DAC6 Examples for Corporates - IP Box Scenario

Previously, BlueBridge had presented a webinar on the DAC6 Intragroup Hallmarks, which target cross-border transactions between (mainly) related parties seeking to arbitrage differing tax treatments across jurisdictions. During that webinar, we explored the underlying aims and EU-wide interpretations of these Hallmarks. Due to time limitations, however, we set up a subsequent webinar in which we explored three concrete examples: The IP box scenario, a hybrids’ scenario and an asset transfer scenario. The following is lifted from our DAC6 Examples’ webinar, including these items:

• An introductory table featuring a brief description of the scenario set out in the particular DAC6 Example and key concepts and DAC6 Hallmarks examined through the DAC6 Example
• A diagram depicting the scenario underlying the DAC6 Example
• The nearly verbatim transcript of our webinar presentation

You can access the 19 May 2021 webinar video and slides in our webinar recap.

Transcript extract [Paul Millen speaking….]

Here we see illustrative example number one. We have a corporate HoldCo that is located in France, and it's owned by a Swiss person and a French person. And at a minimum amongst other activities, perhaps, this corporate HoldCo holds the following three wholly owned subsidiaries, an operating company in France, an operating company in the UK, and then an IP holding company that's located in Cayman. 
 

Deductible Payments

And we're going to consider what happens from a DAC6 standpoint when certain transactions take place. So in theory, the IP HoldCo holds all of the IP of the nonfinancial group, and then it licenses this IP for use in France or the UK to these operating companies.  Of course, the operating companies have to make royalty payments back towards the IP HoldCo. So what happens when the French operating company makes a royalty payment to the Cayman IP HoldCo? Well, what we're going to be looking at here are the deductible payments made to associated enterprises. That's the general topic for the Hallmarks C1.
 
First, two quick points. Deductible payments basically mean any expenses, reasonable expenses incurred in the operation of a business that are not capitalized. So these are not for capital assets. A capital asset is a building or a machine in which over the course of time you're able to take depreciation upon.  Whereas a deductible expense is an expense that you can use to reduce your taxes in the year in which you do it. That can be the salary you pay to your employees, that can be interest payments on loans, or in this scenario that can be royalty payments for IP or other things that you've licensed. 
 

Associated Enterprises

Secondly, the Associated Enterprise definition is a related party definition. To wit, what level of joint ownership would you treat two distinct entities as more connected and not treating each other as completely third parties?  The definition seeks to identify the area where the laws of the market no longer apply to all the transactions, because in an example where you have a HoldCo and an operating company, you could do a deal that's very beneficial for the HoldCo and not beneficial for the operating company. But what really matters is that in the aggregate, it really benefits the corporate group. Here, it helps if you have a consolidated balance sheet, but it can be further afield. It can be people who own these companies and somehow are able to exercise control over them in a range for transactions that again, don't specifically benefit each of the companies individually, but do as a whole benefit the owners of those companies. Associated enterprises and deductible payments, that's what we're looking for and clearly have here, where we have a royalty payment made to a sister company. So from the operating company in France to the IP HoldCo in Cayman, both of these standards are squarely met.

Deductible Payment to Recipient with No Tax Residence

Next let’s look then to HMC1(a), the payment, deductible payment, we have that, to an associated enterprise. We have that, and the Associated Enterprise has no tax residence. Well, as many of you will know, Cayman does not have a corporate tax rate and therefore Cayman has no need to define corporate tax residence for purposes of its corporate income tax. Maybe it has to for other purposes of CRS or FATCA or something like that, but it does not have what's generally referred to as a definition of corporate tax residence. Therefore, you would say, it has no tax residence, and this Hallmark should be met. That is not the case in fact. This Hallmark is not designed to capture jurisdictions that do not have a corporate tax rate, and therefore do not have a definition of corporate tax residence. What they're trying to ferret out are stateless corporations, a much smaller group than corporations located in tax-free jurisdictions. A stateless corporation is a corporation that is set up in a way that it avoids being subject to the laws of any jurisdiction for taxation matters and possibly other matters. The way this works is certain jurisdictions will have a strict definition of corporate tax residence that applies to anyone who is established or incorporated under the corporate laws of that jurisdiction, okay? Other jurisdictions will have a standard that says, no, you are resident where you are effectively managed and controlled.  Also, many jurisdictions will apply both. There's a variety of them. But in an example where you had two jurisdictions each one applying a strict version of these two distinct standards for the definition of corporate tax residence, it would not be impossible to set up the company in the jurisdiction with the effective management and control standard, manage it out of the jurisdiction with a strict place of establishment standard and therefore result in a stateless corporation. This is purely theoretical because I've never actually seen one of these, but I'm sure they exist because if it's possible, it's done. However, the point here is that a corporation set up in Cayman that would be subject to Cayman tax, if there were a Cayman corporate tax, does not satisfy HMC1(i). 
 

