Taxation and Freedom of Movement - Coursework Example

Taxation and freedom of movement Introduction: The EC Treaty does not allow a less favorable taxation of cross border investments as compared to domestic investments. This provision is limited to investments within the Community, however where movement of capital is concerned, the EC Treaty is geared towards the unilateral prohibition of restrictions on the movement of capital between member states and third world countries. The notable aspect of recent ECJ decisions is in the clarification of the relationship between the free movement of capital and the freedom of establishment. The ECJ decisions have underlined the fact that the characteristic of establishment is the possibility for the shareholder to influence the activities of the Company and its decisions. The decisions of the ECJ have found discrimination to exist when there is a difference in the manner in which tax rules of Member States operate where residents and non residents are concerned. However, in view of the standstill clause which allows legislation executed prior to December 31, 1993 to continue to be implemented, the Swedish tax rules may still hold good and be valid. Analysis: The case of X and Y v Riksskatteverket1 raises the issue of whether Swedish tax law is compatible with the provisions of Articles 43 and 49 EC, which prohibit restrictions on the freedom of establishment. As highlighted in this case, Swedish tax law provides that a natural person transferring shares to a Swedish limited company with no foreign owners can be given an immediate tax credit. However if the ownership of the Swedish company is foreign or if the transfer of shares occurs to a foreign registered company then taxation occurs. This imputes a differential treatment of taxation in the case of resident and non resident shareholders. Article 43 EC states that "restrictions on the freedom of establishment of nationals of a Member State in the territory of another member state shall be prohibited."2 This freedom of establishment also includes the right for self employed persons and firms to pursue activities and manage undertakings. However, this does not extend to third world countries, rather restrictions on the movement of capital between member states, as well as between member states and third countries, is prohibited under article 56 to 60 of the EC which regulates the flow of capital.3 Article 48 EC clarifies this further by clearly specifying that companies or firms that are established within a member state "shall be treated in the same way as natural persons who are nationals of member states."4 Where the question of taxation arises, this aspect was raised in the case of C 265/04 M Bouanich v Skatterverket.5 This case was referred to the ECJ by the lower Court of Sundsvall. The issue was one of repurchase of shares in resident companies, where there was a differential treatment of payments to resident and non resident shareholders from the application of Swedish tax laws. According to Swedish law, in the case of resident shareholders, income derived from the repurchase of own shares is treated as capital gains with a right to deduct acquisition costs, however in the case of a non resident shareholder, the same is taxed as a dividend, without the right to deduct the acquisition cost of such shares. This, in effect, results in a more favorable tax position for the residents as compared to non residents. The Court had to determine whether the Swedish system was compatible with article 43 on the freedom of establishment as spelt out in the EC Treaty. The ECJ observed that the right to deduct acquisition costs is equivalent to a tax advantage; however under the Swedish rules, this advantage is reserved only for resident shareholders. This makes it less attractive for investors to make cross border transfer of capital and on this basis; the Court held that the Swedish rules constituted a restriction on the free movement of capital, as laid out under Article 56 EC. The Court also held that this differential tax treatment restricting the flow of capital amounts to a violation of the provisions of article 43 EC on freedom of establishment6. In the case of Skatterverket v A7 the application of Swedish tax rules led to the taxation of dividends paid by a Company that was not established in a state with which Sweden had either concluded a tax treaty or a state in the EEC containing a provision on the exchange of information. The overall result was that companies not established in Sweden were placed in a less favorable tax position. In the case of Skatterverket v A & B8, the Swedish rules were applied to closely held companies which resulted in a less favorable taxation of dividends for shareholders of the Swedish company because it has a permanent establishment in Russia rather than in Sweden itself. The ECJ ruled on this case on 10th May 2007 and stated that the Swedish rules constituted a restriction on the freedom of establishment as spelt out under article 43. The issue that is raised in all of these cases is the question of differential tax treatment for resident and non resident shareholders, as well as for foreign owned companies in Sweden. The decisions of the ECJ in the above cases support the position that such differential taxation may constitute a violation of Article 43 EC. In the case of Cadbury Schwepps plc Cadbury Schwepps Overseas Ltd v Commissioners of Inland Revenue9, the issue in dispute was the validity of UK rules – the CFC rules - in relation to foreign controlled companies. These rules were designed to prevent UK companies from diverting their taxable profits to another country. In the Cadbury case, the UK company in question owned two subsidiaries in Dublin, Ireland and these subsidiaries were engaged in the business of raising finance. Since these subsidiary companies were subject to taxes at only 10%, the CFC rules were applied and the profits of these subsidiary companies were attributed to the UK parent company for taxation purposes. The taxpayer appealed on the grounds that this constituted a violation of the principle of free establishment under article 43EC. In its judgment, the Court noted that the