Court of Justice of the EU clarifies limits to the Parent-Subsidiary Directive's anti-abuse clause

The Court of Justice of the European Union (CJEU) has issued a highly relevant ruling on international taxation, in which it clarifies and reinforces the criteria for the application of the anti-abuse clause contained in the Parent-Subsidiary Directive.

The dispute which gave rise to this judgment arose out of a tax audit carried out in Lithuania on the Nordcurrent Group UAB, a company engaged in the development and distribution of video games. In 2009, the company established a subsidiary in the United Kingdom in order to facilitate the distribution of its products in that market.

However, as of 2017, the subsidiary transferred its functions and risks to the Lithuanian parent company, becoming an entity with no real activity. Despite this, in 2018 and 2019, the subsidiary distributed dividends to the parent company, and the latter applied the tax exemption provided for in the Lithuanian regulations transposing the Parent-Subsidiary Directive (PSD).

Lithuanian tax ruling

The Lithuanian tax authorities considered that the English subsidiary had not been established for valid commercial reasons, given the lack of sufficient human resources necessary for the development of the economic activity, as it had only a director who also managed several other companies, no own place of business or other tangible assets in the UK.

On this basis, the Lithuanian authorities concluded that the English subsidiary lacked economic substance, that its sole purpose was to obtain an undue tax advantage, qualified the operation as an "artificial or distorted arrangement" and consequently refused the application of the exemption provided for in the directive.

Question for the CJEU

Against this background, a number of questions were referred to the CJEU for a preliminary ruling.

Is it in conformity with the PSD to deny the application of the tax benefit when the subsidiary has its own income but has no real economic substance (no human or material resources and no effective economic activity), even if it is not a mere shell or instrumental entity?

Is it consistent with the anti-abuse clause of the PSD to assess only the situation at the time of payment of dividends in order to classify a subsidiary as a "sham arrangement", ignoring the time of its incorporation and its previous activity? In particular, the question arises as to whether a partial and ad hoc assessment is sufficient or whether an overall analysis including the activity and commercial justification of the subsidiary since its creation should be carried out .

Finally, is it sufficient, in itself, to classify the subsidiary as a "distorted arrangement" in order to conclude that the parent company, in applying the exemption provided for in the PSD, has obtained an abusive tax advantage contrary to the purpose of the directive, irrespective of the assessment of the subjective element.

Judgment criteria

In its judgment, the CJEU sets out the following criteria:

1. Regarding the relevance of the economic substance, the judgment highlights that the lack of material and human resources in the subsidiary, as well as the absence of real economic activity, are relevant indications for considering the existence of an artificial arrangement. In addition, the CJEU points out that the anti-abuse clause applies not only to interposed instrumental entities but also to other cases in which the structure lacks business and economic substance.
2. In relation to the overall analysis of the circumstances, the CJEU emphasises the need for a joint and comprehensive analysis of all the circumstances of the case, including facts before and after the distribution of dividends, in order to determine the existence of an abuse. This approach, in the CJEU's view, avoids a fragmented assessment that might not adequately reflect the economic reality of the transaction.
3. With regard to the application of the anti-abuse clause, the court states that it is not sufficient to classify, in the specific case, the subsidiary as a "distorted arrangement" on the basis of a purely objective analysis and disregarding the assessment of the subjective element consisting of the intention to obtain a tax benefit, since otherwise the purpose of the anti-abuse clause itself would be undermined and Community case-law would be infringed. 

Osborne Clarke comment

The judgment of the CJEU establishes clear and forceful criteria on the application of the anti-abuse clause in the Parent-Subsidiary Directive, underlining the importance of the economic substance, the analysis of the business and economic purpose of international structures, an analysis that must be made from a global perspective, taking into account both the objective and subjective circumstances of each specific case.

On the other hand, the CJEU ruling may have relevance for the interpretation of other anti-abuse clauses contained in national legislation and the interpretation of these clauses by national courts, such as those relating to the tax regime for mergers, demergers, transfers of assets and exchanges of securities which allows for deferral of taxation where the transactions are carried out for valid economic reasons.