Full EU Approves Anti-Tax Avoidance Directive
All 28 European Union (EU) member states reached political agreement on the European Commission’s (EC’s) Anti-Tax Avoidance Directive designed to combat multinational corporation tax avoidance.
During negotiations, some amendments were made to the proposal, including the deletion of the controversial “switch-over clause” to prevent double nontaxation of certain income.
The approval came before Britons voted to leave the EU, a move that has significant tax implications (see box below).
The final Anti-Tax Avoidance Directive includes the following:
1. Controlled foreign corporation (CFC) rules to reattribute the income of a low-taxed controlled foreign subsidiary to its (usually more highly taxed) parent company. A common scheme involves first transferring ownership of intangible assets (such as intellectual property) to the CFC and then shifting royalty payments.
2. Exit taxation rules to prevent corporate taxpayers from moving their tax residence and/or assets to a low-tax jurisdiction in order to reduce their tax bill.
3. Hybrid mismatch rules to prevent corporate taxpayers from taking advantage of disparities between national tax systems in order to reduce their overall tax liability, often leading to either double deductions or the deduction of income in one country without the inclusion of the corresponding income in the other country.
4. A general anti-avoidance rule (GAAR) to cover gaps that may exist in a country’s specific anti-abuse rules. Corporate tax planning schemes can be very elaborate, and tax legislation doesn’t usually evolve fast enough to include all the necessary defenses. A general anti-abuse rule enables tax authorities to deny taxpayers the benefit of abusive tax arrangements.
Switch-Over Clause Is Gone
The original directive proposal contained a controversial “switch-over clause” to prevent double nontaxation of certain income (for example, taxing dividend distributions coming into the EU, if they haven’t been properly taxed outside of the EU). That clause has been deleted. Some ministers had feared that the clause would scare away multinational investors.
The agreed measures are aimed at ensuring that the base erosion and profit shifting (BEPS) measures of the Organisation for Economic Co-Operation and Development (OECD) are put into effect in a coordinated manner in the EU, including by seven member states that aren’t members of the OECD, the European Council said. Moreover, pending a revised proposal from the European Commission (EC) for a common consolidated corporate tax base (CCCTB), it takes account of discussions since 2011 on an existing CCCTB proposal within the council.
Three of the five areas above implement OECD best practices (the interest deduction limitation rules, the CFC rules, and the hybrid mismatch rules). The two others (GAAR and the exit taxation rules) deal with BEPS-related aspects of the CCCTB proposal.
The Anti-Tax Avoidance Directive, as agreed upon by the 28 EU member states, will be forwarded to the European Council for adoption.
The EU member states will have until December 31, 2018, to transpose the directive into their national laws and regulations, except for the exit taxation rules, for which they will have until December 31, 2019. Furthermore, the EU member states that have targeted rules that are equally effective to the interest limitation rules may apply them until the OECD reaches agreement on a minimum standard or until January 1, 2024, at the latest.
EU Tax Implications of Brexit
Just before the European Union (EU) acted on the directive, Britain voted to leave the union. The effect of that vote — “Brexit” for short — remains to be seen. Reuters reported that the EU will need to “quickly fill a 7-billion-euro hole in its 145-billion-euro annual budget, which is currently fixed out to 2020, as it loses Britain’s contributions while saving on what Britons receive from EU accounts. The EU will also want to clarify as quickly as possible the status of firms and individuals currently using their EU rights to trade, work and live on either side of a new UK-EU frontier.”
Other potential tax ramifications of Brexit include the following:
- If Britain exits the EU, multinational enterprises (MNEs) with holding companies there may contend with withholding taxes on distributions from their EU subsidiaries. For this reason, Britain might be a less attractive European holding company jurisdiction compared to certain other EU member states. For example, the EU parent-subsidiary directive was originally conceived to prevent companies with operations in different EU states from being taxed twice on the same income. In this regard, it generally exempts dividends and other profit distributions from subsidiaries to their parents from withholding taxes.
- In addition, the EU interest and royalty directive was intended to eliminate the withholding tax on cross-border interest and royalty payments among tax residents of the EU that fall within the scope of its application. As a result, the British patent box regime, intended to protect inventions and intellectual property rights, may need to be evaluated in conjunction with the potential withholding tax on royalty payments from certain EU member states to Britain.
- EU law governs value added tax (VAT), which is a consumption tax charged on most goods and services traded for use in the EU. The EU single market abolished border control for intracommunity trade and allows exports from one EU nation to another to be exempt from VAT. While VAT may be recoverable by British exporters, it may give rise to cash flow problems.
Membership in the EU also provides access to a broad network of preferential trade agreements between the EU and third countries. The impact of Brexit on these and other measures will depend on the terms that are negotiated as part of Brexit, which could take up to two years to negotiate.
