Cross-border business tax

On 12 September 2023, the EU Commission issued the following proposals for Directives:

Business in Europe: Framework for Income Taxation (BEFIT): this is a new legal regime to determine the tax base of groups of companies operating in the EU, which will be mandatory where they have an annual combined revenue of at least €750 million and the ultimate parent entity holds at least 75% of the ownership rights or the rights giving entitlement to profit.
Transfer pricing (TP): rules to ensure common application of the OECD arm’s length principle across the EU and incorporate related OECD guidelines.
Head Office Tax System for SMEs (HOT): simplified provisions for computing the taxable result of permanent establishments (PEs) of certain micro, small, and medium-sized enterprises (SMEs) located in another EU member State (MS).

Corporate taxpayers with cross-border operations in the EU are expected to be significantly impacted by the proposed rules, particularly the first two. The proposals can be summarised as follows:

1. BEFIT (Business in Europe: Framework for Income Taxation)

Background

In 2021, the EU Commission published a Communication on Business Taxation for the 21st Century (read more details here), which announced that a new framework for income taxation for businesses in Europe, called “BEFIT”, would be issued by 2023. BEFIT replaces the pending proposals for a common corporate tax base (CCTB) and a common consolidated corporate tax base (CCCTB), which have been withdrawn.

According to the EU Commission, the complexity and interaction of the different tax systems within the 27 MS increases tax uncertainty and tax compliance costs, discourages cross-border investment, and puts EU businesses at a competitive disadvantage compared to businesses operating elsewhere in the world.

In this context, on 12 September 2023, the EU Commission proposed new rules for a common corporate income tax framework in the EU that will replace the current 27 different ways for determining the taxable base of in-scope groups of companies.

According to the explanatory memorandum, the proposal is consistent with the other proposals made by the EU Commission in the context of the 2021 Communication (i.e. the DEBRA and Unshell proposals – read more details here and here), as well as with the implementation of the OECD/G20 Inclusive Framework Two-Pillar Solution.

Scope

The new rules will be mandatory for companies resident in an MS, including their PEs located in other MS, and for PEs located in MS of entities resident in a third country, provided that:

they belong to a domestic group or to a multinational group (MNE group) which prepares consolidated financial statements (on a line-by-line basis) and had annual combined revenues of €750,000,000 or more in at least two of the last four fiscal years; and
the ultimate parent entity (UPE) holds, directly or indirectly, at least 75% of the ownership rights or the rights giving entitlement to profit of the in-scope entities.

However, the new rules will not apply to companies or PEs with a UPE outside the EU where the combined EU revenues of the group either do not exceed 5% of the total revenues for the group based on its consolidated financial statements or €50,000,000 in at least two of the last four fiscal years.

The new rules will be optional for groups of companies that meet the above conditions save for the €750,000,000 threshold.

BEFIT’s scope is partly aligned with the scope of the Pillar 2 Directive (read more details here), but appears to be more restricted.

4-step approach

Step 1: Calculate the preliminary tax result of each BEFIT group member using a common set of rules

The starting point will be the financial accounting net income or loss for the fiscal year of each BEFIT group member, as determined under the acceptable accounting standard (IFRS as adopted by the EU or the GAAP of the MS) applied by the UPE for the preparation of the consolidated financial statements, before any consolidation adjustments. Where the UPE is not resident in an MS, the acceptable accounting standard applied in the MS where the filing entity is located will apply. The definition of “consolidated financial statements” does not include the notion of “deemed consolidation” found in the Pillar 2 Directive. BEFIT’s scope appears to be limited to groups that actually prepare consolidated financial statements. It is not clear whether groups preparing consolidated financial statements on a voluntary basis can benefit from the new provisions.

The financial accounting net income or loss of a BEFIT group member for the fiscal year will be subject to adjustments. Items to be added back will include, inter alia, borrowing costs paid to parties outside the BEFIT group in excess of the interest limitation rule of the ATAD, fines, penalties, corporate taxes, and Pillar 2 top-up tax. Items to be excluded from the BEFIT base will include, inter alia, 95% of the amount of dividends received from qualifying participations (held for more than one year and carrying rights to more than 10% of the profits, capital, reserves or voting rights), unless they are held for trading or by a life insurance undertaking. Gains or losses from the disposal of shares will be excluded under similar conditions. These specific exclusions differ from the Pillar 2 definition, where adjustments are in particular required for 100% of the amount of dividends received from qualifying participations.

