On 21 June 2016 the EU’s Economic and Financial Affairs Council reached agreement on a draft Directive on tax avoidance practices following expiry of the required period for further issues to be raised. The draft Directive will be presented for adoption at a future Council meeting. The anti-tax avoidance Directive was one of the measures proposed by the European Commission in January 2016 to build on the recommendations of the OECD final reports on base erosion and profit shifting (BEPS).

The Directive applies to all taxpayers subject to corporate income tax in EU member states. The provisions generally aim to combat efforts at tax avoidance through exploiting the disparities in national tax systems, for example by obtaining double deductions or benefiting from low tax rates. These activities distort business decisions and can create conditions for unfair tax competition.

There are five general areas of tax avoidance covered by the Directive:

Interest limitation rules

The rules aim to limit the deductibility of excess interest payments to 30% of earnings before interest, tax, depreciation and amortization (EBITDA). The minimum standards could however be modified by member states, for example by using earnings before interest and tax (EBIT) instead of EBITDA to arrive at an equivalent outcome. Member states would be permitted to decrease the ratio, place time limits on deductibility or restrict the amount of unrelieved interest that could be carried forward or back. It would also be possible for member states to use additional targeted rules to combat avoidance through debt finance, for example thin capitalization rules.

If the taxpayer is a member of a group filing consolidated accounts the group worldwide debt may be taken into account to give the taxpayer a higher interest deduction. The member states could include an “equity escape” rule providing that the interest limitation rule will not be applicable if the ratio of equity over total assets is equal to or higher than the equivalent group ratio.

The interest limitation rule would apply regardless of whether the borrowing costs related to debt incurred at the national level, cross-border debt within the EU or other intragroup debt, or debt from third parties or associated enterprises. The position of all group entities within a member state may be considered in computing the limitation.

The EU Directive would permit a safe harbor amount so that net interest is deductible up to a certain fixed amount, with a maximum of EUR 3 million. Member states could exclude standalone entities from the rule as there is less risk of tax avoidance through interest deductions. Member states also could exclude the financial and insurance sectors from the rules as international discussions on the treatment of these sectors are still ongoing.

Exit Taxation

It is necessary for member states to set out the cases in which taxpayers are subject to the exit tax rules and are therefore taxed on the unrealized capital gains on the assets transferred out of the jurisdiction. They should also specify that transfers of assets between a parent and subsidiary are outside the exit tax rule. The market value of the transferred assets must be determined according to the arm’s length principle, with the right of appeal for the taxpayer against the valuation by the member state.

General Anti Abuse Rule

The general anti-abuse rules (GAAR) would tackle abusive practices that are not dealt with by targeted provisions. They would therefore serve to fill in the gaps in the anti-avoidance legislation without affecting the specific rules. The rules should only apply to arrangements that are not genuine and should apply in a uniform manner to domestic situations, intra EU arrangements and arrangements with parties outside the EU. In assessing whether an arrangement is not genuine member states should consider all valid economic reasons including financial activities.

Controlled foreign companies rules

Member states should limit their controlled foreign companies (CFC) rules to income that has been artificially diverted to the controlled company and the rules should precisely target situations where the decision-making functions related to diversion of income are carried out in the member state of the taxpayer. To save compliance costs certain entities with low profits or low profit margin could be exempted from the rules.

To increase protection for their tax base member states could reduce the threshold for control of the CFC or set a higher threshold for the ratio of actual corporate tax paid to the corporate tax that would have been charged in the member state of the taxpayer. Within the EU the CFC rules should impact only the cases where the CFC does not carry on a substantive economic activity.

Hybrid mismatches

The draft Directive aims to tackle hybrid mismatch situations resulting from differences in the legal characterization of a financial instrument or entity. To neutralize mismatch arrangements rules are necessary whereby one of the two jurisdictions involved in the mismatch denies a tax deduction for the payment leading to the outcome. Further work will need to be undertaken on hybrid mismatches between member states and third countries and other mismatch situations including those involving permanent establishments.

Implementation

Member states will be given until 31 December 2018 to transpose the Directive into their national laws and regulations. For the exit tax rules they will be given a deadline of 31 December 2019. Member states that already have targeted rules that are as effective as the interest limitation rules may continue to apply them until the OECD reaches agreement on a minimum standard or until 1 January 2024 at the latest.