Research on Tax Liability of Public Sector Bodies for Profit Tax Purposes

Research on tax liability of public sector bodies for profit tax purposes

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Public sector bodies first and foremost perform public tasks. They also perform activities that, at least partly, are not governed by public law. These activities could thus be performed by private companies as well. The special position of public sector bodies raises the question as to whether they should be liable for taxes and, if so, how. VAT and profit tax are the two main taxes where this question is an issue. As regards the VAT, the rules of the VAT Directive apply within the EU. Where profit tax is involved there is no coordination whatsoever – each country follows its own approach.

Starting 2016, the Netherlands will thoroughly change the profit tax regime with respect to public sector bodies. One EU law aspect in all of this regards possible state aid aspects of the current Dutch legislation, under which direct and indirect public sector enterprises are exempted from profit tax to a very large extent. Private enterprises, though, are liable for corporate income tax (CIT). Partly due to pressure from the European Commission, as from 2016 public sector enterprises should likewise be liable for CIT if they perform entrepreneurial activities.

On the back of this development it is interesting to know how the levy of profit tax with public sector bodies has been arranged in EU/OECD countries and several selected other countries. To this end, a survey was carried out based on the answers provided by respondents from Deloitte offices specified below to the questions listed below. The following 9 countries have contributed to this survey:

The following 9 countries have contributed to this survey: • Belgium • Hungary • Ireland • Kenya • Lithuania • The Netherlands • Russia • Sweden • Switzerland

Please note that the remarks in this report do not necessarily reflect the formal positions taken by the governments of the countries concerned. Instead, they are interpretations of domestic laws and reproduction of developments in those countries, as provided to us by our local member firms.

Deloitte Tax Lawyers Tax Research Centre, The Netherlands Peter Kavelaars Jasper Korving

1 1. Are public sector bodies (the bodies themselves or a part of the government that has been transferred to a state-controlled legal entity – this may include both central government and lower public sector bodies and other state-controlled bodies, such as universities, academic hospitals, port authorities, etc.) liable for profit tax, either subject to certain conditions or not. If they are, what would those conditions be?

In the countries of the responding member firms, a variety of different tax regimes is applicable in rela tion to public sector enterprises. Most countries – except Belgium, Hungary and Russia – do appear to make a distinction between direct and indirect public sector enterprises. If so, direct public sector enterprises are enterprises directly carried on by a legal entity under public law. Indirect public sector enterprises are, e.g., private limited liability enterprises whose shares are fully held by either legal entities under public law or foundations or associations where the legal entities under public law appoint and dismiss the managing director.

In Ireland, public sector bodies are only subject to profit tax if they carry out a commercial activity. The Irish public sector comprises of organizations that are both commercial and non commercial in character, i.e., bodies that do and do not derive the bulk of their revenue from trading and commercial activities. Irish tax legislation exempts income arising to non commercial state sponsored bodies where these public bodies are listed in Schedule 4 of the Irish Tax Consolidation Act 1997. Central government, universities, hospitals and port authorities which are state-controlled would not be liable to profit tax unless there is a commercial element to an activity they undertake. The manner in which an enterprise is subject to tax depends on its legal form. Companies are subject to corporation tax. Public sector bodies which conduct commercial activities and which take the form of a company are already subject to CIT in Ireland. They are liable for CIT in the same way as a private enterprise. The worldwide profits of the company are taxable. However, where the commercial activity is carried on by an enterprise with a different legal form, i.e., in the form of a public sector board, association or agency, the commercial element needs to be assessed and income tax rather than CIT may be applicable on the commercial element of the activity.

In Kenya, the liability for CIT for both direct and indirect public sector enterprises both depends on what operations are undertaken by the entities and how they fall under the law. Thus, local county governments (previously local authorities) are specifically exempt from CIT. Specific CIT exemptions are also available for entities that are of a public character and that have been set up for the purpose of relief for poverty or for advancement of education, e.g. hospitals, schools, universities. Many public sector entities that carry out trading or commercial activities are subject to CIT, e.g. the Kenya Ports Authority, Kenya Airport Authority, and the national airline carrier (Kenya Airways). Other limited liability companies (whether public or private) where the government has a stake and which are trading entities are also subject to CIT.

