The Inherent Tension Between Holding Companies and Tax Abuse
Distinguishing between genuine and artificial arrangements is often a difficult task when it comes to cross-border holding structures.
Holding financial assets, whether equity or debt, for the purposes of generating passive income is by nature something that may not require much activity. In practice, the reason for implementing holding structures is typically related to activities and considerations unrelated to tax – whether it is for aggregating various investors, legal segregation of assets, structural subordination between lenders or something else, there are often valid reasons behind sometimes ostensibly complex structures.
Nevertheless, due to the passive and abstract nature of the activity coupled with the limited need for physical resources, evaluating cross-border holding structures is amongst the most difficult tasks in the field of international tax law and requires surgical precision. This has resulted in a variety of tax doctrines and rules with a slightly different angle on the same underlying question: Is the holding company a “good” or a “bad” one?
The Duality of Economic Activities and Motive
Pursuant to EU fundamental freedoms, as a starting point, genuine establishment for the purposes of carrying out economic activity within the internal market should be protected, whereas abusive arrangements cannot rely on such freedoms. This consists of two cumulative and distinct components.
First, the motive for using a holding company needs to be assessed. It is essential that sufficient non-tax motives for the use of a holding company can be demonstrated. If a holding company is inserted into a structure devoid of any economic and commercial justification, with the essential aim of benefiting from an improper tax advantage, the existence of the holding company may be disregarded for tax purposes to the extent the structure gives rise to tax benefits that are not commensurate with the purpose of the applicable legislation.
Therefore, as the second component, an evaluation of the purpose of the applicable legislation is required. It must be considered if the structure is only formally meeting the conditions of the legislation granting the tax benefit while reaching a result contrary to its purpose. It is not always an easy task to demonstrate whether a holding company is only formally meeting the conditions of the legislation, or engaged in actual economic activities for which the tax benefit is intended.
The fundamental problem with tax rules revolving around genuineness of holding an activity and motives is that they are difficult to measure or quantify. Regardless of the practical difficulties, when considering a specific structure at hand, one cannot pool all the various tax rules under a single concept of “business reasons” or “substance”. It is necessary to understand the detailed nuances relating to both the underlying legal frameworks and the facts of the structure at hand.
One attempt at trying to answer this perennial question, at least to a certain extent, is the proposed “Unshell Directive”, which lays down rules to prevent the misuse of shell entities. Under the proposed directive, entities not meeting the minimum substance indicators could lose access to tax treaties and tax benefits from EU directives. However, under the proposal (as currently drafted), meeting the substance indicators would not prevent member states from applying other anti-tax avoidance measures. Consequently, the Unshell Directive would not provide much needed clarity and certainty to evaluating holding structures, but instead establishes another layer of complex and ambiguous rules to be followed.
“Having business reasons for a holding structure is not always enough. Nowadays, structuring requires a comprehensive understanding of complex tax frameworks so that unexpected pitfalls can be avoided.”
Predicting the Change
Due to the rigidness of structures and long investment horizons, one must also act as a clairvoyant when structuring investments. An exit from a private equity investment takes years, while investment horizons may span decades in real estate and infrastructure projects, and numerous things may change between closing and exit.
Established business practices from decades ago may no longer pass the more intricate and modern tax doctrines. The EU’s proposed Unshell Directive is only a single manifestation of the broader phenomenon related to holding companies. While tax questions revolving around holding companies are nothing new, the so-called Danish Cases rendered by the ECJ in 2019 have elevated the topic to a new level.
Even though the Finnish Tax Administration has not been particularly active in this sector, we foresee that it is only a matter of time before the pan-European phenomenon of tax disputes relating to holding structures reaches Finland. Therefore, it is essential that also bona fide cross-border investors carefully consider their investment structures in the light of the current legal framework and anticipate upcoming changes in the broader international and domestic tax landscape.
If all the complex and constantly developing tax frameworks relating to holding companies would need to be consolidated into a plain rule of thumb, it would perhaps read as follows:
Ask yourself the following question: “Is there a non-tax reason for the holding company existing and does it do anything?” If the answer to both is “no”, then it probably should not be there.
Naturally, the above does not capture all the intricacies of holding structures and should be taken with a pinch of salt.