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DIRECT TAXATION DIRECT TAXATION AND AND

EUROPEAN LAW EUROPEAN LAW (the recent case law of the ECJ)(the recent case law of the ECJ)

Melchior WATHELETMelchior WATHELETProfessor of European Law at the Professor of European Law at the Universities of Louvain-La-Neuve Universities of Louvain-La-Neuve and Liège (Belgium)and Liège (Belgium)Honorary Judge at the ECJHonorary Judge at the ECJOf Counsel CMS - Bureau Francis Of Counsel CMS - Bureau Francis Lefebvre (Paris)Lefebvre (Paris)

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DIRECT TAXATIONDIRECT TAXATIONFALLS WITHIN THE COMPETENCE OF FALLS WITHIN THE COMPETENCE OF

THE MEMBER STATESTHE MEMBER STATES

BUTBUT

THE MEMBER STATES MUST THE MEMBER STATES MUST EXERCISE THAT COMPETENCE EXERCISE THAT COMPETENCE

CONSISTENTLY CONSISTENTLY WITH COMMUNITY LAWWITH COMMUNITY LAW

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With consistency, the ECJ case-law has defined :

the obligation to exercise the fiscal competence consistently with EC-Lawas the prohibition

in the fields offree movement of - persons

- services- capital

freedom of - establishment

of ANY DISCRIMINATION OR RESTRICTION (BARRIER) except if they are justified.

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Cases decided : 1957-1985 0

1986-1994 5

1995-2006 more than 50

________

over 55(90 % of which declare the

national tax system inconsistent with EC-law)

and only 5 infringement procedures

Pending cases more than 50

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Some pending (or pending again cases)

• Most favoured nation clauseRefusal for some non-residents of tax advantages granted to residents and some other non-residents (in application of a double tax convention)

• CFC rulesTaxation in the head of a resident parent company of profits realized (even not distributed) by a subsidiary resident in a country with a lower tax rate

– NL– NL– UK

– UK

– D (2005)

– Bujara (2005)

– Test Claimants in Class IV (pending – AG 2006)

– Cadbury Schweppes (pending)

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• Thin capitalization rules

– UK

– DE

– Thin Cap Group (pending)

– Lankhorst-Hohorst (2002)

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• Single market restrictions

– Different tax treatment according to whether an insurance contract is signed with (or capital is invested in or transferred to) (or dividends are paid to) a resident or non-resident company or shareholder.

– SE

– BE

– ES

– BE

– DK

– Safir (1998)– Skandia (2003)

– Bachmann (1992)

– Comm vs Spain (pending)

– Comm vs Belgium (pending)

– Comm vs Danemark (pending)

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• Withholding taxes

– for foreign artists

– on payment to foreign service providers

– on pension income of non- residents

– on outbound dividends

– DE

– BE

– Fin

– FR

– Scorpio (pending)(cfr Gerritse 2003)

– Comm vs Belgium(pending)(AG 2006)

– Turpeinen (pending)

– Denkavit (pending)(cfr Fokus Bank – EFTA Court)

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• Free movement of capital with third StatesA vs SKATTEVERKET :

– Is it consistent with EC law that dividends paid to A be taxed because they are paid by a company not established in a Member State (or a State having with Sweden an agreement of exchange of information) ?

A-B vs SKATTEVERKET :– Same question when the tax treatment of the dividends is less

favourable because the subsidiary of the company paying them, has an activity in Russia and not in Sweden.

Article III, 157 of the Constitutional Treaty

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To date, ECJ case law has

I. found a high level of breaches in terms of discrimination or obstacles

II. been very strict in accepting reasons put forward to justify these breaches

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I. High level of breaches found1. Residents and non residents are in theory in

comparable situations and accordingly cannot be discriminated against where the applicable tax rule is not in any way related to residence

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– Rules of fiscal procedure : BIEHL (1990), SCHUMACKER (1995)

– Rule of progressive scales : ASSCHER (1996)

– Tax advantages deriving from a double taxation convention : ST GOBAIN (1999)

– Deductibility of business expenses – Tax ScalesGERRITSE (2003)

– Tax credit on inbound dividendsLENZ (2004) – MANNINEN (2004)

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1) RITTER COULAIS (2006):

– German national, resident in France; all incomes in Germany

– Negative incomes in France not taken into account in Germany because not located in Germany

– Advocate General (01/03/2005)– Discrimination because residents and non-residents are in

comparable situations (as the State of residence cannot take these negative incomes into account in the absence of any income)

– ECJ (21/02/2006)– Infringement of 48 EC because less favourable treatment of non-

resident workers.

