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The Parent-Subsidiary Directive: Closing the Loophole

About The Author

Former Author (Assistant Editor)

Author is a King's College London Law graduate, currently working as a corporate paralegal for a firm based in South West England. Author is due to begin his BPTC at the University of Law in September 2015, having attained a scholarship from Middle Temple.

It has long been the aim of the Chancellor of the Exchequer and other finance ministers across Europe to prevent tax avoidance. In an increasingly global marketplace, it has become the norm for companies to have several operations in multiple countries and it seems that taxation is yet to fully adapt to this change. The tax avoidance of companies such as Google, Amazon and Starbucks brought to light in the last year show how these vast companies are able to exploit their transnational status to reduce their tax liabilities substantially. Indeed the last G20 and G8 meetings have had tax avoidance high on the agenda and it seems that the European Commission have acted on this general anxiety. They issued an Action Plan in December 2012 to help prevent tax fraud and evasion and within this plan was a proposal to amend the Parent Subsidiary Directive, a proposal that was brought forward on 26 November.

The Parent-Subsidiary Directive was first introduced in 1990 to encourage transnational enterprises to do business across the EU by exempting from tax any dividends or profit distributions paid by subsidiaries to parent companies. When this Directive was introduced, there was a real drive from within the EEC institutions to promote intra-community trade and the removal of obstacles to free movement of people, goods and services (Article 26 TFEU). This legislation was designed to prevent the double taxation that had taken place, as income earned in Member State A by the subsidiary would have also been taxed as income of the parent company in Member State B.

The aim of this directive was clearly to promote trade across Member States, but it had one fatal flaw that has been repeatedly exploited by large companies since. This flaw stems from the fact that across Member States assets are classified differently, so something that would be deemed capital in the UK might actually be taxed as income in France. The ‘tax planning tool’ that is used by multinationals to exploit this is known as a ‘hybrid loan arrangement’. These arrangements have the characteristics of both equity and debt, and it is this confusion that may result in the profits made being exempt from tax in the member state of the subsidiary and, by virtue of the Parent Subsidiary Directive, will be exempt from tax in the member state of the parent company. The arrangement can even go further than non-inclusion of profits to tax, as parent companies can shift losses from their subsidiaries to further reduce their tax liabilities.

A practical example this is the Marks & Spencer case which has been litigated over for the past decade. Judgment from the Supreme Court was handed down in May this year which dealt with the implications of a preliminary reference to the ECJ as far back as 2005. The parent company, Marks and Spencer, was based in the UK and had set up a subsidiary in various locations around Europe, but the venture had been a complete disaster financially and the Europe-based subsidiaries sustained heavy losses. The parent company wished to transfer those losses into its UK operation in order to deduct them from any profits made, thus reducing their tax burden to the UK government. This was openly and clearly about reducing tax as much as possible, and Gordon Brown at the time of the preliminary reference said that he would repeal all of corporation tax if the European Court of Justice found in favour of Marks and Spencer, as it would be rendered useless. He was backed by the industry magazine Accountancy Age which claimed that allowing this case to proceed would cost in excess of £20 billion, almost half of the total corporation tax paid in the UK as of 2005. As it was, the Government lost the appeal and the company was able to transfer their losses and deduct from tax. The ECJ relied upon the internal market provisions in what is now Article 49 TFEU and stated that a restriction by a Member State on applications for group relief across borders was disproportionate and contrary to EU law. This decision has been upheld by the Supreme Court and it seems that the litigation over the issue has finally come to an end. Decisions such as this have major implications for the UK economy, as large companies are able to manipulate their balance sheets to prevent the Revenue from being able to tax companies fairly. This distorts the marketplace as larger enterprises are able to exploit this loophole to their advantage whereas SMEs, which are consistently referenced as the ‘backbone’ of any economy, are still liable for all profits made by their business.

The Commission have now amended the Directive to try to prevent this exploitation from taking place by introducing an anti-abuse rule that is similar to the general anti-avoidance rule recently introduced in the United Kingdom in July 2013. The General Anti Avoidance rule introduced in the UK was insufficient to deal with the problem posed by the trans-border nature of these disputes and allows the EU to reconcile practices across Member States. The change has been welcomed by ACCA, the Association of Chartered Certified Accountants and is a victory for common sense. The anti-abuse rule targets these hybrid loan arrangements as they are only constructed for the purposes of tax avoidance so are clearly brought within its scope. Anti-avoidance rules have proved very effective in dealing with some tax avoidance practices and work by ignoring the scheme used or treating them in a way which doesn’t allow for tax liabilities to be lessened. This approach has become accepted practice in the last few years and is one of the most effective tools to deal with these inherently complex systems created by companies as it deals with the spirit of the law, rather than the letter of the law. It is hoped that through changes such as the one to the Parent-Subsidiary Directive will prevent future abuses of the tax system for financial advantage.

I fully support this move towards a tougher approach to tax avoidance, but there is certainly more to be done in relation to international tax law to increase tax receipts. As the Guardian highlighted in October, tax avoidance costs HRMC £35 billion every year, which is a result of the practices of both corporations and individuals. Anti-avoidance rules are a key tool in reducing this figure because they lessen the incentive for complex tax planning because the courts will look to the spirit of the law rather than the precise wording of statute.

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Tagged: Commercial Law, European Union, Tax Law

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