Those operating pan-European fund and deal structures have always been aware that they need to establish substance in the various jurisdictions in which they have legal entities. Reliance on the application of EU law or double tax treaties necessitates a certain level of activity in a country, or anti-abuse provisions can be implicated. In the tax context, several cases recently decided by the Court of Justice of the European Union (CJEU) could have important implications for some European private equity structures. In particular, they demonstrate the evolving European landscape so far as substance requirements are concerned.
These recent cases concerned several Danish companies that were held by (non-EU) private equity funds through structures that included intermediate EU holding companies, with back-to-back arrangements to repatriate funds to investors. The European holding companies had local offices, employees and external costs. Nevertheless, the Danish tax authorities claimed that the benefits of the EU Directives that provide an exemption from withholding tax on interest and dividends should not apply to payments made by the Danish companies to their holding companies. They argued that the intermediate companies were not the beneficial owners of the relevant income and were purely conduits. The question was elevated to the CJEU.
Unsurprisingly, the CJEU ruled that, as a general principle, the benefits of EU Directives must be denied in abusive or fraudulent circumstances. Importantly, the court followed a “substance over form” approach and focused on whether one of the principal objectives of interposing the EU holding companies was to obtain a tax advantage. In this respect, the approach is more aligned with other international tests for abuse, including that being used by the OECD in its BEPS (Base Erosion and Profit Shifting) initiative. Here the court was influenced both by the fact that the EU holding companies were passing on income very quickly after receiving it, and by the fact that it could find little economic justification for the existence of the EU holding companies other than to take advantage of the tax benefits of the EU Directives. It also noted that the existence of ultimate beneficiaries who were outside the EU – and would therefore not otherwise be able to obtain the same tax advantages – was indicative of abuse, but also made clear that local tax authorities did not need to look beyond the company to reach a conclusion that a structure was abusive.
Although these cases concerned the application of EU Directives, the principles could also apply to reliance on double tax treaties and so have wider significance for firms.
National courts and tax authorities of EU Member States will be responsible for assessing the facts and determining whether, in a particular case, an intermediate EU company is to be viewed as a “conduit” company and should therefore be denied the benefit of withholding tax exemptions under EU Directives. The guidance provided by the CJEU in these rulings is unlikely to be applied uniformly across the EU.
But one thing is clear: for private equity firms that operate international structures, the focus on economic substance – meaning the non-tax commercial justification for the holding company to receive income, and the reality of what it then does with it – is becoming more important for tax purposes than the traditional tests for substance, which have tended to focus on the number of people and operations in a particular jurisdiction – although these tests are, of course, somewhat related.