Exit Capital Tax in view of the discrimination of non-residents
The existing Ukrainian Corporate Profit Tax (”CPT”) system appears to be ineffective, creating prerequisites for its reform. The main problems that payers of the CPT face today are the complicated rules of tax base calculation providing for ambiguous and discrete interpretation, which is a constant risk zone for taxpayers, as well as difficulties in tax administration. Moreover, the existing system provides legal mechanisms for aggressive tax optimization resulting in maximum CPT load on diligent taxpayers while making CPT neutral for others.
We believe that introduction of an entirely different philosophy of income taxation is needed. Namely, the one proposed in the Draft Act under the name of the Exit Capital Tax (”ECT”). Detailed analysis of the ECT and its advantages compared to the existing system are published on KMP.UA web-site.
The main idea (concept) of ECT is that only the amounts “extracted” from business shall be subject to taxation. Thus, the ECT shall be paid due to owner’s decision to pay dividends in favor of the non-payer of tax as well as in case of hidden outflow of similar payments (royalties, interests, financial assistance to non-payers of tax, investments etc) and transactions that resulted in necessity to make surcharges under certain conditions (controlled transactions and transactions for which the usual prices are used).
During the discussion on the possibility of implementing the ECT model in Ukraine, the concept was argued as being discriminative and restrictive. Doubts were expressed due to the difference in taxation of cross-border and domestic transactions.
Thus, according to the proposed model the ECT taxpayers are residents – business entities, carrying out business activities both in Ukraine and abroad, as well as non-residents – permanent establishments of non-residents, operating on the territory of Ukraine. Such taxpayers shall pay ECT in respect of the transactions made to non-taxpayers, in particular natural persons as well as non-residents (e.g. parent company located abroad). Consequently, the transactions (e.g. payment of dividends, royalties, interests etc.) made to such persons are subject to ECT. At the same time, the distribution of the profit by one taxpayer to another taxpayer (e.g. from one Ukrainian entity to another Ukrainian entity if the latter operates under general corporate tax system) shall not be taxable.
In such a case, some argue that the proposed ECT system provides for unequal treatment of cross-border transactions compared to domestic transactions restricting the free movement of capital – one of the fundamental principles granted within the EU. In turn, by adopting such a system Ukraine supposably steps back on the way to the EU.
In this respect, let’s consider the EU law as well as the case law in view of the free movement of capital principle and whether the proposed concept is compatible with those.
In the field of direct taxation the most relevant EU Directive is On the Common System of Taxation Applicable in the Case of Parent Companies and Subsidiaries of Different Member States (”Directive”)1. The purpose of Directive is to eliminate double taxation as well as disadvantageous treatment of cross-border transactions as compared to domestic ones. Thereto, art.5 of the Directive stipulates that the profits which a subsidiary distributes to its parent company shall be exempt from withholding tax. Equally, the Directive obliges the state of the parent company either to refrain from taxing dividends received from another Member State or, if it subjects such profits to tax, to entitle the parent company to a tax credit in relation to tax paid not only by the subsidiary but also by any lower-tier subsidiary (art.4). Consequently, the profits are taxed once.
In this respect it shall be considered whether distribution of profits paid by a subsidiary company exempt from taxation is compatible with the Ukrainian ECT system provided that profits paid abroad are subject to ECT.
The Directive does not provide for the definition of the term ”withholding tax”. However, the Court of Justice of the European Union (”ECJ”) interpreted it in a numerous court cases.
The ECJ held that in the meaning of art.5 of the Directive any tax on income received in the state in which dividends are distributed is a withholding tax on distributed profits if three conditions are simultaneously2 fulfilled: 1) the chargeable event for the tax is the payment of dividends or of any other income from shares; 2) the taxable amount is the income from those shares; 3) the taxable person is the holder of the shares3.
Thus, in Burda GmbH case4 the ECJ analyzed whether there was a discriminatory treatment in the situation when non-resident parent companies of resident subsidiaries, unlike resident parent companies, were not granted a tax credit to compensate for the corporation tax paid by the company making the distribution. Please note that the issue in question concerned the compensation of corporation tax actually paid by the subsidiary, not the parent company.
