Department of Law

Spring Term 2014

Masters Thesis in International Tax Law and EU Tax Law

15 ECTS

THE PARENT-SUBSIDIARY DIRECTIVE AND ITS PROPOSED

REVISION

A growing focus on anti-avoidance and hybrid financial instruments

Author: Anna Hank Farag

Supervisor: Professor Mattias Dahlberg
TABLE OF CONTENTS
ABBREVIATIONS ..................................................................................................... 3

I. INTRODUCTION ................................................................................................ 4
1. General problem ...................................................................................................................................... 4
2. Objective .................................................................................................................................................... 5
3. Delimitations ............................................................................................................................................. 6
4. Legal method ............................................................................................................................................ 6
II. THE PARENT-SUBSIDIARY DIRECTIVE AND ITS REVISION ............... 8
1. EU direct tax law framework and sources ....................................................................... 8
2. The current Parent-Subsidiary Directive ......................................................................... 9
a) Legislative development .................................................................................................................. 9
b) Functioning of the Directive ........................................................................................................ 10
3. Legal elements of the Proposal ......................................................................................... 13
a) International context ....................................................................................................................... 13
b) Legislative scheme .......................................................................................................................... 14
c) Principles of subsidiarity and proportionality ........................................................................ 15
III. ANTI-AVOIDANCE UNDER THE DIRECTIVE .......................................... 16
1. Terminology ......................................................................................................................... 16
2. Amended provisions ........................................................................................................... 17
3. Assessment under domestic and European law ............................................................ 19
a) Domestic law ..................................................................................................................................... 19
b) General principles of EU law and case law ............................................................................ 20
4. Evaluation ............................................................................................................................. 21
IV. HYBRID FINANCIAL INSTRUMENTS UNDER THE DIRECTIVE ........ 23
1. The debt-equity conundrum ............................................................................................. 23
2. Hybrid financial instruments ........................................................................................... 25
a) Background ........................................................................................................................................ 25
b) Characteristics ................................................................................................................................... 26
c) General effects .................................................................................................................................. 27
3. Hybrids under the scope of the Directive ....................................................................... 28
a) The concepts of distributions of profit and dividend under the Directive ............ 29
b) Classification mismatches ............................................................................................................. 30
4. The proposed amendment on hybrids ............................................................................ 31
5. Evaluation ............................................................................................................................. 33
V. CONCLUSION ................................................................................................... 35

BIBLIOGRAPHY ..................................................................................................... 38
Treaties ............................................................................................................................................................... 38
Directives .......................................................................................................................................................... 38
Other legislative works ................................................................................................................................. 38
Books .................................................................................................................................................................. 39
Articles ............................................................................................................................................................... 39
Thesis and doctoral work ............................................................................................................................. 40
Case law ............................................................................................................................................................. 40
Internet sources ............................................................................................................................................... 40

2
ABBREVIATIONS

Base Erosion and Profit Shifting (BEPS)

Corporate Income Tax (CIT)
Controlled Foreign Corporation (CFC)
Court of Justice of the European Union (CJEU)
European Court of Justice (ECJ)
European Economic Community (EEC)
European Union (EU)
General Anti-Avoidance Rules (GAARs)
International Bureau of Fiscal Documentation (IBFD)
Organisation for Economic Co-operation and Development (OECD)
Permanent establishment (PE)
Specific Anti-Avoidance Rules (SAARs)
Treaty on European Union (TEU)
Treaty on the Functioning of the European Union (TFEU)
United Nations (UN)

3
 I. INTRODUCTION

1. General problem
The developments of the 21st century have led to extensive effects and
consequences of globalization and international integration, to a connected and
interdependent world where people, information and products travel faster than
ever. International trade, global business arrangements and the liberalisation of
capital movements, inter alia, have enabled corporations to operate cross-border
with a presence and interest in various countries. The European Union (also, the
Union or the Community) builds upon and enhances industrial, economic,
legal and political integration and facilitates the free movement of goods,
services, persons and capital. Multinational enterprises, on the one hand,
function upon this international integration and benefit from the access to
diverse legislative and tax systems, and on the other hand, face strong
competition and complex challenges on the global marketplace. The effects of
the global financial crisis that hit the world in the years of 2007-09 have not yet
abated and it drew an increasing attention on governments deficit and budget
difficulties. Part of the discussion regarding budgetary losses of states and the
broader notion of recent economic changes is international tax avoidance and
the phenomenon of multinationals taking advantage of the existing legal
structures available around the world. The growing focus on multinational
corporations tax arrangements entails that the issue is now on top of the
agendas of several states and international organizations, it constitutes a
frequent discussion topic of tax activist groups, as well as it is a growing
concern of tax advisors of globally functioning corporations.

The European Commission (the Commission) has recently prioritized the

fight against corporate tax evasion and tax fraud at EU level and adopted a
highly intense campaign on the issue. Part of the extensive actions taken by the
Commission is an Action Plan, two Recommendations targeting tax havens and

4
aggressive tax planning and a Proposal1 (the Proposal) to amend the Parent-
Subsidiary Directive (the Directive), one of the most important secondary law
instruments in the field of European direct tax law.

2. Objective
The proposed amendments to the Directive address two main issues, anti-
avoidance legislation and hybrid financial instruments. The objective of the
thesis therefore is twofold. Firstly, the thesis aims at presenting how the issue of
anti-avoidance is addressed under the Directive, specifically relating to its
newly proposed amendments. After a review of the framework and sources of
European law in the field of direct taxation and the Directives legislative
development and present functioning, the current and proposed anti-avoidance
legislation is analysed in light of domestic law, EU law principles and case law.

The second and main objective of the thesis focuses on a specific aspect of anti-
avoidance, identified as the second proposed amendment to the Directive, which
targets mismatches between national tax legislations and hybrid financial
instruments. Firstly, the debt-equity conundrum is addressed from the
perspective of the Proposal, followed by a discussion and evaluation on hybrid
financial instruments under the scope of the Directive.

An underlying question that the thesis discusses is how the different legislative
levels and legal sources, that is domestic, international and European law,
address the two main issues of anti-avoidance and hybrid financial instruments.
Furthermore, the question is examined whether a uniform response on a
European level, such as the Directive, could provide solutions to these
challenges.

1
Proposal for a Council Directive amending Directive 2011/96/EU, COM(2013) 814 final,
(2013).

5
 3. Delimitations
The focus of this thesis is the Directive, the territorial scope of which primarily
only concerns the Member States of the EU, therefore the thesis focuses on
European legislation and its effects on EU Member States. The aim of the thesis
is not to provide a detailed description on the implementation or functioning of
the Directive in each Member State, but to provide an overall and brief analysis
of the Directives operation and impact, throughout which certain Member
States may be highlighted or given special attention in relation to a certain issue.
Furthermore, the thesis only addresses matters relating to anti-avoidance and
hybrid financial instruments, both on a European and international level that are
relevant to the main subject of exploring the Proposals impact in addressing
these challenges. The OECDs Base Erosion and Profit Shifting (BEPS)
Report is addressed by the thesis only to a limited extent and in relation to the
issues raised by and discussed under the Directive. Furthermore, reference is
made to the Interest Royalty Directive as well, however as being out of scope of
the thesis subject, it is not discussed in further detail. Finally, the thesis only
examines the tax treatment of inter-corporate cross-border profit distributions
and hybrid financial instruments specifically in relation to and covered by the
Directive, as a detailed analysis of these financial aspects ought to be subject of
a more extensive study.

4. Legal method
The main methodological issue the thesis is based upon is the different levels of
legal sources that is domestic tax law, tax treaty law and EU tax law - and
their relation and value regarding a given legal problem. Although the thesis
focuses solely on European legislation, which is dealt with in detail in Chapter
II, it is important to evaluate on the particular interaction between these three
sets of legislation, from a legal and theoretical point of view, in order to
understand the problem at hand.

