In this article Dick Hofland and Sacha Leeman of Freshfields describe the facts of the Bosal case,the relevant aspects of the Netherlands participation exemption, and that particular feature of the Netherlands participation exemption that the ECJ held to be contrary to the EC Treaty. This is the rule that, for corporate income tax purposes, only allows a Netherlands parent company a deduction of (interest) costs relating to a subsidiary if the subsidiary is resident in the Netherlands or derives profits taxable in the Netherlands (the Revenue Link).
The issue at stake is whether this rule violated Bosal’s right of free establishment set forth (presently) in article 43 of the EC Treaty.This article will explain why arguably it did,what arguments the Netherlands government put forward against this position and and on what basis the ECJ rejected these arguments. It will then speculate on the potential consequences of the decision for certain other features of the Netherlands participation exemption and for the method by which other EU Member States tax foreign dividends.
The Facts
Bosal Holding B.V.,a Netherlands resident producer of exhaust pipes and related products, held interests (both majority and 100% interests) in a number of subsidiaries in the Netherlands and in other EU Member States.Bosal had financed these investments with interest bearing debt.
Bosal and the Netherlands participation exemption
The Netherlands participation exemption and the Netherlands Revenue Service
With respect to the investments, the Netherlands participation exemption applied. Pursuant to this exemption, dividends and capital gains derived from qualifying subsidiaries are exempt from corporate income tax.The ‘flip side’of this exemption is that,in principle, costs (such as interest costs) incurred in connection with the investment are not deductible. However, as an exception, pursuant to the Revenue Link costs are deductible if,and to the extent that,the income of the subsidiary is taxable in the Netherlands,irrespective whether the subsidiary pays any tax. It is this provision that Bosal challenged. It argued that the Revenue Link makes an investment in a subsidiary with foreign activities (costs not deductible) less attractive than an investment in a subsidiary with Netherlands activities (costs deductible), and that thus it restricts a Netherlands holding’s freedom to establish subsidiaries in other EU Member States as it was laid down in article 52 of the EC Treaty.
Article 52 of the EC Treaty provided (to the extent relevant):”[R]estrictions on the freedom of establishment of nationals of a Member State in the territory of another Member State shall be abolished … Such ..abolition shall also apply to restrictions on the setting up of agencies, branches or subsidiaries by nationals of any Member State established in the territory of any Member State.”Pursuant to article 58 (old, currently article 48) of the EC Treaty, the term ‘nationals’ effectively includes companies formed in accordance with the law of an EU Member State that have their ‘registered office, central administration or principal place of business’ within the EU. Bosal qualified as a national of the Netherlands.
As was to be expected,Bosal’s views were rejected by the Netherlands Revenue Service.When Bosal’s appeal against this decision reached the Netherlands Supreme Court in 2001,this court referred the matter to the ECJ.
The ECJ
Before the ECJ, the Netherlands Government argued that the Revenue Link does not restrict in any way the freedom of establishment or,if it does,there would be the following justifications for such restriction: (i) compatibility of the Revenue Link with the ParentSubsidiary Directive1 (ii) the need to preserve the coherence of the Netherlands tax system, (iii) the objective of avoiding an erosion of the tax base, and, (iv) the principle of territoriality. Implicitly, the ECJ sides with the Netherlands Supreme Court’s position that the Revenue Link constitute a hindrance to establish subsidiaries in other EU Member States.The question therefore arose whether any of the justifications mentioned above were valid.
The Parent-Subsidiary Directive
Pursuant to article 4 paragraph 2 of the ParentSubsidiary Directive,EU Member States can provide that costs in relation to holdings are not deductible from the taxable profits of the parent company. Query whether this means that EU Member States have the unrestricted possibility of partlyrefusing the deductibility of such costs (as the Netherlands did with the Revenue Link)? The answer was negative:the ECJ held that this possibility was subject to the overriding requirement that it can only be exercised in compliance with the fundamental freedoms, including the freedom of establishment. As indicated above,the Revenue Link failed this test.
