This article discusses international tax developments and has been prepared by professionals in the member firms of Deloitte Touche Tohmatsu.
Originally published May 2005
ECJ Advocate General Gives Qualified Support for Cross-Border Loss Relief Claims in Marks & Spencer
Marks & Spencer Plc (M&S) can claim group relief on losses incurred by subsidiaries in other EU Member States, according to European Court of Justice (ECJ) Advocate General (AG) Poiares Maduro, in a case that has been watched closely by international business and Finance Ministers across Europe.
In the highly awaited opinion issued 7 April 2005 (Marks & Spencer plc. v. David Halsey (HM Inspector of Taxes)), AG Poiares Maduro concluded that the U.K. system of group loss relief was incompatible with the freedom of establishment principles of the EC Treaty in not potentially allowing the losses of foreign resident subsidiaries to be offset against the profits of the U.K. parent company, but the AG then went on to indicate that this would not be the case if the right to offset the losses was subject to the condition that the losses cannot be accorded an equivalent tax treatment in the EU country in which the subsidiaries are resident. AG Poiares Maduro indicated that such equivalent tax treatment would be available if the subsidiary was able to impute the losses to another person or carry them forward to other financial years in the country in which it is resident.
U.K. Group Relief Regime
The U.K. group relief regime allows a subsidiary in a group to surrender its losses to another group company so that the latter company can deduct the losses from its taxable profits. The surrendering company forfeits any right to use the losses surrendered for tax purposes and, in particular, may not carry the losses forward for offset in future years. However, the group relief regime is available only if both companies are resident in the U.K. for tax purposes or, from 1 April 2000, if they were carrying on trade in the U.K. through a permanent establishment; in other words, the regime is not available to companies outside the U.K.
M&S is the parent company of a substantial U.K. and international retailing group. M&S expanded its overseas business in the 1990s, in particular by setting up subsidiaries in several EU Member States (through U.K. and Dutch holding companies), including Belgium, France and Germany. The subsidiaries were resident in the European countries in which they were established and were neither resident nor trading in the U.K. After the subsidiaries incurred substantial losses during the years 1998-2001, M&S decided in 2001 to close the subsidiaries and obtain group relief with respect to the GBP 30 million in losses incurred by the foreign subsidiaries in the three countries. M&S wanted to offset the foreign losses of the subsidiaries against its U.K. profits.
Because the U.K. group relief is generally restricted to losses of U.K. resident subsidiaries, the Inland Revenue refused the request. M&S argued that restricting loss relief to domestic companies violates the freedom of establishment principle in articles 43 and 48 of the EC Treaty because, had the loss claims been submitted for losses of U.K. subsidiaries, they would have been allowed for U.K. corporation tax purposes. M&S's appeal to the Special Commissioners in the U.K. was rejected, and the company then appealed to the High Court, which referred the case to the ECJ for a preliminary ruling in 2003. Oral arguments before the ECJ were heard on 1 February 2005.
The primary issues in the case are whether the U.K. group relief rules constitute a discriminatory restriction on freedom of establishment under articles 43 and 48 of the EC Treaty and, if so, whether the rules can be justified.
AG Poiares Maduro concluded that articles 43 and 48 of the EC Treaty, concerning freedom of establishment, did not require a parent company with subsidiaries in other Member States to be given the benefit of the consolidation regime applicable to companies with foreign branches. He also concluded, however, that the U.K. group relief legislation was contrary to these freedom of establishment provisions as it deprived a U.K. parent company with subsidiaries in other Member States of the advantage of being able to offset the subsidiaries’ losses for tax purposes, which would have been available if those subsidiaries had been resident in the U.K. The AG considered that the provisions represented an "exit restriction" that dissuades companies established in the U.K. from setting up subsidiaries in other EU Member States.
Having established that the denial of the relief for loss of foreign resident subsidiaries under the U.K. group relief legislation represented a restriction on freedom of establishment, AG Poiares Maduro then considered whether the restriction could be justified under EC law. He rejected arguments advanced by the German government that the offset of such losses should not be permitted because it would lead to a reduction in tax revenue and to major budgetary difficulties for Member States. This follows ECJ decisions that reduction in tax revenue cannot be regarded as an overriding reason in the public interest to justify measures contrary to a fundamental freedom.
The AG also rejected arguments by the U.K. government that the refusal to allow relief for losses of foreign subsidiaries was in accordance with the territoriality principle that he considered could not be invoked to enable Member States to evade their obligations under Community law.