Lithuania does not subject the state and municipalities to CIT. Implicitly, direct public sector enterprises are exempt from CIT as well. The subjective exemption also applies to budgetary institutions (state or municipalities’ institutions totally or partially funded from the budget, e.g. schools, nursing homes, nursery schools, etc.), the Bank of Lithuania, the state and municipalities, state and municipalities’ institutions, offices, services or organizations, the state company ‘Deposit and Investment Insurance’, and European Economic Interest Groups. All other entities (public limited liability companies, private limited liability companies and other) established and/ or partially or wholly owned by the State and municipalities are subject to either the standard CIT rate of 15% in Lithuania or the reduced CIT rates of 5% or 0%. The same tax rates are applied for private sector companies with the same requirements for a reduced CIT rate. A threshold applies for non-profit entities. Furthermore, certain income, which usually relates to services provided by public bodies, is treated as non-taxable according to the Law on CIT and includes both income received by health care institutions from services financed from the Compulsory Health Insurance Fund as well as seaport and air navigation charges, and funds collected from the lease of seaport land.

Research on tax liability of public sector bodies for profit tax purposes 2 In the Netherlands, the liability for CIT for both direct and indirect public sector enterprises is very limited – it is restricted to types of enterprises explicitly referred to in the law. They include agricultural enterprises, certain industrial enterprises, and trading enterprises. This list specifically excludes the service sector (except for public transport across municipal borders). Municipal real estate departments (whose tasks include the development of building plots for the market) are not liable for taxes either. In addition, there is a limited list on which specific indirect public sector enterprises are explicitly stated as being taxpayers – this includes Schiphol airport and nationalized banks. Legal entities under public law are liable for taxes insofar as they carry on an enterprise. In the event of indirect public sector enterprises the tax liability depends on the legal form opted for. Enterprises carried on by a legal entity under public law, foundation or association are considered to form a single, joint enterprise. This makes it possible to set off profits and losses of various enterprises. In addition, there is tax liability for all separate enterprises carried on by the State. Assessing whether the activities qualify as an enterprise for tax purposes is based on case law in respect of the material definition of an enterprise. The decisive factor here is whether it involves a “long-term organization of capital and labor”; participation in economic transactions; a profit motive; and a profit expectation (objectified). An activity with the outward appearance of an enterprise and as a result of which competition is created, is also considered to be an enterprise.

Hungary appears to only know the concept of an indirect public sector enterprise. In principle, they are subject to tax, unless they are specifically tax exempt. Examples of exempt parties are the Hungarian National Bank, the Hungarian National Asset Management Company, the Hungarian News Agency, public media service providers, political parties, universities and colleges maintained by the state. Certain profits of some types of persons are objectively excluded from the scope of CIT: the “regular” – non-entrepreneurial– activities of foundations and housing cooperatives are not subject to CIT, for instance. Such exemptions generally relate to activities performed for the public interest, charity, etc. In addition, the entrepreneurial activities of such persons may also be exempt from CIT under a certain threshold (pre-tax profit of entrepreneurial activities does not exceed HUF 10 million (i.e. approximately EUR 33,000) or 10% of the total revenue).

Russia, too, only seems to apply the indirect method. According to the Russian Civil Code all legal entities are divided into commercial (LLC, JSC, unitary enterprises) and non-commercial (institutions, foundations, associations, etc.). The Russian Government can hold interests in both commercial and non-commercial ones. However, specific regulations should be applied to unitary enterprises (which only manages its assets, while ownership title remains with the state authority) and non-commercial legal entities (executing the rights of operational control over the state assets). As a general rule, all public sector bodies (both commercial and non commercial ones) are liable for profit tax. Income derived from the use of state-controlled assets is subject to profit tax, while the remaining part of net income should be returned to the state authority.

