Taxpayers are anxious about the EU’s new international tax transparency initiative: The rules can be subjective and the penalties are significant.
As taxpayers have started to read the principles enumerated in the new reporting requirements, known as DAC6, they’re discovering that interpretation may be more difficult than they expected.
The aim of DAC6, or the Directive of Administrative Cooperation, is to further identify cross-border transactions undertaken by EU member states that may be tax motivated. And according to the OECD, mandatory disclosure rules like DAC6 should be clear and easy to understand.
However DAC6 lacks some clarity, which results in uncertainty about what is required.
Not only are the rules different among member states but the mandatory disclosure rules may be subject to different interpretations by member states. It would be easy to inadvertently omit one or more transactions subject to disclosure as one surveys the transaction flows with every EU member state to a third party or intercompany.
And with reporting deadlines looming, where does a taxpayer start? With interpretation.
A great first step for interpretation is understanding the defined—and undefined—terms prior to identification of the relevant transactions subject to reporting.
This article will take a close look at the pieces of DAC6 where there is the most ambiguity and provide examples and insights.
Start at the Beginning
Annex IV to the directive outlines five categories of hallmarks subject to disclosure. Most of the uncertainty in interpretation is in the first two: hallmarks A and B.
A and B include the main benefit test (more on that to come), as well many common business transactions and are generally subjective. The three subsections of hallmark C, which have the main benefit test, are not as common and are easier to interpret. Hallmarks D and E are more definitive and lack the main benefit test.
A “hallmark” means a characteristic or feature of a cross-border arrangement that presents an indication of a potential risk of tax avoidance.
However, an “arrangement” represents an undefined term that is included in each hallmark category. This term is defined by several member states, resulting in a very broad category of transactions that underlies the intent of DAC6 reporting, with very few exceptions.
An “arrangement,” pursuant to French legislation, includes any agreement, scheme, plan, mechanism, transaction, or series of transactions.
Ireland defines the term as a transaction, action, course of action or conduct, scheme, plan, proposal, understanding, promise or undertaking, whether express or implied, and whether or not it is enforceable by legal proceedings.
A “cross-border arrangement” means an arrangement between at least one member state and another country (EU or non-EU), pursuant to meeting at least one of the prescribed conditions.
A “reportable cross-border arrangement” (RCBA) means any cross-border arrangement that contains at least one of the hallmarks in categories A through E.
DAC6 concludes that most of the potentially aggressive tax-planning arrangements span across more than one jurisdiction, thereby the disclosure of that information would bring additional positive results in an exchange amongst member states. Additionally, the automatic exchange of information between tax authorities is crucial to provide them the necessary information to take action where they observe aggressive tax practices.
Also important to define is an “intermediary,” which is a taxpayer that meets one of the following conditions in a member state:
- tax resident;
- permanent establishment (PE);
- incorporated, or governed; or
- registered with a professional association re: legal, tax, or consulting
How Should You Approach Documenting the MBT?
The main benefit test, or MBT, is a prerequisite condition of reporting for hallmarks A, B, and certain elements of C. The definition is subjective, based on a literal reading, resulting in uncertainty for developing documentation and reaching definitive conclusions.
DAC6 Annex IV, Part I, states that, “The test will be satisfied if it can be established that the main benefit or one of the main benefits which, having regard to all relevant facts and circumstances, a person may reasonably expect to derive from an arrangement is the obtaining of a tax advantage.”
OECD Action 12 states that the MBT threshold condition requires an objective assessment of the tax benefits. This test compares the value of the expected tax advantage with any other benefits likely to be obtained from the transaction. This quantification, and supporting documentation, provides an objective methodology for documentation whereby the value of the expected tax advantage, if any, can be compared with commercial and economic benefits to be derived.
Member states have generally conformed their definitions, or implicit reference to DAC6, for consistency.
However, several member states have provided additional interpretations, leading to additional uncertainty for a definitive conclusion.
France provides that legislative intent, and the object of the relevant law, should be considered. The main determining factor is whether the cross-border arrangement would have been carried out in the same way if the tax advantage did not exist. The determination should be a global measurement, while also considering deferred taxation as a tax advantage.
Ireland cross-references the MBT to domestic law, where objective and subjective tests are considered. In looking at subjective tests, it is necessary to determine what was in the mind of the taxpayer at the time the transaction was entered into. Obviously, this is a very high threshold to document, or support.
So how should you approach documenting the MBT?
Start with the OECD Action 12 threshold quantitative approach, using a reasonable basis to measure the value of the tax benefit.
Member states with a subjective test should be further documented, including relevant emails, meeting minutes, and other supporting contemporaneous documentation that form a reasonable basis for the arrangement. This process will be easier going forward, as part of new DAC6 governance. However, the initial reporting period commencing June 25, 2018, may be more difficult. Changes in ownership structures, personnel, ERP systems, and decentralized operations/document retention policies represent reporting challenges for prior periods.
More Art Than Science
Let’s explore the requirements, and insights, of hallmarks A and B.
A1: Confidentiality: Hallmark A1 provides that a condition of confidentiality is required (verbal arrangement/email/written agreement) in addition to the MBT. Several member states provide that the confidentiality clauses to protect a commercial, industrial, trade, or commercial secret would not meet the hallmark standard of confidentiality for reporting.