Deductible Payment subject to Recipient subject to a 0% or Near-0% Tax Rate

Of course, anyone who's been reading ahead on the slide is going to be pretty sure that we do satisfy the next Hallmark HMC1(b)(i). Here we have a deductible payment, check, to an associated enterprise, check. And that Associated Enterprise is subject to a 0% or near 0% tax. As mentioned a moment ago, Cayman has a 0% corporate tax rate. So, this particular payment would seem very much to qualify as a Reportable Cross-border Arrangement subject to disclosure under DAC6. However, for that particular Hallmark, as with about half of all of the total Hallmarks, there is a second criterion that must be satisfied before the Cross-border Arrangement becomes reportable. And that is referred to as the Main Benefit Test. Now, we've talked about the Main Benefit Test a lot on these webinars. So bear with me those of you who have been attending regularly. In fact, we even have devoted an entire webinar to this topic because it's varied, diverse, fragmented across the EU and quite complicated the way different jurisdictions have addressed it. But, I'm going to address it in a fairly simplified manner today, and just share the version of the Main Benefit Test included in the DAC6 directive. That queries whether the main benefit or one of the main benefits, having regard to all the facts and circumstances around the transaction, that a party may reasonably expect to derive from a Cross-border Arrangement is the obtaining of a tax advantage.  Well, it's not hard to see here that having IP in a tax-free jurisdiction and licensing that IP to your operating companies in a higher tax jurisdictions has a real tax advantage to it. It can sharply reduce your consolidated effective tax rate. And it's of course, one of the headline issues that we've seen in recent years, whether it's Starbucks or Amazon, or any number of companies holding their IP in a certain jurisdiction and they're reducing their overall tax outlay by charging strenuous, let's say, licensing fees which can reduce the income of the operating companies that are not taxed in the jurisdiction of the IP HoldCo.
 

The Main Benefit Test

I think pretty clearly that the Main Benefit Test will be met in most circumstances here. Now, an interesting wrinkle could be where the IP is actually developed in Cayman as opposed to transferred there. In many circumstances, the IP will be developed in France or UK or US or Switzerland or wherever you are, but usually not in Cayman or a BVI or the Channel Islands or a place like that. And though typically what happens is that it's developed in a larger country, and then it's transferred over to the IP holding jurisdiction. And in those circumstances, obviously you're going to have transfer pricing issues as well. Then, it'll be hard to argue that tax wasn't the major motivation for sending the IP to the non-tax jurisdiction and setting up this whole licensing process. However, if you had developed the IP in that particular jurisdiction, you could make a defensible argument that this particular transaction was not tax driven. You could try to argue that this particular transaction was driven by the need for the French operating company to obtain a license for this IP and the royalties that it therefore has to pay. The consequences of which are perhaps a tax benefit to the overall company, but are not one of the main benefits of this transaction. That might stand up. It's worth looking to see if you can make the claim. On the other hand, what I would expect is that the tax authorities will then step back and say, okay, but the reason you set up your IP development operations in the non-tax jurisdiction is because you foresaw the tax benefits that you would derive from it. So, perhaps that will work, perhaps not. It depends perhaps on some of the other circumstances around there. Still, I thought when it occurred to me,it was an interesting wrinkle because you don't usually see the IP developed where it's held in a situation like this, in a tax driven situation. Otherwise, in my view, I think this would clearly qualify as a Reportable Cross-border Arrangement, irrespective probably of whether the IP was developed in Cayman or just transferred over there.

Deductible Payment to Resident of a Blacklisted Jurisdiction

Now let's look at the next Hallmark, which is C1(b)(ii). This one says the jurisdiction of the associated enterprise, the recipient of the deductible payment, is it on a blacklist? The EU and the OECD maintain these blacklists that they update on a regular basis. They use them in order to exert significant pressure on these jurisdictions to improve various parts of their financial regulation and tax. Well, let's say to come into line what the EU and the OECD wants them to do from a tax perspective. Now Cayman is not on that list. The only jurisdiction of real interest, I think, to European countries at the moment that is on the list is Panama. Panama of course, is a major flag of convenience. So, shipping companies are particularly interested in Panama being on a blacklist.
 
