EU Mulls ‘Substance Test’ to Determine Zero-Rate Tax Havens

European Union member countries are considering a “substance test” to determine whether a country or jurisdiction with a zero corporate tax rate qualifies as a tax haven that doesn’t reflect “real economic activity.”

After a host of EU member countries rejected in early November the use of a zero corporate income tax (CIT) rate as a criterion to determine which countries end up on an EU tax haven black list due to be finalized by the end of 2017, the Slovakia presidency is pushing to use CITs as an indirect gauge.

Member countries “generally agree that the absence of a corporate tax system, zero or almost zero rate of taxation does not automatically mean that a jurisdiction encourages offshore activities” aimed at attracting profits that don’t reflect real economic activity in the jurisdiction, according to a document presented to the EU Code of Conduct Group of Business Taxation on Nov. 24 and obtained by Bloomberg BNA.

Offshore Structures

The same document adds that there is evidence that jurisdictions that facilitate offshore structures or arrangements “typically have no or very low CIT and that they capture large amounts of global financial flows.

“It would therefore be appropriate to focus on jurisdictions that apply no CIT, zero or almost zero nominal corporate tax rates,” the document states. “In addition it should be verified if the jurisdiction at stake provides for other non-tax incentives such as the existence of legal and regulatory provisions facilitating the setting up of offshore structures or arrangements.”

As a way to evaluate how much the profits attracted to such jurisdictions are related to “substantial economic activity” taking place, EU countries are considering the use of the following:

•  the number of offshore structures or arrangements, including banks and trusts (per number of inhabitants);
•  share of financial services in the total gross domestic product;
• share of assets held by foreign companies; and
• number of employees in the offshore sector.

Two-Tiered Process Concerns

The push by the EU to establish a tax haven blacklist using corporate rates as either a direct or indirect criterion has caused considerable concern with many offshore financial centers around the world that are currently targeted for EU screening due to begin in January. Those concerns are heightened by the decision not to screen EU member states as well as Switzerland and independent territories on the European continent such as Andorra, Monaco, San Marino or Liechtenstein.

“We fully support global standards, but they should apply to everyone,’’ Jude Scott, chief executive officer of Cayman Finance, the association of the financial service industry in the Cayman Islands, told Bloomberg BNA in a telephone interview.

“There should be no difference in the way they are applied in the EU as they are outside the EU. If there are shortcomings, there should be discussions regardless of where they are located.”

Calls for Unbiased Screening

The decision to exempt EU member countries and others on the continent from the tax haven blacklist screening process is also a subject of controversy in the European Parliament.

“The screening process should, of course, also include EU member states and countries such as Switzerland, Andorra etc.,’’ Werner Langen, a German European Parliament member who is also chairman of the institution’s Panama Papers investigative committee set up in the wake of the Panama Papers release, told Bloomberg BNA in an Nov. 29 e-mail.

“The final list should be the result of an unbiased screening process.”

Langen also said that “it should be self-evident that a country with a zero corporate tax rate is a tax haven.”

Common Reporting Standard

However, Scott and others insist the most important criterion for determining whether a country or jurisdiction is conforming to global standards to clamp down on tax evasion should be the Organization for Economic Cooperation and Development’s Common Reporting Standard, to which the Cayman Islands is committed.

“The most effective tool to prevent tax evasion or avoidance is automatic exchange of information through the OECD Common Reporting Standard,” Scott said. “It is inappropriate for the EU to go beyond the OECD.”

Currently both the EU and the OECD are drawing up a tax haven blacklist. Whereas the OECD criteria will judge a country or jurisdiction only on “transparency,” such as the commitment to the Common Reporting Standard or information exchange on request or the OECD, the EU will also use “fair taxation” criteria that include the issue of corporate tax rates and the substantial economic activity test.

European Parliament member Jeppe Kofod, who is the chief spokesman for the Socialist and Democrat political group and serves on the Panama Papers committee, insists the EU must go beyond the OECD.

Referring to the OECD, Kofod told Bloomberg BNA in a Nov. 29 e-mail that history “unfortunately has shown it to be an ineffective forum for setting up a blacklist for tax havens.”

U.S. Dilemma

As EU member states finalize the countries to be screened and the final criteria to be used, they face a major dilemma in how to deal with the U.S., which has not committed to the CRS.

The U.S.’s Foreign Account Tax Compliance Act obliges non-U.S. financial institutions to report the assets and identities of U.S. individuals to the Department of Treasury, in an effort to root out tax evaders. Some EU officials argue that FATCA is a viable subsitute for the OECD’s CRS.

“There is currently an imbalance between what the U.S. has the right to receive in terms of information and what they provide and what all other countries are required to sign up to,” Tommaso Faccio, a lecturer of tax law at the University of Nottingham, told Bloomberg BNA in a Nov. 30 e-mail.

He added that “there are many reasons why the EU may not want to single out the U.S., which are probably similar to reasons why we do not see any EU tax haven on the list or Switzerland.”

January Deadline

EU finance ministers agreed on Nov. 8 to finalize the “fair taxation” criterion by the end of January when the official tax haven screening process will begin.

During the Nov. 8 meeting, the leading low corporate tax rate countries in the EU, such as Ireland, Estonia, Malta, Bulgaria along with the United Kingdom, blocked any direct use of zero corporate tax rates that would automatically consider a country or jurisdiction as a tax haven.

As a compromise, the finance ministers agreed that a country or jurisdiction “should not facilitate offshore structures or arrangements aimed at attracting profits that do not reflect economic activity in the jurisdiction.”

Another “fair taxation” criterion to be used by the EU concerns “preferential tax regimes” such as patent boxes and other measures. The EU is expected to apply OECD Base Erosion and Profit Shifting reforms as a way to gauge whether a country or jurisdiction does not employ preferential tax regimes.