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Saturday, 27th April 2024 |
| Overseas investment by individuals |
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| An anti avoidance provision, section 806, which was originally aimed at preventing tax avoidance arising from the diversion of income by resident individuals to foreign entities, has become an obstacle to foreign investment in a way not originally envisaged. It is poorly aligned with EU law and with other Irish tax measures impacting cross border investment.These measures ignore the need for major investment projects to retain earnings to be viable in the long term. Section 806 together with the general anti avoidance provision, section 811, it is part of a tendency to permit taxation by Revenue discretion , rather than by clear legal provisions. |
The anti avoidance measure S806 started out its career in Irish tax in 1974. It was copied almost exactly from a UP measure which had its roots as far back as the 1930s. It had the capacity for income tax purposes to attribute to a domiciled resident individual, the income of a non resident person. This was permitted if that income arose as a direct or indirect result of a transfer of assets by the Irish resident individual and that individual or his/her spouse had the power to benefit in any fashion from the income in question.
The income was attributable to the individual or his spouse only if the transfer or associated operations on the assets transferred were carried out to avoid Irish income tax. In a subsection that seemed to overlap the requirement just mentioned, the section was excluded if the transfer had been for bona fide commercial reasons and the avoidance of any Irish tax was not one of the main purposes of the transfer.
As originally drafted it was a reasonable anti avoidance measure, whose principal defect was the unfortunate difficulty in deciding when it had application. Few transactions are entered into without regard to possible Irish tax consequences, which made it difficult to decide if the references to purpose of avoiding Irish income tax or other Irish taxes applied to any particular foreign investment by an individual. However as a result of amendments to section 806 made in this year's Finance Bill, and in the Finance Act 1998, the original scope of the section has become very wide, and the protection for bona fide commercial transactions has been significantly weakened. As a result, the section is now potentially a worrying threat to the commercial structuring of investment abroad by Irish resident individuals.
The amendments
The original purpose of the legislation was to prevent avoidance of income tax by a resident individual. However since 1998 the section can apply even if the transfer of assets is not for the purpose of avoiding income tax and even if the transfer is by a person when they are not resident in the State. The courts have not had the opportunity to clarify the scope of the legislation after this amendment but one possible interpretation is that it could apply in almost any situation where an individual directly invests in a foreign entity. In such a situation an individual might have to rely on the exclusion of the section where the investment is for bona fide commercial reasons and where one of the principal purpose of the transaction is not avoidance of Irish tax.
Unfortunately the Finance Act 2007 has restricted that exemption from the operation of the section to an investment involving a trade abroad. The protection of that exemption is now denied to bona fide commercial transactions not involving a trade. This restriction of the exemption could affect, for example, property investment abroad structured through a company or other such non transparent entity.
The result of these two sets of amendments has been to transform a reasonable focused anti avoidance section into a provision whose scope is uncertain and potentially damaging to commercial cross border transactions. At best it leaves unnecessary uncertainty and at worse may leave it to some hapless citizen to ask the courts to decide that the section has gone too far and is unconstitutional as an unjust attack of property rights. That does not seem a sensible outcome to two finance acts. Needless to say, there was no discussion or analysis of the legislation in the Daily during the debates on the Finance Act 2007.
Related legislation
Section 806 is only one of several sections of tax legislation which can affect cross border investment. Section 807A is a closely related section that can attribute the income of a non resident person to Irish resident persons who benefit from that income, even though they did not make a transfer of assets that gave rise to the non resident person having that income. Prior to the Finance Act 2007 this section did not apply where the original transfer of assets from which the income ultimately arose was made for bona fide commercial reasons and did not have the avoidance of Irish taxes as one of its principal purposes. Now however that exemption appears to be effectively restricted to a transfer of assets associated with a trade. This is especially daft since s807A can apply where eg a USA citizen who has never been to Ireland in his life creates a trust from which an Irish resident grand-nephew receives a benefit. As in the case of section 806, it is now difficult to rationalise the the policy behind section 807A.
