Thursday, December 14, 2006


With the exception of the Parent–Subsidiary Directive, there is no specific EC rules concerning dividend taxation. Therefore, it is reasonable to say that dividend taxation falls under the competence of each of the EU Member States, subject to the increasingly important limits under the fundamental freedoms established in the EC Treaty. As we have seen throughout the extensive case-law of the ECJ in the field of direct taxation, EC law impacts on national tax systems as a result of the combined application of the four freedoms and the prohibition of discrimination and discriminatory restrictions.

The decision of the ECJ in the Denkavit II case (C-170/05), which held that the French withholding tax on outbound dividends is incompatible with the freedom of establishment (Art. 43 of the EC Treaty), is a good example of those limits. Under certain tax systems, outbound taxation of dividends was sometimes distinguished from domestic situations, where dividends were paid and receive by resident entities. In the first case, a domestic withholding tax was levied, while in the later case no withholding tax was levied (in order to prevent for example the cascading of tax through chains of companies). This case simply says that in a EU scenario such distinction may prove to be incompatible with the treaty freedoms.

Dividend taxation under international tax law

The structure of the international income tax, drawn from the so-called international consensus, is based on the assumption that income tax is generally levied (i) on the domestic and foreign income of its residents (residence taxation) and (ii) the domestic income of non-residents (source taxation). Under such system, whilst the residence concept establishes a relationship between a particular jurisdiction and the taxpayer deriving the income, the source concept connects the income itself with a particular jurisdiction.

Under that framework, when considering the taxation of dividends it is then important to distinguish: (i) a withholding tax levied on the dividends paid by the company on behalf of the shareholder at the moment the dividends are paid out; (ii) the taxation at the level of the shareholder receiving the dividends.

Under international income tax law, dividends are usually sourced on the basis of the residence of the company paying them. As such, if a resident of one country earns dividend income from a source in another country, double taxation is likely to arise because one country will tax that income on a source basis (usually through a flat-rate final withholding tax on the gross amount of the dividends) and the other country on a residence basis (usually using a progressive income tax rate scale for individuals or a flat-rate for companies).

In this case, the internationally accepted regime is that the source country has the prior right to tax (although limited by reduced treaty rates), and the residence country is responsible for relieving any double taxation that results. Such relief is generally achieved through the exemption system (whereby the foreign income is exempted from tax in the residence country) or the foreign tax credit system (whereby the tax of the residence country on the foreign income is reduced by the amount of source country tax on the income). Under that model, this case has to be distinguished especially from the so-called economic double taxation, i.e. where two different persons are taxable in respect of the same income or capital.

The domestic withholding tax rate on outbound dividends is typically set between 20%-30%, which is then generally reduced to 5%-15% under the respective tax treaties. A usual feature found in outbound dividend taxation relates to the distinction between direct investment (an investor which has a controlling shareholding) and portfolio investment (where no controlling shareholding exists). This distinction is generally defined through an ownership percentage of the capital (for example the OECD Model uses a 25% ownership test).

It should be noted that in respect of inter-company dividends, many countries have chosen recently in their tax treaties to simply eliminate its dividend withholding tax. This situation is related with the wider trend of lowering corporate income tax rates, inclusion of domestic exemptions on certain outbound payments and the enactment of the Parent-Subsidiary Directive, which was recently extended to Switzerland. Nevertheless, at this stage one can say that withholding tax on outbound dividends is still the rule under treaties. The issue now is to see how the same issue is covered under the EC Law framework.

Outbound dividends in Europe - An (in)complete framework

The area of dividend taxation in Europe, in addition to the bilateral treaties, is fundamentally marked by the existence of a EU directive for the taxation of parent and subsidiary companies. The so-called Parent-subsidiary Directive (Council Directive 90/435/EEC) had an immediate effect on cross-border business transactions in Europe, by providing a comprehensive double tax relief throughout Europe for dividends flowing between companies from different Member States when the companies are in a parent/subsidiary relationship.

The Directive, which deals with issues that were previously the exclusive concern of tax treaties, basically requires that Member States: (i) refrain from imposing withholding taxes on distributions of profits made by subsidiary companies to their parent companies in other Member States; and (ii) to grant parent companies double taxation relief in respect of such income either by exempting it from further tax or by granting relief for the underlying company tax on the profits out of which the distribution is made.

Nevertheless, the scope of the Directive seems narrower (on the first element noted above) than the Dividend article found in tax treaties, since its application is limited to certain types of companies established in accordance with domestic law of the EU member states. Even though there have been recent extensions of its scope, there is a range of situations outside the coverage of the Parent/subsidiary Directive that may need to be assessed applying the fundamental freedoms case law.

Just imagine the treatment of EU inter-corporate dividends paid by a company that does not meet the requirements set out in Art. 2 of the Parent-Subsidiary Directive. For example it may be a dividend paid by a type of company that is not listed in the Annex. In addition, just imagine a payment of inter-company dividends that fails the 20% threshold requirements of Art. 3. On a more extreme scenario, just consider individuals, which are not covered by the Parent-Subsidiary Directive and therefore are required to incorporate their holdings, through a "listed" company, to achieve the same objectives of source taxation minimization.

