Editor's Note: Twice a year the Tax Management International Forum brings together leading tax practitioners from a number of different countries to discuss tax issues from the perspective of their particular countries. The meetings promote a lively exchange of ideas and comparisons of the tax laws of the countries represented. Each meeting focuses on two main topics, but additional issues may also be discussed.
The papers for the two topics discussed below were published, respectively, in 27 Tax Mgmt. Int'l Forum (September 2006) and 27 Tax Mgmt. Int'l Forum (December 2006). The Tax Management International Forum is published quarterly by Tax Management International, a division of BNA International, 29th Floor, Millbank Tower, 21-24 Millbank, London SW1P 4QP, England; telephone (+44) (0)20 7559 4800; fax (+44) (0)20 7559 4840; e-mail: marketing@bnai.com.
The Tax Management International Forum convened in London on October 27, 2006, under the chairmanship of Leonard Silverstein of Buchanan Ingersoll & Rooney PC, Washington, D.C., to discuss two topics: the additional adjustments that may have to be made subsequent to a transfer pricing adjustment and the tax treatment of supplemental retirement plans. While the two discussions concerned very different subject matters, a common theme was that, in both taxation areas, the U.S. rules almost invariably aspire to a greater degree of precision and formality than the rules of the European countries represented at the meeting. One manifestation of this tendency is that the United States is more likely to provide specific regulations on particular issues, while European countries are more content for problem areas to be resolved by case law.
ADDITIONAL ADJUSTMENTS TO BE MADE IN THE WAKE OF A TRANSFER PRICING ADJUSTMENT
In the fact pattern established for the discussion of the first topic, it was assumed that H was a business entity formed under the laws of Host Country and engaged in the assembly and sale of computers in Host Country. F, which was related to H, was a business entity formed under the laws of Foreign Country and engaged in the production of hard drives in Foreign Country. Both H and F were considered "corporations" for purposes of Host Country’s income tax law and there was no income tax treaty between Host Country and Foreign Country.
H purchased computer components from various parties, including hard drives from F, and also periodically made loans to F. In 2003, H purchased hard drives from F for u$100 per carton (where u$ = units of Host Country currency). In 2006, the tax authorities of Host Country determined that the fair market value of the hard drives was actually u$80 per carton, and H agreed to that determination. In 2003, H also had a loan outstanding to F on which it accrued interest income of u$1000. In 2006, the tax authorities of Host Country determined that the arm’s length interest on that loan was u$1300, and H agreed to that determination.
In relation to this fact pattern (and assuming that their own country was Home Country) the Forum members were invited to consider:
- What additional adjustments would be made in the wake of the transfer pricing adjustment pertaining to the amount paid for the hard drives in 2003. In particular, how would the additional payment of u$20 per carton made by H to F be treated, assuming, in the alternative, that: (i) F wholly owned H; (ii) H wholly owned F; and (iii) a third corporation owned 95% of H and 100% of F (the remaining stock in H being held by an unrelated individual resident in Host Country). Did the tax authorities of Host Country (or H) have options as to how the additional payment of u$20 per carton would be treated?
- How would the same questions be answered with respect to the transfer pricing adjustment pertaining to the interest income accrued by H in 2003. In particular, how would the difference between the amount actually accrued (u$1000) and the arm’s length amount (u$1300) be treated? Could withholding tax be imposed under Host Country law on an amount deemed paid but not actually paid?
- How would the answers to the questions set out above differ if there were a tax treaty between Host Country and Foreign Country and the competent authorities of the two countries agreed on the transfer pricing adjustments.
Herman Bouma of Buchanan Ingersoll & Rooney PC, Washington, D.C., opened the discussion of the first topic by observing that although in the United States there has been considerable focus on transfer pricing in the past 10 to 15 years, this focus has largely been directed at the question of how to establish an arm’s length price. Less attention has been paid to the question of what additional adjustments might need to be made where an arm’s length price has been established that differs from that applied by the parties to the transaction concerned. Bouma explained that, while §482 of the Internal Revenue Code, the basic transfer pricing section, is very simple and is silent on the issue of additional adjustments, the regulations under §482 do offer some guidance on the adjustments that need to be made after a basic adjustment, referring to such adjustments collectively as "collateral adjustments." Acknowledging that the use of terminology in this context is far from consistent and more than a little confusing, Bouma proposed using the following:
(i) Transfer pricing adjustment: to mean the adjustment made to the price of goods or services as a result of the application of §482.
