Holding companies in the EU: The quest for substance

In this article, the authors will firstly analyse Luxembourg’s substance requirements in terms of recognising such companies as resident for both corporate and tax purposes. Subsequently, the authors will analyse anti-conduit rules and practices that source countries may impose with regards to the substance requirements needed to apply relief from withholding tax, and the need for these to comply with EC Treaty protected freedoms.

I. Introduction

Multi-national enterprises (“MNE”) often internationalise gradually over time. Frequently an enterprise that operates on a strictly domestic basis for several years subsequently begins to explore foreign markets. For example, it might begin by exporting its products and later license its products to a foreign manufacturer or enter into a joint venture with a foreign entity . If its venture into foreign markets is successful it might happen that the next logical step becomes the creation of foreign subsidiaries and moving a portion of its operations abroad by establishing sales or manufacturing facilities.

When considering such a move, it can be worth incorporating a holding company, which could provide the means to own and manage group of affiliates or subsidiaries in a particular region and act as gateway for growth and expanding business operations in new markets and regions, resulting in operational efficiencies. Furthermore, such “centralisation” of subsidiaries under one or several holding companies, generally also provides for efficient financing , cash management , intellectual property ownership management, consolidation for management and reporting purposes as well as the creation of platforms for future business acquisitions, joint ventures and other business opportunities. In summary, a more efficient corporate/business structuring.

When choosing a location to establish such a holding company, an MNE should consider determining features such as the political and investment climate, being part of a currency zone (e.g. the Eurozone), administrative ease, the availability of reputable service firms, infrastructure costs, ease of implementation, expanding or unwinding the structure , expediency of the decision-making process by local authorities, proximity of airports and potential language barriers, etc. In addition to these points, an MNE looking to set up a holding company is within its rights to search for the jurisdiction that offers acceptable, if not attractive, tax conditions under the commonly accepted principle that “taxpayers have the right to arrange their affairs in a way that attracts minimum tax liability” , i.e. the acceptability of tax planning as opposed to abusive tax avoidance.

An example of countries that combine all the above mentioned criteria are those that make up Benelux, specifically Luxembourg where political stability, the investment climate, administrative efficiency with expedient decision making, a privileged geographical location in Europe, coherent and flexible corporate and tax regulations and multi-lingual environment facilitate to a large extent the setting up of holding structures . (In Luxembourg, besides French, German and Luxembourgish, all the tax, documentation and notary deeds of an enterprise may be submitted in English.

Despite the existence of many justifiable reasons for the setting up of holding companies, a pejorative view of holding companies has increasingly been seen, especially with regards to intermediate holding companies. We have seen European Union (EU) holding companies’ regimes being scrutinised in international case law like Indofood and Prevost , in the reports to the Code of Conduit (e.g. the Primarolo Group report submitted to the ECOFIN in November 29, 1999), in the OECD reports on Harmful Tax Competition , in the OECD Conduit Company report and by the EU Commission and European Court of Justice under the state aid rules. This pejorative view and constant scrutiny stems from the suggestion that, when used exclusively for tax reasons (thus without any non-tax justification or without a business purpose), pure intermediate holding companies may be a stepping stone for treaty or directive shopping and thus abusive tax avoidance.

Within this context, countries seek to minimise the risk of loss of tax collection through the potential abusive use of intermediate holdings by enacting anti-abuse provisions, namely anti-treaty or directive shopping provisions (also referred to as anti-conduit provisions). The question is, how far can such provisions go, especially in the European Union where countries are bound to comply with the fundamental provisions of the EC Treaty , namely the protected freedoms (specifically the freedom of establishment and the free movement of capital).

II. Substance requirements in the country of residence of Holding Company: The Luxembourg example

With slight variations, many countries consider that a company is resident for tax purposes as long as it has its registered office in their territory and/or if the Place of Effective Management (“POEM”) is located on their territory.

