Substance Requirements in Tax Planning Structures
The principle of ‘Substance over Legal Form’ is central to the faithful representation and reliability of information contained in the financial statements. The key point of the concept is that a transaction should not be recorded in such a manner as to hide the true intent of the transaction, which would mislead the readers of a company’s financial statements. In this article we intend to investigate how this principle travels outside the scope of financial statements, how it affects the tax planning community and we will analyze the tax ruling practice.
Substance over Legal Form
The doctrine ‘Substance over Legal Form’ allows tax authorities to ignore the legal form of an arrangement and to look into what happened actually. The aim is to prevent artificial structures from being used for tax avoidance purposes. In order for a company to enjoy the beneficial tax regime of its jurisdiction it must comply with the substance requirements of the local tax authorities. Such requirements may vary from country to country, but if analyzed, they all are about the economic substance: there must be substance to the structure of the company and substance to the transactions it enters into. The real substance of the structure is the sum total of many factors that make the company/the transaction ‘real’ and prove its physical presence (its office, its director, its employees) / its economic purpose (answering to the questions: why was this transaction made? how did the parties benefit from it? was the transaction unnecessarily complicated?)
Introduced by OECD (as the European system of accounts principle), nowadays the substance is closely examined not only by tax authorities, but compliance officers, banks, administrative service providers. Gradually, economic substance has become an extremely important issue. It is especially true after a number of internationally known court cases such as the Vodafone case1 in India. What was put to scrutiny is the real justification for the existence of a holding company. The Supreme Court of India resolved that because the purchase of shares of an Indian company by Vodafone was made through two foreign companies (those of the Netherlands and the Cayman Islands) the transaction was not subject to taxation in India. If a company is used in an existing structure already operating, with the obvious reason of gaining access to the benefits of Double Tax treaties, chances are that the structure will fail altogether and be regarded as fictitious thereby not be able to obtain those treaty benefits it sought. What is needed in order not to be exposed to this substantial tax risk is proper and sufficient substance. Another case where the use of a Dutch company (for the receipt of dividends) was the Volvo case2. The court took the side of Volvo, after the use of a Dutch company for tax planning purposes was put to question.
However, in other international cases as the Canadian case of Prévost3 the absence of substance was held not to be an issue. Nevertheless, the recent approach of both OECD as well of most EU States show that substance is indeed a factor that must not be overlooked.
Tax Rulings in the Netherlands
One of the advanced countries with a developed mechanism of real substance identification – the mechanism of tax rulings – is the Netherlands. We will explain how tax rulings work on companies with real substance, thus, securing the tax benefits the jurisdiction offers.
In fact, a tax ruling is an official confirmation of the tax authorities that allows business owners to know in advance their duties and rights, the tax burden under certain circumstances in certain transaction, and the decisive aspect is the substance.
Within the framework of tax ruling there are two types of agreements with the tax authorities. Advance Tax Ruling is an agreement on the Dutch tax classification of international structures in respect of the applicability of the participation exemption and the presence of a permanent establishment in advance. Advance Pricing Agreement is in effect an agreement that approves in advance the determination of the arm’s length price or method of profit calculation with respect to cross border transactions between related (group) companies and cross border transactions between an entity and its foreign permanent establishment.
Advanced Tax Ruling (ATR) can be obtained with respect to certain international structures with hybrid finance activities or with hybrid entities. The ruling needs to be applied for by the inspector competent for the taxpayer who has to submit the ruling request for approval to the APA/ATR-team of the tax inspectorate in Rotterdam in the following situations:
- Ruling requests for certainty in advance regarding the application of the participation exemption of sub-holding companies in international structures, and top holding companies holding foreign subsidiaries that do not have activities in the Netherlands;
- Requests for certainty in advance concerning international structures with hybrid finance activities and/or hybrid entities;
- Requests for certainty in advance whether or not a foreign company has a Dutch permanent establishment.
A detailed description of all relevant facts and names of entities, beneficial owners and countries involved need to be presented. It should be noted that if the ruling request regards the participation exemption, the taxpayer must state that the subsidiaries will be financed by at least 15% capital.
The Dutch taxpayer must confirm that the information mentioned in the ruling is not exempted from the exchange of information clauses under the Dutch International Assistance concerning Taxation Act. If the tax authorities agree with the arrangement the ruling will generally be granted for a period of 4 years. Upon the expiration of the 4-year period the parties may discuss whether or not it is feasible to extend the ruling.
Advance Pricing Agreement (APA) is in effect an agreement that approves in advance the determination of the arm’s length price or method of profit calculation with respect to cross border transactions between related (group) companies and cross border transactions between an entity and its foreign permanent establishment. Generally, the APA request must be filed with the APA/ATR-team in Rotterdam and the proposed length of the APA must be mentioned in the request.
To be able to issue a tax ruling under APA the tax authorities have to make sure that the cross border transactions of the international holding structures where a Dutch company is part to, exist and carry its activities and meet the real substance requirements. The real substance requirements are:
- At least half of the managing directors are resident in the Netherlands;
- The managing directors residing in the Netherlands have the professional skills required for the operation of the business. The board of managing directors has the power to enter into agreements, perform activities on behalf of the company and is responsible for the actions of the company, all within the normal framework. The company has qualified staff or has at its disposal hired staff from third parties, in order to execute and register the activities performed by the company;
- The company has to have a real office in the Netherlands;
- The company has to have salaried employees employed officially;
- The (important) management decisions must be taken in the Netherlands;
- The company must be new or have a good business history;
- The company must pass successfully the compliance procedure;
- The (main) bank account must be kept in the Netherlands;
- The bookkeeping must be done in the Netherlands;
- The company must have met its fiscal obligations (e.g. filing tax returns and paying tax due);
- The company is located in the Netherlands and must not be dual resident for tax purposes;
- The capital (equity) of the company accurately reflects the activities performed by the company.
