double taxation in cases where inheritance tax is levied abroad. Under these rules, Dutch tax is reduced up to a maximum of the inheritance tax levied abroad.

The Netherlands concluded an estate tax treaty with Switzerland in 1969, which was relevant to the facts of the van Hilten-van der Heiden case. The treaty allocates the right to levy inheritance tax on immovable property to the state where the property is situated. Other property may be taxed only by the state in which the deceased had his last place of residence. The treaty includes the fiction that allows the Netherlands to levy inheritance tax in the case of a person who was Dutch resident in the preceding 10 years but who dies in Switzerland. The Netherlands grants a tax credit for any inheritance tax paid in Switzerland.

The case involves a Dutch national, Mrs. Van Hilten-van der Heijden, who emigrated from the Netherlands to Belgium in 1988. In 1991, she moved to Switzerland, where she died in 1997. Mrs. Van Hilten-van der Heijden's estate consisted of immovable property in the Netherlands, Belgium and Switzerland, in addition to several investments and bank accounts. Since Mrs. Van Hilten-van der Heijden died within 10 years of leaving the Netherlands, her successors were taxed on the inheritance based on the residence fiction in the Inheritance Tax Law.

The deceased's successors appealed the assessment to inheritance tax, arguing that the residence fiction is incompatible with the free movement of capital principle in the EC Treaty. The Dutch Court of 's-Hertogenbosch decided to request a preliminary ruling from the ECJ on the issue of compatibility of the Dutch law with the EC Treaty.

Article 56 of the EC Treaty prohibits all restrictions on the movement of capital and on payments between the EU Member States and between EU Member States and third countries, unless the restrictions fall within the scope of the "standstill" provision in article 57 (former article 73C). The scope of the free movement of capital is broader than the other freedoms in the EC Treaty because it is not limited to EU cases, i.e. it also applies to capital movements involving countries outside the EU (e.g. Switzerland).

Making reference to the ECJ decision in the Barbier case, AG Léger first concluded that the transfer of property by inheritance qualifies as a capital movement to which the EC principles on the free movement of capital are applicable. Consequently, all restrictions on this type of capital movement are prohibited under EC law.

The AG held, however, that even though a transfer of property by inheritance qualifies as a capital movement, the tax residence fiction, whereby a Dutch national will be deemed to retain his Dutch residence if he dies within 10 years of emigrating, does not constitute a prohibited restriction. AG Léger’s conclusion is based on several grounds, including:

• The tax residence fiction does not constitute a restriction to the transfer of property although it could affect the individual's actual decision to emigrate. Consequently, the AG is of the opinion that the fiction does not infringe the free movement of capital, but it could, at most, affect the free movement of persons and citizenship.

• A lack of harmonization of tax laws is a justifiable reason for the nontax neutrality of a transfer of residence. The fact that the Netherlands grants a credit for inheritance tax paid in other countries (up to a maximum of the amount of inheritance tax due in the Netherlands) is adequate protection to ensure that nationals who move abroad are not treated less favorably.

• The fact that the tax residence fiction applies only to Dutch nationals that move abroad and not to other EU nationals that move to another country from the Netherlands should not be considered a prohibited discrimination under the EC Treaty. Referring to other ECJ case law (including the Gilly case), the AG concluded that Member States may use the nationality criterion to define the scope of their taxation rights because of the lack of harmonization of tax laws with respect to the prevention of double taxation.

• It is not unreasonable for Member States to be guided by internationally accepted OECD principles when defining their taxation rights. The Dutch provisions are in line with the OECD model estate tax treaty (and its Commentary).

One of the most important points in this opinion is that AG Léger concludes that it is still acceptable for Member States to use nationality as a criterion to define the scope of their taxation rights because of the lack of harmonization of tax laws with respect to the prevention of double taxation. In this respect, the AG compares a Dutch national who moves abroad with other Dutch nationals who, in actual fact, remain Dutch residents. The fact that nationals of other EU Member States who have lived in the Netherlands and move their place of residence abroad are not taxed under the tax residence fiction does not constitute prohibited discrimination under EC law.

