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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
In joined cases C-338/11 to C-347/11, referred to by name as FIM Santander Top 25 Euro Fi, the European Court of Justice (ECJ) ruled on May 10, 2012, that France's 25% withholding tax on dividends paid to non-French (including U.S.) investment funds violated the European Union's (EU's) prohibition on discrimination with respect to the free movement of capital. The case is being referred to as a bombshell, not the least because France will be required to refund as much as $20 billion of taxes illegally collected in past periods. Yet, the writing has been on the wall for at least a decade. The only wonder is why countries in the EU persist in their outmoded approach to taxing investment funds.
The facts of the case are extremely simple. France imposed a 25% withholding tax on French-source dividends paid to any non-French investment fund, commonly referred to in the EU as an "Undertaking for Collective Investments in Transferable Securities" or a "UCITS." France imposed no withholding tax on French-source dividends paid to UCITSs formed in France. The question before the ECJ was whether the differing treatment of French and non-French UCITSs violated the EU's free movement of capital rules, which apply within and outside of the EU.
On its face, of course, the French regime was clearly discriminatory. But the French government argued that such discrimination was justified because the situation of non-French funds was not comparable to that of French funds. France seems to have taken the view that, at least on average, investors in French funds would themselves be French individuals and therefore subject to French tax on their income derived from the funds, whereas investors in non-French funds would be from other countries and thus would never pay French tax on French-source dividends, absent the 25% withholding tax.
The ECJ framed the question as whether the tax posture of a fund's shareholders could be taken into account in determining whether a measure was an impermissible restriction on the free movement of capital. It ruled in the negative on that question. Essentially, the court refused to treat funds as transparent and look through them to inquire into the composition of their shareholders.
And therein lay the root of the French government's dilemma. Because France treats a UCITS as an opaque, separate entity, and does not look through it as if it were a mere partnership or aggregation of investors, it was disingenuous for France to argue that the status of the shareholders should be taken into account in the analysis of the case. If France were to look through a fund and find only French shareholders, it would be within its competence to tax them personally and not tax the fund. But if it did so, it would then have to look through non-French funds to inquire whether their shareholders were French, or were residents of jurisdictions with which France had a tax treaty reducing the rate of the French withholding tax. This, of course, France does not do. As the court put it in ¶ 28 of its decision:… where a Member State chooses to exercise its tax jurisdiction over dividends distributed by resident companies on the sole basis of the place of residence of the recipient UCITS, the tax situation of the latter's shareholders is irrelevant for the purpose of determining whether or not that legislation is discriminatory.
In refusing to take into account the status of the fund's shareholders, the ECJ's decision distinguished the case of Orange European Small Cap Fund,1 dealing with a fund based in The Netherlands. The Dutch scheme for taxing a UCITS, which imposes a zero rate of tax on the fund itself, is explicitly conditioned on the requirement that the fund distribute its profits to its shareholders annually. This type of regime ensures that the income of the fund is taxable at the shareholder level, without deferral. In this type of regime, the status of the shareholders can be taken into account, because they are the ones bearing the tax. In the French system, there is no requirement that a fund's income be passed through to its shareholders.
(As an aside, the French refusal to look through even entities classified as partnerships is well known. It may be due to a concern with the practical difficulty of enforcing a source-based tax outside French borders. The tax treaty between the United States and France attempts to deal with this problem in two ways. First, it provides for partnership look-through rules in derogation of the French norm. Second, it treats certain corporate investment funds as beneficial owners. The latter rule means that any French-source dividends paid to a U.S. mutual fund are subject to tax at the reduced treaty rate of only 15%.)
What could France - and other countries - do to protect their revenue base without running afoul of the EU's four freedoms? As I have argued in the past, the taxation of investment funds needs to be redesigned to take account of modern global investing.2 As the Santander court realized, UCITSs are simply intermediaries through which a collection of persons invests in underlying securities. Because they are so, double taxation of income earned by the fund should be avoided. Individuals who invest in securities through investment funds should be taxed in the same manner as they would be taxed if they had invested in the underlying securities directly.
As the Santander case (as well as the Orange Smallcap case) illustrates, treating a fund as tax-neutral is easy to say, but very difficult to do in practice, particularly where the fund earns income from a third country and/or has shareholders that reside outside the fund's country of residence. The Santander case illustrates only one of these problems, which arises when a source country (here, France) fails to look through a foreign fund to ascertain the status of that fund's shareholders. If the source country were to zero-rate all dividends paid to a foreign fund, it would collect no revenue at all. But if it instead seeks to impose a withholding tax without looking through to the status of the recipient fund's shareholders, it risks overwithholding in violation of EU rules where some of those shareholders reside in its own country, or in countries with which the source state has a treaty reducing the rate of its withholding tax.
Another problem with this approach was illustrated in the Orange Smallcap case. The Dutch fund there received dividends from countries with which The Netherlands had no treaty, or at least no treaty reducing the withholding tax to the rate applicable to Dutch individuals. Dutch legislation solved the problem in part, but did not go far enough. The Dutch legislation provided a tax reduction or "concession" for the foreign taxes withheld when dividends were paid by the Dutch fund to its shareholders, but only in the proportion that its shareholders were Dutch residents. To the extent the fund had non-Dutch shareholders, no concession was given, and the net cost of the third-country withholding tax was, therefore, borne economically by all of the fund's shareholders - including those who were Dutch and including those who would have been entitled to a lower treaty rate of withholding on the underlying dividends had they invested directly. The ECJ ruled that the Dutch legislation violated the prohibition on restriction of the free movement of capital, due to this rather arbitrary regime.
There are only one or two ways to accommodate the revenue interests of all parties in this model. One would be for all countries to give effect to the residence of a fund's shareholders and look through a fund to provide treaty benefits based on the residence of those shareholders. The other would be for all countries to agree to impose a source-basis withholding tax of, say, 15%, and to pass that credit through to all shareholders, with the home country of each shareholder crediting the foreign tax paid. These rules are easy to write on paper, but obviously very difficult to reach agreement on in practice.
An interesting aspect of the Santander case is in its interplay with an assumption that the ECJ made quite explicitly in the Orange Smallcap case. In Orange Smallcap, the court stated that the source country from which dividends were paid was free to collect a withholding tax if its treaty with the fund's state of residence did not provide otherwise. Yet in Santander, the court ruled that France was not free to do exactly that. The reason France was unable to collect its withholding tax was that France discriminated in favor of French funds, withholding no tax in those cases. The court made clear that the French regime would have passed muster if France had imposed the same 25% withholding tax on French funds as it did on non-French ones.3 While this approach would make the French regime non-discriminatory, it would do nothing to alleviate double taxation across countries. The saga will, therefore, certainly continue.
This commentary also will appear in the July 2012 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Milhac and Bailleul-Mirabaud, 961 T.M., Business Operations in France.
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