6
European tax law, applicable to the European Union and its Member States,
refers to primary legislation (fundamental freedoms), secondary legislation
(directives) and case law of the Court of Justice of the European Union (the
Court). International tax law concerns international double taxation
conventions and treaties concluded between states, furthermore it also concerns
the domestic legislation of the states that provide a basis for the application of
both tax treaties and European tax law. In the European legislative system,
direct taxation is a competence of the Member States. Taxation in general is the
sovereign right of states based on the connecting factors, or objective nexus,
between the taxpayer and the state.2 In case a natural or legal person or a certain
income is subject to taxation twice, due to factors that connect the person or the
income to more than one state, the situation is referred to as either juridical or
economic double taxation (respectively). European direct taxation Directives, as
well as double taxation conventions, are aimed at eliminating or mitigating
double taxation. By joining the European Union in general, and more
specifically by adopting and implementing directives, Member States limit their
sovereignty and restrict their taxing rights under certain circumstances. The
purpose of directives, and double taxation conventions as well, is to allocate or
distribute jurisdiction to tax and thereby contracting states bind themselves not
to raise any taxes with respect to taxing rights that are given to the other
contracting state under the directives or tax treaties.3 Consequently, directives
and treaties apply even if the contracting state to which the right to tax is
allocated does not in fact impose any tax.4 This phenomenon can lead to a
double non-taxation and, more in general, to tax avoidance. Tax directives and
treaties therefore do not create tax liability, but merely limit the states right to
tax in certain circumstances.5 Therefore domestic tax law provides a basis for
the application of European tax legislation, and international tax treaties, which
then limit the domestic tax rules in the specified circumstances.

2
M. Lang, Introduction to the Law of Double Taxation Conventions, (2013), pg. 27.
3
Ibid.
4
Ibid.
5
Ibid., pg. 36.

7
Furthermore, directives are only binding as to the result they aim to achieve and
the methods to reach these aims are left for the Member States discretion.6
Consequently, each Member State may implement a directive in a slightly
different manner, resulting in a certain level of uniformity as well as
dissimilarity within the Community. This variation gives rise to opportunities
for legal and natural persons to exploit taxation differences between
jurisdictions despite a common European legislation in place. The main
methodological approach of the thesis examines these certain differences and
their consequences.

The legal method applied in this thesis is based on the notion of interaction
between these three levels of legal sources and focuses particularly on European
legislation, evaluating on any limitations imposed by it in relation to domestic
legislation of the Member States in order to assess its ability of serving its
purpose; which on the one hand is to eliminate or mitigate double taxation and
on the other hand to avoid double non-taxation.

II. THE PARENT-SUBSIDIARY DIRECTIVE AND ITS

REVISION

1. EU direct tax law framework and sources

As mentioned earlier, European law refers to primary legislation (provisions of
the TEU and TFEU) and secondary legislation (directives, regulations), as well
as to the case law developed by the Court. Also, an integral part of European
law is the domestic law of its Member States, however EU law takes precedence
over national law according to the doctrine of supremacy clarified by the Court
in the case of C-6/64 Costa v Enel.7 Direct taxes are not explicitly dealt with in
the Treaties, as opposed to indirect taxes, and as they constitute an important
tool in pursuing various economic and political aims, they remain in the

6
Article 288 of the Treaty on the Functioning of the European Union.
7
Case 6/64, Costa v E.N.E.L. [1964] ECR 585.

8
exclusive competence of the Member States.8 The legal basis for harmonization
in the field of direct taxes is Art. 115 TFEU, which enables the adoption of
directives, directly affecting the functioning of the internal market, based on
unanimous decision by the Council of the European Union (the Council).9
Tax harmonization has been achieved by both positive and negative integration.
Positive integration comprises of harmonization through directives and
coordination through binding (e.g. Arbitration Convention) and non-binding
legal instruments (soft law).10 Directives can be grouped according to their
function, namely directives removing obstacles (Parent-Subsidiary, Merger,
Interest/Royalty Directive) and directives enhancing cooperation among tax
authorities (Mutual Assistance, Recovery Assistance, Savings Directive). 11
Negative integration, which covers case law regarding both primary and
secondary law, plays a particularly important role in the field of direct taxes
where positive harmonization has mostly been limited to directives. The case
law development of the Court has provided a substantial platform for the
interpretation of the fundamental freedoms (goods, services, persons, capital)
and thereby set limits to the application of national tax jurisdictions.12

2. The current Parent-Subsidiary Directive

a) Legislative development
The EEC (predecessor of the EU) focused primarily on indirect taxes, such as
customs duties and turnover taxes, in its first years following its creation in
1957.13 The first significant attempts for the harmonization of income taxes
were made in 1969 when the Commission proposed drafts for a parent-
subsidiary and merger directive, however the proposals were put on hold.14 The

8
M. Lang, P. Pistone, J. Schuch, C. Staringer, Introduction to European Tax Law: Direct
Taxation, (2013), pg. 24.
9
Ibid.
10
Ibid.
11
Ibid.
12
Ibid., pg. 25.
13
H. J. Ault, B. J. Arnold, Comparative Income Taxation: A Structural Analysis, (2010), pg.
159.
14
Ibid.

9
adoption of the Parent-Subsidiary Directive was deemed essential for the
completion of the Single Market in Commissioner Lord Cockfields White
Paper of 1985, however it was not until 1990 when Member States reached an
agreement on its adoption.15 As the legal basis, Art. 100 EEC (now Art. 115
TFEU) provided, a unanimous decision was required in the Council, which
could be reached mostly due to the fact that by this time Member States have
already dealt with the issues the directive covered in the form of national
provisions and double tax treaties. The 1990 Directive essentially uniformed the
already existing rules and its main purpose was to remove obstacles to the
grouping together of companies in different Member States.16 Soon after the
entry into force of the Directive it became clear that its scope was too restricted,
and suggestions to amend it were proposed as soon as 1992 in the so-called
Ruding Report, however this amending proposal was eventually not adopted.17
It was in 2003 when a newly amended Directive (Directive 2003/123/EC)
entered into force, including a number of changes; such as the inclusion of
permanent establishments (PEs) in the legislation and the lowering of the
threshold for qualification as parent and subsidiary companies.18 The Directive
was amended for a third time in 2011 and gained its currently applicable form
as Directive 2011/96/EU on the common system of taxation applicable in the
case of parent companies and subsidiaries of different Member States.

b) Functioning of the Directive

i) Objective
As provided for in the preamble of the 2011 Directive, the objective of it is to
exempt dividends and other profit distributions paid by subsidiary companies
to their parent companies from withholding taxes and to eliminate double
taxation of such income at the level of the parent company in order to ensure

15
White Paper from the Commission to the Council on Completing the Internal Market, COM
(85) 310 final, (1985), pg. 40.
16
B. Patterson, The Taxation of Parent Subsidiary Companies, (2003), pg. 4.
17
Ibid., pg. 6-9.
18
Ibid., pg. 11.

10
the effective functioning of the internal market and to provide for tax rules
which are neutral from the point of view of competition.19 The Directive aims
at mitigating international economic double taxation. Economic double taxation
occurs when the same tax object, the income (or capital), is taxed in the hands
of two (or more) different tax subjects, in other words taxpayers. In a group of
companies, economic double taxation ensues when the distributed profits
(profits after corporate income tax) from the subsidiary to the parent company
are subject to a withholding tax at the level of the subsidiary, and then taxed as
corporate income on the level of the parent company as well. The Directive
aims at eliminating multiple taxation of profits of corporations. In multilevel
participation structures, profits should only be taxed on the level of the
corporation initially generating the profits and on the level of the ultimate
natural person shareholder, and therefore shall not be taxed on the level of
intermediate corporations. 20 The Directive concerns two major taxation
principles; from the subsidiary Member States point of view it relates to the
source principle, and from the position of the parent companys Member State
the residence principle is applicable.

ii) Scope
Pursuant to Art. 1, the Directive is addressed to the Member States who shall
apply the provisions set out in the Directive and implement it into their national
laws. The Directive only applies to distribution of profits, no unrealized capital
gains and losses upon the alienation of the shareholding in the subsidiary is
addressed.21 In order for companies to qualify under the Directive a number of
requirements need to be met. The first condition is that they must qualify as a
company of a Member State. According to Art. 2(a), three conditions are set
out for such a company; it must be incorporated in one of the legal forms in the
Annex; it must be resident for tax purposes in a Member State based on national
law and it may not be resident outside the Union, but may have dual residence

19
Preamble Paragraphs (3) and (4), Directive 2011/96/EU, COM(2013) 814 final, (2013).
20
G. Maisto, International and EC Tax Aspects of Groups of Companies, (2008), pg. 309.
21
B. J. M. Terra, P. J. Wattel, European Tax Law, (2012), pg. 306.

