A corporate tax exemption on foreign income is a good move

The Department of Finance’s public consultation on a corporate tax exemption for foreign dividends and foreign branches ended just before the Christmas break. It’s anticipated that an exemption for dividends will be brought about by the Finance Bill later this year. The consultation asked various questions about how this exemption should be brought about, so it’s good to talk.

The Department’s public consultation document explained that a participation exemption for foreign-sourced dividends is a double taxation relief measure, which operates by exempting certain qualifying foreign dividend income received from corporation tax in the hands of the recipient. The document recognised that Ireland is currently “a significant outlier, being the only EU country and one of a very small number of OECD countries” that does not operate some form of participation exemption for foreign dividends. It explains that Ireland “operates what is referred to as a “tax and credit” system, whereby dividends received are subject to Irish corporation tax, but credit is given in Ireland for tax paid in other jurisdictions, up to the amount of Irish tax payable on the income. Given our competitive corporation tax rate and our comprehensive double tax relief provisions, it is commonly reported that no or negligible incremental tax in Ireland arises on group dividends received”.

Okay, a foreign company pays tax on its profits in Country A and then pays those profits to its parent in Ireland in a dividend. Because of a tax treaty with Country A, or indeed certain unilateral measures contained in Irish law, the parent company gets credit for the Country A taxes paid such that no tax is paid in Ireland by that parent. In that way tax is only paid once on the distributed profits. The participation exemption pushes all that number crunching aside and says just exempt the dividend. Regular readers of this column will know my mantra that when it comes to investment, simplicity eats complexity for breakfast and therefore moving to an exemption approach is a good move.

“Tax and credit” sound easy in theory but it can, and does, involve significant calculations regarding withholding and underlying tax on “dividend-ed” profits as well as research on a country-by-country basis. Much of this is contained in part of the law known as “Schedule 24” and I dare you to say that to any tax adviser and just watch their reaction. That alone will demonstrate the need for simplification. I’m not saying less grey hairs for tax advisers should drive a need for change, but investors want certainty of approach. Minister McGrath noted in his foreword to the consultation document that the exemption, “…will be a significant change to Irish corporation tax; a change which, I believe, will support Ireland’s competitiveness in the years to come”. I concur.

The key point therefore is to make it as simple as possible. Right now, if an Irish company pays a dividend to another Irish company, subject to very limited exceptions, then that dividend is exempt from corporate tax in the recipient’s hands. That’s one approach that could be taken with foreign dividends to put Irish sourced and foreign sourced dividends on an equal footing. Tax nerds will be coughing into their muesli reading this by saying that the European Court of Justice has already implied that the two systems can sit side by side, but this is all about bringing certainty of treatment and indeed less administrative burdens for companies.

However, the exemption needs to work for all companies. Corporate tax law has undergone a metamorphosis in response to the EU's Anti-Tax Avoidance Directives ATADs as well as implementation of the OECD’s action plan on base erosion and profit shifting (BEPS). This includes significant ATAD compliant Interest Limitation rules, anti-hybrid rules, and a 15% rate of tax which is now in effect. All of that means that an exemption for dividends may work for some companies but could bring about additional issues for others. The participation exemption should not giveth on the one hand and taketh with the other had the company just stuck with the old “schedule 24” way of doing things. That’s why any exemption should be as optional and as flexible as possible.

Interestingly, one of the questions asked was whether the exemption should only apply to dividends that emanate from “trading profits”. This could have been brought about by our Capital Gains Tax exemption for disposals of shares by a holding company that meets certain Ts and Cs, one of which is that the group concerned be trading. As readers will know, leaving aside the new-fangled 15% rate for a moment, trading profits are generally taxable in Ireland at 12.5%, whereas other profits are generally taxable at 25%.

The term “trading” is not simple. Sure, in certain instances a trade is like the elephant in that you’ll know one when you see one. But sometimes it’s not that easy. A case came before the UK equivalent of our Tax Appeal Commission a few years ago. It concerned a pharmacist (Akhtar Ali) who bought and sold shares over a period from a room above his shop. Akhtar Ali said he undertook this activity on a commercial basis and to make a profit and he employed locums at his pharmacy so as to free up time for his ‘day trading’ upstairs.

Details are critical in determining trading and in the end the court held he was trading in shares. There’s an immense amount of court decisions on what carrying on a trade means. Meeting that test is a high bar, as it was in Akhtar Ali’s case; similar trading rules apply to humans notwithstanding they don’t benefit from the 12.5% rate. Bringing about a trading test to a participation exemption could bring about additional complexity.

Overall, the move to a participation exemption for dividends, and branches, would be a good move. The key is to ensure the desire for simplicity does not bring about additional complexity and difficulties for certain companies where the old way of working wouldn’t have.