Electronic copy available at: http://ssrn.com/abstract=1356125

Taxation and the Third Country Dimension of Free Movement of Capital in EU Law: the ECJ’s Rulings and Unresolved Issues

By

Martha O’Brien

Reprinted from British Tax Review Issue 6, 2008

Sweet & Maxwell 100 Avenue Road

Swiss Cottage London

NW3 3PF (Law Publishers)

Electronic copy available at: http://ssrn.com/abstract=1356125

Taxation and the Third Country Dimension of FreeMovement of Capital in EU Law: the ECJ’s Rulingsand Unresolved Issues

MARTHA O’BRIEN*

Abstract

The free movement of capital guaranteed by Article 56(1) of the EC Treaty applies not onlywithin the European Union (EU), but also to movements of capital between EU Member Statesand non-EU (or third) countries. Over the last 15 years the Court of Justice of the EuropeanCommunities (ECJ) has ruled repeatedly in intra-EU cases that Member States’ direct taxlaws must not impede exercise of the fundamental freedoms, including free movement of capital.The ECJ has now begun to define how Article 56(1) applies to direct tax restrictions on capitalmovements between the EU and third countries, providing some important indications, but alsoraising many questions, as to the differences and similarities in the way the ECJ will approachthird country cases as compared to intra-EU cases. This article provides an analytical overviewof the EC Treaty provisions on free movement of capital, the range of intra-EU cases thathave held Member State tax laws incompatible with free movement of capital, and discusses theimplications of recent third country decisions and the provisions of the Treaty of Lisbon on thefuture evolution of the third country dimension.

Introduction

The global potential of Article 56(1)

ARTICLE 56(1) of the EC Treaty1 prohibits ‘‘all restrictions on the movement of capitalbetween Member States and between Member States and third countries’’ (emphasis added).This is an extraordinary provision for what is, at its core, a trade agreement creating aregional common market. It extends certain EC Treaty benefits and rights to residentsand citizens of countries that are not party to the EC Treaty, without requiring reciprocity

* Associate Professor, Faculty of Law, University of Victoria, British Columbia, Canada. The researchfor this article was supported by a Jean Monnet European Module Grant from the EuropeanCommission, and by the Social Sciences and Humanities Research Council of Canada.

1 Treaty establishing the European Community, consolidated version, [2006] OJ 2006 C 321/E37. TheEC has concluded numerous association agreements with third countries which provide in some casesfor greater liberalisation of capital movements. The effects of these agreements on free movementof capital between the EU and third countries is beyond the scope of this article. See the views ofnational reporters from some of these third countries in M. Lang and P. Pistone (eds), Free Movementof Capital and Third Countries: Direct Taxation (Linde Verlag, Vienna, 2007) and B.J. Kiekebeld andD.S. Smit, ‘‘Freedom of establishment and free movement of capital in Association and PartnershipAgreements and direct taxation’’ [2007] EC Tax Review 216.

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from these non-Member States. The ECJ has confirmed that this provision has directeffect with respect to third countries,2 so that individuals and companies may take legalaction to assert their rights under Article 56(1) in the national courts of the Member States.

In light of the significant impact that Article 56(1) has on Member States’ direct taxationlaws within the European Union, this article examines the third country dimension offree movement of capital and the implications it may have for third country investors inEU Member States and for EU residents who invest in third countries.

The second part of this article provides, as background and a basis for comparison ofthe cases on the third country dimension of free movement of capital, an overview of thescope and application of Articles 56(1) and 58(1)(a) within the European Union, includingthe definition of capital movements, the ECJ’s jurisprudence not related to taxation, and asurvey of the direct tax cases according to subject matter. The relationship of the networkof bilateral double taxation conventions (DTCs) between Member States to the directtaxation principles of EU law is outlined, and the justifications for restrictions of freemovement of capital are reviewed.

The third part of the article first sets out the points on which the intra-EU andthird country case law coincide. Subsequently it examines the differences: the judiciallimitation to free movement of capital in respect of third countries that has emerged inthe Fidium Finanz case3 as applied to direct tax measures in subsequent cases, the specificlimitation to the third country dimension in the standstill provision, Article 57(1), andthe specific new powers of Council and Commission to approve restrictive tax measuresin the third country dimension in the Treaty of Lisbon. Additional justifications thatmay be applied in third country cases but which have been rejected, or accepted in onlynarrow circumstances, in intra-EU cases are then discussed. The concluding part appliesthe preceding analysis to identify where Member State tax laws are most vulnerable tothird country challenges, followed by a short summary of the outstanding issues and likelyfuture developments.

The evolution of free movement of capital from 1958 to 1993

Free movement of capital has been called the ‘‘runt of the litter’’,4 a ‘‘bit of a wallflower’’5and ‘‘left behind’’6 in comparison with the other fundamental free movement guaranteesin EU law. Article 67 of the original 1957 Treaty of Rome included free movement ofcapital among the foundation provisions of the European common market, but it didnot have direct effect. It was not until 1990, when the third Council directive on the

2 Joined Cases C-163/94, C-165/94 and C-250/94 Sanz de Lera [1995] ECR I-482. More recently andin respect of direct taxation, see Case C-101/05 Skatteverket v A [2007] ECR I-11531 at [26]–[27].The issue of whether Art.56(1) has horizontal direct effect has not been resolved. All ECJ decisionsare available at: http://curia.europa.eu/en/content/juris/index.htm

3 Case C-452/04 [2006] ECR I-9521 (Grand Chamber).4 L. Flynn, ‘‘Coming of Age: The Free Movement of Capital Case Law 1993-2002’’ (2002) 39 Common

Market Law Review 773 at 773.5 B.J.M. Terra and P.J. Wattel, European Tax Law (5th ed., Kluwer Law International, The Hague,

2008) at 58.6 A. Cordewener, G.W. Kofler and C.P. Schindler, ‘‘Free Movement of Capital, Third Country

Relationships and National Tax Law: An Emerging Issue before the ECJ’’ (2007) 47 EuropeanTaxation 107 at 107.

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subject, Directive 88/361,7 became effective, that capital movements were defined forthe purposes of EU law and Member States were required to eliminate barriers in theirnational laws to free movement of capital within the European Union.

The explicit prohibition on restrictions of capital movements between EU MemberStates and third countries was absorbed into the EC Treaty in its current form when itwas amended by the Treaty of Maastricht, with effect from January 1, 1994. The ECJ’sjurisprudence on restrictions of free movement of capital within the EU began to have animpact in the mid-1990s, at approximately the same time that the general principles forinterpreting and applying all of the fundamental freedoms—of goods, workers, services,establishment, as well as capital—to determine the compatibility of national measureswith the EC Treaty reached a stage of relative clarity and consistency, and converged.8The successful challenges by taxpayers (and to a lesser extent by the Commission)to Member States’ direct tax laws, based on the fundamental freedoms, also began tomultiply in the mid-1990s.9 The first case specifically ruling that a direct tax measure wasincompatible with free movement of capital was Staatssecretaris van Financien v Verkooijen(Verkooijen)10 in 2000. In 2006 and 2007 the first cases on the third country dimensionof Article 56(1) and direct taxation reached the Court, and the limitations, as well as thepossibilities, for the reduction of tax barriers to free movement of capital between Europeand the rest of the world began to come into focus.11

The purpose and context of the extension of Article 56 to third countries

The interpretation of provisions of the EC Treaty usually begins with an examinationof their origin and purpose. There is, however, very little commentary to be found inEnglish on how the third country dimension came to be included in Article 56.12

7 Directive 88/361/EEC of 24 June 1988 for the implementation of Article 67 of the Treaty [1988] OJ L178/5. Member States were required by Art.1 of the directive ‘‘to abolish restrictions on movementsof capital taking place between persons resident in Member States’’ by July 1, 1990.

8 See most familiarly Case C-55/94 Reinhard Gebhard v Consiglio Dell’Ordine degli Avvocati e Procuratoridi Milano [1995] ECR I-4165 at [37]. For a critical analysis of the different treatment tax cases havereceived in relation to the fundamental freedoms, see J. Snell, ‘‘Non-Discriminatory Tax Obstacles inCommunity Law’’ (2007) 56 ICLQ 339.

9 For a comprehensive review and analysis of the more recent direct tax case law with respect to thefundamental freedoms, see S. Kingston, ‘‘A light in the darkness: Recent developments in the ECJ’sdirect tax jurisprudence’’ [2007] 44 Common Market Law Review 1321–1359.

10 Case C-35/98 [2002] STC 654; [2000] ECR I-4071. By contrast, the first case on direct taxation andfreedom of establishment, C-270/83 Commission v France [1986] ECR 273 (Avoir Fiscal) was referredto the ECJ in 1983.

11 An early and stimulating analysis of the myriad issues raised by the third country dimension isprovided in P. Pistone, ‘‘The Impact of European Law on the Relations with Third Countries inthe Field of Direct Taxation’’ (2006) 34 Intertax 234. Prof. Pistone addresses numerous issues thatare beyond the scope of this article, including free movement of capital in agreements between theEuropean Union and third countries, the EU power to conclude external agreements in the fieldof direct taxation, and the open skies jurisprudence and limitation on benefits issues in relation totaxation and third countries.

12 A contemporary comment, M. Dassesse, ‘‘The Treaty on European Union: Implications for the FreeMovement of Capital’’ (1992) 6 Journal of International Banking Law 238 provides a brief analysis of therelationship between EMU and free movement of capital but does not discuss the reasons behind theextension to third countries. There are references to commentary in German and Dutch in K. Stahl,

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The objective of extending free movement of capital beyond the EU was, apparently, tosupport the euro as an international reserve currency.13 All of the EU member states at thetime the Treaty of Maastricht was signed were also members of the OECD, so that theremay have been a sense that movement of capital had already been substantially liberalisedbetween the Member States and third countries in accordance with the OECD Code ofLiberalisation of Capital Movements. That this instrument was in the contemplation ofthe drafters of the Maastricht Treaty seems certain, as EC Article 57(1) permits MemberStates to retain their reservations from the Code in place notwithstanding Article 56(1).14

The ECJ has now clearly disconnected the substance of the principle of free movementof capital between the EU and third countries from its underlying motivation. At [31] inSkatteverket v A,15 the Court stated:

‘‘. . . even if the liberalisation of the movement of capital with third countriesmay pursue objectives other than that of establishing the internal market, such as,in particular, that of ensuring the credibility of the single Community currencyon world financial markets and maintaining financial centres with a world-widedimension within the Member States, it is clear that, when the principle of freemovement of capital was extended, pursuant to Article 56(1) EC, to movement ofcapital between third countries and the Member States, the latter chose to enshrinethat principle in that article and in the same terms for movements of capital takingplace within the Community and those relating to relations with third countries.’’

As will be examined in the third part of this article, the third country dimension offree movement of capital is limited in ways that intra-EU free movement of capital isnot. Article 57(1) of the EC Treaty provides for significant and potentially permanentderogations from Article 56(1) in relation to third countries. The ECJ has indicated thatit views the third country dimension as operating in a ‘‘different legal context’’,16 sothat justifications for a restrictive measure that would not be valid as between MemberStates may be accepted in relation to third countries. There are other impediments inECJ jurisprudence to the application of Article 56 to third country capital movementsthat do not have the same constraining effect within the EU. Despite these limitations,the potential impact of the third country dimension on Member States’ direct tax lawscannot lightly be dismissed.

When the Member States agreed to insert Articles 56 to 58 in the EC Treaty inDecember 1991 the ECJ’s jurisprudence on direct taxation was in its early stages, withonly a few cases decided (and no direct tax cases on free movement of capital). Article56 was not judicially recognised as an independent basis for challenging direct taxation

‘‘Free movement of capital between Member States and third countries’’ (2004) EC Tax Review47 and D.S. Smit, ‘‘Capital movements and third countries: the significance of the standstill-clauseex-Article 57(1) of the EC Treaty in the field of direct taxation’’ (2006) EC Tax Review 203.

13 Stahl, fn.12 at 52. The entry into force of new EC Treaty Art.73a-h (now Arts 56–61) on January 1,1994 coincided with the commencement of the second stage of EMU, the third stage of which was theadoption in 1999 of the euro as the common currency of 11 of the then 15 Member States.

14 See D.Smit, fn.12 at 204.15 Case C-101/05 December 18, 2007.16 Skatteverket v A Case C-101/05 [2007] ECR I-11531 at [37], echoing Case C-446/04 Test Claimants

in the FII Group Litigation (FII Test Claimants) [2007] STC 326; [2006] ECR I-11753 at [170]–[171].

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measures until almost a decade later. It may thus be surmised that the huge impact17 of theCourt’s intra-EU fundamental freedoms jurisprudence on Member States’ tax systemswas unforeseen, and that the potential significance of the extension of free movement ofcapital to third countries was equally outside the drafters’ frame of reference. By 2004,when the Treaty establishing a Constitution for Europe was drafted and agreed, theMember States were clearly aware of the potential impact of Article 56(1) on their taxsystems. New powers of Commission and Council in that Treaty (which was not ratified),and in the subsequent Treaty of Lisbon, to limit the third country dimension in respectof direct taxation indicates consensus among Member State governments of the need toensure that the ECJ alone does not determine the impact of the third country dimensionon their tax sovereignty.

The intra-EU scope and application of Article 56

Defining capital movements

Although Directive 88/361 is no longer technically in force, it is settled law that the‘‘nomenclature’’ in Annex I of the Directive (Annex I), listing the transactions andactivities which are to be regarded as movements of capital, is still the most importantand authoritative reference.18 The ECJ also frequently reiterates that the list in Annex I,as expressly stated in it, is non-exhaustive, signalling that it is willing to consider othertransactions and activities as constituting movements of capital.

The list in Annex I is nevertheless very extensive. Some of the defined capitalmovements of most relevance to the issues discussed in this article are: investments in realestate, direct investments in undertakings, establishment and extension of branches orcreation of new undertakings or the acquisition of existing undertakings, participation innew or existing undertakings, and the making of long term loans with a view to establishingor maintaining lasting economic links between lender and borrower. Extension of short,medium and long term credit related to commercial transactions or the provision ofservices, as well as financial loans and credits of any term, operation of bank accounts,personal capital movements such as loans, gifts, inheritances and transfers of assetsconnected with emigration or immigration are all defined as movements of capital, as areall operations necessary for the purposes of capital movements, and related transfers.

Intra-EU jurisprudence on free movement of capital—cases not concerning direct taxation

The non-tax intra-EU cases in which a restriction on free movement of capital has beenfound to exist can be divided into two dominant categories: (a) challenges to laws requiring

17 Ruth Mason cites the cost of ECJ (intra-EU) direct tax rulings to the UK treasury annually as16 to 20 billion dollars in ‘‘Made in America for European Tax’’ working paper dated September2007, electronic copy available at: http://ssrn.com/abstract=1025531 (accessed September 25, 2008)at 3, fn.3.

18 Case C-22/97 Trummer and Mayer [1999] ECR I-1661 at [20-21]; Case C-386/04 Centro de MusicologiaWalter Stauffer [2006] ECR I-8203 (Stauffer) at [22] and more recently Commission v Germany CaseC-112/05 23 October 2007 (Volkswagen) at [18].

