Revenge of the E.U.

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James J. Tobin, Esq.

By James J. Tobin, Esq. Ernst & Young LLP New York, New York

So the European Union is at it again. There is a lot to keep up with these days what with all of the BEPS proposals and the November release of the promised Multilateral Treaty Instrument by the Organization for Economic Cooperation and Development, varying progress on implementation steps for Base Erosion and Profit Shifting taking place at the country level, and the increased prospect of U.S. tax reform after the election of Donald Trump. But obviously the E.U. doesn't want to be forgotten either, so it has been active in proposing Directives inspired by the BEPS agenda — although not always completely in line with the OECD's BEPS recommendations. So far the E.U. has produced two versions of so-called Anti-Tax Avoidance Directives, a proposal for public disclosure of country-by-country reporting data and some nasty State Aid decisions likely with more to come. In November it added a re-proposal of Directives on the Common Corporate Tax Base (“CCTB”) and the Consolidated Common Corporate Tax Base (“CCCTB”), which was last proposed in 2011 as a single proposition. These are now being proposed in two phases — first the double C, which would establish a common approach to the computation of taxable income across the E.U.; and a second phase, the triple C, which would require consolidated filing in the E.U .and apportionment of income among all E.U. member states.

I critically commented on the original 2011 proposal as overly ambitious, impractical and less than fully thought through. Obviously, I was not the only critic; a number of E.U. countries were opposed and indeed the current re-proposal states that the original “CCCTB proposal, being a very ambitious project, would be unlikely to get adopted in its entirety….” So the conclusion of the E.U. was not to abandon the plan but instead to repackage it in the two parts described above. The expectation was that countries should be committed to both elements and thus that the full CCCTB should still be adopted across the E.U. in the “near” term. (And by the way, the new proposal would be mandatory — not optional.) It seems like I am not alone in thinking that a consolidated apportionment system is not a good idea for driving investment growth in the European Union. But it also seems like European Commission authorities with entrenched views are not listening. Perhaps the thinking was that with the E.U. exit of the United Kingdom, which had been critical of the original proposal, this was another opportunity to push it through.

I'll focus this commentary on the CCTB, and not on the triple C proposal on consolidation. While consolidation raises the most concern, I feel there is enough not to like about a mandated common tax base and hope that countries and commentators are vocal about that and do not wait until “round 2” to start expressing their concerns.

First of all, let me point out that as a directive, the adoption of the CCTB requires unanimous consent by all 28 countries that currently are members of the European Union. It is possible to adopt tax principles by way of “enhanced cooperation,” which could be done on a majority basis, but the principles would then apply only in countries that agree to it. In the case of the CCTB or CCCTB, it seems clear that the enhanced cooperation route will not be and is not appropriate to pursue, so adoption of the plan would be all or nothing. I'll point out some double C areas where I feel countries should object. But, historically, some larger E.U. countries — notably Germany, France and Italy — have been supportive of CCCTB. If they are on board, a veto by a smaller country is likely politically difficult. And while the United Kingdom will be at the table for the next few years as it negotiates its “Brexit,” it cannot realistically exercise a veto. On the whole the United Kingdom may not be bothered by some impractical E.U. rules if it will no longer be a part of that club going forward. In fact, the United Kingdom has been promoting itself as open for business and a good investment destination. I believe the way they implemented the Diverted Profits Tax and are proposing to implement the hybrid mismatch rules is very investor-unfriendly and go well beyond an arm's-length standard. But there are potential aspects of the CCTB which have similar features. If I were the United Kingdom and eager to attract business post-Brexit, I might be pleased to see a complex and potentially overreaching E.U. system implemented. Overall, I do think that the CCTB contains a lot to be concerned about. I'll give some examples in this commentary.

So what is the CCTB all about? The goal is to implement a common corporate tax base (but not a common tax rate) across all 28 E.U. countries. The Proposed Directive to accomplish this is 53 pages including explanations. For a U.S. tax guy used to the complexity of the Internal Revenue Code and Regulations, boiling down all aspects of a corporate tax system to 53 pages seems impossible. By definition, there must be lots of details which need to be left to the countries to implement or which must be further articulated by the E.U. technical staffs which could either create lots of inconsistences (which means not such a “common” corporate tax base) or be potentially scary if left to the European Commission to figure out.

Let's go through some of the details of the proposals to see how scared we should get.

  •  First of all, the proposal for the CCTB would apply to all corporate groups that file consolidated accounts which have revenue of over 750 million pounds. That threshold is for worldwide groups and not just E.U. headquartered groups. Thus, U.S. multinationals and non-U.S., non-E.U. multinationals with that level of turnover would be covered regardless of the size of their E.U. subsidiaries or branches. The threshold is similar to the threshold for country-by-country reporting under Action 13 of the OECD initiative, but not exactly the same. The exception for smaller groups or non-consolidated groups would mean that an E.U. country would not be required to conform its local tax rules to the common corporate base for those excluded companies in its country. I am not sure how practical it will be to maintain two corporate tax systems and then to put the burden on the countries to figure out whether a local subsidiary is eligible to the non-CCTB rules.
  •  In defining the scope of the proposed CCTB, it is best to start with revenues. Generally all revenue is to be included in the common tax base. The significant exclusion is with respect to dividends or gain or loss from 10%-or-greater owned subsidiaries. The participation exemption is 100%, as opposed to the 95% exemption in the 2011 proposal. However, the reduction to 95% in 2011 was stated to be a proxy from the disallowance of costs relating to exempt income. The current proposal on its face seems more generous but in regard to expenses specifically would disallow expenses related to exempt income — including participation exemption income — but provides no guidance on how to do so. Presumably, each country could devise (or maintain if they have a current rule in their law) an expense apportionment approach. Again, doesn't sound too “common” a base to me.
  •  The definition of exempt participation income would also be subject to a so-called “switchover” clause. The switchover clause would deny exemption to dividends or capital gain for subsidiaries which are subject to local tax of less than one-half of the rate in the parent/recipient country. In such case, foreign tax credits, rather than income exemptions, would apply. Interestingly, the switchover clause was proposed by the E.U. in the first Anti-Tax Avoidance Directive (“ATAD”) but was excluded from the final ATAD presumably as a result of negotiations and based on objections by the member states. The inclusion in the CCTB proposals is merely three short paragraphs long, seems to just ignore the prior objections and, needless to say, would require the E.U. member states to adopt some very complex foreign tax credit provisions (similar to what we're used to in the United States) to implement. Another example of the E.U. drafters just not listening?

