Monte-Carlo 1996 meeting

The 1980’s and ’90s’ have seen a wave of cross-border mergers and the introduction of the Parent-Subsidiary Directive and the Merger Directive. Mergers take many forms; the Directive is brief and vague and has been implemented in member states in different ways; these differences will need to be reconciled in future years.
It can be difficult to determine to which country a company ‘belongs’ for the purpose of applying the directive; perhaps residence under domestic law is the crucial criterion.

In the case of a merger by way of absorption, Article 4 of the Directive eliminates tax on the capital gain of the company assigning its assets, on terms that the company receiving them inherits the assignor’s base cost. A similar deferral is available where a company is split up under a qualifying ‘division’, where assets are assigned in exchange for shares or on a share-for-share exchange. It is not available on the incorporation of a foreign branch.

In addition to making deferral available to the company, member states are also requested to permit carry forward of losses and fiscal reserves (e.g. for self-insurance) and to permit deferral of capital gains taxation to the shareholder.

Under the Directive, a corporation effecting the merger by inter-corporate transfer of assets is not granted the right to give the shares received in return for the assets and liabilities transferred a value for tax purposes equal to their fair market value (but may be required under domestic law to give them a value equal to the book value of the assets and liabilities transferred), thereby creating an opportunity for the government to tax the transferring corporation effectively for a gain that is already going to be taxed to the acquiring company upon its future disposition of the assets and liabilities.

From a practical perspective, a proposal to use a treasury centre raises immediately the question of control. The question resolved, the tax planning advantages can often be addressed, although a range of detailed tax moves will usually need to be dealt with. At its simplest, a treasury centre is a company with a low tax rate. There may be a price – e.g. a Belgian Co-ordination Centre requires a minimum employment and pays tax on a (favourable) cost plus basis. It provides tax-efficient funding of group companies, acquisitions etc. It may operate also as a cash-box – e.g. up to 1994 a UK company may have had a UK-registered subsidiary resident in the IFSC in Ireland: the subsidiary invested at a melded tax rate which brought it just above the CFC threshold. It may also operate as a bond-issuing vehicle.
Treasury centres are largely a corporate structure, but can sometimes be used by private investors to manage funds, though tax efficiency may be optimised by a combination of a zero-tax centre and a treaty company or other investment-specific tax planning. They may come up against suspicion of tax authorities and have a number of other problems, but can nevertheless produce tax advantages.

Quite apart from tax advantages there are commercial advantages in treasury centres – notably from pooling positive and negative cash balances, which eliminates the spread of the bank or other intermediary and avoids other costs. But the tax analysis is crucial to profitability of the centre, and one of the problems here is that the transactions may give rise to transfer pricing problems – e.g. in valuing the benefit of an inter-group guarantee. Amalgamating short-term cash allied with better control of the cash within the group generally can enable the group to reduce its need for long-term borrowing. Pooling and zero-balancing achieve this result but may have different taxation consequences. Cross-border pooling has of course an international tax planning dimension.

A novel perception in 1977, it is now accepted worldwide that decisions on interpretation of a tax treaty should be regarded as relevant in the interpretation of similar provisions in other treaties – even in other jurisdictions. A tax treaty has a dual status – it is a treaty, but at the same time part of the domestic law.
Different interpretations may be appropriate: the Vienna Convention would take into account a secret agreement between tax authorities, but such an agreement is not part of domestic law.

Article 31(1) of the Vienna Convention requires States to observe the terms of a treaty, even if this is contrary to domestic law. The Committee on Fiscal Affairs considers that the reference in Art 3(2) of the Model treaty to “law” is a reference to the law from time to time in force. The text of the Article has now been revised to this effect. Words in a treaty must now have the meaning they have at the time a treaty is litigated and not at the time a treaty is made – unless the context otherwise requires. A preferable view is that the meaning of a tax treaty term can evolve – in accordance with the intentions of treaty partner States. The history of the treaty may be taken into account in ascertaining its meaning, but subsequent interpretations, rulings or other documents may not have the force of law.

The courts are taking into account the views of commentators – even living ones – but many questions are unresolved. If a treaty cannot impose a tax, which can only be imposed by domestic law, can you pick and choose between domestic and treaty law according to which is most advantageous? Different States characterise income items differently: mismatches can work in favour of, or against, a taxpayer.