Step 2: Aggregate the preliminary tax result of each BEFIT group member into a single BEFIT tax base

The tax base of each BEFIT group member will be aggregated into one BEFIT tax base, thus entailing cross-border tax relief (e.g. tax losses realised by a BEFIT group member in one MS will be used to offset tax profit realised by another BEFIT group member in another MS).

Where the BEFIT tax base in a given year is a positive amount, the profit will be allocated as explained below under step 3. Where it is a negative amount, the loss will be carried forward and set off against the next positive BEFIT tax base.

There will be no withholding taxes on transactions such as interest and royalty payments within the BEFIT group, as long as the beneficial owner of the payment is a BEFIT group member. Where the beneficial owner is not a BEFIT group member, the withholding tax will be shared as explained in step 3 below. Tax credits on income taxed at source will be shared under similar rules.

Step 3: Allocate the BEFIT tax base to the BEFIT group members under a transitional allocation rule

During a transition period (concerning each fiscal year between 1 July 2028 and 30 June 2035), the BEFIT tax base will be allocated to the BEFIT group members on the basis of the average taxable income realised by each BEFIT group member for the three previous fiscal years, in accordance with the following baseline allocation formula:

A BEFIT group member with a negative taxable result should have a baseline allocation percentage set at zero.

To ease the transition, there will be specific procedures (using national corporate taxable results to a certain extent) for determining the average taxable income per BEFIT group member for the first three fiscal years of application of the BEFIT rules to a given BEFIT group.

In addition, the proposal includes provisions to facilitate transfer pricing compliance for intra-BEFIT group transactions that will have to be consistent with the arm’s length principle. There will be a presumption that these transactions are at arm’s length where the expense incurred or the income earned by a BEFIT group member from intra-BEFIT group transactions increases in a fiscal year by less than 10% compared to the average expense or income of the previous three fiscal years from intra-BEFIT group transactions (called the “low-risk zone”). Where the intra-BEFIT group transactions are in the “high-risk zone”, i.e. the transactions increase in a fiscal year by 10% or more compared to the average transactions of the previous three fiscal years, they will be presumed not to comply with the arm’s length principle. The part of the increase which goes beyond 10% will not be recognised for the purpose of computing the baseline allocation percentage of that BEFIT group member, unless evidence to the contrary is provided.

Step 4: Increase or decrease the allocated part at the level of each BEFIT group member

Upon allocation, each BEFIT group member will have to apply additional adjustments in its tax assessment. These include items that should not be included in the preliminary tax result, to avoid sharing them among all MS, but that nonetheless should still be accounted for (e.g. pre-BEFIT losses), or items specific to the tax regime of each MS (e.g. pension provisions, deductible local taxes, gifts and donations to charitable bodies).

In addition, MS may allow increases or decreases to the allocated parts of BEFIT group members in their jurisdiction, through additional items (deductions, tax incentives, base increases), without restriction. The explanatory memorandum clarifies that the only requirement that MS will need to respect in this regard are the rules of the Pillar 2 Directive.

Introduction of a “traffic light system” to facilitate TP compliance with associated enterprises outside the BEFIT group

To reduce the number of transfer pricing disputes, especially with respect to pricing considerations for routine activities, and to offer businesses a higher level of predictability regarding the acceptability of their transfer prices, the BEFIT proposal suggests using “public benchmarks” for low-risk activities (such as distribution activities by low-risk distributors and manufacturing activities by contract manufacturers).

MS tax authorities would be required to assess transactions performed by BEFIT group members with associated enterprises outside the BEFIT group as being low, medium or high risk based on these public benchmarks. Depending on the result, tax authorities may or not be allowed to allocate further resources to challenge the transfer pricing position taken by a taxpayer.

