ECJ: German withholding tax levied from Canadian pension fund violates the EU treaty

ECJ: German withholding tax levied from Canadian pension fund violates the EU treaty

On November 13th, 2019, the European Court of Justice (“ECJ”) published its decision in the “College Pension Plan” case (C-641/17). The ECJ is the highest court of law in the European Union. While the Member State’s court which referred the case to the ECJ renders the final decision, it is bound by the ruling from the ECJ with respect to the questions of EU law.

In this newsletter we discuss the case facts, legal context, legal questions referred to the ECJ, the Attorney General’s Opinion, and the ECJ’s decision. To jump straight to the ECJ’s decision, click here.

1. The case facts

On 23 December 2011, College Pension Plan, a registered Canadian pension plan that is tax exempt in Canada, submitted requests for refund of German withholding tax that was withheld and paid at a rate of 15% from the gross dividend income it derived from its German sourced portfolio equity investments. As the Canadian – German tax treaty allows Germany to tax German sourced portfolio dividends at a rate of 15%, and did not (and does not) provide further relief in the form of a refund provision, the requests were based on the position that the German withholding tax is a restriction of the free movement of capital that is prohibited by article 63 of the EU Treaty.

After an (implicit) rejection of the requests by the German tax administration, College Pension Plan appealed before the Munich Fiscal Court. The Munich Fiscal Court referred to the European Court of Justice and requested two “prejudicial questions” (interpretative questions) of EU law to be answered.

After the ECJ’s judgment, which is expected to be rendered by the end of 2019, it will be up to the Munich Fiscal Court to render a final decision, taking into account the (binding) answers given by the ECJ in its judgment.

German domestic law

Under German domestic tax law, German pension funds are subject to tax on their portfolio investment income. However, they are able to reduce their taxable profit in a tax assessment procedure by deducting the amounts reserved to meet their pension payment obligations, and to neutralize the tax on income from capital through a set-off, and also receive a refund in the event that the amount of corporation tax payable is less than the amount set-off. As German pension funds reserve all or almost all of their annual income from capital for (future) pension payment obligations, generally speaking the total German tax liability on income from capital is zero, or close to zero.

Non-resident pension funds like College Pension Plan that only have German sourced portfolio investment income are not liable to tax in Germany, and therefore not subject to the tax assessment and set-off procedure. As a result, they are not able to deduct the amounts reserved to meet their pension payment obligations, nor are they able to deduct any other expenses relating to the income from capital. To them, the 15% German withholding tax over gross German sourced dividend income is a final levy.

Relevant EU law framework

Article 63 of the EU Treaty prohibits any and all restrictions of the free movement of capital between EU member states, as well as between an EU member state and “third countries” (non-EU member states, such as Canada). A restriction of the free movement of capital may be prohibited if an EU member state treats non-residents less favorable than residents. For example where a member state taxes non-resident while it exempts (or refunds the tax) to residents.

There are two caveats to article 63:

Article 65 of the EU Treaty, which provides that article 63 shall not apply if:

  • the situation of non-residents is not objectively comparable to that of residents, or
  • the restriction is justified by “overriding reasons in the public interest”

If non-residents are not discriminated (because different treatment of objectively different situations is not discrimination), or if overriding reasons in the public interest are present, the taxation of non-residents is not a prohibited restriction.

Article 64 of the EU Treaty, which provides that article 63 shall not apply to the application of restrictions to third countries which exist on 31 December 1993 under national law or Union law adopted in respect of the movement of capital to or from third countries involving indirect investment – including real estate – establishment, the provision of financial services or the admission of securities to capital markets. Article 64 is know as the “standstill clause”, which grandfathers pre-existing restrictions in specific situations. As a derogation of the fundamental principle of free movement of capital, according to the ECJ article 64 must be interpreted “strictly”. This is also reflected by the fact that its application requires to cumulative conditions to be met:

  • The restriction must have already existed on 31 December 1993, and must have remained essentially the same since (i.e. substantial amendments after 31 December 1993 may make an existing restriction a “new” and therefore prohibited restriction); this is also know as the “temporal condition”, and
  • The restriction must be adopted in respect of (must relate directly to) direct investment, establishment, the provision of financial services or the admission of securities to capital markets; also known as the “substantive condition”

3. The questions referred by the Munich Fiscal Court

The Munich Fiscal Court referred the following questions to the ECJ:

  1. Does the freedom of movement of capital under Article 63(1) TFEU in conjunction with Article 65 TFEU preclude legislation of a Member State under which a non-resident institution operating an occupational pension scheme whose essential structure is similar to a German pension fund does not receive any relief from tax on income from capital in respect of dividends received, whereas such dividend distributions to domestic pension funds do not result in any increase in their corporation tax liability, or only a comparatively small one, because the latter are able to reduce their taxable profit in a tax assessment procedure by deducting the amounts reserved to meet their pension payment obligations and to neutralize the tax on income from capital through a set-off, and also receive a refund in the event that the amount of corporation tax payable is less than the amount set-off?
  2. If the answer to Question 1 is yes: is the restriction of the free movement of capital through Section 32(1) No 2 of the Law on corporation tax permissible with respect to third countries under Article 63 TFEU in conjunction with Article 64(1) TFEU because it relates to the provision of financial services?