The company must take real commercial risks. These risks consist of bad debtor risks, currency exchange risks, market risks and operational risks. If the company only takes operational risks, this will not lead to “running actual risks”. The most important factor to determine if actually risks are run, is whether or not capital (equity) held against the assets of the company can be affected. Therefore, it needs to be investigated whether or not the company runs the risks as described above and the company should have sufficient capital in order to bear the risks.
Companies registered in other jurisdictions when entering into transactions also are subject to the procedure of confirming their real substance.
If the company does not run actual risks and/or does not have substance, it is not possible to obtain certainty in advance and source country tax withheld on the interest and royalties cannot be credited against Dutch tax. Moreover the Dutch tax authorities may spontaneously inform the authorities in the source country (the country where the related company that pays interest or royalties to the Dutch service company is located), about the relevant transactions.
The Dutch tax authorities prepare APA tax ruling based on the local laws and the international legislation. In case the countries parties to a transaction have a valid Double Tax Treaty, its provisions are taken into consideration as well as the articles of the OECD model tax treaty.
Depending on the facts and circumstances the following information must be provided to the tax authorities:
- Information on the transactions, products and agreements;
- Information on the companies and permanent establishments involved;
- Details of countries involved;
- Information on the worldwide structure, history, financial data, products, functions and risks of the parties involved;
- A description of the proposed transfer price method, including comparison analysis;
- Critical analysis of the economical and operational facts and circumstances that may affect the price, e.g. exchange rates, interest rates, tax rates, changes of laws;
- A description of the market conditions.
The taxpayer in principle is free to choose the transfer pricing method, provided that the method chosen will lead to an arm’s length price for the specific transaction for which certainty in advance is requested. Otherwise the tax authorities of the Netherlands shall not issue the tax ruling with positive outcome.
Tax ruling in the Netherlands is not a mandatory procedure, however, it is an efficient tool for tax planning which allows to improve business structuring and eliminate financial risks, build up trustful relations with Inland revenue and other authorities. The main criterion for the Dutch tax authorities to grant approval for a holding structure or a certain transaction that requires tax allowances is the real substance. The Netherlands are once of the leading European jurisdictions that have a successful long-standing history of business and can serve a model for the EU-neighbours and other countries.
Should Cyprus adopt the model?
A country which may want to follow the Dutch model is Cyprus. In this island for a holding company to enjoy the benefits of the tax legislation and the numerous Double Tax Treaties it has to prove its tax residency, i.e. that its management and control is indeed exercised in Cyprus. In the absence of a formal definition of the management and control requirement, the following parameters are normally accounted for:
- The majority of the Directors of the Company are tax residents of Cyprus;
- The decisions of the Board are taken in Cyprus (the minutes are recorded locally);
- The office is maintained in Cyprus;
- The Company has an economic substance in Cyprus.
Although there is not yet a recorded case where the Cyprus tax authorities have examined in-depth the substance of a Cypriot company, the substance over form doctrine is starting to take over the Inland Revenue, the local banks and administrative service providers.
The Do-Able Steps
On a more general note, to sum it all we would like to look at some ‘substance over form’ solutions. It is crucial to understand that enhancing substance always should be tailor-made. Any attempt to generalize will rather prove dangerous than useful. Therefore, below are only intend to point out the items to consider. It is in no way a ready solution.
- Always get tax opinion before entering into a transaction or establishing a structure. Getting advice in advance will ensure that every transaction has undisputable economic substance. Get tax ruling where possible. It is important to remember that there is no standard approach to when sufficient substance has been achieved.
- Apply proportionality in the distribution of functions, assets, profits and losses in your companies.
- Directorships: appoint qualified directors who have the ability to make decisions and understand the nature of business. Must be residents of the relevant jurisdiction. Must have the proper background. Avoid setting up a structure in which directors of a foreign company are the same as directors of the source company. In this case tax authorities will almost certainly question the economic substance and the reality of the decision-taking.
- Maintain office presence: make a fully-fledged real office, rent an office space, have a dedicated landline, fax, internet lines, website, email addresses, hire real employees, register with the labour office as an employer
- Maintain business records: original minutes of board meetings and general meetings, emails, general administration, archive, filing and accounting should be kept at the seat of the company.
- Make contracts/agreements through the Company, avoid powers of attorney to execution of contracts and decision taking.
- Continually develop the company. It is essential to demonstrate economic substance throughout the company’s lifetime.
- Use transparent tax planning decisions: some cases, when they are largely tax-motivated, the treatment might not be altered by a tax authority.
- Lastly, and importantly, in anything you do, mind that the tax authorities shall question the substance, i.e. will ask ‘why was this transaction made?’
In this article we attempted at bringing your attention to a relatively new trend – substance requirements for tax planning purposes. Although, no specific requirements are put down in laws, this issue is extremely important: the tax authorities shall look for substance in your transaction/company and take a decision whether you can enjoy tax allowances of a jurisdiction. The tax ruling practice of the Netherlands can serve a successful model for other countries and can bring you closer to the result you look for.
- Vodafone Tax Case v. Arindam Daschowdhury (PGDM 100109) Deepak B.S. (PGDM 100110)16-08-2011
- Volvo/Henlys Case No IV/M.593 95 /C 132/03
- Prévost Car Inc. v. Canada, 2009 FCA 57,  2 F.C.R. 65
The Cypriot Council of Ministers issued a decision on the 19th of March 2014, in relation with the scheme for naturalization of investors in Cyprus by exception on the basis of subsection (2) of section 111A, of the Civil Registry Laws of 2002-2013.
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