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EC Interest Royalties Directive 2

 

The Commission is currently considering amending Council Directive
2003/49/EC of 3 June 2003 on a common system of taxation applicable to interest and
royalty payments made between associated companies of different Member States
(hereinafter “the Directive” or “the Interest and Royalties Directive”).

In the case of cross-border interest and royalty payments, the recipient companies may
face excessive or double taxation due to withholding taxes charged in the source Member
State, which lead to other efficiency losses: namely burdensome administrative
formalities linked to payments, resulting in compliance costs and cash-flow problems.

The purpose of the Directive is to put cross-border interest and royalty payments between
associated companies in the EU on an equal footing with domestic payments by
exempting them from taxes imposed by the source States.

However, the effects of the Directive are limited due to its current scope. If this remains
unchanged, the inefficiencies affecting the functioning of the single market will not be
removed. For example, the minimum shareholding requirements of the Directive currently differ from those of
the Parent-Subsidiary Directive, by requiring 25% rather than the 10% in the Parent-
Subsidiary Directive.

Extension of the list of entities covered by the Directive
Council Directive 90/435/EEC on the common tax regime applicable in the case of parent
companies and subsidiaries of different Member States (“the Parent-Subsidiary
Directive”) shares the aim of the Interest and Royalties Directive, namely the elimination
of double taxation. However, the lists annexed to the two Directives are different. The
one annexed to the Parent-Subsidiary Directive is broader and refers to more national
legal types. The consequence of this is that economic agents have to adopt a legal type
that is included in both lists in order to benefit from all harmonized corporate tax law.

Indirect shareholdings

The Directive only covers payments between associated companies. For this purpose, an
association is deemed to exist when one of the companies has a direct minimum holding
of 25 % in the capital of the other company, or a third company has a direct minimum
holding of 25 % in the capital of both the payer and the recipient companies.
As mentioned, the scope of the Directive is currently limited to direct holdings, while the
scope of the Parent-Subsidiary Directive has no such limitation. The consequence is that,
in order to benefit from all harmonized corporate tax law, economic agents must maintain
a minimum direct holding of 25%.

One option might be for the Directive to eventually encompass unrelated undertakings. It
is self-evident that international double taxation, burdensome administrative formalities
and cash-flow problems, such as cross-border obstacles to transactions between related
companies, are also present in the case of payments between unrelated parties. The
current harmonized tax law fosters activities within multinational groups, but does not
address the double taxation issues that are hampering the smooth functioning of the
single market in the case of transactions between independent parties.

The tax deductibility requirement applicable to payments made by PEs
The Directive covers payments made by permanent establishments (PEs)of companies situated
in an EU Member State. In this case, the obligation of the source State to refrain from
taxing is made conditional on such payments being a tax-deductible expense for the
payer. It is clear from the context that the purpose of the ‘tax-deductibility’ requirement is
to ensure that the benefits of the Directive accrue only in respect of those payments that
represent expenses which are attributable to the permanent establishment. However, on
its wording, the provision would also apply to cases where deduction is denied on other
grounds, such as a payment not meeting all the formal requirements for tax deductibility.

………………….

BACKGROUND
The Directive was adopted on 3 June 2003. The deadline for implementation was 1
January 2004. It has subsequently been amended by Council Directives 2004/66/EC
(OJ L 168, 1.5.2004, p. 35) and 2004/76/EC ( OJ L 157, 30.4.2004, p. 106). The former extends the application of the Directive to companies
and taxes of the new Member States (MS), while the latter grants some of the new
MS temporary derogations from one or more provisions of the Directive. Both
amending directives were implemented by 1 May 2004.

THE DIRECTIVE
Purpose and scheme
The purpose of the Directive is to put cross-border interest and royalty payments on
an equal footing with domestic payments, by eliminating juridical double taxation
and cash-flow disadvantages.
It is of equal concern that such payments should not escape taxation altogether.
According to recital 3, those payments should “…be taxed once in a Member State.”
The scheme consists of exempting interest and royalty payments from taxation at
source, whether by assessment or by withholding tax, while attempting to ensure that
the beneficial owner of the payments is taxed in its MS of residence or, in the case of
permanent establishments (PEs), in the MS where they are situated. The Directive
provides for a refund procedure for those cases where tax has been withheld at
source.
By taxing the beneficial owner in the MS of residence – in the case of PEs, in the MS
where they are located – it is guaranteed that such income is taxed in the same
jurisdiction where the related expenditure is deductable (i.e., the cost of raising
capital in the case of interest income, and research and development expenditure in
the case of royalties).

