Update on mergers and acquisitions

Keith Grima​

Fenech & Fenech Advocates, Valletta

keith.grima@fenechlaw.com

Report on a Taxes Committee session at the 11th Annual IBA Finance & Capital Markets Tax Virtual Conference

Session Chair

Jodi Schwartz Wachtell, Lipton, Rosen & Katz, New York

Speakers

Guillermo Canalejo Lasarte Uria Menendez Abogados, Madrid

Olivier Dauchez Gide Loyrette Nouel, Paris

Michael Lane Slaughter and May, London

Cesare Silvani Maisto e Associati, Milan

Paul Sleurink De Brauw Blackstone Westbroek, Amsterdam

Gunther Wagner Hengeler Mueller, Munich

Migration of the corporate seat and European Union Council Directive 2011/16 (as amended) ('DAC 6')

Corporate migration

Jodi Schwartz, the Session Chair, introduced the panellists participating in the session. Cesare Silvani introduced the first topic on corporate migration, outlining that, by virtue of the EU Anti-Tax Avoidance Directive ('ATAD 1'), effective 1 January 2020, EU Member States are required to implement exit tax rules. Silvani highlighted the fact that, due to different implementations and interpretations of ATAD 1, the application of exit tax across the EU is far from uniform.

Silvani set out an example of the tax basis recognition in the country of destination, and the risk of potential double taxation in cases where there is a mismatch in the valuation of the same assets by the different Member States in the country of origin and destination, resulting in a dispute between Member States. He explained that, although such a dispute may be resolved on the basis of Article 25(3) of the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention (the 'Model Tax Convention'), the competent authorities of the respective states are not compelled to reach an agreement in terms of such a provision of the Model Convention. Having said this, he explained that one should keep in mind that the European Commission (the 'Commission') is still working on common corporate tax base rules.

Silvani considered the interaction between controlled foreign corporation (CFC) rules and tax basis recognition rules because, in some instances, Member States may choose not to consider the taxes paid in the country of origin when determining the value of assets. He outlined that, in Italy – a credit method jurisdiction – the position on this matter is quite strict and, regardless of whether the company that is migrating to Italy is subject to exit tax in the country of origin, Italy does not recognise the fair value of the asset and keeps using the same value it used for the determination of the value for CFC purposes. In Silvani's view, this position is not in line with EU law.

Guillermo Canalejo Lasarte explained that, from an anti-abuse rule perspective and a country of destination perspective, the Directive seems to leave a lot of potential for double taxation issues that are not dealt with under the Directive.

Michael Lane explained that, although the United Kingdom is no longer part of the EU, ATAD 1 was still transposed into its domestic law at the time, and provides that if assets move into the UK upon migration from an EU Member State, and have suffered EU exit tax, a market value step up upon entry may be benefitted from. This does not apply to assets migrating from outside the EU.

Migration of holding companies: impact on participation exemption and CFC

Silvani outlined a new trend occurring in Italy that is making it increasingly difficult to migrate holding companies out of Italy because tax authorities are trying to limit the application of the participation exemption on exit taxation. For example, Italian holding companies cannot apply the participation exemption on the deemed realisation of their participations unless they are pure holding companies.

DAC 6 implications

Silvani discussed DAC6 implications with respect to cross-border M&A transactions and reorganisations.

Reference was made to Hallmark B1, which deals with the acquisition of a loss-making company, mainly driven by the buyer's desire to exploit the tax losses of the target company. This is deemed to be quite wide, and is also subject to the 'main benefit test' (MBT).

Silvani described Hallmark C4 as more troublesome as it is very broad, and applies to an arrangement that includes a transfer of assets, where there is a significant difference in the amount treated as payable in consideration for the assets in the jurisdictions involved. Because this is not subject to the MBT, it may be applicable simply by virtue of the fact that the different jurisdictions price the transaction in a different way for tax purposes. Silvani explained that 'transfer of assets' is very broad and may also cover cross-border mergers or spin offs. In his view, this should not include a simple transfer of a company's seat because there is no transfer of assets between two parties.

Reference was then made to Hallmarks E2 and E3. These hallmarks apply to transactions between associated enterprises, as defined, and may therefore arise more frequently, specifically in pre-closing or post-closing restructuring rather than in the M&A deal itself.