In addition, the AG considers that an ordinary credit, whereby double taxation relief is limited to the tax paid in the home country without providing for a refund of any additional tax paid abroad, is compatible with EC law.

AG Léger concluded that the free movement of capital is not at stake, so he did not consider it necessary to rule on the standstill clause in the EC Treaty. This would have been relevant for pending Dutch cases relating to the nondeductibility of expenses incurred with respect to foreign participations in non-EU/EEA countries.

Since the ECJ generally follows the AG's opinion (although not required to do so), it is expected that the Netherlands will be allowed to continue to use the tax residence fiction.

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France

In a decision issued 18 May 2005, the French Administrative Supreme Court (Conseil d’Etat) provided guidance on the "abuse of law" doctrine, including guidance as to when the doctrine can be invoked to disregard a transaction.

The decision, which concerns the use of a Luxembourg 1929 holding company set up and operated by a bank to hold financial investments.

Under the "abuse of law" doctrine, the French tax authorities can disregard a transaction that results in a tax saving if the taxpayer’s reasons for entering the transaction were purely tax driven. The taxpayers in this case, whose use of the Luxembourg 1929 holding company to hold financial investments resulted in the nontaxation of income derived from those investments, attempted to argue that the transaction was entered into for business reasons, specifically to improve their cash management. The Court concluded that the transaction was an abuse of law because the taxpayers could not produce evidence of any improvement in the return on their investment and because the Luxembourg entity lacked any business function and had no means of influencing the management of the investment.

A French company, together with five other French investors, invested cash in a Luxembourg 1929 holding company in exchange for a 16.6% shareholding in that entity. The Luxembourg holding company was not taxable on the income derived from its financial investments. When the Luxembourg company distributed its profits, the dividend income received by the French shareholder benefited from the participation exemption and was 95% tax exempt.

By using this structure, the French company was able to convert taxable financial income into tax-exempt dividend income. The controlled foreign company (CFC) rules in article 209B of the French Tax Code did not apply because the investment in the Luxembourg holding company was structured in such a way that, while it exceeded the 10% minimum holding required to qualify for the participation exemption, it remained below the 25% threshold that triggered application of the French CFC rules. (The relevant percentages to qualify for the participation exemption and for application of the CFC regime have since been changed to 5% and 10% (rather than 10% and 25%), respectively.)

The French taxpayers had argued that the transactions were not exclusively tax motivated because using a Luxembourg holding company had permitted them to optimize the management of their cash (i.e. it allowed the French company to benefit either from economies of scale or from a higher return on investment).

The Court held, however, that the taxpayers failed to adequately demonstrate the nontax reasons for the transactions and, in the absence of valid nontax reasons, the transactions constituted an abuse of law. The Court emphasized, in particular, that:

• The Luxembourg holding company had no real "substance." The company was completely dependent on the bank that had drawn up the structure for the management of its assets and the company had no financial expertise of its own. Further, the shareholders did not attend shareholders’ meetings or participate in the management of the Luxembourg company.

• The taxpayers were unable to demonstrate any financial benefit resulting from the transfer of the investment to the Luxembourg company other than the tax savings.

Interestingly, despite the lack of business functions and the fact that shareholders’ meetings were not actually held, the Court did not raise the question of the possibly fictitious nature of the Luxembourg entity.

The Conseil d’Etat also rejected the taxpayer’s argument that the French abuse of law doctrine is in conflict with the freedom of establishment principle in article 52 of the EC Treaty (now article 43 EC). The European Court of Justice (ECJ) has held on several occasions that the freedom of establishment principle must be interpreted as precluding a Member State from introducing measures designed to counter tax avoidance that have the effect of hindering the establishment of certain of its nationals in other Member States. Here, the Conseil d’Etat, without referring the issue to the ECJ, concluded that the French law, which has the specific purpose of preventing wholly artificial arrangements structured to circumvent France tax legislation, is not in conflict with the freedom of establishment.

