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ECJ: Advocate General holds German switch-over provision for low-taxed passive income of foreign PEs incompatible with EC Law – details

As reported previously  on 29 March 2007, Advocate General (AG) Paolo Mengozzi of the European Court of Justice (ECJ) gave his opinion in case of Columbus Container Services B.V.B.A. & Co. v. Finanzamt Bielefeld-Innenstadt (C-298/05). Details of the opinion are summarized below.

Advocate General's Opinion. As to the question which fundamental freedom applies, the AG stated that both the freedom of establishment and the free movement of capital could apply to the case. Since the application of both freedoms would lead to the same result, it is enough to examine the provisions at issue in the light of one of them, i.e. the freedom of establishment.

Obstacle to the freedom of establishment

To determine whether the German provisions at issue constitute an obstacle to the freedom of establishment, it has to be seen whether they treat domestic and cross-border situations that are objectively comparable in a different way. According to AG Mengozzi, to decide whether such different treatment exits, two comparisons can be made. On the one hand, the situation of the German partners of the Belgian partnership (Columbus) can be compared with German residents who did not exercise their freedom of establishment in another Member State (domestic situation), and, on the other hand, with German resident partners of a partnership established in another Member State with a higher corporate tax rate than 30%, in which case the switch-over clause would not apply to the foreign PE income derived through the foreign partnership (cross-border situation).

First, the AG found that in comparison with a domestic situation the German partners of Columbus are not subject to a different treatment. As the German government pointed out, the provisions in question do not result in a higher tax burden for a German resident partner in a Belgian partnership than for a German resident partner in a German partnership. The use of the credit method simply increases the tax on the foreign PE income to the domestic level.

Further, according to AG Mengozzi, the fact that the German provisions constitute an override of the Belgium-German tax treaty is irrelevant from the point of view of EC Law, whether or not it infringes public international law.

In addition, the Member States are entitled to allocate taxing rights as between each other in bilateral tax treaties, which includes the right to chose whether or not they want to take actions to avoid double taxation and if so, by which method, either exemption or credit.

Second, AG Mengozzi compared the situation of the partners of Columbus with a cross-border situation. By referring to the Cadburry Schweppes case, specifically to the opinion of AG Léger, AG Mengozzi emphasized the importance of such cross-border comparison.

The German government argued that the disparity in the rates of corporate tax in effect in the different EU Member States constitutes an objective difference justifying such differential treatment as is laid down by the German legislation in question. In contrast, the AG emphasized, if that argument were to be accepted, that would be tantamount to conceding that a Member State is entitled, without infringing the rules of the EC Treaty, to choose the other Member States in which its domestic companies may exercise their freedom of establishment with the benefit of the tax regime applicable in the host state. Such argumentations would lead to a fragmentation of the single market. The German rule constitutes an infringement of EC Law as it treats investments in different Member States differently and may therefore make investments in one Member State less attractive than investments in another Member State. Thus, it deters German residents from investing in the Member State of their choice. Reiterating AG Léger's Opinion, AG Mengozzi stated that a Member State of origin may not restrict the exercise of the freedom of establishment of its residents to certain segments of the single market, even though it does not treat domestic and cross-border situations differently.

Defending its legislation, the German Government referred to the ECJ's decision in the D-case, where the Court has rejected the application of a most-favoured nation treatment within the EU, i.e. a comparison of cross-border activities in two different host Member States.

In reply to Germany's argument, AG Mengozzi recalled the ECJ's case law according to which, although a bilateral tax convention applies only to persons resident in one of the two contracting Member States, there are situations where the benefits under such convention may be extended to a resident of a Member State, which is not a party to that convention (e.g.Saint Gobain case). Whether such extension of the scope of a double tax convention should be allowed, depends on the comparability of the situations of the persons claiming the benefits of the convention. The D-case dealt with residents of two different Member States who were not in objectively comparable situations. In contrast, AG Mengozzi stated that in the present case, the situation of two German residents investing in different Member States is to be compared. Germany cannot claim that its own residents are not in comparable situations depending on the Member State of their investment.
Due to such different treatment, the AG found that the German rules at issue create an obstacle to the freedom of establishment.

Justifications

AG Mengozzi rejected all the public interest grounds on the basis of which Germany tried to justify the restriction on the freedom of establishment.

The German government first argued that the rules at issue represent "self-defence" in order to mitigate the effect of the Belgian Coordination Centre regime that constitutes illegal State aid. AG Mengozzi pointed out that, even if the tax provisions of a Member State constitute harmful tax competition or illegal State aid, this does not give another Member State the right to counter such provisions by imposing compensatory tax burdens. The taking of action against illegal state aid lies solely within the competence of the EC Commission.

With regard to the second justification ground relating to the combat of tax avoidance, AG Mengozzi stated that in order for such justification to succeed the measure at issue must target wholly artificial arrangements intended to circumvent national tax law. To find that a wholly artificial arrangement exists there must be, in addition to a subjective element consisting of the intention to obtain a tax advantage, objective circumstances, which prove the absence of an actual establishment in the other Member State. The German provisions must allow the taxpayer to show, through the evidence of objective elements (e.g. premises, staff and equipment) that such actual establishment exists in the other Member State. In the absence of such possibility to rebut a presumption of a wholly artificial arrangement, the German provisions would be disproportionate. Therefore, the AG suggested, that the referring court should investigate further if there are rules in the German legislation, which allow the taxpayer to provide evidence of such objective circumstances.

Finally, the AG rejected the German government's argument that the provisions in question serve the preservation of the coherence of the tax system. The AG recalled that the principle serves the protection of the integrity of the national tax systems provided that it does not impede the integration of those systems within the context of the internal market. However, since Germany levies wealth tax on foreign branches that are subject to low income taxation, but not on foreign branches subject to high income taxation, regardless of the wealth tax in that country, the German system cannot be considered coherent.

In summary, AG Mengozzi concluded that the freedom of establishment and free movement of capital (Arts. 43 and 56 of the EC Treaty) preclude national treaty-override provisions, which provide for a switch-over from the exemption method to the credit method in respect of low-taxed passive income of foreign permanent establishments, unless such provisions are justified by the necessity to combat artificial structures intended to circumvent the national law. It is up to the national Court to decide if the rule can be justified by such argument.

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