Reforming capital gains taxation of intercorporate share realizations : a law and economics approach from a Nordic perspective

In this article the authors will make an effort to identify and consider (using a Nordic perspective) the main challenges and reform possibilities of corporate capital gains taxation (specifically the tax rules for intercorporate share alienations) in Europe. The high-level general issue of creating a functional and effective corporate tax system has obviously been discussed frequently during the last years.

See for example the recent articles by Avi-Yonah (2016) and Kari (2015).

Nowadays, the concept of so-called participation exemption is widely used to refer to (possible) tax exemption of intercorporate capital gains within a larger structure of groups of companies. Even though the symmetric tax exemption of intercorporate dividends may be related to tax exemption of intercorporate capital gains, the scope of this article does not cover tax issues of intercorporate dividends

See Eicke (2009, 48) and Keskitalo (2012, 59 - 60) about the discussion on the terms participation exemption and tax exemption.

Taxation of capital gains is not in any level an easy and straightforward subject. It effectively touches many different and various aspects of the determination of the tax. Capital gains taxes are also a significant research topic from the economic efficiency perspective. In Finland and many other European countries corporate sector has been noticed to export capital more and more from abroad.

Corporate income taxation should improve economic efficiency by encouraging entrepreneurship and by being competitive and assessable. Growth of capital flows is one of the key features of globalization. Investments, productivity and income have always also been important topics in the economics related discussions. Increasing the amount of capital is investing. Capital can be considered to be everything that is supporting business to generate profit. Technical progress of the country increases the productivity of capital, and country’s output resulting from the investment in the capital depends of the productivity of capital. Income can be considered to be interest of capital value according to the perfect definition of income. On the other hand, corporate capital gains can be considered to correspond to that interest of capital as the value increase of the capital.

Therefore, corporate capital gains taxation is a significant research topic from the whole economics perspective, because findings and future development in that subject matter may considerably boost the dynamics of the international economics. The comparative aspects and results presented in this article are mostly based on the recent results of Anu Torkkeli’s doctoral thesis (June 2016, Hanken publications) Structuring Corporate Capital Gains Tax System in the European Union - A Comparative Finnish Perspective

Anu Torkkeli, Publications of Hanken School of Economics, Nr 296, Helsinki 2016. The academic opponent of Torkkeli’s thesis was professor Mattias Dahlberg from Uppsala. The co-author of this NTJ-article, professor Matti Kukkonen has worked as Anu Torkkeli’s academic supervisor at Hanken. Professor Kukkonen has earlier published a doctoral thesis about capital gains both in tax law (Income Tax Issues of A Company Sale (in Finnish), Helsinki, Lakimiesliiton kustannus, 1994) and economics (Capital Gains Taxation and realization behaviour: evidence from Finnish panel data, HSE A 168, 2000).

Based on Simontacchi (2007, 137, 142) capital gains taxation has the nature of income taxation, because capital gains are considered as an increase in the value of the asset accrued during certain period of time. Even though there is inconsistency in the definition of capital gains between countries, there are certain issues that are generally considered in capital gains taxation.

Different theories of income have formulated the basis for corporate income taxation and thus also for the corporate capital gains taxation over the years.

For the issues related to the ambiguous concept of (taxable) income see the interesting doctoral dissertations (IBFD series) published by Holmes (2001) and Laukkanen (2007). See also Kavelaars (2005).

The discussion on whether to tax only realized or also unrealized capital gains have been colorful. Even though majority of the countries are currently applying realization principle (taxing only realized capital gains), they have noticed the weaknesses of that because they have implemented special rules for special situations. The biggest worry related to using capital gains taxation on the unrealized gains is that companies would not have money to pay taxes when gains have not yet been realized, and that that taxing methodology will increase significantly administrative work.