The AG did, however, consider that restrictions potentially could be justified based on the need to ensure cohesion of the tax system. He noted that the settled ECJ case law required a direct link in the context of the same tax and in the case of the same taxpayer and that, on the basis of these limits, the fiscal cohesion argument would be rejected. However, following an approach of AG Kokott in the Manninen case, he suggested that it was necessary to relax these criteria and to consider cohesion in the light of the aim and logic of the tax regime at issue. On this basis, AG Poiares Maduro concluded that the requirement to allow the offset of the losses for U.K. group relief purposes could be subject to the condition that the losses of the Belgian, French and German subsidiaries cannot receive advantageous tax treatment in those countries where the subsidiaries were resident. He went on to indicate that where those countries enable the subsidiaries to either impute their losses to another person or to carry them forward to other financial years, the U.K. would be entitled to oppose a claim for group relief. He particularly indicated that the companies would not be at liberty to choose in which country their losses were offset.
Implications of the Opinion
The final outcome of the case is subject to the decision of the Court, which is expected later in the year. It is not clear from the AG’s opinion, however, as to exactly how the criteria he is suggesting would be applied in practice. If there would only be an entitlement to claim group relief for losses of a foreign subsidiary where the tax law of the Member State where the foreign subsidiary is resident did not provide for either any offset of the losses against those of another company or any right to carry the losses forward to another financial year, as the opinion appears to suggest, the circumstances where losses of foreign subsidiaries could actually be claimed may be very restricted. They also would not appear to follow the AG’s own view that the U.K. group relief legislation should allow the same relief for losses in respect of foreign resident subsidiaries as is available for subsidiaries within the charge to U.K. corporation tax. This is because the U.K. legislation allows a choice for each period as to whether the losses of subsidiaries are claimed for group relief purposes or carried over to other financial years. It also is not clear as to what the position would be where the tax law in the country where the foreign subsidiary is located only allows a partial carryover of the losses to another year.
Another area of uncertainty is as to whether a claim for group relief in respect of past years could be disallowed simply because the foreign tax law of the country where the subsidiary is resident provided for a tax loss carryover to other companies, or a potential entitlement to carryforward, or if the U.K. group relief law must actually have included such a restriction for the year in question. If the latter interpretation is correct, it may be open to the U.K. government to make retroactive changes to the tax law.
It also is uncertain as to the extent to which the AG’s approach can be similarly applied to the systems of other Member States that may provide for some form of tax consolidation, rather than claims for group loss offsets.
In conclusion, AG Poiares Maduro has potentially established the principle of the entitlement to cross-border loss offsets, but has created very significant uncertainty as to its practical application. Other companies would be well advised to continue considering if they should make claims for potential cross-border loss offsets, until the position becomes clearer.
AROUND THE GLOBE:
Amendments Proposed to Clarify Taxation of Cross-Border Employee Shares or Rights
The New International Tax Arrangements (Foreign-Owned Branches and Other Measures) Bill 2005 (Bill) contemplates major changes to the taxation of employee shares or rights in cross-border situations. The amendments aim to prevent double or nil taxation of employee shares or rights and provide greater certainty by clarifying the treatment of individuals holding employee shares or rights who subsequently become employed in Australia, or who hold such shares or rights on departure from Australia.
In general, the proposed amendments are consistent with the approach taken by the OECD with respect to stock options. The proposed amendments confirm that employee shares and rights should be treated as employment-related income and, therefore, the proposals:
- Provide guidance regarding how income from employee shares or rights should be sourced;
- Clarify the application of Australia’s employee share scheme rules to employee shares or rights awarded before arrival in Australia;
- Confirm the application of Australia’s foreign service exemptions in relation to employee shares or rights;
- Confirm eligibility for foreign tax credit relief in relation to employee shares or rights;
- Remove the potential for double taxation of employee shares and rights under Australia’s Foreign Investment Fund (FIF) rules; and
- Remove the potential for double taxation of employee shares and rights on departure from Australia.
Sourcing of Income
The proposed amendments clarify that income from employee shares or rights is in the nature of employment income and, therefore, such income should be sourced based on where the services related to the award are provided. The proposed amendments indicate that, prima facie, the relevant employment period will be from the date of award to the time the award vests and ceases to be at risk of forfeiture; the specific facts and circumstances, however, will need to be assessed on a case-by-case basis.