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prior official authorisation for certain transactions or activities,19 and (b) ‘‘golden share’’cases.20 In addition to these two types of cases, national measures providing an interestsubsidy or preferential treatment for guarantee fees in respect of loans from domesticallyestablished lenders were successfully challenged.21 A requirement that financial chargeson land be denominated in the national currency or gold in order to be registered inthe land registry22 and a requirement to make a guarantee deposit in a bank on nationalterritory in order to provide services in that territory were also held to be a restrictionof free movement of capital.23 A ban on Belgian residents acquiring bonds issued by theBelgian government through the Eurobond market was also incompatible with Article56(1).24 Thus it can be seen that the prohibition on free movement of capital within theEU is upheld as rigorously as the other free movement guarantees. For example, in oneof the early golden share cases, Commission v France (Elf Aquitaine)25 the Court stated:

‘‘40. (. . .) Article 73b [now 56(1)] of the Treaty lays down a general prohibition onrestrictions on the movement of capital between Member States. That prohibitiongoes beyond the mere elimination of unequal treatment, on grounds of nationality,as between operators on the financial markets.41. Even though the rules in issue may not give rise to unequal treatment, theyare liable to impede the acquisition of shares in the undertakings concerned and todissuade investors in other Member States from investing in the capital of thoseundertakings. They are therefore liable, as a result, to render the free movement ofcapital illusory.’’

In Manninen, the Court confirmed the equality of free movement of capital with the otherfundamental freedoms in the field of direct taxation:

‘‘Any measure that makes the cross-border transfer of capital more difficult or lessattractive and is thus liable to deter the investor constitutes a restriction on the freemovement of capital. In this respect the concept of a restriction of capital movementscorresponds to the concept of a restriction that the Court has developed with regardto the other fundamental freedoms, especially the freedom of movement of goods’’.26

19 These would include currency exports, as in Joined Cases C-358/93 and 416/93 Bordessa [1995]ECR I-361 and C-250/94 Sanz de Lera [1995] ECR I-482; purchases of land by non-residents ornon-nationals, as in Case C-452/01 Ospelt Unabhangiger Verwaltungssenat des Landes Vorarlberg [2003]ECR I-9743 and Case C-302/97 Konle [1999] ECR I-3099; or investment in the host country bycertain groups as in Case C-54/99 Eglise de Scientologie [2000] ECR I-1335.

20 Recent examples are Joined Cases C-282/04 and C-283/04 Commission v Netherlands [2006] ECR I-9141 in which special rights retained by the Netherlands government in respect of privatised nationalpostal and telecommunications companies were incompatible with Art.56(1); and Case C-112/05Commission v. Germany 23 October 2007 in which restrictions on voting powers which prevented aprivate investor from gaining control of Volkswagen AG were held to restrict free movement of capital.

21 C-484/93 Svensson and Gustavsson [1995] ECR I-3955. The EFTA Court has also ruled on guaranteefees in respect of foreign loans under Art.40 of the European Economic Area Agreement in EFTACase E-1/00, State Debt Management Agency v Islandsbankı-FBA, July 14, 2000.

22 Case C-22/97 Trummer and Mayer [1999] ECR I-1661.23 Case C-279/00 Commission v Italy [2002] ECR I-1425.24 C-478/98 Commission v Belgium [2000] STC 830, [2000] ECR I-7587 (Belgian Eurobonds).25 Case C-483/99 [2002] ECR I-4871.26 Case C-319/02 [2004] STC 1444; [2004] ECR I-7498 at [28]. See Snell, fn.8 at 349 for the view that

the Court still relies more heavily in tax cases on finding discrimination than on restrictive effects

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The ECJ has also made clear that the concept of restriction in Article 56(1) applies tooutflows as well as inflows of capital. Measures which are liable to dissuade investors frominvesting their capital in other Member States, as well as those that make it more difficultfor non-residents to acquire investment assets in a host state or an undertaking establishedin one Member State to raise capital in other Member States, are prohibited.27 Thiscorresponds to the jurisprudence on other fundamental freedoms to the effect that thesefreedoms prohibit restrictions of free movement by either ‘‘host’’ or ‘‘home’’ MemberStates. In short, the ‘‘laggard freedom’’ has caught up with the others.

Exceptions and justifications: Article 58

Article 58(1)28 applies to both intra-EU and third country capital movements. The ECJhas ruled that Article 58(1) must, as an exception to a fundamental freedom, be strictlyinterpreted.29

The language of Article 58(1)(a) obviously derives from the analysis of what constitutesdiscrimination in the early ECJ jurisprudence on the fundamental freedoms, when theCourt focused on whether the impugned Member State law discriminated directly orindirectly on the basis of nationality.30 Discrimination was defined as the treating ofsimilar situations differently, or different situations the same. Different treatment ofnon-residents could be indirect (‘‘or covert’’) discrimination on the basis of nationality,given that non-residents were much more likely to be non-nationals than were residents.Most of the more recent direct tax jurisprudence emphasises the restrictive effects of anational law on the exercise of a fundamental freedom rather than the discriminatorynature of the law. However, the ‘‘same situation’’ test in Article 58(1)(a) is an importantpart of the determination of restriction in some cases.31

In interpreting Article 58(1)(a) it might have been anticipated that the internationaltaxation norm that forbids discrimination based on nationality, but generally allows

alone. Professor Snell’s comparison of direct tax measures with regulatory restrictions, especially inrespect of free movement of goods is of particular interest in light of this quotation from Manninen.Kingston, fn.9 at 1328 describes the evolution of the ECJ’s approach through ‘‘pure’’ restriction to amore nuanced discrimination based analysis since 2005.

27 Case C-35/98 Verkooijen [2002] STC 654; [2000] ECR I-4071at [34]–[35]. See also C-484/93 Svenssonand Gustavsson [1995] ECR I-3955 at [10]–[11].

28 Article 58(1) provides: ‘‘The provisions of Article 56 shall be without prejudice to the right of MemberStates: a. to apply the relevant provisions of their tax law which distinguish between taxpayers whoare not in the same situation with regard to their place of residence or with regard to the place wheretheir capital is invested; b. to take all requisite measures to prevent infringements of national law andregulations, in particular in the field of taxation and the prudential supervision of financial institutions,or to lay down procedures for the declaration of capital movements for purposes of administrative orstatistical information, or to take measures which are justified on grounds of public policy or publicsecurity.’’

29 Case C-54/99 Eglise de Scientologie [2000] ECR I-1335 at [17], as to the justifications on grounds ofpublic policy or security in 58(1)(b). This was confirmed to apply also in relation to 58(1)(a) in CaseC-315/02 Lenz [2004] ECR I-7063 at [26], and in Case C-386/04 Stauffer [2006] ECR I-8203 at [31].

30 J.A. Usher, ‘‘Capital Movements and the Treaty on European Union’’ [1992] 12 YEL 35-57 at 40suggests that the failure of the Commission’s original, unsuccessful proposal for a common system ofwithholding tax on interest income put forward under para.5 of Directive 88/361 may help to explainthe presence of Art.58(1)(a) as a derogation for tax measures in particular.

31 See Kingston, fn.9. The application of Art.58(1)(a) in relation to third countries is discussed in thesubheading Comparability of restriction and justifications in third country cases below.

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discrimination based on residence,32 would be adopted by the Court in assessing whetherdirect tax restrictions on cross-border capital movements are prohibited. Indeed, the ECJhas clearly and frequently stated the basic principle that, in relation to direct taxation,residents and non-residents are not generally in comparable situations, so that differenttax treatment of residents and non-residents is not automatically incompatible with Treatyfreedoms. However, the Court places the burden on Member States to demonstrate that,in a given case and in relation to the effects of the particular tax measure, the situationof a non-resident is not objectively comparable to that of a resident.33 If in fact residentsand non-residents are in the same position with respect to a particular tax liability, thenthe less favourable treatment of non-residents is prohibited. The ‘‘Schumacker principle’’,originally applied in relation to free movement of workers, is generally applicable inrespect of services34 and establishment35 as well. It was applied to a distinction basedon where capital is invested in Verkooijen and more clearly reiterated and applied insubsequent cases on direct taxation and free movement of capital. Thus the limitationin Article 58(1)(a) corresponds to the judicially developed principles regarding unequaltreatment in the context of the other fundamental freedoms.

Article 58(1)(b) provides a justification especially pertinent to direct taxation in allowingMember States to ‘‘take all requisite measures to prevent infringements of national lawand regulations, in particular in the field of taxation. . .’’. However, this has not had anyparticular effect on the resolution of cases concerning Article 56 and direct taxation. TheCourt had already accepted that ‘‘overriding reasons in the general interest’’, could justifyrestrictive tax measures, and such overriding reasons include ensuring effective fiscalsupervision,36 the prevention of tax evasion,37 and preservation of the cohesion of thenational tax system,38 before the first case concerning a direct tax measure and Article 56(1)was decided. The ‘‘balanced allocation of taxing jurisdiction between Member States’’ is amore recent addition to the accepted justifications.39 It is much more common for MemberStates to defend their tax laws on these bases than to rely directly on the wording of Article58(1)(b). The (possibly now abandoned) principle that overriding reasons cannot justifydirectly discriminatory measures arises infrequently in direct taxation cases, because

32 The OECD Model Tax Convention on Income and on Capital, OECD Committee on Fiscal Affairs,(OECD, Paris, 2003) (OECD Model) Art.24 Non-Discrimination provides in para.1: ‘‘Nationals of aContracting State shall not be subject in the other Contracting State to any taxation or any requirementconnected therewith, which is other or more burdensome than the taxation and connected requirementsto which nationals of that other State in the same circumstances, in particular with respect to residence, areor may be subjected.’’ (Emphasis added) This wording has been taken to permit Contracting States todiscriminate on the basis of residence, whether or not residents and non-residents are in comparablesituations. See L. Friedlander, ‘‘The Role of Non-Discrimination Clauses in Bi-lateral Income TaxTreaties After GATT 1994’’ [2002] BTR 71.

33 C-279/93 Schumacker [1995] STC 306; [1995] ECR I-225.34 Case C-234/01 Gerritse [2004] STC 1307; [2003] ECR I-5933.35 See as an early example, C-270/83 Avoir Fiscal [1986] ECR 273 at [20] and more recently, Case

C-446/04 FII Test Claimants [2007] STC 326; [2006] ECR I-11753 at [46] and Case C-170/05Denkavit Internationaal [2007] STC 452; [2006] ECR I-11949 (Denkavit) at [25].

36 Case C-120/78 Rewe-Zentrale AG v Bundesmonopolverwaltung fur Branntwein [1979] ECR 649 (Cassisde Dijon) at [8].

37 C-478/98 Belgian Eurobonds [2000] STC 830; [2000] ECR I-7587 at [38]–[39].38 Case C-204/90 Bachmann v Belgium [1994] STC 855; [1992] ECR I-249 at [28]39 Case C-446/03 Marks & Spencer [2006] STC 237; [2005] ECR I-10837 [51] and Case C-231/05 Oy

AA [2008] STC 991 July 18, 2007 at [55].

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direct tax measures rarely discriminate on the basis of nationality.40 The Member Statewhose legislation is challenged has accordingly not been limited to those justificationsexpressly set out in the Treaty.41

Survey of intra-EU case law on direct taxation and free movement of capital

The interaction of Article 56(1) with Member States’ direct taxation systems has alreadyyielded a large number of cases, rivalling if not exceeding the number of non-tax caseson free movement of capital. Taxation rules with respect to dividends, interest payments,capital gains, wealth and inheritance, and income of charities have all been successfullychallenged as unjustified restrictions of free movement of capital.

The following sections of this article are a non-exhaustive overview of the intra-EUcases in which direct taxation measures have been held incompatible with Article 56(1),including an examination of the various justifications which have been put forward. Theobjective is to indicate the potential substantive scope of the third country dimensionof Article 56(1), before turning to the limitations in the EC Treaty and the ECJ’sjurisprudence that may apply in third country cases.42

Dividends

The cross-border payment and receipt of dividends are movements of capital. In Verkooijenthe Court stated that, although not expressly listed in Annex I (of Directive 88/361),the payment and receipt of dividends ‘‘presupposes participation in new or existingundertakings’’ which does appear in Annex I. Further, since in that case the companypaying the dividends was resident in another Member State and its shares were quotedon the stock exchange, the receipt of the dividends could be linked to the ‘‘acquisition. . . of foreign securities dealt in on a stock exchange’’, and was thus ‘‘indissociable froma capital movement’’.43

It is important to note that, within the EU, taxation of cross-border dividends has beenpartially harmonised by the Parent-Subsidiary Directive44 which eliminates taxation ofdividends paid from a ‘‘subsidiary’’ company in one Member State to a ‘‘parent’’ companyin another Member State. In the original version in force from 1992 to 2004, a parentcompany had to hold at least 25 per cent of the capital of a subsidiary. The minimum

40 In Case C-386/04 Stauffer [2006] ECR I-8203 the German tax legislation was directly discriminatoryin that it treated charities formed under the laws of another Member State less favourably thanGerman charities. The Court did not address this point and proceeded to assess the restriction on freemovement of capital in relation to overriding reasons.

41 The public policy and public security justifications in Art.58(1)(b) have not been relied on by MemberStates in direct taxation cases, although they have been put forward in non-tax cases such as CaseC-54/99 Eglise de Scientologie [2000] ECR I-1335 and Case C-452/01 Ospelt [2003] ECR I-9743.

42 See the discussion below under the heading: The third country dimension of free movement ofcapital.

43 Case C-35/98 [2002] STC 654; [2000] ECR I-4071 at [27]–[30].44 Council Directive 90/435 on the common system of taxation applicable in the case of parent companies

and subsidiaries of different Member States [1990] OJ L 225/6 (Parent-Subsidiary Directive) amendedby Council Directive 2003/123 on the common system of taxation applicable in the case of parentcompanies and subsidiaries of different Member States [2003] OJ L 7/41.

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level of capital ownership was reduced to 20 per cent on January 1, 2005, to 15 per cent onJanuary 1, 2007, and will be further reduced to 10 per cent as of January 1, 2009, pursuantto amendments to the directive adopted in 2003.

The directive requires EU Member States to abolish withholding tax on dividends paidto a non-resident parent company. In addition, the parent company’s home state musteither refrain from taxing dividends received from subsidiaries (exemption method), orprovide a tax credit which reduces the parent company’s corporate tax liability by theamount of the subsidiary’s corporate tax paid in its home state in respect of such dividendsup to the amount of tax payable in respect of such dividends by the parent company (creditmethod). From 2005, the directive also requires Member States to provide a credit to theparent company for any lower tier subsidiary’s corporate tax paid in another Member State.

The court’s rulings on free movement of capital and dividends can usefully be dividedinto cases on inbound dividends and cases on outbound dividends. With three importantECJ decisions in as many days on free movement and dividends released in December2006,45 followed by a number of other indicative rulings, it is now possible, at leasttentatively, to identify some basic principles about the types of tax measures that willinfringe these freedoms both within the EU and with respect to third countries.46

Inbound dividends

The established principle is that a Member State must not, under its domestic law, imposea heavier tax burden on the recipient shareholder in respect of inbound dividends than itdoes on domestic dividends. In Verkooijen a tax exemption for domestic dividends thatwas not available for inbound dividends was accordingly held to restrict free movementof capital in that it both discouraged Netherlands residents from investing in foreigncompanies, and made it more difficult for foreign companies to raise capital in theNetherlands. Verkooijen has been followed in a number of cases challenging dividendtaxation measures applicable to individual shareholders, among them Lenz,47 Manninen,48

and Meilicke.49

FII Test Claimants concerned the United Kingdom’s former advance corporation tax(ACT) and franked investment income (FII) dividend tax system utilised from 1973

45 Case C-446/04 FII Test Claimants [2007] 326; [2006] ECR I-11753 (December 12, 2006); CaseC-374/04 Test Claimants in Class IV of the ACT Group Litigation [2007] STC 404, [2006] ECRI-11673 (12 December 2006) (Grand Chamber) (ACT IV ) and Case C-170/05 Denkavit [2007] STC452; [2006] ECR I-11949 (December 14, 2006). For a discussion of the issue raised by these cases,especially in relation to DTCs, see P. Pistone, ‘‘Expected and Unexpected Developments of EuropeanIntegration in the Field of Direct Taxes’’ (2007) 35 Intertax 70.

