Investment Platform or Abusive Conduit?

Speed Read

• Two recent ECJ decisions have discussed the concept of beneficial ownership and abuse of law in the context of the EU Parent Subsidiary and Interest and Royalties Directives.
• The benefits of the Interest and Royalties Directive will only be granted if the (direct or indirect) recipient of the interest payment is the beneficial owner of such payment and is resident in an EU country. The ECJ held that the definition of beneficial owner is to be construed in line with the OECD Model Convention and Commentary. 
• The burden of proof that the recipient is not the beneficial owner lies with the tax authorities, but they are only required to demonstrate absence of beneficial ownership and not who the real beneficial owner of a certain payment is. 
• The ECJ stated that the benefits of the directives should not be granted where the abuse of law principle applied regardless of whether specific anti-abuse measures had been enacted by a Member State. 
• There is an abuse when, despite formal compliance with the relevant directive, the purpose of that directive is defeated and the intent of the taxpayer is to obtain the benefit of the directive by artificially creating the conditions for its application. The ECJ gave a list of "indicia" that a structure is abusive.
• A Luxembourg SICAR may not benefit from the Interest and Royalties Directive withholding tax exemption, as the interest received by the SICAR is, under certain conditions, exempt in Luxembourg. 
• It is expected that the recent decisions will facilitate challenging the application of the directives by the tax authorities in the different EU jurisdictions, in particular on structures set up by the funds. Corporate and finance structures and payments within private equity groups and multinational groups should be monitored. 

Introduction

On 26 February 2019, the Grand Chamber of the European Court of Justice (ECJ or Court) delivered two long-awaited landmark decisions on six cases on the ability of a Member State to deny the withholding tax exemption under the Interest and Royalties Directive (Directive 2003/49/EC) and under the Parent Subsidiary Directive (Directive 90/435/EEC) in cases of abuse. Directive in this briefing refers to the IRD and/or the PSD as appropriate.

The six cases have in common the main factual background: 

• A Danish company paid a dividend or interest, in principle subject to withholding tax under Danish law, to a recipient established in another Member State (Luxembourg, Cyprus, Sweden). 
• The ultimate shareholder or lender was either a private equity fund or an entity established outside the EU, not entitled to the benefits of a Directive. 
• The recipient sought the exemption from the Danish withholding tax based on the Directive. 
• The Danish tax authorities denied the exemptions sought on the grounds of abuse, of the recipient not being the beneficial owner of the payment and of the recipient not meeting the requirements for the application of the Directive. 
• The Danish courts referred the matter to the ECJ. 

The ECJ addressed jointly the cases C 116/16, T Denmark and C 117/16, Y Denmark concerning the application of the PSD (the PSD Cases) and the cases C 115/16, N Luxembourg 1, C 118/16,  Denmark, C 119/16, C Denmark 1 and C 299/16, Z Denmark (the IRD Cases).  

Beneficial Ownership

In the IRD Cases, the ECJ also addresses the definition of "beneficial owner" for the purpose of art. 1 of the IRD. Unlike the PSD, the IRD states that "A company of a Member State shall be treated as the beneficial owner of interest or royalties only if it receives those payments for its own benefit and not as an intermediary, such as an agent, trustee or authorised signatory, for some other person". The ECJ here goes further and clarifies that the definition of beneficial owner is not the formal recipient of a payment, but the person who economically benefits, and has the power to freely determine the use, of such payment. The position of the ECJ is relevant in two respects: 

• It aligns the definition of beneficial owner in the IRD to the definition of the same concept in the OECD Model Convention and Commentary; and
• It clarifies that the beneficial ownership requirement can be achieved indirectly for the application of the IRD: where the immediate recipient of an interest payment is not the beneficial owner of the payment, the requirement for the application of the IRD may be met by the subsequent recipient if resident in a EU jurisdiction.

The ECJ briefly addresses the topic in the PSD Cases as well, even if the PSD does not explicitly require the recipient of the dividends to be the beneficial owner of the payment. More specifically, the Court states that, when the beneficial owner of the dividend is a resident of a third country, the PSD is not applicable irrespective of the demonstration of the existence of a fraud or of an abuse.