11
in different Member States; and finally it must be subject to one of the national
corporation taxes listed in the Annex without being exempt and without the
possibility of an option.22 These three conditions do not have to be fulfilled in
one tax jurisdiction.23 Furthermore, Art. 1 sets out that the Directive applies to
dividends received by a State B permanent establishment (PE) of a State C
company paid by a State A (or C) company; and to dividends paid to a State B
PE of a State A company by a State A subsidiary.24 Once a company (or its PE)
qualifies, two more conditions must be fulfilled under Art. 3 in order to qualify
as a parent or a subsidiary. Pursuant to Art. 3(1)(a) Member States must
attribute such status at least to all companies of which one (the parent) holds at
least 10% of the capital of the other (subsidiary).25 A parent holding shares in a
subsidiary in the same Member State, through a PE in another Member State,
qualifies as well. The minimum holding requirement may refer to holding of
capital or of voting rights, at the discretion of Member States.26 Due to the
holding requirements under the Directive, it only applies to direct investment
dividends and not to portfolio investment dividends. 27 Lastly, a minimum
holding period of two years may be required by Member States.28

iii) Mechanisms
The Directive sets out that distributed subsidiary profits already properly taxed
in the Member State of the subsidiary, received by a qualifying parent (or its
branch) in another Member State, shall not be taxed in the latter.29 According to
Art. 4(1) the Member State receiving the inbound dividend income must either
exempt it or provide an indirect credit. Art. 4 also requires States choosing the
credit system to grant credit not only for corporation tax levied by a direct
subsidiary in another Member State, but also for corporation tax paid on the

22
Ibid., pg. 306-308.
23
Ibid.
24
Ibid., pg. 308.
25
Ibid., pg. 309.
26
Article 3(2)(a) Directive 2011/96/EU.
27
M. Helminen, International Tax Law Concept of Dividend, (2010); pg. 19.
28
Article 3(2)(b) Directive 2011/96/EU.
29
B. J. M. Terra, P. J. Wattel, European Tax Law, (2012), pg. 311.

12
profits of sub-subsidiaries and their lower-tier subsidiaries (a multi-tier credit),
provided they qualify under Articles 2 and 3.30 Furthermore, Art. 4(2) permits
the Member State of the parent company to consider, on the basis of its own
national law, a foreign subsidiary fiscally transparent and therefore to tax the
parent company on its shares of the profits of its subsidiary. 31 Regarding
outbound dividends, the general rule applies that exemption at source of
qualifying dividends from withholding tax in the state of the subsidiary is
mandatory, as provided for in Article 5.32 Withholding taxes are not explicitly
defined in the Directive, but the case of C-375/98 Epson Europe provides
further clarification by stating that they are not limited to certain specific types
of national taxation.33

3. Legal elements of the Proposal

a) International context
Taxation of multinational enterprises is discussed on the one hand on a
domestic, international and European legislative level, and on the other hand it
is subject of a wide social debate and extensive public discussions as well. In
principle, it can be observed that the current international tax system lags
business development and is not in line with the way international businesses
operate and organize themselves. This delay in legislative development to
appropriately address taxation of businesses in our rapidly changing world
results in international corporations not paying tax in certain cross-border
situations.34 The G20 countries mandated the OECD to develop proposals and
amendments, which resulted in the BEPS Report and a subsequent 15-point
action plan to address the problematic areas, including hybrid mismatch
arrangements, and to re-adjust international taxation standards to be better

30
Ibid., pg. 315.
31
Ibid., pg. 322-323.
32
Ibid., pg. 323.
33
Case C-375/98 Ministerio Publico, Fazenda Publica v. Epson Europe BV, [2000] ECR I-
4243.
34
D. Ledure, F. Boulogne, P. Dere, Proposal for amending the Parent-Subsidiary Directive:
European Commission is waging war against double non-taxation, (2014), pg. 1.

13
shaped for the changing global economy.35 The Proposal to amend the Directive
must be viewed within this broader social debate as well, and even though the
initial discussions on amending the Directive took place prior to the BEPS
initiative, it is seen that the Proposal is supported by the findings of the BEPS
Action Plan.36 The Commission does not only consider the BEPS Action Plan to
complement the EU measures, but also to address issues that can only be
effectively dealt with on an international level.37

b) Legislative scheme
In March 2012 the European Council called on the Council and the Commission
to rapidly develop concrete ways to improve the fight against tax fraud and tax
evasion. 38 The first response by the Commission was a Communication
adopted in June 2012 addressing how tax compliance could be improved and
fraud and evasion reduced through a better use of existing instruments and the
adoption of pending Commission proposals. The Communication further
announced the preparation of an action plan identifying concrete steps to
enhance administrative cooperation and to develop the existing good
governance policy.39 The Action Plan was presented in December 2012 along
with two Recommendations on tax havens and aggressive tax planning. The
Action Plan identified the revision of the Directive as a step to be undertaken in
the short term (i.e. in 2013) and correspondingly the Proposal was presented in
November of 2013. 40 The thesis takes these propositions as a basis for
evaluation, however the Proposal might not be identical to the amendments that
may ultimately be approved at a later stage.

35
European Commission Memo, Fighting Tax Evasion and Avoidance: A year of progress,
(2013), pg. 4.
36
Ibid.
37
Ibid.
38
Communication from the Commission to the European Parliament and the Council, An
action Plan to strengthen the fight against tax fraud and tax evasion, COM(2012) 722 final,
(2012), pg. 2.
39
Ibid.
40
Ibid., pg. 9.

14
 c) Principles of subsidiarity and proportionality
As any legislative proposal on a Community level, the amendments to the
Directive must comply with the principles of subsidiarity and proportionality.41
When assessing the second question posed by this thesis on the necessity and
appropriateness of a uniform, European approach to anti-avoidance and
hybridity, the principles of subsidiarity and proportionality provide guidance
from a legislative point of view. The Commission argues in its Proposal in
relation to the amendment on hybrid mismatches that it is the differences
between national legislations regarding the tax treatment of hybrid financial
instruments, and the subsequent employment of certain cross-border tax
planning strategies, that causes the distortion of capital flows and competition in
the Union.42 It is further perceived that other international initiatives, such as the
OECDs BEPS Action Plan, cannot properly address specific EU concerns on
hybrid financial instruments.43 With regards to the anti-abuse provisions, the
current Directive allows Member States to apply domestic and other agreement-
based provisions in order to prevent abuse or fraud, however this rule must be
read in accordance with its interpretation by the Court.44 The Courts case law
adheres to the principle that Member States may not go beyond the general
Community law principles regarding anti-avoidance, as well as the application
of anti-avoidance measures may not lead to infringements of the fundamental
freedoms. 45 This situation creates lack of certainty for taxpayers and tax
administrators alike. 46 The Proposal further states that the recommended
actions, regarding both hybrid instruments and anti-avoidance rules, cannot be
sufficiently achieved unilaterally and individually by the Member States, but
can be better achieved at a EU level, and therefore they comply with the

41
Article 5 of the Treaty on European Union.
42
Proposal for a Council Directive amending Directive 2011/96/EU, COM(2013) 814 final,
(2013), pg. 5.
43
Ibid.
44
Ibid.
45
Ibid.
46
Ibid.

15
subsidiarity principle (Art. 5(3) TEU). 47 As it will be presented in the
subsequent chapter, the proposed actions only target hybrid financial payments
from the source Member States perspective and furthermore, the proposed anti-
avoidance rules are considered to be in line with the proportionality limits set by
48
Courts case law. Therefore the amendments also comply with the
proportionality principle, as the content and form of the Union actions do not
exceed what is necessary to achieve the objectives of the Treaties (Art. 5(4)
TEU).49 The Proposal of the Commission therefore concludes an affirmative
answer to our question whether a uniform response on a European level
provides an appropriate solution to the challenges posed by anti-avoidance and
hybridity, however, this question shall be further explored in the subsequent
chapters.

