This article is written by Ayushi Singh, a qualified lawyer and working with EY in Risk Advisory Services, writes on different methods of preventing economic double taxation in respect of foreign and resident taxpayers in light of FII (C-35/11) and Kronos C-47/12
Both cases were a reference for preliminary ruling relating to clarification of tax treatment of domestic and foreign sourced dividends. Both these cases raised the issue of detrimental treatment of inbound dividends leading to an asymmetrical elimination of double taxation where domestic and foreign sourced dividends received different tax treatment.
Tax Treatment of Dividends
EU has not been conferred with the competence of Direct Taxation by the Member States but due to the fact that taxation affects intra-EU market it is “clearly an internal market issue, and other indirect taxation and direct taxation are caught under the competence heading “internal market” in Article 4(2) (a) Treaty of Functioning of European Union (TFEU), which is a shared competence with pre-emption”. Thus both cases had been brought before the Court.
In both these cases, the principal European Union legislation coming into relevance is the Parent-Subsidiary Directive “which provides a framework of tax rules regulating the relations between parent companies and subsidiaries of different Member States, with the aim of facilitating the grouping together of companies.” These directive bars the imposition of withholding tax where company receiving the dividends hold a minimum percentage of share ( currently 10%, earlier 25%). In particular, Article 4 of the Directive “expressly allows” Member States to adopt Credit and Exemption methods for relieving cross-border double taxation law provided that there is no discrimination which leads to taxing the foreign-sourced dividends at a higher rate than that nationally-sourced dividends. It is clear that EU law regards: CIN – Capital Import Neutrality (exemption) and CEN – Capital Export Neutrality (Credit Method) are the ways through which international economic double taxation is avoided.
In Test Claimants in the FII Group Litigation v. Commissioners of Inland Revenue Case (C-35/11), the facts were that until July 1st, 2009 the UK resident who was the recipient of dividends was exempted from tax if these dividends were payable by resident company (exemption method) while was subject to corporate tax on these dividends with available credits for relevant foreign taxes paid (credit method) when it received dividends from non-resident company. The credit method thus allowed credits for UK resident on actual tax paid by the company making the distribution in the country of residence on the profits thereby distributed. These methods were in -force to curb out the scenarios leading to double taxation of distributed corporate income which would otherwise be taxed in the hand of the corporation making such distribution and then by the person receiving them. The reference was made on the point that whether in the UK, the exemption method offered a more favorable tax treatment in respect of UK dividends than the credit method offered in respect of foreign dividends. Thus the tax that had to be paid on profits underlying UK dividends should be equal to tax at UK’s nominal rate (except in exceptional circumstances).
In Kronos International Inc. V Finanzamt Leverkuse (C-47/12) the claimant- KII group was the company was incorporated in Delaware and had its place of effective management in Germany. Germany until 2001, fully taxed its domestic dividends for the recipient, but provided for certain refund/credit for tax on the corporate tax paid by the parent company up to a certain limit (credit method). Foreign dividends had been exempted under certain conditions (e.g. participation of at least 10%) (exemption method). Since foreign dividends were exempt from tax in Germany, tax credits were not available for claimant which was loss-making. Since the claimant was founded in USA, it could only avail protection under Article 63 (free movement of capital). Under the same, it was argued that the application of different methods of elimination of double taxation of profits distributed by resident and non-resident subsidiaries led to a cash-flow disadvantage for the receiving loss making company and therefore the difference in treatment was contrary to EU Law.
According to the settled case law “discrimination could arise in cases where there is application of different rules to comparable situations or the application of the same rule to different situation.” In both the cases our case discrimination occurs when different tax rates is applied to comparable situation as the situation of a corporate shareholder receiving foreign-source dividends and corporate shareholder receiving nationally-source dividends or when “different levels of taxation” occur in some situations.