Abuse of the Directive

In both the PSD Cases and the IRD Cases the ECJ confirmed that Member States should not grant the benefits of the directives in the presence of a fraudulent or abusive practice recognising though that taxpayers legitimately look for the most tax efficient structure. 

The demonstration of the existence of an abusive practice must be based both on an objective element (the combination of objective circumstances showing that, despite the formal compliance with the relevant provision, the purpose of the directive has been defeated) and on a subjective element (the intention to obtain the benefit of the relevant directive by artificially putting in place the conditions thereof). 

The ECJ provided a list of indicators that the transaction or arrangement is abusive:

• the existence of a group of companies or the interposition of conduit entities lacking economic justifications. The existence of a conduit company may be established where a company does not perform any other activity acting as a passive holding company: the absence of a meaningful activity shall be based on the analysis of the relevant factors relating to the management, balance sheet, costs structure, fund expenditure, staff, premises and equipment;
• the repatriation of the dividends and interest, very soon after they are received, to a company that would not be entitled to the application of the PSD or IRD, respectively, had the payment been made directly to such company; 
• the formal or informal obligation to repatriate the dividends received to a company not entitled to the PSD;
• nominal payments of corporate income tax by the company;
• a short time period between the restructuring and the entry into force of a new set of tax rules.

In both the PSD Cases and IRD Cases, the ECJ stated that the prohibition on granting the benefits of the directives stems from the general principle of EU law and does not require the implementation, under the domestic law of the Member States or in the double tax treaties signed by them, of anti-abuse provisions. This decision is of less importance for the future in light of the recent requirement to implement the general anti-abuse rule in the EU Anti-Tax Avoidance Directive (ATAD GAAR) by the EU Member States.

Finally, the ECJ clarifies that the burden of proof of establishing abuse lies with the tax authorities, which are however not required to demonstrate the identity of who is the actual beneficial owner of the payment for which the directive benefit is refused. 

The decisions of the Court seem to bring the ECJ case law, so far largely based on the Cadbury Schweppes case (C 196/04), in line with the stricter OECD and ATAD GAAR definition (as discussed in the box "Development of the concept of abuse"). 

In previous cases regarding the German (Deister Holding, C-504/16; Juhler Holding C 613 / 16) and French (Eqiom SAS and Enka SA C-6 / 16) anti-treaty shopping rules the ECJ decided that a general assumption of tax avoidance may not justify tax legislation which limits the purposes of a Directive or the use of the fundamental rights under EU law. According to these decisions tax authorities may not rely on general assumptions to assess whether a certain structure is abusive without having an indication of an abusive behavior of the tax payer. These recent cases suggest that the ECJ may now be more prepared to find that abuse exists based on general indicators arising from the structure.

Development of the concept of abuse

In 2006 the ECJ issued its cornerstone decision on the Cadbury-Schweppes case (C 196/04), where it was stated that a domestic anti-deferral rules (like the UK CFC rule) is compatible with the fundamental freedoms only to the extent they apply to wholly artificial arrangements intended to escape the national tax otherwise due. A wholly artificial arrangement does not exist where the taxpayer carries on genuine economic activity, even if motivated by tax reasons. The existence of a genuine activity that reflects economic reality may be demonstrated on the basis of objective factors, often in practice referred to as "substance" (office space, employees, costs and equipment). This decision was broadly followed in the subsequent ECJ case law on direct and indirect taxes (to mention a few: C 255/02, Halifax, C 182/08, Glaxo Wellcome, C 31/08, SGI). 

