Tax Planning in the New E.U. Countries: Slovak Republic

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1 This article originally appeared in April s issue of the Tax Planning International. Tax Planning in the New E.U. Countries: Slovak Republic Bartjan Zoetmulder and Miriam Galandova Loyens & Loeff, Amsterdam and White & Case, Bratislava This is the fourth in a series of articles focusing on tax planning involving the new E.U. countries. The articles focus on tax planning for inbound and outbound investments as well as tax planning structures making use of the new E.U. countries. The articles are written in co-authorship between Bartjan Zoetmulder, tax lawyer at Loyens & Loeff in Amsterdam, head of the firm s E.U. accession team and tax experts in the various new E.U. countries. 1 This fourth article focuses on the Slovak Republic. I. Inbound Investment into Slovakia Structures involving Dutch or Luxembourg companies are commonly used for inbound investments in the Slovak Republic. An important reason for this is the extensive double tax treaty network of both countries eliminating or reducing withholding taxes on interest paid from Slovakia as well as the domestic participation exemption on dividends and capital gains enabling a tax free exit from investments in Slovak companies. As Slovakia levies withholding tax on interest and the Netherlands and Luxembourg do not, Slovak companies that want to issue a bond often use a Dutch or Luxembourg company to issue such bonds, with the aim to on-lend the proceeds thereof to the Slovak company. Apart from saving the withholding tax, the use of such finance company avoids the administrative burden of identifying the beneficial owners, who may change from time-to-time, and which is necessary to levy the right percentage of withholding tax. A. Holding Companies 1. No dividend withholding tax in Slovakia In the case of a 25 percent (or more) shareholding, the Netherlands-Slovakia tax treaty provides for an exemption of tax on dividend distributions. The Luxembourg-Slovakia tax treaty provides for 5 percent tax in similar cases. Following Slovakia s accession to the European Union (EU) on May 1, 2004, Slovakia had to implement the E.U. Parent Subsidiary Directive in its domestic law and should have provided for an exemption of tax on dividends distributed to E.U. resident companies holding 25 percent (since January 1, 2005: 20 percent) or more of the share capital. However, with the aim of simplification and one-level taxation of income, the Slovak Republic introduced a much broader exemption of the dividend income than necessary under the E.U. Parent Subsidiary Directive. With effect from January 1, 2004, profit distributions by qualifying Slovak legal entities are no longer subject to Slovak dividend withholding tax. Slovak qualifying 1

2 entities are a limited liability company (s.r.o.), a joint stock company (a.s.) and a limited partnership (k.s.) for distributions made to limited partners (komanditista). Initially the exemption was limited to profits generated after January 1, However this was deemed incompatible with the E.U. Parent Subsidiary Directive and therefore after E.U. accession this was amended to include profits generated before January 1, 2004 as well, if distributed to qualifying parent companies in other E.U. countries as stipulated in the E.U. Parent Subsidiary Directive. 2. Participation exemption in the Netherlands and Luxembourg The Netherlands-Slovak tax treaty allocates the right to tax capital gains realised on the disposal of shares in a Slovak company to the Netherlands (unless the shares are attributable to a Slovak permanent establishment). This also includes shares in companies that own Slovak real property. The same applies under the Luxembourg-Slovak tax treaty. The treaty between Germany and Slovakia does not protect against this capital gains tax. Slovakia levies a capital gains tax to the foreign shareholder if the shares in the Slovak company are sold to a Slovak resident (individual or company) or a Slovak permanent establishment of a foreign company. One could wonder whether this difference in treatment depending on the residence of the buyer (Slovak or non-slovak buyer) is compatible with E.U. law and/or non-discrimination clauses in tax treaties. In the Netherlands, dividends and capital gains derived from an investment in a Slovak qualifying entity (see above) are exempt from corporate income tax, provided such investment meets the non-portfolio test. This condition however does not apply if the Dutch company owns 25 percent or more of the share capital. 