EC publishes letter that initiated McDonald’s state aid probe
The European Commission (EC) published a version* of its letter regarding its decision to initiate a formal investigation into an alleged illegal tax advantage Luxembourg granted to McDonald’s.
The commission’s investigation into McDonald’s tax arrangements with Luxembourg is emerging as an important legal test case for Europe and the U.S. The probe turns on whether the Grand Duchy misapplied the U.S.-Luxembourg tax treaty in a way that provided illegal state aid to the fast-food restaurant chain.
State Aid Prohibition
The European Union (EU) generally prohibits state aid unless it’s justified by reasons of general economic development. The EC is in charge of ensuring that state aid complies with EU rules. Since June 2013, the EC has been investigating tax rulings in the EU. It noted that certain EU states seem to grant multinational enterprises (MNEs) an advantage by allowing a reduction of the enterprises’ tax burdens.
On December 3, 2015, the EC said it had opened a formal investigation of Luxembourg’s treatment of McDonald’s, holding the preliminary view that a September 2009 Luxembourg tax ruling may have granted McDonald’s advantageous tax treatment, violating EU state aid rules.
Margrethe Vestager, who is in charge of EU competition policy, stated:
A tax ruling that agrees to McDonald’s paying no tax on their European royalties either in Luxembourg or in the US has to be looked at very carefully under EU state aid rules. The purpose of Double Taxation treaties between countries is to avoid double taxation — not to justify double non-taxation.
The EC Probe
The EC’s investigation focuses on two tax rulings issued by the Luxembourg tax administration in 2009 to McD Europe Franchising, S.à.r.l. (McD Europe), a Luxembourg corporation:
1. An initial tax ruling issued in March 2009 following a ruling request by McDonald’s, and
2. A revised tax ruling issued in September 2009 after McD Europe’s tax advisor requested it.
The EC claimed that McD Europe has recorded “large profits” since 2009 on the basis of the two tax rulings but has paid virtually no Luxembourg corporate tax.
As the commission explained, the U.S. branch of McD Europe has been viewed as a U.S. permanent establishment (taxable presence) for Luxembourg tax purposes, but not for U.S. tax purposes. Even though the Luxembourg authorities learned that the U.S. branch wouldn’t be subject to U.S. tax, they exempted the profits in question from being taxed in Luxembourg.
Misinterpretation of Treaty Clause
McDonald’s tax advisor argued that, because a provision in the U.S.-Luxembourg income tax treaty exempts from Luxembourg corporate income tax income that “may be taxed in the United States,” there’s no reference that “effective taxation should occur.” In the revised tax ruling, the Luxembourg tax administration confirmed that interpretation, and McDonald’s was no longer required to prove that the U.S. branch was subject to tax in the U.S.
In the EC’s view, Luxembourg erroneously interpreted the provision, and that resulted in the nontaxation of a sizable portion of McD Europe’s profits. Luxembourg hasn’t provided any justification for the selective treatment of McD Europe.
Citing these and other considerations, the EC reached a preliminary conclusion that the September 2009 tax ruling granted illegal state aid.
The commission stated that its formal probe into Luxembourg’s treatment of McDonald’s would involve an assessment as to whether the Luxembourg authorities selectively granted an advantage unavailable to other companies in a comparable factual and legal situation.
* In the public version of this decision, some information is omitted under EU rules concerning nondisclosure of information covered by professional secrecy.
The IRS recently issued an International Practice Unit (IPU) that outlines for its examiners the general rules for determining the source of fixed, determinable, annual or periodical (FDAP) income.
The tax agency stated that source determination is “critically important,” as the U.S. only has jurisdiction to tax FDAP income sourced to the U.S. A withholding agent that is unable to establish the source of FDAP income would generally be required to presume the income is U.S. sourced and obliged to withhold tax.
Generally, IPUs identify strategic areas of importance to the IRS and can provide insight on how examiners may approach a particular issue or transaction on audit. IPUs aren’t official pronouncements of law or directives and can’t be used as such.
Chapter 3 Withholding
Non-U.S. persons (whether individuals or corporations) are taxed by the United States under two separate regimes:
1. Passive income. The U.S. Internal Revenue Code (IRC) imposes a flat 30% tax on nonresident alien (NRA) and non-U.S. corporations on the gross amount of FDAP income that they receive from sources within the U.S. This gross amount may not be reduced by deductions or personal exemptions. The tax is subject to reduction under an applicable U.S. income tax treaty or exemption under the IRC.
The tax generally is collected by tax withholding at source. The regulations contain detailed rules for implementing this law (commonly referred to as Chapter 3 withholding or the NRA regs).
2. Income from a trade or business in the U.S. (USTB). The IRC imposes a U.S. tax on net (rather than gross) income that’s effectively connected with a U.S. trade or business (called effectively connected income or ECI).