In the case of Luxembourg, substance is required in order to ensure that a company is resident for purposes of corporate law and tax law . From a Luxembourg corporate perspective, the mere incorporation of a company could be considered insufficient in order to ensure that it will be effectively considered a Luxembourg resident company. Indeed, if the principal establishment of a company incorporated in Luxembourg is located outside the country, this company could run the risk of being “de-registered” (i.e. removed from the Luxembourg Trade Registry). From a Luxembourg domestic tax perspective, a company is considered resident if it has its statutory seat or its central administration in Luxembourg . A company meeting either of these criteria is subject to Luxembourg corporate income tax and municipal business tax under Luxembourg domestic tax law.

From a conventional perspective, Luxembourg has 52 Double Tax Treaties in force (and seven pending treaties ). From these: (i) 36 follow the OECD Model, whereby the tiebreaker is the “place of effective management”; (ii) eight determine that dual residence shall be solved through Mutual Agreement Procedure; (iii) three use the “place of actual management” criterion as a tiebreaker; (iv) one uses the “place of head office” criterion as tiebreaker; (v) two use the “actual headquarters” criterion, and finally (vi) one uses “head or main office” criterion.

Thus, it can be said that most Luxembourg double tax treaties follow the OECD Model Convention tiebreaker rule in what concerns the determination of residency in cases of conflicts of residence , i.e. the place of effective management rule, which is defined as “the place where key management and commercial decisions that are necessary for the conduct of the entity’s business as a whole are in substance made”.

Furthermore, Luxembourg includes in its treaties (since 1992) the Beneficial Ownership Condition in the dividend, interest and royalties’ distribution rules, as well as a Limitation on Benefits (“LOB”) provision in the DTT with the United States. With regards to this Beneficial Ownership requirement however, no settled autonomous definition is provided in the OECD Model Convention.

Therefore, Luxembourg tax authorities should probably rely (when dealing with dividends) in the Commentary to Article 10(2) of the OECD Model Convention and on the OECD Conduit Companies Report . Attention may eventually also be given to known international case-law like Indofood (and the consequent HMRC guidance) and especially the recent landmark case, Prevost, where the Tax Court of Canada decided , and the Federal Court of Appeal confirmed that, “the beneficial owner” of dividends is the person who receives the dividends for his/her own use and enjoyment and assumes the risk and control of the dividend he or she received. Thus in this specific case, a Dutch intermediate holding company beneficial owner of dividends paid by a Canadian subsidiary, independently of such holding company receiving said dividends after, would pay them, “in substantially the same amount to its corporate shareholders”.

From a practical perspective, and given the interaction between corporate law requirements and tax law requirements (both domestic and conventional), the typical Luxembourg holding company would generally have the following characteristics:
• Active senior decision making located in Luxembourg: typically, in a holding company in Luxembourg, the Board of Directors (“BOD”) will hold regular meetings in Luxembourg where a quorum of directors are physically present, where it considers and approves all new transactions and takes strategic decisions relating to the Luxembourg holding business. Usually the BOD will include Luxembourg residents or residents in the nearby areas.
• Employees: the number of employees usually depends on the activities effectively carried out by each Luxembourg entity. In addition, the qualifications of the employees are also usually in line with the activities undertaken by the Luxembourg entity, i.e. experienced and qualified in investment and asset management, controlling, financial operations, accounting, legal and treasury.
• Appropriate dedicated office facilities: typically a Luxembourg holding would have a permanent, dedicated, equipped and identified office space in Luxembourg in order to carry out its activities.
• Company’s documentation is archived in Luxembourg: typically, all books and records regarding a Luxembourg holding company (corporate books, management accounts, files, including contracts, bibles, tax returns, etc.) are archived in Luxembourg.
• Financing: typically, a Luxembourg holding company is financed in a manner that means that it is under no obligation to pass the income it earns on its activities directly to its investors and/or shareholders and it incurs an actual entrepreneurial risk.

Please note that some foreign authorities envisage attracting tax residency in cases where the management of a holding company is controlled from such countries (which according to these countries would imply less substance in Luxembourg). That is for example the case of the United Kingdom.