Under Swedish law, municipalities and county councils are allowed to set up enterprises as long as they are not conducted as a business activity with a profitable purpose and they have a public utility business purpose. Even so, these enterprises are not prohibited from making profits. Public sector enterprises carried on by a legal entity under public law are taxed the same way as privately owned enterprises. Normally, they have the form of a limited liability company and are liable for CIT in the same way other companies are. Hospitals and other public functions that are not operated as an enterprise by municipalities or county councils are not liable for profit tax.

3 Switzerland applies a subjective CIT exemption for public sector bodies as well. Consequently, enterprises by public sector bodies remain, in principle, untaxed. The following public sector bodies are exempt: the Confederation and its establishments; the cantons and their establishments; the communes, parishes and other territorial collectivities of the cantons and their establishments; transportation and infrastructure companies that hold a concession from the Confederation; companies’ institutions for professional contingency; social security and compensation; companies whose aim is public service or public utility, on their income which is irrevocably affected to these aims; companies who pursue religious aims on a national basis, on their income which is exclusively and irrevocably affected to these aims. Only when the enterprises of public sector bodies are in the form of associations, foundations, or other corporations, of which the public sector body is a member or shareholder, then the enterprise would be taxed at federal level. In that case, the basic tax rate would be 4.25% instead of 8.5% for regular corporations.

Finally, the system in Belgium deviates the most. Belgium has two separate ways of levying tax on public sector enterprises: (i) the legal entities tax and (ii) the CIT. There are three categories of legal entities tax, with the taxable basis increasing per category (the first category has the lowest taxable base and the third category has the highest taxable base):

• The central government and other levels of government (such as communes, regions, etc.) are subject to the legal entities tax of the first category; • A list of entities which are subject to legal entities tax of the second category is included in the law (Article 180 of the Belgian Income Tax Code (hereafter “BITC”)). This list includes, amongst others, port authorities, authorities responsible for waterways and public transport and, up to recently (see further), so-called “intercommunales”, i.e. legal entities established by a group of communes in order to perform public services (e.g. water distribution, waste disposal, etc.); and • Finally, some entities are subject to the legal entities tax of the third category, either because they are active in a “privileged activity” (such as education, health care, etc.) or because they are not engaged in profit- making activities.

Public sector bodies subject to first and second category legal entities tax are automatically subject to legal entities tax (and cannot be subject to CIT, regardless of their actual activities). The public sector bodies that are not subject to legal entities tax of the first or second category of legal entities tax may either be subject to legal entities tax of the third category or CIT. A factual test on a case-by-case basis is required to determine their direct tax regime. This test is an examination of the actual activities performed by the public sector body. If the relevant body is not engaged in profit-making activities (or is active in one of the abovementioned “privileged activities”), the public sector body will be subject to legal entities tax (of the third category). Otherwise the public body will be subject to the Belgian CIT regime.

2. If public sector bodies are not subjectively liable for profit tax right now, are there any plans to change this? If so, what are these plans? When would those adapted rules become effective?

Seven countries indicated that no changes are to be expected. Only Belgium has amended its legislation in 2014 and the Netherlands will do so as of 2016.

In Belgium, legal entities established by a group of communes in order to perform public services are currently still taxed with second category legal entities tax. By Program Law of December 19, 2014, the second category was deleted. As a result, the so-called intercommunales need to determine whether they can be subject to either third category legal entities tax or regular CIT, depending on the question whether they are engaged in profit-making activities.

Research on tax liability of public sector bodies for profit tax purposes 4 In the Netherlands, the profit tax regime for public sector bodies will be changed thoroughly as from 2016. The rule will be changed in that direct public sector bodies will be subject to profit tax to the extent they carry on an enterprise; indirect public sector bodies are fully liable for taxes, unless an exemption applies. The definition of an enterprise is based on national case law on the carrying on of an enterprise. Other than under the former regulation, the new rule of law no longer explicitly distinguishes between direct and indirect public sector enterprises.

