I was recently asked whether Europeans are more serious about discouraging profit shifting than Americans. To answer, I’ve chosen to rephrase the question. Regardless of what transpires at the OECD level, how serious are EU member states about implementing their own anti-tax-avoidance directive (ATAD)?
Conveniently, the European Commission recently released a report on the progress of ATAD implementation. The findings are a mixed bag of compliance, sporadic infringements, and incomplete analysis. Overall, the transposition checks show that ATAD hasn’t been a smooth operation, and the commission’s report deals only with the project’s low-hanging fruit, such as interest restrictions. The trickier elements of ATAD implementation, including exit taxes and hybrid mismatches, still lie ahead. Perhaps member states’ appetite for cracking down on corporate base erosion shouldn’t be taken as a given.
Excessive Optionality?
ATAD was born in the aftermath of the OECD’s final base erosion and profit-shifting reports, as the EU sought ways to bolster the minimum standards. That resulted in Council Directive 2016/1164/EU, as amended the following year by Council Directive 2017/952/EU — the latter often referred to as ATAD 2. The aim was to discourage the most common varieties of corporate tax avoidance, seen as a fiscal threat to the proper function of the internal market. Individual member states were already free to voluntarily adopt such anti-BEPS measures as they saw fit, but the EU was hoping for a cleaner and more coordinated response.
Time will tell whether that’s what they eventually get. As drafted, ATAD leaves plenty of room for selective optionality. Arguably, that looseness has gone so far that the resulting tax environment doesn’t seem unified.
ATAD is focused on five areas: interest limitations, controlled foreign corporation rules, general antiavoidance rules, exit taxes, and hybrid mismatches. The first three of these areas were to be transposed into national law by the end of 2018 and to apply from January 2019. This first wave of implementation is the focus of the commission’s new report. The remaining topics, exit taxes and hybrid mismatches, will be addressed in a subsequent report.1 We already have reason to think transposition of the hybrid rules will be difficult.2
ATAD contains a derogation from the January 2019 transposition date for member states that believe their domestic tax laws already include measures “equally effective” as the directive in terms of interest treatment. The derogation permits these member states to apply those targeted measures for an additional period of time, linked to the publication of an agreement among OECD members on BEPS action 4, but in no event later than January 2024. In short, a country could attempt to buy itself an additional five years to transpose the directive by claiming its preexisting restrictions on interest deductibility are up to the task. The commission then decides whether specific claims to the derogation are legitimate. Predictably, this has led to situations in which a member state (Ireland) is convinced that its domestic rules were equally effective to ATAD, only to be told otherwise by the commission.3
Directionally, ATAD will see a shift away from principled (subjective) interest restrictions in favor of more mechanical (objective) restrictions. Examples of principled interest restrictions are those that invoke some level of arm’s-length analysis to determine whether a claimed deduction goes too far. An example of a mechanical restriction is the German interest barrier, which inspired the recommendations of the final BEPS report on action 4. A takeaway from that report is that reliance on principled interest restrictions can be problematic because of the inherent flexibility of these approaches. In contrast, mechanical rules tend to be less malleable and allow for greater certainty.
To show that it’s taking ATAD seriously, the commission periodically hands out warnings of inadequate implementation. Last summer, it singled out Austria, Denmark, and Ireland for various shortcomings. It also closed ATAD-related infringement proceedings against another seven member states. This July it was Belgium that received a letter of formal notice regarding the ATAD interest measures. Belgium now has three months to cure the deficiencies or it may receive a reasoned opinion, the last procedural step before the commission refers an infringement case to the Court of Justice of the European Union. It’s doubtful that ATAD will generate a lot of CJEU cases, but we could see more notices and reasoned opinions once the project moves on to hybrids. For now, the interest provisions give us something to ponder.
EBITDA Percentage
The basic rule of ATAD article 4 is modeled on the German interest barrier. It restricts a taxpayer’s ability to deduct excess interest expense — after netting out interest income — to 30 percent of earnings before interest, tax, depreciation, and amortization. EBITDA is a useful gauge of a firm’s operating income without regard to its capital structure. That makes it an accessible proxy for profitability, but not cash flow. Member states may also maintain specific rules for intragroup debt, such as a thin cap regime, but that’s in addition to the basic rule.
The prescribed standard, 30 percent of EBITDA, represents an upper limit on permissiveness. Member states are free to adopt a more restrictive standard (that is, a lower EBITDA percentage) if they wish. The commission’s report indicates that 22 member states rely on the 30 percent standard, with just a single member state opting for a less generous standard. The commission’s analysis is inconclusive for the remaining four member states.
Safe Harbor
Separately, ATAD permits a safe harbor for taxpayers that incur relatively little excess interest expense. This functions as a de minimis rule. The safe harbor allows taxpayers to deduct up to a fixed amount of excess interest expense, irrespective of their EBITDA calculation. ATAD caps the safe harbor at €3 million. Again, that’s an upper limit. Member states are free to adopt a lesser fixed amount or scrap the safe harbor altogether. The report indicates that 16 member states use the maximum €3 million, with another six using a less generous fixed amount. The commission’s analysis is inconclusive for the remaining five member states.
Stand-Alone Entities
The final BEPS report on action 4 acknowledged that most of the risk involving interest expense concerns lending activity among related parties. As a result, there’s a legitimate case for excluding stand-alone entities from the ATAD interest provisions. These are firms not subject to transfer pricing concepts because of their singularity. That’s conceptually distinct from a de minimis safe harbor. ATAD permits member states to exclude these firms from the excess interest restrictions altogether. According to the report, only nine member states offer such an exclusion for stand-alone entities.
