Businesses have always thrived through expansion, synergy and efficiency. Size does matter, but small and lean operations can prove to be very profitable. To deal with this apparent paradox, large multinationals need to be agile in the structuring of their operations.
In the late 1980s and early 1990s, several tax regimes were implemented to help enterprises manage their tax liability (tax consolidation regimes) or their restructuring: the so-called EU Merger Directive implemented a tax deferral regime on mergers, divisions, transfer of assets and exchange of shares in order to remove fiscal obstacles for cross-border reorganizations. Such regime has proved helpful for enterprises to acquire, dispose of or restructure their international operations in a tax neutral way.
Lenient tax rules applicable to tax losses (unlimited carryforward or carryback) were also implemented to help businesses to recover after financial difficulties. These were the “golden days” when tax regimes aimed at assisting the development of enterprises.
Then the 2008 financial crisis came and finger pointing began: large multinational companies did not pay their fair share of tax by using tax optimization schemes. In 2010, a Chapter 9 on “Business Restructurings” was included in the Organization for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines to deal with corporate restructuring realized by multinational enterprises aimed at “tax avoidance,” involving transfer of intangible assets, transfer of functions and risks.
In 2013, the OECD and the G-20 launched the base erosion and profit shifting (BEPS) initiative (completed in 2015) where action points 7 to 10 specifically dealt with transfer pricing and permanent establishment topics connected with business restructuring, in order to address profit shifting. Commissionaire arrangements now create permanent establishments, and profits derived from intangible assets should be split with service providers which used to receive routine profits while performing significant functions for developing, enhancing, maintaining, protecting or exploiting such assets (DEMPE functions).
Another example is the EU Council Directive 2011/16 in relation to cross-border arrangements, also known as “DAC6”, which came into force on June 2018. It provides for mandatory disclosure rules on certain cross-border transactions which meet one or more characteristics (“hallmarks”) showing that they may be tax-motivated. Two hallmarks refer to business restructuring: transfer of hard-to-value intangible assets (E2) and intra-group transfers of functions, assets, or risks (E3). Actual reporting started in January 2021 in most EU countries.
Business restructuring is no longer encouraged by tax administrations, to say the least, and is rather viewed as another tax optimization tool, like transfer pricing and structured financing. At the same time, rules applicable to tax losses have been straitened, in order to challenge the trading of empty shells with tax losses available— change of control or change of activity typically forfeit the use of existing tax losses; also in order to ensure a certain level of tax revenues for governments by limiting the offsetting of carried-forward losses against profits of the year. Over a certain threshold, losses may only be offset up to a certain percentage of the excess; and losses can be carried-back only for a limited period.
Government Tax Measures to Provide Support
Then came Covid-19, with the periods of lockdown having a disastrous effect on the global economy. Governments all over the world took temporary tax and non-tax measures aimed at providing immediate financial leeway to the business community. Tax measures have aimed at enhancing companies’ cash flow position, including deferral of payment of taxes that should have been paid during the first part of the health crisis.
Yet if the cash flow of enterprises has been preserved, thanks to governmental business loan guarantees, many companies have still suffered significant losses in 2020 and expect to remain in a loss position in 2021. Additional flexibility on the use of tax losses would be a relief for these challenged businesses.
In this respect, the European Commission adopted a recommendation on May 18, 2021 on the tax treatment of losses: member states should allow loss carryback for businesses to at least the previous fiscal year. They may extend that period to allow loss carryback up to the previous three years, thus allowing companies to set off their losses referring to fiscal years 2020 and 2021 against already taxed profits in the fiscal years 2019, 2018 and 2017.
Member states should allow businesses to immediately claim the carryback of losses which they estimate to incur in fiscal year 2021, without the need for waiting until the end of the year.
Several countries, whether EU member states or not, have implemented such measures or plan to do so.
Measures in Individual Countries
Norway, which already allows an unlimited an uncapped carryforward of losses, in 2020 extended the right to carry back losses over two years.
In Germany, tax losses can be carried forward indefinitely. With respect to corporations, such losses can be offset against taxable profits, considering a minimum taxation which allows a full set-off of up to 1 million euros ($1.17 million). In the case of higher profits, 60% of the exceeding profit can be set off against tax losses carried forward. This applies for (federal) corporation tax purposes as well as for local trade tax purposes.
As an alternative, for income and corporation tax purposes (but not for local trade tax purposes) Germany provides the possibility to carry back a tax loss for one year. In order to support taxpayers who have suffered losses due to the Covid-19 crisis, the annual amount which may be carried back has been increased from 1 million euros up to 10 million euros for the years 2020 and 2021.
Based on the extension of the amount which can be carried back, taxes paid in the past are refunded after the annual tax return has been filed. If such annual tax return has not yet been filed, tax prepayments may be reduced upon application—either based on concrete calculations provided, or, with respect to 2019, on a flat basis of 30% of the total amount of income for 2019. The previous restriction of 1 million euros applies again as of 2022.
