Head office taxation: Why yellow cards sometimes need a VAR

When watching the 2024 Paris Olympic Games this author was surprised to learn that the video assistant referee (VAR) had found its way into several new sports quite recently. Sometimes, a VAR review can lead to a penalty, like a yellow card. In the European Union, a yellow card procedure exists as well. If a sufficient number of national parliaments decides to draw a yellow card, the European Commission should review whether its draft proposal for EU legislation respects the principle of subsidiarity before continuing with the legislative process. ¹ However, allowing just eight weeks to draw a yellow card based on an initial perception does not always work well. One of the problems with the European Union's yellow card procedure is that national parliaments do not have the luxury of involving a VAR to look back during a legislative procedure and then draw a card before the game is over.

Head office taxation

In 2023, the European Commission launched its head office taxation proposal. ² Its acronym ‘HOT’ is rather appropriate, because both the European Union and its Member States may be burning their fingers on something that can easily get out of control.

The idea was that smaller incorporated companies and partnerships may opt to have their activities in another Member State taxed in accordance with the familiar tax rules applicable to their head office. For example, a French incorporated company with its head office in Paris but also active in Germany would be allowed to determine its German tax base in accordance with French rules. It would still pay taxes on its German activities and at the German tax rate, but only on the amount of profits that would be determined under French rules. The objective is to ease the administrative burden on cross-border activities. France would be calculating all taxes and apply the German rate to the German share of profit. The tax due would then be collected by France and handed over to Germany.

When the European Commission organized a webinar on the HOT proposal in April 2024, the DG TAXUD Director responsible for the proposal was asked whether small and medium sized enterprises (SMEs) could be competing with other SMEs who would be paying fewer taxes when following another country's tax rules. Director Angel's answer was that: ‘the tax base will be the same, the tax rate may not be the same.’ ³ While this may be true from the perspective of the head office's state of residence, from the perspective of the competitor asking the question the answer would have been a simple ‘yes’. Identical business activities in the same Member State may now be taxed differently because of being a cross-border effort! ⁴

The French incorporated company in the previous example may end up paying fewer German taxes than its German competitor while carrying out the same activities in Germany, only because French rules for determining the tax base are different than German rules. As HOT is optional, we may safely assume that an undertaking only opts-in for HOT when it expects to reduce its compliance costs and its tax burden by doing so; HOT is not a zero-sum game as far as taxes are concerned.

As for applying the same tax rate to the same activities, there is also more than meets the eye. By including partnerships, HOT may apply to natural persons as well in some jurisdictions. The Netherlands, for instance, does treat most partnerships as transparent. It will tax the partners instead of the partnership in most cases, and a partner may be a natural person. In the personal income tax, the Netherlands does not apply a separate tax rate to entrepreneurial profits. Instead, it exempts 14% of such profits from taxable income before applying its normal income tax rate structure. In a case like this, HOT will require that 100% of the profits as calculated by foreign rules be multiplied by the Dutch tax rate, as exemptions to the calculated amount of income are not allowed by the proposed HOT Directive.

Why yellow cards sometimes need a VAR

In the Commission's original proposal, HOT was limited to a small group of entities operating cross-border without the use of any subsidiary entity in the other member state(s). Some yellow cards were drawn by national parliaments. This was not enough to trigger a review of the proposal, possibly because national parliaments expected the proposal's impact to be very limited due to its intended scope. ⁵ Things changed when the European Parliament (EP) was consulted and the EP proposed to expand the scope of the HOT proposal to groups with up to two subsidiaries. If these changes are adopted by the Council, which is not certain at all, they lead to a considerable increase in the number of entities that could make use of HOT. In turn, the collection of a more substantial amount of domestic tax revenue may then get into foreign hands. This probably would have triggered more national parliaments to give due attention to the HOT proposal had it been part of the original proposal.

The proposed amendments to extend the scope of HOT deserve a subsidiarity review if adopted, but the yellow card procedure does not allow national parliaments to intervene at this stage anymore. HOT may serve as an example of why national parliaments need to be able to trigger a second subsidiarity review at the final stages of the EU's legislative process. Still, as HOT is subject to a special legislative procedure instead of the ordinary procedure, national parliaments may possibly find an informal way to influence their country's position in the Council as a fail-safe. ⁶

That said, it is unclear whether all national parliaments took a closer look at the original HOT proposal before deciding (often by default) not to draw a yellow card. If they had, they might have noticed that the proposal also touches on personal income taxation and, in return, may affect their social policies. Allow me to explain.

As mentioned above, some countries do not tax partnerships themselves, but they tax the partners on their respective share of profit instead. In Member States that tax profits in the hand of partners, HOT may interfere with equal treatment of individuals. It may affect the national definition of what personal income amounts to, which may have a direct impact on access to tax benefits and social safety nets.

Think of residents who work substantially from their home state but in the capacity of a partner of a foreign partnership opting for HOT. If the foreign partnership is taxed itself, foreign rules may apply to determine the taxable income made by the partner in his home state on behalf of the partnership. If the partner is taxed directly instead, the latter is still considered part of an SME that applies the same tax regime to this partner as is being applied to other partners who are located in the head office jurisdiction. ⁷

Cases like these are still rare today and may therefore have been ignored for the greater good, but if mixing foreign partnerships into domestic activities may contribute to reducing taxes in future, it may be a matter of time before their number increases. The HOT proposal is also missing the necessary transition rules to ensure capital gains are not left untaxed when entering or exiting the HOT regime, thus creating another incentive to establish more cross-border partnerships.

Advancing cross-border entrepreneurship by SMEs may have been the intention of HOT, but hardly for tax-saving purposes. Cutting red tape for smaller enterprises exploring the benefits of the EU's internal market is a cause worth fighting for, but not if it creates new issues of unfair competition.

National parliaments should take (and get) more time

In taxation, subsidiarity is an important tool to uphold sovereignty in situations where EU involvement is not strictly necessary, and it goes to the very heart of safeguarding political independence. Taxes are a source of revenue and a person's taxable income is a measure used to grant or limit access to social safety nets. As long as Member States are responsible for major political domains like health care, defense, infrastructure, education, law enforcement and social security, taxation should remain their prerogative. What is the use of being in charge of these domains, if a government is not able to manage the laws that determine its revenues?

National parliaments need time to determine whether EU involvement is indeed necessary to the extent proposed, also when a legislative proposal has been adapted substantially along the way. The HOT proposal may become an excellent example thereof, should the Council adopt the EP's proposed amendments. For this purpose, the EU's yellow card procedure could be revisited to allow national parliaments to have a last look at the final text of a proposal before adoption, especially in areas as sensitive as taxation. But as long as the special legislative procedure applies to matters of direct taxation, parliaments may have recourse to other ways to safeguard their interests.

In national parliaments, proposed EU legislation should at least be under as much scrutiny as domestic law as it is far harder to roll back. ⁸ Not just with respect to a subsidiarity review, but also with respect to reviewing its broader contents. The EP's proposal to increase the period granted to draw a yellow card from eight to twelve weeks should therefore be welcomed, as it implicitly creates time for both. ⁹ In the end, the EU will be the better for it if that period is well spent, as we need well-informed and actively involved national parliaments to contribute to the future of European (tax) cooperation.