This case highlights the need to be able to clearly and concretely demonstrate valid business purposes for a transaction. While the taxpayers in the case offered a nontax reason for using a holding company that resulted in significant French tax savings, they were unable to provide credible and concrete evidence of that purpose. The Court concluded that failure to produce such evidence implied an abuse of law.

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Germany

Tax Court Finds Implementation Law for Merger Directive Incompatible with Directive

On 17 February 2005, the German Finance Court of Baden-Wuerttemberg held that Germany has not correctly implemented the EC Merger Directive into domestic law. The Court, therefore, applied article 8 of the Merger Directive directly without referring the case to the European Court of Justice (ECJ) for a preliminary ruling.

The case concerned an exchange-of-shares transaction between a German transferring company and a French receiving company. The German implementation law for the Merger Directive requires the foreign receiving company in an exchange-of-shares transaction to adopt the German tax book value of the transferring company for valuing the shares in the tax accounts of the receiving company (the so-called "connection of book values"). If the receiving company fails to comply with this requirement and applies to the shares received by it in the exchange-of-shares transaction a value that is higher than the former German tax book value, the difference between the value applied by the receiving company and the former German tax book value results in a taxable gain (as a result of the share exchange) at the level of the German transferring company. The German Tax Court of Baden-Wuerttemberg held that this requirement is in such an obvious contradiction to the mandate of the Merger Directive that it is unnecessary to refer the case to the ECJ for a preliminary ruling.

Instead, the Finance Court of Baden-Wuerttemberg decided the case based on a direct application of article 8 of the Merger Directive and disregarded the German implementation law that required the French receiving company to adopt the German tax book value. Although the German tax authorities have appealed the decision, the decision of the Tax Court of Baden Wuerttemberg is encouraging for companies affected by the German Merger Directive implementation laws. It is likely that the Federal Tax Court in its decision on the appeal will confirm the lower court’s decision or refer the case to the ECJ for a preliminary ruling. If referred to the ECJ, the ECJ likely would confirm that the German implementation law is incompatible with the EC Treaty.

The European Commission, in its proposal for an Amendment Directive to the Merger Directive of 17 October 2003, had taken the position that the German requirement of a connection of tax book values is not in line with the Merger Directive’s purpose of preventing double taxation. Unfortunately, this amendment was removed during the negotiations at the ECOFIN level to reach the necessary consensus between the Member States.

Nevertheless, even without the adoption of the Amendment Directive in its original form, the legal position of the Commission is that the German implementation law is not in compliance with the Directive.

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Luxembourg

The Holding Company Tax Reform Law, amending the Law of 31 July 1929 on tax-exempt holding companies and bringing the current regime in line with the principles enshrined in the EU Code of Conduct on business taxation, was published 22 June 2005. The draft law was proposed by the government in November 2003 and finally approved by Parliament in April 2005.

The new legislation came into force 1 July 2005, although holding companies incorporated before that date are not required to fully comply with the new rules until January 2011. Holding companies incorporated after the cut-off date must comply with the new rules immediately.

Before the amendment, 1929 holding companies were exempt from all Luxembourg taxes, with the exception of the annual subscription tax levied on their net asset value and the capital contribution tax. Thus, a 1929 holding company could receive dividends from a foreign subsidiary and claim an exemption, even if the distributing subsidiary was not subject to tax or was subject to a tax regime that was notably more advantageous than the regime applicable to fully taxed Luxembourg-resident subsidiaries.

The amended provision states that a 1929 holding company will lose its tax-exempt status for a given year if, during that year, at least 5% of its dividend income, calculated on the basis of the total amount of dividends received, comes from participations in nonresident companies that are not subject to a tax that is comparable to Luxembourg’s corporate income tax. An effective tax rate will be considered to be comparable if it is at least 11%. Companies resident in an EU Member State that qualify under article 2 of the EC Parent-Subsidiary Directive, however, are deemed to automatically meet the comparable tax test. A 1929 holding company that loses its tax-exempt status will be subject to the normal corporate income tax regime.