Before Arrival in Australia
Under current Australian tax law, employee shares or rights awarded before an individual arrives in Australia are generally not subject to Australia’s employee share scheme rules and, instead, are subject to capital gains tax (CGT) on disposal. Depending on the tax treatment in the source country, this can potentially lead to nil taxation on at least some portion of the gain.
The proposed amendments clarify the application of Australia’s employee share scheme rules and ensure that, where vesting has not yet occurred and forfeiture conditions continue to apply to the employee shares or rights after an individual’s arrival in Australia, the employee share scheme provisions will continue to have effect. The individual will then need to assess whether, at the date of arrival in Australia, their employee shares or rights are qualifying, the point at which they will be subject to income tax and the amount of income to be assessed.
Australia’s CGT rules also will be amended to ensure consistency of treatment in this situation.
Foreign Service Exemptions
The amendments broaden the scope of Australia’s foreign service exemptions to apply to income from employee shares or rights on the basis that such income is of an employment nature. Broadly, Australian tax law provides for an exemption from Australian tax where an Australian resident individual engages in foreign service and certain other criteria are satisfied. However, the exemption does not specifically apply to income from employee shares or rights. The proposed amendments will extend the exemption to income from employee shares or rights where such income relates to foreign service.
Foreign Tax Credit Relief
In certain circumstances, an individual holding employee shares or rights who has engaged in foreign service may be subject to foreign tax on the shares or rights. Currently, there is uncertainty as to the availability of a foreign tax credit in respect of foreign tax paid on such benefits. The proposed amendments seek to clarify the nature of income from employee shares or rights to ensure that foreign tax credit relief is available in relation to such benefits.
In certain circumstances, employee shares or rights in a foreign company may be subject to Australia’s FIF provisions. In broad terms, the FIF provisions aim to tax certain foreign investments based on the annual increase in market value of such investments. While the FIF provisions currently provide a mechanism to reduce FIF income in the case of certain employee shares or rights, the reduction may not always be effective in removing double taxation. The proposed amendments are designed to align the method of reducing FIF income to the valuation rules in the employee share scheme provisions to remove this potential double taxation.
Double Taxation on Departure
Currently, where an individual ceases to be an Australian resident upon departure from Australia, the CGT deemed disposal rules may apply to tax unrealized gains on certain assets, including employee shares or rights. However, a subsequent Australian tax liability may arise under the employee share scheme provisions, with no credit provided for tax paid on deemed disposal. The proposed amendments remove this potential double taxation by taking certain employee shares or rights out of the scope of the deemed disposal rules.
The proposed amendments apply to employee shares or rights acquired on or after the date of Royal Assent. The amendments also will apply to employee shares or rights acquired before Royal Assent if the individual holding the shares or rights was not an Australian tax resident immediately before Royal Assent or if he/she becomes an Australian tax resident on or after Royal Assent. The amendments to clarify the CGT treatment will apply to CGT events taking place on or after the day of Royal Assent. The amendments to the FIF provisions apply to years of income ending after Royal Assent.
Authorities Issue Circular on Treaty with Hong Kong
The Belgian tax authorities published an administrative Circular on 25 March 2005 to provide guidance on the new double tax treaty between Belgium and Hong Kong. The treaty was signed on 10 December 2003 and entered into force on 7 October 2004.
The Circular clarifies various articles of the treaty and points out deviations from the OECD Model. Particularly significant are the tax authorities’ comments regarding the treaty method for elimination of double taxation when a Belgian resident company receives dividends from a Hong Kong resident company (article 22, para. 2(b)).
It would appear from a reading of the Circular that a Belgian company can repatriate almost tax-free from Hong Kong both onshore and offshore profits under the application of the Belgian dividends received exemption (participation exemption). This would imply that Belgium, the first EU Member State to conclude a tax treaty with Hong Kong, could be considered as the preferred country for multinationals to organize their business investments in Asia in a tax-efficient manner.
Elimination of Double Taxation of Dividends
Pursuant to article 22, para. 2(b) of the treaty, Belgium will exempt dividends paid by a resident company of Hong Kong in accordance with Belgian domestic law.
The exemption for dividends under Belgian legislation is achieved through a dividends received exemption of 95% of the net dividends received, provided both a participation and a taxation test are met. The participation test requires that the shareholder hold - for a continuous period of at least one year - at least 10% of the capital of the subsidiary or hold a participation with an acquisition value of at least Euro 1.2 million on the distribution date.
