In a landmark decision for companies operating in

Dutch Exit Tax Rules Challenged in National Grid Indus by Tom O Shea Tom O Shea is the academic director of the Master s in Taxation program at the Institute of Advanced Legal Studies at the University of London and a lecturer in tax law at the Centre for Commercial Law Studies at Queen Mary, University of London. In a landmark decision for companies operating in the EU, National Grid Indus (C-371/10), the European Court of Justice held that Dutch exit tax rules on companies transferring their place of effective management to another EU member state were incompatible with the freedom of establishment when such rules prescribed the immediate recovery of tax on unrealized gains. Background National Grid Indus is a limited liability company incorporated in the Netherlands. Until December 15, 2000, its place of effective management was in the Netherlands. On that date it transferred its place of effective management to the United Kingdom. As a result of this transfer, National Grid Indus, under the Netherlands-U.K. income tax treaty, became a resident of the U.K. and ceased to be a resident of the Netherlands. This transfer triggered a final settlement of its tax liabilities, in particular, unrealized capital gains at the time of the transfer. National Grid Indus argued that this exit taxation amounted to a breach of its right of establishment guaranteed under article 49 of the Treaty on the Functioning of the European Union (TFEU). Freedom of Establishment The first issue examined by the ECJ concerned whether the freedom of establishment was applicable to the situation at hand. Following its previous jurisprudence, the ECJ determined that the question of whether article 49 of the TFEU applied is a preliminary matter that can only be resolved by the applicable national law. The Court recalled that a member state: has the power to define both the connecting factor required of a company if it is to be regarded as incorporated under its national law and as such capable of enjoying the right of establishment, and that required if the company is to be able subsequently to maintain that status...a Member State is therefore able, in the case of a company incorporated under its law, to make the company s right to retain its legal personality under the law of that State subject to restrictions on the transfer abroad of the company s place of effective management. 1 The Court noted that in the situation at hand, the transfer of the place of effective management from the Netherlands to the U.K. did not affect its status as a Dutch company. Accordingly, the Dutch rules at issue did not concern: the determination of the conditions required by a Member State of a company incorporated under its law for that company to be able to retain its status of a company of that Member State after transferring its place of effective management to another Member State. 2 Therefore, the Court concluded that National Grid Indus could rely on article 49 of the TFEU for the purpose of challenging the lawfulness of the tax imposed on it by the Netherlands on the occasion of the transfer of the place of effective management. 1 National Grid Indus, para. 27. 2 Id. at para. 31. TAX NOTES INTERNATIONAL JANUARY 16, 2012 201

FEATURED PERSPECTIVES Restriction on Freedom of Establishment The Court highlighted that all measures that prohibit, impede, or render less attractive the exercise of the freedom of establishment must be regarded as restrictions on that freedom. In the situation at hand, the Court noted that a company incorporated under Dutch law that transferred its place of effective management from the Netherlands to another member state was placed at a cash flow disadvantage compared with a similar Dutch company that retained its place of effective management in the Netherlands. The transfer of the place of effective management of the Dutch company meant the immediate taxation of the unrealized capital gains relating to the assets transferred. The Court pointed out that the different treatment of the unrealized capital gains in such circumstances was liable to deter a company incorporated under Netherlands law from transferring its place of effective management to another Member State. 3 Justifications Objective Difference in Situation The Court pointed out that the situation of a company incorporated in the Netherlands that transferred its place of effective management to another member state was the same as a company also incorporated in the Netherlands that keeps its place of effective management in the Netherlands. The Court explained that both companies were in the same situation regarding the taxation of capital gains relating to the assets that were generated in the Netherlands before the transfer of the place of management. Balance in Allocation of Taxing Rights The Court highlighted that the transfer of the place of effective management of a Dutch company to another member state cannot mean that the Netherlands has to abandon its right to tax a capital gain that arose within the ambit of its powers of taxation before the transfer. The Court explained that: a Member State is entitled to charge tax on those gains at the time when the taxpayer leaves the country...such a measure is intended to prevent situations capable of jeopardising the right of the Member State of origin to exercise its powers of taxation in relation to activities carried on in its territory, and may therefore be justified on grounds connected with the preservation of the allocation of powers of taxation between the Member States. 