application of the CFC rules resulted in differences in tax treatment, because if a subsidiary was set up in a state where the taxation rates were lower, then it would be attributed to the UK parent company, but if the taxation rate was higher, this would not be the case. Hence, on this basis, if profits from a subsidiary are attributed to the parent company, it is a disadvantage to the parent company and constitutes differential tax treatment, which hinders the freedom of establishment. Therefore in the Cadbury case, the Court clearly specified that any restrictions on the freedom of establishment would be justified only if it was an overriding public interest. The reason cited by the defendants for the imposition of CFC was to prevent avoidance of taxation or payment of a reduced tax rate, but the ECJ held that this did not constitute a compelling reason. The court held that only if it could be proved that a subsidiary was being set up as a fictitious entity solely geared towards the avoidance of tax, the CFC rules could be validly applied, otherwise it amounted to differential taxation, which was not permissible under Article 43. The ECJ held that even if a subsidiary was set up in another member state to benefit from the reduced tax rates, the UK could not impute those profits to the parent UK companies for purposes of taxation. The UK is required to act in accordance with article 43EC and if its rules are not in accordance with the principles of community law, then they will not apply. This was also in accordance with the principle set out by the ECJ in the case of Marleasing SA v La Comercial Internaticional Alimentacion SA.10 Where the question of taxation is concerned, it is first necessary to determine whether the principles of free movement of capital as established under Article 56 EC will apply. In this respect, it was stated in the case of Test Claimants in the Thin Cap Group Litigation11 that movement of free capital can be excluded in those instances where the tax issues being disputed apply only to those situations which fall in the realm of establishment. In such cases, the question of whether a third country is involved will not apply. But when the dispute in question cannot be specifically ascertained to be restricted to establishment only, then it will become necessary for the court to determine whether the principle of free movement of capital will also apply. In the case of Holbock12the Austrian shareholder received dividends from a company that was in a non EEA country. As compared to the rates of taxation on domestic dividends, the dividends received by the shareholder from the foreign company were taxed at a much higher rate, thereby proving less advantageous for him. The dispute in question therefore concerned a shareholding which did qualify as establishment and the Court had to arrive at its decision while taking into consideration whether the free movement of capital provisions as laid out in Article 56 were being violated, and in this instance, it was necessary to take third countries affected by the tax measure into consideration. On this basis, it could be argued that tax measures that are geared towards impacting upon those situations where the shareholder has a definite influence may lend themselves to the application of the rules of establishment, and the provisions of free movement of capital may not necessarily apply in every case. But in this case, the ECJ held that the determination of an existing restriction will not apply only in those instances where the shareholder has a definite influence on company activities. The Court held that such a taxation policy as practiced by Austria was discriminatory in that it offered a less advantageous taxation policy for income earned from foreign dividends. However, in this instance, the application of the Austrian taxation law was not deemed to be illegal or invalid, mostly because it had been implemented before December 31, 1993 and fell within the purview of the standstill clause. On this basis therefore, it may be noted that not every instance of less advantageous taxation of foreign dividends may be held to be illegal by the ECJ. From the cases that have been discussed above, such as Skatterverket v A and Skatterverket v A &B, it would appear that the ECJ has tended to support the position that differential taxation constitutes a violation of the freedom of establishment under Article 43. However, this does not necessarily lead to the conclusion that every tax restriction is equivalent to a violation of the freedom of establishment under Article 43 EC. Any such measures that were in force against third parties before December 31, 1993 are likely to be held to be effective and applicable, under the standstill clause that is spelt out under Article 57 EC.13 Direct taxes fall within the legislative province of the Member States. As a result, even if differential taxation does exist, it will not necessarily violate the freedom of establishment under 43EC if the provision was in force before December 31, 1993. Moreover, the application of the standstill clause also means that an amendment made to a direct tax measure after the date of December 31, 1993 will not be held to be a new tax measure that will not be subject to the standstill clause. In the case of FII Group Litigation v Commissioners of the Inland Revenue14the question of an amended direct tax measure was at issue and the Court held that where the measures introduced by the amended legislation are essentially the same as that which existed under previous legislation, then such amendments will still fall within the scope of the standstill clause and therefore will not be held to be invalid. The case of FII15 is also significant because the ECJ made a clear distinction between taxation by Member states of cross border economic activities that take place within the Community, as opposed to taxation activity on economic activities that involve Member States and third countries. When considering whether the provisions of free movement of capital between the countries have been violated, the court must also take into consideration any extenuating circumstances that may have led a Member State to place