III. ANTI-AVOIDANCE UNDER THE DIRECTIVE

The first element of the Proposal targets anti-avoidance legislations in the
Community. This chapter takes a closer look at how anti-avoidance is addressed
on a national as well as European level, in relation to the first underlying
question of the thesis, and furthermore, with regards to the second question
posed by the thesis, it assesses whether a uniform European response to tax
avoidance is accurate and effective in its proposed form.

1. Terminology
When assessing the proposal regarding anti-avoidance, it is essential to clarify
the relevant terminology. The lines between the concepts of tax evasion, tax
fraud and tax avoidance are becoming more blurred and the expressions are
frequently used interchangeably in both national and international legal context.
The IBFD defines tax evasion, in contrast to tax avoidance, as an intentional
illegal behavior involving a direct violation of tax law in order to escape the

47
Ibid.
48
Ibid; pg.6.
49
Ibid.

16
payment of tax.50 It is further clarified that within the concept of tax evasion, tax
fraud constitutes a more deliberate evasion of tax, including the submission of
false statements or documents.51 Tax avoidance on the other hand falls short of
evasion and constitutes the removing, reducing or postponing of tax liability, a
concept that is not illegal but against the spirit of the law.52 Tax planning has
been a commonly accepted concept referring to the ordering of ones business
in a way that minimizes tax liability and constitutes a legitimate practice. As
early as 1934, Judge Learned Hand put forward in Gregory v. Helvering that
anyone may so arrange his affairs that his taxes shall be as low as possible
and he is not bound to choose that pattern which will best pay the treasury.53
Therefore domestic laws have traditionally been regarding tax planning as a
legitimate tool as long as borders were not crossed into abusive practice.

2. Amended provisions
The current Directive does not contain a general anti-abuse provision in itself,
but Art. 1(2) allows Member States to apply domestic and agreement-based
provisions required to prevent fraud or abuse. Abuse itself is not defined, it is
merely specified that Member States may rely on anti-abuse provisions to deny
or limit the benefits under the Directive.54 The prohibition of abuse of rights is a
general principle of EU law, a judge-made and unwritten rule, therefore it is
suggested that such a general and unwritten national anti-abuse provision (e.g.
substance over form) may be invoked as well, provided that it is applied in a
targeted and proportional manner. 55 As anti-abuse provisions are in fact

50
Communication from the Commission to the European Parliament and the Council, An
Action Plan to strengthen the fight against tax fraud and tax evasion, COM(2012) 722 final.
51
Fraud, IBFD Glossary,
http://online.ibfd.org/kbase/#topic=doc&url=/highlight/collections/itg/html/itg_fraud.html&q=
fraud+frauds&WT.z_nav=Search&colid=4949, (last visited 21 March 2014).
52
Prof.V.Uckmar, Tax Avoidance-Tax Evasion, IFA Cahiers de droit fiscal international,
(1983), pg. 23.
53
Prof. Dr S. van Weeghel, F. Emmerink, Global Developments and Trends in International
Anti-Avoidance; Bulletin for International Taxation, (2013), pg. 431.
54
B. J. M. Terra, P. J. Wattel, European Tax Law, (2012), pg. 328.
55
Ibid.

17
restrictions to EU rights, they must be applied in a narrow sense and in
accordance with the proportionality principle.56

The Proposal continuously allows for the application of domestic or agreement-

based provisions, and further provides for a general anti-abuse provision
envisaged in Article 1a of the Proposal. The first paragraph of this article
provides that Member States shall withdraw benefits of the Directive in case of
an artificial arrangement which has been put into place for the essential
purpose of obtaining an improper tax advantage under the Directive and
which defeats the object, spirit and purpose of the tax provisions invoked.57
As it has been established earlier, the benefit of this Directive is the elimination
of multiple economic double taxation, therefore one could assume that the
employment of an artificial arrangement with the abovementioned motives shall
result in a subsidiary Member State denying exemption from withholding tax of
a dividend payment or a parent Member State taxing the respective distribution
of profit as corporate income. The second paragraph provides for a
characterization of what constitutes an artificial arrangement, defining it as a
transaction, scheme, action, operation, agreement, understanding, promise or
undertaking that does not reflect economic reality.58 Furthermore, it states
that artificial arrangements may involve one or more of the following situations:
(a) the legal characterization of the individual steps which an arrangement
consists of is inconsistent with the legal substance of the arrangement as a
whole;
(b) the arrangement is carried out in a manner which would not ordinarily be
used in a reasonable business conduct;
(c) the arrangement includes elements which have the effect of offsetting or
cancelling each other;
(d) the transactions concluded are circular in nature;

56
Ibid., pg. 330.
57
Proposal for a Council Directive amending Directive 2011/96/EU, COM(2013) 814 final,
(2013), pg. 9.
58
Ibid.

18
 (e) the arrangement results in a significant tax benefit which is not reflected in
the business risks undertaken by the taxpayer or its cash flows.59

3. Assessment under domestic and European law

In order to evaluate the impact and effectiveness of the anti-abuse proposal,
relevant existing national anti-avoidance legislations, EU law principles and
case law must be reviewed.

a) Domestic law
Several states have recently initiated the application of general anti-avoidance
rules (GAARs) in domestic legislation and the introduction of specific anti-
avoidance rules (SAARs), such as controlled foreign corporation (CFC)
legislation and thin capitalization rules. Furthermore, since a European directive
is only binding as to the result to be achieved and the forms and methods are left
to the choice of Member States, each country may adopt a certain directive in a
different manner.60 Art. 1(2) of the current Directive already allows for the
application of domestic anti-abuse provisions, therefore the question arises
whether a general anti-abuse provision, such as the one proposed, is necessary
and sought for. The fact that directives are binding as to the result and goal to be
achieved allows Member States to incorporate European provisions into their
domestic legislation in the best and most appropriate way possible to correspond
with each unique national legislative system. However, the same fact leads to
the consequence that provisions under a certain directive may not be identically
implemented in each Member State. Directives therefore ensure a certain level
of uniformity and consistency on a European level, but at the same time allow
for leeway and flexibility with regards to their application in Member States.
Consequently, the current Directive has been subject to slightly different
implementations in the Member States as well. Apart from the general anti-
avoidance legislations that several states have employed, such as Belgium,
France or The Netherlands, more specific anti-abuse rules have been introduced

59
Ibid.
60
Article 288 of the Treaty on the Functioning of the European Union.

19
as well that may alter the application of the Directive. In Germany, for instance,
so-called anti-treaty shopping rules 61 were introduced which deny treaty
benefits, such as the reduction of withholding tax and benefits provided by the
Directive, subject to certain additional conditions in situations which may give
rise to abuse. 62 Another example of a recently introduced domestic anti-
avoidance rule is the Swedish interest deduction limitation rule providing that
interest expenses in relation to loans acquired from affiliated companies
are not deductible, regardless of the purpose of the loans and subject to two
exceptions; in case the interest income is taxed at a minimum rate of 10% in the
residence state of the beneficial owner, unless the main reason behind the loan
is to obtain considerable tax benefits, and in case the loan is motivated by
business reasons. 63 France has also introduced similar interest deduction
limitation rules. 64 All these domestic rules in place implicate that the
employment of anti-avoidance provisions has already been possible under the
current Directive and several states have in fact utilized such legislation.

b) General principles of EU law and case law

In relation to the first question identified under this thesis, apart from national
law general European principles and case law must be analyzed as well, since
they constitute significant legal sources in the European Union and its Member
States. The general principle on the prohibition of abuse of law implies that
taxpayers may not fraudulently rely on European law and obtain tax benefits
that are not in line with the purpose of the provision.65 In the C-321/05 Kofoed
case the Court referred to abuse as a general principle for the first time and
clarified that Art. 11(1)(a) of the Merger Directive66 reflects that the prohibition

61
Section 50d(3) of the German Income Tax Law (Einkommensteuergesetz).
62
D. Ledure, F. Boulogne, P. Dere, Proposal for amending the Parent-Subsidiary Directive:
European Commission is waging war against double non-taxation, (2014), pg. 4.
63
E. Nilsson, Sweden-Corporate Taxation, (2014), pg. 28.
64
D. Ledure, F. Boulogne, P. Dere, Proposal for amending the Parent-Subsidiary Directive:
European Commission is waging war against double non-taxation, (2014), pg. 4.
65
M. Helminen, EU Tax Law Direct Taxation, (2011), pg. 47.
66
Council Directive 90/434/EEC of 23 July 1990.

