Relationship between the EU free movement of capital and the freedom of establishment in the field of direct taxation in third country situations

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1 Relationship between the EU free movement of capital and the freedom of establishment in the field of direct taxation in third country situations D.S. Smit LL.M. Tilburg University, Ernst & Young LLP, the Netherlands 1 Introduction In this discussion paper I will elaborate on the question as to the relationship between the free movement of capital and the other EU Treaty freedoms, particularly the freedom of establishment, in third country situations in the field of direct taxation. Examined is whether in the case of concurrence, the provisions on the free movement of capital can actually be invoked or whether the application of the provisions on the free movement of capital in a third-country context can be restricted or excluded by the freedom of establishment. The relevance of this question is obvious: from both EU Treaty freedoms, the free movement of capital also applies in the relationships with non-eu Member States, subject to certain conditions. 2 Concept of establishment and concept of capital movements Before answering the above question, the EU concept of establishment is firstly examined. According to the ECJ, the concept of establishment involves the actual pursuit of an economic activity through a fixed establishment in another Member State for an indefinite period. 1 This fixed establishment may find expression in the form of (the setting-up of) agencies, branches or subsidiaries and, in the case of members of the professions, by establishing a professional base. 2 In Baars, the ECJ held in addition that a national of a Member State who has a holding in the capital of a company established in another Member State which gives him definite influence over the company's decisions and allows him to determine its activities is exercising his right of establishment. 3 However, in the author s opinion one may not infer from this case law that the ECJ has excluded the possibility that both freedoms apply simultaneously. Since in Baars the legislation at hand was found in breach of the freedom of establishment, the ECJ simply did not, as a matter of procedural economy, hold on the question whether the measure at issue also fell within the scope of the free movement of capital. 4 1 ECJ 25 July 1991, case C-221/89 (Factortame Ltd and others), ECR 1991 p. I-03905, para ECJ 30 November 1995, case C-55/94 (Gebhard), ECR 1995 p. I-04165, para ECJ 13 April 2000, case C-251/98 (Baars), ECR 2000 p. I-2787, para Cf. Advocate General Kokott in her Opinion delivered on 14 July 2005, C-265/04 (Bouanich), ECR 2006, p. I , fn. 57 and Advocate General Stix-Hackl in her Opinion delivered on 16 March 2006, case C-452/04 (Fidium Finanz), ECR 2006, p. I-9521, para Similarly: Aigner, Scheuerle and Stefaner, who observe that the ECJ s case law does not say that the free movement of capital is not applicable if the freedom of 1

2 Furthermore, it is observed that there is no legal definition of the concept of capital movements in the EU Treaty. Nevertheless, in Luisi and Carbone, the ECJ held in general terms that movements of capital are financial operations essentially concerned with the investment of the funds rather than remuneration for a service. 5 In addition, in the nomenclature of the former Directive 88/361/EEC a large number of non-exhaustive examples are included. In Trummer and Mayer the ECJ held that, inasmuch as Article 63 TFEU substantially reproduces the contents of Article 1 of Directive 88/361, this nomenclature still has the same indicative value, for the purposes of defining the notion of capital movements, as it did before the entry into force of Article 63 TFEU. 6 From the nomenclature it follows that the concept of capital movements consists of both financial and real capital and can be divided into three main categories: i) direct investments (e.g. establishment and extension of branches or companies, participation in new or existing undertakings with a view to establishing or maintaining lasting economic links and longterm loans with a view to establishing or maintaining lasting economic links), ii) portfolio investments (e.g. operations in securities and financial loans and credits) and iii) other investments (e.g. loans, dowries, inheritances, transfers of assets and patents). From Brugnoni and Ruffinengo one can infer that the liberalization of capital movements not only includes the transfer of funds to and from abroad, but in fact includes all measures that may result in the possibility of executing the underlying transaction being restricted. 7 This observation is of particular relevance as far as direct taxes are concerned. It means that it is possible that the free movement of capital not only covers tax measures that directly affect capital movements, such as capital or stamp duties, but also tax measures of a mere general nature affecting movements of capital in a more indirect way, such as personal and corporate income taxes on income from capital. Indeed, in Verkooijen it appeared that the scope of the free movement of capital extends to Member States direct tax systems. 8 In this case, the ECJ decided that the free movement of capital precludes a Netherlands tax provision that made the grant of an income tax exemption on dividends paid to a Dutch portfolio shareholder subject to the condition that those dividends were paid by a company whose seat was in the Netherlands. Since then, the ECJ has held several times that national direct tax measures which distinguish between domestic and cross-border situations establishment is, H-J. Aigner, U. Scheuerle and M. Stefaner, General Report, in: CFC legislation, M. Lang c.s., Linde Verlag, 2004, p. 41 and, although less explicitly, H. Fleischer in his annotation to ECJ 4 June 2002, cases C-367/98, C-483/99 and C-503/99 (golden shares), CMLR 2003/40, p ECJ 31 January 1984, joined cases 286/82 and 26/83 (Luisi and Carbone), ECR 1984 p , para ECJ 19 March 1999, case C-222/97 (Trummer and Mayer), ECR 1999 p. I-01661, para ECJ 24 June 1986, case 157/85 (Brugnoni and Ruffinengo), ECR 1986, p , para. 22. Cf., a contrario, Article 7 of the former Directive 88/361/EEC which only aimed at transfers in respect of movements of capital, instead of capital movements, thus limiting the scope of the liberalization erga omnes; D. Servais, Een Europese financiële ruimte, Bureau voor officiële publikaties der Europese Gemeenschappen, Luxemburg, 1995, p. 65, fn ECJ 6 June 2000, case C-35/98 (Verkooijen), ECR 2000, p. I