New cases : APPLICATION

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2) BLANCKAERT (2005):

– Non resident in the NL

– Refusal of the NL to grant him some tax deductions

– Court• No infringement : not comparable situations

This tax deduction only granted when social security contributions are not sufficient to offset social security deductions

Therefore, this tax deduction is limited to people affiliated to the NL social security (not the case of Mr BLANCKAERT)

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3) CONIJN (Advocate General 09/03/2006):

– Non resident in Germany, incomes in Germany

– Refusal by Germany law to grant him deduction of tax consultation expenses (granted to residents)

– Advocate General• Infringement of 43 EC : indirect discrimination based

on nationality.

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4) CLT-UFA (2006) :– Company, resident in the Grand Duchy of

Luxembourg, has a branch in Germany.– The tax rate on the profits of the branch is higher than

if the same profits had been distributed by a subsidiary in Germany.

– Advocate General (14/04/2005)• “this violation of EC law stems from the fact that the Member

State treats the non-resident company as a national company to establish the tax basis and then excludes it from the advantages linked with this taxation” (§ 68)

– ECJ (23/02/2006)• § 30 : “German subsidiaries and branches of companies

having their seat in Luxembourg are in a situation in which they can be compared objectively”.

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5) KELLER HOLDING (2006) :– In German Law, financing costs incurred by a parent

company and relating to shareholdings are~ not deductible if they relate to dividends paid by an indirect

subsidiary established in Austria~ deductible if they relate to dividends paid by an indirect

subsidiary established in Germany.

– ECJ• “in both cases, the dividends received … are … exempt from

tax. Accordingly, a restriction on the deductibility of a parent company’s financing costs – as a corollary of the non-taxation of dividends – which affects solely dividends from abroad does not reflect a difference in the situation of parent companies according to whether the indirect subsidiary owned by the latter has its registered office in Germany or in another Member State”. (§ 37)

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6) TEST CLAIMANTS IN THE F II GROUP LITIGATION (Advocate General 06/04/2006) :– UK Law grants a better tax treatment to

dividends paid by resident companies than to dividends paid by non-resident companies

– Advocate General• “Insofar as it chooses to relieve economic double

taxation on its residents’ dividends, a home State must provide the same relief for incoming foreign-source dividends as for domestic dividends and must take foreign corporation tax paid into account for this purpose”. (§ 75)

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• Comparable situation for residents and non residents

NEW CASES : EVOLUTION ?

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D (1) (judgment of July 5th, 2005):– Dutch wealth tax. Deduction only for residents– D is German resident and has immovable property in

the NL– Advocate General (26/10/2004)

• Residents and non residents are in comparable situations Same tax base 100 % of D’s tax base is also liable for wealth tax in the Netherlands Germany is unable to grant deduction as wealth tax does not exist in

Germany

– Court (05/07/2005)• Residents and non residents are NOT in comparable situations

Only a small portion of D’s income is taxable in the Netherlands Germany was unable to grant D a tax benefit

not because there was no taxable income in Germany (as Mr Schumacker in Belgium)

but because wealth tax does not exist in Germany

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• Most favoured nation clause

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D (2) :• Dutch wealth tax. Tax deduction only applies

to some non-residents (double tax treaty with Belgium)

• Equal treatment of non-residents and residents ?

• Advocate General (26/10/2004)– YES (but it is not necessary to reply to this

question).

