Exit Taxation of Cross-Border Mergers after National Grid Indus

AuthorHarm van den Broek
Pages26-49

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Ver Nota1

1. Introduction

In this paper I deal with the question to what extent exit taxation in the case of a cross-border merger infringes upon the freedom of establishment. By mergers the Tenth Council Directive, the SE Regulation and the Merger Directive mean operations in which one or more companies are wound up and transfer, under a universal title, all their assets and liabilities to another company which issues shares to the former shareholders of the dissolving companies. This can be illustrated as follows.

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A merger leads to the winding up of one or more companies. Without fiscal facilities this would generally lead to the final taxation of the transferring companies as if these were liquidated. On that occasion corporate income

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tax is levied on the difference between the real value and the value for tax purposes of the assets and liabilities of the transferring company, in other words, on its latent capital gains. Taxation as a result of a cross-border merger results in an obstacle, in particular because a merger, by contrast to a sale of assets, does not lead to a cash flow to the transferring company out of which the taxes due can be paid. By means of the Merger Directive, the EU has adopted a system of tax deferral2. This system should safeguard Member States’ tax claims and provide a tax-neutral solution. The Merger Directive does, however, not preclude exit taxation in the case of a cross-border merger. Therefore, the question rises to what extent merging companies can invoke the freedom of establishment. In section 2 I discuss the system of tax deferral under the Merger Directive. In section 3 I discuss to what extent a transferring company exercises the freedom of establishment. And in section 4 I deal with the question to what extent exit taxation upon cross-border mergers is allowed. Section 5 contains the conclusions.

2. Exit Taxation and the Merger Directive

At the basis of the Merger Directive are two main objectives3. In the first place, fiscal obstacles to reorganizations must be removed. In the second place, taxing rights of Member States must be safeguarded. In that respect, deferral of capital gains taxation was considered a simple and adequate system.

In order to prevent tax avoidance or tax base erosion, deferral is only mandatory to the extent the assets transferred remain within the tax jurisdiction of the state of the transferring company. Under Article 4(1), mergers may not give rise to any taxation of capital gains:

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‘A merger, division or partial division shall not give rise to any taxation of capital gains calculated by reference to the difference between the real values of the assets and liabilities transferred and their values for tax purposes’.

From this text it follows that the prohibition to levy tax only applies to the ‘transferred assets and liabilities’. The term ‘transferred assets and liabilities’ is, however, confusing. Article 4(2)(b) provides for a definition: ‘‘transferred assets and liabilities’: those assets and liabilities of the transferring company which, in consequence of the merger (…) are effectively connected with a permanent establishment of the receiving company in the Member State of the transferring company and play a part in generating the profits or losses taken into account for tax purposes’. Although, in the case of a merger, all assets and liabilities are legally transferred to the receiving company, the Directive considers to be ‘transferred assets and liabilities’ only those which remain connected to a permanent establishment in the state of the transferring company. Consequently, the system of tax deferral only applies to those assets and liabilities which remain behind in a permanent establishment.

Example

Company X has two activities, A and B. Company Y is established in another Member State. Company X merges with company Y and transfers, as a result of the merger, under general title all its assets and liabilities to Company Y. Company X is wound up. Activity A remains behind in a permanent establishment in the former state of residence of Company X. Activity B is transferred to the state in which Company Y is tax resident. Article 4 Merger Directive precludes Member State X to levy tax on the assets of activity A which remain behind in Member State X. Article 4 does not apply to the assets which are attributable to activity B and which are transferred to Member State Y. One of the assets of activity B is intellectual property with a book value of 400 and a market value of 500. Under the domestic legislation of Member State X, the merger is considered a taxable event, and the latent capital gain of 100 is taxed immediately. Article 4 does not preclude this form of exit taxation on assets which are transferred

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abroad, as Article 4 only applies to assets which remain behind in a permanent establishment in the state of the transferring company.

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Capital gains in respect of assets and liabilities, including goodwill, which must be attributed to the new head office in the state of the receiving company may be taxed upon the merger. This applies for instance to assets which are carried abroad4. Also mergers of companies which do not result in a remaining permanent establishment, for instance holding companies, may be taxed5.

The reason that Article 4 only applies to assets which remain behind in a permanent establishment is quite simple. If Member States X and Y have concluded a tax treaty which is in line with Article 7 OECD Model Convention, then the Member State of the transferring company X loses its tax jurisdiction in respect of the assets which are transferred abroad and which do not remain behind in a permanent establishment. In order to avoid the evaporation of tax claims, Article 4 does not apply to assets which are transferred abroad.

The issue of exit taxation in the case of mergers is similar to the issue of exit taxation in the case of transfers of seat of companies.

Example

Z is a European Company (SE) and has two activities, A and B. Company Z transfers its seat to another Member State. Activity A remains behind in a

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permanent establishment in its former state of residence. Activity B is transferred to the new state of residence. Article 12(1) Merger Directive precludes Member State Z to levy tax on the assets of activity A which remain behind in that state. Article 12(1) does not apply to the assets which are attributable to activity B and which are transferred abroad. One of the assets of activity B is goodwill with a book value of 200 and a market value of 250. Under the domestic legislation of Member State Z, the transfer of seat is considered a taxable event, and the latent capital gain of 50 is taxed immediately. Article 12(1) does not preclude this form of exit taxation on assets which are transferred abroad.

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Therefore, both in the case of mergers and of transfers of seat, the Merger Directive does not preclude exit taxation.6 This does not mean that the Merger Directive infringes the freedom of establishment7, for example in respect of transfers of seat. The Merger Directive does not either justify that Member States levy exit taxes8. The Merger Directive does not oblige Member States to levy exit taxes9. Only Member States have the autonomy to decide when and how to levy direct taxes. And only Member States have

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the responsibility to make sure that their tax laws are in line with the fundamental Treaty freedoms and the relevant case law of the ECJ10.

The Merger Directive does not preclude exit taxation. Therefore, in 2001 the Commission considered the requirement of a remaining permanent establishment a tax obstacle which hampers reorganizations. The Commission audaciously proposed to defer taxation also if no permanent establishment remains behind.11 Until now, this proposal was not adopted. In addition, where Articles 4 and 12(1) Merger Directive only apply to assets which remain behind in a permanent establishment, the Directive lacks a definition of ‘permanent establishment’12. This raises the question which definition must be applied13. The Directive also requires that the assets and liabilities transferred must ‘play a part in generating the profits or losses taken into account for tax purposes.’ These profits must be subject to corporate income tax in the state of the transferring company14. Under Article 8(1) OECD Model Convention, earnings of international shipping and airline activities15 are taxable only in the state where the effective management of the undertaking is situated. Therefore, in the case of a transferring shipping or airline company, there is no remaining permanent establishment to which these assets can be attributed. In 1990, the Council

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adopted Council statement16 number 3 allowing the state of the transferring air company to levy exit taxes in the case of mergers:

‘3. Re Article 4

The Council and the Commission are agreed that in the case of a merger between international shipping companies or airlines, the Member State of the transferring company shall at the time of the merger be entitled to tax capital gain on the ships of aeroplanes which as a consequence of the merger will be...

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