European Tax Federalism — Recent Decisions of the ECJ

By Philip D. Morrison, Esq. Deloitte Tax LLP, Washington, DC

Casual students of American history will recall that judicial decisions regarding taxes played only a minor role in knitting together the various states into a national whole and enhancing the role of the federal government. While McCulloch v. Maryland1 was not unimportant, legislative and executive actions up to and through the Civil War, and especially the Civil War itself, played a much bigger part than any judicial tax decisions in having people switch from referring to the United States in the plural (“These United States they…”) to the more federal-oriented singular (“TheUnited States it…”). The federal/state balance still remains something of a work-in-progress in the United States, of course, but it took an internecine bloodbath2 and the military subjugation of an entire region to truly create a union out of the United States.

Fortunately, Europe is taking a more peaceful route to unity, and taxes and judicial decisions thereon seem to be one important element in progress to date. The United States of Europe still may be somewhere in the future, but federalism with respect to taxes in the EU has made significant progress in the past few years. Indeed, the European Court of Justice (ECJ) seems to be bringing a modicum of uniformity to European taxation almost single-handedly, without executive or legislative assistance. It is accomplishing this task through its decisions holding various aspects of various EU Member States' tax legislation invalid under the EC Treaty.

Since its decision in the Cadbury-Schweppescases in September 2006, the ECJ has decided numerous cases invalidating portions of Member States' tax legislation, a few of which are discussed below. It is important for U.S. international tax planners to know the basics of some of these cases, not simply to understand the evolution of European income taxation, but also because some of them open planning opportunities for more tax-efficient financing, repatriation of profits, or other cross-border flexibility.

Most recently, in the Societe Papilloncase, the ECJ held the French tax consolidation regime invalid under Article 43 of the EC Treaty as a discriminatory restriction on the freedom of establishment. The offending aspect of the French legislation was the restriction against the consolidation of French subsidiaries held indirectly by a French parent through an intermediary holding company resident outside France (including in another EU country). Thus, after this decision, if France is to continue to permit consolidation, it must allow, for example, consolidation of French affiliates even if their French parent holds them through a Luxembourg holding company. Such a system (as currently exists in the United Kingdom) allows for certain “double-dip” financing structures that avoid the U.S. dual consolidated loss rules.

In the Orange European Smallcap Fund case, the ECJ concluded that a portion of the Dutch tax regime applicable to fiscal investment institutions (mutual funds) was inconsistent with the EC Treaty's prohibition against restrictions on the free movement of capital among EU member countries. Dutch rules generally grant relief for foreign dividend withholding tax with respect to dividends received by the fund. However, Dutch law limits the relief if the fund has foreign shareholders. In that case, relief is granted only to the extent that shares in the fund are held by Dutch resident shareholders. The court found this to be an obstacle for Dutch funds trying to raise capital from residents of other EU Member States and a restriction on the ability of such residents to invest in such funds, both in contravention of the free flow of capital guarantee under the EC Treaty.

The ECJ addressed the U.K. system of taxing companies on foreign-source dividends in the Test Claimants in the FII Group Litigationcase decided in December 2006. Like the United States, the U.K. system under attack in that case: (1) exempted intercompany dividends between U.K.-resident companies (but, unlike the United States, allowed a complete exemption regardless of percentage of share ownership); (2) provided an indirect foreign tax credit for foreign corporate taxes imposed on the earnings distributed by foreign companies to U.K. 10%-or-greater shareholders; and (3) provided a direct foreign tax credit for withholding tax imposed on foreign-source dividends. The court concluded that restricting the indirect credit to 10%-or-greater shareholders for foreign-source dividends, while permitting exemption on domestic dividends regardless of the size of the shareholding, was an impermissible restriction on the free movement of capital within the EU.

Similarly, in May 2008, the Advocate General opined that the Belgian dividends-received deduction (DRD) is incompatible with the EC Parent-Subsidiary Directive. The offense apparently was that the 95% DRD could not be claimed in a year when there were insufficient profits against which to use the DRD. Thus, in the case at hand (Cobelfret), dividends from other EU subsidiaries would be subject to double tax since the loss carryforward for the parent would be smaller than if the DRD were permitted.