2 The interposition of a wholly owned Slovak holding company to meet the 25 percent threshold will, however, not avoid the non-portfolio test, based on a specific anti-abuse rule in Dutch law. The absence of a minimum holding period offers flexibility. Costs directly related to the investment in the Slovak company, such as interest expenses, are deductible, subject to specific limitations related to intra-group conversions of equity to debt and subject to the thin capitalisation rules which were introduced in the Netherlands last year. The thin capitalisation limitation is effective if the net intra-group debt exceeds a debt-to-equity ratio of 3:1 plus a margin of 500,000. The deductible costs may be used to offset any other taxable income. In Luxembourg, dividends and capital gains derived from an investment of 10 percent in a Slovak qualifying entity are exempt from Luxembourg corporate income tax, provided such minimum investment is or will be held for at least 12 months. For example, if a Luxembourg company acquires a 100 percent stake, it can sell a 90 percent stake within 12 months. Participations representing less than 10 percent of the share capital can still qualify if the cost price thereof is at least 6 million (for dividends a lower threshold of 1.2 million applies). Luxembourg does not have thin capitalisation rules. The Luxembourg tax administration however applies a debt-to-equity ratio of 85:15 as safe harbour. Costs directly related to the investment in the Slovak company are only deductible to the extent these exceed the exempt dividend income in a given year. Such deducted costs have to be recaptured upon a subsequent realisation of the participation. The recapture can generally be reduced or avoided by the interposition of a holding company which converts capital gains into dividends. 3. Capitalisation of the Slovak, Dutch and Luxembourg company Slovakia does not levy capital duty on contributions to companies and has abolished its thin capitalisation rules with effect from January 1, This makes Slovak companies a very attractive tool for non-e.u. investors to repatriate income from Europe. As mentioned above, the Netherlands applies a debt-to-equity ratio of 3:1. If equity is provided to the Dutch company in the form of a capital, 0.55 percent capital duty will be due on the market value of the contribution (or, if higher, the nominal value of the issued shares) unless an exemption applies. For 2

3 example, where a Dutch company acquires from its E.U. resident parent company all shares in the capital of a Slovak company that carries on a business enterprise, a business merger exemption can be claimed. The Dutch Underminister of Finance has recently announced that the capital duty will be abolished with effect from January 1, 2006 which will make capital duty planning superfluous. Luxembourg levies 1 percent capital duty on capital contributions, unless an exemption applies. Since Slovak does not levy capital duty, the investors could first acquire or capitalise the Slovak company and subsequently sell 85 percent of the shares to, and contribute the remaining 15 percent to the Luxembourg company. The Luxembourg company can claim a share-for-share exemption of capital duty; however, it has to maintain all acquired shares for at least five years. A liquidation of the Luxembourg or Slovak company or a qualifying reorganisation within this five-year holding period is however possible without triggering the saved capital duty. 4. Repatriation of profits from the Netherlands and Luxembourg The Netherlands levies a 25 percent dividend withholding tax which is reduced to 0 percent with regard to profit distributions to shareholders covered by the E.U. Parent Subsidiary Directive, provided the shareholder holds or will hold a stake of 25 percent 3 for at least 12 months. The 12 month holding period can also be met retroactively and does not necessarily have to have lapsed when the dividend is distributed, provided that sufficient security is posted with the Dutch tax authorities. The threshold will be reduced to 15 percent as from 2007 and to 10 percent with effect from On the basis of the reciprocal method, the Netherlands already applies a lower threshold of 10 percent in the case of Germany, Greece, the United Kingdom, Spain, Finland, Luxembourg and Austria. With effect from January 1, 2005, the Netherlands U.S. tax treaty provides for a 0 percent dividend withholding tax, broadly speaking where a U.S. company owns directly 80 percent or more of the voting power in the Dutch company for at least 12 months. With effect from January 1, 2006, the tax arrangement between the Netherlands and the Netherlands Antilles is expected to be amended to include a 0 percent dividend tax as well. Profit distributions by a Luxembourg company are subject to 20 percent withholding tax; however, the rate is reduced to 0 percent if the shareholder is covered by the E.U. Parent Subsidiary Directive and the shareholder holds or will hold a stake of 10 percent for at