The theoretical (and practical) major problem issues related to the taxation of changes in value can be listed as follows:

The extent of the definition of income: whether changes in value are taxable

As Simontacchi (2007, 131-132) discusses, in most countries the income tax is operated on a realization basis, which means that income is only taxed when realized. Capital gains are taxed not earlier than when the alienation is realized. There are some exceptions to this rule of thumb, for example revaluation of assets is taxed based on the accrual principle.

For more discussion on the accrual principle, see Kavelaars (2005).

Bankman et al. (2005, 131), and Mirza and Holt (2011, 115-116) comment that the recognized gains and losses are taken into account, for purposes of computing the taxpayer’s gross income, only to the extent that they are also recognized. An item of property, plant and equipment satisfying the recognition criteria should be recognized initially at its cost. The cost of an asset is measured at the cash price of the date of acquisition. Capital gains are considered to be realized in the alienation, and ownership transfers in the alienation. As Kavelaars (2005, 127) and Laukkanen (2007, 100) discuss capital gains cannot be taxed before the realization, because income is contingent, the taxable amount cannot be defined accurately, and taxation should not happen before income is available for investments with an exact amount. As Laukkanen (2007, 101), Simons (1938???, 87), and Simontacchi (2007, 132) state there are such alienations, however, in which ownership is not transferred. Most of these alienations have specific features, or they do not occur very often.

The total gain of an investment is the sum of running yield, unrealized change in value and realized change in value. Taxable income is however the amount that is defined to be taxed. Often only realized change in value is taxed. Generally realization has meant selling or change of property. Applying realization principle has been often seen as a practical compulsion due to issues related to valuation of property and liquidity.

Schenk (2004b, 374-377).

The liquidity requirement of the concept of realization has been met once property has been moved to money. In this case the taxpayer’s ability to pay tax increases, when the paying ability is measured in cash. If realization would be analyzed only from this perspective changes from one fund to another inside a fund company would not be considered as a taxable transaction. Because this anyhow leads into taxation of capital gains, the improvement of the taxpayer’s liquidity position has not been as a necessary requirement for realization. If the taxpayer borrows money from a bank with the same amount as money invested to the bank, this is not considered as realization. Therefore as Knuutinen (2009, 90-91) and Melz (1986, 66) conclude, the improvement of the taxpayer’s liquidity position is not an adequate requirement for realization.

From the perspective of risk exposure, realization means closing the risk exposure of the position. Realization principle is often justified by the fact that the risk of the investment is permanently removed and income becomes certain in connection with the realization. Normally the sale of the investment instrument makes sure that the variation of the value in the investment instrument does not anymore affect the financial position of the taxpayer. Realization principle is two-way in that it can be either favorable or unfavorable to the taxpayer depending on the case in question. The taxpayer tries to avoid taxation in a situation, in which tax burden would increase, and tries to activate taxation when realization would lead into deductibility of loss. An investor can eliminate the risk related to the investment object with a hedging instrument without a realization event. Also, a realization event can be simulated with hedging instruments without tax consequences.

Goldberg and Watson (1996, 62-67); Paul (1996, 3); Weisbach (1997, 495-506).

The measurability viewpoint in regard of realization has the focus on valuing and calculating income. As Holmes (2001, 113) states often realization is seen to make it possible to define objectively and accurately enough the amount of income received from the investment. Knuutinen (2009, 92) comments that the chance for measurability cannot alone signify realization. The viewpoint of valuation and computability is valuable for example in different exchange situations, in which the liquidity position of the taxpayer is not changing and changes in risk position are marginal. Based on Ault and Arnold (2004, 194) and Bittker (1981, 5-16-5-17) economically realization means changes in the taxpayer’s liquidity and risk position. Liquidity, exclusion of risk, and measurability requirements are significant when analyzing realization in taxation, because in taxation realization is analyzed as a formal, private law related transaction rather than as an economic transaction. The distinction between owning and alienating property is formal and dependent on definitions. It is important for the functionality of the tax system that how realization has been defined in the tax rules.

See also Paul (1996, 50); Powell (1922, 376); Rosenberg (1988, 383); Simons (1955, 84).