“New” instruments may be old instruments in a new dress. A potential borrower is often not obliged to borrow, but will do so in order to expand his business if the terms of the loan are sufficiently attractive. Another kind of borrower wants to offer terms attractive to the lender. The borrower not able to pay interest in cash may issue a so-called Cramdown bond, which pays its “interest” in paper – i.e. in promises to pay later.
The derivative has a large gearing element. The accrued interest scheme for U.K. tax stimulated a new instrument designed to offer the investor a better tax result. Similar tax-driven instruments have been designed to avoid Luxembourg stamp duty, or to take advantage of the absence of withholding tax on discounts, or to effect tax arbitrage.

Fundamentally a financial instrument involves an advance and a return. But instruments also effect sales of rent streams or “stripped” interest – which have an economic effect similar to that of an advance and return. Historically, fiscal manipulation has been confined to the interest element and capital terms have been dictated by purely commercial considerations. Interest may be advanced or retarded, or take the form of a discount. Or a return can be linked to an asset or a venture. The “bull and bear” bond maintains a capital equilibrium but an equity return.

The tax effect both on the lender and on the borrower requires investigation. The approach of general principle is to analyse the result into an income and a capital component. From the lender’s viewpoint, discount includes an item which is really interest and an item which is compensation for income risk. Capital items include those which are compensation for capital risk. The borrower can generally deduct income components as business outgoings, but this general rule has a number of exceptions.

High-tax jurisdictions have adopted a more piecemeal approach – e.g. in facilitating the deduction of a discount, or taxation of accrued interest. An accrual scheme was adopted by the United Kingdom, to counteract tax schemes based on a mismatch between relief but not tax on accruals. In the United Kingdom the tax system for corporation tax is coming back to a general system, basically taxing the results of a business as shown in its accounts. In defeasance lending, the borrower prepaid interest amounting to 30%-40% of the total while the lender wrote down the value of the bond and thereby postponed the tax liability. This tax mismatch has, in the United Kingdom, been swept away by the “business” approach. The trombone issue is made by a borrower who is making a bid and needs to raise a variable amount of cash: the untoward capital gains tax consequences to the lender are avoided by having the bond issued by a subsidiary of the borrower.

The CFC legislation varies hugely from country to country but has a simple common purpose – to stop tax haven companies.
The United Kingdom legislation is characteristic: it provides that a CFC is a non-resident company controlled by a resident person and suffering tax at less than 75% of the domestic rate. A “white” list is published: to qualify as “white” the company must earn 90% of its income in its own jurisdiction. “Income” is calculated on UK principles. There are exceptions and the rules do not apply to an investment entitling the holder to less than 10% of the company’s income. An exemption is accorded to a company which satisfies the “exempt activities” test. This is intended to take out of the CFC category a company carrying on a genuine active business. The “acceptable distribution” exemption now requires a remittance of 90% of the company’s income – “income” calculated on UK principles. The Revenue’s Consultative Document proposes changes. These include moving to self assessment, the abolition of acceptable distribution, a reduction from 90% to 80% of the profits to be charged and a clearance procedure.

Does the CFC legislation conflict with the provisions of tax treaties or the Treaty of Rome? The UK Revenue accept that a capital gain exempt under a treaty cannot be attributed to its parent, but maintain that business profits exempted under a treaty are not what is being taxed under the CFC legislation – being a tax on the UK company on a notional amount. The Treaty of Rome offers a degree of protection relating to the freedom of establishment of operations in Member States and particularly as regards specific incentives sanctioned by the European Commission.

UK companies can still have foreign companies making capital gains or participating in joint ventures. The Dutch “mixer” company still works – “voluntary” tax may not be creditable but it should be noted that sixteen countries have some form of CFC legislation. In general they tax individual shareholders – France and the United Kingdom being the exceptions. Unlike the UK, most other countries include capital gains.

In the U.S., Canada, Denmark, Sweden and Germany, only passive income is attacked. In the sixteen countries, “control” is variously defined; the offending lower level of taxation is ascertained in different ways; the “white” lists, the definition of trading activities and the de minimis rules are not identical.