• ECJ (5/07/2005)– NO : German and Belgian non-residents are not

in the same situation The general balance of the double tax treaty must be

observed (in spite of the same tax base, the same proportion of income in the Netherlands and the non-existence of wealth tax in Belgium and Germany)

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Test Claimants in Class IV (Advocate General 23/02/2006) :in UK law– partial tax credit on dividends paid to Companies

resident in a country only when it is so provided for in the DTC signed by the UK and this country.AG : “ each DTC contains a specific allocation of tax

jurisdiction and priority of taxation between the Contracting States” (§ 95).

– partial tax credit denied to Netherlands-resident Companies if controlled by a resident of a Member State, when no provision for this tax credit in the DTC signed by the UK and this Member StateAG : “ the distinction in a DTC between non-

residents on the basis of the country of residence (and thus applicable DTC) of their controlling shareholder, forms a part of the

equilibrium of jurisdiction and priority reached by the Contracting States” (§ 101).

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2. Any restriction to trans-national operations is in principle inconsistent with the Treaty.

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A.

– different taxation of dividends or interests coming from abroad (Verkooijen (1999) – Lenz (2004) – Manninen (2004) – Comm./France (2004))

– different taxation of insurance contracts according to whether they are signed with resident or non resident companies (Safir (1998) – Skandia (2003))

– different taxation of a subsidiary or a parent Company according to whether the parent company or the subsidiary is established abroad or not (ICI (1998), Metallgesellschaft (2001), St Gobain (1999))

– different taxation of capital gains or asset transfers depending on whether the transferee is established abroad or not (XY (2002), XAB – YAB (1999))

– thin capitalization rules different according to whether the lending shareholder of the subsidiary is established abroad or not…(Lankhorst – Hohorst (2002))

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Illustration

– Exit tax to be paid in case of transfer of domicile is illegal (HUGHES DE LASTEYRIE DU SAILLANT 2004)

BUT NOT IF

– tax is assessed on profits from a shareholding when residence is moved to another Member State

~ if the tax is differed until the shares are disposed of without any further conditions (for ex. : security)

~ If the tax finally levied is not higher than the tax which would have been levied on disposal within the territory (N – AG 2006).

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B. MARKS & SPENCER (transfer of losses)– Advocate General

• General rule : “prevent Member States from creating or maintaining in force measures promoting internal trade to the detriment of intra-Community trade” (§ 39)

• In this case : “the refusal at issue in the present case constitutes an “exit restriction” which is characterised by unfavourable treatment of companies wishing to establish subsidiaries in other Member States”.

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– Judgement of 13/12/2005•« It (the exclusion of group relief) thus constitutes a restriction on freedom of establishment within the meaning of articles 43 EC and 48 EC, in that it applies different treatment for tax purposes to losses incurred by a resident subsidiary and losses incurred by a non resident subsidiary » (§ 34)

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EVOLUTION ?

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• Presumption of residence

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Can national law decide that an individual is still resident despite having moved ?

VAN HILTEN (2006):– Mrs. VAN HILTEN, a Dutch citizen, left the Netherlands

in 1988 and dies abroad in 1997– According to Dutch law, she is presumed to have

maintained tax residency in the Netherlands (10 years);– Advocate General (July 2005)

• No breach of EU law

– ECJ (23/02/2006)• Transfer of residence does not involve financial transactions or

transfers of property : therefore, nothing to restrict

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- before deciding whether the exercise of the fiscal competence restricts transnational operations,

- is there a fiscal competence at all ?

• Preliminary question

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1. TEST CLAIMANTS IN CLASS IV (Advocate General 23/02/2006)

Should, on dividends paid by UK subsidiaries, individual shareholders of a non-UK-resident parent company be entitled to the same tax credit as the individual shareholders of a UK-resident parent company ?

AG : NO as on outgoing dividends, no UK income is levied. There is therefore no UK income tax liability to extinguish with an imputation

credit.

YES if for example under a DTC, the UK has the right to subject these dividends to UK

income tax.

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“Insofar as a Member State does not exercise tax jurisdiction over a non-resident tax payer, then it does not have to give loss relief.”

How to reconcile this with :- Marks & Spencer ?- Bosal Holding ?

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2. KERCKHAERT-MORRES V. BELGIUM (Advocate General 06/04/2006)

- Belgium law applies 25 % tax rate to all dividends received by Belgian residents, whatever their source but refuses to take into account the 15 % withholding tax levied on dividends in the Source State, France.

