Euro Tax Flash from KPMG's EU Tax Centre

CJEU – Spain – Articles 63 TFEU and 65 TFEU – Free movement of capital – Dividend withholding tax – Refund of tax withheld at source to non-resident recipients of dividends – Cross-border investments – Investment funds

The plaintiff is a US collective investment undertaking that qualified as a regulated investment company under US law. During the 2007 to 2010 tax years, the plaintiff received dividends from its investments in Spanish companies. The dividends were subject to Spanish withholding tax (IRNR - impuesto sobre la renta de los no residents, i.e., income tax of non-residents) at a rate of 15 percent. By contrast, Spanish resident collective investment undertakings were subject to a 1 percent corporate income tax rate on comparable dividend income. The plaintiff requested a refund with respect to the difference, arguing that the higher tax burden imposed on non-resident funds constituted a restriction on the free movement of capital under Article 63 of the Treaty on the Functioning of the European Union (TFEU).

Under US tax rules applicable to regulated investment companies, the plaintiff elected a tax-transparent regime under which dividend income was attributed to its shareholders rather than taxed at fund level. The fund also transferred to its investors the foreign tax credit associated with Spanish withholding taxes.

The Spanish Taxation Agency rejected the refund claims on the grounds that the plaintiff’s situation was not objectively comparable to that of Spanish collective investment undertakings, and that, in any event, the restriction on the free movement resulting from the disputed taxes had been neutralized. Following an appeal, the Spanish National High Court upheld the action of the taxpayer and granted the refund with interest, finding that the Spanish withholding tax regime discriminated against non-resident investment funds and that the Spanish tax authorities had failed to demonstrate that the resulting disadvantage had been effectively neutralized through foreign tax credits. In particular, that court held that it is for the tax authorities to prove neutralization by using the information exchange methods provided for by double tax treaties in order to obtain the necessary information, without it being possible to accept a reversal of the burden of proof on the basis of the principle of ‘ease of proof’. The Spanish State Legal Department, representing the Taxation Agency, appealed to the Spanish Supreme Court, which referred the case to the CJEU.

In essence, the Spanish Supreme Court asked the CJEU whether there is a restriction on the free movement of capital under Article 63 TFEU where a fund does not benefit from the same treatment as a comparable domestic fund due to its decision to be treated as tax transparent under the applicable double tax treaty and the fund’s domestic legislation, and transfer the related tax credits to its investors.  The fund could have exercised the option to be taxed (i.e., at fund, rather than investor, level) which would , in principle, have allowed it to deduct the full amount of excess Spanish withholding tax. However, such an option would have been binding with respect to all income earned by the fund.

The Court first noted that, although the request for a preliminary ruling primarily concerned the circumstances in which a restriction on the free movement of capital may be neutralized by a double tax treaty, several governments disputed both the existence of such a restriction and the comparability of a non-resident fiscally transparent collective investment undertaking with a resident investment undertaking. In those circumstances, the Court considered it necessary to determine, before examining the potential relevance of the tax treaty, whether the national legislation at issue constituted a restriction on the free movement of capital and whether the situations concerned were comparable.

Existence of a restriction on the free movement of capital

The Court recalled that Article 63 TFEU prohibits national measures that treat cross-border capital movements less favorably than purely domestic capital movements, as such measures may discourage non-resident entities from investing in a Member State.

In the case at hand, dividends distributed to Spanish-resident investment funds were subject to corporate income tax at a rate of 1 percent, whereas dividends distributed to the plaintiff were subject to Spanish withholding tax at a rate of 15 percent. The Court therefore held that dividends paid to non-resident investment funds were subject to a less favorable tax treatment, constituting a restriction on the free movement of capital.

The Court further clarified that this conclusion was not affected by the fact that the plaintiff was subject to tax on the Spanish dividends in its state of residence under a tax transparency regime and passed both the dividends and the related tax credit through to its investors. The less favorable tax treatment resulted from Spain’s exercise of its taxing powers and arose solely because the dividends were paid to a non-resident fund.

Comparability of resident and non-resident investment funds

The Court recalled that a difference in tax treatment may be compatible with EU law where it concerns situations that are not objectively comparable or, alternatively, where it is justified by an overriding reason in the public interest.

The CJEU noted that, according to its settled case-law, the comparability of a cross-border situation with a purely domestic situation must be assessed in light of the objective pursued by the national legislation at issue, as well as the purpose and content of the relevant provisions. It further emphasized that only the distinguishing criteria established by that legislation are relevant when determining whether a difference in treatment reflects a difference in objective circumstances.

In that regard, the Court observed that, once a Member State chooses to subject dividends received by both resident and non-resident investment funds to taxation, the situations of those funds become comparable for the purposes of that taxation.