46 See in particular F. Vanistendael, ‘‘Denkavit Internationaal: The Balance between Fiscal Sovereigntyand the Fundamental Freedoms?’’ [2007] 47 European Taxation 210 and M.J. Graetz and A.C. Warren,Jr., ‘‘Dividend taxation in Europe: When the ECJ makes tax policy’’ (2007) 44 Common Market LawReview 1577.

47 Case C-315/02 Lenz [2004] ECR I-7063 involved a special preferential tax rate for domestic dividendsthat was not available for inbound dividends.

48 Case C-319/02 [2004] STC 1444; [2004] ECR I-7498. In Manninen and Meilicke, individuals receivingdomestic dividends were granted an imputation credit which was not allowed in respect of dividendsfrom other Member States.

49 Case C-292/04 [2007] ECR I-1835. A case related to differential taxation of inbound and domesticdividends is Case C-242/03 Ministre des Finances v Weidert-Paulus (decided the same day as Lenz)[2005] STC 1241; [2004] ECR I-7379.

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(1994 in the case of the foreign income dividend or FID system) to 1999. Although thissystem was particularly complex and idiosyncratic and is no longer in force, the judgmentcontains some very important rulings of principle.

The test claimants challenged the different treatment of domestic and inbound dividendsas incompatible with both freedom of establishment and free movement of capital. At leastone of the test claimants received dividends from a company resident in a third country.The Court ruled that cases where the foreign distributing company was controlled bythe UK resident recipient company were to be assessed in light of Article 43, freedom ofestablishment,50 and in light of free movement of capital in any other case.

Following the earlier cases, the Court held that foreign dividends may not be subjectto less favourable tax treatment than domestic dividends in the recipient’s home state.To ensure equal treatment of foreign and domestic dividends, the tax credit provided tothe UK company in respect of foreign dividends had to at least equal the tax paid by thedistributing company on its profits in the source state, up to the limit of the recipient’s UKtax liability in respect of the dividends. This eliminates the economic double taxation ofcompany profits by one country and dividends by the other to the same extent the UnitedKingdom relieved such double taxation in the case of domestic dividends. In short, if theparent company’s home state provides tax relief for underlying corporate tax for domesticdividends, it must provide equivalent relief for foreign underlying corporate tax when ittaxes foreign dividends.

Of particular relevance to third countries and free movement of capital, the Court heldthat where the UK company held less than 10 per cent of the voting rights of the foreigndistributing company, the tax credit had to compensate for the underlying corporate taxas well as the dividend withholding tax imposed by the source country, since domesticdividends received this favourable treatment.

Another issue of particular interest here was the compatibility with Article 56(1) of theFID regime introduced from July 1, 1994. The FID regime was intended to mitigatethe less favourable treatment faced by UK companies receiving dividends from foreigncompanies in comparison with UK companies that received only domestic dividends.However, even after the FID regime was introduced, cash flow disadvantages remainedfor UK companies receiving foreign dividends (and their shareholders).51 The fact thatFID treatment was optional did not change the conclusion that it was incompatible withthe Treaty.

Kerckhaert-Morres,52 a challenge by a Belgian couple to the Belgian method of taxingforeign dividends, clarified the ECJ’s assessment of restriction of capital movements.Belgium applied equivalent taxes to both inbound and domestic dividends. The Courtruled that Belgium had no obligation to provide a tax credit to compensate the shareholderfor the withholding tax imposed by the source country, France. The unequal tax burden

50 It is now settled that an investment in shares that gives the shareholder definite influence over thecompany’s decisions and allows it to determine the company’s activities and operations (i.e. effectivecontrol) is an exercise of the right of establishment and only indirectly concerns free movement ofcapital. This delineation originated in Case C-251/98 Baars [2000] ECR I-2787 at [21]–[22], and hasbeen reaffirmed in several subsequent judgments. See also Case C-196/04 Cadbury Schweppes [2006]STC 1908; [2006] ECR I-7998 at [31]–[33].

51 This followed from the rulings in Joined Cases C-397/98 and 410/98 Metallgesellschaft et al [2001]STC 452; [2001] ECR I-1727.

52 Case C-513/04 [2007] STC 1349; [2006] ECR I-10967 (Grand Chamber).

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on foreign and Belgian dividends arose as a consequence of the exercise in parallel by twoMember States of their fiscal sovereignty, not as a result of Belgium’s non-discriminatorydividend tax system. This confirms that, with respect to inbound dividends, the Courtis concerned with unequal treatment that arises solely from the application of the taxsystem of the shareholder’s home country, and does not view juridical double taxation asa prohibited restriction of free movement of capital.

Although the judgment in Kerckhaert-Morres was criticised,53 the ECJ confirmed andextended its reasoning in Orange European Smallcap Fund (OESF).54 The Netherlandssystem for taxation of collective investment entities such as OESF was designed toimpose the same tax burden on income earned through a fund as would be borne by aNetherlands resident individual investing directly in shares of Netherlands and foreigncompanies. OESF was not subject to Netherlands tax on either foreign or domesticdividends, provided its profits were distributed to its shareholders within a given periodafter its year end. The Netherlands provided a full refund of Netherlands tax withheld atsource on domestic dividends, and a concession payment for withholding tax imposed byother countries to the extent a Netherlands resident individual would be entitled to claima credit against Netherlands tax under a DTC between the Netherlands and the sourcecountry.

The Court made two clear and significant rulings regarding prohibited restrictions offree movement of capital. The first was that there is no obligation on the recipient’s homecountry to compensate for economic double taxation in the source state. Secondly, it islegitimate to treat dividends from one Member State differently to dividends receivedfrom other Member States because an investor receiving dividends from a country thatdoes not have a DTC providing for a tax credit is not in the same situation as an investorin receipt of dividends from a country with which the Netherlands had such a DTC.Article 58(1)(a) allows this difference in treatment: it is not arbitrary discrimination nora disguised restriction since it is necessary for the attainment of the policy goal of taxingdividend income received through investment in a collective investment entity in thesame way as dividends received by an individual who had invested directly in shares ofthe foreign or Netherlands company.

In OESF the Court found that one aspect of the Netherlands taxation of collectiveinvestment funds was a restriction of free movement of capital. This was the reductionin the concession in respect of foreign withholding tax in proportion to the non-residentinvestors in the fund. The reduction affected the income received by all investors,whether or not resident in the Netherlands as it was paid to the fund and became part ofits distributable profit. The Court held that this made funds with non-resident investors(whether in other Member States or in third countries) less attractive investments forNetherlands residents, and reduced the funds’ ability to raise capital in the Netherlands

53 See Snell, fn.8 at 361; Graetz and Warren, fn.46 at 1612; R. Mason and G. Kofler, ‘‘Double Taxation:A European ‘Switch in Time’?’’ (2007) Columbia Journal of European Law 14.1; electronic version at20, available at: http://ssrn.com/abstract=979750 (accessed September 25, 2008). However, Kingston,fn.9 at 1341-1343, approves the approach in Kerckhaert-Morres as illustrating ‘‘rationality, simplicityand predictibility’’.

54 Case C-194/96, May 20, 2008, (Grand Chamber). This case addressed issues relating to third countriesas well, as is further discussed in Conclusions below. Case C-101/05 Skatteverket v A December 18,2007 is another third country inbound dividends case primarily of interest in respect of the justificationensuring effective fiscal supervision. It is discussed in relation to justifications in Conclusions below.

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compared with funds that had only Netherlands resident investors and so constituted aprohibited restriction.

Outbound dividends

The Court’s primary concern with respect to outbound dividends is, as with inbounddividends, that measures imposed by a single Member State do not result in a restrictionon cross border capital movements. The Court regards the subjection of corporate profitsto a series of tax charges (first on corporate profits and then on the dividends distributedout of the after-tax profits, or economic double taxation) by a single Member State asrestricting free movement of capital where the Member State offsets the double taxationfor its residents, but not for non-residents.55 Article 56(1) thus prohibits source statewithholding tax on outbound dividends in many cases.

In Amurta56 the Court ruled that Netherlands withholding tax levied on dividendsreceived by a Portuguese company holding 14 per cent of the share capital of aNetherlands company was a prohibited restriction on free movement of capital. TheNetherlands exempted domestic dividends received by companies holding 5 per centor more of the shares or capital of the distributing company from Netherlands tax.The Parent-Subsidiary Directive exempted dividends from other Member States fromwithholding tax provided the Netherlands recipient held at least 25 per cent of thesubsidiary. The Court further ruled that unilateral tax relief provided by the recipient’shome state could not ‘‘neutralise’’ the restrictive effect of the Netherlands withholdingtax. At least in theory, the Court accepted that relief provided in a DTC could neutralisethe restriction,57 but the Court gave no guidance as to what type of relief would havethis effect. Amurta indicates that withholding tax on dividends will in many instances beincompatible with free movement of capital,58 and it is difficult to see how this would notalso constitute a prohibited restriction in the third country context.

Test Claimants in Class IV of the ACT Group Litigation (ACT IV )59 concerned UKtaxation of outbound dividends under the former ACT system. It illustrates the exception

55 See the Court’s conclusions as to the existence of a restriction in Case C-374/04 ACT IV [2007] STC404; [2006] ECR I-11673 at [55], [70] and in Case C-446/04 FII Test Claimants [2007] STC 326;[2006] ECR I-11753 at [87].

56 Case C-379/05 Amurta S.G.P.S. v Inspecteur van de Belastingdienst (November 8, 2007). The December2006 ruling in Denkavit (Case C-170/05 [2007] STC 452; [2006] ECR I-11949) that withholding taxeswere incompatible with the right of establishment where domestic dividends were effectively exemptfrom the second layer of tax gave advance notice of the outcome in Amurta.

57 In Case C-265/04 Bouanich [2008] STC 2020; [2006] ECR I-923, the Court left it to the national courtto determine if the effect of the withholding rate reduction in the relevant DTC was to eliminate theunequal treatment of resident and non-resident shareholders.

58 The Commission has initiated infringement proceedings based on Art.56 against numerous MemberStates regarding withholding taxes on dividends received by foreign pension funds and others. SeeCommission Press Release IP/08/1022 of June 27, 2008 available at: http://europa.eu/rapid/pressReleasesAction.do?reference=IP/08/712&format=HTML&aged=0&language=en&guiLanguage=en(accessed September 25, 2008). The implications of the Denkavit case for withholding taxes arediscussed by Jerome Delauriere, ‘‘Does Denkavit signal the end of withholding tax?’’ (2007) 45 TaxNotes International 303 and in the series of articles published in the Denkavit Special Issue of (2007)European Taxation, fn.46.

59 Case C-374/04 Test Claimants in Class IV of the ACT Group Litigation [2007] STC 404; [2006] ECRI-11673.

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to Amurta, holding that if the home state of the distributing company imposes nowithholding tax on outbound dividends, and there is thus no economic double taxationwithin a single Member State, there is no discrimination or restriction.

To summarise the jurisprudence on Article 56(1) and dividends, the Court begins byconsidering the restrictive effects of the tax rules of the particular Member State whoselaw has been challenged. If the domestic rules have the effect of imposing a heavier burdenon inbound or outbound dividends than on domestic dividends, then in principle there isa restriction of free movement of capital. The Court accepts that a DTC may ‘‘neutralise’’the effect of the more burdensome taxation of non-residents, but leaves the assessment ofthe actual effect of the DTC to the referring court.

Interest

Annex I to Directive 88/361 does not expressly include payment or receipt of interestin the list of movements of capital, but it does list personal, commercial and financialloans and credits of all kinds, and states that all operations necessary for the purposes ofcapital movements, conclusion and performance of the transaction and related transfersare covered by the directive. In Svensson and Gustavsson60 it was held that housing loanswere included in financial loans and credits listed as capital movements under Annex I,and that movements of capital related to such loans were liberalised by the directive. Thatan interest payment in respect of a cross-border loan or debt is a movement of capitalhas never been directly questioned, and would undoubtedly be held to be an operationnecessary for performance of the transaction or a related transfer under Annex I. As theCourt held with respect to dividends and investment in company shares in Verkooijen,the payment or receipt of interest pre-supposes a loan or credit and, therefore, interest iswithin the definition of movement of capital.

There are fewer cases on free movement of capital and direct taxation of interest incomethan there are on dividends. This is no doubt because the potential for economic doubletaxation of interest is very limited, as interest is normally a deductible expense for thepaying entity, and is therefore only taxable in the hands of the recipient. The lender maybe taxed on the interest by both the Member State where the borrower is resident and byits home state, but such juridical double taxation is usually mitigated or eliminated by taxcredits available in the home state, whether or not provided for in a tax treaty, so that theactual tax burden on the interest is no greater than for domestic interest.

Another reason for a dearth of cases on cross-border interest is the partial harmonisationachieved by the Interest and Royalty Directive.61 It requires Member States to abolishwithholding taxes on interest paid by a company in one Member State to an associatedcompany (that is, a company holding at least 25 per cent of the capital or voting rightsin the paying company, or a ‘‘sister company’’ where payer and recipient are both at least25 per cent held by another company) in another Member State, provided the recipientis subject to tax on the payment in its home Member State. This reduces the possibilitythat domestic measures impose a higher tax burden on interest paid to a recipient inanother EU Member State than on domestic interest. However, it does not reduce the

60 C-484/93 [1995] ECR I-3955.61 Directive 2003/49 on a common system of taxation applicable to interest and royalty payments made

between associated companies of different Member States [2003] OJ L 157/49.

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potential for unequal taxation of interest received from foreign and domestic sources, andcertain idiosyncratic provisions in Member State tax laws have resulted in a few indicativecases.

An example of a direct tax restriction in respect of interest received from anotherMember State is Commission v France.62 France allowed individuals resident in Franceto elect to pay a fixed rate of tax on interest income received from a debtor residentor established in France, but taxed interest received from debtors outside France atthe individual’s normal marginal rate. The fixed tax rate was generally lower than theprogressive marginal rate applicable to most taxpayers, and the ECJ had no difficulty inconcluding that the measures discouraged investment outside France and made it moredifficult for borrowers outside France to raise debt capital in France.

