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Alan Sournac
Gide Loyrette Nouel, Paris
alan.sournac@gide.com

 

Report on a session at the 9th Annual IBA Finance and Capital Markets Tax Conference in London

Monday 20 January 2020

 

Session chair

Kim Blanchard  Weil Gotshal & Manges, New York

 

Speakers

Peter Blessing  The Office of Chief Counsel (International), Washington, DC

Guillermo Canalejo Lasarte  Uria Menendez Abogados, Madrid

Olivier Dauchez  Gide Loyrette Nouel, Paris

Andrew Thomson  Sullivan & Cromwell, London

Hamish Wallace  MinterEllison, Sydney

 

The panel discussed new developments and strategies to address deferral in the different represented jurisdictions. Kim Blanchard opened the session by indicating that international taxation of passive investment vehicles (ie, undertakings for collective investment in transferable securities directives (UCITS), mutual funds, partnerships and so on) raises fundamental issues to which each country may and indeed often does give different solutions.

Kim Blanchard explained that the ‘holy grail’ of passive investment taxation is, and should be, that an investor who pools its money with others should be taxed in the same manner that it would have been taxed had it invested directly. This is however generally not the approach taken by different jurisdictions.

For instance, the United States is a jurisdiction which never allows US taxpayers to achieve deferral of investment income (conversely to operating income): in the US, investment income must be taxed currently. This is the case both domestically and for foreign investment via the application of anti-deferral rules, particularly around:

• controlled foreign corporations (CFCs);

• global intangible low tax income (GILTI); and

• passive foreign investment companies (PFICs).

She also indicated that the application of the above-mentioned PFIC rules is of great importance in the context of capital markets. When a foreign vehicle wishes to be an issuer on a US capital market, one of the main questions is whether or not the PFIC rules shall apply to the said foreign issuer.

In addressing this topic, each speaker gave an overview of the rules governing tax deferral of passive investment in their jurisdictions after having firstly discussed some treaty eligibility issues for passive investment vehicles. Also, certain recent relevant case law in France and Spain was addressed. This recognised – subject to certain requirements – the right of non-EU passive investment vehicles to be taxed in a way similar to domestic passive investment vehicles.

Treaty eligibility of passive investment vehicles

Peter Blessing noted that one of the main issues with passive investment vehicles in a cross-border context relates to treaty eligibility.

According to Blessing, the first question is: does the vehicle possess legal personality? He indicated that it is generally not a problem. It may nevertheless sometimes be an issue when certain contractual arrangements are used, like trust or fiducie, for which jurisdictions may have different legal analysis.

The question is then: is the vehicle opaque, fiscally transparent or somewhere in between? In general, investment funds prefer to be opaque since it is easier to be viewed as a ‘resident’ for treaty purposes. Treaty-wise, the residence commonly depends on a ‘liable to tax’ test. In that respect, certain jurisdictions ensure the satisfaction of such test via a minimum taxation of investment vehicles. For example, Spain has a one per cent tax applicable to certain investment funds.

This ‘liable to tax’ test does not generally constitute a major impediment. Blessing used the example of the US regulated investment company (RIC). This vehicle is generally regarded as a ‘resident’ even though it does not pay tax in the US. The ‘liable to tax’ test is nevertheless regarded as met since such vehicle may be subject to tax (the US has a right to impose tax) and it pays withholding tax.

He then noted that difficulties arise when hybrid entities are involved. For these entities the Organisation for Economic Co-operation and Development (OECD) issued a report in 1999 alongside similar reports in the US. The comments in these reports made their way into Article 1 of the 2017 OECD model. These reports and the model set down the principle that the person to test for treaty eligibility is not determined on the basis of the paying countries’ rules but under the recipient countries’ rules.

