In a recent ruling, in the case of Johnson Controls, the Belgian court denied the taxpayer an exemption of Euro 340 million under the EU parent-subsidiary directive, citing the debt structuring arrangement to be abusive. The Court partly upheld the arm’s length nature of the interest paid by the taxpayer.
For interest rate benchmarking, the Court factored in the following:
- The court accepted the modified CUP method used by the plaintiff in its transfer pricing study and expert testimony.
- Starting with the plaintiff’s credit rating, it determined the market risk and made comparability adjustments as required.
- The court agreed with the use of a lower credit rating than assumed by the tax authority because JCI Belgium is not a core entity of the group.
- An increase of one to three notches to reflect implicit support was adequate, it added.
- Further upward adjustments to the comparables, for liquidity and the repayment and extension option, were appropriate, the court said.
On abuse, the Court noted that:
“Proof of abuse requires, on the one hand, a set of objective circumstances showing that, despite formal compliance with the conditions imposed by the Union rules, the aim of those rules was not achieved, and, on the other hand, a subjective element, namely the intention to obtain an advantage granted by the Union rules by artificially creating the conditions under which the right to that advantage arises.”
The objective and subjective element of abuse can be inferred from all the factual circumstances of the case. The court noted the sequence of all the transactions and found that all of the transactions could indeed be considered an artificial arrangement. .
The court noted that purpose of the Parent-Subsidiary Directive is to eliminate double taxation. Therefore, the Parent-Subsidiary Directive results in a one-time tax on profits at the level of the (subsidiary) company that realizes the profit. This presupposes that the subsidiary is subject to this tax. The court observed that the entire tax structure clearly contradicted the purpose of the Parent-Subsidiary Directive. Dividends were currently not taxed anywhere due to an artificial arrangement.
The Court ruled that both the objective and subjective elements of abuse have been met.
Key takeaways:
- Benchmarking for interest will get more nuanced in the years to come even in India. Complex comparability adjustments would need to be factored in. Use of independent experts for rating and comparability adjustments is advisable (from a disputes standpoint). Plain vanilla interest rate benchmarking should be avoided unless conservative.
- Not paying tax in any jurisdiction is viewed as an abuse of law by courts.
- Documentation of commercial rationale is key to refute allegations of abuse.
1 Johnson Controls International BV v. Belgium (No. 21/695/A)
2 First Instance Court of Leuven
Facts noted:
Abbreviations used;
– J. CI (based in the United States): JC Inc.
– JC L .F. sar l (met zetel te Luxemburg): JC L . F.
– J . C. L .H. sar l (met zetel te Luxemburg): JC L . H.
– JCHCI (based in the United States): JC HC Inc.
– J .C. E . Ltd (formerly Y . F. Ltd ) (registered in United Kingdom): JC E .
– J. CI UK Ltd (with registered office in United Kingdom): JC I. UK
– S . Ltd 5 (with registered office in United Kingdom): S.
The following activities were performed within the J. C. group as stated in the ruling:.
“On April 29, 2011, JC H.C. Inc. raised € 800 million in capital at JC L. H. JC L. H., in turn, raised capital at JC L. F. , which allocated these funds to its permanent establishment, which had been established in the US a month earlier.
The permanent establishment, represented by JC Inc., lends the money to the claimant at 7.22 percent for 10 years, which the claimant uses to acquire S. This involves an immediate capital increase at S.
S . then lends the funds to Y . R . (current name: JC E . ) by means of 2 loans, at 11.02 percent and 11.17 percent for 10 years.
J.C. E. establishes J.C. M. H. Ltd & Co. and C.R. H. Ltd. H. C. and provides them with the necessary capital to finance the German acquisitions.
All these transactions, being capital increases and granting loans, all took place on April 29, 2011, from JC H C. Inc. It appears that the funds flowed directly from JC H C. Inc. to JC E , since JC H C. Inc. is the direct parent company of Y. R. (JC E. ) .
JC E. has limited income (dividends received), but high costs due to the two loans totalling approximately EUR 800 million. JC E. pays interest to S. Ltd. This interest represents S.’s profit and JC E. ‘s loss . S. distributes this profit to the claimant in the form of dividends. S. then uses the UK group contribution rules and deducts JC E.’s losses . By using this arrangement, S. has not paid taxes on its profits consisting of the interest received.”
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