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ECJ holds French withholding tax on outbound dividends incompatible with freedom of establishment

On 14 December 2006, The European Court of Justice (ECJ) gave its decision in the case Denkavit International BV, Denkavit France SARL v. Ministre de l'Économie, des Finances et de l'Industrie (C-170/05) to the effect that the French withholding tax on outbound dividends is incompatible with the freedom of establishment set out in Art. 43 of the EC Treaty. The French Supreme Administrative Court had requested a preliminary ruling from the ECJ on 15 December 2004). The ECJ generally followed the Opinion of the Advocate General (AG) Geelhoed of 27 April 2006 and referred extensively to its decision in Test Claimants in Class IV of the ACT Group Litigation v. Commissioners of Inland Revenue (C-374/04) Details of the decision are summarised below.

Issues. The questions referred by the Supreme Administrative Court were in substance the following:

-   whether or not a provision that provides for the taxation of dividends in the hands of a non-resident parent company, whereas it provides for an exemption for French-resident parent companies, is incompatible with the freedom of establishment;
-   if so, whether or not such mechanism, i.e. a withholding tax, remains incompatible with the freedom of establishment in a situation if a tax treaty between France and an EU Member State provides for a tax sharing mechanism by reducing the withholding tax rate and providing for a foreign tax credit to be set off against the tax charged in the other state; and
-   if the tax treaty is to be taken into account when considering the compatibility of the withholding tax mechanism with the freedom of establishment, whether or not the fact that the non-resident parent company cannot make use of the foreign tax credit provided under the tax treaty results in the incompatibility of the withholding tax mechanism with the freedom of establishment.

(c) Decision. The ECJ first pointed out that the case related to tax assessment years 1987 to 1989, so that the EC Parent-Subsidiary Directive 2003/123/EC  (the Directive) did not apply. Accordingly, the decision was based only on the relevant provisions of the EC Treaty.

Question 1

The ECJ first referred to its jurisprudence on Arts. 43 and 48 of the EC Treaty and reinstated the following principles:

-   the registered office of companies serves as a connecting factor with the legal system of an EU Member State, as is the case for the nationality of  individuals;
-   Art. 43 of the EC Treaty precludes any discrimination by the host EU Member State, even minimal, based on the place in which companies have their seat; and
-   a different treatment between resident and non-resident taxpayers is, however, not a discrimination per se and may be categorized as such only if there is no objective difference to justify the different in treatment, i.e. the discrimination test.

The ECJ applied the discrimination test and analysed the two criteria described above, i.e. (i) the difference of treatment and (ii) the comparability.

In respect of (i), the difference of treatment lies in the fact that dividends paid to non-resident companies are subject to a tax charge, i.e. 25% withholding tax, whereas dividends received by resident parent companies are quasi-fully exempt. The ECJ concluded that such a difference in tax treatment between parent companies constitutes a restriction to the freedom of establishment, as it makes it less attractive for companies of other EU Member States to exercise their freedom of establishment in France.

In respect of (ii), the ECJ rejected the argument advanced by the French government. Specifically, the French government had argued that non-resident parent companies with no fixed place of business in France are not in a comparable situation to that of non-resident companies with a fixed place of business in France. In addition, according to the French government, the exemption of French-source dividends in the hands of Netherlands parent companies would undermine the allocation of taxing powers between France and the Netherlands as set out in the tax treaty concluded by these states. The ECJ held that insofar an EU Member State exercises its tax jurisdiction over the non-residents, either unilaterally or by way of a tax treaty, resident and non-residents (with or without a place of business in France) are in a comparable situation. It should be noted that the situation in question is different from the ACT IV case (C-374/04) in which the non-resident shareholders were not subject to tax in the UK. By referring to the AG's Opinion, the ECJ held that, if the source state chooses to relieve economic double taxation domestically for its own residents by way of an exemption, this measure must be extended to non-residents where (internal) economic double taxation is the result of the exercise of its own tax jurisdiction. The ECJ added that the French withholding cannot be justified by the need to prevent Netherlands companies from avoiding any tax liability on the French-source dividends due to the participation exemption in the Netherlands, as French resident companies are themselves exempt from any further tax liabilities.

In summary, the ECJ concluded the French legislation in question, by imposing a withholding tax on dividends paid to non-resident parent companies, whereas providing for a quasi-full exemption for resident parent companies, is incompatible with Art. 43 and 48 of the EC Treaty.

Questions 2 and 3

By examining the second and third questions together, the ECJ first pointed out that in the absence of harmonization in respect of allocation of taxing power between the EU Member States, the EU Member States may freely determine such allocation under bilateral tax treaties, provided that such allocation does not introduce discriminatory measures contrary to EC law.

In the case in question, the Netherlands participation regime prevented the possibility of offsetting the French withholding tax against Netherlands corporate income tax, resulting in an excess tax credit of 5%. Consequently, French-source dividends paid to the Netherlands parent company remained subject to a "double level" of taxation in France (corporate income tax at the level of the subsidiary and withholding tax on dividends at the level of the Netherlands parent company). In contrast, French-source dividends paid to a French parent company were only subject to a "single-level" of taxation, with a quasi-complete relief of economic double taxation. The ECJ concluded that even with the application of the France-Netherlands tax treaty, the French system results in discrimination in breach of Art. 43 of the EC Treaty.

The Court rejected the justification put forward by the French government, under which on the basis of international tax law, it is up to the State of residence of the parent company, i.e. the Netherlands, to rectify the effects of double taxation. France may, therefore, not rely on the provision of a tax treaty to avoid its obligations under EC law. The ECJ added that the combined application of the France-Netherlands tax treaty and the Netherlands participation exemption did not serve to avoid the double economic taxation imposed on the non-resident parent companies. The Court concluded that the French withholding tax on dividends paid by French resident subsidiaries to non-resident parent companies is incompatible with Arts. 43 and 48 of the EC Treaty in the situation in which a tax treaty authorizes such withholding tax and provides for a credit in the state of residence, but the parent company is effectively unable to offset such withholding tax as it is provided under the tax treaty.

(d) Comments. This decision will have an effect on several EU Member States that apply a participation exemption regime for domestic parent companies, whilst applying a withholding tax on outbound dividends paid to EU parent companies (when the conditions for exemption under the Directive are not met). In such a situation, discrimination could still arise in case the holding thresholds for the domestic participation exemption and for that under the Directive differ. Specifically, if the holding of an EU parent company ranges between the minimum threshold of the domestic participation exemption regime and that contained in the Directive (e.g. for France, between 5% and 20% until 1 January 2007, between 5% and 15% between 1 January 2007 and 1 January 2009, and between 5% and 10% thereafter), the EU parent is treated less favourably than the domestic parent due to the withholding tax on outbound dividends pursuant to the AG's analysis in this case.

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