A cascading threat

Could withholding tax in the EU soon be a thing of the past? Jeremy Woolfe reports

One of many bastions that have been holding out against the implementation of the European Union’s single market now looks as if it may fall. The fortification could crumble to the surprising onslaught of a “legal opinion”. This “opinion” is from an advocate-general of the European Court of Justice (ECJ) in Luxembourg, whose crucial conclusion concerns withholding tax charged by the French authorities in a case involving Denkavit International BV, an animal feed company headquartered in the Netherlands.

With reference to Denkavit’s subsidiaries in France, the French Conseil d’Etat is asking the ECJ for its views on whether an EU member state can levy withholding tax on the dividends of a company paying out dividends to its parent company, which is located in another EU member state. It is asking this against the background that the withholding tax would not apply if the parent company was located in the same member state, in this case France. Another factor in the case concerns non-relief under application of the Double Taxation Convention (DTC).

Introducing the case, the advocate-general, Leendert Geelhoed, stated that, because it concerned a member state’s treatment of outgoing dividends, it raised “the issue of the scope of a source state’s obligations under Article 43 EC” of the EC (European Community) Treaty (formerly known as the Treaty of Rome). The article constitutes the right of an individual, or a company, not to be disadvantaged by internal borders within the EU. In other words, borders cannot be used as barriers to the rights of both citizens and companies.

In his conclusion, Geelhoed, whose term as an advocate-general ends in October, recommends that the ECJ should find that: “A measure which subjects non-French resident parent companies receiving dividends from French-resident subsidiaries to withholding tax on the dividends, but does not subject French-resident parent companies receiving dividends from French-resident subsidiaries to any tax on the dividends, is a discriminatory restriction of freedom of establishment contrary to Article 43 EC.”

He adds: “In principle, the actual effect of a DTC on a taxpayer’s situations should be taken into account in assessing whether, in a specific case, that taxpayer is discriminated against…”

Support for the opinion from the ECJ, based in Luxembourg, is not certain. But in 80%-90% of cases, the ECJ does uphold such opinions, at least in general, if not in all the details of the opinion. The system of having an advocate-general advising on cases is unique to the ECJ. Going back to the 1950s, it ensures that two different units look into the same case. For Denkavit, the ECJ’s final decision, which is not subject to appeal, could come later this year.

All this should in turn lead to a cascade of interpretations of EU law. It could eventually spill over from company tax into other fields, including life insurance, pensions and other spheres involving personal taxation, as well as investment instruments.

The advocate-general’s opinion is clearly relevant to the entire history of Brussels’ attempts to enforce single-market principles in practice. For instance, the position is clearly expressed in a “communication” from the European Commission, dated December 2003. Headed “Dividend taxation of individuals in the internal market”, it notes that a better functioning single market for equity will also help to achieve the Lisbon goal of bringing the EU economy up to speed. It states that the taxation of the dividends received by individual shareholders that are portfolio investors is the “area that is the most problematic in practice”. It defines portfolio investors as those who do not aim to influence the management of the target company.

The communication concludes that member states cannot levy higher taxes on inbound dividends than on domestic dividends. Likewise, they cannot levy higher taxes on outbound dividends than on domestic dividends. Member states “that may have focused on domestic effects” while designing their national tax laws are recommended in the communication to examine their systems in the light of the current treaty provision. They should adopt a co-ordinated approach to ensure a rapid removal of the tax obstacles that exist, thereby removing the uncertainty created by potential legal conflict and litigation.

One possible scenario following the Denkavit judgment will apply to international companies trading in the EU, including US companies, which have nearly $1,000bn worth of investments in the zone. For example, in due course, it may make sense for them to centralise pensions funding in Europe, instead of having 25 different funds.

However, the impending judgment over Denkavit, in the case which has been rumbling through the French national system since right back in the late 1980s, is unlikely to result in significant claims for tax wrongly paid in the past. Chas Roy-Chowdhury, ACCA’s head of taxation, told accounting & business that he thinks that when the ECJ comes to give its judgment, it is probable that it will not be so categorical as to backdate dues from governments to wronged companies.

“This will let EU member states off the hook,” he believes. Although the Marks & Spencer case was not directly comparable, he referred to its court caveats that softened any major blows to governments. In reality, the Denkavit opinion would turn out in the end to be not so much as even a shot across the bows for the French authorities, but just a rap across the knuckles, forecasts Roy-Chowdhury. He added that, in any case, the impact in the UK would not be as big as in other countries, because the UK had already abolished withholding tax on dividends.

Another commentator, Peter Cussons, international corporate tax partner at PwC, holds the view that interpretation of the opinion is not that simple. However, he sees as a final outcome that any ultimately unrelieved dividend withholding tax that is only due on a cross-border flow, and not on a comparable internal flow, would appear to be contrary to the EC Treaty. Hence, the Denkavit outcome could have a knock-on effect on the free movement of capital in a (portfolio) situation, and also to unit trusts.

Complaints

Cussons cites as relevant the failure of many member states to exempt from dividend or interest withholding tax (or both) pension funds established in another member state, while according such exemption to domestic funds. On this issue, the Commission received 26 complaints launched in December 2005 by the European Federation for Retirement Provision (EFRP) and PwC against a number of member states.

A commentator from the European Commission, Peter Schonewille, from the unit dealing with direct tax infringement cases, believes that the financial stakes are high, as cross-border intra-EU investments accounted for an important share of the total investments of European pension funds.

If the complaints by the EFRP and PwC were judged to be well-founded, the net income for European pension funds from cross-border intra-EU dividends and interest could go up by between 11%-33%. This was on the basis that the withholding tax rates under attack vary between 10% and 25%.

If a member state had to choose how to eliminate the difference in treatment between domestic and foreign pension funds, it could, said Schonewille, make one of two choices. It could either extend the exemption to withholding tax to the pension funds in the other EU and European Economic Association (EEA) states, or it could start to tax its own pension funds.

In many member states, pension funds were struggling to maintain the proper balance between assets and liabilities. In Schonewille’s view, politicians could find it difficult to disturb this balance by starting to tax the investment results of their pension funds.

Jeremy Woolfe is a financial journalist based in Brussels.