Fiscal coherence
The Netherlands Government argued that the Revenue Link was justified by the need to maintain the coherence of the Netherlands tax system2, in the sense that there was a direct link between,on the one hand the (deductibility or non-deductibility) of costs connected with the parent company’s holding in the capital of the subsidiary and,on the other,the taxation (or non-taxation) of the profits of such subsidiary. In line with its earlier decision in the Baarscase3,the ECJ held that in order for the coherence principle to provide a justification for the violation of the freedom of establishment there should be a direct link in the sense,in the case of one taxpayer,between the grant of a tax advantage and the offsetting of that advantage by a fiscal levy, and both relating to the same tax. In the instant case, the coherence principle failed to apply since the advantage (in the form of a deduction for costs) was granted to the parent company while the disadvantage (in the form of the taxation of profits) was for the account of the subsidiary.In this respect,it did not ‘help’ that the Netherlands system is itself incoherent in that it does not allow foreign corporate taxpayers that earn income from Netherlands source to deduct from their taxable profits interest and other expenses incurred by their parent company.
Erosion of the tax base
According to the Netherlands government, the Revenue Link is justified by the aim to avoid an erosion of the Netherlands tax base.The ECJ found, however,that this aim did not differ from the objective to avoid a diminution of tax revenues, which had already been disqualified as a justification of the restriction on the freedom of establishment.4
The principle of territoriality
The most important argument put forward by the Netherlands government is that subsidiaries of Netherlands parent companies which are established in the Netherlands and (only) make profits that are taxable in the Netherlands and subsidiaries which do not are not in an objectively comparable situation,and that the difference in their tax position justifies the difference in treatment at the level of their Netherlands parent company.What makes the position of these subsidiaries so different is the fact that Netherlands subsidiaries are taxed on their worldwide income, and foreign subsidiaries are only taxable in the Netherlands if they earn income from Netherlands sources (such as profits derived from an enterprise that is carried on partly or wholly through a permanent establishment in the Netherlands).This argument is based on the principle of territoriality.
This justification was first presented in Futura Participations SA and Singer v Administration des Contributions.5 In this case,the question was whether it was in conformity with EC law for Luxembourg to require that for losses of a Luxembourg branch of a French company to be available for carry forward,it had to be demonstrated that they were economically linked to income in Luxembourg and subject to tax there,so that effectively only losses arising from the French company’s Luxembourg branch activities could be carried forward. In Futura the ECJ ruled that (paragraph 22):
“Such a system,which is in conformity with the fiscal principle of territoriality, cannot be regarded as entailing any discrimination,overt or covert,prohibited by the Treaty.”
In the Bosal case, the ECJ admitted that, in general terms, the principle of territoriality could justify an exception to the right of freedom of establishment in the form of a justified difference in tax treatment. However, without giving any clarification, the ECJ ruled that the principle of territoriality can only be applied if the dispute concerns the taxation of a single company,(paragraph 38):
“…it should be noted that the application of the territoriality principle in Futura Participations and Singer concerned the taxation of a single company which carried on business in the Member State where it had its principal establishment and in other Member States from secondary establishments.”
In other words,the principle of territoriality could not provide a justification for different tax treatment of the parent company if the principle of territoriality concerns the position of its subsidiary.Reviewed from the perspective of the parent company, since both income (dividend and capital gains) derived from domestic and foreign participations were treated the same, i.e. exempt pursuant to the participation exemption,there was no reason to treat related expenses differently.