(ii) Income adjustment: to mean the adjustment made to the income (and, where a corporation is involved, to the earnings and profits (E&P)) of a U.S. taxpayer as a result of a transfer pricing adjustment.
(iii) Correlative adjustment: to mean the adjustment made to the tax position of another party to the transaction as a result of the transfer pricing adjustment – for example, where the Internal Revenue Service has adjusted downward the sale price of a product sold by a foreign person to a U.S. person, the resulting decreases to the foreign person’s income and E&P.
(iv) Conforming adjustment: to mean an adjustment made to "make sense of" a transaction with respect to which it has been determined that either too much or too little has been paid for a good or service. Such an adjustment may take the form of a deemed dividend or a deemed contribution to capital, or, in certain circumstances, a deemed loan.
(v) Set-off: to refer to another transfer pricing adjustment that a U.S. taxpayer whose taxable income has been increased as a result of a basic transfer pricing adjustment may, in certain limited circumstances, be allowed to make to decrease its taxable income.
Correlative Adjustments
Turning to the hypothetical situation before the meeting, Bouma explained that in the first scenario (i.e., where H pays F u$100 for a carton of computer hard drives, the arm’s length price of which is established to be u$80) a correlative adjustment would be required that would decrease the income (and E&P) of F by u$20 per carton. If F was not subject to U.S. income tax, such a correlative adjustment would have no direct consequences for F, but the adjustment of E&P would be relevant for determining the extent to which a subsequent distribution made by F was a dividend.
Corresponding Adjustments
While none of the other countries represented at the meeting appeared to provide for correlative adjustments in the U.S. sense (for example, E&P-type adjustments), Bouma’s remarks prompted a discussion of what, if any, adjustments might be made in the other countries represented at the meeting in response to the U.S. basic transfer pricing adjustment and consequent correlative adjustment to the E&P of the foreign party. These adjustments made by other countries may be referred to as "corresponding adjustments." In particular, the discussion addressed the role that recourse to the Mutual Agreement Procedure (MAP) instituted by Article 25 of the OECD Model Convention would play in securing such adjustments. Walter Boss of Blum Attorneys at Law, Zürich, noted that if, in this situation, F were a Swiss resident company, then there could be no corresponding downward adjustment of F’s income for Swiss tax purposes if the relevant assessment had already become final, unless there was an applicable treaty between Switzerland and H’s country of residence and such an adjustment was agreed to under the MAP. If the relevant assessment had not become final, a corresponding adjustment would be possible, subject to the agreement of the Swiss tax authorities. Stéphane Gelin of CMS Bureau Francis Lefebvre, Paris, suggested that, where F was a French company, France would effectively ignore the U.S. treatment of the E&P of the French company, but would provide relief to deal with any double taxation arising as a result of the basic transfer pricing adjustment. Carola van den Bruinhorst of Loyens & Loeff N.V., Amsterdam, thought that where F was a Dutch company, typically a MAP would be initiated to secure a corresponding adjustment; normally, this would not be done on a unilateral basis.
Nicola Purcell of McDermott Will & Emery UK LLP, London, pointed out that within the European Union (EU), as an alternative to the MAP, recourse may be had to the procedures set out in the European Arbitration Convention, though she suggested that this was a road that historically had not been much travelled. This may, however, be changing according to Howard M. Liebman of Jones Day, Brussels, who cited a report recently published by the Transfer Pricing Working Group of the European Commission indicating that there are now more than 200 cases awaiting arbitration under this Convention. Gelin threw further light on the European arbitration procedure’s somewhat fitful progress when he noted that a backlog of cases had built up in the five years during which the Convention was suspended, although he was aware of both French/German and French/Italian cases that had been settled using the procedure. Dr. Rosemarie Portner of PricewaterhouseCoopers, Düsseldorf, pointed out that while the 1989 U.S.-Germany treaty provides for a MAP, the relevant treaty article simply requires the competent authorities of the two countries to consult; it does not require them to come to an agreement. However, the recently signed Protocol to the treaty does provide for the possibility of binding arbitration where the competent authorities are not able to reach agreement. Picking up Portner’s point, Liebman explained that, in contrast to the MAP provided for in tax treaties, which is not binding (although some of the U.S. treaties do make separate provision for mandatory and binding arbitration), the EC Arbitration Convention is binding within the EU.
