The end of thin-capitalization rules as we know them

Adecision opinion issued by the European Court of Justice (ECJ) on December 12 2002 almost certainly means thin-capitalization rules within the EU are ineffective. And the writing may be on the wall for transfer pricing rules too.

This was always on the cards, as it is not a one-off case; it is the latest in a series of cases (including Hoechst [case C-397/98] and Metallgesellschaft [case C-410/98]) that have successfully used EU non-discrimination principles to strike down various tax laws. More are on the way, and it is looking like EU countries could end up with tax systems that, at least in respect of policing cross-border transactions, resemble sieves.

It may be further months or years before the reactions of EU tax authorities are known. Nevertheless, it is not premature to be examining this issue now, because there are some important actions that taxpayers ought to be considering as soon as possible.

Analysis of the opinion

The case of, Lankhorst-Hohorst GmbH v Steinfurt Finance Authority (case C-324/00), concerned the tax treatment of interest that a German company was paying on a loan from its Dutch parent company. The borrower was clearly thinly capitalized.

The ECJ's decision is based on the principle of freedom of establishment for EU companies, which is set out in (what is now) clause 43 of the Founding Treaty of the European Community. The court suggests that freedom of establishment is contravened if a German subsidiary of a non-German parent company is taxed more harshly than it would be if the parent were German.

The German thin-capitalization rules do not apply to interest paid to companies entitled to German tax credits. Although this exemption does not explicitly discriminate on the grounds of residence of parent, the ECJ still found it objectionable because only German parents are likely to qualify. It therefore effectively discriminates. The court was also unmoved that there are some German companies that are not entitled to the credits; the point, to the court, was that a German parent equivalent to the Dutch parent would be exempt from the German thin-capitalization rules. This is unacceptable discrimination.

The ECJ dismissed objections that thin-capitalization rules are necessary to protect the tax base. This worthy objective does not override clause 43.

Implications in other EU countries

There is little doubt that this case is as relevant to other EU countries as it is to Germany. This is borne out by the fact that the UK and Danish governments (as well as the European Commission) took the step of making their own submissions to the ECJ.

This is because all EU countries (and this may be a wider group than might be expected - see the box) are bound by the freedoms that are built into EU primary legislation.

It is beyond the scope of this article to consider the rules in each country. It is possible that some EU countries may impose these rules on domestic loans, so may be unaffected. However, the ECJ's opinion is so robust that it is difficult to imagine how any thin-capitalization rules could survive, unless they genuinely do not discriminate. It may be useful to examine the situation in the UK as a case study, to give an indication how other countries' rules may fare.

There are two main ways in which the UK counters thin capitalization. The first is through deemed dividend rules that re-characterize interest on 'excessive' debt as a distribution, which is therefore not tax deductible for the UK borrower.

The second is through UK transfer pricing legislation, which was specifically worded with the intention to plug various perceived loopholes in the deemed dividend legislation. This does not re-characterize the interest; it denies a deduction for interest on excessive debt on the grounds that, at arm's length, there would have been less debt.

Both sets of rules have an exemption based, broadly, around whether one or both of the companies are UK taxpayers. As with Germany, this is not explicit discrimination on the grounds of residence, but it is unlikely to pass the test used by the ECJ, because a loan from an EU parent would in practice almost certainly be subject to harsher UK taxation than a loan from a UK parent. Some UK-UK loans are caught, but these are rare exceptions, so this is unlikely to offer the UK government a refuge.

Even though the special relationship clause of the interest article of most EU-EU double tax agreements (DTAs) is a specific bilateral authorization to impose withholding tax on interest in cases of thin capitalization, there's a strong case that this also fails the ECJ's test and so is struck down by clause 43.

Likely reactions of EU governments

If thin-capitalization rules do not apply on loans within the EU, this potentially creates a large hole in the tax take of some EU governments.

How this is viewed depends on which side of the fence a person is sitting. On the one hand, thin-capitalization rules sometimes harshly deprive taxpayers of tax deductions for, or impose withholding tax on, perfectly reasonable interest burdens, so arguably this may right a wrong in some cases. And there are often good commercial reasons why many groups would not wish to increase their levels of internal debt funding.

On the other hand, it would be obtuse to pretend that were it not for thin-capitalization rules some groups would not finance their subsidiaries with debt levels well in excess of current levels. It seems likely that if thin capitalization rules are indeed ineffective European subsidiaries may begin claiming tax deductions for interest on billions of euros of additional debt.

Clearly, governments will view this as undesirable, to say the least, and it seems unlikely that they will just shrug their shoulders and live with the shortfall of tax. But do they have a choice? What in practice can they do?

