• Freedom of establishment’s abuse in EU
    New rules for old challenges

    By Lorenzo Savastano


    Fighting letterbox entities in EU

    On 25 April 2018, the Commission presented a package of proposals concerning the reform of EU company law (i.e. “Proposal for a Directive of the European Parliament and of the Council amending Directive EU 2017/1132 as regards cross-border conversions, mergers and divisions”). The set of new rules is intended to clamp down on firms that relocate within the European Union exclusively for shrinking their tax bills, by setting up mere letterbox companies. Under the proposed rules, which need approval from EU states and parliamentarians, Countries where companies are originally headquartered would be able to inhibit their relocation to another Member State if “the operation constitutes an artificial arrangement” meant solely to circumvent tax or workers’ rights, by means of thorough preventive scrutiny of business restructuring’s operation.

    Before of analyse the new rules ‘content, it is crucial to outline the jurisprudential screenplay where this reform stands. Therefore, I will take stock of two well-known rulings of European Court of Justice (ECJ) strictly related to that topic.

    ECJ’s landmarks: Cadbury Schweppes and Polbud – Wykonawstwo

    At the outset, it is relevant to note that on the background of the EU rules’ overhaul, there are a plethora of aggressive tax planning schemes carried out by an increasing number of EU companies over last decades, which often resulted in prominent European Court of Justice’s decisions. At the root of these decisions, there is the abusive exploitation of the freedom of establishment ensured by articles 49 and 54 TFEU (Treaty on the Functioning of the European Union), which include the right to take up and pursue activities as self-employed persons and to set up and manage undertakings.

    Amongst others, I want to stress the importance of two paramount judgements issued by the ECJ on that topic, namely Cadbury Schweppes (ECJ, Case C-196/04) and Polbud – Wykonawstwo (ECJ, Case C-106/16) cases. The combined effect of these two cases, indeed, makes apparent the need for positive harmonization of cross-border operations under EU law.

    In the first mentioned decision, the European Court ruled that the freedom of establishment entails, for companies or firms formed in accordance with the law of a Member State and having their registered office, central administration or principal place of business within the Community, the right to exercise their activity in the Member State concerned through a subsidiary, a branch or an agency.

    In this respect, a national measure restricting freedom of establishment may be justified where it specifically relates to wholly artificial arrangements aimed at circumventing the application of the legislation of the Member State concerned. In order to evaluate the conduct of the taxable person, it is necessary to take particular account of the objective pursued by the freedom of establishment. Indeed, the freedom in question is finalised to allow a national of a Member State to set up a secondary establishment in another Member State to carry on his activities there and thus assist economic and social interpenetration within the Community. To that end, freedom of establishment is designed to enable a Community national to participate, on a stable and continuing basis, in the economic life of a Member State other than his State of origin and to profit therefrom.

    By contrast, in Polbud – Wykonawstwo’s case law, The ECJ held that the freedom of establishment is applicable when the registered office alone, without the real head office, is transferred from one Member State to another, if the Member State of new incorporation accepts the registration of a company even without the exercise of an economic activity.

    On that basis, the ECJ concluded that Polbud, a company incorporated under Polish law, has the right to convert itself into a company governed by the laws of Luxembourg, as long as the conditions laid down by Luxembourg legislation are satisfied and in particular that the criteria adopted by the Luxembourg legislation to recognize a company as being a company governed by the laws of Luxembourg is satisfied.

    In that case, in fact, article 49 TFEU does not require such an economic activity as a precondition for its applicability. The novelty of this case is that the ECJ clearly decided that the principle of freedom of establishment applies to a cross border change of form by means of the sole transfer of the registered office of the company. As such, Polbud is allowed to move its sole registered office to Luxembourg without moving its headquarters, irrespective of the fact whether or not Polbud pursues any economic activity in Luxembourg.

    However, in both cases, ECJ highlights that the mere fact that a resident company establishes a secondary establishment, such as a subsidiary, in another Member State cannot pose a general presumption of tax evasion and justify a measure which compromises the exercise of a fundamental freedom guaranteed by the Treaty.