Based on the paying ability of tax and horizontal justice, the ultimate purpose in measuring the amount of income is for the basis of the fair division of the tax burden. When applying the realization principle, the amount of income is often measured in a wrong way compared to the economic accrual of income. Based on Knuutinen (2009, 93) that is because economically income can be considered to be earned as an asset appreciates, not when it is sold.

See also Halperin (1998, 494); Hasen (2004, 400); Land (1996, 48); Potter (1999, 879); Rosenberg (1988, 380, 494).

In the realization principle the taxpayer may utilize the right to decide her- or himself about the alienation actions and on their timing. The taxpayer can use the options to realize or not to realize depending on the tax impacts. Relating taxation to such transactions that the taxpayer can decide her- or himself are raising questions on justice. Tax law cannot regulate these decisions for the taxpayer. Applying formal realization events may also lead taxpayers to realize such transactions that they would not carry out without those formal tax rules. This makes taxpayers to approach the tax avoidance situations. In addition to justice, another aspect to consider is efficiency when using the realization principle. Immediate efficiency losses are arisen because of the unnecessary transactions done due to tax avoidance and related costs. Realization principle has also been considered to affect different efficiency issues because of its effect on the decisions of investors. One of those efficiency effects is the lock-in effect. Kukkonen (2000, 154-161) comments that investors are unwilling to sell such shares that include a lot of accrued gain, and the realization principle can help investors to avoid the taxation.

See also Blum (1957, 256-259); Cunningham and Schenk (1993, 344-350).

The current EU-level harmonization of some corporate tax situations leads in effect to accrual taxation of capital appreciation. One clear example of this trend is the most recent anti-tax-avoidance directive (ATAD (EU) 2016/1164) which will cover all taxpayers that are subject to corporate tax in a member states, including subsidiaries of companies based in third countries. It lays down anti-tax-avoidance rules for situations that may arise in five specific fields:

Interest limitation rules.

Based on these rules a tax is levied on the transfer of assets if:

Assets are transferred from the taxpayer’s head office to its permanent establishment (PE) in another Member State or third country in so far as the Member State of the head office no longer has the right to tax the transferred assets due to the transfer;

The taxable base is formed by the difference between market value and value for tax purposes at the time of exit of the assets concerned. This means in effect an accrual tax on capital appreciation (gain) which was discussed (from a more theoretical perspective) in detail earlier in this article (accrual or realization based tax?). If assets are transferred to another Member State, those Member States are obliged to allow taxpayers to value the assets at market value. In such cases taxpayers also have the right to defer tax claims arising from exit taxation by paying in installments for five years. This means that there is a postponement possibility for the actual payment of capital gains tax. If a taxpayer chooses to defer a tax claim, interest may be charged and, if there is an actual risk of non-recovery, securities may be demanded by the Member State involved. EU member States should apply this provision by January 1, 2020.

The international viewpoint to the corporate capital gains taxation (tax systems of intercorporate share alienations) can provide some visibility to how the corporate capital gains taxation system should be developed in the future and what a future corporate capital gains taxation model could be. Economic integration takes place most efficiently between such countries, of which the cultural, linguistic and social background is similar and which are located near to each other. The common Nordic market area enhances the diversification of the production and export and strengthens the competitiveness of the companies of the area also outside the area. The capital gains tax system perspective is an important research focus because it would be valuable to the society to re-focus on the innovation at the EU level and to re-allocate capital resources across firms and innovations systems. This means that in the ideal situation the results of the studies among the area of the capital gains taxation would serve as a trigger for EU-wide development of the economic innovations. Even though the main focus is in the system level approach, the current corporate capital gains taxation models in the individual countries have played a significant role in the capital gains taxation development so far, and it may not be possible to introduce a huge harmonization activity to get rid of all features developed in the country-specific corporate income tax regulations. The tax exemption principles of the European Union countries can be split to some key principles or models (see Table 1).