What happens in these ""fringe" cases? Is the Member State authorized per se to withhold tax in those situations (or not provide relief) or do we have to read these "fringe" cases in conjunction with ECJ case-law on discrimination? But then comes along a French case on inter-corporate dividends, which fortunately covered taxable years when the Parent-Subsidiary Directive was still not in place.

The Denkavit II Decision

This case involved a dividend distribution from an (almost) fully owned French subsidiary to its Dutch parent company, Denkavit International BV. The problem derived from the fact that domestic dividends were not subject to withholding tax and were 95% exempt at the level of a French parent company, whilst, dividends distributed to a foreign parent were subject to a 25% withholding tax. This domestic withholding tax was nevertheless reduced to 5% under the French–Dutch tax treaty. Since, Denkavit International BV was unable to credit the 5% withholding tax because its dividend income was tax exempt under the Dutch participation exemption regime, it decided to claim a refund of that withholding tax on the basis that a EU parent company could not be treated less favourably than a French parent company.

The ECJ basically followed Advocate General Geelhoed opinion and held that France is precluded under EC Law to impose a withholding tax on dividends paid to a non-resident parent company if it provides an (almost full) exemption of dividend withholding tax to French resident parent companies. In addition, the ECJ held that the dividend withholding tax is prohibited, even if a tax treaty between the Source and Residence State provides for the Residence State taxation to be set off against the Source State withholding tax, if the parent company is unable to set off tax in the residence State, in the manner provided for by the tax treaty.

In taking this decision, the ECJ first pointed out that since the case related to years where the Parent-Subsidiary Directive did not apply, only the relevant provisions of the EC Treaty should be taken into account.

In a rather short decision, the ECJ arrived quickly to the conclusion that the French tax system, irrespective of the effect of the relevant tax treaty, gave rise to a difference in the tax treatment of dividends paid by a resident subsidiary (no withholding tax on domestic dividends and 25% withholding tax on outbound dividends) and that such difference constitutes in principle a prohibited restriction on the freedom of establishment.

The ECJ rejected therefore the French arguments based on the non-comparability between a domestic parent and a EU parent and the justification based on the territoriality principle (which was apparently ignored by the ECJ).

As to the controversial comparability aspect, the ECJ referred that as soon as France, either unilaterally or by way of a treaty, imposes tax on the dividend income, not only of resident shareholders, but also of non-resident shareholders, from dividends which they receive from a resident company, the situation of those non-resident shareholders (which have or not a fixed place of business in France) becomes comparable to that of resident shareholders.

The ECJ on paragraph 37 of the decision followed the preposition of the Advocate General and held that since the domestic exemption on dividends is designed to avoid economic double taxation, France is therefore required to extend such a relief (i.e. exemption) also to non-residents, to the extent that similar domestic double economic taxation results from the exercise of its tax jurisdiction over these non-residents. (1)

(1) According to the Advocate General, this follows from the principle that tax benefits granted by the source State to non-residents should equal those granted to residents in so far as the source State otherwise exercises equal tax jurisdiction over both groups.

The ECJ went on to state that the heavier tax burden on dividends paid to Netherlands parent companies (as compared to dividends paid to French parent companies) constitutes a discriminatory measure incompatible with the EC Treaty. In conclusion, France should not levy a withholding tax on outbound dividends.

The second part of the judgment concerned the equally controversial issue of the effects of tax treaties on the compatibility of domestic law with EC law. The issue here was whether a different answer should be given if a tax treaty exists between the source state and the resident state, whereby a parent company resident in the resident state may offset the withholding tax levied in the Source State, but because of the resident State tax system (i.e. participation exemption) such parent company is simply unable to set off the respective withholding tax. In fact, the Dutch participation regime simply prevented the possibility of offsetting the French withholding tax against Dutch corporate income tax, resulting in an excess tax credit of 5%.

The ECJ was again short in its argumentation and held that in such a case, the combined application of treaty and Residence State participation exemption rules does not serve to overcome the effects of the restriction on freedom of establishment and therefore constitutes incompatible discrimination against foreign parent companies. In reaching its decision, the ECJ rejected the French argumentation that under international tax law it is for the Residence State and not for the Source State, in which the taxed income has its source, to rectify the effects of double taxation.

What is (not so) clear from Denkavit II?

The Advocate General Geelhoed intellectual construction, which distinguishes between home and source State obligations, appears to have been accepted by the ECJ. This means that the obligation of the Source State only arises insofar as it exercises its tax jurisdiction over the non-residents. In this case, the source State cannot discriminate between resident and non-resident taxpayers. On Denkavit II, the ECJ appears to oblige the Source State (France) to extend a relief for economic double taxation to the non-resident (Netherlands) equivalent to the relief given in the Source State. But is this case applicable on other types of income?

