Residence of Corporate Subsidiaries – Two Wrong Baselines and Four Lines of Defense EATLP Congress 2017 Lodz Wolfgang Schön Max Planck Institute for Tax Law and Public Finance Munich

Residence of Corporate Subsidiaries The concepts of residence and source are decisive for the international allocation of taxing rights with regard to the taxation of income. Source refers to the place where income is earned. Residence refers to the place where income is consumed. As corporate entities do not « consume » income, what sense does it make to make taxing rights dependent on corporate residence?

Residence of Corporate Subsidiaries What role for corporate residence in tax matters? What role for corporate residence of subsidiaries in tax matters? The corporate income tax is meant as a backstop/prepayment for the individual income tax. Corporate residence of parent company is meant as a placeholder for residence of shareholders – hardly sustainable in modern economies with open capital markets Is the residence of a subsidiary also meant as a placeholder for the residence of its (indirect) shareholders? Or is the residence of a subsidiary meant as an indicator of source taxation (running parallel to the „permanent establishment“ concept)?

Residence of Corporate Subsidiaries First Baseline: The residence of subsidiaries as a placeholder for the residence of (indirect) shareholders? Globalisation has led to an increasing disconnect between the residence of shareholders and the residence of the parent company. The structure of a multinational group is built on the location of subsidiaries being distinct from the location of the parent company (largely due to non-tax reasons) The residence of subsidiaries bears no systematic relationship to residence of underlying shareholders!

Residence of Corporate Subsidiaries Option: Corporate residence should follow shareholder majority residence. Residence of subsidiaries should follow parent company residence. (Fleming/Peroni/Shay, Defending Worldwide Taxation With A Shareholder-Based Definition of Corporate Residence, BYU Law Review (2016) p.1681 et seq.) Problem: Shareholder composition is not stable. DAX 30-Companies less than 40 % German stockholders. Change in shareholder basis might lead to „exit taxation“. Insurmountable procedural obstacles to taxation of foreign- based businesses (having no incorporation and no central place of management in the respective country)

Residence of Corporate Subsidiaries Second Baseline: The residence of the corporate subsidiary as an indicator of „source“? BEPS Action Plan: Taxation should follow „value creation“ and „economic activity“. Problem: Taxation according to the „residence“ of a subsidiary is not in line with these goals: Subsidiaries are taxed on a residence basis with regard to „passive“ income (Art.10 – 12 OECD Model Tax Convention); the country of origin is at most in the position to charge a limited withholding tax. Intra-group dealings can be used to shift assets, risks and functions between legal entities irrespective of the territorial location of the underlying activity. The choice between debt and equity in intra-group financing is crucial for the allocation of income between group entities.

Residence of Corporate Subsidiaries Option: Raising the threshold of residency in order to require economic sub-stance and to make tax avoidance more costly. The concept of residence then serves as a „friction“ – a discontinuous disincentive for the taxpayer. (Schizer, Frictions as a Constraint on Tax Planning, 101 Colum. L. Rev. (2001), p.1312 et seq.) Levelling-Up: Free Choice of Tax Liability (Electivity) Incorporation (Registration Fee, Corporate Law Issues) Place of Board Meetings Place of Senior Management Day-to-Day Operations

Residence of Corporate Subsidiaries First line of defense: BEPS-related requirements for profit allocation under transfer pricing rules: analysis of corporate functions and „control“: „The steps in the process set out in the rest of this section for analysing risk in a controlled transaction, in order to accurately delineate the actual transaction in respect to that risk, can be summarised as follows: 1) Identify economically significant risks with specificity (see Section D.1.2.1.1). 2) Determine how specific, economically significant risks are contractually assumed by the associated enterprises under the terms of the transaction (see Section D.1.2.1.2). 3) Determine through a functional analysis how the associated enterprises that are parties to the transaction operate in relation to assumption and management of the specific, economical-ly significant risks, and in particular which enterprise or enterprises perform control functions and risk mitigation functions, which enterprise or enterprises encounter upside or downside consequences of risk outcomes, and which enterprise or enterprises have the financial capacity to assume the risk (see Section D.1.2.1.3).“ (OECD/G20: Aligning Transfer Pricing Outcomes with Value Creation, Action Items 8 – 10: 2015 Final Reports, para 1.60; critical Schön, International Taxation of Risk, Bulletin of International Taxation, 2014, p.280 et seq.)

