New anti-abuse rules question the legitimacy of considering tax issues when deciding where to establish a holding company and put such structures at risk. Individuals and corporations must be aware of these rules when contemplating new investments and the sustainability of existing holdings.
Dividends distributed by operating companies are generally subject to withholding taxes. The disposal of a participation may also trigger income or real estate gain taxation in the country where the investment is located. When participations are held through a holding company, the levy of these taxes entails the risk that the same profits be subject to multiple layers of taxation, which is detrimental to international trades and investments.
In a cross-border context, this risk may be reduced or eliminated on the basis of double taxation treaties or other international agreements. Hence, when it comes to determining the location of a holding company, the availability of a large double tax treaty network is an important element to take into consideration.
On the other hand, countries are keen to counter aggressive tax structures. They do not want to reduce their taxing rights where a double taxation convention is abused and used beyond its initial purpose (i.e., to eliminate tax barriers to cross-border commercial activities). Whether a holding structure may lead to abuse in that area may, for instance, result from a lack of substance at the level of the (holding) entity claiming the benefit of a tax treaty or from the circumstances of a corporate restructuring.
In the framework of addressing aggressive tax planning, the OECD identified a whole set of measures to prevent base erosion and profit shifting—the BEPS project. Some of these measures require amendments of countries’ domestic tax laws, while others are to be implemented in double taxation treaties.
Regarding the latter, 93 jurisdictions (including Switzerland) have signed a multilateral instrument (MLI) or convention to modify more than 1,200 double taxation agreements. This convention includes the principal purpose test rule—a new general anti-abuse rule that forms one of minimum standards to be implemented by jurisdictions committed to applying double tax treaties under the new covered tax agreement. It provides that:
Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement.
The new anti-abuse rule is a principal purpose test (PPT), which focuses on the reasons why a specific arrangement or transaction was implemented or is maintained. It provides, in essence, that the benefit of the applicable double taxation convention will be denied if one of the principal purposes of the arrangement or transaction was to obtain such benefits.
This clause is also being inserted in other double tax treaties on the basis of bilateral discussions and a similar provision is to be found in the EU Parent-Subsidiary directive (as amended on 25 January 2015 by the Council Directive (EU) 2015/121). It aims to provide EU Member States with the legal basis to challenge—in a comprehensive manner—all treaty abuse not captured by other more specific provisions.
As far as withholding taxes on dividends are concerned, the PPT rule will apply to distributions made as from 1 January of the year following the latest date on which the MLI entered into force for a party to the double taxation treaty concerned. For example: the instrument entered into force for Switzerland on 1 December 2019 and on 1 August 2019 for Luxembourg. The new anti-abuse clause therefore applies to dividends paid as from 1 January 2020. The PPT rule had to be taken into consideration for the application of 48 double taxation conventions with regards to withholding taxes on dividends paid as from 1 January 2019. The number of double taxation conventions concerned is in excess of 300 as from 1 January 2020.
The interpretation of the PPT rule is subject to controversy. For example, the issue arises as to whether a holding company will be barred from claiming treaty benefits on the grounds that its main purpose was to avail of a large network of double taxation treaties or if this could already result from the fact that this was only one of its principal purposes. Thus, this appears to reduce the issue to questioning the legitimacy of considering tax issues when choosing to establish a holding company in one jurisdiction over another.
Presently, the PPT rule triggers an uncertainty that will likely remain until it becomes the object of administrative guidelines and consistent case law. Meanwhile, tax professionals expect to see the application of the PPT rule to vary from one EU Member State to another because, so far, the EU Member States are not addressing treaty abuse in a consistent manner. Tax authorities may also struggle to make precise distinctions when addressing cases of abuse between treaties to which the PPT rule will apply and other treaties which include different clauses or even none.
The OECD MC Commentary (ad art. 29(9) OECD MC) provides interesting guidelines in that respect, as well as a number of examples. These guidelines will most probably foster an alignment of EU Member States’ practices in the long run. Although they do not address all possible situations arising in practice, they do convey a clear message—under the OECD standard, persuasive non-tax reasons must be provided to explain "why" a holding company was set up or maintained in a given jurisdiction. Now, the threshold to come up with good business reasons supporting the existence of a holding structure is higher than merely explaining why the arrangement at stake is not unusual.
Taxpayers must show how the holding structure fits into a business model and the necessity to avail of skilled human resources to carry out, typically, investment activities. In other words, it must be translated into real operating substance in the EU Member State in which the holding is established.
The PPT rule will initially apply to 12 Swiss income tax treaties on the basis of the MLI. On top of this, Switzerland is currently conducting bilateral discussions with other jurisdictions to insert the minimum standard (including the PPT rule) in more than 45 of its tax treaty conventions. The minimum standard also forms part of Switzerland’s treaty policy with regards to the conclusion of new treaties.
As a result, the PPT rule will soon apply to a significant portion of income tax treaties concluded by Switzerland. In the near future, this new clause must be considered in relation to proceeds from investments in Swiss business or real estate undertakings held by entities located in typical holding locations such as Luxembourg (as from 1 January 2020 with regards to withholding taxes; and, 1 January 2021 in relation to other taxes), Cyprus, and the Netherlands.
The application of income tax treaties to holding companies is a critical issue for investors and shareholders. In a cross-border context, it provides that the yield and proceeds from investment are not significantly depleted across multiple layers of taxation and different levels of corporate structure.
In that respect, the PPT rule and similar provisions (applicable to an increasing number of tax treaties) may put existing holding structures at risk. This risk will increase significantly starting this year.
Individuals and corporations need to consider monitoring developments regarding the new rules going forward—and to consider the rules’ impact from a short- and long-term perspective in the following circumstances:
Read a January 2020 report prepared by the KPMG member firm in Switzerland
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