III. Source countries’ substance requirements to apply relief from withholding tax: Compliance with EC protected freedoms

As mentioned above, countries frequently enact substance requirements to apply relief from withholding tax, some even know for having very rigid substance requirements.
The question that has to be raised, when dealing with such substance requirements within the European Union, is whether they comply with the EC Treaty protected freedoms.
At EC level, the secondary legislation that deals directly with the taxation of pure holding activities is the Parent-Subsidiary Directive , this is applicable to the distribution of profits from subsidiaries of one member state to its parent companies in another member state, preventing double taxation on such flows of dividends on both the withholding layer as well as the final tax liability.

The Directive, however, clearly allows member states to apply the anti-abuse provisions included in domestic law or tax treaties envisaging the prevention of fraud or abuse, i.e. “serious cases of tax avoidance” . Countries can, within such boundaries of the prevention of fraud and abuse, take matters into their own hands and define any anti-abuse measures that will apply when certain requisites are met, namely whenever the “substance” they deem necessary is not met. Nevertheless, the fact that said Directive allows countries to unilaterally and in an unharmonised fashion legislate anti-abuse measures to deal with the potentially abusive usage of intermediate holding companies, does not, however, exclude such unilateral legislation from the scope of the EC primary law . Accordingly, the ECJ has continuously concluded , in cases concerning direct taxation that, although Member States retain competences in what concerns direct taxes, that does not release them from making use of such competence in full respect for Community Law. That, added to the prohibition to discriminate on grounds of nationality established in Articles 12 and 18, opens the door of negative integration for direct taxation. Member states are consequently free to legislate on direct taxation as they please, as long as they do it within the limits of the treaty, more particularly with the requirements of the fundamental freedoms, provided for in the EC Treaty.

Finally, following the methodology of the ECJ , national provisions that provide a different treatment to intra-community scenarios may only be compatible with the EC Treaty protected freedoms if such different treatment respects situations that are not objectively comparable or, if objectively comparable, the different treatment is justified and proportional. Therefore, in order to understand the conformity of domestic rules regarding substance requirements at residence of the holding company with EC law, it is a necessary starting point to understand whether such rules would have provided a different treatment in a fully domestic scenario.

In order to understand whether a difference of treatment exists, it is necessary to check whether a holding company with subsidiaries in an EU Member State can potentially be subject to a different treatment when compared to the one that would be granted to a similar holding company, resident in said member state.
Having concluded that the domestic law grants a different treatment to intra-community scenarios, and that such treatment is likely to hinder a protected freedom, it is then necessary to verify if such different treatment refers to situations that are objectively comparable. It has been the position of the court that cases of a distinct treatment of residents and non-residents that imply the granting of tax advantages to the residents while simultaneously denying the same tax advantages to non-residents, may constitute discrimination where there is no objective difference to justify such distinction.

Taking into account the precedent case law of the ECJ, it should be concluded that a Luxembourg holding company should be comparable to a holding company in other member states, as long as both entities are liable to corporate income tax in the source member state (i.e. as long as the source member state is withholding tax). Such conclusion is supported in the principles set out by the ECJ in the Denkavit and the Amurta cases. This should be especially recognised when dealing with companies that take on of the forms listed in the Annex to the Parent-Subsidiary Directive.

Taking the above into consideration, it is imperative to conclude that, unless any different treatment is justified based on the jurisprudence-based justifications foreseen in the rule of reason, the double taxation relief granted to resident holding companies in the source member state should be extended under the same conditions to residents in other EU countries, otherwise the freedom of establishment and/or free movement of capital would be hindered.

According to ECJ case law, several justifications have been invoked by member states, among which the following have been accepted: effectiveness of fiscal supervision; cohesion of the tax system; territoriality; prevention of tax avoidance and evasion; balance and reciprocity of treaties and the reunion of a balanced allocation of power to impose taxes, the prevention of using losses twice and the prevention of tax avoidance . Rejected have been: loss of tax revenue, compensatory tax benefits, reciprocal tax benefits, etc.

The two justifications that can most probably be invoked in a scenario like the one under analysis are: the cohesion of the tax system and the prevention of tax avoidance and evasion.