20
of abuse of right is a general EU law principle.67 One of the most significant
cases in the field of direct taxation with regards to the abuse doctrine is the C-
196/04 Cadbury Schweppes68 case. This case puts forward that a restriction by a
Member State on the freedom of establishment may be justified on the ground
of prevention of abusive practices, specifically the prevention of conduct
involving a wholly artificial arrangement which does not reflect economic
reality.69 A wholly artificial arrangement consists of a subjective element, the
intention and purpose to obtain a tax advantage, as well as an objective element,
referring to equipment, staff or economic data of the relevant legal person.70
The Court therefore takes an active role in developing and interpreting general
principles of Community law. These principles have become a significant and
influential source of law in the European legal order, ranking below Treaty
status.71 The decisions of the Court are binding on the Member States, which
view is further supported by Art. 280 TFEU stating that judgments of the Court
are enforceable. 72 Furthermore, the Courts power to introduce general
principles is reinforced by Art. 19 TEU, which provides for the Court to ensure
that the interpretation and application of the Treaties and the law are observed.73

4. Evaluation
In this chapter, anti-avoidance rules have been reviewed in light of different
legal sources with regards to their application under the scope of the Directive.
The anti-abuse provision, as the first element of the Proposal, focuses on
general anti-avoidance within the scope of the Directive. The employment of
domestic and agreement-based anti-avoidance provisions is continuously
allowed for, however a new general provision is introduced as well. The essence
of this general provision is the withdrawal of benefits under the Directive in
relation to artificial arrangements that are employed with the essential purpose

67
Case C-321/05 Kofoed v Statteministeriet, [2007] ECR I-5795 88, para. 38.
68
Case C-196/04 Cadbury Schweppes [2006] ECR I-7995.
69
Ibid., para 55.
70
Ibid., para 64-68.
71
N. Foster, EU Law Directions, (2012), pg. 108.
72
Ibid.
73
Ibid; pg. 109.

21
to obtain unintended tax advantages and that do not reflect economic reality.
Apart from listing possible scenarios that could constitute such a practice, the
provision does not contain further specifications. The main question in relation
to the anti-abuse provision is whether it provides for further protection apart
from what has already been available under domestic and European law.
Although the general anti-avoidance provision is a valid attempt to codify a
uniform rule in the Community, it does not seem to provide for any
opportunities to Member States that did not previously exist. First of all,
domestic laws have already addressed anti-avoidance from several different
perspectives and with different levels of specificity, which makes it less
necessary to introduce a supplementary or overlapping generic rule.
Furthermore, it might create confusion as to which rules prevail in cross-border
situations and whether Member States will be obliged to apply the rules of the
Directive above their domestic laws or whether the more specific domestic rules
will prevail according to the doctrine of lex specialis. This scenario could
potentially lead to double taxation as well, depending on local tax authorities
reaction to circular reasoning based on the different domestic anti-avoidance
rules.74 Secondly, the amended provision refers to artificial arrangements that
do not reflect economic reality, which are two concepts that have already been
widely referred to in existing case law of the Court. The fact that the concepts
are reaffirmed by the Directive is a plausible attempt to create consistency,
however due to the fact that the general principle of prohibition of abuse already
enjoys a high legal status and case law has previously created judicial
precedence for the application of the artificial arrangement concept leads to a
conclusion that no groundbreaking changes are proposed under the first
amendment to the Directive. In relation to the first question posed by this thesis,
it is apparent that while domestic law allows for the enactment of the Directive,
the Directives anti-abuse clause refers back to domestic law and requires its
application in specific scenarios, thereby ensuring a minimum level of

74
D. Ledure, F. Boulogne, P. Dere, Proposal for amending the Parent-Subsidiary Directive:
European Commission is waging war against double non-taxation, (2014), pg. 4.

22
uniformity but maintaining substantial control in the hands of the Member
States when addressing issues of anti-avoidance.

IV. HYBRID FINANCIAL INSTRUMENTS UNDER THE

DIRECTIVE
As put forward in the Proposal, with the increasing number of cross-border
investments, multinational companies have had the opportunity to rely on
hybrid financial instruments enjoying unintended advantages on the one hand
from the mismatches between different national tax treatment of certain
instruments, and on the other hand from the international standard rules of
relieving double taxation.75 The second element of the Proposal therefore targets
and discusses hybrid financial instruments (hybrids) and their treatment under
the Directive. This chapter takes a closer look at the debt-equity conundrum,
which essentially leads to the existence of hybrid financial instruments, analyzes
the treatment of profit distributions under the Directive and in relation to
relevant hybrids, discusses the challenges caused by such instruments and
finally evaluates on how these challenges are addressed and dealt with by the
Proposal.

1. The debt-equity conundrum

The treatment of debt and equity in tax law is at the heart of the discussion
regarding hybrid financial instruments. Although the definitions are not
ultimately clarified, equity is usually defined as representing ownership, while
debt in general represents something that is owed. From an economic point of
view, no distinction is made between the flows on debt capital versus equity
capital.76 Also, from an economic viewpoint, it is incomprehensible to treat
interest expense as a cost of doing business, since both a debt holder and an
equity holder are entitled to payment on capital and therefore there is no

75
Proposal for a Council Directive amending Directive 2011/96/EU, COM(2013) 814 final;
(2013), pg. 6.
76
P. H. Blessing, The Debt-Equity Conundrum A Prequel, Bulletin for International
Taxation, April/May (2012), pg. 198.

23
economic distinction between them.77 From a legal perspective, distinctions are
made based on distinguishing owners (including factors such as risk and
management participation) and non-owners (such as debt-holders) of a certain
entity.78 The distinction between debt and equity under tax law differs to some
extent from the distinctions made from a legal or economic perspective. The
traditional distinction entails that interest on debt is a deductible expense, while
distributions on equity, such as dividends, are non-deductible for tax purposes.79

According to most domestic laws, the basic distinction at the issuer level is that
interest is deductible from the taxable profits (under the cash or accrual method
of accounting adhered to by the issuer) when determining net income for
corporate income tax purposes and dividends are not deductible as such.80 At
the level of the holder of the instrument, interest is generally taxed whether
received from a domestic or foreign (legal) person, while dividends can enjoy a
more favorable treatment.81 The treatment of received dividend differs from
jurisdiction to jurisdiction, but in general most states mitigate economic double
taxation of distributed corporate profits at least to some extent.82 Domestic
inter-company dividends may usually be completely or partly tax exempt, or
alternatively a reduced tax rate, dividend-received deduction or a dividend
imputation credit may be employed.83 A distinction between the treatment of
interests and dividends is observed from another perspective as well, regarding
the timing of income inclusion.84 While interest is usually included according to
the holders accounting principles, dividends (if taxable at all) are included
when declared and paid, regardless of the holders accounting methods

77
Ibid., pg. 207.
78
Ibid., pg. 206.
79
Ibid., pg. 198.
80
Ibid., pg. 199.
81
Ibid.
82
M. Helminen, International Tax Law Concept of Dividend, (2010), pg. 17.
83
Ibid.
84
P. H. Blessing, The Debt-Equity Conundrum A Prequel; Bulletin for International
Taxation, April/May (2012), pg. 199.