Administration and procedure

The rules provide for a common administrative framework (called One Stop Shop), which will allow businesses to deal with one single authority in the EU for filing obligations. The filing entity, which will in principle be the UPE, will file one information return for the whole BEFIT group with its own tax administration only. This tax administration will share the information return with the other MS where the group operates. Each BEFIT group member will also file an individual tax return with their local tax administration, to apply local adjustments to their allocated part.

For each BEFIT group, there will be a BEFIT Team composed of representatives of each relevant tax administration from the MS where the group operates. The BEFIT Team will share information, coordinate and resolve issues through an online collaborative tool.

There are specific provisions on audits, joint audits, and appeals against the BEFIT information return and the individual tax assessments.

Next steps/concluding remarks

The BEFIT proposal must now be agreed unanimously by the MS in the Council of the EU. This may seem more hypothetical than realistic, given the difficulties faced by the CCTB and CCCTB, which were ultimately not adopted.

If adopted, the BEFIT measures will have to be implemented into MS’ national law by 1 January 2028 and will apply from 1 July 2028.

Taxpayers with cross-border operations, particularly those within the scope of the Pillar 2 Directive, should consider now whether they may also come within the mandatory or voluntary scope of BEFIT, and make a preliminary assessment of its impact.

2. Transfer Pricing

Background

According to the current international standards, cross-border transactions between related parties must be priced on the same basis as transactions between third parties under comparable circumstances. This is known as the “arm’s length principle” and is reflected in article 9 (Associated Enterprises) of the 2017 OECD Model Tax Convention on Income and on Capital. However, article 9 does not set out detailed transfer pricing rules. Although the OECD has been evolving its Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations since 1995 (the “OECD TP Guidelines”), which provide guidance to businesses and tax authorities on the meaning and interpretation of the arm’s length principle (read more details here_), these guidelines are a non-binding instrument. In addition, at the EU level, transfer pricing rules are not currently harmonised. As a result, according to the EU Commission, EU companies face tax uncertainty, risk of double taxation and litigation.

To solve these issues, the EU Commission has issued a proposal for a Council Directive on Transfer Pricing (the “TP proposal”) to incorporate the arm’s length principle into EU law, harmonise key transfer pricing rules and clarify the status of the OECD TP Guidelines.

Broad scope

The new rules will apply to taxpayers that are registered in, or subject to tax in, one or more MS, including PEs in one or more MS.

Incorporation of OECD arm’s length principle into EU law

To ensure that the arm’s length principle is applied uniformly within the EU, the new rules incorporate the OECD’s concept of the arm’s length principle into EU law. Hence, the related definitions follow the OECD TP Guidelines. However, it is noteworthy that the concept of “associated enterprises” (article 5 of the TP proposal) is more precise than the definition in the OECD TP Guidelines and the Luxembourg transfer pricing rule. For the purpose of the TP proposal, associated enterprise means a person who is related to another person in any of the following ways:

(a) a person participates in the management of another person by being in a position to exercise a significant influence over the other person;

(b) a person participates in the control of another person through a holding that exceeds 25% of the voting rights;

(c) a person participates in the capital of another person through a right of ownership that, directly or indirectly, exceeds 25% of the capital;

(d) a person is entitled to 25% or more of the profits of another person.

The definition is very broad, as it includes both legal and natural persons and introduces a concept of “acting together”. There are also specific rules for the computation of the 25% threshold in the case of indirect holdings.

Harmonisation of key transfer pricing rules

The TP proposal follows the key transfer pricing rules provided by the OECD TP Guidelines and followed by the Luxembourg transfer pricing rules, including:

The requirement for an accurate delineation of the commercial and financial relations of the associated enterprises and the actual transaction(s) between associated enterprises.
The acceptable transfer pricing methods to determine the arm’s length price for a controlled transaction: the comparable uncontrolled price method, the resale price method, the cost-plus method, the transactional net margin method, the profit split method, as well as any additional method that can be justified as more appropriate.
The criteria to be used to determine the most appropriate transfer pricing method for a given case.
The comparability factors to be taken into account when performing a comparability analysis.
The obligation for taxpayers to make available appropriate transfer pricing documentation. The EU Commission is further empowered to develop common templates and timelines regarding their application.