Bouma suggested that, in circumstances where there is no applicable tax treaty (as envisaged in the hypothetical situation set out above), the other party to the transaction that was subject to a transfer pricing adjustment could approach the tax authorities of its country of residence to attempt to obtain a corresponding adjustment for that country’s tax purposes, although he did not seem to hold out much hope that such an approach would often succeed. Where there is an applicable treaty, double taxation can, of course, still arise where the MAP does not result in an agreement. In this context, Gelin was able to cite statistics issued by the French tax administration to the effect that 90-95% of French cases that go to competent authority do result in the avoidance of double taxation. Portner opined that most MAPs achieve a resolution, because the competent authorities have an interest in settling cases, although she alluded to cases taken by the German Competent Authority where no agreement could be reached, in particular cases involving Korea (ROK) and Brazil. Indeed, she suggested that the intractability of the differences between Germany and Brazil in this context had ultimately led to the termination of the Germany-Brazil treaty. Liebman ventured that there might be problems with the MAP in cases involving developing countries generally, giving India as an example. He also recalled seeing IRS statistics that indicated roughly 80% of U.S. MAP cases were resolved without double taxation, which still left a significant number of cases with unrelieved double taxation. Bouma remarked that there was a general feeling that the MAP has not always run smoothly in cases involving the competent authorities of the United States and Canada. However the two countries have entered into several specific agreements designed to facilitate the process, which according to Bouma "have been helpful."
Conforming Adjustments
Bouma explained that the regulations under §482 specify that a conforming adjustment in the wake of a basic transfer pricing adjustment may take the form of a deemed dividend or capital contribution, or, provided both parties to the transaction concerned are corporations and subject to certain conditions, an election may be made to treat the additional amount as a loan, which would have to bear interest at an arm’s length rate. In some cases, apparently, the IRS has applied deemed loan treatment, even where the taxpayer made no election to that effect. Van den Bruinhorst characterized The Netherlands’ approach to conforming adjustments as essentially the same as that of the United States. The Netherlands shares with the United States the concept of a deemed dividend, and applies deemed dividend treatment even if the other party to the transaction is not the parent of the party whose transaction is subject to the basic transfer pricing adjustment, but both parties share a common parent.
Recharacterization as a deemed dividend is based on old Dutch case law that dates to before the introduction of the transfer pricing rules. The Netherlands may also adopt a deemed loan approach where there is no "shareholder’s motive" to justify treating an additional amount as a deemed dividend. For example, in the first situation envisaged in the scenario set out above (and where F wholly owned H), there would be a deemed loan from H to F, unless the Dutch authorities were able to establish that both H and F were aware of the benefit provided to F by the overpayment of u$20 per carton, in which case there would be a deemed dividend from H to F.
Germany’s approach to conforming adjustments was characterized by Portner as "very formal and strict." The requirement to make conforming adjustments is derived from the application of Germany’s general tax rules, and a conforming adjustment will take the form of either a deemed capital contribution or a constructive dividend (with attendant withholding tax implications) even where the shareholding of the deemed dividend recipient in the deemed payer of the dividend is only 1%. Neither deemed capital contribution nor constructive dividend treatment can be reversed if it is later decided to make an actual repayment of the additional amount concerned. Instead there would be a deemed capital contribution to reflect the amount so returned.
France in a sense goes even further by treating every non-justified payment out of France to a third party as a deemed dividend for French tax purposes, even if the payment is made by a parent to a subsidiary. In principle, tax will have to be withheld on the deemed dividend. However, Gelin explained that, if there is an applicable tax treaty between France and the country of residence of the recipient of the deemed dividend and the definition of "dividend" in the treaty concerned does not cover such a deemed dividend, then it will be regarded as other income for treaty purposes and no withholding tax will apply.
