| Recent decisions of the European Court of Justice (ECJ) have struck down thin capitalisation rules, cast doubts on the legality of aspects of deposit interest retention tax, and struck down exit charges on changing residence. Further judgements are likely to strike down controlled foreign company legislation and denial of relief for overseas losses. |
In the last few months the ECJ has outlawed thin capitalisation rules, cast doubts on the legality of some aspects of DIRT, outlawed exit charges on change of residence, and caused the UK to significantly change its transfer pricing system for fear of being taken before the court if it did not.
There are cases pending before it challenging controlled foreign company (CFC) legislation, and challenging the denial of loss relief for losses incurred by non-resident group members.
The court has shown a determination to strike down every barrier to the free movement of labour and capital throughout the community, and to freedom of establishment of businesses in whatever state the businessperson desires. The court is unwilling to accept the excuse that particular restrictions are needed to safeguard the national revenue, or to defeat tax avoidance, or because they are linked to reliefs elsewhere in the tax system.
The broad thrust of the judgements from the ECJ is, if a tax rule has the effect of making it more difficult to conduct business across national borders, or to make a free decision as to where to carry on business within the EU, then the tax rule must go.
Deposit interest retention tax (DIRT)
The most recent case of significance to the financial service industry has the innocuouss name of the Commission versus France. There is no direct reference in this case to Ireland’s deposit interest retention tax, but the judgement nonetheless may require changes to tax as we know it.
The issue in the case concerned the treatment in France of interest from certain securities. A French resident could elect to suffer withholding tax on French source interest, and pay a flat rate of tax upon such interest. Alternatively they could elect to be taxed on such interest by assessment at their marginal rate of income tax. No similar choice was offered in relation to foreign source income. Such interest was always taxed by way of assessment, and at the marginal rate of income tax.
Fairly obviously, where the flat rate of tax on domestic interest was lower than the marginal rate of interest, a taxpayer would be inclined to elect for the flat rate and suffer a withholding tax accordingly. Such a taxpayer, by definition, would suffer a lower rate of tax on their French source interest than on foreign source interest, including interest from other EU member states. Accordingly their freedom to invest abroad was being inhibited by the tax advantage given to the French interest.
The European Court of Justice held that this was contrary to EU law by interfering with freedom of movement of capital.
In Ireland interest paid by deposit takers is taxed in the hands of individuals at a flat rate of tax (20%), which is levied by a withholding tax. Interest earned on similar deposits in other EU states is taxed by assessment at the marginal rate of income tax, under the self-assessment system. Given the high proportion of Irish individual taxpayers who pay tax at the 42% marginal rate of income tax, it is fairly clear that this dual system of taxation of domestic interest and foreign interest favours investment in domestic deposit accounts, and discriminates against investment in deposit accounts in other EU states.
Probably nothing will happen until some taxpayer, assessed to tax on interest from an EU state at his marginal rate of income tax, takes the matter to appeal. Alternatively the EU Commission may unilaterally take up the issue.
The Savings Directive is due to come into full force on 1 January 2005, subject to final agreement being reached with Switzerland and a handful of havens.
It would make sense for Ireland to review its discrimination against interest income arising in other EU member states at least by the date that the Savings Directive comes into full force. The option facing the government is to extend the 20% flat rate of tax to all interest income, or alternatively to allow domestic interest income to be taxed at marginal rates of income tax rather than being capped at 20%. The latter option is compatible with retaining withholding tax in the form of DIRT.
There is a certain sense of irony involved should it turn out to be the case that aspects of DIRT are contrary to EU law. The Revenue Commissioners are in the midst of a crackdown on bogus non-residence account holders and offshore account holders some of whom, at least, were attempting to evade DIRT. The legal status of DIRT in EU law is unlikely to help such taxpayers however.
Exit charges
Ireland has imposed a capital gains tax charge on trusts and on companies ceasing to be resident in Ireland, and on individuals who ceased to be resident but who do not stay out of the country for at least five years.
Exit charges are quite common throughout the EU. They are normal weapons used by high tax states to prevent persons and businesses from packing their bags and moving to a lower tax state (such as Ireland!).
France (yet again!) had such a tax and imposed it on Monsieur DeLasteyrie who chose to emigrate from France to Belgium. The tax charge in question is imposed by France when a French domiciled individual transfers his domicile abroad while owning shareholding of at least 25% in a company. If the shareholder sells the shares within 5 years after his change of domicile France will charge tax on the gain. This is very similar to Ireland’s exit charge on an individual ceasing residence.
The ECJ concluded that the French exit charge had the effect of discouraging French business people from going elsewhere in the EU to carry on their business or profession.
The implication of the ECJ judgement is serious for all EU member states. All of their exit charges stand revealed as illegal.
The judgement may have implications not only for Ireland’s formal exit charges, consisting of deemed disposal of assets at open market value on the occasion of going non-resident. It may also have implications for our charge of capital gains tax on worldwide disposals for a domiciled person in the three years after they ceased to be resident. This has been a long-standing part of our tax system. It could even have implications for the Irish income tax charge on foreign investment income of a domiciled person in the three years following their ceasing to be resident. All of these charges could be seen as taxes which inhibit a change of residence to another EU member state.
Thin capitalisation
In the Lankhorst Hohorst case, German thin capitalisation rules were declared illegal under EU law by the ECJ. Thin capitalisation rules restrict the deductibility of interest for tax purposes where a company is controlled by non-residents. Such a rule necessarily discriminates between the tax position of a local company controlled by resident persons, and a local company controlled by persons resident in other EU member states.
Although transfer-pricing rules have not yet been ruled on the ECJ, the UK changed their transfer pricing rules recently to avoid a challenge. A sensitive point here is that those countries which have transfer pricing rules usually apply them only to transactions with connected persons which are ‘cross border’. They tend not to apply them to transactions between connected persons both of whom are resident in the State.
The British solution was to extend transfer pricing to UK-UK transactions. The result is to achieve nothing in terms of the efficiency of the tax system, and to add significantly to the administrative cost burden on UK companies.
The ECJ is expected to hear cases taken by UK taxpayers seeking to declare the UK’s controlled foreign company legislation to be contrary to EU law (as it almost certainly is). Controlled foreign company legislation seeks to tax in the UK the profits of UK controlled subsidiaries resident elsewhere, including in other EU member states.
Cases are also pending before the ECJ on aspects of UK rules relating to loss relief. These rules are the same as the rules in Ireland in material respects. Broadly speaking, only losses arising from activities that are within the Irish corporation tax net can be group relieved against profits for the purposes of corporation tax. It is likely that the ECJ will hold that this is contrary to EU law in that if favours a group having all of its activities in one state and inhibits their having parts of their activities in other EU member states.
Where will it end?
The pace of change in tax laws as driven by the ECJ, is revolutionary. The arrival of ten new states on May 1 2004 will add to the problems of the high tax states whose tax defences are being dismantled. There are interesting times ahead. |
Brian Daly, Editor - KPMG Tax Monitor
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| Article appeared in the March 2004 issue.
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