3 may be in conflict with the free movement of capital. 9 It follows that the impact of the free movement of capital on Member States direct tax systems has been significant, at least as far as intra-union transactions are concerned. Given the above, it is submitted by the author that the question of concurrence of the free movement of capital with the freedom of establishment should not be a question of exclusivity or parallelism. It is submitted that it should be addressed as a question of causality between the contested direct tax measure on the one hand and the movement of capital on the other. The basic criterion should therefore only be whether or not there is a sufficient link between the contested direct tax measure and the free movement of capital vis-à-vis third countries. For instance, in Konle, the ECJ held that national legislation on the acquisition of land must comply with the provisions of the EU Treaty on the freedom of establishment for nationals of Member States and the free movement of capital and thus recognized that both EU Treaty freedoms can be applied in tandem. 10 Parallel application of both EU Treaty freedoms is thus possible. This is evidenced by the specific collision rules under Article 49 and Article 65(2) TFEU as these collision rules presuppose the possibility of concurrence of both freedoms. In the author s view, it would follow from the ECJ s case law that causality should be denied only if the above link is too indirect or too tenuous. 11 In recent case law, the ECJ has nevertheless taken another approach in this matter. This is demonstrated in the subsequent sections. 3 The relationship between the free movement of capital and the freedom of establishment Recently, the ECJ has ruled in a number of direct tax cases in which the question of concurrence between the freedom of establishment and the free movement of capital in a third country context was at issue. In some of these cases it appears that the claim on Article 63 TFEU is fundamentally denied by the ECJ. In other cases, the ECJ suggests that the free movement of capital and the freedom establishment can be applied simultaneously. In the below sections, the relevant case law of the ECJ is examined. 9 Cf. ECJ 15 July 2004, case C-315/02 (Lenz), ECR 2004, p. I-7063; ECJ 15 July 2004, case C-242/03 (Weidert and Paulus), ECR 2004, p. I-7379; ECJ 7 September 2004, case C-319/02 (Manninen), ECR 2004, p. I ECJ 1 June 1999, case C-302/97 (Konle), ECR 1999 p. I-3099, para This principle is called the rule of remoteness. See, inter alia, ECJ 7 March, 1990, Case C-69/88 (Krantz vs Ontvanger der Directe Belastingen), ECR 1990 p. I-583, para. 11; ECJ 27 January 2000, Case C-190/98 (Volker Graf), ECR 2000, p. I-493, para