Both in Belgium and the Netherlands the tax liability of seaports is the subject of ongoing discussions; this relates to the question whether an exemption for seaports constitutes state aid and whether there is a level playing field between the EU seaports.

3. If public sector bodies are made liable for profit tax, will this be done according to the same system applicable to comparable private law enterprises?

Under the assumption that public sector bodies would be subject to profit tax, seven out of the nine contributing member firms confirm that these public sector bodies would then be treated the same way as comparable private law enterprises.

Belgium, however, added that a transition regime for specific kinds of entities, like the intercommunales mentioned above or the transition of the Belgian postal services, could deviate from this equal application.

In the Netherlands, enterprises directly controlled by government and indirect public sector enterprises alike are liable for CIT in the same way as private enterprises. However, if the direct public sector enterprise has been transferred to a separate entity, the legal form opted for is important: foundations and associations are solely liable for tax to the extent they carry on an enterprise, while entities whose legal forms are different – such as BVs and NVs – are liable for taxes over their full equity.

If, in Switzerland, the public sector body would have the form of an association, foundation or other corporation, the federal tax rate would be 4.25% instead of the regular 8.5% rate for corporations.

4. Are there any subjective tax exemptions and, if so, which?

Only Sweden, in principle, does not apply subjective tax exemptions. In some cases, however, separate tax rules apply. For instance, municipally held companies supplying housing are taxed under separate rules.

For the subjective tax exemptions granted by Belgium, Hungary, Ireland, Kenya, Lithuania and Switzerland, we refer to the answers to question 1 above. In addition, however, Belgian law provides for a list of so-called “privileged activities”. To the extent the legal entity is engaged in one of those privileged activities, it should in principle be subject to legal entities tax of the third category. This list includes, amongst others, entities engaged in academic, social and health care activities.

5 Under the proposed new rules for taxation of public sector enterprises, the Netherlands introduced a subjective tax exemption for academic hospitals if 90% or more of their activities are performed in that capacity. If so, those hospitals’ profits from other activities are thus exempted too. The exemption applies irrespective of whether the activities have been transferred to a legal entity under private or under public law. Educational bodies, too, are eligible for a subjective tax exemption, provided 90% or more of their activities is spent on providing education or conducting research. As an additional condition, 70% or more of the research should be paid from public funds – either statutory tuition fees, body tuition fees, or school fees -, or contributions from recognized charity bodies for which no contractual consideration is demanded. Finally, under the rules sea port authorities are exempt from taxation. This exemption will be cancelled if a full tax liability for such enterprises will be implemented at a European level, or if this exemption turns out to be contrary to EU state aid rules.

Russia, finally, applies two specific types of exemptions. First, some subjective tax exemptions exist for specific legal entities such as several state corporations, foundations and institutions whose revenues are released from taxation. Secondly, all legal entities engaged in providing social services are granted temporary exemption from profit tax for the period through 2015-2020, if 90% of their revenues comes from such specific activities. As such organizations are mostly controlled by the state, this exemption so far mostly applies to public bodies.

5. Have specific rules been put in place – other than those applicable to private enterprises – with respect to the objective tax liability (determination of profit and objective tax exemptions) and, if so, which?

Five of the responding member firms (Belgium, Hungary, Kenya, Lithuania and Sweden) indicated that no real objective tax exemptions were applicable.

Ireland grants an exemption from chargeable gains accruing to public bodies.

Under the proposed new Dutch legislation, various objective tax exemptions may apply as regards the determination of profit of public sector enterprises. The application of the objective tax exemptions is optional. One of them is an objective tax exemption for the activities in the capacity of an academic hospital or educational body as referred to in the answer to question 5. If the 90% criterion is not satisfied, in principle the public sector enterprises are fully taxed. However, an exemption applies to the extent the activities relate to activities performed in their capacity of academic hospitals or educational institutions. Likewise, there are objective tax exemptions for the benefits from the activities performed:

a) if it concerns the exercise of a public sector task or competence under public law, provided this does not compete with other enterprises; b) as part of a qualifying joint venture between multiple public sector enterprises; and c) in the event of internal procurement operations and quasi internal procurement operations (see the answer to question 10).

