Landmark decision: ECJ overturns unequal treatment of third country dividends for trade tax purposes

Background

Under certain conditions, dividend income from shares in corporations is not subject to trade tax. In the case of a domestic subsidiary, § 9(2a) of the Trade Tax Act (Gewerbesteuergesetz; GewStG) stipulates that a shareholding of at least 15 per cent must have existed at the start of the year. If the subsidiary is domiciled abroad, the law also imposes additional requirements. In particular, § 9(7) GewStG requires the subsidiary to generate certain (so-called “active”) income regulated in the Foreign Tax Act (Außensteuergesetz; AStG). This means that domestic and foreign dividends are treated differently for trade tax purposes. In a ruling of 20 September 2016 (Case 9 C 3911/13 F), the Münster Tax Court expressed doubts as to the compatibility of this unequal treatment with Union law and referred the question to the European Court of Justice (ECJ) for a ruling. This was based on the following state of affairs:

The plaintiff, a German partnership limited by shares (KGaA), was the parent company of a German limited liability company (GmbH) within a fiscal unity for income tax purposes and held a 100 per cent share in the latter. The GmbH in turn held 100 per cent of an Australian limited company, which assumed the role of a holding company for further shareholdings in the Australian and Asian region. In 2009, the year of the dispute, a Philippine subsidiary distributed profits to the Australian holding company. In the same year, the Australian holding company in turn distributed its profit carry forward to the GmbH.

During a tax field audit of the GmbH, the auditors took the view that the conditions for exemption from trade tax for the distribution of profits in accordance with § 9(7) GewStG were not met. This is because the Australian limited company merely assumes a holding function and therefore does not generate any income from its own business activities. A trade tax advantage could only be granted for the “passed through” profit distribution of the operating Philippine company (so-called “second-tier subsidiary privilege”). The non-privileged profit shares were therefore to be added to the trade income attributable to the parent company in the fiscal unity. The defendant revenue service office then issued an amended trade tax assessment notice. The revenue service office rejected the appeal filed against this as lacking merit in its appeal decision. The plaintiff then brought an action before the Münster Tax Court.

Marcel Jordan, M.Sc., MOORE STEPHENS Koblenz GmbH

Legal rulings of the ECJ

After the referral by the Münster Tax Court, the ECJ in its judgement of 20 September 2018 (Case C-685/16) found an infringement of the free movement of capital. According to continuous legal rulings, the tax treatment of dividends may fall both under the freedom of establishment (Article 49 TFEU) and the free movement of capital (Article 63 TFEU). Within the scope of application of the freedom of establishment, a national regulation would apply, encompassing shareholdings with certain influence on the decisions of the company and its activities. On the other hand, regulations on shareholdings that serve only investment purposes and do not have any influence on management or control should be assessed in terms of the free movement of capital.

According to these principles, the trade tax arrangement for dividend income must be assessed on the basis of the free movement of capital, since the required minimum shareholding of 15 per cent does not exclusively encompass those subsidiaries over which certain influence can be exercised. The European Court of Justice regards the unequal treatment of trade tax as a restriction of the free movement of capital between EU and third countries. Because of the less favourable tax treatment of dividends from third country companies, their shares are less attractive to resident investors than the shares of resident companies.

It is true that the application of a discriminatory provision is permissible when the domestic and cross border states of affairs are not comparable or when there is an overriding reason relating to the public interest. In the opinion of the ECJ, however, neither of these two factors could be considered in order to justify the difference in treatment. Therefore, § 9(7) GewStG is not compatible with the free movement of capital.

Outlook and practical implications

The violation of Union law through the unequal treatment of third country dividends for trade tax purposes has long been debated in the literature. The confirmation by the ECJ creates legal certainty and is therefore to be welcomed. A corresponding adjustment of the German Trade Tax Act will therefore be indispensable. It remains to be seen whether national legislators will attach the same conditions to the exemption of third country dividends from trade tax as in a domestic state of affairs in response to the ruling of the European Court of Justice.

However, the violation of Union law could also be eliminated by tightening up the trade tax exemption for domestic dividends. In any case, the applicability of the judgement extends beyond the specific case judged to all open cases in which the trade tax reduction of foreign dividend income has already been restricted or denied in accordance with § 9(7) GewStG. The relevant assessment notices should therefore be kept open. In addition, it should be sought—if necessary, by way of legal action—for income to be treated in accordance with the domestic state of affairs.