It is worth noting that the TP proposal is stricter than the OECD TP Guidelines (and the Luxembourg TP rules) insofar as the arm’s length range is limited to the interquartile range of values (i.e. from the 25th to the 75th percentile of the results).

Application of arm’s length principle

The TP proposal specifies that MS must ensure that the transfer pricing rules are applied in a manner consistent with the OECD TP Guidelines and that further binding common transfer pricing rules could be established in the future.

In Luxembourg, the OECD TP Guidelines are ‘soft law’ only and have no direct binding effect on taxpayers, although the Luxembourg tax authorities and courts refer to the OECD TP Guidelines regarding the application of the Luxembourg transfer pricing rules. However, it is generally accepted that any new OECD TP Guidelines cannot be applied retroactively. The Explanatory Memorandum for the TP proposal indicates that the latest version of the OECD TP Guidelines should be binding when applying the arm’s length principle but does not specify whether the application of the arm’s length principle corresponds timing wise to the performance of the transaction or the review thereof by tax authorities at a later stage. To prevent uncertainty and avoid retroactive application of tax rules, the first reading would be preferable.

Next steps/concluding remarks

The TP proposal must now be agreed unanimously by MS in the Council of the EU.

If adopted, the new rules should be implemented into MS’ national laws by 31 December 2025 and be applicable from 1 January 2026.

Generally speaking, the EU Commission’s proposal to harmonise transfer pricing rules in the EU seems a rather good initiative. Indeed, applying different rules for cross-border transactions typically results in conflicting positions, which lead to double taxation that has to be solved either upfront by bilateral or multilateral advance pricing agreements or ex post by mutual agreement procedures. The TP proposal also has the merit of following the concepts in the OECD TP Guidelines – as opposed to creating sui generis European concepts as had been suggested previously – since most MS follow them already to some extent.

Taxpayers carrying out controlled transactions should continue to monitor developments regarding the potential adoption of the TP proposal in order to ensure compliance thereto in good time.

3. HOT (Head Office Tax System for SMEs)

Scope, eligibility requirements, option and exclusions

The proposal introduces rules for computing the taxable result of PEs of certain head offices (SMEs) located in another MS, although it should be noted that the rules governing the attribution of income to a PE under the tax treaties network would continue to apply.

In brief, to be eligible, SMEs must inter alia:

qualify as micro, small and medium-sized SMEs as defined in Directive 2013/34/EU;
operate in other MS’ exclusively through one or more PEs (i.e. no subsidiary in another MS); and
not be part of a consolidated group for financial accounting purposes.

Eligible SMEs will have the option to calculate the taxable result of their PE(s) based only on the head office taxation rules. The applicable tax rate(s) will remain that/those of the MS(s) where the PE(s) is/are located.

The option and its renewal are subject to eligibility requirements. If the head office opts-in, it must apply the rules to all its PEs for a five-year period.

However, the HOT rules will no longer apply from the tax year following that in which the head office transfers its tax residence out of the head office MS or if the joint turnover of the PEs has exceeded three times the head office’s turnover for the last two fiscal years.

In addition, renewal of the option will be refused in the following cases: (i) for any two fiscal years taken separately, the joint turnover of the PEs exceeded an amount which is equal to double the turnover of the head office, (ii) the SME has set up one or more subsidiaries within or outside the EU, or (iii) the legal entity does not qualify as an SME (as defined under Directive 2013/34/EU) for two consecutive fiscal years.

Centralised procedure/automatic exchange of information

The rules provide for a common administrative framework (called One Stop Shop), which will allow in-scope SMEs to deal with one single tax authority in the EU (i.e. the one of the MS of their head office) for the procedure to opt-in, filing obligations and tax payments. The filing entity (i.e. the head office of the SME) will file one tax return for all the PEs with its own tax administration only. This tax administration will apply the tax rates applicable in the MS where the PE(s) is/are located, collect the tax due and then transfer the resulting tax revenues to the relevant MS.

Each MS will retain the right to carry out audits of PEs in their jurisdiction and may request joint audits.

The HOT proposal also amends Directive 2011/16/EU (referred to as “DAC”) and provides for automatic exchange of the relevant information between the tax authorities concerned through the EU common communication network.