Section 590 can attribute to an Irish resident shareholder of a closely held non resident company the capital gains of that company. There is no restriction on the operation of the section to a case of tax avoidance nor any exclusion for a commercial investment. The operation of the section is automatic in all circumstances where the protection of a double tax agreement is not available. Similar provisions can attribute the gains of a non resident trust to Irish resident persons who receive benefits from it, again whether or not any Irish tax avoidance was involved in the creation or operation of the trust.
None of the legislation referred to above has any exclusion from operation where the non resident entity to which the gains or income arises directly is situated in a member state of the EU. Under existing case law of the European Court of Justice (ECJ) the application of the legislation in such circumstances may in some cases be illegal by reason of interference with the freedom of establishment and the freedom of movement of capital. Ireland does not appear to feel that there is any urgency to bringing its tax laws in this respect fully into compliance with the European treaties.
The Offshore Funds legislation also can impact on cross border investment by an Irish resident individual or company. When it was originally introduced it affected principally investment in foreign roll-up funds. Such investments did not yield income but only capital gains and thus prior to the introduction of the Offshore Funds legislation was liable only to capital gains tax in Ireland and only when realised. Since 2001, income and gains from qualifying off-shore funds (i.e. funds based in EU countries and OECD countries with which Ireland has concluded a double tax treaty) were subject to a maximum income tax rate of 23p.c. and are generally known as 'good' off-shore funds as distinct from off-shore funds outside these jurisdictions ('bad' off-shore funds). The definition of 'good offshore funds' has been considerably restricted in the Finance Act 2007, largely to regulated funds marketed to the public.
Returns from 'bad offshore funds' are taxed principally at the rate of 40p.c. even if they largely reflect capital gains. The returns from some 'bad' funds - personal portfolio investment undertakings - where the investor has influence on the selection of investments are taxed at 43p.c. , with a further 20p.c. surcharge if not properly disclosed ( in addition to all normal penal interest and other 'normal' penalties).
And the policy is?
Our policy makers seem to recognise that if Ireland's indigenous economy is to expand, it is necessary to allow Irish resident individuals to conduct trading operations abroad through companies and similar non transparent entities. A possible exception to the taxation of the income of such entities in Ireland at marginal personal tax rates is provided in section 806, however unclearly. No such exemption is provided in respect of the gains of such foreign trading companies however, even if the gain is invested in the trade. The logic of the possible exclusion from Irish taxation of the trading company is that the funds it generates are required for financing of the trade. But the same logic would apply to the gains in the trading company.
The same logic applies also to many large investments eg the building and leasing of major hotel, office and apartment complexes. Such major investments must, for risk management reasons, borrowing requirements and often foreign legal requirements be carried on through foreign companies. Such foreign companies need the income they generate to service gearing and to expand and to provide a buffer against downturns. They cannot operate in a realistic manner if their income is being taxed in Ireland at 41p.c.
The same failure to distinguish between income generated which is required for reinvestment in a business and income which is available for lifestyle spending is to be found in the Finance Act provision which taxes unallocated partnership income at the top marginal rate although not available to any partner for personal spending. Major partnerships require capital to operate, just a company does. Unallocated profits provided such investment capital. Like foreign enterprises, they cannot be expected to self finance if their income is taxed at 41p.c. even when retained in the business.
Ireland is a major foreign investor. Irish people seem to have a talent for it. It is a legitimate and important way to create national wealth. The economy of the UK in the last century was based as much on such investment as it was on manufacturing. It does not make sense to penalise such investment when made outside a publicly marketed fund within a treaty state.
The layers of tax law that impact on foreign investment by entrepreneurial Irish individuals were borrowed from the UP willy nilly over thirty years. It is urgent that we should stand back now and acknowledge the distinction between income and gains which are available and used for personal consumption and those which are required for reinvestment in a business. It is also important that we take seriously the limitations on penal taxation of overseas ventures that are imposed by EU law. Ireland needs that law to defend foreign investment here from improper attack by overseas Revenues. It is not in our wider interests to take it lightly. |
John Bradley is a tax partner at KPMG.
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| Article appeared in the March 2007 issue.
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