Consequences of the Bosal case in the Netherlands
The Netherlands Budget
The direct consequence of the decision is that interest and other costs incurred by Netherlands companies relating to subsidiaries established in other EU countries6 over the past years will become fully deductible.Most companies that are potentially affected by the Bosal already filed appeals since the early 1990s. Shortly after the Bosal case came out,the Netherlands Undersecretary of Finance issued a directive to tax inspectors in which they were instructed to grant refunds promptly. The Netherlands Government estimates the ‘damage’ of the Bosal case to be in the range of 1.6 billion for the past years and prospectively an expected annual loss of revenue of approximately 1 billion. In order to seek budgetary compensation, the Netherlands Government immediately announced thin capitalisation (thin cap) legislation that will limit the deductibility of interest on intercompany debt to the extent the overall debt-to-equity position (that takes into account both debt owed to related and unrelated parties) of a Netherlands corporate income taxpayer exceeds 3:1.In addition,the legislation severely restricts the right of Netherlands holding and/or finance companies to carry backward or forward tax losses in an effort to limit the damage of the Bosal case.Thus, the Netherlands proves to be a ‘bad loser’.It has yet to be seen, however, whether the limitation of loss carry forward and loss carry backward will have the desired effect as this restriction may very well violate the freedom of establishment as well.
Other features of the Netherlands participation exemption
Following the outcome of the Bosal decision,(at least) three other features of the Netherlands participation may very well be in conflict with the EC Treaty.7 All three, in certain circumstances, impose requirements with respect to non-Netherlands EU subsidiaries that do not need to be fulfilled if it concerns Netherlands subsidiaries.First,if a Netherlands company owns less than 25% of the share capital of the foreign EU subsidiary, for the participation exemption it is required that the shares are not held as a (passive) ‘portfolio investment’. It is virtually certain that this provision will be in conflict with the article 56 of the EU Treaty (free movement of capital) which provision rather than article 43 applies in case of a less than 50% interest in a subsidiary.8 Second, foreign EU subsidiaries have to be subject to tax without being subject to a special regime. From settled case law9,it follows that this requirement implies a restriction that cannot be justified on the basis that it serves to combat abuse or tax avoidance. Finally, the participation exemption does not apply if (i) 70% or more of the assets of the foreign EU Subsidiary (directly or indirectly) consists of shareholdings in companies outside the EU,and (ii) these shareholdings in non-EU companies would not qualify for the participation exemption had they been held by the parent company directly. It is extremely likely that this anti-abuse provision will not be considered specific enough.10
Potential consequences for the taxation of foreign dividends by other EU Member States
Exemption and credit system
Some Member States, e.g. the United Kingdom, apply an exemption system for dividends received from a domestic subsidiary (dividends exempt) and a credit system for dividends received from a ‘foreign’ EU subsidiary (the dividends are taxed but a credit against corporate income tax is provided for tax that is levied from the subsidiary). Under the ParentSubsidiary Directive both systems (article 4) are allowed in order to avoid economic double taxation. Query whether this allows a Member State to apply the exemption system to dividends from domestic subsidiaries and the credit system to ‘foreign’ EU subsidiaries? For several reasons, including (i) that a credit system is more complicated and requires more administrative activities11,and (ii) a credit system can very well result in a higher effective tax burden than an exemption system,this difference in treatment may make it less attractive to invest in foreign than in domestic subsidiaries. This restriction thus violates the freedom of establishment or freedom of capital.12 The Bosal case makes it clear that the possibility that the Parent Subsidiary offers to opt for an exemption or a credit system provides no justification for such a restriction.
Controlled foreign companies legislation
Most CFC legislation that is in place in a number of EU Member States has in common that the profits of foreign subsidiaries in which the parent company owns an interest that exceeds a certain threshold (e.g.in the UK an interest of at least 25%) and that is engaged in ‘passive’ activities such as earning interest or royalty income are treated as the profits of the parent (or are deemed to be distributed) if the applicable tax rate in the country of residence of the subsidiary is considerably lower compared to the applicable tax rate in country (e.g.in the UK,the tax on income profits in the subsidiary’s country of residence is less than 75% of notional tax).A credit against the parent’s corporate income tax is then available for the tax incurred by the CFC.The fact that such CFC rules do not apply to holdings in domestic subsidiaries means that domestic and foreign subsidiaries are treated differently. It is virtually certain that this different treatment restricts the freedom that companies should have to establish subsidiaries in EU Member States with (lower) income tax rates.The question is whether such restriction can be justified.From the Eurowings13 and Skandia14 case it already follows that a difference in tax rate cannot be used as justification for an infringement of one of the four freedoms.None of the arguments which the ECJ put forward in the he Bosal case to strike down the defences put up by the Netherlands government sheds new light on this issue.15 Nevertheless, there is little doubt that Bosal will be an inspiration for those who like to test the validity of the CFC legislation.