- Advocate General : no restriction or indirect discrimination

because the effect of the combination of the avoir fiscal and the withholding tax in France is that Belgian resident shareholders finally keep more of a French-source dividend than from a dividend paid by a Belgian company

BUT ANYWAY

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even if it was not the case the disadvantage would not result from any breach of EC law by Belgium which does not“oblige home States to relieve juridical double taxation resulting from the dislocation of tax base between two Member-States” (§ 30)

SO PLAIN DOUBLE TAXATION WOULD BE LEGAL !

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DENKAVIT (withholding tax on outbound dividends)(only when the dividends are paid to a parent company established abroad)

– Fokus Bank (EFTA Court) : RESTRICTION

The provisions at issue“impede the freedom of companies and individuals resident in another Contracting Party to invest in Norway. They are also capable of having the effect of impeding Norwegian companies from raising capital outside Norway.”

Other pending cases

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CADBURY SCHWEPPES (CFC rules)– Obstacle to invest in other Member States

or– “a difference of treatment between [resident]

taxpayers by adopting, as its criterion, the seat of the companies of which those taxpayers are shareholders” (Baars § 30),not cancelled by an objective difference in the situation of the parent companies, all resident in the UK.

– “the difference in tax treatment… concern parent companies according to whether or not they have subsidiaries making profits in NL, even though those parent companies are all established in that Member State” (Bosal § 39)

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II. Very strict in accepting justifications

Member States have put forward 6 justifications :• Loss of income : unacceptable• Territoriality of tax : acceptable in theory and accepted

in one case out of 55• Non-residents are entitled to tax benefits elsewhere :

unacceptable• Need to improve efficiency of tax audits : acceptable in

theory and accepted in one case out of 55• Need to fight tax evasion or fraud : acceptable in theory

and accepted once.• Tax coherence : acceptable in theory and accepted in

one case out of 55.

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1. Loss of tax revenue(or « aim of avoiding an erosion of the tax base going beyond…mere diminution of tax revenue »)NEVER !

ICI (1998)ST GOBAIN (1999)DANNER (2002)SKANDIA (2003)BOSAL (2003)HUGHES de LASTEYRIE du SAILLANT

(2004)ANNELIESE LENZ (2004)MANNINEN (2004)

But politically ?

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2. Territoriality The ECJ has closed in BOSAL (2003) and

MANNINEN (2004) the door that had been slightly opened in FUTURA PARTICIPATIONS (1997).

MARKS & SPENCER (13/12/2005) “… the fact that it does not tax the profits of

the non-resident subsidiaries of a parent company established on its territory does not in itself justify restricting group relief to losses incurred

by resident companies.” (§ 40).

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3. Anyway, non-residents have other advantages elsewhere.

NO

ANNELIESE LENZ (2004)

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4. Increasing the effectiveness of fiscal supervisionIn principle YES

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but never accepted (with one exception)because « Directive 77/799 concerning mutual assistance in the field of direct taxation provides adequate means… »

SCHUMACKER (1995)BAXTER (1999)VESTERGAARD (1999)COMMISSION-FRANCE (2004)

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5. Preventing the risk of tax avoidance

In principle YES

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but only when the national legislation has the specific purpose of preventing wholly artificial arrangements to circumvent national tax legislation,

“… a general presumption of tax avoidance or fraud is not sufficient to justify a fiscal measure which compromises the objectives of the Treaty…”COMM-FRANCE (2004) pt 27

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what cannot be presumed for : the establishment of a subsidiary

abroadICI (1998)

any situation in which a mother company, for any reason, has its seat abroad

LANKHORST - HOHORST (2002)

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the establishment of the mother company or of a subsidiary abroad.

XY (2002) the transfer of a physical person’s tax

residence outside the territory of a Member State

Hughes de LASTEYRIE du SAILLANT (2004)

the fact that a foreign service provider is not registered

COMM V. BELGIUM (AG 2006)

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MARKS & SPENCER

“It can be justified” [to prevent] such practices which may be inspired by the realisation that the rates of taxation applied in the various Member States vary significantly” (§ 50)

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– Compare

• CENTROS (1999)“the fact that the company was formed in a particular Member State for the sole purpose of enjoying the benefit of more favourable legislation does not constitute abuse even if that company conducts its activities entirely or mainly in that second State”.