In its referral letter to the ECJ, with respect to the first prejudicial question the Munich Fiscal Court considers that it appears that College Pension Plan is in a situation that is objectively comparable to that of German pension funds. In doing so, it draws an analogy with the ECJ’s ruling in the (2012) Commission v. Republic of Finland case (C-342/10). The Munich Fiscal Court further concludes that no overriding reason in the public interest applies in this case. As the Munich Fiscal Court nevertheless refers the question to the ECJ, it is apparently not entirely certain whether College Pension Plan is indeed in a situation which is objectively comparable to that of German pension funds.

With respect to the second prejudicial question, the Munich Fiscal Court reasons that while the domestic legal provisions for German pension funds may have been changed substantially after 31 December 1993, these provisions do not affect non-resident investors. And the domestic legal provisions that do affect non-resident investors have not changed. The Munich Fiscal Court therefore concludes that the temporal condition has been met and asks the ECJ whether, under the circumstances of this case, the substantive condition is also met. In this regard, the Munich Fiscal Court first confirms that there is no direct investment, establishment or admission of securities in the case at hand, which leaves only the question whether the restriction is “in respect of the provision of financial services”.

Based on established ECJ case law (i.e. Wagner Raith, C- 560/13), in order for a restriction to be “in respect of the provision of financial services” it must concern movements of capital that have a causal link with the provision of financial services. According to the Munich Fiscal Court, this is the case because the major part of the investment returns generated by the pension fund increase not only the value of its assets, but also the value of its provisions for pension payment obligations on the liabilities side, because 100% or at least 90 % of such earnings are credited to the individual pension fund contracts, thus increasing the pension fund’s payment obligations with respect to pension benefits. Consequently, the taxation of dividends distributed to a pension fund established in a third country directly affects the claims that the pensioners have against the pension fund because their claims are reduced by the amount of WHT paid by it, and therefore affects the financial service provided by the pension fund.

4. The ECJ AG Opinion

Objective comparability and overriding reasons in the public interest (art 65 TFEU)

On the objective comparability and overriding reasons in the public interest, the AG concludes that:

  • Objective comparability must be tested in light of the aim pursued by the domestic legislation that is the subject of the dispute (the German withholding tax)
  • The referring Munich Fiscal Court has failed to explain the aim pursued by the domestic legislation
  • In view of the arguments brought forward by the parties, non-resident pension funds and German pension funds have common objectives. Like German pension funds, non-resident pension funds such as CPP also have the objective of guaranteeing the pension insurance activity by means of the creation of sufficient capital to cover retirement pension obligations in the future.
  • The AG rejects the argument of the German government that CPP is not in a situation that is objectively comparable with German pension fund because non-resident pension funds and resident funds are subject to different taxation techniques. According to the AG, the test relating to the application of different taxation techniques, in order to establish the comparability of situations between a resident taxpayer and a non-resident taxpayer, is based on tautological reasoning. As a general rule, residents and non-residents are subject to different taxation techniques. This ruling only confirms that the situations are different since the resident and non-resident taxpayers are different. In the main proceedings, resident pension funds are “wholly taxable”, whereas income from foreign pension funds is subject only to a “limited” tax obligation covering only income originating in Germany. In the AG’s opinion, the different taxation techniques only reflect this difference. However, this does not mean that the national legislation in question automatically escapes the scope of the free movement of capital.
  • In light of the above CPP is in a situation that is objectively comparable with that of German pension funds, and the German withholding tax restricts the free movement of capital.

On the presence of overriding reasons in the public interest, the AG simply states that, in the present case, a difference in treatment between resident and non-resident pension funds can not be justified by any of those reason since the interested parties have not discussed this subject in the legal proceedings.

The standstill provision (art 64 TFEU)

On the application of the standstill provision, the AG concludes that the German domestic law has essentially not changed since 31 December 1993, so the temporal condition is met. However, according to the AG the material condition is not met because there is no causal link between the restriction and the provision of financial services. According to the AG, the category of capital movements involved is the payment of dividends to a pension fund. The AG is of opinion that when a pension fund receives dividends, the causal link between capital movements and the provision of financial services is lacking, as the situation concerns the acquisition of direct investment by an investor who wishes to diversify his assets and better spread the risks. As the European Commission has pointed out, the AG says, the participations of a pension fund and the dividends that it receives serve primarily to accumulate financial assets through greater diversification and a better distribution of risks, in order to guarantee its fulfillment of future pension obligations with regard to its members. Furthermore, the restriction in question is based on the application of the full crediting mechanism, which relates to the taxation of dividend distributions to resident pension funds and which cannot benefit non-resident pension funds. In light of the foregoing, the restriction does not apply to capital movements in connection with the provision of financial services to members of the pension fund. Therefore, the standstill provision cannot remedy the restriction.