As summarized in table 1, none of the obvious (or even not-so-obvious) options look that appealing. The figures for the chance of success are not at all scientifically determined. They are a very subjective assessment of the relative chances of success and acceptability. However, the table does illustrate that governments are stuck between a rock and several hard places. No government has yet made any public statements about this dilemma.

Reword local law

As already discussed, above, the ECJ's opinion appears to leave little room for manoeuvre here, because it is concerned with effective discrimination, as opposed to overt discrimination. Any reworded legislation that is likely to give rise to cross-border loans suffering harsher tax treatment than domestic loans seems unlikely to succeed, no matter how much the government in question protests, innocently, that the discrimination is entirely accidental.

Some governments may, nevertheless, be tempted to give this a try, if only in the hope that they can sow enough seeds of doubt that they discourage what they see as thin-capitalization abuse. This might at least buy them a few years breathing space, until the new wording inevitably becomes a new court case and works its way through lower national courts up to the ECJ.

Remove any domestic exemptions

On the face of it, the most obvious way to stop tax revenue haemorrhaging would be to remove the element of the thin-capitalization rules that gives rise to discrimination. Indeed, in a preliminary opinion that the ECJ seems to have followed the Advocate General helpfully suggests that the German authorities may wish to replace the current law with "a provision to extend the rules in respect of reclassification of interest and dividends also to subsidiaries with a resident parent company". He does not explicitly say that this would be acceptable under EU law, but this is clearly implied by his comment, "In the meantime, however, the [German thin-capitalization] is not admissible".

An example of how this might work is that the UK might remove the current UK-UK exemption, so that the thin-capitalization deemed dividend rules apply regardless of whether the lender is a UK taxpayer. Unfortunately, because the UK transfer pricing rules are specifically designed to catch thin capitalization, the UK government would similarly have to extend the scope of the transfer pricing rules. Unless they could find a way to do this in a manner that only applies to thin-capitalization issues - which would be very tricky - such a change would have to affect transfer pricing on any kind of transaction.

Despite the tax revenue that might otherwise be lost, it would be a brave government that took such a step, as there would be uproar from domestic corporate groups that suddenly find they have to comply, pointlessly, with thin-capitalization rules (and perhaps even transfer pricing rules). It is hard to imagine what they would object to the most: the wasted resources used in complying with these rules or the prospect that they might actually lose tax deductions.

Some governments may try to avoid taking flak on this by enforcing the thin-capitalization rules only in the case of cross-border transactions. However, this is not going to be wholly reassuring to domestic groups, because they cannot be sure where they stand. Even if there are careful leaks that it is unofficial policy not to enforce the rules for domestic transactions, companies may still feel exposed, particularly where there is a self-assessment system putting the onus on the company to apply the tax legislation correctly.

Moreover, in view of the potentially sweeping nature of the ECJ judgment, there has to be a real risk that, even if the only discrimination was in the way the rules are applied in practice, thin-capitalization rules could be held to be inadmissible.

Some governments may therefore decide that domestic groups will just have to put up with the compliance burden. They may argue that domestic groups are unlikely to face any additional tax costs, because any loss of deductions for the borrower ought to be balanced out by a corresponding adjustment for the lender. For instance, in some countries a deemed dividend may not be taxable income for the lender, or, as in the case of the UK transfer pricing rules, there may be an explicit right to a corresponding adjustment, reducing the lender's taxable income.

Unfortunately, this may be another weakness in this whole strategy. Despite the Advocate General's encouraging comments, it may not be sufficient to extend thin-capitalization rules to domestic groups, because they inherently will often face no net increase in tax burden, even if there is a thin-capitalization adjustment. Arguably, it would require another case to determine whether this is still unacceptable discrimination, but it seems quite possible that the point will, sooner or later, be litigated.

Use other domestic law

This strategy ought to be a non-starter, because if there were other domestic laws that prevented thin-capitalization abuse, there would have been no need for the specific thin-capitalization rules that most countries have.

For instance, in the UK the Inland Revenue might argue that interest on excessive debt is not incurred "wholly and exclusively" for the purposes of the borrower's trade, and so does not fulfil the requirements of the general deductibility section of the UK Taxes Act. As this section applies to all UK companies, regardless of who owns them, this approach would not, on the face of it, be discriminatory.

If the loan is used for the purposes of the borrower's trade however, arguably this requirement is met notwithstanding that part of the loan would be more likely to have been equity had the lender not been a related party.

There is also speculation in the UK that the Inland Revenue will dust off a tax case, Sharkey v Wernher (36TC275), which related to the price at which the owner of a business took an asset out of the business for personal use.