In Silvani's view, Hallmark E3 should be given special attention with respect to M&A transactions because it may easily apply to mergers, divisions and re-domiciliation. Silvani noted that there are different approaches in different jurisdictions with respect to the definition of earnings before interest and taxes (EBIT), how one performs a projection of the future EBIT of the transferor and whether an intermediary or transferor can be held liable with respect to a wrong projection of EBIT.

Silvani reiterated that, even if one files an advanced tax ruling application in connection with a merger, that does not remove the obligation to file a DAC6 report.

Schwartz explained that, in many instances, intermediaries interpret the hallmarks in a wide manner and are opting to file reports to ensure that they are covered. Therefore, this may be leading to over-reporting, which is inundating the tax authorities. She asked whether everyone will continue to report in such a manner or whether some intermediaries will take the risk not to report when they feel that there is room to manoeuvre.

On this point, Silvani explained that he personally does not like to report transactions just for the sake of being covered when there is room for interpretation as to whether a transaction is reportable or otherwise, and he only reports where there is a need to do so. He explains that if everyone reports transactions only for the sake of covering themselves when they are unsure with respect to their obligation to report, it will be counterproductive as it would be much more difficult for the authorities to ascertain who is committing a violation. He says that reporting is also dependent on how tough the penalties are for failure to report.

Lane commented that, in the past, many UK intermediaries erred on the side of caution and disclosed many transactions, and to counteract this, Her Majesty's Revenue and Customs (HRMC) narrowed the targeted transactions; however, the UK also increased the effectiveness of sanctions with respect to non-disclosure.

Gunther Wagner agreed that the transfer pricing hallmarks are very wide and make it difficult to assess whether there is an obligation to report. He agreed with Schwartz that, in practice, intermediaries still proceed with reporting and disclosing transactions that possibly fall outside the scope, just to be safe. He explained that Germany is looking into the possibility of applying reporting obligations, even in domestic scenarios.

Olivier Dauchez outlined that the French Bar Association and Brussels Bar Association have asked EU courts whether the DAC 6 reporting obligations are contrary to attorney–client privilege, which applies to lawyers in the EU.

EU Directive on shell entities

Dauchez summarised the provisions of the proposed Council Directive on shell entities, published in December 2021. Dauchez stated that this draft directive raises significant EU law issues.

The directive applies to all entities, whether incorporated or otherwise, that are tax resident in a Member State of the EU, and are eligible to receive a tax residency certificate.

Once an entity is within scope, it must conduct a self-assessment on whether the gateways outlined in the directive are met. If such gateways are indeed met, there is a rebuttable presumption that the entity does not have the required substance and accordingly, the entity must commit to the reporting obligations on minimum substance indicators. If the entity does not meet such minimum substance indicators, it must suffer the tax consequences that are outlined in the directive, which would not allow the entity to access tax relief and benefits of the tax treaty network of the Member States, and qualify for treatment under the Parent-Subsidiary Directive and Interest and Royalties Directive. Alternatively, if the entity satisfies the minimum substance indicators, it is disregarded for the purposes of the directive.

Dauchez referred to specific carve-outs that the directive provides for, and which are applicable with respect to such reporting obligations. He explained that the three cumulative gateway criteria refer back two years, and would therefore be applicable as from 1 January 2022.

Dauchez outlined that the provisions of this directive should prevail over the double tax treaties that are in place between Member States. He explained that the Commission is working on the implementation of further rules that would impact shell entities in third countries, and if this does develop further, one should consider the extent to which the directive could prevail over double tax treaties between Member States and third countries.

Canalejo commented that attention should be given to the collateral effects of the proposal, even if the directive is not approved, seeing as the Commission is setting up substance requirements that may be used as a soft law precedence by the authorities and an objective substance test by the courts.

Dauchez said that the substance requirements outlined in the draft directive are quite strict, and that there was a principle of correlation between substance and the activities being carried out. However, he said that the Commission considered the control of assets and the risks that generate relevant income, and that this must be taken into consideration with respect to future M&A transactions.

Global tendencies on cross-border investment structuring

Canalejo discussed how investment structuring is being affected by new tax legislation, and specifically considered the structuring of passive investments, or investments by private equity funds. He explained that the use of investment holding companies in a 'friendly jurisdiction' is being aggressively challenged at domestic, EU and OECD levels, and that the plain vanilla holding structure is no longer tax efficient or tax feasible.