Peter Parmentier of Jones Day, Brussels, contrasted the position in Belgium where no conforming adjustments are made following a basic transfer pricing adjustment, by recharacterizing the additional payment concerned either as a deemed distribution or as a capital contribution. The amount will simply be considered a nondeductible expense and that will be the end of the story. In theory, it would be open to the Belgian authorities to argue that an excess payment was a constructive dividend, but so far they have never done so. The Belgian position prompted Bouma to wonder whether Belgian taxpayers were inclined to use transfer pricing to avoid the withholding tax that would apply to dividend payments to foreign related parties. Parmentier replied that Belgian taxpayers tend not to resort to such a strategy because, since the introduction of more formal arm’s length rules in 2004, it is not possible, where a transfer pricing adjustment is made under those more formal rules, to lessen the tax impact of increased income by offsetting the additional income with current or prior tax losses. In any case, as Parmentier pointed out, where the other party to the transaction was a parent company resident in another EU Member State, no withholding tax could generally be imposed because of the EC Parent–Subsidiary Tax Directive. (The EC Parent-Subsidiary Tax Directive, broadly speaking, provides for a zero rate of withholding tax on dividends paid by a subsidiary resident in one EU Member State to its parent resident in another EU Member State.) Recently, there has also been a proposal to exempt dividends from withholding tax where the dividends are paid to a shareholder resident in any country that is a treaty partner of Belgium, provided there is at least a 15% shareholding relationship between the parties concerned.
Javier Martín of Ernst & Young, Madrid, indicated that there is no express provision in current Spanish law requiring a conforming adjustment to be made in the wake of a basic transfer pricing adjustment, but generally, as a matter of practice, such an adjustment will lead to the taxpayer concerned being treated as having paid a deemed dividend or made a deemed capital contribution. However, a draft law, which awaits the approval of Congress, specifically envisages constructive dividend/capital contribution treatment in these circumstances. The draft law, which, if passed, will go into effect at the beginning of 2007, introduces a broad overhaul of Spain’s transfer pricing rules to bring them into line with those of other EU Member States. Using the term, "secondary adjustment" rather than "conforming adjustment," Christian Emmeluth, who practices in Copenhagen, explained that in Denmark such an adjustment may take the form of a constructive loan, a hidden profit distribution or a taxable contribution. Secondary adjustments may, however, be avoided in certain circumstances where an undertaking is made to make actual payments to adjust the cash position of related parties to that which it would have been had the transaction concerned taken place at arm’s length.
Purcell reported that, like Belgium, the United Kingdom has no rules providing for conforming adjustments in a cross-border context. A consultation document prepared in 1997, in advance of the U.K.’s 1998 overhaul of its transfer pricing regime, directly addressed the issue of secondary adjustments, but did not propose any specific provisions to impose such adjustments, preferring instead simply to express the Government’s wish to encourage the voluntary repatriation of funds to restore the arm’s length cash position (which remains a tax-neutral event). Interestingly, the 2004 changes, which essentially brought the U.K.’s thin capitalization measures within the transfer pricing regime, introduced a provision for a compensating adjustment designed to relieve payments of excessive interest from the double taxation that would otherwise arise as a result of the excess not being recharacterized under U.K. rules. Under the old thin capitalization rules, payments of excess interest to a group member abroad were generally recharacterized as dividends, which treatment did not give rise to double taxation because the United Kingdom does not impose withholding tax on dividends. Under the new rules, excessive interest is not recharacterized but remains interest; this creates potential double taxation – both nondeducibility for U.K. tax purposes and the imposition of U.K. withholding tax – because there is no treaty withholding tax relief for excessive interest. The United Kingdom has, therefore, provided for a compensating adjustment that allows such excessive interest to be paid to a foreign lender without deduction of tax. Purcell cautioned, however, that there is no equivalent compensating adjustment for payments of excess royalties, which therefore remain subject to potential double taxation.
Grant of a Loan at a Reduced Interest Rate
Bouma then turned to the second scenario envisaged in the fact pattern set out above, where H accrues interest income of u$1,000 on a loan to F, and it is determined by the Host Country tax authorities that the arm’s length interest on the loan is u$1,300. In these circumstances, F is deemed to have paid the additional interest to H, and H is then deemed to have paid the amount of the additional interest back to F (the difference between this scenario and the first being, therefore, that in this scenario there are two deemed payments, instead of one actual payment consisting of two parts, one of which is a deemed dividend, deemed capital contribution, or deemed loan). Bouma explained that the United States could treat the deemed payment back to F either as a deemed dividend (i.e., where H is a subsidiary of F) or as a deemed capital contribution (i.e., where F is a subsidiary of H). As in the first situation, subject to certain requirements H would also be able to make an election to have the deemed payment to F treated as a loan.