Table 1

Comparison of the corporate capital gains taxation models in the European Union countries (2014)

Corporate capital gains are taxed based on the net distributions in Estonia (double taxation avoided because only taxed at corporate level). In Germany 95 percent of the capital gains from the sale of shares of resident and non-resident companies are fully exempt regardless of the level of shareholding, length of the holding period or number of voting rights. In Netherlands the minimum ownership share is defined based on the paid-in capital, and there are additional requirements based on wealth and the level of taxation. United Kingdom’s corporate capital gains taxation is a combination of the source and residence based taxation, and tax exemption applies to substantial shareholdings in trading companies.

The future focus could have at least a couple of interesting considerations. Tax rate harmonization could stay at a reasonable level, which will not remove fully the natural life cycle of companies seeking for the most competitive location for the business. The economic impact of different corporate capital gains taxation systems and corporate capital gains taxation renewals could be investigated further. Corporate capital gains taxation could also be developed so that it supports the innovations and development type of work. The tax exemption principles of the Nordic countries can be split to a couple of key principles (see Table 2).

For more details for these countries, see Torkkeli (2016, chapter 5).

Table 2

Comparison of the corporate capital gains taxation models in the Nordic countries (2016)

Common feature of the development of the corporate capital gains taxation in the Nordic countries has been lowering the corporate income tax rate to follow the international corporate income taxation trend of the last years. Flat proportional tax rate is used as the corporate capital gains tax rate. Rates could be still aligned between countries in the future.

Requirements for the subject and object companies for the tax exemption have been defined in the corporate capital gains tax regulations of the Nordic countries. Sweden has paid attention to tax avoidance by creating special taxation rule for shell companies as object companies and trading companies as subject or object. Norway was using a percentage limit for tax-exempt items in 2008-2011. Denmark has created special regulations regarding the holding company structures as alienator to avoid tax avoidance situations. Key differences of the Nordic corporate capital gains taxation models are in the regulations created for tax avoidance and the regulations created to identify a share ownership with business relationship.

The various identification requirements complicate the interpretation of the exemption rules. In some cases there is only a thin line between normal tax exemption and tax avoidance. As an example of this ambiquity see below for a published Finnish tax case from the Supreme Administrative Court concerning the business nature of a two-level corporate ownership structure between an investment company and business company. This case reflects the current tax law interpretation of Finnish participation exemption rule.

In the current economic situation, there are actually several significant options to renew the corporate income taxation in Finland, all Nordic countries and more generally within the EU. To increase the competitive edge of the EU in the world economy, the member states should consider a general-level tax harmonization between the countries. That could boost the latent entrepreneurs or ideas for enterprises to implement new business activities in other European Union countries. However, the actual (real) tax harmonization in the European Union requires skillful tax and public finance specialists to negotiate the common future outlook and also to build the needed authorities not only to administer the European Union -wide corporate taxation system but also to manage that change so that the subsidiarity of the member states is not neglected. It is yet difficult to assume that a common tax base (see below) could be a real possibility in the near future, at least not for the SMEs.

Neither the total harmonization or the total abolition of corporate tax should probably be a dictating force in the short term at least. The main focus could instead be in setting up cross-border bodies for investigating the corporate capital gains taxation systems, searching for best practices, investigating the impacts of the corporate capital gains taxation systems to economics and sharing knowledge and information to EU member states on other EU member states. This would improve the quality of the possible changes in the future corporate capital gains taxation systems. Even Constitution Act supports the approach - when interpreting a wider context - that the corporate income taxation is set out so that EU member states are in the equal position with each other based on the corporate income taxation system. It is also possible that in the future harmonization of the corporate income taxation between the EU member states could be made easier with a multilateral agreement, which would make implementing of changes quicker.