According to a survey made by IBFD, ten MS
do not levy withholding tax on outbound interest payments (with a further
two MS granting broad exemptions), and that six MS do not levy withholding tax on
royalty payments (an exception, in the case of one MS, for patent royalties).
The Directive is relevant even for those MS that
do not levy withholding taxes (or tax by assessment) on interest or royalty payments,
inasmuch as Articles 4 and 5 limit the discretion of all MS to recharacterise interest
or royalty payments as profit distributions and levy taxes thereon.
‘Beneficial owner’
The beneficial ownership condition aims at ensuring that relief under the Directive is
not wrongfully obtained through the artificial interposition of an intermediary.
While there are differences of wording between the beneficial ownership criteria for
companies and PEs, respectively, the key difference lies in the reference to
“…income in respect of which that permanent establishment is subject…to one of the
taxes…”. The Directive here makes explicit that the payments as such must be taxed
in the hands of the beneficial owner.
The MS have adopted different approaches in respect of the
beneficial ownership criteria. With regard to companies, some MS have chosen not
to transpose the Article 1(4) definition at all, others have relied on domestic
definitions, and yet another group of MS have transposed it with deviations. As
regards PEs, some MS have chosen either not to transpose Article 1(5) at all, or to
transpose it with national variations.
Those differences of approach could lead to relief being denied in one MS, but being
granted, in identical circumstances, in another. The
co-existence of 27 potentially different interpretations would undermine the
effectiveness of the Directive.

PE – ‘Tax-deductible expense’
In the case of payments made by PEs, the obligation of the source State to refrain
from taxing is made conditional on such payments being a tax-deductible expense for
the payer.
It is clear from the context that the purpose of the ‘tax-deductibility’ requirement is to
ensure that the benefits of the Directive accrue only in respect of those payments that
represent expenses which are attributable to the PE. However, on its wording the
provision would also apply to cases where deduction is denied on other grounds.
While the IBFD found no cases in the surveyed MS of relief having been denied on
the grounds that the payment was a non-deductible expense, it cannot be excluded
that such cases may occur in future, and that the host state of the PE might in that
situation impose a withholding tax on the payment.
In order to avoid an unjustifiable difference of treatment as between a subsidiary and
a PE, consideration might be given to rewording Article 1(3) in order to make it
more precise.