No doubt other countries will similarly have legal principles they may try to use, but this sort of approach is unlikely to be satisfactory for governments because co-opting legislation or case law is at best going to do the job very inefficiently.

As with the previous strategy, there is also the problem of the impact on domestic taxpayers. Governments may be able to dig up domestic law which - little did anyone realize - has apparently always allowed them to apply thin-capitalization principles. But unless they start applying this law in a non-discriminatory fashion, to domestic loans as well as to cross-border loans, arguably this is discrimination by administrative practice. Moreover, they will be vulnerable to the argument that if their interpretation of the law were correct, you would have expected them to have been applying it in this manner in the past, to any loans that were exempt from the specific thin-capitalization rules. Unless they can show a record of having done this, their interpretation will be suspect.

Despite its weaknesses, this may be a popular approach among governments, because it is the only one that even stands a chance of providing grounds for tax authorities to resist requests for refunds for previous years. Some very inventive applications of domestic law should be expected over the next year or so.

Rewrite the Treaty of Rome

As the tax bases of all EU members will be eroded by this case, it might be expected that this is, at worst, a temporary problem for governments, because they will just change the bit of the Treaty of Rome that is causing the problem. In practice, this is highly unlikely.

First, the Treaty of Rome is not changed lightly, any more than, say, the US amends its Constitution lightly. Such a change would require a unanimous vote from all 15 member countries and the EU usually moves at a glacial pace.

Secondly, even assuming a vote was held this decade, unanimous approval could not be assumed. Not all member countries would suffer proportionately because the levels of inward investment vary from country to country. Those with little to lose would see this as one more bargaining counter, to trade off in return for other concessions, such as preservation of regional aid, the common agricultural policy, or fishing quotas.

In other words, it is not that the likely big losers - countries like Germany and the UK - would be unable to secure a change in the rules, it is just that other countries would extract payment in return, so it might be better to put up with the loss of revenue.

EU tax harmonization supporters will gleefully suggest that the best solution to Lankhorst is to move to an EU-wide tax base.

EU-EU exemption

There would not appear to be any wholly satisfactory means of resisting the impact of this case and governments need to consider whether there will really be a big net loss of tax revenue or whether they are better simply to go with the flow.

Certainly, the UK is going to end up giving more interest deductions to subsidiaries of German and French companies. But many UK parents will similarly be ensuring that their German and French subsidiaries are maximizing their interest deductions, so the UK will get to tax more interest income than it otherwise would. Obviously, there will be winners and losers, but the net loss or gain may not be as great as might first be thought.

An important point to note here is that EU law only frowns on member state A discriminating against companies resident in other member states (and their subsidiaries in member state A). Discriminating against non-EU companies is fine. Any non-EU companies hoping that any widening of exemptions will be intended to encompass them are likely to be disappointed. This is about as likely as, say, the US government abolishing its thin-capitalization (earnings stripping) rules in sympathy with the EU.

Inevitably, many non-EU parents will look for back doors into the EU. And a problem with this approach is that it is difficult to see how EU governments can prevent this, without discriminating against EU lenders that happen to be subsidiaries of non-EU companies.

Scrap corporation tax

Another solution is to scrap corporation tax and increase the VAT rate to compensate. However, this is about as likely as another potential solution: leaving the EU.

What it means for transfer pricing

As the arm's-length principle underlies both thin capitalization and transfer pricing, there would appear to be a good chance that transfer pricing rules may also be incompatible with EU freedoms.

However, tax authorities may argue that there are distinctions. Thin capitalization is (at least usually) based on recharacterizing debt as equity and interest as a dividend. It is therefore inextricably linked to the parent's obligation to provide equity capital to its subsidiary. In contrast, transfer pricing may involve transactions where the connection with the parent's freedom of establishment is not as direct - say, goods sold by one company to a sister company.

In this connection, it is worth noting that the German thin-capitalization law considered in Lankhorst only refers to loans from substantial shareholders. In some cases, thin-capitalization rules apply to loans where the lender and borrower are under common control, even if the lender is not the parent of the borrower. This was not explicitly considered in Lankhorst. Arguably, the position is similar to that of transfer pricing rules.

The odds are good that transfer pricing rules are contrary to EU law, though it may take another case to prove this. Such a case is already in the lower courts in Germany, so there may not be too long to wait. In the meantime, taxpayers should consider taking action now, along the lines set out in the box at the start of this article.

Gareth Green (ggreen1@uk.ey.com) and Jonathan Levy (jlevy@uk.ey.com), London