4 The Court noted that under the Dutch legislation, when National Grid Indus transferred its place of effective management to the U.K., it was regarded as resident in the U.K. in accordance with the provisions of the Netherlands-U.K. income tax treaty. Therefore, a final settlement was drawn up regarding the capital gains relating to the company s assets in the Netherlands at the time of the transfer. Under the income tax treaty, capital gains realized after the transfer are taxed in the U.K. Therefore, the Court determined that legislation such as the Dutch rules at issue was appropriate for ensuring the preservation of the allocation of powers of taxation between the member states. Unrealized capital gains are thus taxed in the member state in which they arose. Proportionality Next, the Court investigated whether the legislation at issue went beyond what was necessary to attain its objective. The Court noted that both the establishment of the amount of the tax debt and the recovery of the tax take place at the time of the transfer of the place of effective management when the company ceased to be taxable in the Netherlands. The Court determined that in order to assess the proportionality of the legislation a distinction had to be made between: the establishment of the amount of tax; and the recovery of that tax. Establishment of Amount of Tax The Court highlighted that it was proportionate for a member state to determine the tax due on the unrealized gains at the time when its power of taxation regarding the company in question ceases to exist (at the time of the transfer of the place of effective management to another member state). The Court recalled the N case (C-470/04), where it had pointed out that decreases in the value of assets after the emigration of the taxpayer had to be fully taken into account in order for the national rules to be regarded as proportionate, unless those decreases in value had already been taken into account in the host member state. However, the Court distinguished the circumstances of National Grid Indus from N by pointing out that since: the profits of a company which transfers its place of effective management are, after the transfer, taxed exclusively in the host Member State, in accordance with the principle of fiscal territoriality linked to a temporal component, it is also for that Member State...forreasons relating to the symmetry between the right to tax profits and the possibility of deducting losses, to take account in its tax system of fluctuations in the value of assets of that company which occur after the date on which the Member State of origin loses all fiscal connection with the company. 5 Therefore, the Court held that the member state of origin was not obliged to take account of any exchange 3 Id. at para. 37. 4 Id. at para. 46. 5 Id. at para. 58. 202 JANUARY 16, 2012 TAX NOTES INTERNATIONAL

rate losses that may occur after the transfer of the place of effective management to the U.K. The Court noted that the tax due on the unrealized capital gains was determined at the time of the transfer of the place of effective management to the U.K. (when the member state of origin s power to tax the company ceased to exist). The Court indicated that the taking into account: by the Member State of origin either of an exchange rate gain or an exchange rate loss occurring after the transfer of the place of effective management could not only call into question the balanced allocation of powers of taxation between the Member States but also lead to double taxation or double deduction of losses. 6 The Court stressed that it was: in accordance with the principle of fiscal territoriality linked to a temporal component, namely residence for tax purposes on the national territory during the period in which the taxable gain appeared, that the capital gain generated in the Member State of origin is taxed at the time of the transfer of the place of effective management of the company. 7 The Court also commented that the host member state generally will take account of capital gains and losses realized regarding those assets after the transfer of the place of management but: a possible omission by the host Member State to take account of decreases in value does not impose any obligation on the Member State of origin to revalue, at the time of realisation of the asset concerned, a tax debt which was definitively determined at the time when the company in question...ceased to be subject to tax in the latter Member State. 8 The Court explained that the TFEU: offers no guarantee to a company...that transferring its place of effective management to another Member State will be neutral as regards taxation...such a transfer may be to the company s advantage or not, according to circumstances. 9 Immediate Recovery of Tax at Time of Transfer The Court accepted that the recovery of the tax debt at the time of actual realization in the host Member State of the asset for which a capital gain was established by the member state of origin may avoid the FEATURED PERSPECTIVES cash-flow problems which could be produced by the immediate recovery of the tax due on unrealised capital gains. 10 Administrative Burden The Court noted that there could be a significant administrative burden if the tax debt was deferred, particularly if a large number of assets were involved. In such cases, the Court highlighted that: an accurate cross-border tracing of the destiny of all the items making up the company s fixed and current assets until the realised capital gains incorporated into those assets are realised is almost impossible, and that such tracing will entail efforts representing a considerable or even excessive burden for the company in question. 