The discussion that followed Bouma’s explanation of the U.S. rules made it clear that the other countries represented at the meeting would take essentially the same approaches to the deemed payment back to F (after the deemed interest payment to H) as they would take to the excess payment made by H for the hard drives, as discussed above. Thus, for example, Germany and Switzerland would treat the deemed payment as either a constructive dividend or a capital contribution, depending on the shareholder relationship between H and F; France would treat it as a deemed dividend, irrespective of the shareholder relationship; and Belgium and the United Kingdom would simply add the deemed interest payment back to the taxable income of H, and not worry about a deemed payment back to F.
Effect of a Transfer Pricing Adjustment on Other Taxes
Gelin raised the interesting question of what impact, if any, transfer pricing adjustments of the kinds envisaged might have on other taxes and levies, in particular value added tax (VAT) and customs duties. Martín noted that under the EC Sixth Directive, the taxable base for VAT purposes is the actual consideration (i.e., the invoiced amount). Thus, in principle, a transfer pricing adjustment for income tax purposes should have no consequences for the charging of VAT within the EU. However, Martín also explained that the EU Member States may apply for an exception to the general rule, which allows them to insist on VAT being charged on the arm’s length value of the goods or services concerned, where these are supplied between related parties. The United Kingdom has been granted such an exception. Spain has applied, but has not yet had its application accepted. Spain would, however, adjust its customs duties to reflect the arm’s length value of goods established by an income tax transfer pricing adjustment. Bouma and Gelin were of the opinion that neither the United States nor France, respectively, would be likely to make an adjustment for customs duty purposes. Liebman also thought it unlikely that Belgium would make such an adjustment, if only because of Belgium’s very formalistic approach to customs duties generally. Van den Bruinhorst said that, theoretically, because the basis for customs duty in The Netherlands is the arm’s length price, an adjustment could be made for customs duty purposes in response to a transfer pricing adjustment that established an arm’s length price for goods that differed from the price actually charged. She thought, however, that such an adjustment would be very difficult to achieve in practice. Portner confirmed that the position in Germany was the same as that in The Netherlands, i.e., obtaining an adjustment for customs duty purposes is a theoretical possibility that is unlikely to be achieved in practice.
THE TAX TREATMENT OF SUPPLEMENTAL RETIREMENT PLANS
The following fact pattern formed the background to the discussion of the second topic.
H Co. is a large, publicly traded (in Host Country) corporation that operates through subsidiaries in over 100 countries (Foreign Countries). Many H Co. executives work in different parts of H Co.'s worldwide operation, often spending several years working for a subsidiary in one Foreign Country and then being transferred either back to H Co. headquarters in Host Country or to the operations of another subsidiary in a different Foreign Country.
H Co. and its subsidiaries provide their employees with standard benefit packages typical of the country in which the operation is located. These usually include retirement benefits, health benefits and various fringe and other welfare benefits. H Co. also allows certain senior executives to participate in a supplemental retirement plan, which is designed to provide the participating executives with retirement benefits in addition to the standard retirement benefits provided to the general employee workforce. The supplemental retirement plan does not satisfy all of the requirements for tax-favored retirement plans under the Host Country's tax laws.
Against this background, the Forum members were asked to consider the following questions (assuming that their own country was Host Country):
- What are the tax consequences to H Co. and the executives with respect to the
retirement benefits provided by the supplemental retirement plan?
- Would the answers to the above question be different if the supplemental retirement benefits attributable to services performed in a Foreign Country are provided
under a separate supplemental retirement plan maintained by the subsidiary that operates
in the Foreign Country (instead of a single supplemental retirement plan maintained
by H Co. for all of its worldwide executives)?
- Would the answers to the above questions be different if the company maintaining the supplemental retirement plan regularly sets aside company assets (whether or not in a trust) to pay the retirement benefits when they become due?
