By Mayur Nayak ,Tarunkumar G. Singhal, Anil D. Doshi
Chartered Accountants
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Part II
In the first part of the Article published in November, 2011, we dealt with some of the recent important foreign decisions on cross-border taxation. The remaining decisions are covered in this part.
8. New Zealand — Supreme Court decision on tax avoidance
On 24 August 2011, in a significant unanimous decision by five judges, the Supreme Court in Penny and Hooper v. Commissioner of Inland Revenue, SC 62/2010 (2011) NZSC 95 held that the transfer of the taxpayers’ medical practices to companies owned by family trusts was lawful, being a business structure choice that the taxpayers were entitled to make. There was nothing artificial or unusual for companies under the taxpayers’ control to pay salaries to the taxpayers. However, fixing the salaries at an artificially low level to avoid paying tax at the highest personal tax rate did constitute tax avoidance. The commencement of paying lower salaries coincided with the increase in the top personal income tax rate to 39%, while the corporate rate was 30%. In addition, the taxpayers maintained control of all of the companies’ income and were able to, and did, transfer funds from the companies for their own, and their families’ use.
The Court acknowledged that there circumstances where the setting of a salary at a low level may be justified, e.g., where a company has a commercial need to retain funds for capital expenditure, or where a company faces, or is about to experience, financial difficulties. In these situations, tax avoidance does not arise when low salaries are paid. However, where the setting of the annual salary is influenced in more than an incidental way by the impact of taxation, the whole arrangement is considered to be tax avoidance. In this case, the tax advantage was at least one of the principal purposes and effects of the taxpayers’ arrangements, rendering them void u/s. BG 1 of the Income-tax Act, 2007.
The Court stated the basic principle as follows:
— “. . . . the policy underlying the general antiavoidance provision is to negate any structuring of a taxpayer’s affairs whether or not done as a matter of ‘ordinary business or family dealings’ . . . unless any tax advantage is just an incidental feature. That must include using a company structure to fix the taxpayer’s salary in an artificial manner”; and
— “Parliament must have contemplated and been content that people may structure their transactions for commercial reasons or for family reasons in which any tax advantage is merely incidental, but that they will not be permitted to do so when tax avoidance is more than a merely incidental purpose or effect of the steps they have taken.”
The Supreme Court decision followed Peate v. Commissioner of Taxation of Commonwealth of Australia, (1962-1964) 111 CLR 443, affirmed (1967) 1 AC 308 (PC), where a doctor similarly used a company, which paid him a low salary, to avoid taxation that would have been paid if the doctor had derived the income himself and then applied it for the benefit of his family. The doctor nevertheless retained control of all of the income.
On a separate matter, the Court also criticised the practice (which was evident in this case) of expert witnesses going beyond their role as authorities in their field of expertise and expressing their views on legal issues in the case at hand. The Court considered the practice undesirable and a wasteful duplication of time and effort, and rather pointedly directed that the practice stop and, if it did not, lower courts should require amended briefs to be filed.
There is now a call from tax practitioners seeking Inland Revenue certainty about what constitutes artificially low salaries. It is difficult to see Inland Revenue drawing a definitive line given that there are circumstances where, on a case-by-case basis, low salaries can be justified, as noted by the Supreme Court. Reference :
TNS:2010-06-07:NZ-1; ITS:NZ; ITA:NZ; IGTT:NZ.
9. Estonia — Application of CFC and GAAR — Substance over Form Principle — Supreme Court rules Re attribution of foreign company’s profits to Estonian company
On 26 September 2011, the Supreme Court of Estonia gave its decision in the case of Technomar v. Tax Authorities, (Case No. 3-3-1-42-11) where it, among other issues, decided for the first time on the attribution of a foreign company’s income to an Estonian company.
(a) Facts
The Estonian resident individual held shares in a taxpayer, Estonian resident company, Technomar. A Manx company (Ltd.) and a US company (L.L.C.) derived their income from (i) purchasing goods from third parties and selling them for a higher price to Technomar, or from (ii) purchasing goods from Technomar and selling them for a higher price to third parties. Both of these companies were incorporated and controlled by the above-mentioned individual shareholder of Technomar.
L.L.C. transferred EEK 118 million from its Estonian bank account to its Austrian account.
The tax authorities considered that Technomar used Ltd. and L.L.C. as conduit companies to evade taxes. Therefore, the tax authorities applied the look-through approach and concluded that all the transactions, profits and assets of Ltd. and L.L.C. were Technomar’s and, correspondingly, all transfers from the bank account of L.L.C. must be treated as made directly by Technomar.
Further, as, due to the bank secrecy rules, the tax authorities did not manage to receive information from the Austrian authorities on the L.L.C.’s bank account in Austria, the EEK 118 million transferred by L.L.C. to Austria was treated as undocumented expense of Technomar. As a result, the tax authorities assessed Technomar in respect of these transfers.