Cohesion of the tax system
The court initially accepted this justification in Bachmann but subsequently it seemed to consistently have taken a restrictive view towards such justification in the following years, denying acceptance of such justification, which made scholars like Ben J. M. Terra and Peter J. Wattel conclude that the court regretted having accepted it at all and wants to get rid of it . Nevertheless, it could be argued that the cohesion of the source country tax system requires that an exemption of withholding taxes should not be extended to non-resident holding companies, since it can not be secured that the investors in such companies, in contrast to what would happen in a domestic scenario, are generally taxable on their income in such source state. Nevertheless, in Baars , the court determined that a direct link between the discriminatory rule and its counterpart must exist and no such direct link exists when fiscal cohesion refers to different taxes and different taxpayers as it is the case of the shareholders in a holding company, the holding company and the subsidiaries.

Prevention of tax avoidance and evasion
The prevention of tax avoidance and evasion as a justification has been thoroughly analysed by the ECJ.
In Avoir Fiscal, the court firmly and curtly rejected this justification, stating that the EC Treaty provision (on freedom of establishment) did not permit any derogation on such ground.
Later, in Eurowings the court established that using the internal market in order to obtain any tax advantage resulting from low taxation in another member state cannot justify a less favourable treatment.
In ICI and Metallgesellschaft the court specified that the use of group companies in other member states in itself, cannot be regarded as abusive, as those companies are liable to corporation tax in their states of residence . Subsequently the court went further and tried to define abuse, in Oy AA, where a purely artificial arrangement is defined as a creation devoid of economic reality, with the aim of escaping the tax normally due on the profits generated by activities carried out on national territory. In ICI the same concept of “wholly artificial arrangement” was applied to the risk of tax avoidance. In Halifax the court tried to clarify the definition of abuse considering that it exists only if, firstly, the transactions concerned result in the accrual of a tax advantage, the grant of which would be contrary to the purpose of those provisions and, secondly, due a number of objective factors showing that the essential aim of the transactions concerned is to obtain a tax advantage. Based on that, it is possible to conclude that the mere attainment of tax advantages is not enough in order to characterise an operation as abusive.
Finally in Cadbury Schweppes and CFC and Dividend Group Litigation, the existence, or not, of abuse was deeply discussed and the ECJ concluded that, in order to find if there is a purely artificial arrangement, there must be, in addition to a subjective element consisting of the intention to obtain a tax advantage, objective circumstances showing that, despite formal observance of the conditions laid down by Community law, the objective pursued by freedom of establishment was not achieved. Thus, in the case where a company carries out genuine economic activity there would be no abuse.
Taking this line of argument into account, the authors tend to conclude that the prevention of tax evasion and abuse cannot be accepted as justification in cases where the underlying economic activity is genuine and real . In addition, the holding activities of a company, although passive activities, are naturally part of the real and genuine economic activity of a company or group of companies, as already referred to.
It may be, therefore, thorny to justify domestic rules on substance that use of such unreasonably demanding tests, namely because according to the ECJ , using the internal market in order to obtain any tax advantage resulting from low taxation in another member state cannot justify a less favourable treatment, and the use of group companies in other member states, in itself, cannot be regarded as abusive as those companies are liable to corporation tax in their states of residence. This assertion is even more valid when such rules do not actually test whether the holding company is a “purely artificial arrangement” as a creation devoid of economic reality, with the aim of escaping the tax normally levied and the transactions concerned do not result in the accrual of a tax advantage, the granting of which would be contrary to the purpose provisions of the participation exemption (relief of double taxation).

IV. Conclusions

Taking all of the aforementioned into account, it is clear that EU Member States, although free to legislate for the prevention of fraud and abuse with regards to the domestic participation exemption regimes on outbound dividends, can only do so in compliance with the fundamental provisions of the EC Treaty.
Substance regulations and rules are useful anti-avoidance tools, but taxpayers can also find themselves jumping from acceptable tax optimisation to tax evasion. EU Member States sometimes find themselves asking for substance in an exaggerated way and thus jump into a position where they are hindering the protected freedoms essential to the existence of the common market within the European Union.
From a pragmatic perspective, companies should be carefully aware of the substance requirements that source countries will demand whenever dealing with holdings independently of where they are located. Despite this, it is important to be aware that, in the European Union scenario, a common market is in place and that the protected free movement of capital and freedom of establishment need to be complied with by member states in order to have a competitive internal market, especially in current times and context.