EU court issues landmark decision on Member State power to deny tax benefits

By Jian-Cheng Ku & Rhys Bane, DLA Piper Nederland N.V.

In a key decision issued February 26, the European Court of Justice (ECJ) has concluded an EU Member State does not need to adopt an anti-abuse provision into law to deny tax benefits granted under either the Parent-Subsidiary Directive or the Interest and Royalty Directive if fraud or abuse is involved.

In joined cases T Danmark (C-116/16) and Y Denmark Aps (C-117/16), the ECJ addressed questions on the interpretation of the Parent-Subsidiary Directive, whereas in joined cases N Luxembourg 1 (C-115/16), X Denmark A/S (C-118/16), C Danmark I (C-119/16) and Z Denmark ApS (C-299/16), the ECJ addressed questions on the interpretation of the Interest and Royalty Directive.

Parent-Subsidiary Directive

Pursuant to the Parent-Subsidiary Directive, under certain conditions, EU Member States may not levy withholding taxes on dividends paid to parent companies in other EU Member States.

The EU Member State of the parent company must, in certain circumstances, either apply the credit method (provide a tax credit for the foreign corporate income tax paid) or the exemption method (exempt the inbound dividends from tax) to inbound dividends from other EU Member States.

The Parent-Subsidiary Directive also contains an anti-abuse provision, allowing EU Member States to deny the benefits of the Parent-Subsidiary Directive in the case of fraud or abuse. The Netherlands has implemented this anti-abuse provision in domestic law (in both the Corporate Income Tax Act of 1969 (CITA) and the Dividend Withholding Tax Act of 1965 (DWTA).

In the joined cases T Danmark and Y Denmark Aps, the central question asked was whether a domestic anti-abuse provision is required for the prevention of fraud or abuse, or whether a more general provision can be used.

The ECJ ruled that a more general anti-abuse provision can be invoked by an EU Member State to deny the benefits of the Parent-Subsidiary Directive.

This can even be based on the EU principle of abuse of law (viz. that no domestic anti-abuse provision is necessary).

The ECJ does, however, reiterate its Cadbury Schweppes standard, namely that the transaction at issue must be economically purely artificial and must be designed to circumvent the application of the legislation of the Member State concerned.

Interest and royalty directive

Pursuant to the Interest and Royalty Directive, EU Member States may not levy withholding taxes on interest and royalties paid to companies in other EU Member States insofar the recipient of the interest or royalties is the beneficial owner of the interest or royalties and are taxed in the receiving country.

The ECJ identified three central issues in the joined cases N Luxembourg 1, X Denmark A/S, C Danmark I and Z Denmark ApS, the two most important being:

• The definition of ‘beneficial owner’ in the Interest and Royalty Directive; and
• The constituent elements of any abuse of rights and the conditions for proving it.

Beneficial ownership

The ECJ refers to the OECD Model Tax Convention and the commentary thereto for defining beneficial ownership.

As such, if a company is a beneficial owner of the interest pursuant to a tax treaty based on the OECD Model Tax Convention, it is also likely that the company is the beneficial owner of the interest pursuant to the Interest and Royalty Directive.

The ECJ based this on the references made in the documents accompanying the Interest and Royalty Directive proposal.

Anti-abuse provision

The ECJ’s conclusions were exactly the same about the constituent elements of any abuse of rights and the conditions for proving it as described above with respect to the  joined cases T Danmark and Y Denmark Aps as it relates to the Parent-Subsidiary Directive.

Key takeaways

The ECJ judgment in the joined cases T Danmark and Y Denmark Aps and joined cases N Luxembourg 1, X Denmark A/S, C Danmark I and Z Denmark ApS is especially relevant for EU Member States that have not implemented domestic anti-abuse rules prescribed by the the Parent-Subsidiary Directive.

Under the EU abuse of law doctrine, the benefits of the Parent-Subsidiary Directive, being no withholding tax in the Member State of source and a tax credit or tax exemption in the receiving Member State, may be denied by a Member State.

The ‘purely artificial’ criterion introduced by the ECJ in the Cadbury Schweppes case and reiterated in later case law, remains the relevant criterion when assessing if a transaction is fraudulent or abusive.

As the Netherlands has specific domestic anti-abuse provisions in line with the ones in these directives, this opinion should have no direct impact on Dutch taxpayers.

Furthermore, as the Netherlands currently has no withholding taxes on interest and royalties, this ECJ decision as it relates to the definition of beneficial ownership of interest, should have no or limited impact on Dutch taxpayers.