Danish withholding tax on dividends to foreign funds contrary to EU law

The ECJ has held that a Danish withholding tax on dividends paid to foreign investment funds was contrary to the free movement of capital: Fidelity Funds v Skatteministeret (Case C-480/16). The Danish Government was unable to offer a justification for the difference in treatment between dividends from Danish companies paid to domestic funds (which were exempt from the withholding tax) and dividends paid to foreign investment funds (which were not). In particular, it was clear to the ECJ that a less restrictive regime could have been implemented by Denmark to achieve the same underlying purpose of moving the level at which taxation applied from the fund to the investor.

Background

Fidelity Funds, Fidelity Investment Funds, and Fidelity Institutional Funds (Fidelity) are funds qualifying as UCITS and resident in the United Kingdom and Luxembourg. They invested in shares in Danish companies and received dividends from those shares which were subject to Danish withholding tax. The investments were all portfolio investments which did not exceed 10% of the capital in the investee companies. However, investment funds resident in Denmark were exempt from the withholding tax on dividends from Danish shares provided that they elected to be treated as a “distributing fund” in accordance with the rules set out in section 16C of the Danish Tax Assessment Act. Fidelity claimed a repayment of withholding tax levied on the dividend distributions arguing that the imposition of the withholding tax was contrary to the freedom of establishment.

Decision of the ECJ

The Danish Government accepted (and the ECJ agreed) that the effect of the Danish system was that, in certain circumstances, UCITS established in Denmark and UCITS established in another Member State are subject to different tax treatment as regards dividends received from companies established in Denmark. However, Denmark argued that the restriction could be justified, first, by the need to safeguard the coherence of the tax system and, second, by the need to ensure a balanced allocation between the Member States of the power to impose taxes.

The ECJ noted that the aim of the Danish exemption was “to ensure equality of the tax burden on private individuals investing in companies established in Denmark through a UCITS and of that on private individuals investing directly in companies established in Denmark”. The legislation prevents economic double taxation which would occur if the dividends were taxed at the level of the UCITS and at the level of its members. On the question whether resident and non-resident funds were in a comparable position, the ECJ noted that as soon as a Member State, either unilaterally or by way of a convention, subjects not only resident companies but also non-resident companies to tax on the income which they receive from a resident company, the situation of those non-resident companies becomes comparable to that of resident companies. As Denmark chose to exercise its powers of taxation on the income received by non-resident UCITS, they were consequently in a situation comparable to that of UCITS resident in Denmark as regards the risk of economic double taxation of dividends paid by Danish companies.

However, the aim of the withholding tax was to ensure that the dividends distributed by Danish companies do not escape Danish tax on account of the exemption at the level of UCITS, and are actually taxed once. The Danish tax rules chose to defer the taxation to the level of the domestic UCITS’ members by providing that, in order to have Article 16C fund status - and consequently exemption from withholding tax - a domestic UCITS must deduct withholding tax from the minimum distribution calculated in accordance with Article 16C. In contrast, Denmark was not able to subject a non-resident UCITS to such an obligation to deduct withholding tax from the dividends that it distributed.

The ECJ has held that, in this context, although the aim of the legislation is to move the level of taxation from the investment vehicle to the shareholder, it is, in principle, the “substantive conditions” of the power to tax the shareholder’s income that must be considered decisive, not the method of taxation used. For example, a non-resident UCITS may have members with tax residence in Denmark whose income is in fact taxed in Denmark. “In that respect, a non-resident UCITS is in a situation that is objectively comparable to a UCITS resident in Denmark.” And whilst Denmark cannot tax non-resident members on the dividends distributed by non-resident UCITS, that is still “consistent with the logic of moving the level of taxation from the vehicle to the shareholder”.

Balanced allocation of taxing rights

Denmark nevertheless argued that the restriction was justified by the need to ensure a balanced allocation of taxing rights. Requiring Kingdom Denmark to grant an exemption from withholding tax on dividends distributed to non-resident UCITS, when it is unable to levy tax on the distribution of dividends to members, would in effect force Denmark (the source State of those dividends) not to exercise its power of taxation in relation to income generated on its territory.

The ECJ has rejected this justification. The court pointed out that it has already held that, where a Member State has chosen not to tax resident UCITS in receipt of domestic dividends, it cannot rely on the argument that there is a need to ensure a balanced allocation between the Member States of the power to tax in order to justify the taxation of non-resident UCITS in receipt of such income (Santander Asset Management SGIIC and Others (Cases C 338/11 to C 347/11)). Moreover, the court pointed out that dividends distributed by companies resident in Denmark to non-resident UCITS have already been subject to taxation in Denmark in respect of the distributing company’s profits. The fact that the taxation of dividends is deferred to the level of resident UCITS’ shareholders did not justify the restriction.

Coherence of the tax system

Denmark also argued that there was a direct link between the exemption from withholding tax in relation to dividends paid to domestic UCITS and the obligation on those UCITS to deduct withholding tax on dividends that they distribute to their members, such that the restriction was justified by the coherence of the tax system.

The ECJ noted that a domestic UCITS may be exempted from withholding tax on dividends distributed by a company resident in Denmark, provided that it makes a minimum distribution from which tax is deducted at source. As such, the advantage of the exemption from the withholding tax was, in principle, offset by the taxation of the dividends, redistributed by those undertakings, in the hands of their members. A direct link existed, in principle, therefore.

However, the ECJ went on to hold that limiting the exemption to UCITS resident in Denmark went beyond what is necessary in order to safeguard the coherence of the tax system. The coherence of the Danish tax system could be maintained if foreign UCITS, which could show that they satisfied the conditions of Article 16C, were also eligible for exemption from withholding tax, provided that the Danish tax authorities are able to confirm that “the latter pay a tax that is equivalent to the tax which Danish Article 16C funds are required to retain, as a withholding tax, on the minimum distribution calculated in accordance with that provision”. Allowing such foreign UCITS to enjoy the withholding tax exemption would be less restrictive. Consequently, the ECJ held that the restriction could not be justified by the need to safeguard the coherence of the tax system.

Comment

The case is the latest of a number of successful challenges to the imposition of discriminatory taxes and withholding taxes on dividends in relation to portfolio holdings of shares by funds. Funds investing cross-border should consider whether they have been affected by discriminatory taxation provisions and take action accordingly.

Since the decision is based on the free movement of capital, it should also apply, in principle, to third country situations as well as dividends received by EU funds. However, it is possible that considerations around availability of information and the ability of a Member State to confirm the accuracy of that information in third country scenarios may limit the scope to apply this judgment in some third country situations.