• BARBIER (2003)“a Community national cannot be deprived of the right to rely on the provisions of the Treaty on the grounds that he is profiting from tax advantages which are legally provided by the rules in force in a Member State other than his state of residence”.

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CADBURY SCHWEPPES (CFC rules)– France has abolished its CFC system

“with the exception of wholly artificial arrangements…”

– UK Legislation• Very general• General presumption, excepted negative

evidence

Pending case

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6. Cohesion of the tax systemalways invoked by Member States … because the ECJ accepted it … once in 1992… (BACHMANN)

[Belgian law did not allow the deduction of life insurance premiums paid abroad. The Belgian system gave the choice of either deducting premiums but taxing future benefits or not deducting premiums and having future benefits exempted. The cohesion of the Belgian system required the certainty to tax the benefits if the premiums had been deducted, what was not the case if the benefits were paid abroad.]

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but systematically refused it afterwards because the concerned national system did not fulfil the conditions imposed by the definition of the ECJ

Cohesion of a tax system may only be invoked when :

1) One taxpayer only is concerned (difficult to meet this criterion for groups of companies, when parent companies and subsidiaries are concerned)

ICI (1998)

METALLGESELLSCHAFT (2001)BOSAL HOLDING (2003)ANNELIESE LENZ

(2004)

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2)One taxation is concerned (not possible to « compensate » corporation tax and income tax or corporation tax and wealth tax)

ASSCHER (1996)BAARS (2000)VERKOOIJEN (2000)ANNELIESE LENZ

(2004)

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3)There is a direct link between a tax relief and a taxation,

DANNER (2002)BOSAL (2003)LANKHORST-

HOHORST (2002)SKANDIA (2003)

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But for 2 Advocates General (in Maninnen and Marks & Spencer)

these criteria are “OVER-RIGID”

“to relax [them],… I propose to revert to the criterion of the aim of the legislation at issue”.

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MANINNEN MARKS & SPENCER

• Objective of the legislation

• to avoid double taxation of the same profits

• to ensure fiscal neutrality of the effects of the creation of the group of companies

• the legislation at issue

• does not avoid the double taxation of the profits distributed by a Swedish company (cfr FOKUS Bank)

• refusing systematically any transfer of losses of foreign subsidiaries does not ensure the neutrality

• and if the Member State says that it cannot charge to tax the profits of the Swedish company or of the foreign subsidiaries ?

• this objective (to avoid a reduction of tax revenues) is not admissible (cfr FOKUS BANK) (and BACHMANN ?)

• the State would then have objectives (protection of the revenue or favoring groups only active on its territory) contrary to EC law

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If it is necessary to allow NON-RESIDENT SUBSIDIARIES to transfer losses if RESIDENT SUBSIDIARIES are allowed to,two remaining questions :

A. “double dipping” ?NO, according to the Advocate General. Why ?

“coherent” with the objective of “neutrality” (Advocate General) The “only once” rule does not create any obstacle to transnational

activities (Gerritse (2003))

B. “loss shopping” ?PRIORITY TO THE STATE OF ESTABLISHMENT if “equivalent” system

(carry forward ? transfer ?) (legally ? in fact ?)

(cfr the priority to the State of residence given by the Court in the cases Gerritse (2003) – De Groot (2002))

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Judgement Marks & Spencer of 13/12/2005

Evolution ?

Coherence : NOTHING

Risk of tax avoidance and two justifications with a new name

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• « balanced allocation of the power to impose taxes between the different Member States » (§ 44 to 46)Is it not simply another name for the protection of tax revenue ?

• « risk of double use of losses » (§ 47 and 48)

• « risk of tax avoidance »It can be justified “[to prevent] such practices which may be inspired by the realisation that the rates of taxation applied in the various Member States vary significantly” (§ 50)We are very far from “wholly artificial arrangements whose purpose is to circumvent or escape national tax law”.