In March 2007, in the Columbus Container Servicescase, the Advocate General opined against a portion of Germany's CFC rules known as the “switch-over clause.” The switch-over clause provides for application of the credit method rather than the exemption method to avoid double taxation in respect of low-taxed passive income derived by a foreign permanent establishment (PE) of German resident taxpayers. The AG concluded that the switch-over clause constituted a restriction on both the freedom of establishment and the free movement of capital principles because it only applied where the corporate income tax burden in the PE country was lower than the German burden (as was the case at hand, dealing with a Belgian Coordination Center).

Also in March 2007, the ECJ rendered its decision in the Rewe Zentralfinanzcase, holding a German restriction on foreign subsidiary losses incompatible with the freedom of establishment principle of the EC Treaty. Under the German rules, German parent companies were allowed to write down the value of their shares in loss-making German subsidiaries but were restricted in writing down the value of shares of loss-making non-German subsidiaries. A limited exception to the rule was not applicable because the taxpayer did not meet the requirements for an “activity test.” The court concluded that the activity test went beyond what is necessary to target purely artificial arrangements. While the decision has limited direct applicability due to German law changes since the years at issue, the decision puts into question all activity clauses applied under national laws of EU countries to cross-border situations.

In January 2008, the ECJ struck down a Belgian thin cap rule that reclassified excessive interest as a dividend. The offending rule provided that interest is reclassified as a dividend to the extent that a loan exceeds the sum of paid-up capital and taxable reserves. Unfortunately for Belgium, the reclassification was not mandated where the putative interest was paid to a director that is a Belgian company. In N.V. Lammers & Van Cleeff,the ECJ held that these provisions conflicted with the freedom of establishment principle.

While the ECJ has no real jurisdiction in such cases, the European Commission even occasionally reaches outside of the EU to try to force tax law changes (at least as regards treatment of EU-based companies). In February 2007, the Commission complained that certain Swiss cantonal tax regimes that favor holding and management companies (and that had succeeded in attracting the headquarters of some European multinationals) were a form of prohibited “state aid.” Of course, Switzerland is not a member of the EU, so the concept of state aid in the form of lower taxes for special sorts of operations being prohibited under EU law was not applicable to the Swiss. The Commission justified its complaint, however, by claiming that the “state aid” violated the 1972 EU-Switzerland Free Trade Agreement. Since the FTA only addresses trade in certain goods, and does not address harmonization of company taxation, these claims also surprised the Swiss. This bit of overreaching on the part of the European Commission might also have dismayed free traders in other low-tax jurisdictions around the world, since such a claim surely will not encourage others to enter into free trade agreements with the EU without clarity that company income taxation is not mandated to be uniform.

The ECJ and the Advocate General seem to be moderately aggressive in deciding that various national tax rules are incompatible with the EC Treaty. They also seem to have been presented by taxpayers and national courts with a very large number of opportunities to so find. It also appears that national legislatures relatively quickly respond to these decisions, enacting changes to their countries' tax laws to fix the offending provisions within a short period of time. It also seems as though it is increasingly challenging for national legislatures within the EU to combat creative tax planning in ways other than those directed at clear abuses. Where European freedoms established by the EC Treaty may be infringed, scalpels must be wielded where once hatchets worked.

So, without Directives or EC-level legislation, the EU is moving closer and closer to income tax harmony. The EU judicial system, through the ECJ and the Advocate General, are actively pushing the disparate EU income tax systems much closer together. And, so far at least, there are no signs of any impending diplomatic, let alone military, reactions.

This commentary also will appear in the February 2009, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Liebman, 999 T.M., Business Operations in the European Union.

1 17 U.S. 316 (1819) (overturning Maryland's statute taxing the Bank of the United States, “The power to tax is the power to destroy….”).

2 Bloodbath is not hyperbole. Out of an 1860 total U.S. population of 31,440,000 (some 4 million of whom were slaves), approximately 620,000 soldiers died during the Civil War, a vastly higher percentage than in any American war before or since. Since military units were typically drawn from single localities, and since some units suffered horrific levels of casualties, the effects were often devastating. One regiment, the 26th North Carolina, lost 714 of its 800 men at Gettysburg -- in numbers and percentage terms the war's greatest losses.