The Commission has referred Portugal to the ECJ for failure to repeal its 20 percent withholding tax on interest paid by Portuguese residents to non-resident banks andother lenders.63 The withholding tax applies to the gross amount of interest; Portugueselenders are taxed on their net income, so that they are able to deduct their expenses ofmaking capital available in computing their tax liability. The Commission relies on thejudgments in Gerritse64 and Scorpio,65 where withholding taxes on payments for servicesmade to foreign service providers were held to be permissible, but not where they wereimposed on gross payments without allowing for deduction of expenses and so resulted inhigher taxation. The Commission’s case is based on both Article 49, freedom to provideservices and free movement of capital. There are infringement proceedings underwayagainst certain Member States for discriminatory treatment of interest paid to foreignrecipients.66

There are a number of cases on thin capitalisation67 measures which deny full deductionof interest paid by a subsidiary to a parent company in another Member State in order toprevent a reduction in taxable income of the subsidiary which is considered inappropriateby the Member State concerned. These cases have been decided on the basis of freedomof establishment, as such measures have been found to apply only within company groupswhere the subsidiary amounted to an establishment of the parent. The implications ofthese cases in the third country context is discussed in detail below.68

62 Case C-334/02 [2007] STC 54; [2004] ECR I-2229 (Fixed Levy).63 Pending Case C-105/08 [2008] OJ C 116/26.64 Case C-234/01 [2004] STC 1307; [2003] ECR I-5933.65 C-290/04 FKP Scorpio Konzertproduktionen GmbH [2007] STC 1069; [2006] ECR I-9461.66 See, e.g. against Lithuania for discriminatory treatment of interest paid to foreign companies,

investment funds and pensions funds: Commission Press Release IP/08/334 of February 28, 2008available at: http://europa.eu/rapid/pressReleasesAction.do?reference=IP/08/334&format=HTML&aged=0&language=en&guiLanguage=en (accessed September 25, 2008) and against Germany inrespect of foreign pension funds: Commission Press Release IP/08/143 of 31 January 2008available at: http://europa.eu/rapid/pressReleasesAction.do?reference=IP/08/143&format=HTML&aged=0&language=en&guiLanguage=en (accessed September 25, 2008).

67 Case C-324/00 Lankhorst-Hohorst [2003] STC 607; [2002] ECR I-11779; Case C-524/04 TestClaimants in the Thin Cap Group Litigation [2007] STC 906; [2007] ECR I-2107 (Thin Cap) and CaseC-492/04 Lasertec [2007] ECR I-3775.

68 See the discussion under the heading: The third country dimension of free movement ofcapital.

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Capital gains

Annex I lists many types of investment in capital property as movements of capital.Among these are investments in real estate, including purchases of buildings and land andthe construction of buildings by private persons for gain or personal use, and investmentsin shares and securities whether or not normally dealt in on the capital market, and unitsof collective investment undertakings. The ECJ has held that national capital gains taxrules are incompatible with Article 56(1) in several intra-EU cases.

In Commission v Spain69 the preferential tax rate applied to gains realised by Spanishresidents on shares listed on Spanish stock exchanges, relative to the rate applied to gainsrealised on shares listed on foreign exchanges, was held to infringe free movement ofcapital. In Gronfeldt v Finanzamt Hamburg-Am Tierpark70 the taxation by Germany ofgains realised on sales of shares representing only 1 per cent of foreign companies, whilecapital gains realised on sales of up to 10 per cent of the shares of German companieswere exempt from tax, infringed free movement of capital, even though the difference intreatment was temporary.

Three recent judgments of the ECJ have addressed discriminatory taxation of capitalgains on private residences. In Commission v Portugal,71 the deferral of tax on a capitalgain realised on the sale of a residence located in Portugal, if a replacement residence inPortugal was purchased within two years of the sale, was held to infringe free movementof workers, establishment and citizenship rights under the EC Treaty, and free movementof workers and establishment under the EEA Agreement. The Commission also reliedon free movement of capital but the Court ruled that it was not necessary to considerseparate arguments on that ground, having already found incompatibility with the otherfreedoms. Swedish capital gains tax deferral rules have been held incompatible on thesame grounds.72 A Portuguese tax measure that exempted residents of Portugal from 50per cent of the gain realised on sale of real property in Portugal while non-residents weresubject to taxation on the full gain has been held incompatible with Article 56(1).73

Inheritance tax

Inheritances and legacies are listed under personal capital movements in Annex I, sothat where at least two of the inherited assets, the deceased testator or the heirs are indifferent Member States (or a third country), Article 56(1) may apply.74 Taxpayers havesuccessfully challenged provisions that allow a particular deduction in calculating thevalue of property inherited from residents, but not from non-residents.75

69 Case C-219/03, December 9, 2004 (unpublished): available in Spanish and French at: http://curia.europa.eu/en/content/juris/index.htm (accessed September 15, 2008).

70 Case C-436/06 December 18, 2007.71 Case C-345/05, October 26, 2006 [2006] ECR I-10633.72 Case C-104/06 Commission v Sweden January 18, 2007 [2008] STC 2546; [2007] ECR I-671.73 Case C-443/06 Erika Hollman v Fazenda Publica, October 11, 2007 [2008] STC 1874. As with

dividends and interest, the Commission has announced additional infringement proceedings.74 Case C-513/03 Heirs of van Hilten-van der Heijden v Inspecteur van de Belastingdienst [2008] STC

1245; [2006] ECR I-1711 (van Hilten).75 Case C-364/01 Barbier [2003] ECR I-5013. Old Art.67 and Directive 88/361 were in force at the time

this case arose. See also Case C-11/07 Eckelkamp v Belgium, September 11, 2008, in which the ECJ

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Different rules for valuing inherited property, or availability of a partial tax exemption,depending on whether the property is situate in the taxing jurisdiction or abroad havealso been held incompatible with free movement of capital.76

Taxation of charities and charitable gifts

In Stauffer,77 the ECJ held that the German tax law which exempted German charitiesfrom tax but did not exempt the German rental income of charities established in otherMember States was an unjustified restriction on free movement of capital. The Italiancharity in the case would have qualified as a tax exempt charity in Germany if it had beencreated under German law. The taxation of its rental income in circumstances in which aGerman charity would have been exempt was therefore a restriction on capital investmentin Germany by a non-German charity.

Stauffer supports the view that less favourable tax treatment of cross-border charitabledonations, at least where the foreign charity would qualify as a charity for tax purposesunder the laws of the donor’s Member State are incompatible with free movement ofcapital.78 A German measure refusing a deduction for a gift in kind to a charity resident inanother Member State is at issue in a pending case.79 Charitable gifts made by a residentof one Member State to a charity in another EU Member State may be consideredcapital movements under Annex I, as a gift or endowment listed under personal capitalmovements.

Pensions and insurance contributions, premiums and benefits

Annex I lists ‘‘transfers in performance of insurance contracts’’ and ‘‘premiums andpayments in respect of life assurance’’ as movements of capital. There have been severalcases considering various types of unfavourable tax treatment of disability and lifeassurance premiums and contributions to pensions contracted with insurance and pensioncompanies that are not resident or established in the same Member State as the personwho makes the contribution and/or will later be entitled to the insurance or pensionbenefits. Although in many of these cases the denial of tax relief was challenged as arestriction on the free movement of capital, the ECJ has never expressly held that themeasure was incompatible with free movement of capital, basing its ruling in each case on

ruled that legislation allowing a deduction for financial charges against real property in computingthe value of the property for Belgian inheritance purposes only where the deceased was resident inBelgium is a prohibited restriction under Art.56(1).

76 Case C-256/06 Jager v FA Kusel-Landstuhl January 17, 2008.77 Case C-386/04 [2006] ECR I-8203.78 See M.H. Robson, Case Note Centro di Musicologia Walter Stauffer v Finanzamt Munchen fur

Korperschaften ‘‘‘Je, sans frontieres, soussigne. . .’ transnational gifts to charity within the EuropeanUnion’’ [2007] BTR 109 and S.J.C. Hemels, ‘‘The Implications of the Walter Stauffer Case forCharities, Donors and Governments’’ (2007) 47 European Taxation 19.

79 Pending case C-318/07 Persche. The Commission is pursuing action based on Art.56 againstBelgium, Ireland, Poland and the United Kingdom regarding their less favourable tax treatment ofdonations to charities resident in other Member States in comparison with donations to charitieswhich are resident in the donor’s state of residence. See Commission Press Release IP/06/1879of December 21, 2006 available at: http://europa.eu/rapid/pressReleasesAction.do?reference=IP/06/1879&format=HTML&aged=0&language=en&guiLanguage=en (accessed September 25, 2008).

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one or more of free movement of services, establishment or workers. On the other hand,the Court has never completely excluded the possibility that such tax measures infringefree movement of capital since the early Bachmann case.80

The Court in Bachmann held that the denial by Belgium of a tax deduction forcontributions to a sickness or disability insurance plan or a pension fund carried byan insurance company not established in Belgium was a restriction on free movementof workers and the freedom of foreign insurers to provide services in Belgium, butwas justified as necessary for preserving the cohesion of the Belgian tax system. Inthe Court’s view, there was no less restrictive way of ensuring the cohesion of theoffsetting deductions and inclusions, and the restriction was therefore justified in thepublic interest.

At the relevant time in relation to Bachmann, Article 67 was still in its original form andDirective 88/361 had not been adopted. The Court held that the denial of the tax deductionwas not contrary to Article 67 (or to former Art.106 on liberalisation of payments) becauseit did not prohibit restrictions which ‘‘did not relate to the movement of capital but whichresult indirectly from restrictions on other fundamental freedoms’’.81 There have beenseveral cases since Bachmann in which taxpayers and the Commission have asked theCourt to find tax rules that favoured life assurance and pension arrangements contractedwith companies established in the same Member State as the beneficiary (or his or heremployer) making the contributions to the policy or fund. In all of these,82 the national taxrules have been held incompatible with free movement of services and in some instancesalso with free movement of workers or establishment. The separate consideration of freemovement of capital was considered ‘‘not necessary’’.

Commission v Denmark83 is of interest not least because the Commission began itsinfringement procedure in 1991, before the ECJ’s ruling in Bachmann. The Commissionargued that the Danish tax rules were incompatible with all four freedoms: workers,services, establishment and capital. Denmark denied that its legislation restricted freemovement of capital, citing the Court’s statements in Bachmann quoted above. TheCourt found that the Danish rules restricted the first three freedoms, and that it wastherefore not necessary to consider the legislation separately in light of free movement ofcapital.

From the above survey it can be seen that, in intra-EU cases, the Court has, perhapsintentionally, avoided the issue of whether and when freedom to provide insurance andpension services overlaps with the freedom to invest in life and disability insurance andpension funds in other Member States by ruling that it was not necessary to considerArticle 56. This may indicate that the Court intends to return Article 56(1) to its earlysubordinate status relative to the other freedoms, only applying it where no other freedomis directly affected, as it did in the Bachmann case.84

80 Case C-204/90 [1994] STC 855; [1992] ECR I-249.81 Case C-204/90 Bachmann [1994] STC 855; [1992] ECR I-249 at [34]82 Case C-136/00 Danner [2002] STC 1283; [2002] ECR I-8147; Case C-422/01 Skandia and Ramstedt

[2003] STC 1361; [2003] ECR I-6817; and Case C-118/96 Safir [1998] STC 1043; [1998] ECR I-1897.83 Case C-150/04 [2007] STC 1392; [2007] ECR I-1163. In Case C-522/04 Commission v Belgium [2007]

ECR I-5701, essentially the same result was obtained.84 This is discussed further below under the heading: ‘‘Overlapping freedoms: Fidium Finanz and its

implications in direct tax cases’’.

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Justifications: overriding reasons in the general interest

Member States have been almost completely unsuccessful in justifying their direct taxmeasures that restrict the exercise of a fundamental freedom. Whilst the ECJ has acceptedsome justifications in principle, it has only very rarely found that a measure is actuallyjustified, and has rejected outright numerous bases of justification.

As noted, the Court accepts that ensuring effective fiscal supervision can justify arestrictive tax measure.85 However, the Court has never ruled in an intra-EU case thata particular national tax provision was justified solely on this basis.86 This is usuallyattributable to the existence of the Directive on Mutual Assistance87 in direct tax matters.In the Court’s view, the directive’s provisions for the sharing of tax information withinthe EU allow Member States to obtain the information they need to ensure properenforcement of their tax laws with respect to non-resident taxpayers and income fromforeign sources. Accordingly, the denial of tax relief that is available to domestic taxpayersand income is not justified by the lack of available information from other EU jurisdictions.

At a relatively early stage in the development of its direct tax jurisprudence the Courtrecognised that measures for the prevention of tax evasion could be justified despite theirrestrictive effect on the exercise of a fundamental freedom.88 Again, however, the Courthas strictly limited the scope of this justification, usually finding that the legislation is notjustified because it is disproportionate to the objective.89 Anti-avoidance legislation willnot satisfy the proportionality test unless it is designed to apply only to purely artificialarrangements aimed at circumventing tax laws, and in such a way as to allow a case bycase assessment of whether improper avoidance or evasion has in fact occurred.90 TheCourt has shifted its position slightly in more recent cases, reversing the emphasis so thatan anti-avoidance measure may be justified except where it applies indiscriminately to alltransactions or payments of a given type.91 The Court now also allows the risk of taxavoidance or evasion to be combined with another justification as discussed below in theMarks & Spencer and Oy AA cases.92

The ECJ has repeatedly rejected the argument that a tax measure is justified asnecessary to prevent erosion of a Member State’s tax revenues or tax base, noting that aninfringement of a fundamental freedom cannot be justified on purely economic grounds.93

Nor will the Court permit a Member State to impose a higher tax on cross-border

85 Case C-120/78 Cassis de Dijon [1979] ECR 649.86 In Case C-250/95 Futura Participations SA [1997] STC 1301; [1997] ECR I-2471, the Court

indicated that, although the disputed accounting requirements were not justified because they weredisproportionate to the objective, this justification would apply to a less onerous requirement.

87 Directive 77/799 concerning mutual assistance by the competent authorities of the Member States inthe field of direct taxation [1977] OJ L 336/15.

88 Case C-264/96 ICI [1998] ECR I-4695 at [26].89 As in Case C-433/04 Commission v Belgium [2006] ECR I-10653.90 Case C-324/00 Lankhorst-Hohorst [2003] STC 607; [2002] ECR I-11779 at [37]; Case C-9/02 de

Lasteyrie du Saillant [2004] ECR I-2409 at [50]–[51].91 Case C-524/04 Thin Cap [2007] STC 906; [2007] ECR I-2107 and Case C-196/04 Cadbury Schweppes

[2006] STC 1908; [2006] I-7998.92 Case C-446/03 Marks & Spencer [2006] STC 237; [2005] ECR I-10837 and Case C-231/05 Oy AA

[2008] STC 991.93 Case C-315/02 Lenz [2004] ECR I-7063.

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transactions or sources of income to ‘‘equalise’’ the total tax burden on a taxpayeroperating from a lower tax jurisdiction with the burden it imposes on its own taxpayers.94

In almost every direct tax case since Bachmann the preservation of cohesion of thenational tax system has been relied on as a justification for restrictive tax measures, butit has never been applied by the Court to justify restrictive legislation in any subsequentcase. In many rulings, the necessity of a direct link between a tax advantage and acorresponding charge to taxation applicable to a particular taxpayer was not met.95

As set out above, even in the more recent cases concerning taxation of insuranceand pension premiums and benefits, and in particular in Case C-150/04 Commission vDenmark, the Court refused to accept this justification as the legislation did not satisfythe proportionality requirement. The Danish tax rules carefully balanced deduction withinclusion, so that if a taxpayer contributing to a foreign pension plan was unable todeduct contributions, the benefits would be exempt from tax, similar to the Belgianrules in Bachmann. However, the Court, following a new and stricter argument of theCommission, imposed an important proportionality based limitation on the test of whatis necessary to ensure cohesion. The Commission argued that cohesion of the tax systemonly became a basis for justifying denial of the deduction where Denmark cannot tax thepension benefits when they are later paid to the individual. This is only the case where anindividual who, having paid into a foreign pension plan and claimed a deduction for suchcontributions, later ceases to be resident in Denmark and receives pension benefits froma non-Danish fund. The inability of Denmark to tax the pension benefits is the resultof the transfer of residence by the individual. Denying a deduction for all contributionsto foreign pension plans cannot therefore be justified by the need to preserve cohesion;the tax measure must be tailored to recovering the tax relief provided to the emigratingtaxpayer.