The U.S. tax on ECI is imposed at the graduated rates applicable to individuals and corporations. The net income calculation takes into consideration applicable deductions and exemptions. ECI can include both U.S.- and foreign-source income under the “force-of-attraction” rule. This rule reflects the idea that a USTB attracts to itself virtually all U.S.-source income whether or not it actually generated that income.
In general, income taxable under these provisions includes interest, dividends, royalties, rents, compensation, and other “fixed or determinable annual or periodical gains, profits, and income” (that is, FDAP).
To be subject to the NRA regs, the payment must be made to a non-U.S. payee. The key issue when looking at the payment and the payee is determining the beneficial owner of a payment, defined as the person who is required to include the payment in gross income under U.S. tax principles.
In general, the new IPU assumes that a withholding agent pays the FDAP income to an NRA or foreign corporation. It focuses on how to determine the source of the income and offers the following example of when a withholding agent may not be able to determine the source:
If a U.S. corporation engages a foreign law firm to provide legal advice, the firm’s fee may be treated as FDAP income. Whether the compensation for the legal services is sourced to the United States or outside of it generally depends on where the services are performed. If the corporation, as the withholding agent, can’t confirm that the law firm performed the services outside of the United States, it “must withhold on the entire undetermined amount of income.” In other words, the fee paid to the law firm would be net of a U.S. withholding tax.
The corporation may keep the withheld amount in escrow until it can determine the source (for no more than one year). However, if the foreign law firm supplies proper documentation, such as a valid Form W-8ECI (“Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States”) (a type of withholding certificate), to the corporation to assert that the fee is ECI, no U.S. withholding tax is required.
Source of FDAP Income
The IPU reminds IRS examiners that Chapter 3 withholding must usually occur when a gross payment is made to the foreign person. A withholding agent must generally withhold 30% if it can’t determine the character and source of payments before they are made.
According to the IPU, withholding agents have created different methods of reviewing payment to determine character and source. For this purpose, a withholding agent might:
- Split its payments into those made to U.S. vs. foreign persons,
- Consider whether each payment to a foreign person is FDAP income, and
- Consider whether the income is U.S. vs. foreign source.
What Is and Isn’t FDAP Income?
The IPU lists items of income that are “usually FDAP” and describes the general factors in determining the source of each item (noting that exceptions may apply):
- Interest income is generally sourced to the residence of the payer.
- Dividend income is generally sourced to the place of incorporation of the payer/issuer.
- Substitute dividends or interest, as paid in securities lending or sale-repurchase transactions, is generally sourced the same as the interest or dividends paid on transferred securities.
- Rental income is generally sourced to the location of the property.
- Royalty income arising from natural resources is generally sourced to the location of the property.
- Royalty income arising from patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and “other like property” is generally sourced to where the property is used.
Compensation for personal services (as in the illustration above) is generally sourced to where the services are performed.
“In most cases, dividend and interest income is from U.S. sources if it is paid by domestic corporations, U.S. citizens or resident aliens, or entities formed under the laws of the United States or a state,” the IPU explains.
It also lists items of income that are “usually not FDAP,” such as salaries, wages, and gains from sales of inventory, real property, natural resources, and personal property. It also describes the general factors in determining the source of each item, noting that exceptions apply.
Certain U.S. entities with international transactions are required to report their international trade to the Bureau of Economic Analysis (BEA). Additionally, certain kinds of foreign entities also must file BE forms if they have transactions with U.S. entities. This required reporting, for U.S and foreign entities, is done through the use of the BE series of forms, available on the BEA’s website: https://bea.gov/international/index.htm#surveys. These forms are informational only and do not assess tax, but entities and individuals that are required to file can be penalized for failing to file the required forms.
Entities with international business activities that are required to file BE forms fall into four categories: shipping businesses, financial services firms, U.S. persons with large payments to non-U.S. persons, and entities with ownership of a foreign business. The first category, shipping businesses with international transactions, includes airline operators and ocean carriers. The financial service category includes financial service providers, insurance companies, and credit card companies. The third category consists of U.S. persons which pay over $1,000,000 USD to foreign individuals. The final category comprises U.S. entities which own foreign entities and U.S. entities which are owned by foreign entities.
If you own or participate in an entity that is included in one of these categories, then you and/or your entity may have a requirement to file one or more forms listed on the BEA’s website. Determining the correct form to file can be a difficult process, since the forms are changed regularly and there are multiple versions of many of the forms. Also, some entities will also need to file multiple forms; for example, a U.S. entity owned by a foreign entity may need to file a BE-605, BE-13, and a BE-15 form. If you are concerned that you may have a filing requirement, please contact us for assistance in wading through the BE website and forms to determine what forms you might be required to file.
Austin Pena, CPA
Senior Tax Accountant