The somewhat more limited tax harmonization option would be to renew, as a start, the corporate tax systems and taxation of corporate gains through the harmonization of tax rates or, more specifically tax exemptions between the Nordic (dual income tax) countries. Taxation of corporate capital gains is one challenge that the Nordic and European countries could start cooperating more to enhance the entrepreneurship, to increase the overall economic activity and to speed up the dynamics of the economy. Harmonization discussions have here two important aspects. First, cooperation in the area of corporate capital gains taxation inside the Nordic countries is a necessity, because all the Nordic countries are not part of the European Union. Second, the Nordic countries could lead the way to building cross-border corporate capital gains taxation development bodies. After having shown some results, the whole European Union could start seeing the value of that kind of renewal and may start building similar kind of bodies inside the European Union.

This would also mean that a more modern and multidisciplinary approach would be used for the corporate tax reforms in Europe. More cooperation and organizational bodies working towards the common targets of a good corporate income tax system is needed both at the level of the Nordic countries and European Union. The future corporate income taxation should be challenged with new cross-scientific perspectives. In addition, the focus should be in the cross-border taxation issues, because in the current globalizing world there is no way to avoid situations, in which there are group companies in the Nordic countries and European Union but also in the third countries. To ease the companies to allocate their time as much as possible to drive the business itself in an international arena instead of paying much money and spending a lot of time for administrative tax questions, the corporate income taxation should be as simple as possible.

According to our view, a functional and realistic corporate capital gains tax system for intercorporate capital gains (share alienations) can be created by combining the current features of the Danish, Dutch, and UK corporate capital gains taxation system (see the Figure 1 above). More focus should be allocated on the interface between the group taxation overall, group structures and corporate capital gains. The current corporate capital gains taxation systems in the Nordic countries and in the European Union have been mostly prepared purely from the taxation point of view except for the flow-through approach that has been applied in a couple of countries. A new corporate capital gains tax system should utilize more efficiency and simplicity as the features of a good taxation system. Corporate capital gains taxation system should not cause too much administrative work for tax authorities, and at the same time the tax regulations should be simply understandable and usable for companies.

Figure 1

Denmark and United Kingdom have clear object company requirements with ownership share and substantial shareholding that could be used in a new future corporate capital gains taxation system. Netherlands have developed tests, with which companies can test, whether the ownership share in an object company are business-related. By combining the provisions for the object company applied in Denmark, Netherlands, and United Kingdom, it would be possible to decide, whether the shareholding in an object company is substantial and business-related. In summary, defining a future corporate capital gains taxation system would require renewal not only in the creation phase of the new system by setting up new cross-border bodies and combining multidiscipline knowledge but also in the implementation phase by defining the regulations so that they include enough practicalities for following the regulations as well as linkages between different subject matters or scientific areas. In the future model it would be reasonable to clearly describe the corporate capital income taxation model as a wholeness and then make the needed references to the generic corporate capital income tax regulations inside the Business Income Tax Act such as business income and deductible cost.

Separation of the direct investment shares and portfolio shares create the baseline in the future development as well as identification of substantial shareholdings and business relationship. Subject (selling company) requirements could be simplified so that the subject company is a legal person.

Object (the target company to be sold) requirement could include at least two options: –

As the first option, the requirement could be that the object company is a subsidiary company, which means that the owner company owns the certain percentage of the equity and the equity is divided into shares (based on the Dutch feature).

Less than 50 percent of the total assets of the object company should be passive, which ensures that the object of the alienation is business-related. The meaning of the passive assets could be defined more accurately than in the Netherlands to avoid interpretation issues. In addition to these requirements, the future corporate capital gains taxation model should refer to the definition of business income.

More attention should be still put in the future studies for the corporate capital gains taxation from the perspective of an effective and neutral group and double taxation. More focus should also be given on the taxation topics from the viewpoint of the economic growth and business innovation. The viewpoint of the group could be investigated further and the future corporate capital gains tax model drafted above could then be compared to the flow-through approach, in which the focus is rather on the terms of holding company and subject company instead of the simple and clear corporate capital gains tax model.