How to minimize the exit tax of natural persons – Taxation
To print this article, simply register or connect to Mondaq.com.
What is the exit tax?
As defined in the EU Anti-Tax Avoidance Directive (ATAD), Council Directive (EU) 2016/1164, exit taxes ensure that a member state can tax the economic value of capital gains created in its territory when the taxpayer moves assets or tax residence outside the tax jurisdiction (even if this gain has not yet been realized at the time of exit).
We focus on the exit tax which is triggered when a natural person has lived for a certain period of time in a Member State (usually 10 years) as a tax resident, then permanently renounces his residence and therefore that Member State loses the right to tax capital earns. If there is a participation in a company of at least 1%, the State of departure can assume a fictitious sale and impose tax on the difference between the nominal value and the market value of the participation.
The exit tax can also be triggered if the shares are inherited to a beneficiary who is not taxed indefinitely in the country where the deceased person resided.
In the event of a donation to a beneficiary that is not taxed indefinitely in the donor’s country of residence, this situation may even lead to double taxation (exit tax and donation tax).
How is exit taxation regulated in 2021?
Until a country has transposed Article 5 of the ATAD into its local tax law, the provisions define a deferral: residence in the EU and the European Economic Area and move to a third country outside of EU / EEA.
In some cases, it is possible to move to another EU / EEA country, set up an appropriate structure there as a holding company, and then leave the internal market for a non-EU / EEA third country. We can also benefit from a reduction in the value of hidden reserves between the first exit (from the original departure state to the destination state in the EU) and the second exit to a non-EU country.
Member states have different tax systems and policies, and ATAD articles have been implemented in different ways in local law.
Some EU countries do not have such strict residency regulations, so formal residency in these countries is possible even with a physical presence of less than 183 days per year. However, the person must not reside in another EU / EEA country for more than 183 days.
Some countries have strict regulations in place which have been in place since early 2022, and for example German advisers report huge demand from people who want to leave those countries and stay in the European internal market before the end of 2021.
The EU requires Member States to cooperate on information and enforcement. While sending states are interested in cooperation, some destination states may have a limited interest in collecting taxes for the sending state if wealthy investors decide to settle in their country.
What exactly is mentioned in ATAD?
The directive asks countries to specify the cases in which taxpayers are subject to exit tax rules and taxed on unrealized capital gains that have been built up in their transferred assets. The assessment of a market value at the time of exit is based on the arm’s length principle. In the event that the assets enter a structure, the State of destination establishes the same valuation as the State of departure.
Taxpayers have the right to pay the amount immediately or in installments over a certain number of years (ATAD mentions 5 years), possibly with interest and a guarantee.
However, the exit tax should not be levied where the change is of a temporary nature or for assets which remain effectively linked to a permanent establishment in the first Member State.
Does the exit tax include investments in foreign companies?
While ATAD mentions “created in its territory”, some Member States have their own interpretation and also tax capital gains on a participation in a foreign company. Therefore, there are rumors that some taxpayers first move within the EU / EEA to a country where the return does not include foreign holdings before leaving the EU / EEA.
How to minimize or how to avoid the exit tax?
Selection of the best evaluation method:
The shareholders of a company have different rights: to collect dividends, sell the shares, collect the proceeds in the event of liquidation and vote at a general meeting. There may be valid reasons for a shareholder to waive or transfer some of these rights before leaving the country. Then the value of its assets at the time of exit is also lower.
When it comes to assessing the market value of a business, there are different valid methods based on substance, based on profits, based on a mixture of the two, or based on future cash flows. Most of the methods therefore include estimates of the future. If a business is run by a competent entrepreneur who resigns long before they exit, the assessment should include the fact that they will no longer be available for the business.
Corona measurements can also lead to a lower valuation of a business.
Temporary change of residence:
Depending on the situation, a temporary move may be possible. Then the income will be taxed in the State of destination (the new tax residence), but the exit tax cannot be triggered in the State of departure.
To prove that the move is not permanent, an apartment may still be available in the starting state, and there must also be a plausible explanation why the focus remains there.
Donations, trusts, foundations:
In countries where there is little or no gift tax, assets may be deposited in foundations, trusts or be donated before the change of residence.
Partnership as a shareholder:
If the shares of the company with hidden reserves are concluded in a local partnership, the State of departure does not lose the right to tax. In most cases, the valuation will be at book value without additional consideration. On the other hand, the departure of the partners of a partnership is generally not subject to the exit tax provided that certain specificities are respected.
To avoid the qualification of abuse, it is recommended to create a commercially active company with a visible permanent establishment in which the shares of the company are functionally assigned to the corporate object. If the partnership only provides management services for a fee to the company, this may not be sufficient.
Ultimately, it may be useful to put the shares in a foreign holding company and to put this foreign holding in a local partnership before the exit. It can be useful to establish rather complex international structures with several shareholders and units at different levels and contracts between them.
Transform the business into a partnership:
If a company is transformed into a partnership, a company’s capital reserves are taxed, but not the difference between book value and market value. The moving person should not remain the sole managing director of the company, because if he develops significant business activities abroad, it may raise questions of profit sharing.
The downsides can be an increased level of liability, a potential loss of tax deferral, a higher tax rate and possible payroll taxes. In addition, a partnership structure which only avoids the exit tax may be characterized as an abuse and, therefore, the entanglement tax may be increased.
Taxation of the entanglement:
Imposition of entanglement occurs if individual assets (entanglement), activities (offshoring of functions) or the entire company are relocated abroad. This includes the transfer of business to a foreign entity. National laws differ on this aspect, and before any transfer of contracts, clients or other assets, a local tax advisor will be contacted to structure the transaction in an optimized way.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.