Holding period
Eleven of the 20 surveyed MS have availed themselves of the option provided for by
Article 1(10) to impose a minimum holding period as a condition for enjoying the
benefits of the Directive. According to the survey, three of these MS require this
condition to be satisfied at the time of payment, with no possibility for a subsequent
fulfilment of the condition to be taken into account retroactively.
The latter requirement appears to be inconsistent with the purpose of the Directive in
general and of Article 1(10) in particular, and with the relevant ECJ case law. In the
Denkavit case, concerning the holding period option provided for by Article 3(2) of
the Parent-Subsidiary Directive, the Court found that as a derogation from the
principle of exemption from withholding taxes laid down by that Directive, the
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holding period option was to be interpreted strictly.5 It further noted that the
provision in issue was “aimed in particular at counteracting abuse whereby holdings
are taken in the capital of companies for the sole purpose of benefiting from the tax
advantages available and which are not intended to be lasting”6.
The above findings have direct relevance for the interpretation of Article 1(10) of the
Directive. As in the case of Article 3(2) of the Parent-Subsidiary Directive, Article
1(10) constitutes a derogation from the principle of exemption from withholding
taxes, and is therefore to be interpreted strictly. It also shares the same purpose as
Article 3(2), i.e. to counteract abusive enjoyment of the benefits of the Directive
through temporary, purely tax-motivated holdings. That purpose is achieved if the
holding is maintained for the required minimum period, regardless of whether that
period has already come to an end at the time of payment or whether it comes to an
end only at some later time, such as the date on which an application for relief is
submitted.
The ECJ has held that MS are not obliged to grant the exemption from the beginning
of the holding period without being certain of being able to recover the tax if the
holding were not maintained for the minimum period or to grant the exemption
immediately on the basis of a unilateral undertaking by the parent company7.
However, this judgment was delivered before the Council amended Directive
76/308/EEC in order to extend the scope of administrative cooperation in the
recovery of claims to taxes on income8. This new legal context could modify
Member States’ obligations under the Directive since they now have new tools to
recover tax debts.
3.3.4. Article 2 – ‘Interest’ and ‘Royalties’
The survey did not reveal any significant discrepancies between the Article 2(a)
definition of ‘interest’ and those relied on in the context of national legislation
transposing the Directive. Nor do there appear to be any obvious differences between
the Article 2(a) definition and that of Article 11 of the OECD Model Tax Convention
(MTC) that might be of relevance for the application of the Directive.
According to the survey, two MS applied a narrower definition of royalties than that
contained in Article 2(b). Thus, some royalty payments from those MS could at that
time have been subjected to withholding tax, depending on the content of national
law and relevant double tax conventions (DTCs). Since the survey was finished, one
of the MS has subsequently amended its legislation in order to align its domestic
definition on that of the Directive.
The definition contained in Article 2(b) is precise and unambiguous. It follows that
MS can depart from that definition only to the extent that by so doing they grant
relief that is identical to, or more generous than, that prescribed by the Directive.
5 Judgment of 17.10.1996 in Joined Cases C-283/94, C-291-94 and C-292/94 Denkavit International BV
a.o. v Bundesamt für Finanzen, paragraph 27.
6 Paragraph 31.
7 Denkavit, paragraph 33.
8 Council Directive 2001/44/EC of 15 June 2001 amending Directive 76/308/EEC on mutual assistance
for the recovery of claims resulting from operations forming part of the system of financing the
European Agricultural Guidance and Guarantee Fund, and of agricultural levies and customs duties and
in respect of value added tax and certain excise duties, OJ L 175, 28.6.2001, p. 17–20.
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3.3.5. Article 3(a) – ‘Company of a MS’
3.3.5.1. The Annex – List of entities
Several MS have chosen to extend the benefits of the Directive to payments from a
broader range of entities than those listed in the Annex, while maintaining the Annex
requirements in respect of the recipients of the payments.
3.3.5.2. Transparent entities
It is conceivable that one or more of the entities listed in the Annex could be
regarded as fiscally transparent by a MS other than that in which the entity is
registered or incorporated.
The Directive does not contain any provision allowing MS to ‘look through’ nonresident
qualifying9 entities. It follows that a MS has no legal basis for refusing to
apply the Directive to a non-resident entity which meets the requirements of Article
3.
However, even if it were permissible to apply a look-through approach, the logic of
that approach would require the MS in question to extend the benefits of the
Directive to the partner/shareholder. That view would be consistent with the position
taken in the OECD Partnership Report and the Commentary on Article 1 of the
MTC10.
3.3.5.3. Place of effective management
Three of the surveyed MS appear to require, as a condition for granting exemption,
that the company receiving a payment should be subject to corporation tax in the MS
in which it has its place of effective management. This could lead to a denial of the
benefits of the Directive in a situation where, for instance, both the MS in which the
company is incorporated and that in which it has its place of effective management
rely, in their domestic legislation, on the place of incorporation as the relevant factor
for determining tax residence.
There is no support in the text of the Directive for imposing one tax residence
criterion in preference to another. If the company is resident in one MS only, it
matters not whether the criterion applied by the MS of residence is the place of
incorporation or the place of effective management. If the company is dual resident,