 

As for deductions allowed in computing the CCTB, business costs would generally be deductible with some interesting points below:

  •  Interest costs would be deductible but with limits on net interest costs set at 30% of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) consistent with the ATAD and with Action 4 of the OECD BEPS proposals. There is an exception for interest incurred with respect to infrastructure and a grandfathering of pre-effective date loans.
  •  Rules are provided for depreciation and amortization of fixed assets. Specific useful lives are provided for certain assets subject to straight line depreciation. For intangible assets, only intangibles that are eligible of being valued independently are included in depreciable fixed assets. Therefore, it would seem that overall goodwill of a business is excluded and would not be amortizable. This seems like a big deal as many countries in the E.U. do allow currently for goodwill amortization. Should they object?

 

Four seemingly favorable provisions are included:

  •  A tax-free rollover provision would be allowed when gain is realized on a fixed asset and a replacement asset is acquired before the end of the second year after the tax year of disposal.
  •  A special deduction would be provided, in the nature of an allowance for growth and investment. This would operate similar to a notional interest deduction. An increase in a company's equity for a year would produce a notional deduction for the next 10 years equal to the equity increase times an interest rate equal to the 10-year government bond rate in the Euro area (gratefully with a floor of zero at any time when Euro rates are negative). Note that this allowance could be positive or negative. If a company's equity were decreased, the “notional interest” would result in an increase in taxable income.
  •  A special super-deduction would be allowed for research and development expenses. Taxpayers would be allowed an extra deduction equal to 50% of their R&D costs for the year (25% to the extent the R&D costs exceed $20 million). However, there is no mention in the proposed directives of patent-box-tax-type regimes which are increasingly common around Europe. It seems to me that the special R&D deduction is meant to be in lieu of a special patent box/intellectual property (IP) box tax rate. If so, that is a big deal and will raise objections.
  •  There would be an allowance for the deduction of cross-border losses of subsidiaries or branches — “to make up for temporarily depriving taxpayers from the benefits of consolidation,” at which time all profits and losses of a group would be naturally consolidated. However, the deduction of such losses will be subject to recapture in the deducting company when profits are realized by the subsidiary or, in any event, no later than five years after the loss was deducted. At today's low interest rates this seems of minimal benefit but would add lots of complexity.

 

The CCTB proposal does include the various anti-avoidance provisions included in the E.U. ATAD proposals.

  •  As indicated above, the interest limitation rules of OECD Action 4 are included with a bit of amendment.
  •  There is a provision for exit taxation.
  •  There is a general anti-avoidance regime (“GAAR”) and there are mandatory CFC provisions which are focused on passive income and re-invoicing activities.
  •  Hybrid mismatch rules are included also encompassing imported mismatch similar to the OECD Action 2. Interestingly the OECD Action 2 recommendations ran about 300 pages. The hybrid mismatch legislation in the U.K. ran over 50 pages (so some stuff is left to the imagination). A separate E.U. directive on hybrids (also issued in November 2016) runs for 19 pages, whereas Article 61 of the CCTB on hybrids runs slightly more than one page. This is further evidence that the countries will likely need to fill in the gaps and MNCs will be left with lots of uncertainty and lots of potentially aggressive local interpretation that could lead to double taxation.

 

So overall, it doesn't seem to me that a very common corporate tax base is anywhere near assured based on the high-level definitions and concepts provided. All the E.U. countries have working corporate systems of their own which are based on their overall policy objectives as well as how they have decided to set their tax rate. I admit that, as a U.S. practitioner, I am used to detailed rules. Maybe the idea here is more along the lines of a principles-based approach with high-level minimum standards for dealing with difficult or potentially tax-abusive areas. But it doesn't seem like that's the idea. The explanatory introduction to the proposed directive in relation to the anti-avoidance elements of the ATAD states that “the norms would need to be part of a common E.U. wide corporate tax system and lay down absolute rules, rather than minimum standards.” So these vague provisions with lots of open questions seem to be the E.U.’s idea of absolute rules. And if the high-level open questions are meant to be interpreted consistent with certain principles, I'm worried about the principles that various E.U. tax authorities who seem to be revenue focused and seem to have developed an entrenched view of many multinationals as unscrupulous tax avoiders have in mind. So in my view, this is not a very favorable proposal for companies. And I see little upside for E.U. countries to go through the complex, sovereignty ceding process of adopting the vague but complex system in anticipation of an even more complex consolidation and apportionment system, which will certainly produce distinct winners and losers among the E.U. member states.

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