The particular features of this case appear also to point out that it only applies in circumstances where the Residence State is an exemption country. This link (between the exemption method and the outcome) although not entirely clear may be extracted from paragraph 54, which refers to the combined application of the tax treaty and the relevant domestic legislation (which in that case “does not serve to overcome the effects of the restriction on freedom of establishment”). Is this sufficient to rule out a case under the credit method?

First question: Does the ECJ mean that the case is only applicable to dividend withholding tax situations such as the one found in France-Netherlands? What if the residence state operates through a credit method? What about withholding tax on other types of income?

Another problem, left untouched, is that by doing so (i.e. extending the relief), the Netherlands parent company is slightly better of than a "comparable" French resident company. This is the case, since the exemption in France covers only 95% of the dividend income, whilst the Dutch participation exemption covers the full dividend income (100%). In limit, this should not prevent France to levy a least a withholding tax on the difference (33% of 5%= 1.65).

Second question: Is France then still allowed to tax this residual amount? If yes, at which rate? Treaty rate or CIT rate?

It is needless to say that this decision will have also an impact on Member States that apply a participation exemption regime for domestic parent companies, while applying a withholding tax on outbound dividends paid to EU parent companies, namely when the conditions for exemption under the Parent-Subsidiary Directive are not met. Just imagine, as is the case in various EU member states, that that holding thresholds for the domestic participation exemption and Parent-Subsidiary Directive differ. Nevertheless, governments may easily correct this difference by simply adjusting (upwards) the domestic thresholds or (downwards) the outbound thresholds. The problem here is that experience has shown that the adjustments made as a consequence of ECJ case law have in many instances worsened the position of domestic taxpayers. For example the legislative reaction to the Lankhorst Hohorst case (C-324/00), which found the German rules on thin capitalization in violation of the Treaty, resulted in some cases on the extension of thin-cap rules to domestic creditors.

Third Question: how will governments react to Denkavit II?

Another issue will be, whether such a case would be decided in the same way for portfolio participations that fall under the scope of free movement of capital (Art. 56 EC). The existing ECJ case law seems already to indicate that the same conclusion may be drawn. And what if we are in a third-country scenario? And what if the residence state has a credit system and there is an apparent cash-flow disadvantage on having a withholding tax on the outbound dividend and only later a credit? Here the pending Amurta case (C-379/05) will probably provide an answer in that respect.(2)

(2) The Amurta case, which also focuses on the compatibility of withholding tax on intercompany dividend, deals with the specific case where a company (resident in Portugal) owning 14% of the shares of a Dutch company, receives a dividend from which 25% Dutch withholding tax was withheld. Amurta filed an objection against the levy of withholding tax and argued that such levy violated the free movement of capital as included in Art. 56 of the EC Treaty, arguing that, had the company been resident in the Netherlands, no dividend withholding tax would have been due (based upon the participation exemption rules).

Fourth Question: can we apply the same line of reasoning of Denkavit to cases falling under the free movement of capital? Again, what if the residence state is a credit country and not an exemption?

The ECJ apparently ignored or diplomatically avoided to touch upon the controversial position used by former Advocate General Geelhoed, which distinguishes between “true” and “quasi” restrictions, whereby the latter restrictions fall outside the scope of the Treaty and therefore should only be eliminated by legislative action.(3)

(3) Using the words of the former Advocate General Geelhoed, "Quasi-restrictions result directly and inevitably from the juxtaposition of systems and in particular from: (1) the existence of cumulative administrative compliance burdens for companies active cross-border; (2) the existence of disparities between national tax systems; and (3) the necessity to divide tax jurisdiction, meaning the dislocation of the base."

Fifth Question: does this mean that the distinction between “true” and “quasi” restrictions is still hanging in the air?

In the end, litigation in this area will result in the necessity of symmetry between thresholds of participation exemption. In that regard, another area now left open by this case is its impact on "fringe" cases that fall outside the directive, such as dividends paid by type of companies that are not listed in the Annex of the parent-subsidiary Directive. This discussion of course raises the issue of the relationship between primary (EC Treaty) and secondary Community law (Directives), which is far from clear. One can say, that even if a certain area has been harmonized through a Directive, this does not entail the creation of an invulnerable domain, immune from the influence of the fundamental principles set out by the EC Treaty.

Sixth Question: can we apply the same line of reasoning of Denkavit II to cases outside the subjective scope of the Parent-Subsidiary Directive?

And what about individuals? Is it another ball game altogether as some say or can we also apply the same principles? As the EU Commission rightly puts it in the communication "Dividend taxation of individuals in the Internal Market (COM (2003) 810), "a Member State cannot levy tax a withholding tax on outbound dividends and exempt domestic dividends, as it would tax outbound dividends higher than domestic dividends." Nevertheless, the Commission also alerted to the fact that in assessing the higher burden, a simple comparison of the withholding tax rates is not sufficient. In fact, the basis of comparison should be for the domestic dividends the combined effect of any domestic withholding tax rate plus the domestic income taxation and for the outbound dividend the withholding tax rate on the outbound dividend. Looking at the existing case-law of the ECJ, which has mainly focused on inbound dividends, also here some doubts start popping!

Seventh Question: what about individuals? Is it another ball game altogether?

Any other questions?



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