24
employed. 85 Therefore it is widely considered that this differentiation in
treatment under most domestic tax law systems leads to a so-called bias
towards the issuance of debt.86 From a policy viewpoint, this tax motivated
debt-bias, stemming from the more favorable treatment of debt as opposed to
equity, creates concerns in relation to social welfare.87 It does not only lead to
tax arbitrage and base erosion, which results in revenue as well as
administrative costs for the states, but also leads to a certain financial
engineering employed by financial institutions that, some argue, have even
contributed to the financial crisis.88

The consequences of the disparity in treatment of debt and equity could further
be due to the issuer and investor being located in different jurisdictions.
Dividends could enjoy a favorable treatment in a domestic context, but could on
the other hand be subject to withholding tax in a cross-border scenario. 89
Interest payments to foreign persons are often exempt from taxation under
domestic laws, while dividend payments (apart from a few exceptions) are not.90
Furthermore, classification of instruments could be different among tax systems
and therefore be exploited in a cross-border situation. Consequently, the
classification of debt and equity influences how corporate financings are
structured not only domestically, but also internationally.91

2. Hybrid financial instruments

a) Background
Hybrid financial instruments have been first used as early as the 16th century by
the first English companies, however European companies have traditionally
preferred the use of straight debt from banks and the issuance of share capital as

85
Ibid.
86
Ibid.
87
Ibid., pg. 205.
88
Ibid.
89
Ibid.
90
Ibid.
91
Ibid., pg. 202.

25
their sources of financing.92 Hybrid instruments may either be debt instruments
with equity features or equity instruments combined with debt features.93 The
use of hybrid instruments by non-financial companies was rather unusual until
the introduction of the euro, and it was not until the year of 2005 when hybrids
started to be widely employed by European companies outside the financial
sector.94

b) Characteristics
Hybrid instruments cannot be generally defined, but they do retain a few
common underlying characteristics. A financial instruments hybrid character is
embodied in the fact that it carries traits of both debt and equity. Many
securities have such double characteristics even under domestic law.95 Some
instruments that are on the borderline of debt and equity include; preference
shares, convertible bonds (including zero-coupon convertible bonds),
participating loans (which provide the lender a participation in the gross receipt
or the net income of the issuer) or perpetual debt (with no fixed maturity date)
and century bonds (with a 100-year maturity).96 Apart from an instruments
hybrid character under domestic law, differences between jurisdictions can exist
as well, creating cross-border hybridity.97 Due to classification of debt and
equity being a domestic matter, the independent decisions of states might not
correspond with each other, thereby creating possibilities of mismatches. The
same financial instrument could be classified as representing equity in one state,
and debt in another. Furthermore, hybrids can be classified differently for
accounting, rating and even legal purposes.

92
J. Bundgaard, Classification and Treatment of Hybrid Financial Instruments and Income
Derived Therefrom under EU Corporate Tax Directives-Part 1, European Taxation, October,
(2010), pg. 442.
93
Ibid.
94
Ibid., pg. 443.
95
Ibid.
96
Ibid.
97
P. H. Blessing, The Debt-Equity Conundrum A Prequel, Bulletin for International
Taxation, April/May (2012), pg. 203.

26
 c) General effects
A typical scenario of hybridity entails an issuer of an instrument in one country,
paying interest that is deductible, and a holder in another country receiving
dividend, which is exempted. While country number 1 classifies the instrument
as debt and therefore corresponding interest is deductible as business expense,
country number 2 classifies the instrument as equity and therefore the
corresponding dividend income is exempted for tax purposes under respective
domestic legislation, which scenario leads to a double non-taxation. One of the
obvious effects of arrangements including hybrid instruments is that they
facilitate transactions that have as their effect significant reduction and erosion
of the home countrys tax base. 98 Furthermore, the effects of such hybrid
financial instruments increase the incentive to make use of the double dip
phenomenon, a deduction without income inclusion by the related party
lender.99 The question arises whether and to what extent is it the responsibility
of individual states that such hybrid instruments exist, since according to the
respective domestic jurisdictions the classification of the instruments is
appropriate. Furthermore, an important aspect to consider is also whether and to
what extent does the employment of hybrids constitute some sort of tax
arbitrage, since multinational enterprises making use of such arrangements
strictly comply with formal requirements, taking advantage of the existing
international rules, and therefore their practice cannot be regarded as anything
more severe than legitimate tax planning. Most likely this is the point where the
international communitys work comes into place and organizations such as the
OECD or the EU assume their obligation and power to act.

The OECDs BEPS Report is one such instrument that addresses the issue.
Action 2 of the 15-step Action Plan addresses hybrid mismatch arrangements
and states that hybrids can be used to achieve unintended double non-taxation or
long-term tax deferral by, inter alia, creating two deductions for one borrowing

98
Ibid.
99
Ibid.

27
or deductions without corresponding income inclusions or by misusing foreign
tax credits and participation exemption schemes.100 The OECD further states
that the problem with mismatches lies in the difficulty to determine which state
has in fact lost tax revenue since laws have been complied with in both states
involved, however the situation creates an overall tax reduction for all states
involved causing harm for competition, economic efficiency, transparency and
fairness.101 The OECD proposes the amendment of both treaty and domestic tax
law provision, including changes to the OECD Model Tax Convention ensuring
that hybrids cannot obtain unduly benefits, introduction of domestic law
provisions preventing firstly exemption of payments deductible by the payor,
secondly denying deductions for payments that are not includible in income by
the recipient and thirdly denying deduction for payments that is also deductible
in other jurisdictions.102 The expected outcomes of this action by the OECD are
therefore changes to the OECD Model Tax Convention and recommendations to
redesign domestic provisions, both of which outputs are expected to be achieved
by September 2014.103

3. Hybrids under the scope of the Directive

Hybrids have been widely discussed under European legislation as well. The
two major European Corporate Tax Directives that address tax law subjects of
hybrid equity (debt-like equity) instruments and hybrid debt (equity-like debt)
instruments are the Parent-Subsidiary Directive and the Interest Royalty
Directive, respectively. As in line with the objectives of this thesis, the
subsequent chapter focuses solely on the Parent-Subsidiary Directive and
treatment of yields and financial instruments under its direct scope.

100
OECD, Action Plan on Base Erosion and Profit Shifting, (2013), pg. 15.
101
Ibid.
102
Ibid.
103
Ibid.

28
 a) The concepts of distributions of profit and dividend under the
Directive
As established in earlier chapters, the Directive covers inter-corporate
distributions of profit. Hybrid equity instruments include characteristics of
equity and debt alike therefore the instrument may wholly or partly be classified
as equity, and consequently the yield on the instrument as dividend.104 Since the
Directive applies to yields on equity, one must consider the interpretation of
distributions under the Directive in order to determine the treatment of hybrid
financial instruments as a whole. 105 Determining what distribution means
under the Directive is also a significant matter when considering the first
question identified by this thesis on how the different legal sources address the
question of hybridity. Distributions of profits and dividends are not
explicitly defined in the Directive therefore the question arises whether there is
a uniform definition or whether these terms should be interpreted in the light of
domestic law. Some commentators argue that there should not be an
autonomous understanding of these concepts that is totally independent from
domestic law concepts since the Directive is in essence concerned with the
domestic law distributions in different states. 106 Other commentators argue
however that a uniform concept is indispensible for the sake of
harmonization.107 According to these diverse viewpoints, there has been little
clarity with regards to which legal source prevails when determining the
meaning of these concepts and consequently, the scope of the Directive. The
absence of clear guidelines has left a blurry playing field for European
companies with regards to the employment of hybrid financial instruments,
however the Proposal clearly concludes that certain hybrid instruments do fall
under the scope of the Directive and consequently addresses their treatment.

104
J. Bundgaard, Classification and Treatment of Hybrid Financial Instruments and Income
Derived Therefrom under EU Corporate Tax Directives-Part 1, European Taxation, October,
(2010), pg. 446.
105
Ibid.
106
Ibid.,pg. 447.
107
Ibid.

29
 b) Classification mismatches
Due to the fact that Member States classify certain financial instruments
differently, mismatches occur within the Community that may give rise to either
double taxation or double non-taxation. An example that illustrates such a
mismatch is the so-called profit participating loan, which is a loan with a long
duration (usually over 50 years) under which the payment owed by the borrower
depends on the annual profit of the borrower.108 The two scenarios under which
a parent company providing a profit participating loan to its subsidiary leads to
either double taxation or double non-taxation are depicted in Exhibit 1.

Exhibit 1: Double non-taxation and double taxation under a profit participating loan
Member State Member State
A A

Parent company Parent company

PPL PPL
(exempt (tax subject
dividend interest
income) income)

Member State Member State

B B

tax deductible non-deductible

Subsidiary Subsidiary
interest dividend
expense payment

DOUBLE NON-TAXATION DOUBLE TAXATION

In case a country, such as in fact Belgium or France, qualifies the loan in

question as a debt instrument (a loan), the payment in relation to the loan
constitutes interest. 109 In other countries, such as the Netherlands and
Luxembourg, profit participating loans are qualified as a shareholding in the
subsidiaries of the parent companies, due to their long duration and the fact that
the payment is dependent on profit, therefore the payment made on the

108
D. Ledure, F. Boulogne, P. Dere, Proposal for amending the Parent-Subsidiary Directive:
European Commission is waging war against double non-taxation, (2014), pg.2.
109
Ibid. pg. 3.