It should be noted that only dividend income is examined in determining whether a 1929 company falls foul of the 5% test. Other income, such as interest or royalties and the realization of capital gains, should not cause a 1929 holding company to lose its status.

To remain eligible for the tax exemption, an auditor or accountant of the 1929 company will need to issue an annual statement certifying that the 5% threshold has not been exceeded.

Grand ducal regulations may further specify how the provision will be applied (including administrative procedures) and may specify the conditions under which the tax-exempt status can be regained in a subsequent year.

Although the new law originally was intended to have retroactive effect to 1 January 2004, to avoid any legal uncertainty, it was decided to make the amendment effective beginning 1 July 2005, the date the EU Savings Directive is implemented into Luxembourg national law.

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Switzerland

A circular issued 22 June 2005 by the Federal Tax Administration abolishes the long-standing "50/50" and "80/20" practices as from 1 July 2005.

The circular was issued in response to criticism by the OECD that these practices do not adhere to the arm’s length standard. It should be noted, however, that grandfather provisions in the circular allow existing rulings obtained before 30 June 2005 to continue to receive the benefits of the 50/50 and 80/20 privileges until the end of 2008.

The 50/50 and 80/20 practices are administrative practices developed by the Swiss federal tax authorities to determine the tax base of certain corporate taxpayers where it may be difficult to substantiate expenses. Under Swiss tax law, the burden is on the taxpayer to demonstrate that expenses are tax deductible, and the tax base is determined according to the commercial balance sheet.

The 50/50 practice, which generally applies to reinvoicing companies, estimates deductible expenses to be 50% of gross profit (typically defined as trading turnover less costs of goods sold), with 50% of profit subject to Swiss taxation. Under the 80/20 ruling, intellectual property (IP) branches are permitted to deduct a lump sum of up to 80% of their gross foreignsource income, with the remaining 20% subject to Swiss tax. Under both practices, the taxpayer is not required to substantiate the expenses, although it can choose to demonstrate that its expenses are higher than 50% or 80%.

While Switzerland does not have specific transfer pricing legislation, the country does follow the OECD guidelines, in particular the application of the arm’s length standard. After examining some of Switzerland’s tax practices, the OECD concluded in 2004 that the cost-plus-5% practice, and now the 50/50 or the 80/20 practice, are not in line with the arm’s length principle.

Under the new tax practice, all expenses will need to be commercially justified in detail and will need to meet the arm’s length standard. The tax administration will continue to grant advance rulings in specific cases to provide for certainty as to whether particular expenses are appropriate, but will not accept unsubstantiated lump-sum deductions.

The 50/50 and 80/20 practices provided an expeditious and certain method for determining the tax base. In the future, however, third party benchmarking, will play a more critical role in justifying tax deductible expenses. While, ultimately, the new approach may result in the same or possibly a more beneficial tax basis calculation, a more prudent documentation process will be required.

The importance of Switzerland’s foreign branch exemptions and back-to-back transactions will have a more prominent role in the Swiss tax environment in setting up new structures. For existing 50/50 and 80/20 IP branch structures, the grandfather provision for years up to December 2008 provides for ample time to take proper action and restructure to amend the flow of funds, as needed.

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United Kingdom

In a decision published 24 May 2005, the compatibility of the U.K. controlled foreign company (CFC) rules with EC law has again been referred to the European Court of Justice (ECJ) (Vodafone 2 v. HMRC v. Special Commissioners).

The case concerned inquiries by the Inland Revenue into foreign subsidiaries of the Vodafone group. Vodafone had indicated on its relevant U.K. tax return that the profits of a particular subsidiary in the group were excluded from the CFC legislation by one of the exemptions under the legislation, known as the motive test. The Inland Revenue requested extensive information about the company to determine whether the motive test applied. The company declined to provide the information on the grounds that the subsidiary concerned was resident in an EU Member State and that the imposition of a tax charge under the CFC legislation was contrary to the provisions of the EC treaty concerning freedom of establishment and free movement of capital. As the Revenue continued to pursue the inquiry, Vodafone applied to the Special Commissioners (a tribunal that initially hears tax appeals in the U.K.) for the inquiry to be closed. It was admitted that the application of the CFC legislation was the only issue in the inquiry.