4 3.1 Test Claimants in the Thin Cap GLO, Skatteverket versus A and B and Lasertec: exclusive application of freedom of establishment where the contested tax measures is targeted only at relations within a group of companies The case Test Claimants in the Thin Cap Group Litigation concerned the former UK thin capitalization rules, under which tax-deductible interest payments could be characterized as nondeductible dividend distributions where a UK company/debtor paid interest to an affiliated company established in another EC Member State or third country. Under reference to the Baars case, the ECJ firstly determines that the UK legislation applied only to situations where the lending company has a definite influence on the borrowing company or is itself controlled by a company which has such an influence. It subsequently rules that legislation which is targeted only at relations within a group of companies, falls within the scope of the freedom of establishment. 12 It then concludes that the UK rules primarily affect the freedom of establishment. The restrictive effects on the free movement of capital must be seen as an unavoidable consequence of any restriction on freedom of establishment and do not, according to the ECJ, justify an independent examination of the UK legislation in the light of Article 63 TFEU. 13 A similar result was reached in Skatteverket versus A and B. This case concerned a Swedish measure which aims at preventing certain substantial shareholders in a company, from which they are also employee, convert high-taxed income from labour into lower-taxed income from capital. To the extent the amount of dividends distributed by this company exceeds a certain threshold, these dividends are taxed as income from labour. This threshold is, in part, determined by the amount of wages paid to other employees of this company, including the company s subsidiaries or branches. Nevertheless, only wages paid out in Sweden may be taken into account. As a result, in the case at hand wages paid out to employees of a Russian branch are not included. The issue is whether this is in conflict with the free movement of capital. According to the ECJ, the Swedish rules primarily have the result that it becomes less attractive for a Swedish company to establish a branch in a third country, since such an establishment places the shareholders of that company in a less favourable tax position compared to the position they would have had if the branch had been established in Sweden. As a result, according to the ECJ, the Swedish legislation primarily affects the freedom of establishment. Provided that the Swedish legislation has restrictive effects on the free movement of capital, such effects must be seen as an unavoidable consequence of the restriction on freedom of establishment and do not justify an examination of that measure in the light of Articles 63 TFEU. 14 As a result, no separate examination of Article 63 TFEU need take place. 12 ECJ 12 December 2006, Case C-446/04 (Test Claimants in the FII Group Litigation), ECR 2006 p. I-11753, para. 118; ECJ 13 March 2007, Case C-524/07 (Test Claimants in the Thin Cap Group Litigation), ECR 2007, p. I-2107, para ECJ 13 March 2007, Case C-524/07 (Test Claimants in the Thin Cap Group Litigation), ECR 2007, p. I-2107, para ECJ 10 May 2007, Case C-102/05 (Skatteverket vs. A and B), ECR 2007, p. I-11531, para

5 In Lasertec, lastly, the German thin capitalization legislation was at issue. Earlier, in the Lankhorst-Hohorst case, the ECJ held this legislation to be in breach of the freedom of establishment. 15 In the case at hand, however, the shareholder/creditor is established outside the Union, i.e. in Switzerland. Again, the question arises whether the German rules, as far as they are applied in a third-country context, are in conflict with the free movement of capital. The ECJ has held that in order to ascertain whether national legislation falls within one or the other of the freedoms of movement, the purpose of the legislation at issue must be taken into consideration. Although the legislation at hand equally applies in cases of majority and minority interests, the ECJ again concludes that the freedom of establishment is primarily affected. This is because the national measure at issue is designed to apply, irrespective of a precise threshold, to holdings giving the holder a definite influence on the decisions of the company concerned and allowing him to determine its activities. 16 If the contested national measure has restrictive effects on the free movement of capital, such effects must be seen as an unavoidable consequence of the restriction on the freedom of establishment and do not justify an examination of that measure in the light of Article 63 TFEU. 17 Again, no separate examination of Article 63 TFEU thus takes place. The above cases thus show that where the contested tax measure exclusively applies to situations where a taxpayer has a definite influence on a company s decisions, the free movement of capital does not apply. Such legislation is considered to be targeted only at relations within a group of companies which exclusively falls within the scope of the freedom of establishment Glaxo Wellcome: exclusive application of free movement of capital where the contested tax measures is targeted only to capital transactions The Glaxo Wellcome case more or less mirrors the case law as discussed in the previous section as it demonstrates that tax measures that are only targeted to capital transactions, like dividendstripping rules at stake in this case, exclusively fall within the scope of the free movement of capital. In this case, the ECJ ruled that the free movement of capital aspect of the contested German legislation prevailed over that of the freedom of establishment. This was based on the observation that the tax legislation at issue did not depend on the size of the holdings acquired from the non-resident shareholder at issue and on the purpose of the legislation at issue viz. preventing non-resident shareholders from obtaining an undue tax advantage directly through the sale of shares with the sole objective of obtaining that advantage, and not with the objective of 15 ECJ 12 December 2002, Case 324/00 (Lankhorst-Hohorst), ECR 2002 p. I ECJ 10 May 2007, Case C-494/04 (Lasertec), ECR 2007, p. I-3775, para Para ECJ 12 December 2006, Case C-446/04 (Test Claimants in the FII Group Litigation), ECR 2006 p. I-11753, para. 118; ECJ 13 March 2007, Case C-524/07 (Test Claimants in the Thin Cap Group Litigation), ECR 2007, p. I-2107, para