Research on tax liability of public sector bodies for profit tax purposes 6 In Russia, objective tax exemptions can be categorized as follows: 1) Subsidies, subventions and other kinds of target financing received by state-controlled bodies from the state/local authorities are exempt from taxation if cash is spent on the proper aims (with some minor exemptions). 2) Most state controlled assets managed by public sector bodies continue to be owned by the federal or local government. Therefore, the transfer of limited rights to the public sector bodies (for the purpose of its effective management) is not regarded as income for profit tax purposes. Should the transfer of limited rights with regard to the assets be ignored for profit tax, depreciation of such assets is also disregarded for profit tax. 3) Most local authorities grant regional tax incentives and the income of state-controlled entities is taxed at a lower rate of between 13.5% – 15.5% (instead of the standard 18% rate payable to the regional tax authority).

In Switzerland, various objective exemptions apply. This covers, amongst others, profits from (i) companies whose aim is public service or public utility and (ii) companies that pursue religious aims on a national basis, but both only to the extent that the income is irrevocably attributable to these aims.

6. Do tariff facilities apply to public sector bodies? If so, which?

In principle, none of the responding member firms is aware of any tariff facilities for public sector enterprises. Russia, however, does differentiate the applicable tax rate based on the type of activity. Still, that would equally apply to comparable private companies. Switzerland also applies a different, i.e. lower, federal tax rate for associations and foundations, but it does so irrespective of whether these associations and foundations are publicly or privately owned.

7. Is a distinction being made between central government and lower levels of government? If so, which?

In most cases, central government and lower levels of government are treated the same way for tax purposes. Ireland and, under its new legislation, the Netherlands, though, exempt the central government from CIT, while lower levels of government are only taxed to the extent they carry out profit-making activities.

8. Is there a debate about whether the taxation of public sector enterprises may be contrary to EU law (the free movement provisions, the state aid rules)? If so, what arguments are being put forward?

Only Belgium, the Netherlands and Sweden appear to be facing discussions on the compatibility of currently existing legislation with EU law.

Both Belgium and the Netherlands have discussions with the European Commission on state aid aspects of the tax treatment of sea ports. In Belgium, seaports are mainly classified under the second category legal entities tax. The European Commission takes the position that the seaports should be taxed under the general CIT principles and initiated a state aid investigation. The Netherlands faces a state aid investigation in relation to its tax treatment of seaports as well. The proposed new rules are the consequence of a state aid discussion for the general treatment of public sector enterprises. However, under the new rules, seaports are still tax exempt. Potentially, this is still contrary to the EU state aid rules (EC press release of July 9, 2014, IP/14/794).

In Sweden, several ad hoc discussions have taken place. These have not, however, led to a fundamental change, or a discussion on the incompatibility of the tax system for public sector enterprises.

7 9. Do specific rules apply for internal procurement operations (internal services within the public sector) and quasi services (internal or otherwise – internal services within the public sector through a separate public sector body)? If so, which?

Hungary, Kenya, Lithuania, Sweden and Switzerland do not apply specific rules for internal procurement operations.

Ireland and the Netherlands considered that both internal procurement operations and quasi internal procurement operations are eligible to a tax exemption on benefits from such activities. Specifically for Ireland, the operations should be legally listed.

In Belgium a distinction has to be made between (i) a public body that plays a central or supporting role in a group of public bodies and (ii) a public body that plays a role in a group of public bodies, as well as their performance of similar activities for third parties. Authoritative doctrine claims that a public body that plays a central or supporting role in a group of public bodies should principally be subject to the legal entities tax, even if the entity in question is not performing any activities similar to those of its affiliated public bodies within the context of their social purpose (or the social purpose of the group in general). If, however, the public body is also performing similar activities for third parties, it has to be verified whether the non-profit organization does not carry out profit-making activities. Based on this subjective test it will be determined whether the non-profit organization is subject to legal entity tax (of the third category) or CIT.