Changes arising after the OECD Base Erosion and Profit Shifting project significantly broadened the concept of abuse:

• The ATAD GAAR provides that Member States shall ignore an arrangement or a series of arrangements which, having been put into place for the main purpose or one of the main purposes of obtaining a tax advantage that defeats the object or purpose of the applicable tax law, are not genuine having regard to all relevant facts and circumstances. An arrangement or a series thereof is treated as non-genuine to the extent that they are not put into place for valid commercial reasons which reflect economic reality (art. 6 ATAD). Demonstrating the existence of a commercial rationale for the arrangement, or showing an adequate level of substance, is not sufficient to escape the application of the anti-abuse provision. 
• The Principal Purpose Test in the Multilateral Instrument (MLI) requires that treaty benefits are denied whenever "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" (art. 7 MLI). There is no exception for taxpayers that can demonstrate the valid commercial reasons reflecting economic reality behind the transaction or arrangement. The measure is broader at several levels: 

(i) it includes a subjective valuation ("it is reasonable to conclude");

(ii) it is sufficient that the tax advantage is one of the main purposes of the arrangement;

(iii) the benefit can be direct or indirect; and

iv) not only an "arrangement" but also a "transaction" can be considered abusive.

Directive entitlement of Luxembourg SICARs 

Another issue addressed by the ECJ is the IRD entitlement of a Luxembourg SCA SICAR, a company fully subject to tax in Luxembourg, which however benefits from an exemption of the income derived from risk capital investment in the form of securities. The ECJ stated that, to the extent SCA SICAR is not taxable on the interest received, such interest may not benefit from the IRD (to be determined by the referring court). Such decision appears to be in contrast with the general position that the subject to tax requirement in the IRD (as well as in the PSD and in double tax treaties) is subjective (it refers to the recipient of the income in general) rather than objective (the actual taxation of the specific item of income is irrelevant). 

It is also interesting to note how a Swedish company, and not the SICAR, was the direct recipient of the interest payment. The fact that the Court, pursuant to the question of the Danish court, examines the IRD entitlement of SICAR, confirms that the IRD can be applied to an indirect recipient, provided that the latter meets the prescribed requirements. The same principle is explicitly mentioned by the Court  when dealing with the concept of beneficial ownership. 

The Luxembourg SICAR

The Luxembourg SICAR (société d'investissement en capital à risque) was introduced by the law of 15 June 2004. It is a regulated vehicle that can be set up as a partnership or as a corporate entity. In the latter case, the SICAR is fully subject to corporate income tax in Luxembourg (impôt sur le revenu des collectivités, mentioned in art. 3 of the IRD as applicable corporate income tax) and as such is generally considered a resident of Luxembourg for tax purposes, entitled to the application of EU Directives and of double tax treaties. Income and gains from transferable securities are however exempt in the hands of a corporate SICAR, as well as the income from funds waiting to be invested in ventures. 

As in the N Luxembourg 1 case, SICARs typically function as funds, and make every single investment through Luxembourg or foreign SPVs. 

Currently, there are about 500 SICARs established in Luxembourg.

Conclusions

The two recent judgements carry important clarifications, such as the definition of beneficial ownership in the IRD and the possibility to apply the benefits of a directive to the indirect recipient of a qualifying payment. 

It remains to be seen how this will be applied in the EU member states in which interest, royalties or dividends arise. It may be used by tax authorities in the EU member states as a tool to challenge the availability of withholding tax exemptions in relation to claims relying on the Directives but also on double tax treaties where the same beneficial ownership ownership question arises.

Secondly, the ECJ takes its position in the ongoing evolution of the concept of "abuse" in international tax. In particular, after more than ten years of application of the Cadbury-Schweppes doctrine, where only wholly artificial arrangements could be denied access to the fundamental freedoms, the ECJ seems to align its view to the more recent abuse definition of the ATAD GAAR and of the MLI: an investment structure set up for, among others, tax reasons, may be denied the benefits of a EU directive. In simple terms, where Cadbury-Schweppes said that tax motives are worth of protection where they are supported by adequate substance, the new concept of abuse seems to condemn any transaction of arrangement that is wholly or mainly aimed at obtaining abusive tax advantages. 

In recent years, our experience has been that holding companies are taking steps, where appropriate, to review and increase their substance in jurisdictions such as Luxembourg, the Netherlands and Ireland. This case reinforces the need for such action.