The European Union Direct Tax Recast – Part II: Merger Directive Catches Up With Company Law, But Not With Tax Reality

In Part I of this series, I looked at the proposed amendments to the Parent-Subsidiary Directive and the Interest and Royalty Directive.

Part II turns to a less visible, but equally important, part of the EU Tax Simplification Package: the proposed amendments to the EU Merger Directive.

The Merger Directive is one of the core instruments of EU direct tax law. Its basic purpose is simple: cross-border reorganisations within the EU should not be prevented or distorted by the immediate taxation of latent gains.

Mergers, divisions, transfers of assets and exchanges of shares within the EU should be capable of taking place on a tax-neutral basis, with taxation deferred until the actual disposal of assets or shares.

This is not merely a technical tax rule but an important part of the legal construct of the Internal Market.

The problem identified by the EU Commission was that EU company law moved forward while the Merger Directive did not fully keep pace. The result is a mismatch between what company law permits and what tax law clearly neutralises. The EU Commission’s proposal seeks to close that gap.

Amendments to the Merger Directive

• The proposal first aligns the definitions in the Merger Directive with the more recent EU company law framework.
• The concept of merger is also expanded to include simplified mergers, where no new shares are issued because the ownership structure already makes such issuance unnecessary.
• The definition of division is also amended to include division by separation, where part of the assets and liabilities of a company are transferred to one or more recipient companies in exchange for shares issued to the company being divided.
• A new set of rules is introduced for cross-border conversions (redomiciliation). This is particularly important because the current Directive only expressly covers transfers of the registered office of a European Company (SE) or European Cooperative Society (SCE).
• Under the proposed new regime, a cross-border conversion should not trigger immediate taxation of capital gains in the exit Member State, provided that the company remains tax resident there or that the relevant assets and liabilities remain effectively connected with a permanent establishment in that exit Member State.
• The neutrality principle for those cross-border conversions is preserved through typical continuity rules. Depreciation, gains and losses must generally continue to be computed as if the cross-border conversion had not taken place. The proposal also allows certain tax-exempt provisions or reserves to be carried over by a permanent establishment in the exit/departure Member State. Losses may also be carried forward or carried back by that permanent establishment, provided that such treatment would have been available in comparable circumstances to a company that had remained tax resident in that Member State.
• At shareholder level, the proposal is also positive because it clarifies that a cross-border conversion should not in itself trigger taxation of income, profits or capital gains, but only on the subsequent disposal of those shares. This is important as some EU countries had proposals or even enacted deemed liquidation dividend distribution rules to dissuade redomiciliations.
• Finally, as with the other Direct Tax Directives, the Annex listing eligible company forms is updated, and the Commission is empowered to amend it in the future by delegated acts to reflect new company forms introduced under national or EU law, particularly relevant if the EU Inc. (28th Regime) corporate framework proposal is enacted.

Key Takeaways

• The Commission’s proposal as regards the Merger Directive is useful, but rather narrow. It is mainly a company-law alignment exercise, not a full tax simplification exercise. It fixes a mismatch between EU company law and EU tax law but leaves some structural weaknesses of the Merger Directive untouched.
• The core issue of the proposal is, understandably, coherence with EU company law. It makes little sense for EU company law to facilitate cross-border conversions and divisions if the EU tax framework does not clearly provide corresponding tax neutrality. Extending the Directive to cross-border redomiciliations is therefore important. In that point, the proposal reduces the need for artificial structuring steps used solely to make a restructuring fit within the existing categories of the Merger Directive.
• The extension to simplified mergers and divisions by separation is also welcome. These are not aggressive tax planning transactions by nature. They are ordinary corporate law tools that should have a clear tax treatment.
• The proposed rule for cross-border conversions does not remove exit taxation in all cases. It only defers tax where the departure or exit Member State still keeps a real taxing connection with the assets, either because the company remains tax resident there or because the assets remain linked to a local permanent establishment. In practice, this may be difficult to apply. A redomiciliation is often not just a change of registered office. It may also involve moving management, treasury or other business functions. If that happens, the question will be which "value" has effectively moved abroad.
• The treatment of losses and reserves will also be important in practice. If implemented properly, the new rules may avoid the destruction of valuable tax attributes merely because a company changes legal form or registered office. However, the proposal does not solve the broader defects of Article 6 that remains fragmented, narrow and underdeveloped, especially in relation to the allocation and cross-border use of losses.
• Finally, the update to the Annex is relevant and useful. This also matters in light of the broader EU Inc debate: if the EU wants to facilitate more flexible pan-European corporate forms, the tax framework must be able to adapt quickly. Directive coverage is therefore critical.