a restriction on third country investments by way of differential taxation. As a result, where a third country is concerned, it may be possible for a member state to justify its imposition of differential tax standards or less advantageous taxation. In the case of FII however, despite noting that such tax restrictions may be justifiable in some instances, the ECJ did not accept the grounds of justification that were proffered by the UK Government to justify the imposition of restrictions against third countries. In its final judgment, the ECJ held that the restriction placed on third countries was in violation of the freedom of movement of capital. Therefore, in effect, the ECJ has ruled yet again that any form of differential taxation that imposes a restriction is equivalent to a violation of the principles of freedom from restriction in establishment and movement of capital. Conclusion: One important aspect emerging from these cases, which must be taken into consideration is the increasing influence of the ECJ decisions in the area of direct taxes. The term direct taxes refers to taxes on income and gains and in general, the province of direct taxes is intended to fall within the scope of the law of individual member states rather than being the subject of European law, which is to extend only into the jurisdiction of indirect taxes16. Indirect taxes include VAT and customs duties, where the ECJ will have a wider range of authority since they constitute the province of European law. However, the cases which have been discussed above show that the ECJ has been playing an activist role in the realm of direct taxation. In the cases mentioned earlier, the ECJ has held that differential taxation where a domiciled person is taxed more advantageously as compared to non resident shareholders constitutes a form of discrimination, since a distinction is made on taxation based upon the taxpayer’s nationality or seat. The ECJ in its decisions has therefore equated the residence status of taxpayers as being equivalent to their nationality.17 When the effect of direct taxation rules of Member States is such that it constitutes discrimination between residents and non residents, or between companies domiciled in a Member state as opposed to those that are established in another country, then such rules have been held to be in violation of the freedom of establishment principle set out under Articles 43 and 48 EC , as well as constituting a restriction on the free movement of capital, especially when it involves a third country. However, as may also be seen from the matter detailed above, the freedom of movement of capital will apply only in those cases where a third country is involved. The freedom of establishment as spelt out under Article 43 and 48 EC may however, apply even in those cases where a third country is not involved. The decisions of the ECJ has indicated above, appear to demonstrate that the ECJ is playing an increasingly activist role where direct taxation by Member States is concerned. On this basis, Sweden’s tax rules have been held to be discriminatory, because they result in less advantageous taxation of non residents as compared to the taxation levied upon residents. Therefore, in effect, it is violative of the principles of freedom of movement. The question of whether or not legal liability will be imposed for such violation of the freedom of movement will however depend upon the dates when such legislation was executed – if it was before 31st December, 1993, then the ECJ may follow its precedent in the Holbrook case and may not hold such differential taxation rates to be illegal. However, in instances where the tax legislation has been implemented after December 31, 1993, such as the new tax rules on partial divisions, which have been executed in order to implement the requirements of the EC Merger Directive (2005/19/EC)18, the ECJ is likely to deem a violation of freedom of movement to have occurred. As demonstrated by the cases detailed above in which the ECJ has rendered its decisions, almost all of the cases where there has been a difference in taxation rates for residents and non residents or for foreign companies has been held to be a violation of the freedom of movement in terms of free movement of capital as well as freedom of establishment. However, this is not necessarily a rule in every instance, since the application of the standstill clause will negate the finding of discrimination, since such a tax rule was in existence before the period of December 31, 1993. Therefore, it is only the new tax rules that have been implemented which will be subject to a finding of discrimination. If a tax rule implemented after December 31, 1993 is an amendment of an earlier legislation which essentially retains the spirit of the earlier legislation, it may not be deemed to be a restriction on the freedom of movement. Bibliography * ECJ holds unequal treatment of non resident shareholders in case of repurchase of own shares by a Swedish company incompatible with free movement of capital”. December 24, 2007 * EC Nice Treaty Provisions: Extracts" December 24, 2007 * European Union: What you should know about free movement of capital to and from non EEA countries.” December 24, 2007. * “Sweden. Implementation of amendments to EC Merger Directive.” December 24, 2007 http://www.internationaltaxreview.com/?ISS=23497&PUBID=35&Page=10&SID=677952&TYPE=20 * Taxation: How far will Europe go?” December 29, 2007. http://www.robertneweytaxlaw.co.uk/surrey%20tax%20law%20talk.html * Treaty establishing the European Community. December 23, 2007. * Treaty Provisions. December 24, 2007 Cases: * C 265/04 M Margaretha Bouanich v Skatterverket * C 101/05 -Skatterverket v A * C 102/05 Skatterverket v A &B * Cadbury Schwepps plc Cadbury Schwepps Overseas Ltd v Commissioners of Inland Revenue (Case C-196/04, 2 May 2006), * FII Group Litigation v Commissioners of the Inland Revenue (Case C-446/04) * Marleasing SA v La Comercial Internaticional Alimentacion SA (Case 106/89 (1990) ECR I-4135. * Test Claimants in the Thin Cap Group Litigation (Case C-524/04) * The Holbock case (Case no: 157/05) * X and Y v Riksskatteverket, Case no: C-436/00 Read More