Similar measures are under discussion before the parliaments in France and in the U.K.: in France, tax losses incurred in the first fiscal year between June 30, 2020 and June 30, 2021 could be carried back without limitation on the three preceding years (currently, carryback is limited to one year and to 1 million euros); in the U.K., similarly, tax losses incurred during fiscal years between April 2020 and March 30, 2022 could be carried back on the three preceding years, without limitation for the first year, and with a cap at 2 million pounds ($2.7 million) for years two and three.
Other countries have decided to relax their carryforward rules.
In Portugal, losses could be carried forward over five years, with a 70% cap: for 2020–2021, tax losses can be carried forward over 12 years, with an 80% cap.
In the Netherlands, current rules provide for a one-year carryback and carryforward limited to six years. A Royal Decree was published on June 4, 2021, providing for new rules effective as of January 1, 2022. The carryback rules are untouched, but the carried forward period become indefinite.
Limits are introduced for the use of such losses: tax losses can only be offset against the first 1 million euros of taxable profit in a given year, and if the annual taxable profit exceeds 1 million, losses may only be offset up to 50% of the excess (a similar rule applies in Germany and France for example). This limitation would apply to profits generated by a debt waiver, which is a sensible transaction for challenged Dutch affiliates of international groups.
In this respect, if parties are currently considering a business-motivated debt waiver, the obvious solution is to have the debt cancellation take place prior to the entry of the new rules. Care should be taken on the tax treatment of the debt waiver on the creditor side, as certain countries would apply limitation to the deductibility of such a waiver: in France, for instance, only the waiver of commercial debt (as opposed to financial debt) would be tax deductible.
Another option would be to grant the Dutch affiliate a conditional debt forgiveness whereby the debt would be reinstated when the Dutch affiliate recovers: this should create a deductible tax expense fully offsettable against the taxable profits of the year of the reinstatement.
While the use of tax losses may be extended by the recent measures described above, it remains the case that they could be forfeited in a change of ownership or change in activity, which is likely to happen in the current period. Such restrictive rules exist in most countries, and there is no sign yet that they may be relaxed. Careful review should therefore be carried out to estimate the consequences of an acquisition or of a business restructuring aimed at focusing a distressed company on its core activity.
Business restructuring could prove efficient in saving taxes: in Spain, due to the limitation of the participation exemption on dividends (from 100% to 95%) as of January 1, 2021, taxation is levied at every level on dividends. So, on a distribution made from a second level subsidiary there would be a double tax leakage of 1.25% (25% of the non-exempt 5%) before the dividend is received by the holding company; it is then tax efficient to merge entities in order to limit the number of dividend distributions. If one of the entities has carried forward losses, a merger in Spain would not forfeit such losses provided the merger was realized under the tax neutrality regime.
It should be stressed that in most countries, the general rule would be to consider that carried-forward tax losses of the absorbed entity would be forfeited by a merger since the legal entity which generated the losses is no longer in existence.
In France, carried forward losses can remain available provided a tax ruling is obtained. By law, the ruling is automatically granted provided certain conditions are met, mainly that
- the merger is not tax driven; and
- there is no significant change in the transferred business, with respect to customers, employees, equipment, and nature of volume of the activity.
Based on these provisions, one can see there are many situations where the French tax administration could deny the ruling.
Fortunately, the Administrative Supreme Court recently applied a pragmatic approach (Alliance Negoce, April 2, 2021): further to the merger, the absorbing entity had significantly restructured the activity of the absorbed entity (trading of agricultural products) by laying off all 10 employees, replaced by the secondment of employees of other entities of the group, and sold all the transportation equipment to another entity of the group which then provided transportation services to the merged entity.
The French tax administration considered that the facts above characterized a significant change in the business (from 10 to zero employees, total assets decreased by 65%), and refused to grant the ruling. The company challenged the decision before the tax courts and lost before the first level court and the Court of Appeal.
The Administrative Supreme Court ruled in favor of the taxpayer, considering that the main condition was the tax motive, and that the company was still able to maintain its business by other means.
Businesses hope that this ruling is a message from the Supreme Court that such anti-abuse tax provisions should be interpreted in favor of the taxpayer when the goal of the taxpayer is not to evade tax.
Similar provisions apply in the general case of change in activity, and one can also hope that tax courts would take the same pragmatic approach when a self-standing company takes the necessary steps in terms of employment and assets to maintain its business.
It seems obvious that the business community needs all the help it can get from governments to bounce back now that the health crisis may be (almost) behind us. Legislators have already shown the way for tax losses carryback. Facilitating the transfer of legal restructuring would be appreciated. It is also up to the field tax agents and the tax courts to confirm that the nations stand behind businesses in these challenging times.
We will discuss debt repayment in a later article.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Stéphane Gelin is Head of Global Tax with CMS.