The Court further noted that it was ultimately for the referring court to determine whether the situations at issue were objectively comparable. However, the wording of the request for a preliminary ruling suggested that the referring court considered the US and Spanish investment funds to be in objectively comparable situations.

Neutralization under a double tax treaty

The Court then considered whether the restriction could nevertheless be neutralized through the application of the Spain-US double tax treaty.

The CJEU recalled its settled case-law according to which discriminatory treatment between resident and non-resident taxpayers can be neutralized through a double tax treaty concluded with another Member States or with a third country. However, in order for equivalent treatment between residents and non-residents to be ensured, the application of the treaty must offset in full the disadvantage resulting from national legislation. The Court reiterated that a mechanism that limits a credit for tax paid in the source state to the amount of tax payable in the state of residence does not guarantee neutralization in all circumstances. Full relief is possible only where the tax due on the dividends in the state of residence is at least equal to the withholding tax imposed by the source state.

The Court continued by addressing the arguments of the referring Spanish Supreme Court, the governments participating in the proceedings, and the European Commission that the treaty potentially allowed the additional Spanish tax burden to be fully credited in the United States¹. The CJEU noted that it is for the Spanish Supreme Court to determine whether the double tax treaty concluded between Spain and the United States permitted such a full credit. The Court also reiterated that it is not competent, in preliminary ruling proceedings, to interpret the provisions of a tax treaty concluded between a Member State and a third country.

Theoretical deduction at the level of the fund

Whilst refraining from expressing a view on whether the double tax treaty actually provides effective neutralization, the Court examined whether the discriminatory Spanish withholding tax could, in principle, be neutralized at the level of the fund itself through the Spain-US double tax treaty.

In this context, the Court observed that, even if the treaty allowed the Spanish withholding tax to be fully deducted against the fund’s US tax liability, the plaintiff could not benefit from that deduction. Having opted for a tax transparency regime, the fund was not taxed on the dividends in the United States and passed both the dividends and the corresponding Spanish tax burden to its investors. As a result, any deduction at fund level was purely theoretical.

The Court further found that a Member State cannot be regarded as having complied with its obligations where a non-resident investment fund cannot benefit from the relevant treaty because it chose a non-mandatory tax transparency regime, absent any abuse or fraud. Accordingly, the differential treatment between resident and non-resident funds could not be regarded as neutralized at the level of the fund.

Possible neutralization at investor level

Against that background, recognizing that the tax transparent regime operates by passing both the dividend income and the associated foreign tax credit to the investors, the Court considered whether the neutralization analysis should instead be carried out at the investor level. In particular, the Court noted that under Article 24(2)(a) of the Spain-US double tax treaty the United States allows its residents or citizens to credit against income tax due in the US not only income tax paid in Spain by them but also such tax paid on their behalf.

In the Court’s view, it cannot therefore be ruled out that the doubled tax treaty between Spain and the United States might allow the plaintiff’s unit-holders (investors) to benefit from the deduction or the tax credit corresponding to the withholding tax levied in Spain on the dividends. It is for the referring court to verify whether the treaty could be interpreted in this way. In this regard, the Court made clear that neutralization can be established only if the investors are able, in practice and not merely in theory, to obtain full relief for the Spanish tax burden.

Conclusion

The CJEU concluded that a restriction on the free movement of capital may be considered neutralized only where the non-resident investment fund (that elects to be treated as transparent for tax purposes and passes on to its investors both the dividends received and the tax credit corresponding to the Spanish withholding tax) is able to rely effectively on the applicable tax treaty to reduce its tax liability in its State of residence by an amount corresponding to the difference between the tax rate applied in Spain to dividends paid to non-resident investment funds and the tax rate applied to dividends paid to resident investment funds.

The CJEU decision is broadly in line with its previous case-law on the circumstances in which a restriction on the free movement of capital may be regarded as neutralized through the application of a double tax treaty. Importantly, the CJEU confirmed that a restriction on the free movement of capital cannot be neutralized simply because fund could have chosen a tax treatment in its state of residence that could have allowed it to use the foreign tax credit. Furthermore, the mere existence of a theoretical possibility to claim a foreign tax deduction is not sufficient. Rather, neutralization requires that the taxpayer concerned, or potentially its investors, can effectively obtain full relief for the discriminatory tax burden, i.e., for tax paid in excess of what is due by a comparable resident fund.

It remains to be seen whether the Spanish Court can determine whether the discrimination was neutralized at the level of the shareholders. In its decision, the CJEU did not comment on who that burden of proof should rest with, i.e., the tax authorities, based on information exchanged under the relevant treaty provisions (as concluded by the Spanish National High Court), or the plaintiff.

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