In Russia procurement is based on tender conditions. Since the budget of a state-controlled entity is negotiated with the state, all purchases of goods, works and services are subject to negotiation.

10. Do specific rules apply to certain public sector activities or bodies? If so, which activities and/or bodies are involved and are they bound to specific rules? Examples of activities this may include are waste collection, operating car parks, street parking, the lease of property, providing education, any and all health care activities (“cure and care”), property development (building plots and public areas), renting out sports accommodations in the widest sense, operating swimming pools (whether or not combined with hotels and catering), the management of theaters, museums, etc. (whether or not combined with hotels and catering), services to other public sector bodies (such as the secondment of staff) whether or not in the form of a joint venture, operating a sea port or marina, providing loans.

Almost all responding member firms noted that specific rules apply to certain public sector activities or bodies. In all these cases, they refer to a subjective or objective tax exemption.

In that respect Belgium, Kenya and the Netherlands referred to the subjective tax exemptions regarding academic hospitals. For Kenya and the Netherlands this could be extended with educational bodies and sea port authorities respectively. Furthermore, Dutch public sector bodies are not liable for taxes if their activities have been assigned to them by law in the form of tasks. According to the government an exemption applies for issuing identification documents, blessing marriages, issuing licenses and dispensations, collecting market funds, and collecting parking taxes for parking on public roads, unless these activities compete with private parties.

Irish tax legislation exempts income from non-commercial, state-sponsored bodies, if the public bodies are listed. These public bodies are included in various government boards, councils and agencies. Furthermore, an exemption from chargeable gains accruing to public bodies is available.

Research on tax liability of public sector bodies for profit tax purposes 8 11. Suppose a public sector activity in itself would be loss-making – but if such activity were performed by a private company such loss would be covered by a grant from the public sector -, would such public sector body then be liable for taxes and, if so, under which rules?

Ireland, the Netherlands and Sweden consider any and all structurally loss-making public sector activities not to be liable for taxes.

Belgium, Kenya and Lithuania do subject these companies to CIT. No specific exemption is applicable and, thus, the general CIT rules are effective. In Belgium, the structural loss position could lead to discussions on whether the company concerned should be subject to legal entities tax instead of CIT. Russia takes the position that the subsidy, whether for the purposes of development of the company or for covering its loss, is subject to tax.

12. In terms of the liability for profit tax of public sector bodies, is it relevant whether consumers of public services are social bodies or commercial parties?

No, generally there is no such distinction in either of the nine countries of the responding member firms.

13. Does the arm’s length criterion or a business motive test play a role as to whether public sector activities or commercial activities are involved, both for determining the profit for tax purposes and for determining the profit of the public sector body?

As a main rule in Ireland, Kenya, Lithuania, the Netherlands, Russia, Sweden and Switzerland, transactions between public bodies and their indirect public sector enterprises, or for some countries also with third parties, should basically be at arm's length. The determination of profit is generally based on actual revenues and actual costs. This is only deviated from in specific circumstances. The same basically applies to Hungary, with the addition that taxpayers in which the state has direct or indirect majority control, and public-benefit non-profit companies are not obliged to prepare transfer pricing documentation.

Due to the differentiation in Belgium between CIT and legal entities tax, a distinction is to be made on the applicability of transfer pricing rules in either situation. The arm’s length criterion does not apply to public bodies that are subject to legal entities tax (of either category). Transactions may, hence, be at cost or with a mark-up, without any risk of tax corrections. The arm’s length criterion only applies to public bodies subject to CIT. Due to the specific nature of the implementation of the arm’s length criterion under Belgian CIT, special caution needs to be made in situations where both an entity subject to legal entities tax and an entity subject to CIT are involved. Under certain circumstances, such transactions (which would not be at arm’s length), may lead to upward corrections of the taxable base of the CIT payer. This is a rather complex matter, which needs to be analyzed on a case-by-case basis.

9 Contacts

Peter Kavelaars Jasper Korving Partner Tax Manager Tax [email protected] [email protected] +31882880954 +31610042398

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