Recent EU Tax Developments

With the various global crises, budget spending to address inflation and post-COVID-19 pandemic effects continuing to weigh on fiscal budgets globally, governments will at some point soon need to recoup lost revenue.

As regards the EU, there are a large number of current and upcoming legal developments that will significantly change the tax landscape and need to be monitored.

Most notably, in mid-December 2022, the EU Member States agreed on the EU Directive implementing Pillar 2 on the 15% effective minimum corporate tax rate that will need to be transposed into national laws by December 31, 2023[1]. During 2023, expect further focus related to discussions on Pillar 1 (the digital nexus or, alternatively, digital services taxes), DEBRA (Debt-equity bias reduction allowance), Unshell (ATAD 3), SAFE (Securing the activity framework of enablers) and BEFIT (Business in Europe: Framework for Income Taxation).

Implementation of Pillar Two in the EU

The Directive implementing Pillar 2 of the OECD/G20 Anti-Tax Avoidance and Profit Shifting (BEPS) Inclusive Framework was unanimously adopted by EU Member States on December 14, 2022.[2]  Pillar 2 aims to reduce the scope for tax base erosion and profit shifting by ensuring that large multinationals with an annual turnover of at least €750 million pay an effective minimum global corporate tax rate of 15%.

The now adopted EU Directive introduces the EU version of Pillar 2.  Essentially, the Directive requires EU Member States to impose a surcharge if an in-scope company’s effective tax rate on its covered income is less than 15%.  In principle, the surcharge is levied through the Income Inclusion Rule (IIR).  The IIR is supplemented by the minimum tax under the Undertaxed Profit Rule (UTPR) if the country in which the parent company is resident does not apply the IIR.  In such case, the countries in which the subsidiaries operate can levy the UTPR on their payments abroad.  The political motivation is to reduce the risk of tax base erosion and profit shifting and limit the race to the bottom in corporate tax rates.

We have separate detailed materials available on the two Pillars and are happy to share that with you upon your request.

DEBRA

As part of the EU strategy on corporate taxation, the EU Commission presented the DEBRA draft directive.  DEBRA aims to address the unequal tax treatment of debt and equity that result in certain tax advantages of debt over equity financing in most EU countries with the aim of reducing incentives to raise debt capital DEBRA provides for two measures: a notional tax deductible allowance for increases in equity and a further limitation of the tax deductibility of interest expenses.  DEBRA would apply to taxpayers that are subject to corporate income tax in a Member State with the exception of financial companies.

Under the interest expense deduction limitation of DEBRA, only 85% of net interest expenses (interest expenses exceeding interest income) would be tax deductible.  This rule will work alongside the Anti-Tax Avoidance Directive (ATAD) interest limitation rule pursuant to which the deductibility of interest is limited to €3 million or, if higher, to a maximum 30% of the taxpayer’s EBITDA.  Taxpayers will have to calculate both the deduction amount set by DEBRA and ATAD.  Companies will only be able to deduct the lowest amount in a tax year, but would generally be able to carry the difference forward or back.

The tax deductible allowance for equity increases works as follows: the difference between (i) the net equity at the end of the current tax year and (ii) the net equity at the end of the previous tax year is multiplied by a notional interest rate.  The result is the tax deductible allowance for the amount of an equity increase in a given year.  The notional interest rate corresponds to the 10-year risk-free interest rate for the respective currency to which a risk premium of 1% is added (1.5% for small and medium-sized enterprises).  The allowance is in principle deductible in ten consecutive tax years, provided that the annual deduction is capped at 30% of the taxpayer’s EBITDA (unused excess can generally be carried forward for 5 years).  In addition, DEBRA provides for various special features and rules to prevent abuse.

The EU Member States will be required to implement DEBRA (if adopted) by the end of 2023.  The first-time application of DEBRA is planned from January 1, 2024. Member States that already provide for a tax allowance for equity may defer DEBRA application up to ten years.

Unshell

The Unshell draft directive aims at preventing abuse by the use of shell companies in the EU that serve no genuine economic purpose.  In summary, Unshell provides for a two-tier substance test, based on total revenues, asset location and outsourcing of management at the first tier, and reporting and verification requirements at the second tier.  An entity is not qualified as a shell if it has its own business premises, actively uses its own bank account in the EU and either has at least one managing director in the entity’s member state who has and uses sufficient decision-making powers and is not additionally employed by a company outside the group, or has employees, the majority of whom are resident in the company’s member state and are appropriately qualified for their work.  If such criteria are not met, the existence of a shell company is rebuttably presumed.  The qualification as a shell results in the denial of certain tax benefits (e.g., denial of no application of a double tax treaty), the taxation of the income of the shell company at the level of the shareholder as well as the denial of a residence certificate in the state of residence of the shell, which is regularly required to claim withholding tax relief provided for in DTAs or EU Directives.  The proposal of the new directive is to be transposed into national law by June 30, 2023 and is expected to be applicable for the first time as of January 1, 2024.

SAFE

The EU Commission concluded a consultation on its initiative known as SAFE, short for “securing the activity framework of enablers.”  In short, the SAFE initiative aims to tackle the role that enablers can play in facilitating arrangements that lead to tax evasion or aggressive tax planning in EU Member States.  The key objective of SAFE is to prevent enablers from setting up complex structures in non-EU countries the purpose of which is to erode the tax base of Member States.

SAFE will interact and build upon existing initiatives, notably the mandatory reporting regime of cross-border arrangements known as DAC6, the ATAD, the Anti-Money Laundering (AML) Directive and the Whistle-blowers Directive.  In the Commission’s view, it is noteworthy that those measures primarily aim at the taxpayer, but do not target those who enable aggressive structures (arguably with the exception of DAC6 reporting).  The Commission contemplates several policy options.

In addition, it has been contemplated that EU taxpayers would in future have to declare in their tax returns any shareholding in an unlisted company based outside the EU that amounts to 25% or more of the shares, voting rights or other controlling rights.

The stakeholder consultation for the SAFE resulted in almost universally negative feedback.

The EU Commission announced that a proposal for a SAFE Directive would be forthcoming in the first quarter of 2023.

BEFIT

The EU Commission stated, as in the past, that the lack of a common corporate tax system in the Single Market acts as a drag on competitiveness, resulting in distortions of investment and financing decisions (where these are driven by tax optimization strategies rather than other considerations), and higher compliance costs for businesses active in more than one EU Member State.  This creates a competitive disadvantage compared to third country markets.  The Commission will propose a new framework named BEFIT, short for “business in Europe: framework for Income Taxation.”  BEFIT would be a single corporate tax rulebook for the EU, based on the key features of a common tax base and the allocation of profits between Member States based on a formula (formulary apportionment).

BEFIT would be based on the OECD’s two-pillar solution regarding the partial redistribution of profits (Pillar 1) and the calculation of the tax base (Pillar 2).  The EU Commission has announced that a legislative proposal for BEFIT will be forthcoming in the third quarter of 2023.  In the past, the EU initiatives for a common consolidated corporate tax base (CCCTB) never made it into law, but it remains to be seen whether the OECD inclusive framework Pillars 1 and 2 facilitate BEFIT.

[1] The forthcoming rules for joint audits in the various EU Member States implementing the 7^th amendment to the EU Directive on administrative cooperation (known as DAC7) will change the landscape for large audits and DAC8 will include new reporting rules for crypto assets, automatic exchange of information regarding tax rulings for wealthy individuals and penalties for non-reporting.

[2] In October 2021, almost 140 countries working together in the OECD’s inclusive framework reached political agreement on the Pillar 1 and 2 proposals.