Technomar appealed against the assessment to the administrative Court, which upheld the tax authorities’ position. Subsequently, the Court of appeal also decided in favour of the tax authorities. Technomar appealed to the Supreme Court.
(b) Legal background
U/s.22 of the Income-tax Law (ITL), resident individuals are taxable on the income of a controlled company established in a low-tax territory, whether or not such company has distributed any profits. As retained earnings of resident companies are tax exempt, the ITL does not contain such a provision for companies.
Section 84 of the Law on Taxation sets out the general anti-avoidance rule which provides that where, from the content of a transaction it is evident that such a transaction is performed for the purposes of tax evasion, the conditions corresponding to the actual economic substance shall apply for tax purposes (substance-over-form principle).
(c) Issue
The issue before the Court was, in essence, whether or not the transactions and bank transfers of Ltd. and L.L.C. could be attributed to the Estonian company under the general anti-avoidance rule, and whether bank transfers to accounts, of which the tax authorities have no means to receive information about, can be qualified as taxable hidden profit distributions under the ITL.
(d) Decision
The Court agreed with the tax authorities that the substance-over-form principle allows the authorities to attribute the income of a foreign company to an Estonian company if the circumstances of the transactions demonstrate that the transactions of the foreign company have not been directly concluded for the interests of the individual who manages and controls the company, but to conceal the transactions related to the economic activities of the Estonian company.
Technomar’s argument that Ltd. and L.L.C. were separate legal persons with separate tax liabilities and, therefore, the tax authorities should have, instead of applying the general substance-over-form principle, applied specific provisions such as section 22 ITL or section 50(4) ITL (transfer pricing), was not upheld. The Court stated that in order to apply the latter provisions, the companies should have been engaged in independent economic activities. In the case at hand, the Court agreed with the tax authorities that Ltd. and L.L.C. did not engage in such activities and the transactions concluded by them were fictitious.
Also, the Court did not recognise the position of Technomar that transfers of funds from one account of the company to its other account, whether Estonian or foreign, cannot be considered as a non-business expense. The Court held that in certain circumstances it is allowed to tax as a non-business expense payments from one account of the company to another or withdrawals of cash. The pre-condition for the non-taxation of retained corporate profits is the use of these profits in business. However, such use must be proven. Any transfer or cash payment which makes it impossible to exercise control over the use of funds must be taxed as a non-business expense. If the movement of attributed funds on the bank accounts is not reflected in the company’s books and the tax authorities have no means to receive information on the use of funds on some accounts, then the transfer to such account constitutes a payment for which there is no source document certifying the transaction. In this regard, there is no difference in which country the bank account is situated or for which reason the tax authorities are not able to obtain information about the account.
The Court upheld the position of the tax authorities and the lower Courts, and dismissed the appeal of Technomar.
Reference: CTA:EE:10.
10. Brazil — CFC — Superior Court of Justice rules on impossibility of setting off tax losses of foreign-controlled and affiliated companies against taxable profit in Brazil
The Superior Court of Justice (Superior Tribunal de Justiça — STJ) in the session held on 27 September 2011, within the case records of Special Appeal n. 1161003 filed by Marcopolo S/A against the Federal Treasury, ruled on the question of the impossibility of offsetting tax losses of foreign-controlled and affiliated companies against taxable profits of the parent company in Brazil.
(a) Background
Law 9,249/1995 determines that profits accrued by foreign-controlled and affiliated companies of Brazilian companies are taxable in Brazil. When imposing this obligation, Law 9,249/1995 expressly provides that potential tax losses resulting from activities carried out by these foreign entities could not be offset against the taxable profits of the parent company in Brazil.
Subsequently, Provisional Measure 2,158/2001 (PM 2,158) anticipated the timing for recognition and taxation of foreign profits earned by foreign-controlled or affiliated companies to the end of the same calendar year in which they are accrued in the balance sheet of the foreign companies, regardless of their actual distribution to the Brazilian parent company.
PM 2,158 was silent vis-à-vis the impossibility of offsetting tax losses incurred by foreign-controlled and affiliated companies against the taxable profits of the parent company in Brazil. Therefore, Marcopolo S/A has argued that PM 2,158 has actually revoked the prohibition set forth by Law 9,249/1995 and, from that moment on, the offsetting would be allowed.
(b) Decision
The Justices of the Superior Court of Justice, in a unanimous decision, ruled that tax losses of foreign-controlled and affiliated companies cannot be offset against the taxable profits of their parent company in Brazil. This reasoning was based on the argument that this would provide a double advantage to the Brazilian company, given that these tax losses could be used to offset the profits to be generated by the same foreign-controlled and affiliated companies in the following tax years.