A more flexible approach to justification is apparent in the judgments in Marks &Spencer,96 and Oy AA,97 both concerning freedom of establishment and restrictions oncorporate group loss relief. In Marks & Spencer the Court accepted in principle thatcertain restrictions on the deduction by a parent company of losses realised by subsidiariesresident in other Member States may be justified as compatible with the internationaltax principle of territoriality,98 that is, that since the parent company’s home Member

94 C-294/97 Eurowings [1999] ECR I-7449 [44]–[45]. In Lenz Advocate General Tesauro asserted thatmeasures designed to combat competitive distortions in favour of low tax Member States could notjustify unequal treatment at [62].

95 Some commentators discern in Manninen (Case C-319/02 [2004] STC 1444; [2004] ECR I-7498) arelaxation of the requirement that the advantage and tax charge apply to one and the same taxpayer.This is apparent in the Opinion of Advocate General Kokott in that case of March 18, 2004 at [64]–[65]but is not clear in the ECJ’s judgment.

96 Case C-446/03 [2006] STC 237; [2005] ECR I-10837. See for fuller discussion, among many otherarticles, Melchior Wathelet, ‘‘Marks & Spencer plc v Halsey: lessons to be drawn’’ [2006] BTR 128;Tom O’Shea, ‘‘Marks and Spencer v Halsey (HM Inspector of Taxes): restriction, justification andproportionality’’ (2006) EC Tax Review 66; A. Cordewener and I. Dorr, ‘‘Case C-446/03 Marks &Spencer Plc v. David Halsey (HM Inspector of Taxes) Judgment of the Court of Justice (GrandChamber) of 13 December 2005,’’ Common Market Law Review 43: 855-884 (2006); Michael Lang,‘‘The Marks & Spencer Case—The Open Issues Following the ECJ’s Final Word’’ [2006] 46 EuropeanTaxation 54.

97 Case C-231/05 [2008] STC 991.98 In Case C-250/95 Futura Participations SA [1997] STC 1301; [1997] ECR I-2471 at [22] the Court

used this principle to allow a source state, Luxembourg, to limit the ability of a branch of a non-resident

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State did not have the power to tax the subsidiary’s profits earned abroad, it should notbe required to allow deduction of the subsidiary’s foreign losses against profits earned inthe parent’s home state, as this could jeopardise the balanced allocation of the power toimpose taxes between Member States (at [46]). Combined with the risk of tax avoidanceif the losses were claimed twice (in both the subsidiary’s home state and the parent’s)or were transferred artificially within a corporate group so that they could be deductedin another jurisdiction with higher tax rates, the restriction on deduction of losses ofnon-resident subsidiaries was held to satisfy the test of fulfilling an overriding reason inthe public interest. Thus the cumulative effect of justifications that individually wouldnot be sufficient can protect an otherwise restrictive tax measure.

In Oy AA, the ECJ was even more willing to apply justifications cumulatively. In thatcase a Finnish wholly-owned subsidiary wished to transfer (and deduct from its Finnishtax base) profits to its loss-making UK parent, under Finnish rules which allowed suchtransfers within 90 per cent owned corporate groups where transferor and transferee wereboth resident in Finland. The Court accepted the justification of preserving a balancedallocation of taxing power between Member States where the impugned rules are designedto prevent conduct that might jeopardise the entitlement, according to that allocation,of Member States to exercise their taxing powers over income from activities carriedon in their territory. If companies could elect to have their income taxed in anotherMember State, this would undermine that balanced allocation of taxing power. It wouldalso encourage tax avoidance, or the use of artificial arrangements, to shift income withincorporate groups to low tax jurisdictions. The Court held that these two, linked, bases ofjustification constituted overriding reasons in the general interest.

Another very significant aspect of the judgment is that the Court relaxed its usual strictproportionality test, holding that the Finnish legislation was not disproportionate to itsobjective, even though it was ‘‘not specifically designed to exclude from the tax advantageit confers purely artificial arrangements, devoid of economic reality, created with the aimof escaping the tax normally due. . .’’.99

These two cases, particularly the strong statement in Oy AA, indicate that the Courtis more willing to give effect to the norms accepted internationally for allocating taxjurisdiction. When the balanced allocation of taxing power is put in jeopardy, combinedwith a clear risk of tax avoidance, the Court will be more lenient in applying theproportionality principle.

From the above it can be seen that in intra-EU cases, the Court has not allowed MemberStates to justify restrictive tax measures except in very limited circumstances. It is onlyrecently, with the new willingness of the Court to recognise the entitlement of MemberStates to allocate taxing power unilaterally or by tax treaty as deserving of its protection,that a broader base for justification of tax measures that would otherwise be incompatiblewith fundamental freedoms is discernible.

company to carry forward losses of previous years to those losses which were economically linked toincome from activities carried on in Luxembourg. The territoriality or balanced allocation of taxingpower argument has been shifted from consideration in relation to the issue of whether there is arestriction to the justification analysis, and applied to a residence state, by Marks & Spencer and OyAA.

99 Case C-231/05 Oy AA [2008] STC 991 at [63]. This relaxation in the application of the proportionalityprinciple is in sharp contrast with the more stringent application of it in connection with the cohesionjustification in Case C-150/04 Commission v Denmark [2007] STC 1392.

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The significance of DTCs in EU direct tax law

The effect of the reciprocal commitments in DTCs on a Member State’s unilateralobligations under Article 56(1) is a relevant but difficult and unresolved factor indetermining how the third country dimension of free movement of capital will apply in agiven situation.

The Court has recently reaffirmed the competence of Member States to ‘‘define, bytreaty or unilaterally, the criteria for allocating their powers of taxation, particularlywith a view to eliminating double taxation.’’100 The criteria for allocating taxation powercommonly applied in tax treaties based on the OECD Model are generally acceptable tothe Court.101

Although the ECJ’s jurisprudence lacks clarity on many points concerning DTCs, itcan be stated with certainty that, at least within the EU, the provisions of a DTC do notallow a Member State to avoid its obligations to uphold the fundamental freedoms.102

Conversely, it may not cite the lack of reciprocal relief (often provided in DTCs) forits residents in the other Member State as a justification for denying the benefits of afundamental freedom to a resident or national of that Member State.103 The ECJ will takeinto account, as part of the legal context, the provisions of a DTC to determine whether,on the basis of domestic law and the actual effect of the tax treaty in combination, thereis unequal treatment or a restriction of a fundamental freedom.104 The application of arelevant DTC in a particular case is usually left to the national courts.

The scope for reliance on DTCs to shape EU direct tax jurisprudence seems quitelimited because the Court is concerned with discriminatory treatment of residents andnon-residents that results from a single Member State’s tax law. DTCs are primarilyconcerned with minimising or eliminating juridical double taxation by allocating taxjurisdiction between the state of source and the state of residence, usually obligating thetreaty partners to reduce withholding tax rates and provide relief for income taxed inthe other state, either by exempting such income from tax or crediting the foreign taxagainst the tax liability in the home state. The Court does not consider juridical doubletaxation per se as constituting the restriction of a fundamental freedom.105 It is simply aninevitable result of two countries exercising their sovereign tax powers according to theallocation that has been established either unilaterally or in a DTC.

In Amurta, the ECJ confirmed the principle that the source Member State may not relyon a tax advantage granted unilaterally (i.e. in its domestic law) by the home MemberState to avoid its obligation to treat outbound dividends equally to domestic dividends.However, a tax advantage provided in a DTC may be taken into account. In principle, itseems that if the effect of a DTC is to eliminate any inequality in treatment or a restrictiveeffect, a Member State’s tax law will not be incompatible with a Treaty freedom.

100 This is the effect of EC Treaty Art.293 second indent; see Case C-524/04 Thin Cap [2007] STC 906;[2007] ECR I-2107 at [49] and cases cited there.

101 Case C-513/03 van Hilten [2008] STC 1245; [2006] ECR I-1711 at [48].102 C-270/83 Avoir Fiscal [1986] ECR 273 at [26]; Case C-170/05 Denkavit [2007] STC 452; [2006] ECR

I-11949 at [53] and Case C-379/05 Amurta at [78].103 C-270/83 Avoir Fiscal [1986] ECR 273.104 Case C-265/04 Bouanich [2008] STC 2020; [2006] ECR I-923 and Case C-170/05 Denkavit [2007]

STC 452; [2006] ECR I-11949.105 Case C-513/04 Kerckhaert-Morres [2007] STC 1349; [2006] ECR I-1096752.

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The Court’s statements about what types of relief provided in a DTC will neutralise arestriction are inconclusive. For example, there is no explicit ruling on whether a DTCthat provides for a tax exemption or tax credit for dividends in the shareholder’s homestate can neutralise economic double taxation of the outbound dividends in the otherstate. In Amurta, the Court left it to the national court to determine whether the effect ofthe DTC was to neutralise the restriction of free movement of capital resulting from theseries of charges to tax imposed by the source state on outbound compared to domesticdividends.

It seems that a Member State can defend an otherwise restrictive tax measure in its owndomestic law by demonstrating that the measure’s restrictive or discriminatory effects areoffset by obligations imposed by a DTC on that Member State to provide relief.

ACT IV and FII Test Claimants are cases where a Member State’s grant of a tax creditbased on the existence of an obligation in a DTC (or domestic law in the case of FIITest Claimants) prevented its taxation of outbound (in ACT IV ) and inbound (in FIITest Claimants) dividends from constituting a restriction of free movement of capital.106

In ACT IV, the UK legislation granted a tax credit to foreign dividend recipients ifthe relevant DTC permitted the United Kingdom to impose withholding tax on thedividend. The ECJ considered that this eliminated economic double taxation by theUnited Kingdom that would otherwise have applied to the outbound dividend subject towithholding tax. In this way, the United Kingdom’s system complied with its EC Treatyobligations through the combined provisions of domestic law and DTCs. In FII TestClaimants, tax credits provided by the United Kingdom, either in its domestic law or arelevant DTC, for both foreign withholding tax on dividends and underlying corporatetax on the income, equalised the UK tax burden on domestic and inbound dividends sothat the restrictive effect of taxing inbound dividends while exempting domestic dividendswas eliminated. These cases can also be viewed as simply recognising that obligationsimposed by DTCs are effectively part of the domestic law of the treaty partner, so thatthey affect whether, under the law of a single Member State, the impugned tax treatmentis restrictive or discriminatory.

It is permissible for a Member State to discriminate amongst the other Member States(or third countries) based on the existence of, or obligations contained in, a DTC withthe other country. In the D Case107 the ECJ ruled that there was no ‘‘most favourednation’’ principle that allowed a resident of Germany to insist on the favourable treatmentaccorded by the Netherlands to residents of Belgium under the tax treaty between theNetherlands and Belgium. Further, the existence and terms of a DTC determines whethertaxpayers are in the same situation under Article 58(1)(a). It is only those non-residentswho are in a comparable position to a resident of one of the contracting states who canclaim the benefits of the tax treaty, as in the Saint Gobain108 case. The D Case wasemphatically affirmed in OESF109 in which the Court held that the Netherlands was not

106 Bouanich (Case C-265/04 [2008] STC 2020; [2006] ECR I-923) is another such case, where the issueof whether the obligation imposed by the DTC on Sweden to reduce its withholding tax rate ondividends paid to French residents eliminated the unequal treatment in Swedish domestic law wasleft for determination by the Swedish referring court.

107 C-376/03 [2005] ECR I-5821 (Grand Chamber).108 Case C-307/97 Compagnie de Saint-Gobain, Zweigniederlassung Germany v Finanzamt Aachen-

Innenstadt [1999] ECR I-6161.109 Case C-194/96, May 20, 2008.

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precluded from making access to a tax benefit in respect of inbound dividends conditionalon the existence of a DTC with the source country providing for such relief. Dividendsreceived by OESF from companies in Portugal and Germany were not entitled to the sametreatment as dividends from countries that had such a DTC with the Netherlands, becausethe investment of capital in Portugal and Germany was not objectively comparable to aninvestment in a country with a DTC providing the relief.

The third country dimension of free movement of capital

General comments on third country jurisprudence to date

In just over two years, between February 2006 and May 2008, the ECJ issued 10 judgmentson the third country dimension of Article 56(1) and direct taxation.110 In seven, the Courtfound either that there was no restriction (van Hilten, ACT IV ), that another Treatyfreedom excluded consideration of Article 56(1) (Thin Cap, Lasertec, Stahlwerk ErgsteWestig, Skatteverket v A and B), or that the disputed measure was protected by Article57(1) (Holbock). In two cases, FII Test Claimants and Skatteverket v A, the Court referredthe determination of the application of Article 57(1) back to the national court for afinal ruling. In the latter case, the ECJ also accepted the justification of guaranteeing theeffectiveness of fiscal supervision. Thus taxpayers have been unsuccessful in relying onArticle 56(1) in all but FII Test Claimants and OESF (and may yet be unsuccessful in FIITest Claimants). This is a very different record of success compared to intra-EU directtax cases generally, which have found measures to be incompatible with EU law in anoverwhelming majority of cases.

On the fundamental issue of what constitutes a prohibited restriction of free movementof capital, it is now clear that the principle in Article 56(1) is the same in the third countrycontext as in intra-EU cases.111 The definitions of capital movements, and of ‘‘directinvestment’’ in Annex I apply equally in both contexts.112

From the variety of intra-EU cases surveyed above in which direct tax measureshave been found to be incompatible with Article 56(1) within the EU, it is evident thatthere are many as yet untested possibilities for challenging Member States’ tax laws intheir application to third countries. However, there are a number of formidable (andinterconnected) obstacles that limit the possibilities for the third country dimension offree movement of capital to parallel the intra-EU dimension. These are analysed in thefollowing sections.

110 For reference, these are Case C-513/03 van Hilten [2008] STC 1245; [2006] ECR I-1711; CaseC-446/04 FII Test Claimants [2007] STC 326; [2006] ECR I-11753; Case C-374/04 ACT IV [2007]STC 404; [2006] ECR I-11673; Case C-524/04 Thin Cap [2007] STC 906; [2007] ECR I-2107 andC-492/04 Lasertec [2007] ECR I-3775; Case C-102/05 Skatteverket v A and B [2007] ECR I-3871;Case C-157/05 Holbock [2007] ECR I-4051; Case C-415/06 Stahlwerk Ergste Westig [2007] ECRI-152; Case C-101/05 Skatteverket v A [2007] ECR I-11531 and Case C-194/06, OESF May 20, 2008.Admittedly, ACT IV does not directly address third country issues but impliedly encompasses them,and OESF is primarily concerned with intra-EU discrimination. There are three third country casesthat do not concern taxation, Case C-452/04 Fidium Finanz [2006] ECR I-9521; Case C-250/94 Sanzde Lera [1995] ECR I-482; and Case C-358/93 and 416/93 Bordessa [1995] ECR I-361.

