The residence of a person is defined in the national tax laws and in the double taxation treaties.
National tax laws usually define the country of residence where the person has a dwelling available under circumstances indicating that he maintains and uses it.
If a double tax treaty is applicable, residency is defined in article 4 in the following hierarchy:
- a person shall be deemed to be a resident only of the state in which he has a permanent home available to him;
- if he has a permanent home available to him in both contracting states, he shall be deemed to be a resident only of the state with which his personal and economic relations are closer (centre of vital interests);
- if this cannot be determined or if the person has not a permanent home available in either state, he shall be deemed to be a resident only of the state where he is usually present.
For tax planning purposes, the person must first decide, if there shall be a residence in a country or not in a certain country. If there is no dwelling available, there usually is no tax residence. But terminating the residence permanently may trigger exit tax.
Exit Taxation – explanation
Exit taxation (sometimes called departure tax or expatriation tax) may be triggered when a person resides long time in a country (usually 7 of the last 12 years), moves the residency permanently out of this jurisdiction and holds a participation in a corporation of at least 1%.
Many countries include in the tax basis the participation in foreign corporations. Then the departure state may assume a deemed sale and tax the hidden reserves, which is the difference between the nominal value and the market value of the participation. Exit tax can also be triggered if shares are inherited or donated to a recipient who is not unlimited taxed in the country where the deceased person was residing.
Article 5 of the Anti-Tax Avoidance Directive of the EU (ATAD; the Council Directive (EU) 2016/1164) and the corresponding national tax laws deal specifically with this topic. Until the laws are fully implemented, the current status considers the right of free movement: tax liability is “sleeping” (deferral) if a person changes the residency to a country within the EU or EEA, however it is triggered when the person moves (from there) to a third country outside EU/EEA.
Exit Taxation until the implementation of Article 5 of ATAD
Before all the national legislation is in place, it may be possible to move first to a destination country within EU/EEA, form there a proper structure as a holding and then move to a third country. To attract investors, some EU countries allow a formal residency in their country without looking too much at the physical presence. This allows to win time and to benefit from a possible decrease in value of the hidden reserves between the moves. Also, in case of a request for administrative cooperation, the destination states may have limited interest to invest resources in order to collect taxes for the departure state if wealthy investors decide to move to their country.
Because some countries have implemented strict exit tax regulations from 2022, advisors reported a huge demand from people who wanted to leave these countries within 2021.
While ATAD mentions “created in its territory”, some member states tax also the capital gains on a participation in foreign corporations. Therefore, there are rumors that some taxpayers move first within the EU/ EEA to a country where the declaration does not include foreign participations before they move out of the EU/ EEA.
Exit Taxation after the implementation of Article 5 of ATAD
The directive asks the countries to specify cases in which taxpayers are subject to exit tax rules and taxed on unrealised capital gains. The valuation of a market value at the time of exit shall be based on the arm’s length principle. In case the assets enter into a structure, the destination state shall establish the same valuation as the departure state (which sometimes allows depreciation).
Taxpayers shall have the obligation to immediately pay the amount or in instalments over a certain number of years (ATAD mentions 5 years), possibly together with interest and eventually a guarantee.
However, exit tax should not be charged when the change is of a temporary nature or for those assets which remain effectively connected with a permanent establishment in the first Member State.
How to minimize or how to avoid exit taxation?
Temporary change of residency:
With a temporary move, income will be taxed in the destination state (the new tax residence) but exit tax may not be triggered in the departure state.
To create evidence that the move is not permanent, an apartment can be still available in the departure state, and if there is a double tax treaty in place, there also shall be a plausible explanation why the centre of interest remains there.
Some countries like Germany have modified the return- rules: if EU/EEA citizens move within the EU/EEA and plan to return within 7 years, authorities shall be notified, but they shall not ask for securities. On application, the return period can be extended for additional 5 years.
This rule allows to leave the country temporarily, return and then exit permanently with little or no exit tax, if the value of the hidden reserves in the participations has decreased during the first period of absence.
