European Commission proposes Head Office Tax System Directive for SMEs

• On 12 September 2023, the European Commission issued the proposal for a Directive establishing a Head Office Tax system for micro, small and medium sized enterprises (SMEs) and amending Directive 2011/16/EU.

• If adopted, the Directive will introduce a one-stop-shop regime for easing corporate income tax compliance for in-scope SMEs operating cross-border in the EU through permanent establishments in other Member States.

Executive summary

On 12 September 2023, the European Commission (the Commission) published a new legislative proposal, a Directive "establishing a Head Office Tax system for micro, small and medium sized enterprises (SMEs)" (Head Office Tax Directive (pdf)).

The proposal sets forth rules introducing the possibility for SMEs operating cross-border within the European Union (EU) to continue applying the tax rules that they are familiar with in their Member State of residence to calculate the taxable result of their permanent establishments (PEs) in other Member States. The Directive will also amend Directive 2011/16/EU (pdf) (DAC Directive) to enable the exchange of information between Member States on the subject matter of the Head Office Tax Directive. Commission President Ursula von der Leyen announced this initiative in her 2022 State of the European Union Address, under the "SME Relief Package."

The rules in the Directive will create a one-stop-shop regime whereby the tax filing, tax assessments and collections for PE(s) would be dealt with through a single tax authority ("filing authority"), i.e., the tax authority in the Member State of the head office. Audits, appeals and dispute resolution procedures would remain domestic and in accordance with the procedural rules of the respective Member State.

The draft Directive will now move to the negotiation phase among Member States with the aim of reaching unanimous agreement. The Commission proposes that the Member States transpose the Head Office Tax Directive into their national laws by 31 December 2025 for the rules to come into effect as of 1 of January 2026.

Detailed discussion

Background

On 14 September 2022, the president of the European Commission Ursula von der Leyen announced in her State of the Union address the release of an SME relief package aimed at removing obstacles that hold small companies back in their development and making it easier to do business in the EU.

On 12 September 2023, the Commission published a draft Directive proposing the introduction of a simplified tax system for SMEs operating cross-border in the EU through PEs, targeting higher tax-compliance costs that SMEs encounter in comparison to larger entities, which often can achieve scale efficiencies.

The draft Head Office Tax Directive

Scope

The proposed rules would apply to SMEs fulfilling all of the following criteria:

1. Were established under the law of a Member State and take one of the forms listed in the Directive
2. Are resident for tax purposes in a Member State
3. Are subject to, directly or at the level of their owners, a tax on profits listed in the Directive, or to any other tax with similar characteristics
4. Qualify as micro, small and medium-sized (SMEs), as defined in Directive 2013/34/EU (pdf), thereby having:
   • A balance sheet total below €20 million
   • Net turnover below €40 million
   • Fewer than 250 employees, on average, during the financial year
5. Operate in other Member States exclusively through one or more PEs
6. Are not part of a consolidated group for financial accounting purposes and constitute an autonomous enterprise, according to applicable EU definitions

The Directive shall not affect the right of Member States to determine the tax rates applicable to PEs, nor the applicability of bilateral conventions for avoiding double taxation or the rules on the social protection of workers.

Given the Commission's intent to control "tax avoidance risks associated with transferring the tax residence of an SME," and to "monitor the evolution of the turnover attributed to the permanent establishment(s) in order to maintain their operations as secondary to the main activity which should be carried out by the head office," the Directive introduces some eligibility requirements to enter the regime:

• The joint turnover of PEs for the last two fiscal years shall not exceed an amount equal to double the turnover generated by the head office.

• The head office must have been resident for tax purposes in the head office Member State during the last two fiscal years.

• The head office must have qualified as an SME for the last two fiscal years.

• The regime must be applied to all PEs.

Exclusions apply for head offices deriving income from shipping activities subject to a tonnage tax regime.

Head Office Tax Regime

When an SME opts for the Head Office Tax Regime, it must file the head office tax return with the filing authority, including information on the tax liability of the SME with regard to the taxable result of each PE in other Member States. The Directive does not detail the applicable rules for determining the taxable base of each PE, particularly as there is no reference to the use of double tax treaties in force to (eventually) limit domestic rules applicable in the head office Member State.

The tax liability must be computed by applying the national tax rate of the respective host Member State to the taxable result, as it was computed in accordance with the head office taxation rules.