Six Missed Opportunities?

But the benefits of the proposal should perhaps not be oversold. Here are six points where the Merger Directive could have possibly been improved.

1. The Directive still does not clearly say which tax obstacles it is meant to remove. The case law has repeatedly had to clarify the boundaries of the neutrality principle. The recent Nova Iberomoldes case (C-837/24) is a good example of this problem. The Court of Justice had to address the compatibility of Portuguese real property transfer tax (IMT) with EU law in the context of a restructuring involving the contribution of shares in real-estate-owning companies. The analysis was not based on the Merger Directive, but on Directive 2008/7/EC concerning indirect taxes on the raising of capital. That shows the limits of the Merger Directive as a source of reorganisation neutrality, and why clarifications in the Directive could have a powerful effect.
2. The 10% cash limitation has its origin in the historical company law idea that a merger should preserve shareholder continuity, and that cash should only play a supplementary role. This is perhaps the clearest example of the Directive’s formalism. It treats the presence of cash as a threat to tax neutrality, instead of asking whether the transaction is economically a reorganisation or a sale. This rule is under-inclusive and conceptually outdated. If shareholders receive cash, that cash can be taxed at shareholder level. One may argue it confuses two separate questions: whether shareholder liquidity should be taxed, and whether the underlying business reorganisation should remain tax neutral.
3. The same type of criticism applies to the branch of activity requirement. The branch of activity test converts what should be an economic assessment into a formal eligibility condition. The relevant question should not be whether the assets transferred fit neatly within a rigid definition of an autonomous branch (just see how Member States use this concept to limit neutrality), but whether the transaction is a genuine business reorganisation. If the concern is abuse, that concern should be addressed through the GAAR, not through overly rigid definitions.
4. Another unresolved issue is the permanent establishment (PE) architecture of the Directive. The neutrality mechanism remains built around the idea that assets must remain effectively connected with a PE in the departure Member State. However, PE concepts is not defined. A simple fix would be to expressly refer to applicable tax treaties, using the OECD Model definition as a fallback for PE definition where no treaty exists.
5. A further omission or opportunity concerns the relationship between the Merger Directive and primary EU and EEA law. The case law has shown that the formal limits of the Directive do not always end the analysis. In A Oy (C-48/11), the Court of Justice required equivalent tax treatment in an EEA exchange of shares scenario, not because the Merger Directive itself applied to Norway, but because the EEA freedom of establishment required non-discriminatory treatment. For genuine third-country situations, the position is even less clear. The Commission’s proposal does not address this part of the architecture, which could have been an opportunity to address the disputed third-country scope for exchange of shares.
6. The last missed opportunity relates to anti-abuse. The Merger Directive contains its own anti-abuse rule, but key concepts such as "principal objective", "tax avoidance" and "valid commercial reasons" remain open-textured. The ATAD GAAR and the Merger Directive anti-abuse rule pursue the same objective, but operate through different wording and legal tests. This was another opportunity to move towards a single, coherent anti-abuse standard across EU direct tax law.

None of these six points are new. As early as 2010, the EY survey prepared for the European Commission on the implementation of the Merger Directive had already identified several of the same improvement areas. The current proposal should therefore be welcomed but not overstated. It fixes the company-law mismatch, while leaving untouched some structural issues that have been known for more than fifteen years.

In short, the proposal simplifies the Directive only at the edges. It updates the map but does not repair the road.