The following dividends are excluded from exemption under the taxation test:
- Dividends distributed by a company that is either not subject to corporate income tax or not subject to a foreign tax similar to the Belgian corporate income tax (subjective taxation test);
- Dividends distributed by a company that is resident in a country where the common tax regime is substantially more favorable than the Belgium regime (objective taxation test); and
- Dividends distributed by a company that is subject in its country of residence to a tax regime that deviates from the common tax regime. This rule focuses, in particular, on companies with offshore income or companies that qualify as finance, treasury or investment companies.
The Belgian tax authorities confirm in the Circular that they do not consider the Hong Kong tax regime to be "more favorable" than the Belgian tax regime, nor is the Hong Kong territorial tax regime substantially more favorable and companies resident in Hong Kong do not benefit from a tax system that deviates from the normal regime. According to the Circular, dividends distributed by a Hong Kong resident company to a Belgian company, therefore, are not subject to the exclusion rules in the third bullet above.
It is unclear whether the tax authorities intended to change their position through the Circular in cases where the income of the Hong Kong resident company originates exclusively from offshore sources. However, such cases are exceptional because generally at least some onshore finance income will be generated.
The Circular implies that, although Hong Kong is considered an offshore jurisdiction, in practice, Belgian companies could repatriate onshore and exempt offshore profits from Hong Kong almost tax-free under the dividends received exemption.
Government Partially Revokes Controversial Measures
Under enormous pressure against a further increase in the tax burden, the Brazilian government has decided to revoke certain provisions of Provisional Measure (PM) 232/04.
PM 232/04, which was published on 30 December 2004 and was scheduled to enter into effect on 1 April 2005, included significant changes to the taxation of certain exchange gains and losses and introduced a new profitability rate for service providers adopting the deemed taxable profit regime. Under PM 232/04, exchange gains or losses derived from equity held by Brazilian companies abroad were deemed to be and would accrue as financial income or interest expense (as the case may be) for the Brazilian company. As a result, such exchange gains would have been subject to corporate income tax and the social contribution on net profits (combined rate of 34%). PM 232/04 also introduced a new profitability rate for the assessment of the monthly estimated income tax and for companies subject to the deemed taxable profit regime, both based on gross income. The rate was increased from 32% to 40% and applied to a broad range of services. These controversial changes as introduced by PM 232/04 have been revoked by PM 243/05, published 31 March 2005.
Under PM 243/05, certain provisions of PM 232/04 continue to be valid. Such provisions include those relating to adjustments of the individual income tax brackets and applicable personal allowances. The revocation of article 36 of Law 10.637 of 30 December 2002, which allowed for the deferral of capital gains taxation in certain group restructuring plans involving Brazilian companies, remains valid.
Both PM 232/04 (with respect to the remaining provisions) and PM 243/05 still must be approved by the Congress to be officially converted into law.
Revenue Agency Introduces Small Taxpayer APAs
The Canada Revenue Agency (CRA) on 18 March 2005 issued procedures for small business taxpayers to improve access to the Advance Pricing Agreement (APA) program.
The Canadian APA program, introduced in July 1993, has been perceived as essentially geared to large multinational corporations. The need to make the program accessible to a broader taxpayer group while reducing onerous requirements for smaller taxpayers led to the new procedures.
Canadian tax authorities have been seen as one of the more aggressive administrations in terms of audit coverage and compliance. Taxpayers are witnessing an increase in audit activity, the issuance of transfer pricing documentation request letters and the levying of penalties, regardless of the size or complexity of the organization. This aggressive enforcement environment will be a factor in the strategic decision-making of small taxpayers assessing whether this initiative is appropriate for seeking transfer pricing certainty.
The key elements of the Small Business APA Program can be summarized as follows:
- The CRA’s Competent Authority Services Division will administer the program;
- The program will have a fixed nonrefundable administrative fee of CD 5,000;
- The Canadian entity must have gross revenues of less than CD 50 million or a proposed covered transaction of less than CD 10 million to be considered for the program;
- The program will cover only transactions of tangible goods (that have not been bundled with nonroutine intangibles) and routine services;
- Taxpayers need only submit a functional analysis (rather than a functional and an economic analysis, as would be required under the traditional APA program);
- Only requests for a unilateral APA, without rollback, will be accepted; and
- Annual reporting under the program will be limited to stating, in writing, whether the critical assumptions have or have not been breached. Under the traditional APA program, taxpayers must file an annual report describing compliance with the terms of the APA.