Recent case law identified in France and Spain in relation to passive investments

Guillermo Canalejo Lasarte began by recalling that European Union Member States’ legislations must comply with some basic freedoms deriving from EU law such as freedom of services, freedom of establishment and freedom of movement of capital. The latter freedom is relevant for passive investment vehicles since Article 63 of Treaty on the Functioning of the European Union (TFEU) disallows restrictions on cross-border capital investments. Certain Member States of the EU had refused (and continue to refuse in certain respects) to fully acknowledge that freedom of movement of capital has tax effects.

Lasarte took the example of Spain. Spain does not have domestic rules protecting non-EU mutual funds against withholding tax on Spanish-sourced income comparable to the rules for Spanish funds. Since these non-EU mutual funds are not protected by Spanish domestic rules, they must rely on the EU freedom of movement of capital to be taxed on an equal basis to Spanish mutual funds on Spanish-sourced income.

The Spanish tax authorities refused to acknowledge equal tax treatment for non-EU mutual funds until a decision of the Spanish Supreme Court on 13 November 2019. In this decision, the Spanish Supreme Court ruled, on the basis of the freedom of movement of capital, that a US RIC must be taxed in the same way as if it were a Spanish resident.

The key element is how to determine if the non-EU fund is comparable to an EU mutual fund. Since it is based on the EU freedom of movement of capital, the Spanish Supreme Court held that the comparison test must be based on the UCITS directive. The comparability test is hence based on the legal features of the non-EU mutual funds. Lasarte also indicated that the burden of proof to demonstrate that a non-EU mutual fund has legal features comparable to the one of an EU mutual fund relies on the taxpayer.

Olivier Dauchez confirmed this reasoning for all EU Member States, including France, which has had clear domestic statutory provisions on this since 2012. He also explained that a French exempt investment fund can be very loose and poorly regulated. Hence, it is relatively easy to meet the said comparison test.

He then drew attention to a recent French case law (Conseil d’Etat, 10e-9e ch 27-11-2019 no 405496, Sté Vorwerk Elektrowerke GmbH et Co KG) relating to the tax treatment of foreign partnerships. The French Administrative Supreme Court (FASC) held that a German limited partnership (GmbH & Co KG) would be subject to French corporate income tax if it were French. In its reasoning, the FASC disregarded the German tax regime (such entity being tax-transparent for German tax purposes) and based its decision solely on the German entity's legal features. The FASC considered that it would be discriminatory for France to apply a withholding tax on the French-sourced dividends the German LP receives, since the German entity would have been able to benefit from the parent subsidiary exemption on such dividends if it were French.

Olivier Dauchez pointed out that this decision raises the question as to whether it would be discriminatory to apply a French withholding tax on French-sourced dividends distributed to a US limited liability partnership (LLP) Indeed, owing to the US LLP's legal features, one may argue that it should be assimilated to a French joint-stock company regardless of the fact that it may be transparent for US tax purposes. He insisted that achieving a withholding tax exemption on this ground would only be available in the event the holding of the French shares by the US LLP were not a ‘direct investment’ within the meaning of Article 64 of the TFEU. In this respect, a recent decision of the FASC held that a eight per cent stake in a French company must be regarded as a ‘direct investment’, provided such stake allows its owner to actively participate in the management of the subsidiary (Conseil d’Etat, 30 September 2019, no 418080, Sté Findim Investments).

The United Kingdom

Andrew Thomson addressed the basic rules applying in the UK in relation to passive investment vehicles. He started by indicating that it is rather difficult to achieve deferral in the UK for onshore investment funds.

The UK has a number of regimes for onshore funds, including those for Real Estate Investment Trusts (REITs), investment trusts and authorised investment funds. All three of those are treated as fiscally opaque; the capital gains made by the fund vehicle are exempt from UK tax, as are the dividends received. Authorised investment funds are deemed to distribute all income available for distribution so that UK investors are then taxed on those deemed distributions. REITs and investment trusts are required to distribute most of their income with such distributions being taxable in the hands of the UK investors. Accordingly, none of these three types of vehicles are well adapted for rolling-up income tax-free.