In the FII case in the application of the exemption method, it was assumed that the tax was borne by the dividend payer at a nominal rate. Unequal treatment resulted when the national system provided for reliefs (such as for research and development rebates etc.) which would commonly reduce the effective tax rate so that domestic source income, if exempted in the hands of the dividend recipient, would usually be taxed at a lower rate than foreign source income which would always be taxed at least to the nominal rate. The HMRC also admitted that the effective level of tax paid in respect of the profits underlying UK dividends was lower than the nominal rate of tax in the majority of cases. Thus in effect, the exemption method allowed the benefit of a credit equal to the nominal tax rate, irrespective of the fact that the actual amount of UK tax paid by the dividend-paying company was usually less. However, the credit method for foreign sourced dividends gave credits only for the tax paid in the state of origin. Consequentially UK law was regarded as a restriction on freedom of establishment and on capital movements that is prohibited by the TFEU. Thus the Court arrived at the conclusion that the way in which UK had historically taxed its dividends is contrary to EU law.
In the Kronos case since the foreign dividends were exempt from tax, tax credits were not made available for claimant which was loss-making. Since the claimant was founded in USA, it could only avail protection under Article 63 (free movement of capital). Under the same, it was argued that the application of different methods of elimination of double taxation of profits distributed by resident and non-resident subsidiaries led to a cash-flow disadvantage for the receiving loss making company and therefore the difference in treatment was contrary to EU Law. The CJEU noted that in the situation where the company receiving dividends incurs tax losses, reimbursement of tax paid by the distributing company could be regarded as a cash-flow advantage, but in the case at hand, the difference in treatment of domestic and foreign dividends did not arise from the application of the relevant German legislation since Germany had relinquished its powers of taxation over the foreign-sourced dividends. As a consequence, Germany is not obliged by Article 63 TFEU to allow offsetting of the tax burden resulting from the exercise of the tax powers of another Member State or of a third state.
Coherence of a tax system
In the direct tax field there are five main justifications which have been “upheld by the Court to justify discriminatory tax behaviour: (i) the need to ensure the coherence of the national tax system; (ii) the need to ensure the effectiveness of fiscal supervision; (iii) the need to prevent the risk of tax avoidance; (iv) the need to ensure the balanced allocation of taxing rights;(v) and the need to ensure recovery of tax debt”.
In FII judgment the court dismissed the justification provided by the United Kingdom Government who contended that the different tax treatment was justified by the need to ensure the cohesion of the national tax system which is justified only “by an overriding reason in the public interest”. Such justification should be “necessary [and] its application [shall] be appropriate to ensuring the attainment of the objective question and not go beyond what is necessary to attain it”. The ECJ opined that the cohesion should result from the logical balance between recognition of a tax advantage and the right to tax income. The ECJ applied the “two elements proportionality test” and opined that even though the relief method is granted to avoid economic double taxation of distributed profits, it would be less prejudicial if credits for foreign-sourced dividends were allowed on nominal rate of overseas tax rather than an amount actually paid or by taxing foreign dividends in an amount equal to the difference between the nominal tax rates in the UK and the overseas jurisdiction to ensure cohesion of tax system. This would ensure that the obligations of freedom of establishment and the free movement of capital are not violated while without compromising the cohesion of tax system. The court however overlooked the scenario in which the foreign company was subject to different nominal rates of tax on different types of profits.
The same argument of cohesion of tax system was raised again in Kronos where the CJEU held that the case of domestic and foreign dividends is not comparable in this case, and therefore under the EU law, Kronos cannot claim a refund/credit of foreign Corporate Tax in Germany. The CJEU noted that in the situation where the company receiving dividends incurs tax losses, reimbursement of tax paid by the distributing company could be regarded as a cash-flow advantage, but in the case at hand, the difference in treatment of domestic and foreign dividends did not arise from the application of the relevant German legislation since Germany had relinquished its powers of taxation over the foreign-sourced dividends. As a consequence, Germany is not obliged by Article 63 TFEU to allow offsetting of the tax burden resulting from the exercise of the tax powers of another Member State or of a third state.
Both cases raised comparable issues and arguments on discrimination caused due to the application of the credit and exemption method. Unlike the Kronos case, in the FII case, the court favored the taxpayer. Both cases can be called upon to further sought the situation of treatment of dividends and have clarified the scope of valid defense and their application to respective situations. The Court always interprets the European Union law or decides the validity of a European Union act but does not adjudicate upon the dispute itself. It is for the national court or tribunal to dispose of the case in accordance with the Court’s decision, which is similarly binding on other national courts or tribunals before which a similar issue is raised.