The new initiative appears to provide welcome relief to smaller taxpayers seeking to comply with domestic transfer pricing requirements. However, the attractiveness and cost-effectiveness of the program must be balanced by a consideration of some risk management and business management concerns. The lack of rollback and the unilateral nature of the process may well outweigh the short-term benefits of a small business APA, particularly in light of the newly introduced Canadian accelerated competent authority procedure (ACAP). Also, enticing taxpayers into the program by limiting the necessary submissions to information that is "functional analysis" in nature may create a false sense of compliance for uninformed taxpayers.
Clearly, taxpayers are always best served by advocating their position and supporting it with their own economic analysis. Nothing prevents taxpayers from doing this, and, in general, taxpayers should be very cautious about allowing the CRA to perform the economic analysis and dictate a result. Taxpayers should almost always perform their own economic analysis; otherwise, they may then lack the ability to effectively negotiate or influence the results or findings of the CRA. Furthermore, in the context of bilateral transfer pricing compliance, taxpayers must satisfy documentation rules for multiple countries. The reality is that a Canadian taxpayer is normally ill advised to think only in terms of a unilateral Canadian solution, especially when the CRA’s conclusion may be seen as aggressive by other taxing authorities.
No doubt the simplicity of the small business APA program has an allure for some taxpayers but taxpayers should be aware of the pitfalls and risks, and therefore should seek guidance in assessing all the appropriate options for managing their transfer pricing compliance.
AG Issues Opinion in Case Involving Discriminatory Tax Treatment of Foreign Branches
European Court of Justice (ECJ) Advocate General (AG) Léger concluded in the CLT-UFA case (CLT-UFA v. Finanzamt Köln-West) that, according to the freedom of establishment principle of articles 52 and 58 of the EC Treaty (now articles 43 and 48 EC), profits of a German permanent establishment (PE) of a company resident in another EU Member State must not be subject in Germany to a higher corporate income tax burden than distributed profits of a German subsidiary of a foreign EU parent company.
The case concerns the assessment year 1994, during which CLT-UFA SA, a public limited company resident in Luxembourg, operated its profitable German business as a branch office. The branch qualified as a PE for corporate income tax purposes, and its profits were subject to German corporate income tax at a rate of 42%. At the time, Germany still applied its split rate tax system, according to which retained profits of corporations resident in Germany were subject to a 45% corporate income tax that was reduced to 30% to the extent those profits were distributed. If a dividend distribution to an EU parent qualifying as a parent company under the EC Parent-Subsidiary Directive took place before 1 July 1996, the net distributed amount was subject to a 5% withholding tax, bringing the combined German corporate income tax/withholding tax burden (not taking trade tax into account) at the level of the subsidiary and a shareholder up to 33.5%.
The case was referred to the ECJ for a preliminary ruling on whether the fact that there was no possibility for the PE to benefit from the reduced tax rate constitutes prohibited discrimination under the EC Treaty and whether equal treatment would require a reduction of the tax rate to 30% or 33.5%.
AG Léger bases his discussion on articles 52(1)2 and 58 of the EC Treaty (now articles 43(1)2 and 48 EC), according to which companies are free to choose between operating in the form of an agency, branch or subsidiary when exercising their freedom to establish in another Member State.
It is clear to AG Léger that a rule whereby German PEs of foreign companies were definitively taxed at a rate of 42% without the possibility of having a reduced rate apply makes a German PE less attractive than a German subsidiary. This detrimental treatment is prohibited by article 52(1)2 of the EC Treaty (now article 43(1)2 EC) because a PE and a subsidiary are in comparable situations. First, the taxable basis of both types of entity generally is determined according to the same rules. Second, the profits of a PE and dividends distributed by a subsidiary to its parent company are tax-exempt at the level of the Luxembourg parent under the Germany-Luxembourg tax treaty and Luxembourg's implementation of the EC Parent-Subsidiary Directive. Third, the transfer of profits from a PE to the foreign head office of the same legal entity is comparable to a dividend distribution from a subsidiary to its parent – different legal techniques lead to comparable economic results as regards the transfer or availability of profits at the level of the PE or the subsidiary. Finally, even taking into account that a subsidiary would theoretically not always distribute all of its profits, proportionate tax rules could have been, but were not, developed for PEs.