Here you could say, okay, no problem. Cayman's not on the blacklist, EU or OECD anymore. So this will not trigger reporting. That's fine. But what's key to think about here is the timing of the blacklist. If we have a situation like this where one party is licensing the IP chances are there was a contract made and the contract runs for five, 10, 20 years, however long is relevant for the particular industry. If you look closely though at the DAC6 language, they don't talk about when was the contract set up to make these deductible payments, they ask when the deductible payment was made. So it would be possible for this arrangement to have been set up today or years ago and be not subject to disclosure under this particular Hallmark. But in five years when the contract is still running, then you might have Cayman for some reason, I don't think it will, but for Cayman to end up on the blacklist.  In which case, all of a sudden all of these IP royalty payments made into Cayman are going to be subject to disclosure under DAC6. So that's something to keep in mind is that if you're in charge of setting up these arrangements, you may want to future-proof them somehow by perhaps allowing the contract to be annulled if the jurisdiction of the IP holding company ends up on an OECD or EU blacklist, if it's worth it, just something to keep in mind.  It may not be worth it. I mean, disclosing something like this is not going to get you in trouble.

Deductible Payment Subject to a Preferential Tax Regime

Let’s go to the final Hallmark that we're going to look at in illustrative DAC6 example number one, which is where the payment is subject to a preferential tax regime. Now we can ignore Cayman for now.  Cayman doesn't need a preferential tax regime because its entire tax regime is preferential if you will. You can't get much better than 0%. But in other jurisdictions, including many EU ones, Switzerland, Luxembourg and many other places, they have specific reduced tax rates for certain types of activities.  And you can find these preferential rates for software development or IT development, you see that. You see it with shipping tax that can have a reductive effect on the taxes for shipping companies in order to encourage them to operate out of their jurisdictions. But by far the most popular one is a patent box or an IP box. For that, you would have a jurisdiction that says, okay, we have whatever, 10, 20% tax rate for normal corporate income. However, if you can establish that that corporate income is tied to intellectual property licensing fees, then it gets reduced to 10% or 5% or whatever is appropriate. 
 
In that situation, if we had the French operating company paying into an IP HoldCo in a jurisdiction where that particular type of income was subject to a lower tax rate than the normal corporate income is, then you would have HMC1(b) satisfied on the surface.  Now, here we come to one of those fragmentations that we're seeing in DAC6 across the EU. The EU itself has looked at preferential tax regimes, and split them into harmful and non-harmful types of preferential tax regimes. And while the DAC6 directive itself says nothing about the harmful versus non harmful distinction, it just refers to preferential regime, certain jurisdictions in the EU, such as Cyprus and a few others that have such preferential tax regimes on the books that have been deemed to be not harmful by the EU have taken the position that preferential is synonymous with harmful. Therefore if the tax regime is not harmful, then even if it looks like a preferential tax regime and acts like a preferential tax regime there is no disclosure requirement under DAC6. 
 
Here, we have an interesting problem that might arise where you have this particular type of arrangement between entities in two different EU member states and one adopts the harmful preferential equals harmful and the other does not, and a transaction becomes reportable in one jurisdiction, but not another jurisdiction. This can be particularly troubling where perhaps the two entities involved, the ones who would normally have the disclosure responsibilities under DAC6, perhaps they would both treat this as preferential equals harmful. And therefore they would say something that's not harmful is not preferential and so it doesn't meet DAC6. But what if there is a so-called Relevant Taxpayer? The beneficiary of the tax advice. What if they're in a jurisdiction like Germany, for example, that completely jettisons the harmful non-harmful distinction? Then you're looking at a situation where the payment subject to the preferential tax regime is not a Reportable Cross-border Arrangement in the jurisdictions of the intermediary. And therefore you think, fine, but then you have to look to see if it's reportable in the jurisdiction of the Relevant Taxpayer. If it were, the reporting responsibility under that particular Hallmark should fall on the Relevant Taxpayer. In this wrinkle, you can see where the fragmentation across the EU is creating a whole raft of unexpected and really unwelcome, unintended consequences.

Conclusion

That's what happens when an operating company in France makes their payment to the HoldCo in Cayman. It's disclosable almost certainly because it's a payment made to an Associated Enterprise in a jurisdiction with a 0% corporate tax rate.  And it's almost certainly going to satisfy the main benefit tax because so many of these situations are–in part at least–tax driven.