least 12 months. The Luxembourg company has to obtain sufficient security from its shareholders if it distributes free of tax within the 12 month period as it remains liable for the payment of withholding tax, if any. Even in the case where the shareholder holds less than 10 percent, its stake can qualify if its cost price amounts to at least 1.2 million. Luxembourg does not levy withholding tax on liquidation distributions. Distributions made in connection with a partial liquidation are also not subject to withholding tax. A partial liquidation generally means the transaction whereby all shares which a shareholder holds in the company are repurchased and cancelled. It is obvious that this exemption makes Luxembourg an attractive holding company location for investors that cannot benefit from the E.U. Parent Subsidiary Directive or tax treaty rates. B. Finance Companies Under the new legislation effective from January 1, 2004, Slovakia abolished its thin capitalisation rules limiting the tax deductibility of interest. Therefore, a Slovak company can in principle be funded with almost 100 percent debt. As explained below, this will not in all cases be tax efficient. Although Slovakia does not levy capital duty, the level of equity is often kept at a minimum as the repayment of contributed capital is usually more burdensome than in the case of debt financing. Furthermore, contrary to interest payments, dividends may only be declared if the company has distributable reserves available. The advantage of debt financing is that the interest due by the Slovak company is a tax-deductible expense which can be offset against taxable income. As Slovakia does not know the concept of group taxation, one may have 3

4 to use a Slovak take-over company which is fully leveraged. Following the acquisition of the profitable Slovak target company and a reverse merger whereby the take-over company disappears, the debt is pushed down into the surviving target company in order to achieve reduction of the tax burden. Interest paid to a foreign lender generally is subject to a final Slovak withholding tax of 19 percent. However, under the Netherlands-Slovak tax treaty as well as the Luxembourg-Slovak tax treaty, the withholding tax is reduced to 0 percent. Furthermore, in compliance with the E.U. Royalty & Interest Directive that became effective from January 1, 2004, Slovakia does not apply withholding tax where the interest is paid to the E.U. parent company or E.U. sister companies (25 percent shareholding relation for the period of at least 24 months). It therefore makes sense to interpose a Dutch or Luxembourg finance company between the Slovak target company and the investors as in principle neither the Netherlands nor Luxembourg levies a withholding tax on fixed or floating interest payments. It is noted that in connection with the E.U. Savings Directive, Luxembourg will introduce (likely as of July 1, 2005) a 15 percent withholding tax on interest paid via a Luxembourg paying agent to E.U. resident individuals, unless the recipient opts for exchange of information or provides a residence certificate from its tax authorities. The withholding tax will be gradually increased to 35 percent as from In the Netherlands it is possible to structure the finance company as a risk free or as a risk bearing finance company. The risk free financing company typically will, based on the Dutch tax law, not include the interest income and expenses in its taxable basis and only report a profit on a cost-plus basis. A risk bearing finance company is required to have an equity that is sufficient to bear the risk related to borrowing and on-lending. The tax law prescribes that the equity should be equal to the lower of 1 percent of the funds lent out and 2 million, but the tax authorities in the Netherlands apply a broader definition of suitable equity, depending on all facts and circumstances. The tax authorities in the Netherlands have kept the prerogative to spontaneously exchange information on the Dutch finance company if it does not meet the minimum equity criteria and certain other substance criteria. In practice, the criteria are relatively easy to meet. Moreover, the Dutch finance company is allowed to credit foreign withholding tax, reducing the tax burden. Of course this does not play a role if the finance company only provides loans to an entity in the Slovak Republic. Luxembourg does not require a minimum equity level for a finance company. In both countries, the interest margin on the financing activities may be offset against the interest expenses due on the loans that finance the participations so as to keep the tax burden moderate. C. Negative Tax Rate Arbitrage The tax advantage of the debt funding will also depend on the taxation of this income at the level of shareholders. The