Furthermore, the Justices understood that PM 2,158 has not revoked the prohibition set forth by Law 9,249/1995 in that regard and, therefore, the provisions brought by the latter are still applicable.
It is expected that Marcopolo S/A would file an appeal against this decision before the Brazilian Supreme Court (Supremo Tribunal Federal — STF).
Reference: CTS:BR:1.5.1., 6.1.1.; CTA:BR:1.8.1., 7.2.2.
11. Netherlands; European Union; France; Ger-many; Portugal — Thin capitalisation rules Netherlands Supreme Court — AG opines on application of thin capitalisation provision under tax treaties with France, Germany and Portugal
On 9 September 2011, Advocate-General (AG) Wattel delivered his opinion in case No. 10/05268 on the application of the Dutch thin capitalisation rules under the France-Netherlands tax treaty on income and capital of 16 March 1973 as amended, the Germany-Netherlands tax treaty on income and capital of 16 June 1959 as amended and the Netherlands-Portugal tax treaty on income and capital of 20 September 1999 (‘the treaties’).
(a) Facts:
The taxpayer is a company resident in the Netherlands, which in 2004 was owned for 95% by a French company. In 2004, The taxpayer had debts to companies, established in France, Germany and Portugal, belonging to the same group as the taxpayer. The taxpayer deducted the negative balance of the group interest. The tax inspector rejected the deduction based on the Dutch thin capitalisation provision of Article 10d of the Corporate Income Tax Act (CIT).
(b) Issues and opinion:
The issues before the Supreme Court are as follows:
Issue (1)
The AG considered that the thin capitalisation provision is compatible with EU law with reference to the decision of the European Court of Justice (ECJ) of 25 February 2010 in the case C-337/08, X-holding, in which it was held that the Netherlands rules disallowing cross-border group taxation are compatible with freedom of establishment and a decision of the Supreme Court of 24 June 2011, nr. 09/05115, in which it was decided that the loss relief restriction applicable to holding companies is not incompatible with EU freedom of establishment (see TNS:2011-06-27:NL-3). In addition, the AG considered that EU law does not oblige to allow a cross-border consolidation and also not to separate from a package deal group regime, parts which in domestic situations result only from the full consolidation.
Issue (2)
The AG refers to the decision of the ECJ of 21 July 2011 in the Case C-397/09, Scheuten Solar Technology. The AG observed that the aim of the Directive is not a broadening of the tax base of the related company paying the interest, but the prevention of legal double taxation at the level of the receiving company. Therefore, the AG takes the view that the thin capitalisation provision is compatible with Article 1 of the Interest and Royalty Directive.
Issue (3)
The AG rejected the appeal based on Article 25(5) (non-discrimination) under the treaty with France because the taxpayer is not treated differently from another company which is not part of a group and is not comparable with a group company. In addition, the AG held that the non-discrimination provision does not oblige to allow a cross-border fiscal unity.
Furthermore, the AG rejected the appeal based on Article 6 of the treaty with Germany and Article 9 of the treaty with France, because the application of a thin capitalisation provision is not incompatible with those arm’s-length provisions. Based on the wording ‘may’, the AG opined that those provisions do not preclude the application of thin capitalisation provisions without the possibility of proof to the contrary.
In addition, the AG pointed out that these treaty provisions textually do not concern capital structures or the determination of the tax base, but transactions.
The AG did not take the 1992 Commentary to the OECD Model Convention into account, because the tax treaties with France and Germany were signed before, but noted that the 1992 Commentary supports the view of the taxpayer.
In addition, the AG referred to the group test, included in the thin capitalisation provision. Under this test, companies may opt that the excessive debt is determined by multiplying the difference between the average annual debts and the average annual equity using a multiplier based on the commercial debt/equity ratio of the group. The AG held that this option may be regarded as a possibility of proof to the contrary.
The AG accepted the taxpayer’s appeal based on Artilce 9 of the treaty with Portugal and Article X of the protocol to that treaty and held that this arm’s-length provision obliges the treaty states to allow the taxpayer with the possibility of providing proof to the contrary.
Consequently, the AG opined to overturn the decision of the Lower Court Haarlem and held that the case should be referred to another Court for further fact finding.
Reference: tnS:2010-11-19:nl-2; tnS:2011-06-27:nl-3;
CtS:nl:7.3.; Cta:nl:10.3.; hold:nl; tt:Fr-nl:02:enG:1973:tt;
tt:de-nl:02:enG:1959:tt; tt:nl-Pt:02:enG:1999:tt;
tt:e2:82:enG:2003:tt; eCJd:C-337/08; eCJd:C-397/09.
Acknowledgment/Source:
We have compiled the above summary of decisions from the Tax News Service of IBFD for the period September to October, 2011.