Finally, AG Léger concludes that the German government was correct in not suggesting any justification for the rule because not even the coherence argument could justify the application of a higher corporate income tax rate to a PE of a company resident in another EU Member State.
As regards the second question, AG Léger opines that it is for a national judge to determine the proper tax rate (i.e. 30% or 33.5%). However, if a foreign parent suffered (until 30 June 1996) an additional withholding tax of 5% on the distributed net amount, this also would have to be taken into account.
If the ECJ follows the non-binding opinion of AG Léger, the specific effect on CLT-UFA would be significant. The general effect might, however, be more limited, since foreign investors usually operate in Germany through subsidiaries rather than PEs. Furthermore, the German corporate income tax rate for retained earnings of subsidiaries and PEs was reduced to 40% as from assessment year 1999, and the split rate system was abolished as from 2001 with all retained and distributed earnings subject to German corporate income tax at a rate of 25%.
Should the ECJ follow AG Léger’s opinion? AG Léger’s failure to exclude the application of a combined 33.5% corporate income tax/withholding tax burden in the case is questionable. First of all, a simple postponement of a dividend distribution until after 30 June 1996 would have avoided the additional tax on the dividend distribution to the nonresident parent. Second, the answer suggested by AG Léger is the result of a comparison between a German PE and a German subsidiary of a foreign company. An additional comparison between the taxation of a German subsidiary held by a foreign parent and a German subsidiary held by a German parent also would be illustrative. Such a comparison would have revealed that, in a cross-border situation, the 5% withholding tax on the distributed amount would lead to an additional definitive tax burden, which was not applied in the purely domestic German context. Hopefully, the ECJ will avoid the sanctioning of such discrimination.
AG Issues Opinion in VAT Avoidance Cases
Advocate General (AG) Poiares Maduro of the European Court of Justice (ECJ) issued his opinion against the taxpayers in the combined cases of Halifax, BUPA and University of Huddersfield. The three cases involve transactions entered into for the purpose of gaining a tax advantage in terms of a right to deduct input VAT. The ECJ has been asked to determine whether the transactions had a VAT avoidance motive and whether any transactions entered into solely for VAT avoidance purposes should be disregarded under the EC principle of "abuse of rights."
AG Poiares Maduro concluded that arrangements that have the sole intention of obtaining a VAT advantage are an abuse of the tax system and the tax authorities are entitled to challenge arrangements using the "abuse of rights" doctrine if the taxpayer’s sole motive was to avoid VAT. However, in a potential blow to the U.K. government’s anti-avoidance policy, the AG stated that the tax authorities are not permitted to simply disregard transactions, but instead they must be able to demonstrate that an "abuse" has taken place. To determine whether a taxpayer should be denied the right to recover input VAT, AG Poiares Maduro said that two objective elements must be found:
- The aims and results intended by the VAT legislation are not achieved if the VAT recovery were permitted; and
- The right to recover input VAT arises from activities for which there is no explanation other than the creation of the right to recover VAT.
VAT avoidance is becoming a highly scrutinized area in the EU as well as in many other countries. The U.K. government has estimated it suffers a revenue loss of around GBP 3 billion per annum as a result of VAT avoidance.
This opinion potentially impacts all taxpayers and focuses on the motivation underlying business arrangements that have been entered into to reduce VAT costs. It is, therefore, recommended that businesses that have been or that are likely to be challenged evaluate any commercial structures that may be affected. Businesses should consider the robustness and purpose of their operational structures and whether the structures are entered into for sound commercial reasons and not solely to avoid VAT.
If, as expected, the ECJ follows the opinion, the tax authorities will be able to apply the decision to a wide range of so-called VAT avoidance schemes to prevent taxpayers from obtaining VAT benefits. The ECJ is expected to make a final decision in summer 2005.
Bulgaria and Romania to Join EU
Bulgaria and Romania signed the Accession Treaty to the EU on 25 April 2005. The two countries should become EU Member states on 1 January 2007, bringing the EU to 27 countries. The accession date, however, still may be postponed if Bulgaria or Romania fail to fully implement the acquis communautaire. Both countries have made considerable progress in bringing their laws, regulatory frameworks and administrative practices in line with EU requirements for membership.