30
instrument is classified as dividend.110 Consequently, in the first scenario of
Exhibit 1, Member State A qualifies the loan as shareholding and the payment
received as dividend, therefore a dividend income from the subsidiary is exempt
in Member State A. Member State B, on the other hand, classifies the loan as
debt (a loan) and consequently the payment as interest, which payment is tax
deductible in the subsidiarys Member State. In this scenario, the subsidiary is
able to deduct its interest expenses from its tax base in relation to the loan and
the parent companys dividend income is exempt from tax, hence the double
non-taxation. In the second scenario of Exhibit 1, the opposite situation is
illustrated. Member State A qualifies the loan as debt and the payments received
on the loan as interest, which income is subject to tax in Member State A.
Member State B, however, classifies the instrument as a shareholding and the
payment as dividend, therefore the payments from the subsidiary are not tax-
deductible expenses, such as interest would be. Consequently, this scenario
entails a non tax-deductible payment by the subsidiary and an income subject to
tax in the parent companys state, thereby creating a situation of double
taxation.

4. The proposed amendment on hybrids

In relation to the first question of the thesis, it has been discussed how the
different legislative sources address hybrid financial instruments and the focus
shall now turn to the second question of how the Directive addresses these
issues and whether it provides a uniform solution to classification mismatches.
The actual changes proposed to the Directive with regards to hybrid instruments
are rather brief, modifying only Article 4, a provision applicable to parent
companies receiving distributed profits from their subsidiaries. Paragraph 1 of
the Article is replaced with the following phrase: (a) refrain from taxing such
profits to the extent that such profits are not deductible by the subsidiary of the
parent company; or ().111 In essence, the Proposal entails that exemption in

110
Ibid.
111
Proposal for a Council Directive amending Directive 2011/96/EU, COM(2013) 814 final,
(2013), pg. 9.

31
the parent companys state may only be given as long as the dividend is not
deductible in the subsidiarys state, but once a dividend is deductible by the
subsidiary the parent companys income must be taxed in its state of residence.
The differences between the current and proposed scenarios are illustrated in
Exhibit 2.

Exhibit 2: Current and proposed situation under the Directive112

CURRENT SITUATION PROPOSED AMENDMENTS

Member State Member State

B B
tax exempt TAXED hybrid
hybrid loan loan payment
Parent company payment Parent company
(dividend)

Member State Member State

A A
tax tax deductible
deductible hybrid loan
Subsidiary hybrid loan Subsidiary payment (interest)
payment
(interest)

According to the Commission, the best option to address double non-taxation

under the Directive is to deny the tax exemption to profit distribution payments,
which are deductible in the source Member State and thereby ensuring that no
company can escape taxation by loopholes from hybrid cross-border
financing.113In other words payments from a subsidiary that are deductible as
expense from the tax base shall not be exempt in the state of the parent
company, a scenario illustrated in Exhibit 1 as double non-taxation. When
comparing the proposals of the Commission and the OECD, it is apparent that
both organizations mainly aim at addressing the problem on an international
level. While the OECD proposes that domestic tax law provisions shall be

112
European Commission Memo, Questions and Answers on the Parent Subsidiary Directive,
Memo/13/1040, (2013), pg.3
113
Ibid. pg. 4.

32
altered based on internationally administered recommendations, the
Commission states that the heart of the mismatch problem lies within the
differences between Member States and therefore individual reactions by states
cannot effectively solve the problem. The Commissions Proposal on hybrids
therefore does not support single uncoordinated initiatives by Member States, as
that might create further mismatches, and also does not propose particular
classification of financial instruments, but instead suggests that once an interest
payment in the state of the subsidiary constitutes a tax-deductible expense, the
corresponding income cannot be tax exempt in the state of the parent.

5. Evaluation
The Proposal is a targeted and well-founded attempt to address hybrid
instruments within the European Union, as it recognizes the problem being the
classification differences among Member States and accordingly recommends a
solution that would eliminate the benefits of a tax-deductible expense and a
corresponding tax-exempt income with the use of a hybrid instrument in a
cross-border scenario. However, the Proposal does leave certain aspects unclear.

The first apparent observation when assessing the provision on hybrids is that
its language and scope is somewhat limited. It merely puts forward that
exemption under the Directive in the parent companys Member State should
only be allowed as long as the payment is not deductible in the subsidiarys
Member State. The Proposal does not cover, for example, the scenario when the
subsidiary considers the payment as dividend and the parent classifies it as
interest income114, even though this scenario would most likely lead to double
taxation, but still constitutes a mismatch that leaves possibilities for setups
resulting in either double taxation or double non-taxation, both of which are
undesirable under the Directive.

114
D. Ledure, F. Boulogne, P. Dere, Proposal for amending the Parent-Subsidiary Directive:
European Commission is waging war against double non-taxation, (2014), pg.5.

33
Furthermore, while the Proposal targets and addresses scenarios of double non-
taxation it fails to ensure that by employing certain anti-avoidance techniques
double taxation would not occur either. For instance, in case of the so-called
circularly-linked rules, whereby the domestic treatment of hybrid instruments
is linked to the treatment in the foreign country, mismatches are eliminated,
however double taxation could still occur if the parent companys state does not
exempt profit distributions, if such profits are deductible in the subsidiarys
state, and the subsidiary cannot deduct interest expense, if such payments are
exempt in the parents state.115 It is apparent therefore that there are certain
scenarios in which double taxation could occur thereby contradicting the
original aim of the Directive. Rules of linking domestic and foreign countries
tax treatment is yet again a plausible attempt to address double non-taxation,
however it does not ensure that double taxation is eliminated as well. In order to
appropriately eliminate scenarios of both double taxation and non-taxation,
tiebreaker rules could provide further certainty, however the Proposal does not
contain such rules to date. Additionally, a uniform and harmonized definition of
debt and equity could provide further clarity in relation to hybrids throughout
the Union, thereby decreasing the likelihood of classification mismatches,
however the Proposal does not cover such definitions.

Lastly, and in connection to the second underlying question of the thesis, a

major issue remains unanswered until the implementation of the Proposal, since
the decision on the actual application of the Proposal is now in the hands of the
Member States. As it has been established in earlier chapters, Member States
are free to choose their method to achieve the aims of directives and this leaves
certain leeway to states when it comes to the addressing of both anti-avoidance
and hybrid instruments under the Directive. Therefore it is still not ensured that
upon the implementation of the Proposal differences between Member States
would not exist and consequently not lead to continuous mismatches. The
answer to the question whether a uniform response is appropriate seems to be

115
Ibid. pg. 141.

34
positive and reassuring when looking at the aims of the Proposal, but cannot be
a final and definite answer until implementation into domestic law has occurred
in all Member States.

V. CONCLUSION
Clearly, the Commission has moved from its initial approach in the early years
of the Community of promoting and facilitating the elimination of cross-border
double taxation to an approach today that declares fight against double non-
taxation and tax evasion. The priorities of European legislative bodies and legal
instruments, as well as priorities of national governments and international
organizations, have shifted from ensuring that businesses operate without cross-
border obstacles of double or multiple taxation to ensuring that multinational
corporations are not able to escape their duty of paying tax even in a complex
cross-border setting.