111 See Case C-101/05 Skatteverket v A [2007] ECR I-11531 at [31].112 Case C-446/04 FII Test Claimants [2007] STC 326; [2006] ECR I-11753 at [179]; Case C-513/03 van

Hilten [2008] STC 1245; [2006] ECR I-1711 at [39].

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Overlapping freedoms: Fidium Finanz and its implications in direct tax cases

In Fidium Finanz,113 the Court laid down a new and unanticipated rule, the effect ofwhich is to exclude Article 56 from consideration in many third country cases. In a verybroad range of circumstances a national measure may restrict the exercise of more thanone of the fundamental freedoms. In intra-EU cases, the Court had in the past sometimesexamined the effects of a particular measure on all the affected freedoms, or, particularlywhere a measure restricted both goods and services, chosen one or the other as primarilyand directly affected. Until the judgment in Fidium Finanz, the Court had never selectedonly one of two or more affected freedoms against which to judge the compatibility ofa measure in circumstances where this could change the practical result of the case. InFidium Finanz, the first third country case where the circumstances concerned both freemovement of capital and another freedom, the Court excluded consideration of Article56(1).

Fidium Finanz concerned German legislation that required financial services providersto obtain official authorisation to offer financial services to German residents unlessthey were established in an EU or EEA Member State. Fidium Finanz AG was aSwiss enterprise offering short term consumer loans via internet to German residents.It challenged the German authorisation requirement on the basis that it restricted freemovement of capital with a third country.

The Court found that while the German measure concerned both services and capital,the purpose or substance of the measure was to regulate access to the German financialservices market. The Court applied its ‘‘principal aspect’’ criterion, that in cases wherea Member State’s law relates to more than one freedom at the same time, the Court willconsider to what extent the exercise of each is affected, and whether, in the circumstancesof the case, one prevails over the other. The authorisation requirement was most directlyand primarily a restriction of the freedom to provide services without being established inGermany, a Treaty freedom which does not extend to third countries. The obstacle to thecapital movement (the grant of consumer credit) was merely an inevitable and indirectconsequence of the regulation of financial services, and it was therefore ‘‘not necessary’’to consider the compatibility of the German law with Article 56(1). In reaching thisconclusion, the Court cited its judgment in Bachmann.114

113 Case C-452/04 [2006] ECR I-9521. For a fuller analysis of this case, see Martha O’Brien, CaseAnnotation Fidium Finanz AG v Bundesanstalt fur Finanzdienstleistungsaufsicht (2007) CML Rev. 44,1483. For other critiques of the ECJ’s approach in Fidium Finanz as extended to the third countrytax cases, R. Fontana, ‘‘Direct Investments and Third Countries: Things are Finally Moving . . . inthe Wrong Direction’’ (2007) 47 European Taxation 431; S. Hindelang, ‘‘The EC Treaty’s Freedomof Capital Movement as an Instrument of International Investment Law?: The Scope of Article 56(1)in a Third Country Context and the Influence of Competing Freedoms’’ in International InvestmentLaw in Context (A. Reinisch and C. Knahr (eds), Eleven International Publishing, Utrecht, 2007);D. Webber, ‘‘Fidium Finanz AG v Bundesanstalt fur Finanzdienstleistungsaufsicht: the ECJ gives thewrong answer about the applicability of the free movement of capital between the EC Member Statesand non-member countries’’ [2007] BTR 670; and D.S. Smit, ‘‘The relationship between the freemovement of capital and the other EC Treaty freedoms in third country relationships in the field ofdirect taxation: a question of exclusivity, parallelism or causality?’’ (2007) EC Tax Review 252.

114 Case C-524/04 Thin Cap [2007] STC 906; [2007] ECR I-2107 at [34]. See text following fn. 80.

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The Court’s position in Fidium Finanz has solidified in four subsequent direct tax casesconcerning third countries. In Thin Cap115 two of the test claimants were UK companiesthat had borrowed from a related company resident or established in a third country,and either the direct lender was established in a third country, or the ultimate parentcompany was resident in a third country. The UK tax rules denied or limited deductionof interest paid to non-resident companies who were members of the same corporategroup in certain circumstances. These ‘‘thin capitalisation’’ rules were challenged as arestriction of freedom of establishment,116 or, where the lender or parent company wasnot resident in an EU Member State, free movement of capital. The Court consideredthat since the restrictive tax rules only applied to loans between members of controlledgroups of companies, freedom of establishment was primarily and directly concerned. Aseparate assessment of the compatibility of the thin cap rules in light of Article 56 was‘‘not justified’’ (as opposed to ‘‘not necessary’’ in Fidium) and, indeed, was positivelyexcluded.117 That there is no right to invoke Article 56 in such circumstances wasconfirmed in Lasertec.118 In that case, although the rules did not apply exclusively wherethe lender or a related company controlled a majority of the voting shares of the borrower,the Court found that they were intended to apply only where there was effective control.The underlying purpose of the legislation was thus the most significant factor. Freedomof establishment was directly and primarily concerned, and as a matter of settled law, theapplication of Article 56(1) was excluded. The same reasoning was applied in StahlwerkErgste Westig,119 and in Skatteverket v A and B.120

The Fidium Finanz approach has a negligible impact on the result in intra-EU cases,but is clearly having a very significant one in third country cases. The logic of denyingrecourse to Article 56(1) by third country claimants on the basis that the impugnedmeasure is more directly concerned with another freedom which does not apply to them,is somewhat questionable.121 Advocate General Stix-Hackl in her Opinion in FidiumFinanz concluded that where both free movement of services and capital were concerned,

115 For a fuller discussion of this case supporting the ECJ’s ruling in relation to the third countrydimension, see Tom O’Shea, ‘‘Thin Cap GLO and Third Country Rights: Which Freedom Applies?’’(2007) Tax Notes International 371.

116 The thin capitalisation provisions were incompatible with Art.43 when the lender was established inthe EU so that the starkly different results for intra-EU and third country cases due to the FidiumFinanz ruling were clear.

117 Case C-524/04 Thin Cap [2007] STC 906; [2007] ECR I-2107 at [104].118 C-492/04 [2007] ECR I-3775.119 Case C-415/06 [2007] ECR I-152. In this case the German rules denying deduction of losses realized

by a US permanent establishment in determining income of a German resident company were held toconcern freedom of establishment and free movement of capital was not applicable.

120 Case C-102/05 [2007] ECR I-3871. In this case, employees holding very small shareholdings in theiremployer, a Swedish company, were taxed on dividends at the higher rate applicable to salary astheir salaries from working at a Russian branch were not included in the formula for determining ifsalary was being converted inappropriately to dividend income. The ECJ saw this as a freedom ofestablishment case, even though the more logical approach was that it was either free movement ofworkers (to Russia) or free movement of capital, in respect of the dividends on the small proportion(less than two per cent) of shares held. The tax rules only indirectly discouraged establishment by theSwedish company in Russia, as there was no effect on the company’s Swedish tax liability.

121 In Case C-102/05 Skatteverket v A and B [2007] ECR I-3871 the Swedish Tax Commission held thatsince none of the other freedoms were applicable in third country cases, Art.56 had to be considered,and was infringed in that case.

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the Court’s then existing jurisprudence did not exclude consideration of the measureas a restriction of free movement of capital.122 She noted that the specific permissionprovided to Member States in Article 57(1) to maintain in force measures which restrictdirect investment which amounts to establishment or financial services in respect of thirdcountries (discussed in the next section) would be meaningless if Article 56 was never toapply if the movement of capital was connected to activities that amounted to exercise ofthe right of establishment or free movement of services.

The application of the Fidium Finanz approach to determining which freedom is moredirectly and primarily affected may have become more nuanced in some direct tax casesas a result of the Holbock case.123 In that case, an Austrian individual held two-thirds ofthe shares of a Swiss company. The less favourable tax treatment of inbound dividendsby comparison with domestic dividends under Austrian law had already been foundincompatible with Article 56(1) in Lenz.124 Given that Mr Holbock had definite influenceover the Swiss company, it might have been expected that the Court would follow FidiumFinanz and rule that freedom of establishment was the only freedom to be considered.However, it considered that the dividend taxation rules applied generally to dividends,whether the recipient controlled the distributing company or held only a small percentageof the shares. The dividend tax rules therefore fell within both freedom of establishmentand free movement of capital. However, as the Austrian rules had been in place as ofDecember 31, 1993, they were saved by the standstill provision in Article 57(1) in relationto third countries even if Mr Holbock was entitled to invoke Article 56(1).

Following Holbock, the overlap issue is refined, but still fraught with uncertainty. Froma direct tax perspective, Holbock indicates that general tax measures that are not limited tosituations where a relationship of control exists between the shareholder and the company,are not necessarily excluded from consideration in relation to Article 56(1), even where arelationship of control exists in the particular case. This is a slightly different position tothat taken in FII Test Claimants, where it appeared the Court was drawing a line betweendividends received from controlled companies, in which case freedom of establishmentwas concerned, and from companies in which the shareholder did not have a controllinginterest, in which case free movement of capital was engaged. In that judgment, it seemedthat a UK company receiving dividends from a controlled third country company hadno right to invoke Article 56(1) even though the same tax rules applied where the thirdcountry company was not controlled by the UK company.

The small opening afforded by Holbock notwithstanding, the Fidium Finanz, ThinCap, Lasertec, and Stahlwerk Ergste Westig cases effectively exclude the third countrydimension of Article 56(1) in respect of four of the most important types of measures used

122 She based her views primarily on the Svensson and Gustavsson case (C-484/93 [1995] ECR I-3955)21where both freedoms were considered equally applicable. See also the Opinion of Advocate GeneralKokott, September 12, 2006 in Case C-231/05 Oy AA [2008] STC 991 at [16], and in Case C-265/04Bouanich [2008] STC 2020; [2006] ECR I-923 at [71] for the view that freedom of establishment andfree movement of capital can be applied ‘‘in parallel’’. These two Opinions, and the position taken bythe Commission in Case C-452/04 Fidium Finanz [2006] ECR I-9521, show how unexpected and evensurprising the position taken by the Court in the latter case was. It is nevertheless fully establishedas ‘‘settled law’’ by the time of the judgment in C-492/04 Lasertec [2007] ECR I-3775 at [19]. Theoldest case cited in that paragraph is Case C-196/04 Cadbury Schweppes [2006] STC 1908; [2006] I-(decided after AG Kokott’s Opinion in Fidium Finanz).

123 Case C-157/05 [2007] ECR I-4051.124 Case C-315/02 [2004] ECR I-7063.

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by Member States to protect their corporate tax base: controlled foreign corporation,125

thin capitalisation, group loss relief126 and transfer pricing127 rules, because these all applyonly to controlled corporate groups.

The degree to which transactions and activities that constitute capital movements areconnected to and overlap with those that involve the exercise of freedom of services or theright of establishment (and to a lesser degree, free movement of workers) is evident fromeven a cursory examination of Annex I. This means that the issue of which is primarilyand directly concerned will arise very frequently in the third country dimension. TheCourt has identified two bases on which it will determine that a freedom other than capitalis primarily and directly concerned and consequently exclude application of Article 56(1):when the purpose of the restrictive measure is to regulate market access in respect ofservices, as in Fidium Finanz, and where the measure applies exclusively to those factualcircumstances that constitute exercise of another freedom, even if those circumstancesalso involve a movement of capital, as in Thin Cap. Both of these two determinants are wellentrenched in the jurisprudence already. They are defensible to the extent they addressdirectly the need to prevent third country investors from gaining other free movementrights indirectly and illegitimately by invoking the free movement of capital. However,these two bases for excluding Article 56(1) in third country cases provide no guidance onwhen it may be invoked to challenge general tax measures, so that the impact of Holbockremains unclear.

Evidence that the emergence of the third country dimension may be causing the Courtto avoid applying Article 56(1) in intra-EU cases can be seen in recent infringementcases initiated by the Commission. When the challenge to compatibility of national taxmeasures with fundamental freedoms is abstract, as in Article 226 actions, the Court isquite willing to consider the restrictive tax measure in relation to more than one freedom,yet still avoids consideration of Article 56(1). For example, in the decision in Commissionv Denmark,128 the Court held that free movement of services, workers and the right ofestablishment were all restricted but that it was ‘‘unnecessary’’ to consider the measuresseparately in relation to Article 56(1).

The following example illustrates the potential for inappropriate results based on theexclusion of Article 56 where another freedom may also apply. In Article 226 infringementcases brought by the Commission, the Swedish and Portuguese discriminatory rules oncapital gains tax relief were incompatible with free movement of workers, establishmentand citizenship rights, and separate consideration of Article 56 was not necessary.129 Inthe taxpayer-initiated reference, Hollman,130 only free movement of capital was in issueas the taxpayer did not ‘‘move’’, whether in her capacity as worker, entrepreneur, citizen

125 As in Cadbury Schweppes (Case C-196/04 [2006] STC 1908; [2006] I-7998), at least where thelegislation applies only where the foreign subsidiary is under the effective control of the EU parent.

126 As in Case C-446/03 Marks & Spencer [2006] STC 237; [2005] ECR I-10837 and Case C-231/05 OyAA [2008] STC 991.

127 Although transfer pricing rules have not yet been challenged, since these also depend on a relationshipof control between the transferor and transferee, they will not be prohibited by Art.56(1) in respect ofthird countries.

128 Case C-150/04 [2007] STC 1392; [2007] ECR I-1163.129 Case C-345/05 Commission v Portugal October 26, 2006 [2006] ECR I-10633 and Case C-104/06

Commission v Sweden January 18, 2007 [2008] STC 2546; [2007] ECR I-671.130 Case C-443/06 [2008] STC 1874.

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or otherwise. This raises the incongruous prospect that the Court could find that a thirdcountry national is not entitled to invoke Article 56(1) to challenge discriminatory taxationon selling her home in one Member State to take a job or start a business in anotherMember State, but could invoke Article 56(1) if she is simply an investor and not also aworker.

The Commission has not to date commenced infringement proceedings under Article226 in any third country case, and does not include the third country dimension of freemovement of capital when it takes action against Member States based on Article 56.131

However, the positions it takes in intra-EU cases should shed light on the scope of Article56 in references for preliminary rulings. In the intra-EU cases under Article 226, it isnot clear that the Court’s position that it is ‘‘unnecessary’’ to consider the measure inlight of free movement of capital means that Article 56(1) is to be absolutely excludedfrom consideration as it is in the third country cases. The unanswered concern is whetherthe willingness of the Court to consider compatibility of a national measure with morethan one freedom where the issue is presented in the abstract, while refusing to assessthe measure in relation to Article 56 even in intra-EU cases, indicates an intention tosubordinate Article 56(1) to the other freedoms in a manner that has not been evidentsince Bachmann.

From the review above of the intra-EU direct tax case law on Article 56,132 two typesof direct tax measure that exclusively, or at least most directly and primarily, concernfree movement of capital are wealth and inheritance taxes and the taxation of charitabledonations. These are therefore the least likely to be excluded from the third countrydimension of Article 56(1) by the Fidium Finanz approach. An EU resident should be ableto claim the same tax relief for donations made to third country charities as to charitiesin his home country, at least where the third country charity would qualify as a charityin the donor’s country of residence. A German resident should be able to claim the samefavourable tax treatment in respect of inheritance tax for his Canadian real property as forreal property situated in Germany or France.