6 exercising the freedom of establishment or as a result of exercising that freedom. 19 As a result, the ECJ held that any restrictive effects on the freedom of establishment had to be considered the unavoidable consequence of any restriction on the free movement of capital and do not justify an independent examination of that legislation in the light of Article 49 TFEU FII and Holböck versus Burda, KBC Bank NV, Aberdeen Property Fininvest Alpha Oy and SGI: parallelism in case of generic restrictions? In FII, the compatibility with the free movement of capital of the former UK tax regime, under which inbound dividends could be taxed less favourably than domestic dividends, was at issue. Regarding the taxation of dividends from third countries, the ECJ holds that, since the UK legislation at issue applies to payments of dividends to resident companies irrespective of the size of their holding, it is capable of coming within the scope of both Article 49 TFEU on freedom of establishment and Article 63 TFEU on the free movement of capital. 21 Thus, in so far as the preliminary question also concerns companies established in non-member States which, accordingly, do not fall within the scope of Article 49 TFEU, the ECJ goes on by examining whether the UK legislation also contravenes Article 63 TFEUin this respect. 22 This question is ultimately answered in the affirmative. 23 The Holböck case, lastly, concerns the former Austrian half-tax rate, which only applied to domestic dividends. In the case at hand, dividends were received from a Swiss company and, accordingly, taxed at the Austrian regular tax rate. The question was whether this is in accordance with Article 63 TFEU. The ECJ firstly held that the purpose of the legislation concerned must be taken into consideration when examining whether national legislation falls within the scope of one or other of the freedoms of movement. 24 It then observes that the Austrian legislation at issue is not intended to apply only to those shareholdings that enable the holder to have a definite influence on a company s decisions and to determine its activities. Accordingly, the Austrian legislation may fall within the scope of both Article 49 TFEU on freedom of establishment and Article 63 TFEU on free movement of capital. 25 Nevertheless, the claim based on Article 63 TFEU was rejected, since the Austrian legislation is covered by the standstill clause under Article 64(1) TFEU. The above cases thus indicate that where the contested measure is of a generic nature and thus can apply both to situations where there is and those where there is not a definite influence, the 19 ECJ 17 September 2009, Case C-182/08 (Glaxo Wellcome), paras Para ECJ 12 December 2006, Case C-446/04 (Test Claimants in the FII Group Litigation), ECR 2006 p. I-11753, para. 36 and para Para Para Para ECJ 24 May 2007, Case C-157/05 (Holböck), ECR 2007, p. I-4051, paras

7 free movement of capital can be invoked even in cases where the taxpayer has, as a matter of fact, a definite influence. Following this case law, the free movement of capital and the freedom of establishment can be applied at the same time (parallelism). Other case law of the ECJ, by contrast, indicates that the free movement of capital cannot be invoked in cases where the taxpayer has a definite influence, even if the contested tax measure is of a generic nature. For instance, in Burda the ECJ decided that in the case at hand, the dispute related exclusively to the effect of the national measure at issue on the situation of a shareholder which has a definite influence. 26 Therefore, the ECJ ruled that only the freedom of establishment applied to this situation. Should the contested tax measure have restrictive effects on the free movement of capital, those effects would be the unavoidable consequence of an obstacle to freedom of establishment, and would therefore not justify an independent examination of that legislation in the light of the free movement of capital. 27 A similar approach is taken by the ECJ in the recent cases KBC Bank NV 28 and Aberdeen Property Fininvest Alpha Oy A call for clarity It is concluded that, in the author s opinion, the question of concurrence of the EU Treaty freedoms should not be a question of exclusivity or parallelism. Rather, it should be a question of causality between the contested direct tax measure and the movement of capital. This conclusion should equally apply as far as the free movement of capital vis-à-vis third countries is concerned. The basic criterion should therefore only be whether or not there is a sufficient link between the contested direct tax measure and the free movement of capital vis-à-vis third countries. In the author s view, it would follow from the ECJ s case law that causality should be denied only if the above link is too indirect or too tenuous. In a number of recent direct tax cases, the ECJ has taken a position in this matter. The ECJ appears, however, to follow a more strict approach. In a number of cases the ECJ presented its decision, it is true, as a matter of causality, but essentially decided the question of concurrence as a matter of exclusivity. The following principles can be derived from the case law of the ECJ. When examining whether a third country investment is unlawfully restricted by a tax measure, consideration must first be given to whether the free movement of capital can actually be invoked. From the case law of the ECJ, it follows that the purpose of the contested national legislation must be taken into account in this regard. Where the contested tax measure exclusively applies to situations where a taxpayer has a definite influence on a company s decisions respectively where the contested tax measures is targeted only at relations within a group of companies, the free movement of capital does not apply. Conversely, where the contested tax 26 ECJ 26 June 2008, Case C-284/06 (Burda), ECR 2008, p. I-4571, para ibid., para ECJ 4 June 2009, Joined Cases C-439/07 and C-499/07 (KBC Bank NV and Beleggen, Risicokapitaal, Beheer NV, not yet reported, paras ECJ 18 June 2009, Case C-303/07 (Aberdeen Property Fininvest Alpha Oy), paras. 30 et seq. 7

