The European Court of Justice sets aside withholding tax on interest payments as discriminatory
As a result of the judgment Danish withholding tax may have been levied in contravention of EU law
On 13 July 2016 the European Court of Justice passed judgment in the Brisal case (case C-18/15, Brisal and KBC Finance Ireland v. Faxenda Pblica).
In the case Supremo Tribunal Administrativo (the supreme constitutional court of Portugal) had referred questions as to whether it is inconsistent with the freedom to provide services if nonresident financial institutions are taxed on interest from Portugal at a final withholding tax rate of 20 % of the gross income without the possibility of deducting financing costs or other business expenses, whereas the interest income of resident financial institutions is included in the ordinary taxable income on a net income principle with the possibility of deducting business expenses from the interest income. The Portuguese corporate tax rate was 25 %, thus higher than the withholding tax rate of 20 %. The judgment sets aside the Portuguese withholding tax scheme. In our opinion the judgment directly affects the Danish withholding tax schemes which have many similarities with the now overruled scheme.
The case concerned interest paid to a financial institution in another Member State. The reasons given in the judgment are sufficiently broadly worded that in our opinion they can also be applied to other lenders than financial institutions and may further be applied to withholding taxation of other income sources than interest, including for example share dividends. Thus, the judgment could potentially have an extensive influence on European withholding tax schemes, including the Danish schemes. It should be noted in this regard that the Danish government submitted an observation during the proceedings which in any case illustrates that the Danish government has found the case relevant for Denmark and the Danish scheme on withholding taxes on interest payments.
The facts of the case and The European Court of Justice's ruling
The case concerned a dispute on the taxation of interest paid by Brisal (an entity resident in Portugal for tax purposes) to KBC (an entity resident in Ireland for tax purposes). On the interest paid by Brisal to KBC in accordance with a financing contract in 2005-2007, taxes were withheld on the gross amount without KBC being able to deduct neither the financial expenses nor other business expenses directly related to the loan from which the taxable interest payments originated. Contrarily, interest payments received by comparable Portuguese entities were taxed on the net amount meaning the residual income after deduction of business expenses.
Brisal and KBC argued that a higher tax burden was imposed on non-resident financial institutions than on resident financial institutions, which is contrary to the freedom to provide services set out in article 49 EC (which has subsequently been replaced by article 56 TEUF).
As justification for the Portuguese scheme it was argued that taxpayers with unlimited and limited tax liability are not in objectively comparable situations, that the lower nominal tax rate applicable to taxpayers with limited liability compensated for the lack of deductibility, that securing a balanced allocation of taxation powers could justify a scheme intended to avoid the same expenses being deducted in both Portugal and the country of residence, and that taxation of gross income is necessary in order to ensure an effective collection of taxes.
The Portuguese government specifically argued that under the double taxation treaty with Ireland, Portugal was entitled to tax interest payments at the source at a rate of 15 % and that Portugal could not make use of this agreed upon distribution of the right of taxation if Portugal could not levy withholding taxes.
The judgment of the European Court of Justice
The European Court of Justice dismissed the arguments of the Portuguese government.
Firstly the court emphasised that resident and non-resident service providers are in comparable situations with regards to the deduction of business expenses directly connected to the activity pursued.
The court further concluded that the Portuguese legislation constitutes a restriction on the freedom to provide services in article 49 EC (now article 56 TEUF), as it entails non-resident financial institutions being taxed at the source on interest payments earned in Portugal without the possibility of deducting business expenses directly related to the operation of the business, whereas resident financial institutions do have the possibility to deduct such expenses.
The court did not find that the restriction could be justified by overriding reasons in the public interest.
In regards to the lower tax rate the court declared that an unfavourable tax treatment cannot be justified by the existence of other potential advantages.
The court found that member states are required to respect the principle of equal treatment and the freedoms of movement. The allocation of Member States' taxation power under double taxation treaties and national legislation must respect these obligations. The court did not find that the allocation of taxation powers could justify why resident and non-resident entities should be treated differently in relation to deductibility of business expenses directly connected to the operation of the business.
The need to ensure an effective collection of taxes was not found to be able to justify the discrimination either. It is up to the individual tax payer to decide if they wish to invest resources in procuring documentation for the costs with the intention of deducting them.
The court found that entities with limited tax liability in principle must be able to deduct the same expenses as fully liable entities are allowed to deduct if directly related to the activity pursued. In the case which was about interest payments, the relevant expenses were not just creditor's own financing expenses and travel and accommodation expenses related to the specific loan, but also a proportional share of the creditor's general expenses.
The judgments influence on Danish law
The Brisal case determines that entities with limited tax liability must have the same access to deduct expenses directly connected to the operation of the business as fully liable entities. Thus it is not compliant with EU law to tax non-resident entities on gross income when resident entities are taxed on a net income principle.
Following the judgment it is unlikely that the Danish scheme on withholding taxes on interest payments can be upheld as, like the Brisal case, the levying of withholding taxes is done based on gross income while fully liable entities may deduct expenses and only pay taxes on the net income.
Entities with limited tax liability that have paid withholding taxes on interest payments should therefore consider applying to have the taxable amount reduced by the sum of relevant expenses and subsequently claim repayment of a proportionate amount of the taxes paid.
The ongoing cases on beneficial ownership are characterised by the creditor having financing expenses which more or less are equal to the interest payments on the loan to the associated Danish business. The creditor should in these cases be able to claim that expenses related to the loan are deducted in the taxable interest payments. All things equal this will result in the taxes being reduced to a fraction of the already paid taxes.
The reasons given in the judgment have a general wording and can in our opinion be directly transferred to withholding taxes on other sources of income. The deciding factor is that by levying taxes on gross income, non-resident entities in objectively comparable situations are discriminated against. If the objective tax liability is independent of the tax payer being resident or non-resident, which is the case in the Danish schemes, resident and non-resident entities are in objectively comparable situations in our opinion. Gorrissen Federspiel is currently conducting two cases at the Danish Eastern High Court regarding limited tax liability on property and dividends respectively where the focus is whether entities with limited tax liability are in a comparable situation with fully liable entities.