    Tax abuses ‘phenomena identified

    According to the proposal of Directive, corporate restructurings and transformations such as cross-border conversions, mergers and divisions, are part of companies' life cycle and represent a natural way for companies to grow, adapt to a changing environment and explore opportunities in new markets.

    The objective of the proposal at issue is two-fold: providing specific and comprehensive procedures for cross-border conversions, divisions and mergers to foster cross-border mobility in the EU while, at the same time, offering company stakeholders adequate protection in order to safeguard the fairness of the Single Market. Such action forms part of creating a deeper and fairer Single Market, which is one of the priorities of the current Commission.

    The aforementioned typologies of corporate restructurings are defined as follows:

    • Cross-border conversions: an operation whereby a company, without being dissolved, wound up or going into liquidation, converts the legal form under which it is registered in a departure Member State into a legal form of a company of a destination Member State and transfers at least its registered office into the destination Member State whilst retaining its legal personality;
    • Cross-border mergers: an operation between companies in which a company being acquired transfers all its assets and liabilities into the acquiring company without issuing new shares. Such an operation will fall under the scope of the proposal in question, if the merging companies are owned by the same person or the ownership structure in all merging companies remains identical after the completion of the operation;
    • Cross-border divisions: an operation in which a company (the company being divided), after its dissolution, but without going into liquidation, contributes its assets and liabilities to two or more pre-existing or newly formed companies (the recipient companies) in exchange for the issue of shares to shareholders.

    In such cases, competent Authorities of the Member State of the person that intends to carry out one of the above-mentioned operations can:

    • Release a Pre-operation certificate: The Member State of the company shall ensure that the competent Authority shall not authorise the business restructurings (i.e. conversion, merger or division) when it is likely that it constitutes an artificial arrangement aimed at obtaining undue tax advantages or at unduly prejudicing the legal or contractual rights of employees, creditors or members. For that purpose, an examination of the specific case and all relevant facts and circumstances is needed.
      Moreover, the national law of the Member State of the company in question shall govern the part of the procedures and formalities in order to obtain the pre-operation certificate. On the other hand, the national laws of the Member States of the recipient companies shall govern the part of the procedure and the formalities to be complied with following receipt of the pre-operation certificate in compliance with Union law.
    • Undertake an In-depth assessment: in case of business restructurings, competent Authorities will have to undertake an in-depth analysis. In such an assessment, Tax authorities have to consider all relevant facts and circumstances and shall take into account at a minimum the following features:
      (…) the characteristics of the establishment in the Member States concerned, including the intent, the sector, the investment, the net turnover and profit or loss, number of employees, the composition of the balance sheet, the tax residence, the assets and their location, the habitual place of work of the employees and of specific groups of employees, the place where social contributions are due and the commercial risks assumed by the company being divided in the Member State of that company and Member States of recipient companies. Those elements may be only considered as indicative factors in the overall assessment and therefore shall not be considered in isolation (…)” [see artt. 86n(1); 160p(1) of the Proposal of Directive].

    Concluding remarks

    To conclude, the proposal at issue is a further step in the pivotal fight against the abuse of the freedoms guaranteed by the European Union law within Single Market. It is needless to say that copying with artificial arrangements is a multi-pronged issue, investing not only commercial concerns but also (and above all) tax wrongdoings. It is apparent, indeed, that tax alarms are the priority of the proposal of Directive, since the misuse of letterbox entities is targeted. Thereby, the proposal represents a higher level in the contrast to aggressive tax planning than stand-alone rulings of ECJ, but the clear fine-tuning of an enforcement mechanism against letterbox entities in the EU market has still a long way to go.

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  • The information provided in this article is for general information purposes only. The information is not intended to be comprehensive or to include advice on which you may rely. You should always consult a suitably qualified professional on any specific matter.

Lorenzo Savastano

Lorenzo Savastano is an Italian police officer belonging to Guardia di Finanza, a highly specialised military Corps committed in fighting economic and financial crimes, both on national and international level. He obtained two master’s degrees with honors, respectively in Law and in Economic and Financial Security. In addition, he attended several courses of advanced studies in International and Corporate Tax Law as well as in Tax crimes investigations. As aggressive tax planning and financial law enforcement specialist, he currently deals with corporate illicit activities and white collar crimes investigation.

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