Tax harmonisation has long been an aim of the Commission. But the member states have not wanted to pursue this policy, if only because harmonisation in other areas was eroding their sovereignty to some extent. Some progress has been made on exchange of information and in 1990 the Commission presented proposals for harmonisation in corporate tax. The Ruding Committee was appointed and the Council of Ministers adopted principles which resulted in the Merger Directive and the Parent-Subsidiary Directive. Some countries have introduced anti-abuse measures when enacting the provisions of the Parent-Subsidiary Directive; some of these may be held to the excessive. Companies in the Dublin IFSC, the Co-ordination Centres in Belgium and the tax-paying companies in Madeira comply with the Directive as they are subject to corporate tax. Companies in the Canary Islands, paying 1% tax and similar projected companies in the Basque country will also comply as they also do not benefit from a general tax exemption. Some member states are unhappy about this.
Also adopted by the Council of Ministers in 1990 was the Arbitration Directive. The proposal for the abolition of withholding tax on interest and royalties was withdrawn. A proposal for set-off of losses between parent and subsidiary was not adopted.

The Ruding Committee was concerned to eliminate double taxation on cross-border transactions; their recommendations are under discussion, and methods of exchange of tax information among member states have been explored. And the recommendation of a standard minimum corporate tax rate of 30% is being studied but may not be pursued.

A further concern of the Commission is the regulation of tax competition so that it is compatible with the objectives of a single market. Article 92.3 of the Treaty prescribes specific circumstances where aid may be permissible: the Dublin IFSC and Madeira free zone and the Financial Services Centre in Trieste were approved under this heading; other schemes are still under examination.

In order to make further progress in the area of taxation in view of the creation of a single currency and the introduction of an Economic and Monetary Union, the Commission started in early 1996 an initiative to come to a possible agreement and commitment of Member States on what specific measures ought to be taken in order to stabilise their revenues and to ensure the smooth functioning of the single market. The Commission’s priority is the proper completion, application and functioning of the single market by removing tax barriers which will bring benefits for individuals and business.

A “fiscally transparent entity” (“FTE”) is one which is not itself taxable. A partnership is a UK example. Analysis requires a distinction between S – the country of source, E – the country of the enterprise and P – the country of the participator. Typically, there is a treaty between S and E, of which the participator in P wants to take advantage, while E suffers no tax.
Article 1 of the OECD gives persons who are resident of the contracting states. Article 3(1)(a) defines “person”: it is an inclusive definition and not limited to entities having legal personality. “Company” is not limited to registered companies. Article 4(1) defines residence. Does “liable to tax” mean that the entity is actually paying tax? The cautious view is that the entity is liable to pay tax even if it is not actually paying any. The OECD Working Party may clarify this issue.

FTE’s come in many types. At one extreme are FTE’s which have no access to treaties; at the other extreme are those which certainly do. A contractual joint venture is wholly transparent. An EEIG has an existence, but is nevertheless transparent – by reason of Article 40 of the EEIG Directive. An English or Scottish partnership has a reporting responsibility but is still transparent – e.g. the S corporation and some French entities – e.g. the EURL. Some have the option not to be transparent – e.g. the société en nom collectif, the GIE, some LLC’s, those which elect to be taxed have access to the treaty; those which do not are still resident persons, and therefore should have access.

Some entities have partial transparency – e.g. the French Société en Commandité Simple, which is taxable on that part of its income which is payable to French resident general partners but not on the part payable to non-resident limited partners. The same is true of the Dutch Open CV.

A trust with a life interest has variable transparency where part of the income is accumulated.

Practical transparency is enjoyed by some entities – e.g. a US trust, where the trustees deduct distributions, or a UK IHC which has enough foreign tax credit to absorb its mainstream corporation tax liability. Such an FTE undoubtedly has treaty access.

In Padmore, the UK court held that a Jersey partnership had treaty access. The Inland Revenue take the view that a partnership should not have access to UK treaties: this is reflected in recent UK treaties. In Canadian treaties “person” is very widely defined. The US generally has a wide definition of person but a limited application to cases where partners are themselves resident.

Does a US LLC have access to the UK treaty? Is it a “corporation”? It seems that it is, and if it is, then it is automatically a “resident” of the US.