tax deduction of interest leads to a tax reduction of 19 percent in Slovakia assuming that the withholding tax on interest is reduced to 0 percent. Thus, if the investor is located in a country with a higher than 19 percent rate it would not be tax efficient to finance the Slovak operation through debt unless the foreign entity is in a loss position or can find a way to avoid taxation of interest income, for example, through a re-qualification of the debt instrument as equity for tax purposes in the jurisdiction of the recipient. The holding structure through Luxembourg or the Dutch company combined with the financing vehicle established in the country with low corporate income tax rate (e.g., Cyprus) usually leads to a tax beneficial structure. As an example, a Dutch company could capitalise a Cyprus subsidiary, which could provide a loan to a Slovak group company. The interest would be deductible against the 19 percent Slovak corporate income tax rate and taxable in Cyprus against 10 percent 4 and subsequently the profit could be distributed to the Dutch company without Dutch corporate income tax under the participation exemption. Needless to say that establishing such structures involves certain costs relating to setup and operation of the entities involved and triggers certain anti-avoidance risk and thus must be carefully planned. D. Slovak Tax Incentives The Slovak legislation still provides for some investment incentives which are always questioned 4

5 by first-time foreign investors. Slovak investment incentives fall into four general categories: regional aid; aid for training; aid for job creation; and other state support. One of the common forms of regional aid is tax incentives. The Investments Incentives Act, Income Taxes Act, State Aid Act and E.U. state aid legislation set the legal framework for provision of the tax incentives, based on which companies with seats in the Slovak Republic may be granted a 100 percent reduction of income tax for 10 consecutive tax periods if they meet certain criteria. Major criteria are as follows: establish a new enterprise, modernise an existing enterprise or purchase an enterprise having financial difficulties; invest at least SKK400 million (approximately 10 million) in the acquisition of the fixed assets; at least SKK 200m ( 5 million) must be covered by the equity of the company (these limits are decreased by 50 percent if the business activities are performed in a region with an unemployment rate of at least 10 percent); derive at least 80 percent of total revenues from business activities listed in the application form for the provision of incentives; beginning of business activity within three years from the day of issuing of approval of incentives. The aim of tax system s simplification results in the deletion of tax incentive provisions from the current wording of the income tax law. However, the transitional provisions enable the application for the tax holidays defined in old tax law for taxpayers whose decision on provision of tax incentives is issued prior to December 31, Because of the accession process of Slovakia to the European Union, all investment incentives, including tax incentives, are provided on the state aid basis. This means that there is a ceiling set as a percentage of eligible costs and the percentage depends on how developed the region is where the investment is to be realised. An investor has to file an application and investment project and apply for the state aid. An application procedure involves negotiation with the Slovak Investment and Trade Development Agency (SARIO) in the first instance, and approval of the Ministry of Economy, the European Commission and the Government of the Slovak Republic. Usually, only large and important investments which lower the unemployment rate are approved. Currently, the investors investing in the eastern part of Slovakia and operating in other than automotive industries, especially in high tech business, are preferred. Dutch companies investing in Slovak companies enjoying a special tax regime may have problems with the application of the participation exemption. As long as the tax incentives have the character of a tax holiday, participation exemption will be granted. The Luxembourg participation exemption requires that the Slovak company is not exempt and neither has an option to be exempt from Slovak corporate income tax. A temporary tax holiday which is approved by the E.U. authorities will normally not jeopardise the application of the participation exemption. II. Outbound Investment from the Slovak Republic When implementing the E.U. Parent Subsidiary Directive, the Slovak Republic introduced a rather broad exemption of the dividend income. Based on the transitional provisions, however, this exemption applied generally only to the profits realised after January 1, As this condition was not in line with the E.U. Parent Subsidiary Directive, it was amended shortly after its introduction. Thus, based on the current wording, profit distributions out of reserves generated before 2004 are also exempt from income tax provided the recipient is covered by the E.U. Parent Subsidiary Directive. Costs directly related to exempt income are non-deductible. The dividend income is exempt from Slovak income tax provided that: (i) the foreign entity has a legal form similar to the legal form of 5