Residence of Corporate Subsidiaries Second line of defense: Limitation on Benefits-Provisions in Double Taxation Conventions making the availability of treaty benefits for corporate entities dependent on the domestic residence of persons that own (…) at least 75 per cent of the beneficial interests of the resident; on the „active conduct of a business“. (Art.7 par.6 et seq. of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting) It is very clear that the first prong relates to „economic activity“ (source) and the second prong relates to the residence of the ultimate shareholders.

Residence of Corporate Subsidiaries Third line of defense: CFC Rules providing allocation of corporate income to the parent company on the basis of Substantial level of foreign shareholders Passive income Low tax level No economic substance (EU Law): “If checking those factors leads to the finding that the CFC is a fictitious establishment not carrying out any genuine economic activity in the territory of the host Member State, the creation of that CFC must be regarded as having the characteristics of a wholly artificial arrangement. That could be so in particular in the case of a ‘letterbox’ or ‘front’ subsidiary (see Case C-341/04 Eurofood IFSC [2006] ECR I-0000, paragraphs 34 and 35). ECJ, Case C-196/04 (Cadbury Schweppes) para 68.

Residence of Corporate Subsidiaries Fourth line of defense: nexus-requirement for intangible-related tax benefits “This approach looks to whether an IP regime makes its benefits conditional on the extent of R&D activities of taxpayers receiving benefits. The approach seeks to build on the basic principle underlying R&D credits and similar “front-end” tax regimes that apply to expenditures incurred in the creation of IP. Under these front-end regimes, the expenditures and benefits are directly linked because the expenditures are used to calculate the tax benefit. The nexus approach extends this principle to apply to “backend” tax regimes that apply to the income earned after the creation and exploitation of the IP. Thus, rather than limiting jurisdictions to IP regimes that only provide benefits directly to the expenditures incurred to create the IP, the nexus approach also permits jurisdictions to provide benefits to the income arising out of that IP, so long as there is a direct nexus between the income receiving benefits and the expenditures contributing to that income. This focus on expenditures aligns with the underlying purpose of IP regimes by ensuring that the regimes that are intended to encourage R&D activity only provide benefits to taxpayers that in fact engage in such activity.” (OECD/G20, Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5: 2015 Final Report)

Residence of Corporate Subsidiaries Conclusions: The Concept of Residence is precarious for parent companies and next to useless for subsidiaries Thresholds for residence work as costly „frictions“ as regards the free allocation of corporate income. These thresholds are complemented by additional requirements under Transfer Pricing Rules, LOB Provisions, CFC Rules and the Nexus Approach.

Residence of Corporate Subsidiaries Epilogue: What happens if we disregard the distinct status of the subsidiary as a corporate entity and self-standing taxpayer altogether? Depending on the respective tax regime there will be world-wide current taxation of both passive and active income or territorial taxation – depending on adherence to the credit method or the exemption method for foreign-sourced income. Profit allocation would follow the „Authorized OECD Approach“ which treats the PE as functionally equivalent to a subsidiary and looks to „significant people“: “The functional and factual analysis takes account of the functions performed by the personnel of the enterprise as a whole including the PE – “people functions” – and assesses what significance if any they have in generating the profits of the business. People functions can range from support or ancillary functions to significant functions relevant to the attribution of economic ownership of assets and/or the assumption of risk “ (OECD, 2010 REPORT ON THE ATTRIBUTION OF PROFITS TO PERMANENT ESTABLISH-MENTS, para 62)