11 This might represent a hindrance to the freedom of establishment just as harmful as the immediate recovery of the tax debt. On the other hand, the Court recognized that there would be occasions when the nature and extent of the company s assets would make it easy to carry out the cross-border tracing of such assets. Therefore, in coming to its determination on the issue of proportionality, the Court concluded that proportionate national rules could offer a choice to a company transferring its place of effective management to another member state between first, the immediate payment of the tax with no subsequent administrative burden but with a definite cash flow disadvantage and second, deferred payment of the tax with an administrative burden regarding the tracing of the assets. Such rules would be more proportionate that the Dutch rules at issue. In such circumstances, the Court commented that if the company considered that the administrative burden in connection with deferred recovery was excessive, it could opt for immediate payment of the tax. 12 The Court also pointed out that account should also be taken of the risk of non-recovery of the tax and held that that risk could be taken into account by the member state in designing its rules applicable to deferred payments of tax debts, indicating that measures such as the provision of a bank guarantee might be appropriate. Mutual Assistance The Court indicated that the mutual assistance directive and recovery of taxes directive were sufficient to enable the member state of origin to check the truthfulness of the tax declarations made by companies that opt for deferred payment of tax and to actually recover the tax debt in the host member state. 6 Id. at para. 59. 7 Id. at para. 60. 8 Id. at para. 61. 9 Id. at para. 62. 10 Id. at para. 68. 11 Id. at para. 70. 12 Id. at para. 73. TAX NOTES INTERNATIONAL JANUARY 16, 2012 203

FEATURED PERSPECTIVES Coherence of Tax System The Court accepted that the requirements of coherence of the tax system and the balanced allocation of powers of taxation coincide. 13 However, it pointed out that only the determination of the amount of tax at the time of the transfer, and not the immediate recovery of the tax, should be regarded as not going beyond what was necessary for achieving that objective. The Court explained that deferred recovery of the tax: would not call into question the link existing in the Netherlands legislation between, on the one hand, the tax advantage represented by the exemption allowed to unrealised capital gains relating to assets as long as a company obtains profits taxable in the Netherlands and, on the other, the offsetting of that advantage by a charge to tax determined at the time when that company ceases to obtain such profits. 14 Risk of Tax Avoidance Finally, the Court dismissed the argument that the Dutch rules were justified by the need to prevent tax avoidance, pointing out that: the mere fact that a company transfers its place of management to another Member State cannot set up a general presumption of tax evasion and justify a measure which compromises the exercise of a fundamental freedom. 15 The Court s Conclusion The Court concluded that article 49 of the TFEU must be interpreted as not precluding national exit tax rules that fix the amount of tax definitively, without taking into account decreases or increases in value that may occur after the date of transfer of the place of effective management. However, the Court held that article 49 of the TFEU precludes national exit tax rules that provide for the immediate recovery of tax on unrealized gains of a company at the time it transfers its place of effective management to another member state. Analysis The judgment of the Court in National Grid Indus is one of the Court s most significant judgments of 2011 and a landmark case in the Court s jurisprudence. The Court resolved a number of important issues concerning corporate emigration and corporate exit taxes, in particular, whether the Dutch company could rely on the freedom of establishment in the circumstances of 13 Id. at para. 80. 14 Id. at para. 82. 15 Id. at para. 84. the case and whether exit tax rules (which required immediate recovery of taxation upon emigration) were compatible with EU law. The Court provided further guidance on cash flow disadvantages caused by the rules of one member state and confirmed that the need to preserve the allocation of taxing powers between the member states is a legitimate general interest objective for national tax legislation. The Court also pointed out that both the need to ensure the coherence of the tax system and the need to prevent tax avoidance were not acceptable justifications in this case. Finally, the Court distinguished the circumstances of the National Grid Indus case from those that existed in the N case. Freedom of Establishment The ECJ has continued to develop the concept of freedom of establishment in its jurisprudence over the past 50 years. In Daily Mail (Case 81/87), the Court stated that: in the present state of Community law Articles 52 and 58 of the Treaty, properly construed, confer no right on a company incorporated under the legislation of a Member State and having its registered office there to transfer its central management and control to another Member State. Thus, in 1988, when the judgment in Daily Mail was delivered, it appeared that freedom of establishment did not apply to companies transferring