The U.K. courts already had referred two other cases to the ECJ concerning whether the U.K. CFC legislation is contrary to EC law. One case involves Irish financing subsidiaries of the Cadbury Schweppes group and the other is a test case under a group litigation order concerning common claims by a substantial number of U.K. companies that the application of the CFC legislation is illegal under EC law.

The Special Commissioners in the Vodafone 2 case, however, decided that a further reference to the ECJ was appropriate as the case concerned issues that went beyond those referred to the ECJ in the other cases. The Special Commissioners concluded that, if the CFC legislation is not compatible with EC law, they would have been required to accept Vodafone’s application for a notice to the Revenue to close their inquiry. The Special Commissioners also noted that there were significant differences between the position in the Vodafone 2 case as compared to that in the Cadbury Schweppes case. In Cadbury Schweppes, it had been admitted that the Irish financing subsidiaries did not qualify for any of the statutory exemptions under the CFC legislation and that the companies had been established to take advantage of the favorable tax regime in the Irish International Financial Services center so that their profits would not be subject to U.K. tax. Vodafone, on the other hand, claimed that its subsidiary was excluded from the CFC legislation by the motive test.

The Special Commissioners also decided that an immediate reference to the ECJ was appropriate and that it should not be delayed pending an expected appeal against their decision by the Revenue. Notably, the Special Commissioners also accepted criticism by Vodafone’s counsel that the Inland Revenue had, at every stage, obstructed the progress of Vodafone’s case. It has been suggested that this may be because the Revenue wanted the Cadbury Schweppes case to be heard by the ECJ without reference to cases such as Vodafone 2 because the facts of Cadbury Schweppes appeared much more favorable for the Revenue; in Cadbury Schweppes, it had been admitted that the company had no other defense to a charge under the CFC legislation than the incompatibility with EC law. Vodafone, however, also relies on the motive test exclusion.

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Another Unsuccessful Claim for Relief under Tax Treaty Nondiscrimination Article

In a decision published 7 June 2005, in the case of UBS AG v. HMRC, the Special Commissioners rejected a claim by a U.K. branch of a Swiss bank that the nondiscrimination article of the U.K.-Switzerland tax treaty entitled the bank to claim to offset losses against certain dividend income so as to be able to reclaim the U.K. tax credits applicable to the dividends. Under U.K. domestic law, such a claim could be made by a U.K. resident company, but nonresident companies, such as the Swiss bank, were excluded.

Although the case relates to legislation that has since been repealed, the case is notable as the Special Commissioners decided that the U.K. branch of the Swiss bank did represent a permanent establishment of a Swiss enterprise on which tax was less favorably levied than that on a U.K. enterprise carrying on the same activities so as to come within the scope of the nondiscrimination article in the U.K.-Switzerland treaty. However, the Special Commissioners went on to conclude that the relevant provisions of the treaty had not been incorporated into U.K. law to enable the Swiss company to succeed in a claim for repayment of the tax credits.

The Special Commissioners said they had reached their decision with considerable reluctance and regarded the position as wholly unsatisfactory. They indicated that the U.K. had entered into a treaty, but had not given effect to it in its domestic law and that this was a breach of the treaty in the sphere of international law. The Special Commissioners noted that there had been three previous cases where the U.K. had been found to have not fully incorporated a double tax treaty into its domestic law. The most recent was the case of NEC Semiconductors Limited v. IRC, where a treaty nondiscrimination article claim for compensation in respect of advance corporation tax paid on intragroup dividends was similarly rejected by the High Court on the basis that, although it was considered that the nondiscrimination article could be interpreted as giving the right to the relief, the U.K. legislation giving effect to the treaty did not allow for such relief from advance corporation tax.

The Special Commissioners ended by suggesting that the U.K. Parliament should reconsider the legislation that incorporates double taxation treaties into U.K. law. However, there has been no indication by the U.K. government or revenue authorities of any intention to make such a change.