The ECJ noted that ”as a condition for the existence of a withholding tax … the taxable person must be the holder of the shares…”5. However, in the case described such a condition was not met (the subsidiary was liable to corporation tax when it distributed profits to the shareholders; the tax at issue was not paid from the profit distributed to the parent companies (shareholders). Thus, in this case the holders of shares were not taxable persons, which is required for the ”withholding tax”. For this reasons, the ECJ ruled that the distribution of profits by the subsidiary to the parent company when the subsidiary is liable for taxation cannot be regarded as withholding tax in meaning of art.5 of the Directive, noting that ”a provision of national law which, in relation to cases where profits are distributed by a subsidiary to its parent company, provides for the taxation of income and asset increases of the subsidiary which would not have been taxed if they had remained with the subsidiary and had not been distributed to the parent company does not constitute withholding tax within the meaning of art.5 of the Directive”6.
If applying these conditions to the ECT model it can be seen that the third criterion is not met. That is, the taxable person is the holder of the shares, as under the ECT concept the taxpayer fulfils its own tax liability paying the ECT and there is no further withholding tax from dividends distributed to a recipient, irrespective of the domicile of the recipient.
In the Oy AA case, the ECJ held that Directive does not constitute the first taxation of income arising from a business activity of a subsidiary7, when under the ECT system the tax constitutes the first taxation of the profits distributed by the subsidiary, nevertheless the tax is being levied only when the profits are distributed.
Moreover, it is also settled law that discrimination can arise only through the application of different rules to comparable situations or the application of the same rule to different situations8. When analyzing the ECT model, it cannot be said that the different rules are applied to residents and non-residents, thus depending on its domicile, because ECT is paid when the transaction is made to the non-taxpayer, which can also be a resident of Ukraine (e.g. Ukrainian legal entity – payer of the unified tax). Therefore, there is no disadvantageous treatment in respect of residence status of the taxpayer. The same is with the cross-border transactions being compared to domestic ones. If the profits are distributed to the non-payer in Ukraine (individuals, payer under unified tax) it is subject to ECT as well.
For the sake of completeness, even though considering the proposed concept being restrictive basing on the residence status, according to ECJ ”In relation to direct taxes, the situations of residents and non‑residents are, as a rule, not comparable… A difference in the treatment of resident and non-resident taxpayers cannot therefore in itself be categorized as discrimination …”9. In case Truck Center SA case the ECJ held that ”the difference in treatment…consisting in the application of different taxation arrangements to companies established in Belgium and to those established in another Member State, relates to situations which are not objectively comparable… In the first case, the Belgian State acts in its capacity as the State of residence of the companies concerned, while in the second case it acts in its capacity as the State in which the interest originates”10.
In terms of ECT the situations of taxation of transactions to residents and non-residents, while transactions made in respect of residents under certain conditions are also taxed, cannot be comparable as such.
To sum up, the proposed ECT system is compatible with the Directive, which is supported by the ECJ case law. It cannot be regarded as disadvantageous for cross-border transactions compared to domestic ones as well.
1Directive 2011/96/EU of 30.11.2011;
2Directive 90/435/EEC of 23.07.1990,being in force before adoption of Directive 2011/96/EU of 30.11.2011;
3Case C-446/04 of 12.12.2006 (FII Group Litigation v Commissioners of Inland Revenue), para.108;
4Case C-284/06 of 26.06.2008 (Finanzamt Hamburg-Am Tierpark v Burda GmbH);
5Case C-284/06 of 26.06.2008 (Finanzamt Hamburg-Am Tierpark v Burda GmbH), para.61;
6Case C-284/06 of 26.06.2008 (Finanzamt Hamburg-Am Tierpark v Burda GmbH), para.64;
7Case C-231/05 of 18.07.2007 (Oy AA), para.27;
8Case C-279/93 of 14.02.1995 (Finanzamt Köln-Altstadt v Roland Schumacker), para.30;
9Case C‑282/07 of 22.12.2008 (Belgian State-SPF Finances v Truck Center SA), para.36-39;
10Case C‑282/07 of 22.12.2008 (Belgian State-SPF Finances v Truck Center SA), para.41-42.