Insights: Use this general guidance, absent reference to a tax administration, tax advisor or tax advantage, to show that the agreement is a non-reportable arrangement. Supporting documentation would evidence and demonstrate a nil value of the tax advantage, which fulfills the objective assessment test for the MBT determination.
A2: Intermediary: Hallmark A2 provides that an arrangement via an intermediary (e.g., an in-house tax department for different member states) that includes a fixed fee arrangement re: the amount of tax advantage, or whether or not a tax is actually derived, in addition to the MBT, qualifies as an RCBA.
The language of this hallmark re: a tax advantage would automatically meet the MBT.
An intermediary is any person that provides, directly or by means of other persons, aid, assistance or advice with respect to designing, marketing, organizing, making available for implementation or managing the implementation of a RCBA.
Intermediaries, who sell reportable cross-border tax arrangements to taxpayers, should report information on the arrangement to the tax authorities of their home member state.
However, the obligation to report the arrangement shifts to the “relevant taxpayer” when (i) the intermediary is a non-EU intermediary, (ii) there is no intermediary (i.e., an in-house arrangement), or (iii) the taxpayer is notified that an intermediary has the right to a waiver due to legal professional privilege.
Several member states include tax arrangements developed by an in-house tax department as subject to intermediary rules.
Insights: It is important to discuss these arrangements with intermediaries to align the form, content, and verification numbers for reporting to relieve the taxpayer from reporting.
An emerging trend is to have DAC6 intermediary language in each statement of work to formally outline the reporting responsibilities of each party potentially subject to a RCBA.
A3: Standardized Documentation: Hallmark A3 states that a “plug-and-play” standardized arrangement fulfilling the MBT and available to more than one “relevant taxpayer” without substantial customization, is a RCBA.
If substantial customization (vs. a change in names, dates, etc.) is required, the arrangement does not qualify as a RCBA.
Council Directive 2018/822/EU defines “relevant taxpayer” as: any person to whom a RCBA is made available for implementation, or who is ready to implement a RCBA, or has implemented the first step of such an arrangement.
This hallmark is comprehensive, although Germany has provided a white list of transactions that are excluded from reporting, including:
- Intercompany loans
- Licensing (e.g. royalties, etc.)
- Secondment of employees
- Service agreements
- Opening of bank accounts
- Settlement of standard banking transactions
Insights: Germany’s white list provides examples of documentation required to be reported in other member states, absent specific exclusion. The white list is a helpful roadmap for reporting. Hopefully, other member states will provide similar lists prior to the reporting date.
B1: Specific Hallmarks: Hallmark B1 targets the use of tax losses, via acquisition, to reduce its tax liabilities. It consists of a series of steps to acquire a loss-making company, directly or indirectly, terminating its main activity and taking advantage of those losses to reduce its tax liability in one or more jurisdictions.
The use of tax losses automatically qualifies these steps as meeting the MBT.
Insights: This fact pattern may occur due to economic reasons, including Covid-19, although there may not have been an intent of terminating its main activity at the time of acquisition. Germany provides several examples of reportable and non-reportable arrangements, noting the lack of economic reasons for the respective steps would lead to an assumption that the design is to be used specifically to avoid or circumvent taxes.
B2: Specific Hallmarks: Hallmark B2 states that a conversion of income, or an income producing asset (e.g., note receivable) to equity and meeting the MBT is a RCBA.
Insights: A common example of this hallmark is an entity that distributes a dividend-in-kind of a note receivable to its shareholder, converting future taxable interest income to an equity distribution. The taxable nature of the interest income should qualify as meeting the MBT. Sweden provides this example in its explanatory notes.
B3: Specific Hallmarks: Hallmark B3 is broad and subjective, including circular transactions that result in the round-tripping of funds, namely through involving interposed entities without other primary commercial function or transactions that offset or cancel each other or that have other similar features.
Insights: Common examples of this hallmark are sale-leaseback and cash pool transactions, both meeting the MBT. As an example, a cash pool leader may provide a loan to entity A, which makes a capital contribution to entity B, its wholly-owned subsidiary, which then uses the monies to repay intercompany debts to entities C & D, and the round-tripping concludes with Companies C & D lending those monies back to the cash pool.
DAC6 disclosure rules are inherently subjective and include many common business transactions. The rules stem from interpretations in prior BEPS Actions and EU Directives, as they are not focused on disclosures of particular transactions in a tax return, regulations, unilateral interpretations, etc. A taxpayer may obtain legal opinions or country specific advice to support such disclosures, as penalties are very specific.
To avoid pitfalls, take the time to read the related BEPS Action documents and EU Directives for context.
And since DAC6 lacks the certainty of science, embrace the art of interpreting the hallmarks.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Keith Brockman is a CPA, CGMA, and authors a Best Practices international tax blog at strategizingtaxrisks.com. He is a frequent presenter at international tax conferences, having over 30 years of experience as a corporate tax executive. He has served on tax committees in the U.S. and Europe with Tax Executives Institute and Manufacturers Alliance for Productivity and Innovation.