The thesis has presented, first of all, that both anti-avoidance in general, and
more specifically, hybrid instruments are addressed by certain Member States of
the European Union through diverse national anti-avoidance tools and
provisions. In addition, existing European principles, case law and the latest
Proposal to the Directive provide for further actions to be taken on a European
level, along with an ongoing international effort mainly coordinated by the
OECD in the form of the BEPS Report. The Proposal continuously allows for
domestic anti-avoidance legislations to be applied and further proposes a
general anti-avoidance clause targeting artificial arrangements that do not reflect
economic reality. The Proposal, on the hand, reflects the established case law
practice and corresponds to European legal principles, thereby providing further
consistency. However, for the same reasons, the Proposal on anti-avoidance
does not particularly add further specificity or clarity and continues to rely
heavily on the eventual actions of Member States taken under the overarching
Directive. In relation to hybrid instruments, the Proposal aims to tackle double
non-taxation by requiring that no exemption may be given in a parent

35
companys state, if the corresponding payment in the subsidiarys state was tax-
deductible. Although the Proposal on hybrids is very targeted, clear and
manages to address mismatches on an overall level without going into extensive
technical details and requirements regarding actual classifications in Member
States, its wording and scope may prove to be too narrow. A number of
classification issues are left unaddressed, such as a scenario involving certain
circularly-linked rules or the continuing possibility of double taxation under
the Proposal dependent on its implementation in Member States. Therefore, it
can be concluded that although the Proposal constitutes a plausible attempt to
address both anti-avoidance and hybrids on a uniform level, it still leaves certain
loopholes open that could continuously allow for a scenario of cross-border
double non-taxation - or double taxation - of hybrid instruments and the
existence of tax arrangements primarily built with the purpose to reduce tax
costs of multinational corporations.

It is arguable whether the Proposal, on top of some of the newly introduced

individual domestic provisions and along with other international efforts (such
as the OECDs BEPS Report) would provide further guidance or rather more
ambiguity and uncertainty. Furthermore, the Proposals success depends
substantially on how and in what form and wording it will eventually be
implemented in the Member States. Despite the criticism on the limited
legislative power and broad, somewhat unclear, scope of the Proposal, it must
be acknowledged that a directive is not meant to or designed to do more than
giving a legislative aim that is eventually executed by the Member States.
Therefore it could be argued that the Proposal has reached its aim by raising
awareness of the issue and obliging Member States to adopt anti-avoidance
legislation at least to some extent, regardless of the eventual implemented form
of the provisions. The European Union is a community established by and for
its Member States, and it is eventually up to its Member States to commit to the
actions proposed by the Community. An undoubtedly important role of the
European Union is however to represent European citizens legal or natural

36
persons alike - and their interests and ensure prosperity, fair competition and
sustainable economic growth within its borders. The fight against tax avoidance
is a controversial one because on the one hand is society demanding a fair
allocation of responsibility taken by citizens and corporations to contribute to a
common state budget, and on the other hand are multinational corporations
facing enhanced competition in a highly complex international setting making
sophisticated business decisions in order to maximize profit and minimize tax
expenses within the given legal setting they operate in. The author believes that
despite extensive international legislative efforts, law will continue to lag
business development and loopholes in tax systems will continue to exist, which
multinational corporations will not omit to utilize, leading to an ever-enduring
clash between the interests of governments and businesses.

37
BIBLIOGRAPHY

Treaties
Treaty on the European Union, OJ C 326

Treaty on the Functioning of the European Union, OJ C 326

Directives
Council Directive 2003/123/EC of 22 December 2003 amending Directive
90/435/EEC on the common system of taxation applicable in the case of parent
companies and subsidiaries of different Member States, 2003, OJ L 007.

Council Directive 2003/49/EC of 3 June 2003 on a common system of taxation

applicable to interest and royalty payments made between associated companies of
different Member States, 2003, OJ L 157.

Council Directive 2011/96/EU of 30 November 2011 on the common system of

taxation applicable in the case of parent companies and subsidiaries of different
Member States, 2011, OJ L 345/8.

Council Directive 90/434/EEC of 23 July 1990 on the common system of taxation

applicable to mergers, divisions, transfers of assets and exchanges of shares
concerning companies of different Member States, 1990, OJ L 225.
Other legislative works
C (2012) 8805 final Commission Recommendation of 6 December 2012 regarding
measures intended to encourage third countries to apply minimum standards of good
governance in tax matters, Brussels, 2012.

C (2012) 8806 final, Commission Recommendation of 6 December 2012 on

aggressive tax planning, Brussels, 2012.

COM (2012) 351 final, Communication from the Commission to the European
Parliament and the Council on concrete ways to reinforce the fight against tax fraud
and tax evasion including in relation to third countries, Brussels, 2012.

COM (2012) 722 final, Communication from the Commission to the European
Parliament and the Council final An Action Plan to strengthen the fight against tax
fraud and tax evasion, Brussels, 2012.

COM (2013) 814 final, Proposal for a Council Directive amending Directive
2011/96/EU on the common system of taxation applicable in the case of parent
companies and subsidiaries of different Member States, Brussels, 2013.

COM (85) 310 final, White Paper from the Commission to the Council on Completing
the Internal Market, Brussels, 1985.

MEMO/13/1040, European Commission Memo, Questions and Answers on the Parent

Subsidiary Directive, Brussels, 2013.

38
MEMO/13/1096, European Commission Memo, Fighting Tax Evasion and Avoidance:
A year of progress, Brussels, 2013.

OECD, Action Plan on Base Erosion and Profit Shifting, OECD Publishing, 2013.
Books
Ault H.J., Arnold B. J., Comparative Income Taxation: A Structural Analysis, 3rd
edition, New York: Aspen, 2010.

Foster N., EU Law Directions, 3rd edition, Oxford University Press, 2012.

Lang M., Introduction to the Law of Double Taxation Conventions, 2nd edition, Wien:
Linde, 2013.

Lang M., Pistone P., Schuch J., Staringer C., Introduction to European Tax Law:
Direct Taxation, 3rd edition, Wien: Linde, 2013.

Maisto G., International and EC Tax Aspects of Groups of Companies, Amsterdam:

IBFD, 2008.

Terra B. J. M., Wattel P. J., European Tax Law, 6th edition, The Netherlands: Kluwer,
2012.
Articles
Blessing P.H., The Debt-Equity Conundrum A Prequel, Bulletin for International
Taxation, April/May, Volume 66, No 4/5, 2012.

Bundgaard J., Classification and Treatment of Hybrid Financial Instruments and

Income Derived Therefrom under EU Corporate Tax Directives-Part 1 and Part 2,
European Taxation, Volume 50, No 10, October 2010.

Ledure D., Boulogne F., Dere P., Proposal for amending the Parent-Subsidiary
Directive: European Commission is waging war against double non-taxation,
Internationale Fiscale Actualiteit nr. 2014/01, 2014.

Marchgraber C., Tackling Deduction and Non-Inclusion Schemes The Proposal of

the European Commission, European Taxation, Volume 54, No 4, April 2014.

Patterson B., The Taxation of Parent Subsidiary Companies, European Parliament, DG

for Research, Briefing ECON 543 EN, Luxembourg, 2003.

Uckmar Prof.V., Tax Avoidance-Tax Evasion, IFA Cahiers de droit fiscal

international, Vol. 68a, Kluwer,1983.

Weeghel Prof. Dr S. van, Emmerink F., Global Developments and Trends in

International Anti-Avoidance; Bulletin for International Taxation, Bulletin for
International Taxation, IBFD, 2013.

39
Thesis and doctoral work
M. Helminen, International Tax Law Concept of Dividend, Kluwer Law International,
Internet source
http://books.google.se/books/about/International_Tax_Law_Concept_of_Dividen.html
?id=2_c4vfNQY_8C&redir_esc=y (last visited 25 May 2014), 2010.
Case law
Case 6/64, Costa v E.N.E.L. [1964] ECR 585.

Case C-196/04 Cadbury Schweppes [2006] ECR I-7995.

Case C-321/05 Kofoed v Statteministeriet, [2007] ECR I-5795 88.

Case C-375/98 Ministerio Publico, Fazenda Publica v. Epson Europe BV, [2000] ECR
I-4243.
Internet sources
IBFD Country Analyses - E. Nilsson, Sweden-Corporate Taxation,
http://online.ibfd.org.ezproxy.its.uu.se/kbase/#topic=doc&url=/collections/cta/html/cta
_se_chaphead.html&WT.z_nav=Navigation&colid=4916, (last visited 25 May 2014).

IBFD Glossary,
http://online.ibfd.org/kbase/#topic=doc&url=/highlight/collections/itg/html/itg_fraud.h
tml&q=fraud+frauds&WT.z_nav=Search&colid=4949, (last visited 21 March 2014).

40