Public Infrastructure
Similarly, the long-term financing of public infrastructure projects also presents minimal BEPS risks. ATAD allows member states to exclude the interest on these debt instruments for the interest cap, subject to a few geographic restrictions. The operator of the infrastructure project must be based in the EU. The report indicates that 16 member states offer this exclusion. It is one of the ways Belgium got itself in hot water. According to the commission, Belgium’s definition of what constitutes a long-term public infrastructure project deviates from what is acceptable under ATAD.
Consolidated Groups
ATAD lets taxpayers take advantage of increased interest deductibility if they’re a member of a consolidated group for financial accounting purposes, depending on their relative debt standing. The theory is that by choosing to consolidate, each member of the corporate group is relinquishing the ability to play games with related-party lending. Once inside debt is canceled out, outside (third-party) debt should be all that’s left on the books — and that’s not viewed as a major BEPS risk. Basically, it’s the same rationale as the exclusion for stand-alone entities.
Member states may choose between an equity escape provision, in which the taxpayer must show that its equity-to-asset ratio is at least equal to that of the group (proving the group hasn’t stuffed it with debt); or a group-ratio provision that allows for greater interest deductions based on the group’s overall third-party debt. The commission’s report indicates that 14 member states permit this relief for members of a consolidated group. Eight member states have the equity escape provision, while another six have the group-ratio provision.
Financial Undertakings
ATAD reflects that there was no international (or European) consensus on the applicability of interest restrictions for taxpayers in the financial sector. As with BEPS version 2.0, it seems that banks and insurance companies are special cases. ATAD allows member states to completely exclude designated financial undertakings from the scope of the basic interest barrier. The report indicates 17 member states have chosen to go down that path. This is another area in which Ireland was cited for an improper variance. According to the commission, Ireland was excluding one or more categories of entities that should not have been classified as financial undertakings.
Grandfathering and Carryforwards
ATAD allows member states to adopt a grandfather clause excluding interest expense derived from loan obligations incurred before June 17, 2016. An antiabuse rule limits the scope of the grandfather clause if preexisting debt obligations are modified as to the amount or duration of the original loan. One-third of member states have adopted this kind of grandfather provision.
In addition to the above carveouts, ATAD tries to adjust for routine volatility in a firm’s profitability by allowing various types of carrybacks and carryforwards. Generally, disallowed interest expense can be carried forward without limitation, and carried back for a maximum of three years. Member states can impose their own further restrictions. According to the report, 21 member states permit some degree of carryforward. The commission’s analysis is incomplete for the remaining six member states.
Circling Back
ATAD implementation remains a work in progress. To the extent it has already been absorbed into domestic law, it doesn’t seem like a unified response to BEPS. That said, a patchwork solution is preferable to none at all. There’s some evidence that EU member states have done more to implement BEPS action 4 than non-EU countries.4
Let’s return to our initial inquiries. Are Europeans serious about implementing ATAD? That’s a qualified yes, as long as each member state retains some meaningful discretion as to how its post-BEPS landscape will look. There’s a healthy tension between that discretion and what’s demanded by ATAD, which explains the embarrassing holes in the commission’s transposition report.5
Are Europeans more serious about responding to BEPS than Americans? Not really. It just seems that way because European tax law isn’t federalized to the same extent as its U.S. counterpart — meaning that large-scale, pan-European legal endeavors are bound to stand out and gather heaps of attention. Attempts to coordinate national tax regimes tends to get conflated with a grassroots passion for crackdown on BEPS risks. While that kind of gusto may exist in Brussels, it’s not always detectable among the member states. If left to their own instincts, member states won’t necessarily legislate based on what’s best for the internal market. All politics is local, even for members of a treaty-based club like the EU.
Will there ever be a U.S. equivalent to ATAD? Absolutely not.
It isn’t that Washington opposes the principles, but it believes we are adequately addressing the BEPS minimum standards in our own way. The IRC already has interest restrictions, CFC rules, and so forth — such as they are. It’s possible the U.S. tax code will acquire a few more BEPS-type measures in the years to come, but only when lawmakers become so desperate for revenue raisers they go back and dust off the 2015 BEPS reports. A disingenuous exercise, perhaps, but it still counts. The global intangible low-taxed income and base erosion and antiabuse tax provisions are statutory law, regardless of how they got there. Rules that counter base erosion need not be objects of elegance; they just need to work.
Is that orientation so different from the abundance of optionality we observe in Europe’s approach to satisfying the BEPS minimum standards? I don’t think so, but I am willing to be convinced otherwise after the commission gets around to addressing the thornier issues of exit taxes and hybrid mismatches. We will see how many infringements that produces.
Either way, the lessons derived from the ATAD experiment will be instructive. They should influence our expectations for what is achievable through the OECD’s inclusive framework and the twin pillars. If the EU can’t implement the BEPS minimum standards in a more straightforward manner, who can?
FOOTNOTES
1 The commission’s review of implementation efforts was mandated by ATAD article 10 and was due by August 9. That portion of the review relating to hybrid mismatches is due by January 1, 2022.
2 For related analysis, see Lee A. Sheppard, “Anticipating EU Tax Haven Hybrid Rules,” Tax Notes Int’l, Sept. 23, 2019, p. 1217.
3 Jennifer McLoughlin and Stephanie Soong Johnston, “European Commission Slaps Member States With ATAD Warnings,” Tax Notes Int’l, July 29, 2019, p. 441.
4 Jennifer McLoughlin, “Non-EU Countries Converging Less on Interest Deductibility Rules,” Tax Notes Int’l, Sept. 16, 2019, p. 1184.
5 Particular attention is directed at the commission’s table on ATAD transposition checks, appearing on page 10 of the report.
END FOOTNOTES