Notes:
1 Council Directive 90/435/EEC of 23 July on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States.
2 This doctrine was developed in Case C-204/90,Bachmann [1992] ECR I-249.
3 Case C-251/98,Baars [2000] ECR I-2787.
4 Case C-264/96,ICI [1998] ECR I-4695.
5 Case C-250/95,Futura Participations and Singer,[1997] ECR-I-2471.
6 As well as member countries of the European Economic Area (Norway,Liechtenstein,Iceland),as explicitly confirmed by the Netherlands tax authorities in their decree regarding the application of the participation exemption of 11 August 2003,no.CPP03-1611.
7 There is another provision relating to the Netherlands participation exemption that may also be in conflict with EC law.Under Netherlands law,no dividend withholding tax needs to be withheld by a Netherlands subsidiary on dividend distributions to its Netherlands parent if the participation exemption applies.In summary,this will be the case for participations of at least 5% in the capital of the subsidiary (with the understanding that,if the shares are not held as passive portfolio investment no minimum percentage is even required).By contrast,in case of a dividend distribution to a ‘foreign’EU parent more stringent rules apply for such relief at source i.e.the ‘foreign’EU parent needs to hold for at least one year at least 25% of the capital of the subsidiary.(If the EU parent’s country of residence applies a minimum percentage of 10%,this lower holding percentage applies.If the proposed amended Parent-Subsidiary Directive is adopted and subsequently implemented in the Netherlands law this holding percentage will be reduced to 10% for all EU Member States).It is likely that,on the basis of the ECJ’s reasoning in the Bosal case,the low threshold for the exemption that applies to Netherlands corporate shareholders should apply to foreign EU corporate shareholders as well.
8 Case C-251/98,Baars,[2000] ECR I-2787,paragraph 22.
9 According to article 2(c) of the Parent-Subsidiary Directive,this Directive only applies to companies that are subject to one of the taxes mentioned in this article,without the possibility of an option or of being exempt.It,however,does not,impose the requirement that the subsidiary may not be subject to a special regime.Given the fact that thus the Parent-Subsidiary contains a specific provision on the subject-to-tax issue, the Netherlands legislator is not allowed to introduce additional anti-abuse provisions on the basis of the general anti-abuse provision,see Cases C-283/94,C-291/94 and C-292/94,Denkavit,VITIC and Voormeer,[1996] ECR-I 2063.
10 Case C-28/95,Leur Bloem,[1997] ECR I-4161.
11 Case C-250/95,Futura Participations and Singer,[1997] ECR-I-2471.
12 Case-251/98,Baars,[2000] ECR I-2787.
13 Case-294/97,Eurowings,[1999] ECR I-7447.15 Case 422/01,F?rs?kringsaktiebolaget Skandia.
15 Prima facie,it is not clear how Bosal can provide fresh ammunition for those who have critically commented on the decision by the Special Commissioners in Marks & Spencer PLC v David Halsey (HM Inspector of Taxes).For an overview of the views expressed on this case see e.g.F.Vanistendael,The compatibility of the basic economic freedoms with the sovereign national tax systems of the Member States,EC Tax review,2003-3,M Meussen,The Marks & Spencer case:reaching the boundaries of the EC Treaty,EC Tax review,2003-3,P.Pistone,Tax treatment of foreign losses:an urgent issue for the European Court of Justice,EC Tax review,2003-3,D.Gutmann,The Marks & Spencer case:proposals for an alternative way of reasoning,EC Tax review,2003-3,J.Ivinson and J.Hamer,Not Quite the End,the Tax Journal, 13 October 2003,P.Martin,letter to the editor of the Tax Journal,the Tax Journal 27 October 2003.