Thomson then gave an overview of the UK offshore fund rules. The main purpose of these rules is to tax the gain upon disposal of an interest in an offshore fund, not as a capital gain but as income (the latter being taxed at a higher rate). Before 2009, these rules were based on a regulatory definition of ‘mutual fund’. This regulatory definition allowed structuring around the rules.

In 2009, these rules moved to a tax-specific definition because of concerns that the previous regulatory definition of ‘mutual fund’ had been used to facilitate avoidance. For this tax-specific definition, a ‘mutual fund’ is broadly a vehicle which the UK does not consider transparent, that is foreign in some sense and which is in effect open-ended.

Australia

Hamish Wallace addressed the basic rules applying in Australia in relation to passive investment vehicles and noted the conceptual similarities with the UK. He indicated that it is rather difficult to domestically achieve deferral in Australia. Onshore funds are generally structured as trusts with taxation at the level of the investors.

He then turned to the Australian foreign deferral rules, particularly the CFC rules (although there are also anti-deferral rules which apply to foreign trusts). Wallace explained that Australia has fairly robust CFC rules to prevent the deferral of tax on foreign income in respect of controlling interests in companies not carrying on an active business which are generally regarded as exceeding the OECD's standards.

One particular feature of Australia’s international tax law relates to the taxation of interests held in foreign LPs. In Australia, LPs are not taxed on a flow-through basis but treated as companies. This analysis may lead to double taxation and loss of tax credit issues for Australian investors when the foreign LPs are taxed on a flow-through basis abroad. To tackle this issue, Australia issued specific foreign hybrid rules which allow, under some conditions, Australian investors to be taxed on a flow-through basis when they hold an interest in foreign partnerships. The practical application of these rules causes some difficulties when the foreign partnership is located in certain jurisdictions.

Spain

Lasarte indicated that Spanish collective investment vehicles are – unlike other jurisdictions – taxpayers for corporate income tax purposes. They nonetheless benefit from a one per cent rate if they:

• are regulated under the UCITS directive; and

• have more than 100 investors.

He explained that Spanish collective investment vehicles incorporated under the form of société d'investissement à capital variable (SICAV) are widely used by high net worth individuals: it allows them to achieve deferral on passive investments by solely paying the aforementioned one per cent tax. In order to meet the 100 investors requirement and enjoy the one per cent tax, it is quite typical to structure the Spanish SICAV with 99 investors holding only one share each. The dividends distributed by the Spanish SICAV and the sale of units in such vehicle are generally fully taxable without available exemption. Since these Spanish collective investment vehicles are subject to tax, they are ‘residents’ for treaty purposes and may enjoy the benefits of the Spanish treaty network.

Lasarte also indicated that Spain does not have specific anti-deferral rules other than CFC rules. For these rules to apply to investment funds, a controlling interest is required in the foreign entity: this is usually not the case in practice (except when you are in a private management area). The Spanish CFC rules do not apply when the investment fund is incorporated within an EU Member State. High net worth individuals typically rely on this safeguard provision and usually set up Luxembourg UCITS qualifying vehicles which do not require the presence of more than one investor. Lasarte drew attention to the fact that there are specific rules providing for mark-to-market taxation when an investment fund is incorporated in a ‘tax haven’.

France

Dauchez explained that deferral for passive investment is the norm rather than the exception in France, except for:

• individuals owning an interest exceeding ten per cent in an investment fund (when such fund is not an EU regulated fund); and

• for companies subject to mark-to-market taxation.

In terms of inbound investments, France has a very interesting vehicle: the société de libre partenariat (or SLP). An SLP is tax-exempt and does not alter the nature and origin of the income it receives. This allows its stakeholders to access double tax treaties at the time the SLP distributes itself the income.

In terms of outbound investment, French investors usually invest in a foreign LLP to obtain an exemption on the dividends received out of the foreign LLP, regardless of the fact that the foreign LLP may be exempt or fiscally transparent abroad.

 

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