In a landmark decision rendered on 10 May 2012, the European Court of Justice (the “ECJ”) ruled that EU law must be interpreted as prohibiting French withholding taxes on French-source portfolio dividends paid to non-French investment funds, since such dividends are tax exempt when received by similar French mutual investment funds. This decision is applicable to EU funds as well as non-EU funds (including US investment funds).
Facts. French mutual investments funds – i.e., “Fonds communs de placement” (“FCP”) and “Sociétés d’investissement à capital variable” (“SICAV”) – are tax exempt on the dividends they receive. By contrast, non-French investment funds are subject to a French withholding tax on French-source dividends at a rate of 25% (increased to 30% since 1 January, 2012), possibly reduced by applicable tax treaties.
Several EU and US investment funds have claimed a refund of French withholding taxes suffered on French-source dividends on the basis that a difference in treatment between French and non-French funds constitutes a restriction to the EU principle on free movement of capital which cannot be supported by any valid justification.
Position of the French State. The French State argued that taxation takes place in France at the level of the investors and not at the level of the investment funds and that the comparison should therefore be made at the level of the investors. Since French investors are duly taxable in France on dividends received through French investments funds, a withholding tax imposed on non-French investors receiving French-source dividends through non-French investment funds should not be discriminatory.
ECJ decision. In its 10 May 2012 decision, the ECJ took the position that the French withholding tax constitutes a discrimination. The main reason is that the tax exemption granted to French investment funds is not conditional upon the taxation of the investors on the dividends they receive through the funds and therefore the comparison must be made at the level of the investment funds without taking into consideration the tax treatment applicable to investors.
Due to the significant amounts the claims filed by the taxpayers could represent, the French State had asked the ECJ to restrict the effect of its decision to future withholding taxes. The ECJ did not recognize that this request was justified by an overriding reason of public interest.
Consequences of the ECJ decision. Non-French investment funds may claim, under certain conditions, a refund of French withholding taxes levied on French-source dividends. Since the free movement of capital includes not only investments within the European Community but also investments made by residents in non-EU countries, both EU and non-EU investment funds (e.g., US funds) should be eligible for the withholding tax exemption, under certain conditions.
The first condition to benefit from this case law is to show that the relevant investment fund must be “comparable” to French tax-exempt investment funds. The ECJ has not provided clear guidelines on the criteria to be used in this respect.
A second condition resides in the type of investment that may benefit from the withholding tax exemption. According to the EU Treaty “standstill clause”, restrictions on the free movement of capital would be authorized in the case at hand if they involve an investment that establishes long-standing relationships between the investor and the company (by contrast with a portfolio investment). Therefore, provided that the shares in the French distributing company held by the fund are portfolio investments, the fund should not be subject to the French withholding tax.
In addition, in order to comply with EU law, the French Government will have to amend French law so as to treat French and non-French funds the same way. It is to be noted that, when the French Supreme Court decided that foreign not-for-profit entities should not be subject to French withholding tax on dividends because French not-for-profit entities were tax exempt, the reaction of the French legislator was to impose a 15% tax on dividends received by French not-for-profit entities, so that the withholding tax imposed on foreign not-for-profit entities (generally at the rate of 15% under applicable tax treaties) would no longer be viewed as discriminatory. For investment funds, the French Government may decide in a similar manner to introduce a withholding tax on French-source dividends received by French funds, such tax being creditable by French investors when they receive the corresponding distributions.