Donations, trusts, foundations:
In countries where there is no or little gift tax, assets can be entered into foundations, trusts or be donated before the change of residency.
Sometimes it is possible to form a foundation in the same country that receives and holds the assets. Then there is no exit tax if the natural person changes the residence country.
Partnership in the departure country as shareholder of the corporation:
If the shares of the corporation with hidden reserves are entered into a local partnership, the departure state does not lose the right of taxation. Depending on the country, the valuation shall happen at the book value without granting additional consideration. Some countries allow such transactions tax-free. On the other hand, the departure of partners of a partnership is usually not subject to exit tax provided that a few special features are observed.
To avoid qualification as misuse, it is recommended to create a commercially active partnership with a visible permanent establishment in which the shares in the corporation are functionally assigned to the business purpose. If the partnership only provides management services for a fee to the corporation, this may not be sufficient.
Eventually it can be useful to put the shares into a foreign holding and to put this foreign holding into a local partnership before the exit. Generally spoken, it may be useful to establish rather complex international structures with several shareholders and units on different levels and contracts between them in order to have better arguments for the evaluation.
Selling for a low price with a warrant depending on future profits:
A shareholder forms a company with regular share capital that purchases the original company for a low price plus a debtor warrant.
When the shareholder leaves the country, there are no hidden reserves in the holding and therefore there is no exit tax.
The argument of the low price with a warrant is understandable if there are no long term contracts.
Change the company into a partnership:
If a company is transformed into a partnership, the capital reserves of a company are taxed, but not the difference between the book value and the market value. The person moving away shall not remain the sole managing director of the partnership, because if he develops significant business activities from abroad, this may raise questions regarding profit sharing.
Disadvantages may be an increased level of liability, potential loss of tax carry- forward, a higher tax rate and eventual social charges. In addition, a partnership structure that only allows to avoid exit tax may qualify as misuse, and eventually even entanglement tax can be raised.
Atypical silent partnership:
An aggressive variant of this idea is a so called atypical silent partnership. This legal form is created by contract and constitutes a transparent entity for tax purposes in the exit country, if there is a permanent establishment.
Minimize the valuation of the corporation:
Shareholders of a company have different rights: to receive dividends, to sell the shares, to receive the proceeds in case of liquidation and to vote in the general assembly. There may be valid reasons for a shareholder to give up or transfer some of these rights before leaving the country. Then the value of his assets at the moment of the exit is lower.
There are different valuation methods for the market value of a company based on substance, on earnings, on a mix of the two or on future cash flow. Most methods include estimations about the future, and it is possible to find reasonable arguments for a valuation. For example, if a company is managed by a competent person who resigns before his exit, the valuation cannot be based on the assumption that this person continues to be available for the company in the future and that all the business partners will continue their relationship.
Corona measures may allow a lower evaluation of a company, too.
Using national legislation, instruments like merger, splitting or pure migration rules, legal persons can move to another country. Within the EU and associated countries, the merger directive already limits the taxation rights.
To attract investments, some countries allow companies that relocate to their destination to raise the entry value of their assets tax free from book value to market value and to eliminate hidden reserves. This so called “step up” can therefore help to avoid exit taxation, but to avoid qualification as misuse, it needs to be planned and implemented in a very careful way and in coordination with qualified experts.
Entanglement taxation happens if individual assets (entanglement), activities (relocation of functions) or the entire company are relocated abroad. This includes the transfer of business to a foreign entity. The national legislations of the departure countries are different in this point. Currently, some countries allow a “step up” (valuation of incoming assets at market value instead of the exit value), but ATAD requires the destination state to establish the same valuation as the departure state.
To avoid taxation in the exit country, it is recommended to separate old business (that remains in the old country) from new business (in the new country). If there is a brand, the rights to use can be licensed, but then the company in the destination country may have to pay withholding tax at source. In the EU, such source tax can be avoided if the licensor and the licensee fulfill certain requirements of related companies.
To ensure a legal and optimized procedure, we highly recommend getting an opinion from a local expert in the departure country.
(Updated November 2023)