6 qualified Slovak entities (e.g., a limited liability company, a joint stock company); and (ii) the profits are distributed after being taxed at the level of foreign entity. If the profits do not qualify for the exemption, the income will be subject to Slovak tax at a rate of 19 percent. From a practical perspective, the application of these rules could be rather problematic having regard to the various tax systems and mechanisms for tax base determination used abroad. Especially in situations where profit distributions consist of several profit elements, a portion of which is exempt from tax (e.g., capital gains) the question arises, whether the whole profit share must be taxed to meet this criteria. Under the terms of a highly rigid interpretation, the exemption should apply only to the portion of profits already taxed at the level of the distributing company. On the other hand, it could be argued that this condition is fulfilled if the foreign entity is generally subject to tax on its worldwide income in its resident tax jurisdiction. During 2004, the Slovak Ministry of Finance issued an Instruction (not legally binding) according to which profit from foreign sources are not subject to tax in Slovakia if they are paid by a foreign legal entity which reports its tax base on similar principles as qualified Slovak legal entities. Such interpretation could lead in some cases to incorrect implementation of the E.U. Parent Subsidiary Directive (as some E.U. legal entities listed in the Annex to the E.U. Parent Subsidiary Directive may determine their taxable basis on the different principles). Currently, the Ministry is preparing a new Instruction confirming the more beneficial interpretation of the term taxed. With regard to the interest income, it is generally treated as taxable income subject to 19 percent corporate income tax at the level of the Slovak recipient. It may thus be tax efficient to lend funds to a foreign subsidiary which can deduct the interest against a higher tax rate. company. As mentioned above, the investment can be sold by the Dutch or Luxembourg company tax-free and the sales profit can be distributed as a dividend to the Slovak parent company. III. Conclusions As Slovakia levies 19 percent income tax on capital gains when shares are sold to a Slovak buyer and since Slovakia levies interest withholding tax (and the tax treaty benefits are not applicable), it will often be worthwhile to make inbound investments through a Dutch or Luxembourg holding company. In this way, the Slovak company can be sold free of income tax and interest can leave Slovakia free of withholding tax. The absence of thin capitalisation rules in Slovakia makes it possible to reduce the taxable base and to take out funds from Slovakia in a straightforward way. Slovakia may also become an important holding company jurisdiction, together with a Dutch or Luxembourg sub-holding company to convert capital gains into dividends, to exit the European Union free of dividend withholding tax. Key successful factors include: the subject to tax rule is clarified; company law is relaxed with regard to the increase and decrease of the share capital, the distribution of (interim) dividends and division of voting power. Miriam Galandova Bratislava Office Tel: (421-2) mgalandova@whitecase.com Due to the general nature of the discussion, this article should not be regarded as legal advice. Copyright 2005 White & Case Based on the above, the investment in equity of a foreign entity meeting the above-mentioned criteria for dividend exemption seems to be the best tax planning solution for the outbound investment of the Slovak entities as well as Slovak individuals. Since capital gains are subject to 19 percent income tax, they may be converted into dividends by holding the foreign investment through a Dutch or Luxembourg 1 Special thanks to Heico Reinoud, who recently joined L&L s E.U. Accession Team after having spent five years in Loyens & Loeff Luxembourg 2 Law proposal presented on March 16, 2005 will change this percentage to 20 percent retroactively with effect from January 1, See footnote 3 4 Assuming the interest is not qualified as passive income, which would increase the effective tax burden in Cyprus to 15 percent 6