their central management and control to another member state. This position was not really clarified in the Court s jurisprudence until Cartesio (C-210/06) and National Grid Indus. Cartesio In Cartesio, a Hungarian limited liability partnership transferred its registered office to Italy. Hungarian rules did not allow a company incorporated in Hungary to transfer its seat abroad while continuing to be subject to Hungarian law as its personal law. The Court held that: a Member State has the power to define both the connecting factor required of a company if it is to be regarded as incorporated under the law of that Member State and, as such, capable of enjoying the right of establishment, and that required if the company is to be able subsequently to maintain that status. That power includes the possibility for that Member State not to permit a company governed by its law to retain that status if the company intends to reorganise itself in another Member State by moving its seat to the territory of the latter, thereby breaking the connecting factor required under the national law of the Member State of incorporation. 16 16 Cartesio, para. 110. 204 JANUARY 16, 2012 TAX NOTES INTERNATIONAL

The Court went on to highlight that: the situation where the seat of a company incorporated under the law of one Member State is transferred to another Member State with no change as regards the law which governs that company falls to be distinguished from the situation where a company governed by the law of one Member State moves to another Member State with an attendant change as regards the national law applicable, since in the latter situation the company is converted into a form of company which is governed by the law of the Member State to which it has moved. 17 National Grid Indus This reasoning was applied by the Court in its National Grid Indus judgment. The Court noted: the transfer by National Grid Indus of its place of effective management to the United Kingdom did not, however, affect its status as a company incorporated under Netherlands law, in accordance with that law, which applies the incorporation theory to companies. 18 Therefore, the Dutch company could rely on the freedom of establishment. The Court pointed out that the Dutch company, therefore: benefits, in accordance with Article 54 TFEU, from the Treaty provisions on freedom of establishment, and can thus rely on its rights under Article 49 TFEU, in particular for challenging the lawfulness of a tax imposed on it by that Member State on the occasion of the transfer of its place of effective management to another Member State. 19 Evolution of EU Law The National Grid Indus case demonstrates that EU law is constantly evolving. In Cartesio, the Court determined that conversion situations fell within the scope of freedom of establishment. In SEVIC (C-411/ 03), the Court determined that a merger situation fell within the scope of establishment. Now, in National Grid Indus, the Court has concluded that the transfer of the place of effective management of a company incorporated in an EU member state, whose national law FEATURED PERSPECTIVES allows the company to remain in existence after the transfer of the place of effective management, also falls within the scope of the freedom of establishment. The judgment is to be welcomed for adding some significant clarity to exit tax situations in the EU, but it has equally generated the puzzling question of whether the member state of arrival (the host state) must grant a step-up in value for the assets on the date of arrival. In other words, can the host member state impose capital gains tax on the acquisition cost of those assets rather than on their market value on the date of arrival in the host member state? If no step-up is granted, then clearly, double taxation is possible. Applying the reasoning of the Court in Kerckhaert-Morres (C-513/04), it may be that such double taxation must be accepted given the current state of development of EU law because, as the Court noted in Kerckhaert-Morres: the adverse consequences which might arise from the application of an income tax system such as the Belgian system at issue...result from the exercise in parallel by two Member States of their fiscal sovereignty. 20 Moreover, in National Grid Indus, the Court, recalling its previous case law, highlighted that: the Treaty offers no guarantee to a company covered by Article 54 TFEU that transferring its place of effective management to another Member State will be neutral as regards taxation. Given the relevant disparities in the tax legislation of the Member States, such a transfer may be to the company s advantage in terms of tax or not, according to circumstances. 21 Indirect Discrimination One final thought is that it may be possible to argue that the host state rules, which fail to grant the step-up in value upon the transfer of the place of effective management of the company from another member state, amount to indirect discrimination. In other words, even though they are even-handed in nature, such rules mainly affect foreigners because it will usually be foreigners who transfer their place of effective management to the host member state in the exercise of their right of establishment and are prejudiced by such rules. This line of argument can be found in O Flynn (C-237/94) and in tax judgments such as Biehl (C-175/88) and Ritter-Coulais (C-152/03). 17 Id. at para. 111. 18 National Grid Indus, para. 28. 19 Id. at para. 32. 20 Kerckhaert-Morres, para. 20. 21 National Grid Indus, para. 62. TAX NOTES INTERNATIONAL JANUARY 16, 2012 205