2.3.2.2 Forms of control

Legal control

The first and most ‘basic’ variant of control is legal control.1 To determine whether or not there is legal control, the shares held in a subsidiary must be considered to determine the percentage of voting rights.2 Following the percentage of voting rights is a relatively simple starting point for both taxpayers and the tax authorities. Focusing on the voting rights is based on the idea that if an entity holds a certain number of voting rights in another entity, the former is authorised to take decisions about the management. In this way, if an entity has legal control over another entity, this serves as a basis for the determination. Instead of taking the voting rights as a starting point often the size of the shareholding is used as an approximation of control. However, the size of the shareholding is not necessarily indicative of the influence that can be exercised over the business activities.3 Therefore, determining whether control exists by adhering to the amount of voting rights will reflect the economic reality better.

The advantage of the legal control criterion is that it provides legal certainty: the group can be described with simple and clear boundaries.4 However, a fixed percentage of voting rights to determine whether there is legal control – depending on the preferences of a company – may result in tax planning. The ownership interest could be adjusted carefully, taking into account whether consolidation or separate reporting is more advantageous or disadvantageous from a tax point of view for a group.5 After all, if there is a clear criterion, it is easier to ensure that the criterion is or is not met, provided that the business interests allow for this. Anti-avoidance rules could be introduced to combat such tax planning.6 Additionally, tests that take into account the entitlement to acquire shares, e.g., via contingent rights, may mitigate some of the weaknesses of a system based on legal control.7

Another disadvantage of considering legal control is the fact that a group of associated entities that does not meet the stipulated percentage of voting rights can be very strongly intertwined in economic terms.8 Furthermore, the situation of legal control could be circumvented by inserting a holding company. The insertion of this additional company could mean that there is no longer legal control. This problem could be overcome by applying the concept of legal control to both direct and indirect relationships.

If legal control would be used, the precise voting right threshold should be determined. A high threshold may be seen as an attempt to reconcile the control and integration test. The higher the required voting percentage, the higher the chance that the group members are economically interdependent. However, a high threshold would mean less companies fall within the scope of the group, leading to the possibility to move profits out of or into the taxable group. A relatively low threshold (e.g., 50%) would reduce the feasibility of transfer pricing strategies to lower the tax burden. The parties that are not part of the group would then likely not be under control, and thus fall outside the scope of application of transfer pricing.9

All in all, if the group concept is based on legal control, entities in which a certain percentage of voting rights is held belong to a group. Approaching the group concept from a legal perspective leads to a clear group definition. A disadvantage of such a clear group definition is that it may encourage abuse. Using only legal control as a starting point for a group concept therefore does not seem effective in combatting abuse. If legal control is defined as direct and indirect control, the objection with regard to the potential for abuse seems to be less. A clear advantage of legal control as an indicator of the existence of a group is a relatively modest administrative burden for both tax administrations and taxpayers. There is always a clear concept, about which there can be little discussion. This also ensures practicability and legal certainty.

The concept of economic control10 focuses on the entitlement to profit as well as the entitlement to the capital and the assets of the company in certain circumstances, such as in the case of liquidation or dissolution.11 This test takes into account that an entity can have influence on another entity due to the fact that the former is entitled to the underlying value of the company, while the latter does not hold the majority of the shares. Legal control and economic control will often be held by the same person.12 In that case, entitlement to profits (and liability to losses) go hand in hand with exercising control over the activities of the entity.

An advantage of applying the principle of economic control is that it ensures objectivity. After all, it must be determined on the basis of the facts of the specific case whether or not there is economic control. If economic control and dependence are considered important, for the group concept certain shared economic characteristics, such as a significant flow of goods or services, could also be considered.13 A point for attention is that economic control, just like legal control, can in some cases be avoided by inserting a holding company. In such a case, the factual situation is virtually unchanged, while there is no longer any economic control. On interpreting the concept of economic control in substantive terms, there would still be control even if a holding company were interposed. After all, a parent company would retain control over, for example, liquidation distributions received by a subsidiary.

If economic control is used as the basis for the group concept, consideration is given to the profit entitlement and the entitlement to the capital of the company in the event, for instance, it is wound up or dissolved. Using economic control as a basis for the group concept provides an objective criterion, for which the facts of the specific case must be considered. The foregoing means that an economic control test contributes to the prevention of abuse. However, the economic control test as such is not effective in preventing abuse. In this context, the same problem arises as with legal control: in a formal approach there would no longer be any control if a holding company is inserted. Hence, to combat abuse a substantive interpretation of the concept must be applied. The substantive approach of opting for economic control as a starting point entails an increase in the administrative burden for tax authorities and taxpayers in comparison with a system based on legal control. At the same time, there are more problems of practicability and legal certainty compared with a legal control test.