the tie-breaker rule of the relevant DTC will usually determine residence on basis of
the ‘place of effective management’ criterion. In the latter situation, it may be
reasonable to expect that the company should be “subject to one of the following
taxes without being exempt” [Article 3(a)(iii)] in the MS in which the company has
its place of effective management.11
3.3.5.4. Subject-to-tax requirements
While most MS appear to apply a ‘subjective’ subject-to-tax requirement – i.e. it
applies to the company as such, rather than to the specific interest or royalty payment
– some MS require that the payment itself should be subject to tax (an ‘objective’
subject-to-tax requirement).
9 I.e. that meet all of the criteria of Article 3.
10 See in particular paragraphs 6.4 and 6.5.
11 A position that could conceivably be challenged on the grounds that in a case where a PE is the
recipient of an interest or royalty payment it should suffice that the company is subject to tax in the MS
of the PE on profits attributable to the latter.
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According to the survey, one MS requires that the company should not have an
option of being exempt. That MS furthermore requires that the company should be
subject, in its MS of residence, to a tax that is of the same or similar character as the
income tax in the first MS.
There is no support in the Directive for either requirement. On the contrary, the
conditions of Article 3(a) are exhaustive, thus leaving no scope to impose further
conditions and restrictions.
3.3.6. Article 3(b) – ‘Associated company’
3.3.6.1. Holding threshold
According to the survey, no MS had relaxed the 25% direct minimum holding
threshold, although one MS accepts indirect holdings. However, several MS had
either moved from a ‘capital’ criterion to a ‘voting rights’ criterion, or allowed the
alternative use of either criterion.
The survey found that one MS requires that both criteria, ‘capital’ and ‘voting
rights’, be satisfied simultaneously. There is no support in the Directive for such a
dual requirement.
3.3.6.2. Companies ‘involved’
One MS has extended the scope of relief available under the Directive by dispensing
with the requirement that the common parent in the situation described in Article
3(b)(iii) should be EU-resident. MS can be more generous than the Directive.
3.3.7. Article 3(c) – PE – Definition
The definition of a PE is clearly modelled on that of Article 5 of the OECD MTC,
but without reproducing the list of examples and exceptions contained in Articles
5(2) to 5(7).
The fact that the Directive’s definition differs somewhat from that of Article 2(2) of
the Parent-Subsidiary Directive, and that neither definition reproduces exactly
Article 5 of the OECD MTC, may create a situation of legal uncertainty, in particular
concerning the situation of dependent agent PEs.
When implementing the Directive most MS have chosen to rely on the general PE
definition contained in their respective domestic tax legislations. However, five MS
have introduced a specific definition for the purpose of implementing the Directive.
3.3.8. Article 4(2) – Exclusion of payments as interest or royalties
Article 4(2) is a transfer pricing provision. As is clear from the commentary on the
Article contained in COM (1998) 67 final, it is also intended to be a thin
capitalisation provision. The commentary also argues that any amount reclassified as
a profit distribution should be granted the benefits of the Parent-Subsidiary
Directive12.
The survey found that one MS would deny the benefits of the Parent-Subsidiary
Directive for interest and royalty payments reclassified as hidden profit distributions,
on the grounds that under domestic case-law such distributions cannot be regarded as
12 Cf. the opinion of AG Mischo of 26.9.2002 in Case C-324/00 Lankhorst-Hohorst.
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dividends. However, that MS finds itself unable to charge withholding tax if there is
a DTC, since the dividend Article of the DTC would not apply.13
There is a need for further reflection regarding the tax treatment of excess amounts
of interest or royalties, whether or not reclassified as profit distributions. Depending
on the circumstances, there could conceivably also be a question of discrimination
vis-à-vis the treatment of similar domestic payments.
In this context it should be noted that the Court has found that the discriminatory
application of thin capitalisation provisions involving a fixed debt/equity ratio, with
no let-out clause, constitutes a disproportionate, and therefore unjustifiable,
restriction of the freedom of establishment.14
3.3.9. Article 5 – Fraud and abuse
Several MS appear to interpret Article 5 as authorising the denial of relief in cases
where the receiving company is controlled by a third-country resident.
One MS appears to deny the benefits of the Directive to a receiving company of
another MS which is owned or controlled by a person ordinarily resident or
domiciled in the first MS.
Article 3(b) requires that “holdings must involve only companies resident in
Community territory”. The Directive does not however stipulate that a parent
company receiving an interest or royalty payment from its part – or wholly- owned
subsidiary must be controlled by an EU resident (or by a resident of a MS other than
that of the subsidiary) in order for the payment to qualify for relief.
Article 5 must moreover be interpreted in the light of the relevant ECJ anti-abuse
case-law, which requires anti-abuse measures to be appropriate and proportionate.15
Domestic legislation or a DTC provision that denies relief on the sole grounds that
the parent company is controlled by a third-country resident – or by one of its own
residents – is unlikely to meet the proportionality test, as it does not “have the
specific purpose of preventing wholly artificial arrangements”.16
It should be recalled that the ‘beneficial owner’ condition of Article 1 is specifically
designed to tackle artificial conduit arrangements. It may therefore be doubted
whether a company that satisfied the ‘beneficial owner’ test, could be considered an
artificial conduit when applying Article 5.
3.4. Issues not addressed by the survey
3.4.1. Intra-company payments
The scope of the Directive is currently limited to payments between separate legal