5. The ECJ’s decision

The ECJ rules that the German dividend withholding tax levied from CPP violates the free movement of capital and constitutes a prohibited restriction thereof when, like German pension funds, CPP uses the dividend income received for pension liability provisioning (i.e. adds the dividend income to the pension liability reserve) either voluntarily or because it is required to do so under (Canadian) law. The question of pension liability provisioning is one of fact which the ECJ refers back to the referring Court of Munich to answer.

The ECJ rejects the position of the Munich Fiscal Court that the German dividend withholding tax distinguishes between taxpayers who are not in the same situation with regard to their residence or the place where their capital is invested. According to the ECJ, CPP is in a situation which is objectively comparable with that of German pension funds.

Firstly, the German dividend withholding tax is not limited to providing for differences in residence or place where the capital is invested. It is also likely to lead to total or almost total exemption to resident pension funds and thus to provide a benefit to them.

Secondly, the ECJ reminds that it is settled case law that, with regard to expenses, such as expenses directly related to an activity which generated the taxable income (in this case the dividend income), residents and non-resident are in a comparable situation. Despite strong similarities, the ECJ contrasts this case against the similar Commission v. Republic of Finland case (8 November 2012, C-342/10) where the Finnish legislator equated pension liability provisioning with expenses incurred to acquire or maintain income from an economic activity. No such direct relationship exists in German law. However, in the case at hand, where the dividends received automatically increase the pension provisioning, the (taxable) result for the pension fund always remains unchanged. And since pension provisioning, which reduces the result, is a direct consequence of the dividend income, CPP is in a situation which is objectively comparable with that of German pension funds.

The ECJ further rejects the position of the Munich Fiscal Court that the violation of the free movement of capital is justified by overriding reasons in the public interest. The ECJ gives this more consideration than the AG did. With respect to the need to ensure balanced allocation of taxing rights, the ECJ rules that this justification ground does not apply when a member state chooses to exempt all or almost all resident pension funds. With respect to the need to preserve the coherence of the tax system, the ECJ reminds that in order for this justification ground to apply, there must be a direct link between the tax benefit concerned and the compensation of that advantage by a specific tax levy. Since the German government has not relied on such direct link, this justification ground can not apply here. Finally, with regard to the need to ensure effectiveness of tax audits, the ECJ rules that the case file contains no indications whatsoever that the German withholding tax is appropriate to achieve that objective (proportionality principle is not met).

Finally, the ECJ rejects the position of the Munich Fiscal Court that the standstill provision justifies the discrimination because it was already in place on 31 December 1993. Two cumulative conditions must be met in order for the standstill to apply: the temporal and material condition (see part 2 of this newsletter, re EU law context).

On the material condition, the ECJ contrasts this case against the Wagner-Raith case (21 May 2015, C-560/13). While in Wagner-Raith the investment in shares of an investment fund enables the investor, by virtue of the financial services provided by that investment fund, to benefit from greater diversification of assets and distribution of risks, the investments in the case at hand constitute, first and foremost, a means which CPP uses to meet its pension obligations, not a service that it provides to the policyholders. The requisite causal link between the dividend income and financial services provided to policyholders is missing and the material condition is not met.

On the temporal condition, the ECJ rules that while the taxation of non-resident pension funds may have been in existence on 31 December 1993 and not have changed in substance since then, based on the case facts it cannot be ruled out that an exemption was introduced for resident pension funds after 31 December 1993. If that were the case then the temporal condition cannot be considered fulfilled. The ECJ refers that question of fact to the referring Munich Fiscal Court. For CPP, this appears hardly relevant as the material condition is already not met and the conditions for application of the standstill clause are cumulative. The ECJ dissents from the AG, who had opined that the temporal condition was met.

6. Our thoughts and “takeaways”

With this decision serving as a precedent, we recommend all foreign pension funds (non-German pension funds) that have incurred German dividend withholding tax in years that have not yet become statute barred and that have not yet filed claims to file claims for refund of German dividend withholding tax (2015 claims can still be filed until 31 December 2019). We recommend foreign pension funds that had already filed completed claims for refund of German dividend withholding tax more than 6 months ago, and that have not received any response, to consider filing an “action for failure to respond” in order to trigger the processing of their claims. We recommend foreign pension funds that had already filed protective claims for refund of German dividend withholding tax to complete their claims and, in case of no response within 6 months, file an action for failure to respond. Your trusted Taxology advisor will be pleased to assist any pension funds in these processes.

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