In determining de facto control, other factors – such as who actually takes the decisions in respect of an entity – play a role.14 To determine where an entity is established, many countries take as a basisthe place of effective managementof an entity.15 In this context, it is the place where the board of a body exercises its managerial role. In order to determine whether there is de facto control, one could also look at who carries out the managerial tasks with regard to a body. In addition, consideration could be given to whether one body has the possibility to influence the daily activities of the other body. The existence of contractual agreements establishing de facto control could be considered as well.

The main benefit of the de facto control test is the fact that all facts and circumstances have to be taken into account to determine whether control exists. It should be assessed who actually takes the decisions in relation to a body. This would involve an essentially subjective analysis of the facts and circumstances. It means the test reflects economic reality and would in principle not provide tax planning opportunities. Therefore, it would contribute to legal form neutrality.

The fact that all facts and circumstances have to be taken into account is the main strength, but also the main weakness of the test. The test leads to a subjective assessment, making the boundaries of the firm somewhat ‘blurry’. If the de facto control test has to be applied, this leads to reduced legal certainty and increased administrative burdens for tax administrations and taxpayers. Apart from that, there could be manipulation as to who performs a managerial task. In addition, the test negatively affects legal certainty.

The de facto control test can function on a standalone basis or can serve as an anti-abuse provision to ensure that other tests are not circumvented. The test requires an extensive analysis of the relevant facts and circumstances of the case. This makes the test effective in combatting abuse. Interposing a holding company would not influence whether or not de fact control exists. Moreover, an additional ‘acting-in-concert’/’acting together’ test16 or similar provision would be superfluous.

Introduction

The aforementioned concepts of control may be recognised in the way we address consolidation for accounting purposes. This is called control based on consolidation.17The idea behind consolidated reporting is that income earned by a group of related entities engaged in the same business activities is, in effect, the income of the enterprise as a whole. The financial statements should provide insight into the financial situation of a group or part of a group. This insight is intended for the management of the group, the shareholders of the group (companies) and other stakeholders. The rules that apply with respect to the consolidation – or non-consolidation – of the financial results of various entities differ worldwide. Below is a description of the consolidation rules under the International Financial Reporting Standards (IFRS), as these consolidation rules are applied in a large part of the world.18 The IFRS are accounting standards drawn up by the International Accounting Standards Board (IASB) for annual reporting of businesses.19 Listed companies in the EU are even required to report on the basis of these accounting standards.20

Control is the underlying principle in determining the composition of a group for accounting purposes.21 Whether or not control exists, needs to be determined for each group company. A parent can be defined as an entity that controls one or more entities, whereas a subsidiary is an entity that is controlled by another entity. A group simply consists of a parent company and its subsidiaries.22 IFRS 10, which contains the rules for the presentation of consolidated financial statements, does not define the word entity. A predecessor of IFRS 1023 stated explicitly that the term subsidiary encompassed an unincorporated entity. This clarification has not been included in IFRS 10. However, it seems logical that under IFRS 10, too, an entity does not necessarily have to be a legal entity (it can also, e.g., be a partnership or a trust).

A parent company can control entities directly, or indirectly via other group companies. IFRS 10 requires an entity, that controls another entity, to prepare consolidated financial statements.24 In these consolidated statements the assets, liabilities, equity, income, expenses and cash flows of the parent and its subsidiaries are presented as those of a single economic entity. In IFRS 10 the principle of control of an investee is defined as:25

Control is thus defined as consisting of three elements: power over the investee, exposure to variable returns, and an investor’s ability to use power to affect its amount of variable returns.26 An entity must satisfy all three criteria. If an entity, for instance, has exposure to the majority of the variable returns of another entity, in itself this is not sufficient to conclude that control exists. If an investor has power over the investee, but has no exposure to variable returns, there is no control of the investor over the investee. To determine whether control exists, an investor should consider all facts and circumstances. If there are changes to one of the three elements of control, a reassessment should take place to determine whether the investor still controls the investee.27

Only one investor can control an investee.28 If two or more investors each have rights that give them the ability to direct relevant activities, it should be determined which investor’s returns are most significantly affected.29 Two or more investors are considered to collectively control an investee if they have to act together to direct the relevant activities. In that case each investor accounts for its interest in the investee in line with the relevant standard.30