The filing authority will then issue a tax assessment notice for the head office and a draft tax assessment notice for each PE that, if accepted by the host Member State, requires the head office to settle, through the filing authority, its own income tax liabilities and those of its PEs.

The Commission shall be empowered to establish practical arrangements to ensure the collection and transfer of the tax corresponding to the tax liability of the PE(s) from the head office Member State to the host Member State.

Administration, audits and appeals

Once an SME opts into the Head Office Tax Regime, it must apply those rules for a period of five fiscal years, which can be renewed. The regime would cease to apply before the expiration of the five-year term if either (i) the SME transfers its tax residence out of the head office Member State or (ii) the joint turnover of its PEs exceeded an amount equal to triple the turnover of the head office for the last two fiscal years.

Based on the draft Directive, once the head office tax return is filed, the filing authority shall communicate to the tax authorities of the host Member States the contents pertaining to their jurisdiction and the determination of the tax base therein, including information to allow the assessment of additional national or regional nonprofit or profit-based taxes or surcharges or other interrelated features of personal income tax, in accordance with the tax rules of the host Member State.

Host Member States shall accept or reject the draft tax assessment notice for the PEs within two months. If rejecting the draft notice, the host Member State must revise it by attributing profits to the PE in accordance with the applicable bilateral convention for the avoidance of double taxation between the host and head office Member States.

The head office may appeal the final tax assessment notice in its Member State of residence, and disputes involving the allocation of profits to the PEs must be settled in accordance with the applicable bilateral convention for the avoidance of double taxation or the provisions set out in Council Directive (EU) 2017/1852 (pdf). Regardless, the Directive safeguards national rules of Member States that govern local tax audits, legal remedies and proceedings.

Once the amount of taxes due becomes final, either after the acceptance of tax assessment notices or the conclusion of appeals/judicial procedures, the filing authority shall collect the tax corresponding to the tax liability of each PE of the head office in the EU, apply the tax rate to the respective host Member State and transfer the relevant amount to the appropriate competent authority.

Amendments to the DAC Directive

In light of the introduction of a new European regime to simplify the taxation of SMEs operating cross-border, the draft Head Office Tax Directive includes amendments to the DAC Directive necessary to enable the tax authorities to efficiently exchange information and contents relating to the Head Office Tax Regime.

Next steps

Article 115 of the Treaty on the Functioning of the EU (pdf) forms the legal basis for the draft Directive. Therefore, the proposal is subject to the Council's unanimity for adoption, while the European Parliament only has an advisory role. The next step will be for the 27 EU Member States to discuss the proposal.

As with previous Directives on direct taxation, changes will likely be made to the proposal during the negotiation process. Consequently, the final Directive, if and when adopted, could differ significantly from the current proposal.

Once unanimity is achieved, the next step would be for the Directive to be published in the Official Journal of the European Union. The Commission proposes that the Member States transpose the Directive by 31 December 2025 and apply the provisions from 1 January 2026.

Implications

Adoption of the proposed Directive would mark a significant step for SMEs by giving them an opportunity to benefit from the internal market with lower tax-compliance burdens. The Directive does not fully harmonize the tax system, however, given that Member States may apply additional national or regional nonprofit or profit-based taxes or surcharges and other interrelated features of personal income tax.

Although it is not yet known whether Member States will embrace the Commission's proposal, businesses should closely monitor the adoption process for any changes or clarifications to the proposal. In-scope businesses should conduct an initial analysis of their tax-compliance processes and costs based on the current draft, begin simulating the effects that the new proposal may have on their business and consider engaging with EU policy makers.

For additional information with respect to this Alert, please contact the following:

Ernst & Young Belastingadviseurs LLP, Rotterdam

• Marlies de Ruiter

• Maikel Evers

• Andromachi Anastasiou

EY Studio Legale Tributario (Italy), Treviso

• Gregorio Piran

Ernst & Young Belastingadviseurs LLP, Amsterdam

• Konstantina Tsilimigka

EY Société d'Avocats, Paris

• Jean-Pierre Lieb

Ernst & Young LLP (United States), Global Tax Desk Network, New York

• Jose A. (Jano) Bustos

Published by NTD’s Tax Technical Knowledge Services group; Carolyn Wright, legal editor

For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.