Direct taxation : EC Communication on the application of anti-abuse measures - guide

11 December 2007
by eub2 -- last modified 11 December 2007

The European Commission adopted on 10 December 2007 a Communication inviting EU Member States to carry out a general review of their anti-abuse rules in the direct tax area, in light of the principles flowing from relevant ECJ case law, – and to explore possible coordinated solutions in this field. In order to prevent tax abuse, Member States have implemented anti-abuse rules with the aim of preventing economic operators from eroding the tax base in their territory by diverting their income to other countries. Member States' existing anti-abuse rules often do not properly take into consideration the freedoms of the Treaty and are therefore increasingly challenged. In the framework of an EU-coordinated approach in direct taxation (IP/06/1827), the Commission is willing to assist Member States in bringing their anti-abuse rules in line with EC law requirements and to explore the scope for constructive and coordinated responses to the challenges faced by Member States.

What constitutes abuse?

According to the doctrine of abuse of rights developed by the ECJ in its (mainly non-tax) case law, abuse occurs only where the purpose of law is defeated despite formal observance of the conditions laid down in the law, and there is an intention to obtain an advantage by artificially creating the conditions for obtaining it.

On direct taxation, in addition, the ECJ has held that the need to prevent tax avoidance or abuse can constitute an overriding reason in the public interest capable of justifying a restriction on fundamental freedoms. The notion of tax avoidance is however limited to wholly artificial arrangements aimed at circumventing the application of the legislation of the MS concerned.

Tax avoidance or abuse needs to be distinguished from tax fraud which involves deliberate unlawful behaviour which is generally punishable by law (e.g. submission of deliberately false statements or fake documents).

What are anti-abuse rules?

The notion of "anti-abuse rules" covers a broad range of rules, measures and practices through which Member States seek to protect their (corporate and individual) tax bases. For example, MS may apply a general concept of abuse based on legislation or developed in case law and/or more specific anti-abuse provisions, such as Controlled Foreign Corporation (CFC) and thin capitalisation rules which aim to protect the tax base from particular types of erosion (see below). Other types of specific anti-abuse provisions include, for instance, switch-over from exemption to credit method in certain cross-border situations and provisions explicitly targeted at passive investment in other countries.

What are Controlled Foreign Corporation (CFC) and thin capitalisation rules?

These are the most common types of specific anti-avoidance rules with which many MS seek to protect their tax bases against particular types of cross-border tax avoidance schemes. In brief, their scopes and objectives could be summarised as follows.

CFC rules: The main purpose of CFC rules is to prevent resident companies from avoiding domestic tax by diverting income to subsidiaries in low tax countries. The scope of CFC rules is generally defined by reference to criteria regarding control, effective level of taxation, activity and type of income of the CFC. They typically provide that profits of a CFC may be attributed to its domestic shareholders (usually a parent company) and subjected to current (immediate) taxation in the hands of the latter (whereas normally the parent company would be taxed on the profits of its foreign subsidiary only at the time of repatriation).

Thin capitalisation rules: There are many different approaches to the design of thin capitalisation rules but the background to these rules is similar. Debt and equity financing attract different tax consequences. Financing a company by means of equity normally results in a distribution of profits to the shareholder in the form of dividends, but only after taxation of such profits at the level of the subsidiary. Debt financing, in turn, will result in a payment of interest to the creditors (who can also be the shareholders), but such payments generally reduce the taxable profits of the subsidiary. Dividend and interest may also attract different withholding tax consequences. As the source state's taxing rights on interest are generally more limited than on dividends, debt financing can lead to the erosion of the tax base in the state of the subsidiary. To counter this problem, many MS have introduced specific thin capitalisation provisions dealing with structured debt financing schemes. Typically these limit the deductibility of interest paid on loans taken with (or otherwise arranged by) shareholders to the extent that the subsidiary is considered to be excessively "thinly" capitalised.

Why has the Commission issued this Communication?

As with other coordination initiatives in the direct tax field the obvious catalyst for the need to address issues related to the application of MS' anti-abuse rules lies with the development of the European tax law. Over the past few years the European Court of Justice (ECJ) has handed down a number of important judgments in this area in which it has clarified the limitations on the lawful use of anti-avoidance rules. The judgments will have a significant impact on the existing rules which have not been formulated with these constraints in mind. There is thus a need for a general review by MS of their anti-avoidance rules.

While it is important to ensure that there are no undue obstacles to the exercise of the rights conferred upon individuals and economic operators by Community law provisions, MS also need to be able to operate effective tax systems and prevent their tax bases from being unduly eroded because of abuse.

It is also vital that MS avoid overreacting to the case law. It would be regrettable if, in order to avoid the charge of discrimination, MS simply extended the application of anti-abuse measures designed to curb cross-border tax avoidance to purely domestic situations where no possible risk of abuse exists. Such unilateral remedies only add unnecessary red tape – and thus, they undermine the competitiveness of the MS' economies, and are not in the interest of the Internal Market. Moreover, it remains debatable whether such extensions can successfully bring all restrictive measures into line with MS' EC Treaty obligations

Moreover, and notwithstanding the guidance laid down by the ECJ to date, there remains scope for exploring the practical application of the relevant principles beyond the circumstances of the particular contexts in which they arose. The Commission therefore wishes to invite the MS and other stakeholders to work with it to promote a better understanding of the implications for MS' tax systems.

Is there (still) scope for application of anti-abuse measures within the EU/EEA?

