A decision in Europe’s highest court may make it harder for EU-based holding vehicles established by private equity firms to receive dividends and interest free of withholding tax, and could influence how national tax authorities interpret and implement new anti-abuse rules relating to international double-tax treaties.
Asset managers will need to consider carefully the potential impact on their holding structures and be prepared to meet a higher bar for continued access to directives and treaties that protect from frictional tax costs.
Earlier this year, the Court of Justice of the European Union (CJEU) was asked to rule in respect of several Danish cases in which the Danish companies had claimed exemption from withholding tax under EU tax directives – the Parent-Subsidiary Directive and the Interest and Royalties Directive. In four of those cases, the companies were owned by private equity funds using Luxembourg entities between the funds and the companies. The Danish authorities had refused to grant the benefits of the directives, which resulted in withholding tax on the interest and dividend flows. In its ruling, the CJEU backed up the Danish tax authority’s decision on the grounds that the Luxembourg holding companies were mere conduits and did not meet the standards needed to claim access to the directives.
Private equity firms and other investment fund managers have long used Luxembourg to house their funds and holding structures for very sound commercial reasons. However, the continued drive to stamp out perceived tax avoidance has led to global tax reform and an explosion of new rules and changing interpretations of long-standing principles. These changes, in particular the OECD’s Base Erosion and Profit Shifting (BEPS) initiative, have led to complexity and uncertainty.
Invest Europe supports these initiatives and the desire to stamp out abusive practices but also recognises that the complexities of the fund industry may lead to inadvertent consequences arising from these changes. We have worked tirelessly to explain fund structures to policymakers and to try and alleviate some of these knock-on impacts. We continue to monitor the roll-out of these standards internationally to ensure they do not unfairly penalise our industry.
Nevertheless, the CJEU decision presents challenges for funds to navigate. The court conflated the concepts of “beneficial ownership” and “abuse”, deciding that if a holding company did not have beneficial ownership of the income stream in question, this was an indicator that it was a conduit entity – which in turn was indicative of abuse. Of particular relevance to private equity was the court’s view that to establish beneficial ownership companies must have “economic enjoyment” of money received. The court viewed the fact that, shortly after receiving the money, the holding companies paid some or all of it on to others, as an indication that they did not have “economic enjoyment” and so were not the beneficial owners of the income. It is clear that such factors as traditional substance (including people, offices etc.) at holding companies would probably not be enough to substantiate “economic enjoyment”.
In general, the court looked at the purpose of the structure in order to decide if it was abusive – the lack of economic enjoyment being one of the indicators that, in its view, supported a tax motivation for the structure. This signals a move away from previous court decisions, which looked at whether a transaction was a “wholly artificial” arrangement in deciding if it was abusive. Rather, the court more closely aligned itself with OECD concepts in recent global tax reform, such as the Principal Purpose Test (PPT), as well as the Anti-Tax Avoidance Directive’s General Anti-Abuse Rule (ATAD GAAR), both of which look at whether “the main purpose or one of the main purposes of a transaction is the obtaining of a tax advantage”.
In addition, the court examined the use of “SICARs” as holding vehicles and concluded that these types of entities (i.e. regulated entities that enjoy tax exemptions for certain income streams that fall within the regulatory parameters) did not qualify for the benefits of the EU tax directives.
In practice, the ruling may mean that some national tax authorities in the EU could take a harder stance towards common holding structures used by asset managers. Going forward, the ability to demonstrate economic activity in a territory will be increasingly important to show that structures are not abusive and for access to EU tax directives to continue. Moreover, it is likely that some EU national tax authorities will apply a similar standard for tax treaty access as they do to EU directives. These cases may well shape domestic policy for interpreting new anti-abuse measures being rolled out to a wide network of double tax treaties.
It will likely take time for member states to digest the CJEU ruling and for the full effects to be understood. Nevertheless, private equity firms may wish to take an objective look at the structures they operate and the issues they may present. Managers about to take funds to market should consider the potential impacts of the rulings on the structures proposed and take a flexible approach to fund documentation that could allow for restructuring in the future. Where risks may exist it will be important to avoid knee-jerk reactions and instead look at the individual facts and circumstances, as well as the background, that has led to this ruling.