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U.K. Pension Rules May Affect Repatriation under New U.S. Rules

All companies that operate a U.K. defined benefit pension scheme may be affected by new U.K. pension rules. In particular, U.S. groups intending to make repatriations under the elective temporary repatriation provision introduced in the American Jobs Creation Act of 2004 (Internal Revenue Code §965)) from U.K. subsidiaries before the end of calendar year 2005 need to take the new rules into account now. Where the relevant U.K. subsidiary has a deficit in its defined benefit pension scheme, it may be necessary to obtain "clearance" from the Pensions Regulator (the new regulatory body for work-based pension schemes) before repatriation can be made.

The Pensions Regulator was established by the Pensions Act 2004 and entered into effect on 6 April 2005. The main purpose of the Pensions Regulator is to ensure that schemes are properly funded, administered and supported. The Regulator is charged with protecting the benefits of members of pension schemes and reducing the risk of situations arising that might lead to claims for compensation from the new Pension Protection Fund. Risk situations include: under-funding of pension schemes; poor administration of a scheme by a trustee; and deterioration in the company’s financial ability to support the scheme.

The Regulator has significant powers to intervene in a wide range of corporate transactions where it believes there is a direct or indirect impact on the ability of the company to fund an under-funded pension scheme. These transactions include merger and acquisition transactions, the granting of charges and returns of capital. All types of corporate transactions, even those with no obvious direct link to a pension scheme, may be affected.

To protect member benefits in a pension scheme and to ensure that employers do not avoid their pension liabilities or fail to support them in a meaningful way, the Pensions Regulator has been granted specific powers to deal with two particular situations:

• To issue a contribution notice when there is an action (or failure to act) to avoid pension liabilities; and
• To issue a financial support direction when the employer has insufficient resources with respect to a pension scheme.

The Pension Regulator has the ability to demand cash contributions from parties to a transaction that the Regulator deems to be detrimental to a pension scheme and can require financial responsibility to be taken for pension schemes by related companies where the sponsoring company is insufficiently resourced.

A statutory clearance procedure is available to provide greater certainty to those considering transactions involving companies with defined benefit schemes. Clearance applications are optional but can provide certainty to parties considering transactions that potentially could fall foul of the legislation. Clearance should be sought in at least the following situations, where material:

• M&A deals involving a change of control of the sponsoring company (e.g. change in parent company or ultimate holding company of the employer or change in related or associated parties that could be subject to a financial support direction);
• The granting of a new charge over company assets; and
• A return of capital outside the group (e.g. share buy-back).

In the context of repatriation under §965, the Regulator suggests clearance be sought where:

• The U.K. company has a pension deficit (as calculated under FRS 17, the U.K. GAAP pensions accounting standard); and
• The dividend is paid to an entity outside the EU; and
• The U.K. company would have negative distributable reserves if the pension deficit and proposed dividend were deducted from distributable reserves; and
• The cumulative annual return of capital (including the dividend) is large or unusual (more than two times the average of the last three years or reducing dividend cover to less than 1.25 times).

There also is a requirement for companies to notify the Pension Regulator of certain events where the company has an under-funded pension scheme. These currently include a breach of a banking covenant; a downgrading of credit rating; a change in control; and more than two changes in senior positions in a year (e.g. Chairman, CEO, CFO, and similar).

Pension issues are becoming increasingly business critical and, where a company has a U.K. subsidiary, the new rules must be taken into consideration before undertaking any material transactions that may affect the ability of the U.K. company to fund its defined pension scheme.

This article is intended as a general guide only, and the application of its contents to specific situations will depend on the particular circumstances involved. Accordingly, we recommend that readers seek appropriate professional advice regarding any particular problems that they encounter. This bulletin should not be relied on as a substitute for such advice. While all reasonable attempts have been made to ensure that the information contained in this bulletin is accurate, Deloitte Touche Tohmatsu accepts no responsibility for any errors or omissions it may contain, whether caused by negligence or otherwise, or for any losses, however caused, sustained by any person that relies on it.

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