With respect to dividends, interest and capital gains, where free movement of services,workers or establishment may overlap with free movement of capital, the third countrylitigant should be able to invoke Article 56(1) in respect of direct tax measures thatapply generally to these types of receipts, following Holbock, and at the very least wheninterest and dividend income flows from portfolio investments. A Chinese shareholder ofa French corporation should be able to claim an exemption from French withholding taxon dividends if French (or Dutch) shareholders are not required to pay a second charge onthe French corporation’s profits. A Greek shareholder of a Canadian company should beable to claim an exemption from Greek tax on the dividends received, if dividends fromGreek companies are exempt. A Spanish resident should be able to claim the same capitalgains tax relief under Spanish law on disposition of his home in Argentina as he would inrespect of Spanish or Portuguese real property. A French lender receiving interest froman Australian borrower should be entitled to the same beneficial tax treatment in respectof the interest as he is for interest from a French borrower.

131 The Commission does, however, submit observations, often supporting the taxpayer on at least somepoints, in third country references for preliminary rulings. It may also be the case that third countryinvestors have not yet begun to complain to the Commission about tax restrictions of free movementof capital.

132 See subheading: Survey of intra-EU case-law on direct taxation and free movement of capital.

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Article 57(1): the standstill provision

Article 57(1)133 derogates substantially from the third country scope of Article 56(1),allowing Member States to retain restrictions in existence on December 31, 1993 in respectof certain enumerated categories of capital movement, even though these categories arewhere one would anticipate the most extensive increase in international investment,and so where the euro would gain the most international recognition. Article 57(2) wasapparently intended to protect reservations made by Member States under the OECDCode of Liberalisation of Capital Movements and the OECD Code of Liberalisation ofCurrent Invisible Transactions.134

There are two direct taxation cases at the time of writing where Article 57(1) has beenapplied to save a national measure that restricted free movement of capital, Skatteverketv A and Holbock. In addition, in FII Test Claimants it seems clear that the High Court ofEngland and Wales will find that the pre-1994 UK legislation is also preserved in the caseof direct investments and controlled groups and likely that the 1994 FID amendmentswill also be protected.

Article 57(1) requires a restrictive measure to form part of a Member State’s legal ordercontinuously from December 31, 1993 to the relevant time, so that Member States cannotclaim its protection for measures that had been repealed but were reintroduced after thatdate. The ECJ has held that post-1993 amendments that do not change the substanceof a pre-1994 measure, or that reduce or eliminate obstacles to free movement of capitalare also grandfathered by Article 57(1).135 In Skatteverket v A,136 the ECJ ruled that theimpugned Swedish tax law was to be regarded as in existence on December 31, 1993,because, despite the various changes to Swedish law before and after the critical date, therewas no point after December 31, 1993 when Swedish law extended the favourable taxtreatment accorded to domestic stock dividends to stock dividends from third countries.This means that as Member States remove restrictions in their tax laws in respect of otherMember States and under the EEA, they may retain the pre-1994 restrictions vis-a-visthird countries in the categories enumerated in Article 57(1).

As noted earlier, one of the implications of applying the Fidium Finanz approach forassessing whether Article 56(1) may be invoked in third country cases is that the standstillobligation in Article 57(1) will be far less important. All national tax laws, whether ornot in existence as of December 31, 1993, will be immune from challenge under Article56(1) if the measure is more directly connected with another freedom than with capital;the enumerated categories protected by the standstill will be largely irrelevant in thissituation. Hindelang137 points out that this allows Member States to exclude Article 56(1)

133 Art.57(1) provides: ‘‘The provisions of Article 56 shall be without prejudice to the application tothird countries of any restrictions which exist on 31 December 1993 under national or Communitylaw adopted in respect of the movement of capital to or from third countries involving directinvestment—including in real estate—establishment, the provision of financial services or theadmission of securities to capital markets.’’ The Treaty of Accession of the Republic of Bulgaria andRomania adjusted Article 57(1) to permit restrictions existing in the national laws of Bulgaria, Estoniaand Hungary as of December 31, 1999. See the Act concerning the conditions of accession of theRepublic of Bulgaria and Romania [2005] OJ L157/209 at Article 16.

134 See Smit, fn.12.135 Case C-157/05 Holbock [2007] ECR I-4051 at [41].136 Case C-101/05 [2007] ECR I-11531 at [48]–[52], available at: http://curia.europa.eu/en/index.htm.137 Fn.113 at 61.

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selectively in respect of third countries by choosing a regulatory approach directed atanother freedom.

The interpretive issues of whether a national (or Community) law is ‘‘adopted in respectof the movement of capital to or from third countries’’ and whether it ‘‘involves’’ one ofthe enumerated categories of direct investment, establishment, the provision of financialservices or the admission of securities to capital markets are not easily resolved.138 Thisis despite the statement of the Court in Sanz de Lera139 that Article 57(1) is ‘‘preciselyworded, with the result that no latitude is granted to the Member States or the Communitylegislature regarding either the date of applicability of the restrictions or the categories ofcapital movements which may be subject to restrictions.’’

An objective interpretation of Article 57(1) would allow its application only to measuresthat are primarily directed at capital movements between Member States and thirdcountries involving the enumerated categories. However, the ECJ’s application of Article57(1) in Holbock rejects this approach. The impugned tax measures were general intheir application to all inbound dividends regardless of whether the Austrian shareholderheld all, or only a tiny fraction of, the shares of the foreign company and whether thecompany was resident in the EU or a third country. Applying a subjective approach tothe application of Article 57(1) to Mr Holbock’s particular circumstances, and specificallyhis two-thirds shareholding in the Swiss company, the Court held that the impugned taxmeasure involved direct investment or establishment. Article 57(1) therefore protected therestrictive tax measure, which dated from before 1994, in its application to the dividendsreceived on the shares.

One might ask how a general dividend taxation measure can be ‘‘adopted in respect ofthe free movement of capital’’ when it applies equally to all dividends whether derivedfrom a shareholding of only a fraction of one per cent, or from a shareholding amountingto exercise of the right of establishment. The answer must be that the Court readsArticle 57(1) with emphasis on ‘‘without prejudice to the application to third countries ofrestrictions’’140 and interprets inclusively the condition that the law be adopted in respectof free movement of capital. On this basis, a general law that, regardless of its primarypurpose, has restrictive effects on capital movements in its application to a third countryis saved by Article 57(1) if the circumstances of the case involve direct investment orestablishment (or the other categories). The Court’s often repeated statement in othercircumstances, that limitations on fundamental freedoms are to be interpreted narrowly,has not been made in relation to Article 57(1).

The Holbock approach to Article 57(1) based on the particular circumstances of thecase potentially gives this provision extraordinary scope. Article 57(1) could be appliedto ‘‘grandfather’’ restrictive capital gains taxation measures that apply generally to allcapital property where the property is real property, or a direct investment of any kind.141

This would mean that the application of Article 57(1) is not restricted to measures thatare within its purpose, that is, to allow Member States to retain their pre-1994 marketaccess restrictions protecting certain sensitive and regulated sectors from third country

138 See the analysis of D.S. Smit, fn.12.139 C-250/94 [1995] ECR I-482 at [44]140 Emphasis added.141 At the extreme, it could apply to exclude the application of Art.56(1) to dividends on portfolio

investments in securities admitted to capital markets, but given the approach in FII Test Claimantswith respect to the dividends from third countries on portfolio holdings, this seems very unlikely.

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investors. It would allow Member States to continue to apply general measures that restrictfree movement of capital with third countries, even when market access is unrestricted,provided the capital movement is connected to any of the enumerated categories.

As outlined earlier, it seems that a third country resident who sells residential realproperty in Finland in circumstances where an EU national (or resident) would beentitled to capital gains tax relief should be able to rely on Article 56 to gain entitlementto equivalent tax relief, based on Hollman. If the Finnish tax rules were in place at theend of 1993, Article 57(1) may grandfather them as a restriction involving real estateaccording to Holbock, even though the purpose of the tax rules is not to protect againstexcessive foreign ownership of Finnish land. With respect to capital gains tax on sharesor units of collective investment undertakings listed for trading on capital markets, onecan anticipate an argument that Article 57(1) applies, as it protects restrictions involvingadmission of securities to capital markets. The Holbock method of applying Article 57(1)transforms it from a general provision allowing pre-1994 national restrictions on accessto the EU market to remain, to a provision that can be applied either where the specificfacts involve the enumerated categories of investment or the restrictive measure generallyapplies to movements of capital including the enumerated categories.

Although ‘‘direct investment’’ is defined by Annex I and the Court has adopted thisdefinition in a number of judgments,142 there is still uncertainty as to its parameters.The concept concerns investments of any kind, and in particular the acquisition of sharesin companies or the lending of funds which serve ‘‘to establish or maintain lasting anddirect links’’ between the persons providing the capital and the undertaking that receivesthe capital for carrying out economic activities. With respect to company shares, a directinvestment implies that the shareholder holds sufficient shares to allow the shareholder,either according to relevant law or in some other way (perhaps through a shareholdervoting agreement), to participate effectively in the management of that company or inits control. However, direct investment is met at a lower threshold than establishment,which implies the holding of actual legal (or de facto) control by a single shareholder, notsimply ability to participate in control. Portfolio investments in shares are made ‘‘solelywith the intention of making a financial investment without any intention to influence themanagement and control of the undertaking’’.143

The line between direct and ‘‘portfolio’’ investments is obviously critical in determiningwhether Article 57(1) can protect a national measure. ‘‘Direct investment’’ is not a termdefined by international tax norms. There are a range of possible levels of investment inshares that may amount to direct investment. In Amurta, 14 per cent was seen as fallingwithin free movement of capital but this does not necessarily lead to a presumption thatthis was a portfolio holding, as Article 57(1) was not in issue in that case. Other possiblethresholds are 10 per cent,144 as is implied by the Parent-Subsidiary Directive’s definitionof parent and subsidiary as of 2009, or 25 per cent as is the threshold in the Interestand Royalty Directive. In DTCs between OECD members, the reduced withholding rate

142 Case C-446/04 FII Test Claimants [2007] STC 326; [2006] ECR I-11753 at [180]–[181]; Case C-157/05 Holbock [2007] ECR I-4051at [34]-[35]; Case C-284/04 Commission v Netherlands [2006] ECRI-9141 at [19].

143 Case C-284/04 Commission v Netherlands [2006] ECR I-9141.144 A.J. Easson, Taxation of Foreign Direct Investment: An Introduction Series on International Taxation

No. 24, (Kluwer Law International, The Hague, 1999) at 2 states that ‘‘usually, a threshold figure of10 percent is taken to distinguish direct from portfolio investment.’’

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for inter-corporate dividends tends to fall between 10 per cent and 25 per cent, perhapsindicating that the line between portfolio and direct investment falls within that range.

Since ‘‘direct investment’’ is a matter of EU law for the purposes of Articles 56 and57, the definitions in national law and considerations applied by the national courts indomestic cases and DTCs will not necessarily be adopted by the ECJ. The definition isbased in part on intention and circumstances, as is the definition of portfolio investment inthe ECJ’s case law. It will therefore have to be given substance on a case-by-case basis. A10 per cent shareholding in a company may be a direct investment in some circumstances,but not in others, depending on the relative voting power of the other shareholders andthe length of time the shares are held, or the intention of the holder in acquiring them.

The intra-EU direct tax case-law has compelled the Member States to amend their taxrules in numerous areas, often in anticipation of, rather than in response to ECJ rulings.145

The Commission often takes a judgment in favour of a taxpayer against a particularnational tax law in a preliminary ruling reference as a model for infringement proceedingsagainst other Member States, so that the process of delineating the scope of Article 56 isongoing, even in the intra-EU context. The absence of direct tax rulings based on freemovement of capital before 2000 (and 2006 in relation to third countries) could mean thatsince 1993 there have been many changes to Member States’ tax laws that restrict thirdcountry capital movements and are not protected by Article 57(1).

Article 57(2): existing Community competence and amendments in the Treaty of Lisbon

Article 57(2) sets out the Council’s power to legislate by qualified majority in the samebroad categories of capital movements as are listed in Article 57(1) with respect tothird countries, and requires unanimity where the measure ‘‘constitutes a step back’’ inliberalisation of capital movements.146 In the case of direct tax measures, unanimity isrequired for EU legislation in any event pursuant to Articles 94 and 95(2). Althoughunanimity is very difficult to attain in an EU of 27 Member States, it is quite conceivablethat the Council could adopt a measure to protect national (or EU) direct tax laws fromchallenges by third country litigants, and indeed the pending amendments in the Treatyof Lisbon, described below, indicate that all Member State governments have approvedthis in principle.

145 For example, many Member States amended their inbound dividend rules in response to the Verkooijenline of cases and the Communication from the Commission to the Council, the European Parliamentand the European Economic and Social Committee, ‘‘Dividend taxation of individuals in the InternalMarket’’ COM(2003) 810 final, Brussels, December 19, 2003. These include Germany, France, theUnited Kingdom, Italy, Belgium and the Netherlands. See R.J.Vann, ‘‘General Report’’ and U. Ilhiet al., ‘‘Dividend Taxation in the European Union’’ in Cahiers de droit fiscal international (Kluwer,Law International, The Hague, 2003) Vol. LXXXVIIIa 21 and 71 respectively; and the discussion of‘‘The Demise of Imputation’’ in M.J. Graetz and A.C. Warren Jr., ‘‘Income Tax Discrimination andthe Political and Economic Integration of Europe’’ (2006) 115 Yale Law Journal 1186 at 1208.

146 Art.57(2) provides: ‘‘Whilst endeavouring to achieve the objective of free movement of capital betweenMember States and third countries to the greatest extent possible and without prejudice to the otherChapters of this Treaty, the Council may, acting by a qualified majority on a proposal from theCommission, adopt measures on the movement of capital to or from third countries involving directinvestment—including investment in real estate—establishment, the provision of financial servicesor the admission of securities to capital markets. Unanimity shall be required for measures underthis paragraph which constitute a step back in Community law as regards the liberalisation of themovement of capital to or from third countries.’’

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Article 57(2) is not easily interpreted. This provision has not been expressly reliedon as the legal basis of any Community tax measure, and the ECJ has not had occasionto address its scope. It seems clear at least that liberalising measures on third countrymovements of capital which involve the enumerated categories require only a qualifiedmajority. Measures which have the effect of placing additional restrictions on suchEU-third country capital movements require unanimity.

As discussed with respect to Article 57(1), it is not obvious how to determine whethera measure is ‘‘on’’ capital movements to or from third countries ‘‘involving’’ (or not)direct investment, etc. If the Court applies a strict approach, a measure would have tobe directly or primarily concerned with capital movements with third countries, andinvolve the enumerated categories, for Article 57(2) to apply. If Article 57(2) covers anymeasure that has effects on third country capital movements, whether or not this is theintended, primary or direct effect, and also involves the enumerated categories, it is a verybroad basis of legislative competence given the extensive overlap of capital movementswith financial services, establishment, direct investment and securities admitted to capitalmarkets.

