The principle of ‘Substance over Legal Form’ is central to the faithful representation and reliability of information contained in the financial statements. The key point of the concept is that a transaction should not be recorded in such a manner as to hide the true intent of the transaction, which would mislead the readers of a company's financial statements. In this article we intend to investigate how this principle travels outside the scope of financial statements, how it affects the tax planning community and we will analyze the tax ruling practice.
The doctrine ‘Substance over Legal Form’ allows tax authorities to ignore the legal form of an arrangement and to look into what happened actually. The aim is to prevent artificial structures from being used for tax avoidance purposes. In order for a company to enjoy the beneficial tax regime of its jurisdiction it must comply with the substance requirements of the local tax authorities. Such requirements may vary from country to country, but if analyzed, they all are about the economic substance: there must be substance to the structure of the company and substance to the transactions it enters into. The real substance of the structure is the sum total of many factors that make the company/the transaction ‘real’ and prove its physical presence (its office, its director, its employees) / its economic purpose (answering to the questions: why was this transaction made? how did the parties benefit from it? was the transaction unnecessarily complicated?)
Introduced by OECD (as the European system of accounts principle), nowadays the substance is closely examined not only by tax authorities, but compliance officers, banks, administrative service providers. Gradually, economic substance has become an extremely important issue. It is especially true after a number of internationally known court cases such as the Vodafone case in India. What was put to scrutiny is the real justification for the existence of a holding company. The Supreme Court of India resolved that because the purchase of shares of an Indian company by Vodafone was made through two foreign companies (those of the Netherlands and the Cayman Islands) the transaction was not subject to taxation in India. If a company is used in an existing structure already operating, with the obvious reason of gaining access to the benefits of Double Tax treaties, chances are that the structure will fail altogether and be regarded as fictitious thereby not be able to obtain those treaty benefits it sought. What is needed in order not to be exposed to this substantial tax risk is proper and sufficient substance. Another case where the use of a Dutch company (for the receipt of dividends) was the Volvo case . The court took the side of Volvo, after the use of a Dutch company for tax planning purposes was put to question.
However, in other international cases as the Canadian case of Prévost the absence of substance was held not to be an issue. Nevertheless, the recent approach of both OECD as well of most EU States show that substance is indeed a factor that must not be overlooked.
One of the advanced countries with a developed mechanism of real substance identification – the mechanism of tax rulings – is the Netherlands. We will explain how tax rulings work on companies with real substance, thus, securing the tax benefits the jurisdiction offers.
In fact, a tax ruling is an official confirmation of the tax authorities that allows business owners to know in advance their duties and rights, the tax burden under certain circumstances in certain transaction, and the decisive aspect is the substance.
Within the framework of tax ruling there are two types of agreements with the tax authorities. Advance Tax Ruling is an agreement on the Dutch tax classification of international structures in respect of the applicability of the participation exemption and the presence of a permanent establishment in advance. Advance Pricing Agreement is in effect an agreement that approves in advance the determination of the arm’s length price or method of profit calculation with respect to cross border transactions between related (group) companies and cross border transactions between an entity and its foreign permanent establishment.
Advanced Tax Ruling (ATR) can be obtained with respect to certain international structures with hybrid finance activities or with hybrid entities. The ruling needs to be applied for by the inspector competent for the taxpayer who has to submit the ruling request for approval to the APA/ATR-team of the tax inspectorate in Rotterdam in the following situations:
A country which may want to follow the Dutch model is Cyprus. In this island for a holding company to enjoy the benefits of the tax legislation and the numerous Double Tax Treaties it has to prove its tax residency, i.e. that its management and control is indeed exercised in Cyprus. In the absence of a formal definition of the management and control requirement, the following parameters are normally accounted for:
On a more general note, to sum it all we would like to look at some ‘substance over form’ solutions. It is crucial to understand that enhancing substance always should be tailor-made. Any attempt to generalize will rather prove dangerous than useful. Therefore, below are only intend to point out the items to consider. It is in no way a ready solution.
1. Always get tax opinion before entering into a transaction or establishing a structure. Getting advice in advance will ensure that every transaction has undisputable economic substance. Get tax ruling where possible. It is important to remember that there is no standard approach to when sufficient substance has been achieved.
2. Apply proportionality in the distribution of functions, assets, profits and losses in your companies.
3. Directorships: appoint qualified directors who have the ability to make decisions and understand the nature of business. Must be residents of the relevant jurisdiction. Must have the proper background. Avoid setting up a structure in which directors of a foreign company are the same as directors of the source company. In this case tax authorities will almost certainly question the economic substance and the reality of the decision-taking.
4. Maintain office presence: make a fully-fledged real office, rent an office space, have a dedicated landline, fax, internet lines, website, email addresses, hire real employees, register with the labour office as an employer
5. Maintain business records: original minutes of board meetings and general meetings, emails, general administration, archive, filing and accounting should be kept at the seat of the company.
6. Make contracts/agreements through the Company, avoid powers of attorney to execution of contracts and decision taking.
7. Continually develop the company. It is essential to demonstrate economic substance throughout the company’s lifetime.
8. Use transparent tax planning decisions: some cases, when they are largely tax-motivated, the treatment might not be altered by a tax authority.
9. Lastly, and importantly, in anything you do, mind that the tax authorities shall question the substance, i.e. will ask ‘why was this transaction made?’
In this article we attempted at bringing your attention to a relatively new trend – substance requirements for tax planning purposes. Although, no specific requirements are put down in laws, this issue is extremely important: the tax authorities shall look for substance in your transaction/company and take a decision whether you can enjoy tax allowances of a jurisdiction. The tax ruling practice of the Netherlands can serve a successful model for other countries and can bring you closer to the result you look for.