The future of Luxembourg, Switzerland, Cyprus, Malta, the Crown dependencies of Jersey, Guernsey and the Isle of Man and similar economies relies heavily on their financial services industries, one of the major reasons why these economies have grown significantly over the past few decades. If we examine the structures that have been created and that have funded such economic growth, we can reflect on the number of holding companies established in Luxembourg since the country first introduced the concept of holding companies to avoid double taxation in their law of 31 July 1929 — almost a century ago. As the world woke up to how the new entities were being used, countries universally decided to exclude them from double tax treaties entered into with Luxembourg. Principally this was because the structures created with holding companies were not designed to avoid double taxation, but to mitigate the effects of even a single level of taxation.
The SOPARFI regime was then introduced in Luxembourg to replace the so-called “pure” Luxembourg holding companies; these being companies subject to full Luxembourg taxation but enjoying the benefits of a relaxed participation exemption regime. This regime in fact was also designed to mitigate foreign taxation without the corresponding level of Luxembourg taxation being paid. The OECD in its BEPS initiative has now decided to attack such holding companies, as well as finance and licensing companies on the basis that they should again be denied treaty access, unless their shareholders effectively would have been entitled to obtain the same treaty benefits on a direct relationship with the payer entity.
In order to provide certainty of the absence of Luxembourg taxation (or a minimum level of taxation for financing and licensing companies), the Luxembourg authorities have been requested by professional advisers to global companies to grant tax rulings confirming the level of taxable income that would be acceptable to them. In the absence of bona fide commercial justifications, many of these tax rulings, not previously made public, have now been declared by the European Commission to create State Aid for the international companies of which the Luxembourg entities are a part.
Countries such as Jersey, Guernsey and the Isle of Man have been used for decades for real estate investments into the UK, benefiting from the existing treaties these countries have with the UK, thereby avoiding the concept of creating a ”permanent establishment” (a taxable presence) in the UK. It is no exaggeration to state that nearly all of these companies were effectively managed by persons other than those directors (locally resident) who were appointed to the boards of these companies. It is quite surprising to me that over the past 20-30 years, HMRC has not attacked these companies on the basis that they are managed and controlled in the UK or, if the beneficial owner is elsewhere, that such attacks have not been made by the tax jurisdictions where these beneficial owners are resident. It is now likely that these countries will follow suit behind the UK with the creation of publicly available registers disclosing beneficial ownership of these companies, despite the claim that this infringes security and potentially endangers the relevant beneficial owners. If such publicly available registers are legally required, the scope for residence attack by tax authorities on the grounds of management and control is likely to be significantly increased.
Countries such as Cyprus and Malta have lowered their effective corporate tax rates in order to encourage trading companies to become resident in their countries. Thus until the recent post-crisis increase of the tax rate to 12.5%, Cyprus taxed corporate income at 10% for many years. Again, as with Luxembourg, Cyprus initially created so-called Cyprus incorporated offshore companies. These were not subject to Cyprus taxation at all, but again, when Cyprus’ treaty partners started denying treaty access to these companies, the Cyprus government accepted that such offshore companies would be abolished. Instead all Cyprus companies would be taxed at a corporate tax rate of 10% — an acceptable rate to the business community. As for Luxembourg and many other jurisdictions (including the UK), Cyprus has a favourable holding company regime which may still exempt such companies from Cyprus taxation on receipt of foreign income, and the Cypriot authorities have hitherto been prepared to grant tax rulings which provide certainty and beneficial profit margins in respect of finance and licensing income. With the latest OECD initiative on treaty access, these companies may not be able to obtain treaty benefits as hitherto.
In Malta, recognising that foreign jurisdictions would require a significant corporate tax rate to enable Maltese companies to benefit from double tax treaty arrangements, Malta introduced a 35% corporate tax rate, but with a catch. On distribution of profits to the shareholders of Malta companies, either 5/7ths or 6/7ths of the tax paid would be refunded, resulting in an effective corporate tax rate of either 10% or 5% in respect of distributed profits. It has surprised me that treaty partners have accepted this system without question, but again treaty access limitation rules will affect these companies as well.
So what are the treaty access limitation rules being proposed by the OECD? It is intended that countries should include anti-abuse rules in their double tax treaties, as well as implementing domestic anti-avoidance legislation to counter perceived ‘treaty shopping’. While the latter remains mostly in the domain of national legislation, albeit heavily influenced by OECD’s recommendations, the former is expected to reflect a “three-pronged” approach:
- Treaties should include in their title and preamble that broadly their purpose is to avoid creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance;
- Treaties should have a specific limitation on benefits rule, which is reminiscent of the rules existing in the US Model treaties; and
- Treaties should have an additional more general anti-abuse rule that looks at the principal purposes of transactions or arrangements.
In future, it is intended that double tax treaty benefits would only be available to defined ‘qualified residents’ of the relevant country. Such qualified residents would include inter alia individuals, quoted public companies, companies engaged in active business, and, potentially, collective investment vehicles. The proposals are very complex and I do not propose to elaborate further on these basic exclusions from the proposed limitation on benefits (LoB) article.
So what, then, is the future for these jurisdictions? Under the treaty access limitation rules, one of the exemptions is for active trading companies. Such companies need to have the relevant level of substance required to demonstrate that the companies are effectively managed in the location they claim to be resident in. Thus although there may be no requirement for local directors, it would help not only to have local directors but also a local manager and relevant key personnel with appropriate skills sets for the operations being carried out by the trading company. All of the countries mentioned in this article have the appropriate infrastructure to attract international operations and can create incentives to local companies offering services to global corporations for such trading activities.
Another exception to the treaty access prohibition may be companies which are registered to carry out investment activities. Collective Investment Vehicles such as private equity funds may fall within this exception, and may be attracted to those jurisdictions who have developed an awareness to offer incentives both to the funds themselves (such as the SIF legislation in Luxembourg) and equally as important, to their fund managers. This is particularly relevant in the current era of limitation of bank lending, where private equity funds may be the only alternative to raising finance from conventional banks. As mentioned in the introduction, the discussion groups that IBSA is holding in Luxembourg, Malta and the UK will examine the type of incentives that may be offered to investors wishing to pool their investments through a tax neutral entity.
I have shown in previous newsletters how the international business structuring world has changed so dramatically even in the past twelve months. I am proud that the association I have created, the International Business Structuring Association or the IBSA, is growing rapidly and is featuring these changes in its discussion groups being held around the world. For IFS Newsletter readers who have the acceptable qualifications but who haven’t yet joined the IBSA, we need to further develop the multi-disciplinary and multi-jurisdictional approach which makes the discussion groups such a vital part of our knowledge bank. The IBSA website at (click here) has a tremendous amount of information within the Knowledge Bank and also explains the benefits of membership.