United States
Keith Mong of Buchanan Ingersoll & Rooney PC, Washington, D.C., introduced the second topic by remarking on the extent to which companies are having to provide supplemental benefits to increasing numbers of internationally mobile executives as the globalization of the world economy continues. As Mong observed, many countries have tax-favored retirement plans, but because of the limitations invariably imposed on such plans as to the level of benefits they can provide, companies cannot afford executives a sufficient level of retirement benefits though such plans alone. In the United States, abuses involving non-qualifying retirement plans have attracted much attention because of the role they played in the corporate scandals (involving, most notoriously, Enron and Worldcom) of the early 2000s. These scandals provided the final impetus for the 2004 reform of the U.S. rules relating to non-qualifying retirement plans. The pre-2004 U.S. rules, which were in place for roughly 40 years and which Mong characterized as "well-settled and simple," essentially deferred the taxation (in the hands of an executive) of an unsecured, unfunded promise to pay compensation at a future date until the compensation was actually paid. The company providing the benefit was not entitled to a deduction until the compensation was actually included in the executive’s taxable income. One of the perceived abuses to which non-qualifying plans were susceptible under these rules arose from what were known as "haircut provisions." These provisions allowed plan participants to elect to receive their deferred compensation at any time provided they agreed to receive a discounted amount. Executives who could foresee that a company was likely to experience economic difficulties could thus cash out their retirement benefits before the company collapsed. Rank and file employees, on the other hand, who only had access to qualifying retirement plans, could not cash them out until after the company’s collapse and if their retirement benefits were invested entirely in company stock, they lost everything. Another practice that was perceived to be abusive was the setting up of "Rabbi" trusts to hold assets to fund non-qualifying deferred compensation arrangements. Even though assets held by such trusts were technically subject to the claims of general creditors (as was necessary to avoid current income recognition), they were actually invested offshore, where it would be difficult for the creditors to get access to them in the event of the company’s bankruptcy. Liebman remarked in this context that, at least in certain instances, assets may have been placed in asset protection trusts, where they are not subject to the claims of general creditors, although they may remain accessible to such creditors (under the common law Statute of Elizabeth) if there has been what is known as a "fraudulent conveyance." Some tax havens, however, have passed laws setting aside the Statute of Elizabeth.
For some years, the IRS had been trying to attack these and other perceived abuses through the courts with little success and, in October 2004, new §409A of the Internal Revenue Code was added by the American Jobs Creation Act of 2004 to address the problem more directly. Mong explained that the new U.S. rules have three main features: (i) election restrictions (which impose requirements as to the timing of both initial deferral elections and elections with respect to the form and timing of distributions); (ii) acceleration restrictions (which provide that deferred compensation generally cannot be accelerated, effectively putting an end to the viability of haircut provisions); and (iii) distribution restrictions. The last provide that deferred compensation can only be received on the happening of one of six events: (i) separation from service; (ii) disability; (iii) death; (iv) the expiration of a specified time; (v) a change in the ownership or control of the corporation concerned; and (vi) an unforeseeable emergency. Section 409A also introduces new funding rules the effect of which is to tax immediately in the hands of the executive amounts transferred outside the United States. The consequences of violating the new requirements are severe: current inclusion in income of all deferred income that is not subject to a substantial risk of forfeiture; an interest charge equal to the underpayment rate plus 1% from the date originally deferred; and an additional 20% excise tax.
The Netherlands
Van den Bruinhorst explained that The Netherlands only allows for deferral of taxation in the case of qualifying pension plans. Where contributions are made to a non-qualifying plan, the annual accrual of pension benefits will be taxable income in the hands of the employee concerned, the annual accrual being determined by the level of the contributions made. Nor will the employee’s contribution reduce taxable remuneration, but the employer’s contribution will be a taxable benefit in kind. On the company side, the deductibility of contributions to non-qualifying plans is subject to a number of limitations.
On the other hand, contributions are deductible when they are paid to a qualifying Dutch plan. Van den Bruinhorst indicated that it is also possible for foreign executives working in The Netherlands and contributing to a plan in their home country to request the approval of the Ministry of Finance (MOF) to have their home country plan treated as a qualifying plan. In deciding whether to grant such approval, the MOF will examine the rules of the home country plan to ascertain whether they are similar to those applying to Dutch qualifying plans.