How should the three elements of control be interpreted? An investor is considered to have power over an investee in line with IFRS 10 if it has the existing rights that give it the current ability to direct the relevant activities of the investee.31 To determine whether power exists, substantive rights32 (e.g., voting rights) and rights that are not protective33 should be considered.34 The relevant activities of the entity are the activities that significantly affect the investee’s returns.35 Determining whether an investor has power depends on the relevant activities, decision-making with respect to those activities, and the rights of the investor and other activities in relation to the investee. When an investor holds the shares including associated voting rights in the subsidiary, it will be relatively straightforward to establish that the investor has power over an investee. When power results from one or more contractual arrangements, the assessment will be more complex.36

The definition of control does not necessarily require a certain percentage of shares to be held. This means that a shareholding of less than 50% can – in specific cases37 – lead to the conclusion that the parent company de facto controls the investee. So even if, for instance, 40% of the shares in a subsidiary are held, this could lead to the conclusion that consolidated financial statements should be prepared. In that case, de facto control38 should be assessed via a two-step test. Firstly, the voting rights over the subsidiary should be determined by considering the rights derived from contractual arrangements, potential voting rights held by the investor and other parties, as well as the investor’s voting rights in comparison to the rights of other parties. If after this first step it is not clear whether or not control due to the relationship of voting rights exists, as a second step an additional investigation is required. For that additional investigation, the facts and circumstances of the situation should be taken into account.39 The facts and circumstances that should be taken into account include the voting patterns at previous shareholders’ meetings.40

When the investor’s returns have the potential to vary as a result of the investee’s business activities, markets and performance, the investor is exposed to variable returns. It does not matter in this respect whether the returns are positive, negative or a combination of both.41 Even fixed returns could be seen as variable returns if they are subject to risks. Control and returns should be distinguished. If there is one investor that has control, there can still be multiple beneficiaries for returns.42

To come to the conclusion that one entity controls another one, there should be a link between power and returns. The investor should have the ability to use its power to affect the investor’s returns from its involvement within the investee.43 An investor should determine whether it is a principal or an agent. In brief, a principal is a real decision maker. If an investor is acting on behalf of another party, which means there is only a delegated power with respect to decision-making rights, there is no control. In such a situation the investor merely acts as an agent and does not benefit from variable returns.

The table below summarizes the abovementioned group definition as used for the preparation of the commercial financial statements:

IFRS uses the notion of control to determine whether an entity should prepare consolidated accounts including the results of another entity. In general, all entities subject to the control of the reporting entity must be consolidated.

Under IFRS 10 a parent company should prepare consolidated accounts including the results of a shareholding if it is exposed to variable returns from its involvement and has the rights that give the power to direct the activities that most significantly affect the returns of the subsidiary. This power can be based on voting rights with respect to relevant areas of the business activities of the subsidiary or generally by having a controlling influence over the subsidiary.

Under IFRS a parent company generally controls a subsidiary if it has at least 50% of the voting interest. Control could even exist at a lower shareholding percentage. On top of that, de facto control is acknowledged under IFRS.

For accounting purposes, voting rights and other ways in which one entity exerts influence on another are considered. The consolidation rules use the concept of control to determine whether or not to consolidate. Under IFRS, power over the investee goes hand in hand with exposure to variable returns. In essence, the question is whether an investor has the ability to exercise its power to influence the returns. This control test largely corresponds to the legal, economic and the de facto test. The combination of the different tests limits the possibilities for abuse. In this context, however, it does not involve a fully subjective test, as required under the de facto control test. After all, the investor's voting rights in relation to those of other shareholders, potential voting rights and contractual agreements must be examined first. Only if this test is not conclusive, the facts and circumstances of the case will be examined. The IFRS group definition may be helpful in some situations, but not necessarily for others. The question is therefore whether this definition would be effective in making sure there are no opportunities for abuse. After all, the starting points of the accounting principles are different from those of the international tax law principles.

An advantage of using the test prescribed by the IFRS is the fact that it is an already existing criterion. This would mean that the increase in administrative burden would be limited. However, not all companies apply IFRS. In the EU, for example, IFRS is only compulsory for listed companies. Various countries prescribe a local set of Generally Accepted Accounting Principles. The benefits described above of familiarity with the group definition do not apply in such cases.

The IFRS group definition seems to be a workable definition for taxpayers and tax administrations. Furthermore, it would have a positive impact on legal certainty. However, adherence to an existing definition means that there is no flexibility regarding the interpretation of the group concept. In addition, any adjustment to the group concept for accounting purposes would, in principle, be reflected in the definition for tax purposes on a one-to-one basis. This would lead to the undesirable situation that tax laws would partially depend on the decisions of an independent, private-sector body (the IASB). In conclusion, using the accounting definition does not seem to be a viable option.