What is exit taxation?
According to the definition in the Anti-Tax Avoidance Directive of the EU (ATAD), the Council Directive (EU) 2016/1164, exit taxes shall ensure that a member state can tax the economic value of capital gains created in its territory when a taxpayer moves assets or the tax residence out of the tax jurisdiction (even though that gain has not yet been realised at the time of the exit).
We focus on the exit taxation that is triggered when a natural person lived for a certain period in a member state (usually 10 years) as a tax resident, then gives up its residency permanently and so this member state loses the right to tax the capital gains. If there is a participation in a corporation of at least 1%, the departure state can assume a fictitious sale and impose tax on the difference between the nominal value and the market value of the participation.
Exit tax can also be triggered if shares are inherited to a recipient who is not unlimited taxed in the country where the deceased person was residing.
In case of a donation to a recipient who is not unlimited taxed in the residence country of the donor, this situation can even result in double taxation (exit tax and gift tax).
How is exit taxation regulated in 2021?
Until a country has implemented article 5 of ATAD into its local tax law, the provisions define a deferral: the tax liability is “sleeping” if a person changes its residence within the EU or EEA, however it is triggered when the person gives up the residency in the EU and the European Economic Area and moves to a third country outside EU/EEA.
In some cases, it is possible to move to another country within EU/EEA, form there a proper structure as a holding and then move out of the internal market to a third country outside EU/EEA. One may also benefit from a decrease in value of the hidden reserves between the first exit (from the original departure state to the destination state in the EU) and the second exit to a country outside the EU.
Member states have different tax systems and tax policies, and the articles of ATAD have been implemented in different ways into local legislation.
Some EU countries have not so strict regulations regarding residency, so a formal residency in these countries is possible even in case of less than 183 days physical presence per year. However, the person should not reside in another EU/EEA country more than 183 days.
Some countries have implemented strict regulations that are in place from beginning of 2022, and for example German advisors report a huge demand from people who want to leave these countries and stay within the internal European market before the end of 2021.
The EU requires the member states to cooperate regarding information and enforcement. While the departure states are interested in cooperation, some destination states may have limited interest to collect taxes for the departure state if wealthy investors decide to move to their country.
What is exactly mentioned in ATAD ?
The directive asks the countries to specify cases in which taxpayers are subject to exit tax rules and taxed on unrealised capital gains which have been built in their transferred assets. The valuation of a market value at the time of exit shall be based on the arm's length principle. In case the assets enter into a structure, the destination state shall establish the same valuation as the departure state.
Taxpayers shall have the right to immediately pay the amount or in instalments over a certain number of years (ATAD mentions 5 years), possibly together with interest and a guarantee.
However, exit tax should not be charged when the change is of a temporary nature or for those assets which remain effectively connected with a permanent establishment in the first Member State
Does exit taxation include participations in foreign corporations?
While ATAD mentions “created in its territory”, some member states have their own interpretation and tax also the capital gains on a participation in a foreign corporation. Therefore, there are rumors that some taxpayers move first within the EU/ EEA to a country where the declaration does not include foreign participations before they move out of the EU/ EEA.
How to minimize or how to avoid exit tax?
Selection of the best method for evaluation:
Shareholders of a company have different rights: to receive dividends, to sell the shares, to receive the proceeds in case of liquidation and to vote in the general assembly. There may be valid reasons for a shareholder to give up or transfer some of these rights before leaving the country. Then the value of his assets at the moment of the exit is lower, too.
When it comes to the evaluation of the market value of a company, there are different valid methods based on substance, based on earnings, based on a mix of the two or based on future cash flow. Most methods therefore include estimations about the future. If a company is managed by a competent entrepreneur who resigns plenty of time before his exit, the valuation must include the fact that he will not be available for the business anymore.
Corona measures may allow a lower evaluation of a company, too.
Temporary change of residency:
Depending on the situation, a temporary move may be possible. Then income will be taxed in the destination state (the new tax residence), but exit tax may not be triggered in the departure state.
To create evidence that the move is not permanent, an apartment can be still available in the departure state, and there also shall be a plausible explanation why the centre of interest remains there.
Donations, trusts, foundations:
In countries where there is no or little gift tax, assets can be entered into foundations, trusts or be donated before the change of residency.
Partnership as shareholder:
If the shares of the corporation with hidden reserves are entered into a local partnership, the departure state does not lose the right of taxation. In most cases, the valuation shall happen at the book value without granting additional consideration. On the other hand, the departure of partners of a partnership is usually not subject to exit tax provided that a few special features are observed.
To avoid qualification as misuse, it is recommended to create a commercially active partnership with a visible permanent establishment in which the shares in the corporation are functionally assigned to the business purpose. If the partnership only provides management services for a fee to the corporation, this may not be sufficient.
Eventually it can be useful to put the shares into a foreign holding and to put this foreign holding into a local partnership before the exit. It may be useful to establish rather complex international structures with several shareholders and units on different levels and contracts between them.
Change the company into a partnership:
If a company is transformed into a partnership, the capital reserves of a company are taxed, but not the difference between the book value and the market value. The person moving away shall not remain the sole managing director of the partnership, because if he develops significant business activities from abroad, this may raise questions regarding profit sharing.
Disadvantages may be an increased level of liability, potential loss of tax carry- forward, a higher tax rate and eventual social charges. In addition, a partnership structure that only allows to avoid exit tax may qualify as misuse, and consequently entanglement tax can be raised.
Entanglement taxation happens if individual assets (entanglement), activities (relocation of functions) or the entire company are relocated abroad. This includes the transfer of business to a foreign entity. The national legislations differ in this aspect, and before any transfer of contracts, customer bases or other assets, a local tax advisor shall be contacted to structure the transaction in an optimized way.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.