Belgium
Parmentier outlined the various requirements that must be met for contributions to employment-related pension plans to be deductible for Belgian tax purposes. Among those he highlighted were that the capital built up by the contributions may not exceed an amount that would generate annuities amounting to 80% of the final annual salary of the employee concerned and that the contributions must be made to a Belgian insurance company or to the Belgian branch of a foreign insurance company. This latter requirement is currently the subject of a case before the ECJ, in which the European Commission has claimed that the requirement infringes all four freedoms provided in the EC Treaty. The Attorney General’s opinion on this case, which was issued on October 3, 2006, supports the view of the European Commission. Retirement benefits paid out by employment-related pension plans are, in principle, subject to tax in an employee’s hands as employment income at normal progressive rates, but (subject to the fulfilment of certain conditions) may benefit from a favorable tax regime.
Switzerland
Boss explained that all Swiss employers are required either to set up or to join a Swiss occupational pension plan. These compulsory occupational pension plans are the second pillar in Switzerland’s three-pillar social security system, the first pillar being the state old-age pension insurance scheme and the third, voluntary pension and life insurance schemes. The compulsory occupational pension plan rules provide for a minimum level of benefits (designed, in combination with the state pension scheme, to give retired employees retirement income equal to about 60% of their pre-retirement earnings), but such plans are free to provide benefits in excess of the statutory minimum. Interestingly, all employer contributions under such schemes are deductible as business expenses, provided they are reasonable from a business standpoint. Employees are taxable on their employment income net of their own contributions to such plans and benefits are only taxable in their hands when they are paid out to them.
Denmark
Emmeluth confirmed that the Danish rules are similar to the Belgian rules in that the deductibility of contributions to a pension plan is conditioned on the plan being established in Denmark or taken out with a Danish insurance company or a Danish branch of a foreign insurance company. Unlike Belgium, Denmark imposes no limit on the amount of contributions to such plans, except in the case of self-employed persons, whose annual contributions are capped at DKK 46,000 (approximately US$7,500). The cap can be avoided where the taxpayer undertakes to keep contributing the same annual amount to the pension plan for at least 10 years. If the taxpayer fails to maintain the contributions for 10 years, his taxable income is recalculated as if he or she had contributed a smaller amount in the years previous to that in which the failure occurs. Another rule introduced in 2004, allows a self-employed taxpayer to contribute up to 30% of his taxable business profits to a plan with an insurance company or bank, provided the plan meets certain requirements, in particular that it provides for the payment of an annuity for a period of at least 10 years. Denmark also has a special scheme for sportspersons under which they can contribute up to DKK 1,568,200 (approximately US$261,000) per year and may withdraw money from the scheme at an earlier age (46) than is normally permitted (60). There is generally no taxation until retirement benefits are paid out, although there is an annual tax on a pension fund’s profits from the investment of the contributions made to it.
France
French labor law requires employers to withhold from salaries paid to their employees contributions to the French social security system, which are designed to fund the state pension, although according to Gelin the system is "in danger of collapse." Also mandatory, and also deducted from salaries are payments to complementary retirement schemes managed by qualified joint agencies.
Contributions to both systems are shared between employers and employees, are calculated by reference to the salary earned by the employee concerned, and are deductible for income tax purposes for both employers and employees. Pensions in the form of annuities are taxable as employment income when paid out.
However, Gelin observed that, because of declining returns from these compulsory plans, French companies have increasingly been establishing a "third tier" of supplemental retirement plans for their executives. The rules governing such plans were substantially overhauled as recently as 2003. Under the new rules, these plans benefit from some degree of favorable tax treatment, where certain conditions are met. Gelin pointed in particular to the requirement that to qualify for favorable treatment, a supplemental plan must be made available to a specified group of employees, i.e., it cannot be made available only to specific individuals. Although the case law on this subject is somewhat convoluted, one principle that has emerged is that executives as a group are acceptable as a "specified group" for these purposes. Where the requisite conditions are met contributions will be deductible and, where the plan is a "defined benefits" plan, not taxable as remuneration in the hands of the executive. Where the plan is a "defined contributions" plan, contributions will regarded as remuneration and therefore subject to income tax, but will benefit from a capped deduction for income tax purposes. Gelin noted in this context that, pursuant to a very recent Ordonnance (n°2006-344 of March 23, 2006), and subject to certain conditions, French companies will be able to outsource their supplemental plans to a nonresident dedicated insurance company established in the EU or the European Economic Area without jeopardizing the income tax deduction referred to above. (The Ordonnance will not enter into force until the necessary governmental decrees have been passed.) Pensions, which are generally paid out in the form of annuities, will be subject to income tax when they are received, although executives are likely to pay less tax at this stage because of the effect of France’s progressive personal income tax rates.
