In an alarming development for some private equity funds, the Court of Justice of the European Union (the CJEU) has issued two judgments in the combined N Luxembourg 1 (Case C-115/16), X Denmark (Case C-118/16), Danmark I (Case C-119/16) and Z Denmark (Case C-299/16) v Skatteministeriet and T Danmark and Y Denmark Aps (C-116/16 and C-117/16) (I'll call them the Danish conduit cases) which implies support for, or at the very least fails to quash, the proposition that the establishment of holding companies in Luxembourg and other European jurisdictions can be abusive and may not qualify for exemption from withholding tax under the Interest and Royalties Directive (2003/49/EC) or the Parent-Subsidiary Directive (90/435/EC, now replaced by 2011/96/EU), even where the holding companies are established on a commercial basis. This follows a recent decision of the Italian Supreme Court (No. 32255), which also denied the withholding tax exemption under the Parent-Subsidiary Directive, though for different reasons

The CJEU judgment does not actually decide the cases, which will now return to the Danish courts to interpret and apply to the facts in light of the typically Delphic pronouncements of the CJEU

There are slight differences between the fact patterns in the various cases, which will also be relevant to multinational companies and others that have made use of intermediate holding companies. The first case (C-115 and C-116) is relatively typical and will be a familiar scenario to those involved in private equity transactions. A consortium of private equity funds with a typically diverse pool of investors acquired a Danish company (a service provider). In order to make the acquisition, the funds set up a string of Luxembourg and Danish companies. The acquisition was partially financed by a loan from the funds to the Danish acquisition company. When Denmark introduced withholding tax on interest, the group reorganised so that the debt was acquired by one of the upper tier Luxembourg companies, which was itself financed by back to back loans leading back to the funds. The Danish acquisition company paid interest on the debt without withholding tax in reliance on the Interest and Royalties Directive. Following a further reorganisation, the Danish acquisition company paid dividends to another of the upper tier Luxembourg companies, this time relying on the Parent-Subsidiary Directive to escape withholding tax

SKAT, the litigious Danish tax authority, now asserts that withholding tax should have been paid and is seeking to recover it from the Danish acquisition company (or its successor).

Private equity holding companies

The question of the entitlement of private equity holding companies to treaty benefits is extremely topical in light of BEPS action 6, leading to the ongoing introduction of principal purpose tests (PPT) into a number of double tax treaties and the inclusion of new examples on this question in the commentary to the OECD model tax convention (see our article 'Tax issues on private equity transactions' (Brenda Coleman, Andrew Howard & Leo Arnaboldi III), Tax Journal, 7 November 2018). This judgment serves as a reminder that, at least in the eyes of several tax authorities, similar questions already arise under existing law, whether as a matter of domestic law or as a matter of interpretation of double tax treaties or EU Directives

Before going on to consider the CJEU judgment, it is worth looking at the question of intermediate holding companies from the perspective of a private equity fund. A typical fund will have a wide range of investors; many will be established in jurisdictions with a good double tax treaty network, such as the US, and/ or will be generally tax exempt, such as large pension funds or sovereign wealth funds. The aim of private equity structuring is to avoid the investors being subject to an increased level of taxation compared to direct investment. Unlike a large corporation, the fund will not have a natural home jurisdiction. The manager effectively has a free choice when it comes to determining which jurisdiction to establish the fund vehicle (commonly a tax transparent partnership) and any holding companies in. Both investors and financiers are likely to require that the fund makes its investments by establishing at least one holding company. Notwithstanding the impracticality of subjecting its investors to having to suffer withholding or claim exemption from withholding, it is not in any case practicable for a fund to simply invest directly into a target company.

The fund then faces the question as to where to establish the holding company. A number of European jurisdictions, notably Luxembourg, but including Denmark at one time, as well as the UK, have explicitly developed tax regimes which are favourable for holding companies. While tax will be a factor there are multiple other factors. Funds are likely to favour jurisdictions where they have a presence, and many funds have developed a presence in Luxembourg over time. It is common for such funds to make investments through Luxembourg holding companies even where there is no tax benefit (and often a tax cost) in doing so and some funds will structure all their investments through a master holding company there

Private equity funds have traditionally provided a significant portion of the capital for their investments in the form of debt. In many jurisdictions, within the limits permitted by transfer pricing, the interest on such debt would have been deductible against the business profits of the target. BEPS developments have now made it increasingly difficult to achieve deductibility for shareholder debt. Nonetheless, many structures still use shareholder debt due to commercial drivers such as the ease of repatriating funds by repayment of debt, and the priority afforded to debt claims in an insolvency. As a result, many funds have also established platforms in particular jurisdictions which they use to establish finance companies

Here, too, Luxembourg is a favourite jurisdiction: access to treaties and EU directives is undoubtedly a factor in that success. Such a finance company will typically have premises, and suitably qualified directors/ employees. It can be expected to make a turn which is more than sufficient to cover its costs. However, it should also be noted, as it was by Advocate General Kokott (the AG) in one of her opinions on the Danish conduit cases, that group finance companies, like holding companies, are not labour intensive: there is simply not very much to do during the life of a performing transaction.

Stepping back, though, there is little doubt that the use of Luxembourg and other holding companies produces a better tax outcome than direct investment out of the fund, both in light of the reduced admin, but also because while a significant majority of investors may otherwise be entitled to exemption from withholding taxes, this is unlikely to be 100%.

There is a question for the jurisdictions imposing the withholding taxes too. Is it a sensible exercise of their taxing powers to impose a gross tax, often at rates in the region of 30%, on foreign investment, bearing in mind the significant deterrent effect that is likely to have on such investment?

The OECD, beneficial ownership and conduit companies

The OECD has grappled with the question of treaty entitlement for holding companies for some time. It has been fairly clear since 2003 that naked treaty shopping – where a company in jurisdiction A, which doesn't have a treaty with jurisdiction B, simply interposes a conduit SPV in jurisdiction C, which does have an appropriate treaty – will not be effective. In that case, the conduit will not be the beneficial owner of the interest and so will not qualify for reduced rates of withholding. However, it is also fairly clear (on my reading at least) that this is only intended to catch the most egregious situations. Beyond that it is a question for the source jurisdictions, to whom it is open to address a wider range of situations through domestic or treaty based anti-avoidance provisions, on my reading of the OECD commentary to the model double tax agreement

The EU appeared to take a similar approach to the Interest and Royalties Directive and the Parent-Subsidiary Directive, both of which made it clear that their terms should not 'preclude' member states from combatting fraud or abuse. On a plain reading, this appears to allow the member states' own anti-avoidance rules to override the directives but does not introduce a free-standing antiavoidance rule into the directives (though such a rule has been added to the Parent-Subsidiary Directive in 2015).

Denmark challenges both of these propositions, it apparently being common ground that Denmark's domestic anti-avoidance rules do not catch the situations it wishes to contest.

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Originally published by Tax Journal

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