Revised Parent and Subsidiary Directive: Towards a Fairer Tax System

By Thomas Neale, Head of Unit, Company Taxation Initiatives, EU Commission (01/05/2014)

During the mandate of this European Commission (2009 – 2014), the EU and global approach to taxation has made a big step forward.

For decades, the focus of international tax policy has been on lifting tax obstacles to trade, in particular double taxation. Recently, a second leg of international taxation has been put forward both at EU and global level: ensuring that individual countries could enforce their tax rules in an international context and fighting double non taxation. At global level this new approach is incarnated by the work of OECD at the request of G20 on a global standard for automatic exchange of information and on base erosion and profit shifting.

On the European level we have seen unprecedented progress, too. On 6 December 2012 the Commission adopted a very ambitious Action Plan in order to give a more effective European response to tax fraud, evasion and avoidance.

Since the adoption of the Action Plan, the Commission has tabled concrete proposals to expand automatic exchange of information, better fight VAT fraud, monitor international tax good governance, launch a much-needed debate on digital taxation and ease VAT compliance. Progress in this field is vital: each year vast amounts of money are lost due to tax fraud and evasion in the EU. Not only is this is a loss of much-needed revenue in times of budgetary constraint, it is also a threat to fair taxation and fair competition in the single market.

The most recent initiative within the framework of our Action Plan is the revision of the Parent-Subsidiary Directive (PSD).

The PSD was originally conceived in 1990 in order to prevent same-group companies based in different Member States (a parent company and a subsidiary, for example) from being taxed twice on the same income (double taxation). To do so, the Directive gives a tax exemption for dividends and other profit distributions paid by subsidiary companies to their parent company. However, in an increasing number of cases, companies abuse the Directive to avoid paying taxes in any Member State (double non-taxation). Companies do so using a particular tax planning technique called ‘hybrid loan arrangement’.

The purpose of the revision of the Directive is to close this loophole and to make sure that all businesses make their fair contribution to public finances. We made two changes to the Directive which Member States have to adopt by 31 December 2014.

First, hybrid loan arrangements are being tackled. They are financial instruments that have the characteristics of both debt and equity and are therefore subject to different tax treatment in different Member States. As a result, cross border hybrid loans may be treated as debt (ie, a tax deductible expense) in the Member State of the subsidiary and as a tax exempted dividend in the Member State of the parent company. This can – until now – result in a deduction in one Member State followed by tax exemption in the other. Under the proposed amendment, the Member State in which the parent company resides, would not grant the tax exemption.

Second, a general anti-abuse rule (GAAR) has to be implemented by the Member States in order to generally block off tax avoidance strategies. If, for example, a parent company outside the EU has a subsidiary operating in a Member State that levies withholding taxes on dividend payments, the parent can – until now – be tempted to create an artificial intermediary company in another member state which does not charge withholding taxes. The subsidiary can then avoid the withholding tax by channelling its profits through the artificial intermediary towards the parent company. Harmonising Member States GAAR will ensure that Member States have a common approach in rejecting artificial tax planning instruments. These two changes will make sure that not only the letter of the law, but also the spirit of the PSD, will be respected in the future.

Hybrid loan arrangements are a typical example of how some multinational companies try to abuse differences in the tax codes of the Member States in order to artificially reduce their tax bills. The revised PSD illustrates how committed the Commission is to closing such loopholes and to creating a level playing field for honest businesses across Europe.

However, it is also an illustration of the Sisyphean work the Commission is doing to keep pace with the increasing complexity of international taxation and its exploitation by tax avoiders. Despite the substantial progress already achieved under this Commission, the ultimate step to putting a lasting end to harmful tax avoidance strategies would be more harmonisation across the EU such as the Commission proposal for a Common Consolidated Corporate Tax Base. More similar national tax codes mean fewer differences that can be exploited. What has become reality in several other field of European economic policy is equally true in the field of taxation: We need a single approach for the single market.