Germany
Like the French and Swiss systems, the German pension system has three tiers: the state pension; company pensions; and pensions built up by the voluntary contributions made by individuals out of pre-tax income. While German employees cannot rely on the state pension, Portner suggested that company pensions can be an effective vehicle for providing them with an adequate level of income on retirement. She highlighted two particular tax benefits of company pension plans. First, if the company simply makes a promise to pay a pension to an employee on retirement (i.e., the plan is an unfunded plan), such a promise does not give rise to taxable income in the hands of the employee at the time it is made. Second, if the company instead makes contributions, for example, to an insurance company, and the employee also contributes, the employer can take a deduction for its contributions for corporate income tax purposes, and the employee can have his or her salary reduced by the amount of his/her contributions and will only be taxed on the reduced amount. Nor is there any limit at all to the level of such contributions, which, in Portner’s words, makes it "a rare and very generous German tax break."
A provision in the German tax code makes it possible for a German resident to deduct contributions even where they are made to an insurance company established outside Germany if the insurance company is established in the EU or the EEA and provided the foreign insurance company is permitted to do business in Germany. The foreign insurance company does not actually have to set up a branch in Germany, which means that the German rules, unlike the Belgian rules (and the French rules, at least until Ordonnance n°2006-344 enters into force), are compliant with EC Law.
International Tax Aspects
Mong noted that, because the United States taxes its citizens and residents on their worldwide income, globally mobile executives who fall into either or both of these categories will be subject to the applicable U.S. rules on deferred compensation, so that careful planning is required when designing such arrangements for U.S. executives, regardless of whether the relevant plan is sponsored in the United States or in a foreign country. Such executives may be eligible for an income tax exclusion with respect to compensation for services or for foreign tax credit relief. Where the executive concerned is a non-resident individual, any compensation relating to services performed in the United States will be regarded as income effectively connected with a U.S trade or business and therefore subject to U.S. taxation. In this context, Mong emphasized that deferred compensation relating to services performed in the United States will retain its status as effectively connected income, irrespective of whether the executive is engaged in a U.S. business in the year in which it is paid and will be subject to U.S. taxation even if the executive is no longer resident in the United States. It will be important in these circumstances to consider the implications of any applicable U.S. tax treaties, although Mong pointed out that not all U.S. treaties specifically address the taxation of retirement income and those treaties that do, generally limit relief to tax-qualifying plans.
In the European countries, there is considerable variation in the tax treatment of accrued pension rights in the hands of a tax resident of one of these countries who subsequently becomes a nonresident. For example, Portner explained that unlike the U.S. tax rules, the German rules do not provide for any German taxation of retirement benefits accrued in Germany when they are received by an employee who has subsequently become a nonresident of Germany. The position is somewhat more complex when a foreign employee who has been working in The Netherlands and has become a Dutch resident for tax purposes, subsequently becomes a nonresident, although ultimately, according to van den Bruinhorst, it should be possible to ensure that the value of the employee’s accrued pensions rights escapes immediate taxation on his or her departure from The Netherlands. If the foreign employee continues to participate in his home country pension plan, his or her departure from The Netherlands will trigger the making of a protective or "conserving" assessment with respect to the accrued rights, but the tax under the assessment will not be collected unless and until the employee cashes in his or her rights under the plan. Alternatively, it may be possible, though not easy, to have the foreign plan approved as a Dutch qualifying pension plan, with the same consequences, i.e., that there will be no immediate taxation on the employee’s becoming a nonresident of The Netherlands. The Belgian approach to this situation is yet again different: where a Belgian resident individual becomes a nonresident, the individual is taxed on the value of his or her accrued pension rights at the time he or she becomes nonresident. Parmentier suggested that this treatment is presumably in conflict with EC law, because it represents a restriction on the free movement of individuals, which is otherwise protected under the EC Treaty.
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