Article 2(60)147 of the Treaty of Lisbon will, when (and if) it enters into force, amendArticle 57(2) to clarify the legislative process for acts relating to the liberalisation ofcapital movements with third countries. The European Parliament and the Council willjointly adopt such measures in accordance with what is now the ‘‘co-decision procedure’’in Article 251. The second sentence of the current Article 57(2) will become paragraph57(3), so that ‘‘only the Council, acting in accordance with a special legislative procedure,may unanimously, and after consulting the European Parliament, adopt measures whichconstitute a step backwards in Union law as regards the liberalisation of the movement ofcapital to or from third countries.’’148

Most significantly, a new paragraph (4) is added to Article 58, that applies whereno measure has been adopted pursuant to the new Article 57(3). It will empower theCommission to adopt a decision, on the request of a Member State, that ‘‘restrictive taxmeasures adopted by a Member State concerning one or more third countries are to beconsidered compatible with the Treaties in so far as they are justified’’ by a Union objectiveand compatible with the proper functioning of the internal market. If the Commissionfails to adopt such a decision within three months of the Member State’s request, theCouncil may adopt the decision by unanimity.

New Article 58(4) reinstates a hierarchy between free movement of capital within theEU and with third countries that was eliminated in 1994 by Article 56(1), empoweringthe Union institutions to limit the latter in any situation where the restrictive tax measurewill not impede the functioning of the internal market. Since the purpose of the extensionof Article 56(1) to third countries in 1994 was ostensibly to support the euro as aninternational reserve currency, and no specific objective related to the internal market hasbeen identified, it is difficult to make a case that tax measures that restrict free movementof capital with third countries can impede the functioning of the internal market. The

147 In the consolidated versions of the new treaties as they will read after the Treaty of Lisbon is ratified,[2008] OJ C 115/47 at 73, Art.58(4) will be renumbered as Art.65(4) of the Treaty on the Functioningof the European Union.

148 New EC Treaty Art.249A states that a special legislative procedure refers to specific cases providedfor in the Treaties where the Council adopts an act with the participation of the European Parliament,or vice versa.

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euro has already achieved global status as an important international currency rivaling theUS dollar, so that it will be difficult to show that a restrictive tax measure could jeopardiseachievement of that goal.

More interesting will be the invoking of Union objectives to justify restrictive taxmeasures, as these will be less a matter of Treaty interpretation by judges and more aquestion of political and economic vision as to the future goals of the Union by MemberState and Union governance actors. New Article 58(4) could eliminate, from a practicalperspective, the standstill obligation on Member States in Article 57(1) with respect totheir tax laws, depending on the willingness of the Commission to approve new restrictivemeasures, or the solidarity of the Member States in the Council in defending eachother’s tax sovereignty vis-a-vis third countries. The three-month time period for theCommission to adopt a decision under Article 58(4) is very short, perhaps indicating thatMember States prefer to have control over the policy in the Council.

New Article 58(4) is also clearly a significant restriction of the Court’s jurisdictionto define the third country dimension of free movement of capital. The opportunity toregain power for the Member States in negotiating tax treaties, and reinstate reciprocityin the liberalisation of free movement of capital with third countries may well influenceCommission and Council in exercising their power under the new provision. The Court,by contrast, has held that loss of negotiating power and reciprocity as a result of theextension of free movement of capital to third countries is not a decisive consideration indetermining whether a tax measure is restrictive under Article 56(1) in respect of thirdcountries.149

Comparability of restriction and justifications in third country cases

As indicated at the beginning of this Part, the judgments in Skatteverket v A and FII TestClaimants in particular confirm that the prohibition of restrictions on free movement ofcapital applies in principle in third country cases as in intra-EU situations. However, theCourt also affirmed in these cases that it views the third country dimension in a differentlegal context that results from the degree of legal integration within the EU.

The different legal context is relevant to both stages of the inquiry, that is, to whethertwo differently treated situations are objectively comparable for the purposes of Article58(1)(a), and thus whether a measure is incompatible with Article 56, as well as to whetherthe measure is justified.150 Even though this has not been the basis of a ruling so far, ina future case the Court may rely on differences between the legal context inside the EUand in third countries to find that the situations are not the same, and that in the thirdcountry situation Article 58(1)(a) precludes a finding of restriction.

With respect to justifications, those that have been accepted in intra-EU cases discussedabove151 are undoubtedly also valid in the third country context, supplemented by others

149 Case C-101/05 Skatteverket v A [2007] ECR I-11531 at [38].150 Case C-446/04 FII Test Claimants [2007] STC 326; [2006] ECR I-11753 at [170]–[171]; Case

C-101/05 Skatteverket v A [2007] ECR I-11531 at [36]–[37] and Case C-194/06 OESF May 20, 2008at [89]–[90].

151 See the subheading above: Justifications: overriding reasons in the general interest.

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that have been rejected in intra-EU cases, based on the different legal context.152 Thejustification, always unsuccessful in intra-EU cases, of preventing erosion of the nationaltax base or diminution of government revenues is one of these. In FII Test Claimants,this argument, made in the abstract, was dismissed by Advocate General Geelhoed, butnot rejected as untenable in all circumstances. In OESF,153 the Netherlands governmentput forward this justification for the reduction in the concession it paid OESF, basedon the proportion of shareholders of OESF that were resident outside the Netherlands.The reduction was designed to ensure that the Netherlands recouped the differencein withholding tax on profits of the fund distributed as dividends to residents (25 percent) and the lower withholding tax of 15 per cent applied to dividends distributed tonon-residents. The ECJ rejected this argument as a justification in respect of reductionsrelated to investors resident in the EU since a reduction in tax revenue cannot justifya restriction of a fundamental freedom. On the issue of whether the measure could bejustified in relation to residents of third countries, the Court did not reject outright thepossibility that a reduction in tax revenue could be justified in the third country context.However, since the reduction had the same effect for residents of the EU and thirdcountries, it could not be justified on this basis. This may imply that the measure mightbe justified if the less favourable tax treatment affected only third country investors, butthe judgment is not clear on this.

The justification of ensuring the effectiveness of fiscal supervision was accepted inSkatteverket v A as an independent and sufficient justification for a tax restriction. Inthat case, Swedish tax legislation provided a tax exemption for dividends consisting ofshares of a subsidiary of the distributing corporation received from companies residentoutside Sweden, subject to a number of conditions. One of the conditions was thatthe DTC between Sweden and the country of the distributing corporation contain aprovision for the exchange of tax information. The Sweden-Switzerland DTC did notallow for the exchange of tax information as fully as the Mutual Assistance Directiveor the OECD Model Treaty. The taxpayer and the Commission argued that makingthe exemption dependent on the Swedish authorities’ ability under the DTC to ensurethe cooperation of the Swiss authorities was disproportionate given that Sweden couldrequire the taxpayer to provide that necessary information to establish that the necessaryconditions were fulfilled.154 However, the Court held that with respect to third countries,capital movements take place in a different legal context which affects the applicationof the principle of proportionality. Since the Community legislation on exchange of taxinformation (and requirements to publish company accounts) were not applicable, theCourt held that it was legitimate for a Member State to refuse a tax advantage that wasdependent on conditions that it is not able to verify without obtaining information fromthe third country and which that country is under no contractual obligation to supply.

The requirement to ensure effective fiscal supervision will undoubtedly be relied onoften in third country cases following Skatteverket v A. For third states, there is noequivalent multilateral instrument to the Mutual Assistance Directive, although there are

152 FII Test Claimants at [171]. See the discussion of justifications in third country cases in Cordeweneret al., fn.6 at 114 and in particular the view that the Court may be willing to justify measures thatcounteract competition from low tax jurisdictions at 117.

153 Case C-194/06, May 20, 2008 at [93].154 This position has been upheld by the Court within the EU in many cases. Recent among these is Case

C-451/05 ELISA 11 October 2007 at [97]–[98].

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other mechanisms for sharing of tax information, including the Convention on MutualAdministrative Assistance in Tax Matters, sponsored by the Council of Europe and theOECD. Belgium, Denmark, Finland, the Netherlands, Poland, Sweden and the UnitedKingdom have ratified this Convention, as have a number of EEA and other non-EUMember States including the United States.155

Some DTCs between EU Member States and third countries contain broad provisionsfor exchange of tax information, and even mutual assistance in tax collection. However,the provisions of the Convention and DTCs may not be seen as equivalent to the MutualAssistance Directive if they do not require the same level of automatic disclosure ofinformation and possibility for cooperation of tax authorities generally. The Court maytreat the Mutual Assistance Directive as having more significance as a tool for obtaininginformation from foreign competent authorities because it is a ‘‘domestic’’ EU measurewith direct effect and of which the Court is the ultimate interpreter.

The justification of prevention of fiscal evasion is closely related to and overlaps withthat of ensuring effective fiscal supervision, so it may be anticipated that the ECJ willbe equally willing to accept the former justification more broadly in third country cases.Moreover, given the Court’s evident concern that Article 56(1) could be illegitimatelyrelied on to obtain access to the other fundamental freedoms, the doctrine of ‘‘abuseof law’’ that allows the Court to refuse the benefit of a fundamental freedom if it isimproperly or fraudulently used to circumvent national law arises for consideration in thethird country dimension.

The issue arose in Fidium Finanz, where it was argued that the Swiss lender wasseeking to abuse Article 56(1) in order to circumvent the German law on supervision offinancial undertakings. The Advocate General recommended that this issue be referredto the national court for an objective determination of whether the conduct of FidiumFinanz was within the objectives of free movement of capital between the EU and thirdcountries, and a subjective determination of whether Fidium’s intention was to artificiallycreate the conditions to use Article 56(1) to circumvent the law on supervision of financialdealings.156 (The ECJ did not address this issue, having found that Article 56(1) wasinapplicable.)

In Cadbury Schweppes,157 the Court held that the fact that a Community national seeksto take advantage of lower taxes in another Member State cannot of itself constitute anabuse of the freedom of establishment. The purpose of freedom of establishment is toallow EU nationals the opportunity to choose where to base their commercial activities,and thereby to benefit from more favourable legislation in the host Member State.158 InBarbier159 the Court held that a Community national cannot be deprived of the right torely on Article 56(1) just because he has taken advantage of a rule in another MemberState that legally permits him to avoid or delay a tax liability.

In the third country direct tax cases, the question of abuse of law has two aspects. Itcould arise where a third country individual or undertaking seeks to rely on Article 56(1)

155 Norway, Iceland and Azerbaijan have also ratified this Convention. Canada and the Ukraine havesigned the Convention but it is not yet in force in these countries.

156 Case C-452/04 [2006] ECR I-9521 at [94]–[99].157 Case C-196/04 Cadbury Schweppes [2006] STC 1908; [2006] I-7998 at [35]–[37].158 Two leading cases on abuse of law in the area of freedom of establishment are Case C-212/97 Centros

[2000] STC 446; [1999] ECR I-159 and Inspire Art [2003] ECR I-10155.159 Case C-364/01 Barbier [2003] ECR I-5013 at [71].

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to gain access to other Treaty freedoms (as in Fidium Finanz), or when Article 56(1) isinvoked to challenge a national tax law that imposes a heavier tax burden on third countrycapital movements. The first situation will likely arise infrequently, as the Court hasclearly signalled its intention to exclude application of Article 56(1) where another Treatyfreedom is directly concerned, though on a different legal theory. In the second situation,where only free movement of capital is applicable, such as in respect of dividends onshareholdings that do not amount to establishment, it is difficult to see reliance on Article56(1) to obtain equal tax treatment as abusive unless there is an element of artificiality inthe investment.

Conclusions

Points of vulnerability in Member States’ tax laws

As discussed above, the taxation of income from portfolio investments, by third countryinvestors in EU shares and other securities, and by EU investors in such assets in thirdcountries, as well as wealth and inheritance tax, capital gains tax relief and donations toand taxation of foreign charities are the least likely to be affected by the two primarylimitations resulting from the Fidium Finanz judgment and the effects of Article 57(1). Itis in these areas that the third country dimension is likely to have the greatest impact.

The discriminatory tax treatment of investments by third country pension andinvestment funds in shares and interest-bearing debt issued by EU entities are potentiallysubject to challenge, given the number of intra-EU infringement actions initiated bythe Commission within the EU based on Article 56. In many cases, Member Statesprovide tax exemptions or other relief for resident funds but impose withholding taxon interest and dividends paid to foreign funds. In the other direction, third countryinvestors in a collective investment entity established in a Member State may be entitledto equivalent tax treatment to investors resident in the relevant Member State. OESFclearly prohibits more favourable treatment of collective investment funds that have onlyresident shareholders over those that have shareholders resident in other Member States;this most likely extends to funds that have shareholders resident in third countries.

With respect to inbound dividends received by an EU resident from a third country,the Member State’s system for taxing domestic dividends will be compared to the taximposed on the foreign source dividends. Following FII Test Claimants, a measurefavouring domestic over foreign dividends will infringe the third country dimension ofArticle 56(1) in the case of portfolio dividends. Article 57(1) will save tax restrictionsapplied to non-portfolio dividends where the restrictive tax rule was in existence before1994. The system of taxation of dividends in each Member State, particularly those thatacceded after 1993, will have to be analysed to see which restrictive measures are ofsufficient vintage to survive.

The future

The third country dimension of Article 56(1) is potentially very significant for theinternational taxation of investment and income from capital. Given the very impressiveflows of capital between the EU and third countries, the implications for EU MemberStates’ tax systems and revenues could be significant. The future third country direct tax

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cases must address complex issues with regard to when a measure involves free movementof capital and not, or not primarily, another freedom, the application of Article 57(1),the role of DTCs in neutralising restrictions and the circumstances in which existingjustifications as well as new ones applicable to the third country dimension should beapplied.

The first of the issues that has yet to be fully illuminated is how to draw the line betweendirect and portfolio investment for the purpose of applying the standstill in Article 57(1).The Court (and Annex I) have provided broad parameters, but the actual determinationwill often be left to the national court that referred the case. Nevertheless, it is to be hopedthat the Court will take future opportunities to refine the test in the interest of certaintyand uniformity. The related issue of the proper application of Article 57(1) has been fairlywell defined by the ECJ, allowing the national courts to carry out the factual analysis ofwhether a measure is to be treated as in place from December 31, 1993.

Another unresolved issue is how the Court will develop the application of thepredominant aspect test in tax cases. At one end of the spectrum of possibility, theCourt may apply the Fidium Finanz/Thin Cap approach broadly to exclude Article 56(1)wherever the impugned tax measures affect income or deductions derived in connectionwith transactions which involve financial services or establishment, or in connection withthe exercise of free movement rights by workers and EU citizens. Or, less probably, it mayfavour the Holbock analysis, treating general tax rules as not primarily concerned witha particular freedom, so that recourse to Article 56(1) is not automatically excluded incircumstances where another freedom would also be relevant if the movement of capitalwas between EU Member States.

In looking to the future, it must be recognised that the new powers of the Commissionand Council under the Treaty of Lisbon, if and when it enters into force, to declarerestrictive Member State tax measures with respect to third countries to be compatiblewith EU law could have the effect of excluding any significant impact of the third countrydimension on direct taxation. This will depend on the way these institutions, and theMember States, perceive the scope and proper use of these powers. Although the ECJ willstill have ultimate power to determine whether Commission or Council has exercised thepower within the authority conferred by the EC Treaty in a given instance, the powersaccorded by new Article 58(4) are undoubtedly broad, and it is difficult to imagine a taxrestriction with respect to one or more third countries that would not be consistent withthe functioning of the internal market.

The potential impact of Article 56 in relation to free movement of capital betweenEurope and the rest of the world is clear and significant. The actual impact will dependon the degree to which investors in both third countries and the EU assert their rights inMember State national courts.

EC law; Free movement of capital; Third countries

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