Canalejo outlined the current context with respect to investment structuring and explained that there is a minefield of anti-abuse rules to consider, both as advisers and also as investors. He believes that there is not much more legislation that can be introduced in terms of anti-abuse rules.

In this context of anti-abuse rules in cross-border M&A activities, Canalejo explained that, in Spain and in other EU Member States, one may observe three distinct structure approaches with respect to an M&A deal:

1. Active: This ensures that the investment is made from a place in which there is adequate substance and adequate economic functions that support the existence of the entity that is making the cross-border investment. Thus, one would ensure that the anti-abuse rules do not apply.

2. Passive: This is effectively the opposite of an active structure, where a tax-transparent partnership-type investment platform is utilised, which may be located in almost any jurisdiction. In this structure, there is no intermediate holding company interposed between the investors and the target entity.

3. Regulated: This is a highly regulated investment platform structure that enjoys a favourable tax regime for itself and investors, for example, undertakings for the collective investment of transferable securities (UCITS), alternative investment funds (AIFs) and venture capital entities (VCEs).

Use of specific risk insurance

Lane provided a brief overview of what specific risk insurance entails and explained that identified risks may be covered separately for an additional premium. He explained that this is becoming more common as more corporate sellers look for a 'clean break' and do not want to stand behind a specific indemnity.

Lane provided several examples of risks that may be covered by specific risk insurance, including the risk of a particular exemption not applying, risk of an opaque entity being treated as transparent or vice versa, and risk of losses not surviving a sale process and being available to set against future profits. He also explained that there have been recent examples of insurers who are willing to insure the outcome of an open enquiry.

Lane considered the main risks with respect to specific risk insurance and outlined the fact that the insurer expects to be provided with all relevant materials, and highlighted the importance that the provision of such materials must be done carefully to avoid losing any privilege and creating new, unprivileged assessments of the taxpayer's position.

Lane explained that, in an M&A context, there may be four potentially interested parties in any insurance claim: the seller, purchaser, taxpayer and insurer. Accordingly, attention should be paid to this because, although the interests of all parties often align, this is not always the case; therefore, this can make negotiating issues particularly difficult.

M&A management packages and compensation

Wagner explained how the management packages and compensation offered in an M&A context have become increasingly important in recent years, as stakeholders continue to realise that good and motivated management is the real value creator.

In this regard, one must distinguish between ordinary income that is generally subject to the manager's individual tax rate, and capital income, which typically requires that the manager holds shares in the company and is usually taxed at a lower rate than ordinary income, using Germany as an example. Wagner explained that management equity participations (MEPs) are installed by investors to incentivise the company's management, and commonly, three MEPs are found: plain vanilla, sweet equity and hurdle share.

Plain vanilla MEPs are described as a pure shareholding with no additional leverage. Sweet equity MEPs are described as shareholding and leverage generated by a disproportionate investment in shares in relation to the grant of shareholder loans. Therefore, the manager's ratio of equity to debt is higher than that of the investors, and hence, bears a higher risk, with a potentially higher reward. Finally, the hurdle share is defined as a shareholding with negative liquidation preference. This means that a certain 'hurdle' must be met for the hurdle share to actually be profitable.

Wagner outlined the importance that the terms of MEPs should comply with the arm's-length principle, which means that the acquisition of shares must be made at fair market value, otherwise, the tax authorities may challenge the treatment and apply the ordinary income tax rate. Shares should participate in the losses of the company, and there should be no downside protection. Wagner reiterated this by explaining how MEPs are being increasingly scrutinised by the tax authorities of EU Member States. If these principles are adhered to, there should be no direct nexus to the employment activity of the manager, and therefore, income should be treated as capital income and charged to tax at the applicable tax rates.

Wagner then considered the term 'carried interest' and explained the general rule of distinguishing between the different levels because carried interest is generally granted to the managers of the fund and not to the managers of the target. In this event, it is an entitlement of the fund's managers to share the fund's profit after the return of capital to investors. Carried interest may only be calculated once the last asset in the fund is sold, and depending on the jurisdiction, the question arises as to whether such interest should be taxed as ordinary employment income or capital income.