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ECJ: German thin capitalization rules reclassifying interests paid to substantial shareholders in third States are not incompatible with EC law

On 10 May 2007, the European Court of Justice (ECJ) gave its decision in the case of Lasertec Gesellschaft für Stanzformen GmbH v. Finanzamt Emmendingen (C-492/04), by way of a reasoned order, on the compatibility of the German thin capitalization rules with EC law in situations involving third States (non-EU countries). According to the first subparagraph of Art. 104(3) of the Rules of Procedure of the ECJ, when the answer to a question referred to the ECJ is clearly deducible from existing case law, the ECJ may issue its decision in the form of a reasoned order. Details of the order are summarized below.

(a) Legal background. The German thin capitalization rules were introduced on 13 September 1993 and became applicable from 1 January 1994. Under these rules, repayments of loans by companies to substantial shareholders not entitled to the then applicable imputation credit were to be considered hidden profit distributions and added back to the distributing company's taxable income, if:

-   the repayments were structured as fractions of the capital; and
-   the loan exceeded the shareholder's proportional equity threefold; unless 
-   the arm's length test was met.

For the purposes of these rules, equity capital was defined as the subscribed capital less outstanding capital contributions. Substantial holdings were defined as direct or indirect holdings of more than 25%. Unsubstantial holdings were to be treated identically, if the unsubstantial shareholder exercised controlling influence over the company, either independently or in collaboration with other shareholders.

(b) Facts. In the case at hand, a Swiss resident company, Lasertec AG, held DM 200,000 in the nominal capital of a German resident company, Lasertec Gesellschaft für Stanzformen mbH (Lasertec), established in 1994. This amounted to a holding of two-thirds of Lasertec's capital. As a non-resident, Lasertec AG did not qualify for the imputation credit. On 5 January 1995, Lasertec AG granted a loan of DM 700,000 to Lasertec, which was to be repaid in quarterly instalments over 2 years. However, by 5 January 1995 it had contributed only DM 50,000 to Lasertec's capital, the outstanding equity was contributed only on 10 January 1995. In consequence, the German tax administration applied the thin capitalization rules, and added interest charges on the amount exceeding 3 times the contributed capital (i.e. 700,000 - (3 x 50,000) = DM 550,000) back to the Lasertec's profits in 1995. The German company filed an objection to this assessment.

(c) Issue. In the course of the litigation procedure, the Finance Court Baden-Württemberg referred the case to the ECJ to decide on:

-   whether the terminology of the stand-still clause of Art. 57(1) of the EC Treaty has to be interpreted to apply to national laws restricting the free movement of capital for which the legislative process has already been completed by 31 December 1993, but which are not yet applicable on that date; and
-   whether the free movement of capital enshrined in Arts. 56 and 58 of the EC Treaty precludes the reclassification of interest payments of companies resident in a Member State to substantial shareholders resident in third countries into hidden profit distributions.

(d) Decision. The ECJ first examined the question on the basis of which freedom the challenged German provision is to be analysed. By reference to its settled case law (Cadburry Schweppes, Fidium Finanz, ACT IV,  FII, Thin Cap GLO, the Court stressed that the purpose of the national legislation at issue must be taken into consideration in order to decide which fundamental freedom is applicable. Thus, as it was held in the Baars decision, national provisions relating to shareholdings giving the holder a definite influence on the decisions of the company concerned and allowing him to determine its activities fall under the material scope of the freedom of establishment. As for the case at hand, the Court reasoned that it falls within the scope of solely the freedom of establishment, because:

-   the German thin capitalization rules at issue target cases where a shareholder has definite influence on the decisions of the company concerned and is allowed to determine its activities, irrespective of a precise threshold in the shareholding; and
-   the German thin capitalization rules at issue target cases where a shareholder has definite influence on the decisions of the company concerned and is allowed to determine its activities, irrespective of a precise threshold in the shareholding; and

If the said national rules have 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 (Lankhorst-Hohorst), and do not justify an examination of the rules in the light of the freedom of capital (Cadbury, Fedium Finanz, Thin Cap GLO). Consequently, according to the Court, there is no need to answer the posed questions relating to the free movement of capital. The freedom of establishment, however, is not applicable to third state nationals. Thus, the Court concluded that, by analogy with the freedom of services (Fidium Finanz), national thin capitalization rules which re-qualify interest payments to substantial shareholders resident in third States as hidden profit distributions:

-   primarily affect the freedom of establishment; and
-   are compatible with EU law, since the freedom of establishment cannot be relied on in such situations.

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