8 measures is targeted only to capital transactions, the free movement of capital exclusively applies. Where, in addition, the contested measure is of a generic nature and thus can apply both to situations where there is and those where there is not a definite influence, matters are a bit more complicated. In such a case, the free movement of capital can, in any event, be invoked in situations where there is no definite influence. One may think of the case of a third country portfolio investment, for instance. Less certain is whether the free movement of capital also applies where a taxpayer actually has a definite influence. One can infer from the above that the case law of the ECJ regarding the relationship between the freedom of establishment and the free movement of capital is not fully clear in this regard. This is furthermore demonstrated by the fact that also the Supreme Courts of the various Member States recently arrived to completely opposite conclusions. Both the Dutch Supreme Court and the Austrian Supreme Court held that the free movement of capital cannot be invoked in cases where the taxpayer has a definite influence, even if the contested tax measure is of a generic nature. 30 In other words, when determining whether or not the free movement of capital can be invoked, it is only the actual fact pattern, and not the underlying rule, that is decisive. The German Supreme Court, on the other hand, decided that the free movement of capital can be invoked in cases where the taxpayer has a definite influence, even if the contested tax measure is of a generic nature. 31 Furthermore, Advocate General Kokott in her Opinion in Société de Gestion Industrielle dated 10 September 2009 did not examine the contested tax measure in the light of the free movement of capital for reasons of procedural economy only and thus suggests that the application of the free movement of capital is not automatically excluded in case there is, as a matter of fact, a definite influence. 32 As the ECJ did not consider it only necessary to assess the contested tax legislation in the light of the freedom of establishment in this case, one might infer that the ECJ followed the Advocate General s approach. 33 It is true that the most recent case law of the ECJ, notably KBC Bank NV and Aberdeen Property Fininvest Alpha Oy seems to indicate that the first approach is followed by the ECJ. Nevertheless, given the fact that the Supreme Courts of different Member States have come to opposite conclusions in this regard, it is submitted that for the sake of legal certainty the ECJ should now urgently decide this matter more explicitly. 30 Netherlands Supreme Court 26 September 2008, no , para ; Decision of the Austrian Verwaltungsgerichtshof delivered on 17 April 2008, 2008/15/ Decision of the Bundesfinanzhof delivered on 26 November 2008 I R 7/08, IStR 2009/7, para 3. In its earlier decision dated 9 August 2006, I R 95/05, IStR 2006, 864, the German Supreme Court arrived to the same conclusion. 32 Opinion delivered by Advocate General Kokott on 10 September 2009, Case C-311/08 (Société de Gestion Industrielle), not yet officially reported, para ECJ 21 January 2010, Case C- 311/08 (Société de Gestion Industrielle), para

9 In addition, the following issues will in all likelihood give rise to further debate in the future regarding the relationship between the freedom of establishment and the free movement of capital: - How should one determine whether a domestic tax measure is targeted only at relations within a group of companies (Test Claimants in the Thin Cap GLO, Skatteverket versus A and B and Lasertec); - How should one determine whether a domestic tax measure is targeted to capital transactions only (Glaxo Wellcome); - How should one determine in case of generic restrictions whether there is, as a matter of fact, a definite influence (Burda, Aberdeen, KBC); and - To which extent do the above mentioned principles similarly apply under the EEA- Agreement and the various European Association, Partnership and Cooperation Agreements? All questions may be subject to debate. Clarity by the ECJ on these matters in the future is anticipated. 9