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That being said, these three justifications, justify the only measures taken to prevent :

• the double dipping – (as far as the risk of double use of losses is concerned “it

must be accepted that Member States must be able to prevent that from occurring” (§ 47)).

• the loss shopping– (« to give companies the option to have their losses taken

into account in the Member State in which they are established or in another Member State would significantly jeopardize a balanced allocation of the power to impose taxes between Member States … » (§ 46))

– (as far as the risk of tax evasion is concerned, … “the possibility of transferring the losses incurred by a non-resident company to a resident company entails the risk that within a group of companies losses will be transferred to companies established in the Member States which apply the highest rates of taxation and which the tax value of the losses is therefore the highest » (§ 49).)

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The conclusion ought to have been :• the measures to prevent double dipping :

justified

• the measures to prevent loss shopping : justified

• the rest of the British legislation, i.e. the prohibition of group relief when non-resident subsidiaries are concerned even when there is no risk of double dipping or loss shopping : not justified

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About the hard core of the UK legislation, the Court does not say anything. Instead, it reasons on the basis of proportionality :STRANGE. Indeed,

• when the Court analyses the proportionality of a measure, it is normally because this measure is in principle justified, what the Court does not say here (and, in any case, it is not possible to see which justification could be invoked)

• or proportionality is becoming in itself a justification (with the risk of a case law which becomes less foreseeable, more dependant on individual cases and finally less objective).

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N (Advocate General 30/03/2006)

§ 92 In Marks & Spencer, the Court recognised that preservation of the allocation of the power to impose taxes between Member States constituted a legitimate purpose which could justify restrictions on freedom of establishment. In that context, the principle of territoriality… can be the determining principle on the basis of which the Member States allocate the power to impose taxes.

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In three cases of 2006, CLT-UFARITTER-COULAISKELLER HOLDING,

the Court comes back to its previous reasoning on the justifications.

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Coherence : KELLER HOLDING (2006)

§ 43 “the legislation at issue… does not establish any relationship between the deductibility of the financing costs relating to the shareholdings of the parent company and the profits in respect of which the indirect subsidiary is liable to tax. Moreover, the profits realised by that indirect subsidiary which enabled it to distribute dividends are subject to corporation tax in Austria, just as the profits of an indirect subsidiary which has its registered office in Germany are taxable in that Member State, since the place of establishment of the parent company is of no importance in that regard”.

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Coherence : CLT UFA (2006)§ 27 “in respect of a German subsidiary of a

Luxembourg company, it must also be added that the reduced tax rate which applies to the profits of such a subsidiary, in relation to the rate applicable to the profits of a branch, is not compensated for by applying a higher tax rate to the profits of the Luxembourg parent company”

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Coherence : RITTER COULAIS (2006)

§ 40 “it is sufficient to state that while the German tax system takes into account positive income deriving from the use of a dwelling in another Member State for the purposes of determining the rate of taxation, fiscal coherence is not a suitable justification on any ground for refusing to take into account for the same purposes, income losses of the same kind arising in the same State”.

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Territoriality : KELLER HOLDING (2006)

§ 44 “that legislation cannot be regarded as an application of that principle [of territoriality] since it excludes the deductibility of finance costs incurred by a parent company subject to unlimited tax liability in Germany and receiving dividends from an indirect subsidiary established in Austria by reason of the fact that they are exempt from tax in Germany whereas dividends paid to the same parent company by an indirect subsidiary subject to unlimited tax liability in Germany and having its registered office in that Member State also benefit in fact by means of the method of offsetting the tax paid by the distributing company, from such an exemption”.

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As well to decide whether there is a forbidden restriction or not as to decide whether a restriction is or not justified, new weight is being given in the case law

– to the competence of the Member States to allocate among themselves the fiscal competence (and the allocation of the fiscal competence comes before the exercise of this competence) (TEST CLAIMANTS IN CLASS IV – KERCKHAERT-MOORES – AG)

– to a balanced allocation of the power to impose taxes between the different Member States (MARKS & SPENCER)(N – AG).