Guidance Issued on Tax Regime for Expatriates
The French tax authorities issued an administrative instruction on 21 March 2005 that provides guidance on the favorable tax regime applicable to individuals seconded to France. The regime was introduced to encourage nonresident companies to send employees and senior executives on temporary assignment to related companies in France.
Two incentives are available under the expatriate regime:
- An income tax exemption for an expatriate’s compensation allowance; and
- Income tax deductions for foreign social security and retirement pension contributions made in the home country.
To qualify for the benefits under the regime, the individual must be seconded to France as from 1 January 2004 for a maximum period of six years and may not have been tax resident in France in the previous 10 years. The government recently proposed to reduce the prior residence requirement from 10 years to five years.
Under the regime, compensation elements relating to the assignment in France – typically housing, cost of living allowances, mobility premiums, taxes paid by the employer, etc. – which are specified in an addendum to the employment contract or in an assignment letter, will be exempt from income tax in France. The foreign employer should determine, before the individual’s departure from the home country and in conjunction with the host company, which compensation elements are assignment-related and considered supplementary to the employee’s initial salary. These additional benefits will be exempt from income tax in France provided the individual’s remuneration declared and taxable in France is not lower than the taxable remuneration paid to a local employee holding an equivalent post. Any excess remuneration will be included in taxable income. The instruction clarifies that, in making the remuneration comparison, employee stock plan gains or income derived from employee savings arrangements should not be included in taxable compensation.
The instruction confirms that contributions to provident funds or supplementary pensions may be deducted from taxable income only by individuals seconded as of 1 January 2004. The supplementary pension plan must be a plan established in conformity with national legislation and practice, such as a group insurance contract, pay-as-you-go scheme, funded scheme or comparable arrangement intended to provide a supplementary pension for employees. In addition, the assignee should contribute to this plan prior to his assignment and should be able to prove such payment; contributions paid on contracts signed by the individual without any ties to employment are not deductible.
The administrative instruction also confirms that, even if an employee is seconded to France before 1 January 2004, social security contributions paid in the employee’s home country may be deducted from taxable compensation. The tax authorities are expected to issue further guidance detailing the conditions that must be satisfied to benefit from this deduction.
New Equity Incentive Scheme Introduced
The French 2005 Finance Law, in effect as from 1 January 2005, introduces a new era for employee share options in France by providing an alternative to qualified stock option plans. The new scheme includes both a legal and tax framework for granting free shares by a French company to its employees and favorable tax treatment of such plans.
Before adoption of the new law, the only discretionary employee share schemes permitted under French law were qualified employee stock option plans. French company law permitted the granting of free shares to employees only under very limited, prescribed circumstances: French companies could only offer up to Euro 3,450 worth of newly issued shares – offered collectively and exclusively to employees participating in that company’s collective savings plan. To fill the gap, in August 2004, the French securities authorities began allowing certain companies (on a case-by-case basis) to grant free shares to employees. While this exceptional free share grant received widespread press, most companies were reluctant to request permission to grant free shares because the procedure was administratively burdensome and the benefit related to the free shares gave rise to social security and tax charges as salary.
Under the 2005 Finance Law and provided certain requirements are met, qualifying shares will be exempt from the (costly) social security contribution, resulting in savings of about 20% for the employee and up to 50% for the employer; and the shares will be subject to income tax at a rate of 41% (rather than marginal rates up to 48.09%), which is deferred until the shares are sold. To qualify for favorable tax treatment under the new rules, the following requirements (inter alia) must be met:
- The shareholders must determine a minimum vesting period, which may not be less than two years, and a minimum holding period, which may not be less than two years after the vesting date, during which the shares may not be disposed of;
- The shareholders must authorize the Board of Directors to adopt a "free shares plan" as well as a time period in which the shares may be granted under the plan (not to exceed 38 months); and
- The shareholders must determine the maximum share capital that may be attributed to the plan, which may not exceed 10% of the company’s share capital.
While there are other legal requirements, the Board of Directors retains broad discretion in determining the beneficiaries and other conditions governing the grant of free shares. The qualified free share plan can be a discretionary or a collective plan, keeping within the same parameters as its predecessor, the qualified stock option plan.
Under a literal reading of the law, the benefits of the free shares plan are not limited to companies governed by French law. The French tax administration is expected to issue a regulation (although this may take years) detailing application of the regime to non-French-based companies, as it did with respect to qualified employee stock option plans. The latter regulation included an exemption from certain company law procedures for qualified stock option plans.