As the ECJ has confirmed in a number of occasions, the need to prevent tax avoidance or abuse can constitute an overriding reason in the public interest capable of justifying a restriction on fundamental freedoms. But in order to be lawful national anti-avoidance rules must be proportionate and serve the specific purpose of preventing wholly artificial arrangements. It is in particular clear that those rules must not be framed too broadly but be targeted at situations where there is no genuine establishment or more generally where there is a lack of commercial underpinning.

It is clear from the case law of the ECJ that, for instance, CFC and thin capitalisation rules are generally apt to achieve their intended purpose and that they are not per se incompatible with the EC Treaty freedoms. However, such rules must be accurately targeted at situations of abuse and proportionate to the objective of preventing abuse.

Moreover, as Community law does not require MS to avoid discrimination in relation to the establishment of their nationals outside the Community, or the establishment of third-country nationals in a MS the issue of discrimination does not arise, for instance, in the cases of a controlled company or a creditor/shareholder resident in a third country. MS should therefore not be precluded from applying CFC and thin cap rules in relation to third countries.

How does this initiative relate to those on "harmful tax competition"?

MS cannot hinder the exercise of the rights of freedom of movement simply because of lower levels of taxation in other MS. This is the case even in respect of special favourable regimes in the other MS' tax systems.

Moreover, distortions to the location of business activities due to EC Treaty incompatible state aid and to harmful tax competition do not entitle MS to take unilateral measures intended to counter their effects by limiting freedom of movement; rather they need to be resolved at source through the appropriate judicial or political procedures. The Commission will continue to monitor the application of the EC Treaty state aid rules in the direct tax area and to lend its full support to the work undertaken in the Council by the Code of Conduct Group.

Why does the Commission not just litigate?

The number of infringement proceedings begun by the Commission has increased over the last few years. It is not always necessary for such cases to end up before the Court because often MS respond by removing the unlawful restriction.

But while the Commission has the legal obligation to ensure that MS observe their EC Treaty obligations it also has a political responsibility to seek and promote constructive tax policy solutions to that end. Moreover, through constructive solutions we may avoid situations where, in order to avoid the charge of discrimination, MS resort to extending the application of anti-abuse measures designed to curb cross-border tax avoidance to purely domestic situations where no possible risk of abuse exists. Such unilateral remedies only undermine the competitiveness of the MS' economies, and are not in the interest of the Internal Market.

What could be achieved in this area by coordination?

Coordination and cooperation between the MS can enable them to attain their tax policy goals and protect their tax bases while observing their EC Treaty obligations and ensuring the elimination of double taxation.

It is in the interest of all MS and other stakeholders, that MS remain capable of operating effective tax systems and that their anti-abuse rules are accurately targeted at situations of abuse and are predictable and proportionate. It is also in the general interest of the Internal Market that the ECJ's case law does not result in more draconian tax systems due to overreaction on the part of the MS. This could be the case if MS' unilateral remedies extended existing restrictions on cross-border activities also to purely domestic operations. Coordination is a flexible approach which can take many forms and which could provide adequate solutions to challenges faced by the MS in this area. Therefore the Commission considers it useful to explore the scope for possible specific co-ordinated solutions with a view to:

• developing common definitions for abuse and wholly artificial arrangements (to provide guidance on the application of those concepts in the direct tax area);
• improving administrative co-operation so as to more effectively detect and contain abuse and fraudulent tax schemes;
• sharing best practices that are compatible with EC law, in particular with a view to ensuring proportionality of anti-abuse measures;
• reducing potential mismatches resulting in inadvertent non-taxation; and
• ensuring better coordination of anti-abuse measures in relation to third countries.

Why is there a need to distinguish between the application of anti-abuse rules within the EU and in relation to third countries?

As regards the EC law compatibility of national anti-abuse measures, a distinction has to be drawn between their application within the EU/EEA, (where the four fundamental freedoms apply) and their application vis-à-vis third countries (where only the free movement of capital applies). The application of anti-abuse rules targeted at arrangements entered into by corporate groups beyond the geographical limits of the EU/EEA is thus generally less restricted by the EC Treaty. Community law does not require MS to avoid discrimination in relation to the establishment of their nationals outside the Community, or the establishment of third country nationals in a MS. Therefore, MS should not be precluded from applying CFC and thin capitalisation rules, for example, in relation to third countries.

The Commission moreover considers that, in order to protect their tax bases, MS should seek to improve the coordination of the application of their anti-abuse measures in particular in respect of international tax avoidance schemes. Such co-ordination could usefully consist of administrative co-operation, (e.g. exchange of information and sharing of best practices). The Commission would also encourage MS, where appropriate, to enhance administrative co-operation with their non-EU partners.

How does this initiative affect Member States' revenues?

The Commission supports MS' efforts to prevent their tax bases from being eroded. The possible coordinated solutions should enable the MS to attain their tax policy goals and protect their tax bases while observing their EC Treaty obligations. The key objectives of this initiative are indeed to strike a proper balance between the public interest of combating abuse and the need to avoid disproportionate restrictions on cross-border activity within the EU as well as to improve the coordination of the application of MS' anti-abuse rules in relation to international tax avoidance schemes in order to protect their tax bases.

How will taxpayers benefit from this initiative?

Taxpayers will benefit not only from the removal of disproportionate obstacles to their cross-border activities but also from successfully implemented coordinated solutions through improved clarity and predictability of the application of anti-abuse rules. It is equally in the interest of taxpayers if the coordinated solutions can help the MS to avoid extending existing restrictions on cross-border activities to purely domestic operations. Also, more generally, that MS remain capable of operating effective tax systems allows them to meet the requirement of equality – and it is not in the interest of honest taxpayers to finance the erosion of tax bases due to abusive practices and overtly aggressive tax planning schemes entered into by others.

Source: European Commission