Anti-Tax Avoidance Directive: Implications for Dutch Subsidiaries

In today's world tax planning strategies are scrutinized by tax authorities. Especially measures are taken to tackle strategies that exploit gaps and mismatches in tax rules (the so-called base erosion and profit shifting (BEPS)). Although Japanese companies are generally not into aggressive tax planning, the measures taken may still impact these companies.

On 12 July 2016 the Council of the EU adopted the Anti-Tax Avoidance Directive (Council Directive (EU) 2016/1164, the "Directive"). It came out as a part of the anti-tax avoidance package, which is a set of EU legislative and non-legislative initiatives, aiming to strengthen rules against corporate tax avoidance and to make corporate taxation in the EU fairer, simpler and more effective. The rules adopted by the Directive basically build on the EU case law and the 2015 OECD recommendations to address tax base erosion and profit shifting.

According to the Directive, each member state is required to implement provisions concerning interest limitation, exit taxation, general anti-abuse rule (GAAR), controlled foreign company (CFC) legislation and hybrid mismatches. Generally, these provisions need to be effective as from 1 January 2019. Below is a short overview on the implications of the Directive for Dutch companies, including Dutch subsidiaries of Japanese companies.

Interest limitation
The Directive provides interest limitation rules in the form of an earning stripping rule, which limit interest deduction to 30% of earnings before interest, tax, depreciation and amortization (EBITDA). Although some exceptions (e.g. EUR 3 million de minims thresholds, other escape clauses and a grandfathering provision) may be introduced by each member state, the main rule generally limits the possibility to shift profits to other jurisdictions by paying interest.

Under current Dutch law, there are several rules already to limit interest deduction which are applicable to specific situations. However, the proposed measure is more general and covers a broader scope. Accordingly, if Dutch subsidiaries are financed by substantial amounts of debt, even if it is not driven by tax considerations, interest deduction can be denied to some extent systematically under the new rule. Therefore, the manner of financing of subsidiaries may need to be reconsidered.

To illustrate this, for example, if a Japanese parent company finances its Dutch subsidiary with debt, the interest paid to the parent company is generally deductible at the subsidiary level, and it is taxable at the hands of the parent company. Accordingly, the taxable income is effectively transferred from the Netherlands to Japan (which is usually not tax efficient because corporate tax rate in Japan is higher than in the Netherlands), and in this point, the interest deduction might be limited to 30% of EBITDA. This can lead to a permanent double taxation because the interest is not fully deductible in the Netherlands although it is fully taxable in Japan.

Whereas, if the parent company finances the subsidiary with equity instead of debt, the dividend paid to the parent is not deductible at the subsidiary level, and so no profit shifting occurs. Although the dividend is not deductible, overall tax burden can be less than the previous scenario, because most of the dividend is exempt in Japan under the participation exemption regime and so there would be no double taxation.

Exit taxation
The Directive provides for exit tax rules, which require immediate recognition of unrealized capital gains (including those assets which are not registered for accounting purposes such as goodwill) when a taxpayer transfers its assets, residence or business to other jurisdictions. The rule includes a deferral mechanism for payment of an exit tax over 5 years for transfers within the EU/EEA, otherwise immediate payment is required.

Please note that also under current Dutch legislation, such a transfer may be lead to recognition of unrealized capital gains.

General anti-abuse rule (GAAR)
The Directive provides a GAAR to disregard artificial arrangements, which consists of both a motive test (to check whether the main purpose of arrangements is obtaining a tax advantage) and a substance test (to check whether arrangements follow economic reality). If some arrangements are seen as driven by tax considerations, and they violate the purpose and objective of the applicable law because such arrangements lack economic substances to be granted the benefit thereof, such arrangements are artificial arrangements and would be disregarded for tax purposes.

Under current Dutch law, apart from the implementation of the Parent-Subsidiary Directive, under which the participation exemption will be denied for artificial arrangements, there is also an abuse of law doctrine, according to which the tax authorities may disregard transactions if the principal motive is the avoidance of tax and the taxpayer violates the purpose and objective of the tax legislation. Nevertheless, the doctrine was developed through case law and not explicitly stipulated in the Code and is subject to strict requirements.

Therefore, the tax authorities might challenge more often intra-group transactions involving Dutch subsidiaries if the GAAR is introduced in the Code. In particular, if Dutch subsidiaries are intermediate companies as opposed to operating companies, it would be even more important in the future to have sufficient economic substances such as premises, staff and equipment so as not to be denied benefits from tax treaties and the EU Directives.

Controlled foreign corporation (CFC) legislation
The Directive provides for CFC legislation, which avoids shifting passive income (which is easy to move) to subsidiaries or permanent establishments in low tax jurisdiction by requiring that a CFC's income be taxed at the shareholders' level if the income is derived from passive activities or artificial arrangements without substantial economic activities. An entity is treated as a CFC if the shareholder holds more than 50% of voting power, capital or entitlement to the profits and also the effective tax rate of CFC's jurisdiction is less than 50% of that applicable at the jurisdiction of the shareholder.

Under current Dutch law, there is already an obligation to perform an annual mark-to-market revaluation - resulting in a deemed profit recognition on which the participation exemption is in principle not applicable - for substantial (25% or more) investments in passive investment subsidiaries, which are not subject to an effective tax rate of at least 10% and the assets whereof consist, directly or indirectly, for 90% or more of low taxed portfolio investments. Nevertheless, the CFC legislation is harsher and the scope is wider. Therefore, it is expected that the new rule would have impact on the structure of multinational enterprises involving Dutch intermediate companies.

Thus, as the GAAR requires so, it will be also important from the CFC legislation point, to make sure that Dutch intermediate companies perform substantial functions with economic substances such as staff, equipment, assets and premises, in particular if they make investment in low tax jurisdictions where the tax rate is lower than 12.5%.

Hybrid mismatches
The Directive provides anti-hybrid mismatches rules, which avoid double non taxation as a result of hybrid mismatches (i.e. different treatment of entities or instruments) between EU member states. Under the rules, where mismatch results in a deduction in the state of the payment without inclusion in the state of the receipt, the deduction must be denied. Also, where mismatch results in a double deduction, a deduction is only allowed in the state of the payment. Importantly, these rules currently cover only EU situations and not third state situations.

Under the current Dutch law, following the Parent-Subsidiary Directive, the participation exemption will be denied for hybrid financial instruments from which the payment is deductible at source. In addition to this, the new rule would have impact on the deductibility of the payment within EU member states. Accordingly, if there are transactions within EU involving Dutch subsidiaries, it would be important to review the tax treatment of financial instruments or entities in other EU member states as well as in the Netherlands, and check whether there is a mismatch between them.

Conclusion
The implementation of the Directive will most be effective as from 1 January 2019 at the latest. At the same time, it makes sense to already take into account these new rules when setting up and structuring business through the Netherlands.