In the meantime, companies must operate in the absence of clarifying guidance from the tax authorities. A nonresident company could opt for a no-risk approach and choose to follow the French company law procedure in adopting its free share plan for French employees or request a specific ruling from the French tax administration as to whether the company’s free share plan qualifies in France. Alternatively, the company could decide to take a risk it determines to be acceptable and adopt an otherwise qualifying plan in compliance with its governing company law in anticipation of a forthcoming French regulation.
Despite some uncertainties in application and its failure to address certain issues, the new law offers, on balance, an attractive alternative to stock option plans. French companies can offer competitive compensation packages to their executives worldwide, ensuring lower costs for both employees and the company. Free shares have been growing in popularity and many global companies have moved away from stock options and toward a broad-based restricted stock program. Free shares are considered less volatile and thus comprise a dependable element of executive compensation, while minimizing dilution of company capital.
Lump Sum Taxation of Interim Gains from Foreign Investment Funds Violates EC Law
The Tax Court of Berlin held on 8 February 2005 that the lump sum taxation of interim gains under the German Foreign Investment Tax Act conflicts with the free movement of capital principle in article 56 of the EC Treaty because there is no comparable taxation for German investment funds. Additionally, such lump sum taxation is not required to guarantee effective tax supervision or to prevent tax avoidance and, therefore, it violates the principle of proportionality. That discrimination cannot be justified by the protection of savers or by the rules of the EC UCITS Directive (on undertakings for collective investment in transferable securities).
This case relates to fiscal years before 2004 because the Foreign Investment Tax Act was replaced by a new Investment Tax Act on 1 January 2004. Lump sum taxation within the meaning of the Foreign Investment Tax Act is only applicable to "black" funds. A black fund is a foreign investment fund that is not registered, is not listed and has no appointed tax representative. Therefore, if a fund qualifies as a black fund, the income, which is distributed on the foreign investment units, and 90% of the additional amount resulting from the difference between the first redemption price (net asset value) of the foreign investment unit set in the calendar year and the last investment unit redemption price (net asset value) set in the calendar year, will be attributed to the investor. At least 10% of the last redemption price (net asset value) set in the calendar year will be attributed. If the foreign investment units are alienated or the rights arising from the investment units are assigned, 20% of the consideration for the alienation/assignment will be taxed as a deemed interim gain in addition to a potential taxable capital gain.
Because the free movement of capital applies to discrimination between EU Member States as well as to discrimination against residents of countries outside the EU, the reasoning of the case is applicable to funds resident in EU and in non-EU countries.
The decision has been appealed to the Federal Tax Court, which could request a preliminary ruling from the European Court of Justice (ECJ). That scenario seems likely, as the Fiscal Court of Cologne held on 22 August 2001 that penalty taxation of black funds under section 18(3) of the Foreign Investment Tax Act could be justified by the goal of effective tax supervision.
As mentioned above, the Foreign Investment Tax Act was replaced by a new Investment Tax Act on 1 January 2004. Although lump sum taxation of interim gains was abolished and lump sum taxation with respect to current income is applicable to both German and foreign funds under the new Act, it seems that the 2004 Investment Tax Act also conflicts with the principles of the EC Treaty. The 2004 Act applies only to domestic funds that are organized as investment funds within the meaning of section 2(1) of the Investment Act (which is separate from the Investment Tax Act), or as investment stock corporations within the meaning of section 2(5) of the Investment Act (regulated funds), whereas the scope of application for foreign funds also includes non-regulated funds comparable to German partnerships or corporations.
The extended scope of application for foreign funds might prevent investors resident in Germany from investing capital in unregulated funds based in other EU Member States. Also, German residents may opt to invest in unregulated German partnerships or corporations because of the risk of being taxed on a lump sum basis if the foreign fund does not fulfill the reporting requirements of the Investment Tax Act. That discrimination against unregulated funds cannot be justified by reasons of the public interest, deficits in the national tax revenue or that other incentives can compensate for the discrimination. However, a final decision on the issue can be made only by the ECJ.
It should be noted that, on 22 April 2005, the German Federal Ministry of Finance announced that the Investment Act, dealing with regulatory issues, will be amended next year. Amendments are being considered, for example, to certain hedge fund-related issues, real estate mutual funds and the application of the Act to foreign non-regulated investment vehicles. The Ministry has asked interested parties to participate in the consultation process and to comment on the above issues by 30 June 2005.