4.3.5.3 Exit tax rule

The ATAD1 exit tax rule

The fair market value of business assets of a company may be higher than their book value for tax purposes. This difference is generally taxed by states upon realization. An entity that changes its residence to another jurisdiction (emigration) ceases to be a tax resident in the former residence state.1 Exit taxes ensure that if a taxpayer moves assets or its tax residence out of the tax jurisdiction of a state, the economic value of a capital gain that can be allocated to its territory can be taxed, even though that gain has not been realized at the time of exit. Exit taxation can lead to double taxation of capital gains if the unrealized increase in value of an asset is taxed in the former residence state due to a change of residence, while the new residence state taxes the capital gain at the moment the asset is sold.2 However, it can also lead to double non-taxation if one country allows a transfer at book value, whereas the new residence state values the transferred asset at market value.3 In essence, the issue with respect to exit taxes seems to be a lack of alignment regarding the valuation, leading to mismatches.

The second rule included in ATAD1 concerns a rule on exit taxes. The measure specifies in which cases taxpayers face exit tax rules. That is the case in the following four situations:4

In all these cases the difference between the market value of the business assets at the time of the transfer and their value for tax purposes forms the basis of the exit tax.5 The market value is defined as the amount for which an asset can be exchanged or mutual obligations can be settled between willing unrelated buyers and sellers in a direct transaction.6 The value is thus based on the arm’s length principle.7 The new Member State will accept the value established by the Member State of the taxpayer as the starting value of the assets for tax purposes, unless this does not reflect the market value.8 In that case the receiving state has the possibility to dispute the value of the transferred assets via existing dispute resolution mechanisms.9 There is thus not necessarily a full alignment with regard to the valuation of assets under the ATAD1 exit tax rule.

The preamble clarifies that transfers of assets, including cash, between a parent company and its subsidiaries should not be subject to exit tax rules.10 Apart from that, a taxpayer should have the right to immediately pay the amount of exit tax or defer payment of the tax over a certain number of years. If there is a transfer of assets of a temporary nature and the intention is for the assets to return to the Member State of the transferor, no exit tax should be levied.11

The exit tax rule as provided in ATAD1 does not provide for a variant of a group approach. Exit taxation is a topic that can be important for standalone companies as well as for groups of companies. For the flexibility of international groups, the possibility to move business across borders can be important to be able to respond to commercial changes and to pursue new opportunities.

Exit taxes & the OECD MTC

Would a provision similar to the ATAD1 provision on exit taxes be desirable on a tax treaty level? Exit taxation is generally seen as consistent with the OECD MTC.12 A tax treaty thus does not prevent the application of a domestic tax rule that deems a person to have alienated its property for capital gains tax purposes.13 The idea behind that seems to be the fact that the deemed disposal ‘occurs’ before the emigration, making it a purely domestic transaction not within the scope of a tax treaty. If it is assumed that the gain in value should be allocated to the former residence state, exit taxation is to a large extent a timing issue, and timing issues are generally not covered by tax treaties. Even if exit taxes would be within the scope of the Convention – either via art. 13 or any other potential applicable article14 – the taxing rights of the exit state are generally not affected.15 Exit taxes may prevent the avoidance of capital gains tax through a change of residence before a treaty-exempt capital gain is realized.16 After all, via the main rule in the OECD MTC the state of residence has the exclusive right to tax the alienation of shares.17

As explained, exit taxes could lead to double taxation if the person becomes resident of another state which taxes the same income at a different point in time, for example when the assets are sold to a third party. According to the OECD Commentary such cases could be dealt with via a MAP.18 It could also be an option to include a provision in a tax treaty which provides that relief should be granted for the part of the income that accrued while the person was a resident of the other state.19 In practice, there are several countries that added a specific provision to the capital gains article of the tax treaty to address a change of residence. By applying such a provision, the taxing rights are shared between the emigration state and the immigration state. The specific clauses that address a change in residence are non-uniform. However, the provisions in general only apply to individuals.20

Double taxation and tax avoidance possibilities that can be the result of the exit tax or the lack of exit taxation do not match with the goals pursued with the OECD MTC. In short, as for the application of the provisions of a tax treaty it is not relevant when tax actually is paid, exit taxes may lead to double taxation as the relevant income can be taxed both in the departure state and the new residence state.21 However, a change of residence can also lead to double non-taxation if no exit tax is levied and the other country provides for a step-up and consequently only taxes gains that accrue after the immigration.

Even though this problem is not limited to groups of companies, in my view it would be advisable to solve this problem for groups of companies at the international tax treaty level, as that would improve the flexibility of international groups and end tax avoidance opportunities. This can be done on a somewhat ad hoc basis by including a rule in tax treaties to deal with exit taxation. This rule should at least secure that the same valuation is applied in both the former residence state and the new residence state, which ensures that there can be no mismatch. Alternatively, consideration could be given to introducing an overarching solution in international tax treaty law, which replaces the emphasis on the separate entity with a group approach. Under such a group approach exit taxation as such would no longer be an issue. Even though the former is probably a somewhat more realistic approach, as the latter provides for a holistic solution, this is in my view the preferred approach. More on this will follow in the following chapters.