entities. Thus, it does not cover the intra-company situation, for instance actual or
13 This may not be beyond doubt. In a reservation on Article 10(3) of the OECD MTC, the MS in question
reserves “the right to amplify the definition of dividends in paragraph 3 so as to cover all income
subjected to the taxation treatment of distributions”. A payment need not therefore necessarily qualify
as a ‘dividend’ under the domestic law of that MS in order to be considered a ‘dividend’ when applying
Article 10(3).
14 Case C-105/07 Lammers, paragraph 32. See also Case C-524/04 Thin Cap Group Litigation, at
paragraph 92.
15 E.g. judgment of 17.7.1997 in Case C-28/95 Leur-Bloem v Inspecteur der
Belastingdienst/Ondernemingen Amsterdam 2, paragraph 44.
16 E.g. judgment of 13.3.2007 in Case C-524/04 Test Claimants in the Thin Cap Group Litigation v
Commissioners of Inland Revenue, paragraph 79.
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notional payments between a head office and a PE, or between two PEs of the same
company.
In the context of the OECD work on the attribution of profits to PEs, the question has
arisen whether, under DTC, the source state (usually the state of the PE) would be
entitled to levy a withholding tax, or other form of taxation at source, on notional
interest or royalty payments to the head office or other PE of the same company.
The matter is still under debate, but some OECD countries have indicated that they
would be minded to impose a withholding tax on the above payments.
Taxation at source on intra-company payments would create disadvantages for crossborder
investment similar or identical to those that prompted the adoption of the
Directive. It would therefore seem appropriate to consider extending the scope of the
latter to cover such payments.
3.4.2. Holdings
The threshold: Article 3(b) of the Directive currently stipulates that ‘holdings’ within
the meaning of that provision should meet or exceed a threshold of 25% of capital or
voting rights. Under Article 3 of the Parent-Subsidiary Directive, which contains a
similar provision, the threshold for ‘holdings’ has gradually been reduced from 25%
to currently 10% of capital or voting rights as of 2009 (cf. also Article 7(2) of the
Merger Directive).
Thus, even though all three EC company tax directives share the aim of creating
conditions analogous to those of an internal market, a company group for the
purposes of the latter two directives remains something less than a company group
under the Interest and Royalties Directive, thereby increasing the planning and
compliance costs of companies involved in cross-border operations.
The difference between thresholds may produce incongruous results, for instance in
the context of a reclassification of an interest or royalty payment as a profit
distribution. An interest or royalty payment between companies associated through a
‘holding’ of at least 10%, but less than 25%, would not qualify for relief under the
Interest and Royalties Directive, but would qualify for relief under the Parent-
Subsidiary Directive if reclassified as a profit distribution.
Indirect holdings: the scope of the Directive is currently limited to direct holdings,
while that of the Parent-Subsidiary Directive has no such limitation. Since both
directives share the same purpose – i.e. to eliminate double taxation – there is no
obvious justification for this difference.
Extension of the scope: while the elimination of inconsistencies in respect of
thresholds and direct/indirect holdings would represent a significant improvement on
the existing situation, it can be deduced from Article 8, read in conjunction with
recitals 2, 4 and 9, that it was the intention that the Directive should eventually
encompass unrelated undertakings, and that the current limitation to associated
undertakings should be seen only as an experimental first step. It is self-evident that
international double taxation, burdensome administrative formalities and cash-flow
problems, as cross-border obstacles to transactions between related companies, are
also present in the case of payments between unrelated parties.
As regards royalty payments, an extension of the scope of the Directive to unrelated
undertakings would be consonant with the Article 163 EC objective of
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“…strengthening the scientific and technological bases of Community industry and
encouraging it to become more competitive at international level…”
It should also be noted that extending the scope would be consistent with Articles 11
and 12 of the OECD MTC, which make no distinction between related and unrelated
undertakings.
Finally, the budgetary impact of an extension would have to be considered. However,
it should be noted that it is likely to be limited, since most MS already waive their
taxing rights partly or wholly, either through domestic legislation or in their DTCs
with other MS.
4. CONCLUSION
While the survey indicates that overall implementation has been satisfactory, it has
also highlighted a number of cases of questionable transposition and interpretation,
e.g. in respect of the minimum holding period, tax residence of the beneficial owner,
holding threshold, reclassification of hidden profits, the interrelation between the
Interest and Royalties Directive and the Parent – Subsidiary Directive and the fraud
and abuse clause.
It is also clear that further discussion and guidance in respect of key Directive
concepts may be necessary in order to achieve uniformity of interpretation, and
reduction in legal uncertainty. There is a need to reflect on the implications of a nonuniform
implementation and interpretation of the ‘PE’ concept in the context of the
Directive, and of having a PE definition that diverges from that of Article 5 of the
MTC, e.g. with regard to the possible exclusion of agency PEs.
As to amendments that might improve the operation of the Directive, a rewording of
Article 1(3) could remove what may be seen as an unjustifiable discrimination
between subsidiaries and PEs. And in terms of coherence and consistency, aligning
the holding criteria of the Directive with those of the Parent-Subsidiary and Merger
Directives should clearly be an urgent priority. Consideration might now be given to
extending the scope of the Directive to unrelated undertakings, with a view to assess
its potential to further the Lisbon objectives.