The concept of “Abuse of Law” within the context of ECJ case law and its practical application

1. The concept of “Abuse of Law” within the context of ECJ case law and its practical application Carmen Botella García-Lastra Inspector of the State Finance Authority Member of the Royal Academy of Case Law and Legislation Madrid, June 7, 2009

2. Aspects to be developed • Principles from ECJ case law. • Guidance from EU Commission. • Practical application in Spanish tax system. • Impact of new characterization principles on Accounting/Corporate Law.

3. ECJ case law in the context of the 6th VAT Directive • The concept of tax advantage: ECJ judgment 21/02/06 • Case C-255/02 Halifax • Case C-419/02 Bupa Hospitals • Case C-233/03 University of Huddersfield • Abuse of Law is prohibited in the context of Community Law. • The application of Community legislation cannot be extended to cover abusive practices by economic operators, that is to say, transactions carried out not in the context of normal commercial operations, but solely for the purpose of wrongfully obtaining advantages provided for by Community law.

4. ECJ case law in the context of Directive 69/335 • The formation of a company in a Member State (MS) under wholly artificial arrangements which do not reflect economic reality, with the aim of avoiding the tax normally payable, goes beyond the protection which Directive 69/335 must afford to the companies to which it applies. • Directive 69/335 must not favor conduct characterized by the putting in place of artificial arrangements with the sole aim of obtaining a fiscal advantage. • It is for the national court to verify whether there is objective evidence of action constituting an abusive practice of that kind in the circumstances of the main proceedings.

5. ECJ case law in the context of Directive 90/434 • Judgment 17 July 1997: Leur-Bloem (C-28/95) . The only purpose for the creation of a holding company through an exchange of shares is to allow the offset of subsidiaries’ tax losses. The concept of valid economic reason is broader than the search for a tax advantage. • Judgment 15 January 2002 (C-43/00) Andersen og Jensen. Examination of the effective functional independence and of the overall financial position of the entity. Comprehensive assessment of the circumstances of the specific case. • Judgment 5 July 2007 (C-321/05) Kofoed. The regime of the Directive applies regardless of the reasons for the transaction, although its application can be rejected where it only seeks a tax advantage.

6. Communication from the EU Commission on the application of anti-abuse measures in the area of direct taxation, of 10 December 2007 • The fundamental freedoms cannot be restricted under a preventive approach (safeguard of MS financial interests), but only in cases of “overriding reasons in the public interest”. • The need to prevent tax avoidance or abuse can constitute an overriding reason in the public interest capable of justifying a restriction on fundamental freedoms. The notion of tax avoidance is however limited to “wholly artificial arrangements aimed at circumventing the application of the legislation of the MS concerned”. • To be lawful, the national tax laws must be proportionate and applied solely for the purpose of avoiding “purely artificial arrangements”.

7. Commission’s summary of ECJ case law • Factors that do not of themselves suffice to constitute abuse, i.e. a wholly artificial arrangement: • The fact that a subsidiary is established in a Member State or is carrying out activities by a PE. • It is legitimate for tax considerations to play a role in the decision on where to establish a subsidiary, as long as the arrangements entered into do not amount to an artificial transfer of profits. • In so far as taxpayers have not entered into abusive practices, MS cannot hinder the exercise of the rights of freedom of movement simply because of lower levels of taxation or special favorable regimes in other MS.

8. Practical application in Spanish tax system. Mechanisms. • Specific anti-abuse provision in Article 96.2 of Corporate Income Tax (CIT) Law • Conflict in the application of the tax provisions: Article 15 of General Taxation Law Does not give rise to the application of penalties. • Simulation: Article 16 of General Taxation Law Formal characterization, only producing tax effects. Penalties can, if appropriate, be imposed. • Characterization principle: Article 13 of General Taxation Law Characterization must be made according to the legal nature of the event, act or transaction.

9. Valid economic reasons in corporate restructurings Article 96.2 CIT Law (former 110.2) • The regime will not apply where the main purpose of the transaction is the tax fraud or evasion. • In particular, the regime shall not apply where the transaction is not performed for valid economic reasons, such as the restructuring or rationalization of the activities of the entities participating in the transaction, but rather merely to achieve a tax advantage. • Requests for binding rulings may be submitted.

10. Excessive-debt transactions with international parent companies or related entities • ECJ’s Thin Cap judgment. • Position of Directorate-General of Taxes (DGT): application of fraud upon the law proceeding. • DGT report of 31/03/2006. • TEAC (Central Economic Court) decision of 17/05/2007. • Possibility of characterization according to economic substance?

11. Inspection practice: Proceedings • Case-by-case examination in light of case law and past rulings. • Special attention to artificial arrangements without lasting economic substance and to the evolution of the tax burdens borne by the companies involved over time. • In the event of dispute, the company bears the burden of proving the economic aim of the transaction and the inspectors that of the fraud or abuse.

12. Conclusions • The fraud upon the law (conflict) and simulation proceedings do not cover all cases of abuse. • Advisability of importing the concept of “abuse of law” (defined as the artificial abuse of legal forms apart from their aim) to combat avoidance practices aimed at creating structures without taxation or with “negative taxation”. • The general principles of tax characterization (Article 13 of the General Taxation Law) and the accounting of the transaction may foster the direct use of this formula by the inspectors, given that auditors can already use it.