German WHT on dividends paid to EU/EEA minority shareholders violates free movement of capital

The European Court of Justice (ECJ) issued a decision on 20 October 2011 (Case C-284/09, Commission vs. Germany), concluding that German withholding tax on outbound dividends paid to foreign (EU/EEA) corporations violates the free movement of capital provisions in the Treaty on the Functioning of the European Union (TFEU) and the EEA Agreement.

Situation in Germany

Even though Germany levies withholding tax on dividends distributed by a German company to both resident shareholders and shareholders established in other EU Member States, the outbound dividends are treated less favorably under German tax law as compared to domestic dividends. Dividends distributed to domestic corporate shareholders generally enjoy an effective 95 % exemption (100 % of the dividends are treated as exempt, with 5 % treated as a nondeductible business expense). Domestic companies are granted a tax credit for the withholding tax levied, as a result of which the withholding tax is effectively refunded if no other income than dividend income is earned. By contrast, no credit is granted to a nonresident shareholder so the withholding tax becomes a final tax burden and thus a true cost.

ECJ decision

The ECJ has ruled that this difference in treatment constitutes a restriction of the free movement of capital provisions of the TFEU and the EEA Agreement and that it cannot be justified. The ECJ held that the fact that domestic dividends potentially are subject to German trade tax (at rates ranging from 7 % to up to approximately 17 %) cannot offset the disadvantageous treatment of outbound dividends for corporate income tax purposes. The 5 % add-back on dividends (i.e. the fact that 5 % of all dividends received are considered a nondeductible expense that is subject to corporate income and trade tax at the level of a German company) was not even considered by the ECJ. The court pointed out that “resident companies receiving dividends suffer no tax burden as a result of the withholding tax.”

Implications for taxpayers

As a result of the ECJ decision, all EU/EEA corporations that suffered a definitive German withholding on dividends received from German corporations should be entitled to a refund of the full amount of German withholding tax. The most common instance of when German tax would have been withheld would be minority shareholdings that are below the threshold in the EU Parent-Subsidiary Directive (currently 10 %). However, even if the participation threshold of the Directive is met, distributions on German profit-participating bonds that are treated as equity, distributions of liquidation proceeds that are not covered by the Directive and deemed distributions in certain types of reorganizations (conversions of corporations into partnerships) where domestic law excludes the application of the Directive also should be covered by the ECJ decision. The ECJ has not addressed whether third country resident shareholders could also rely on the principles of the decision. As the tax authorities and the German legislator are unlikely to extend the principles of the decision to third country resident taxpayers when reacting to the decision, these taxpayers would have to take their cases to court in separate proceedings.

The ECJ did not limit the temporal effects of its decision, but taxpayers wishing to file reclaims should do so as quickly as possible. Although procedural rules for these types of reclaims are still unclear in Germany, it is prevailing opinion that a reclaim must be filed within four years after the year in which the relevant dividends were received (i.e. for claims filed until end of 2011, tax withheld on dividends received in 2007 and subsequent years could likely still be reclaimed).

Further developments in Germany should be monitored carefully as the ECJ decision (which resulted from infringement proceedings initiated by the European Commission) could force the German tax authorities to issue guidance with regard to the procedural rules applicable to these reclaims, including the identification of the authority competent to deal with the reclaims which is currently still unclear and which did not have to be addressed by the ECJ.

Other pending cases

A decision on withholding tax refunds to pension institutions (Case C-600/10) is still outstanding. No proceedings have been initiated yet for investment funds, although it is expected that this is simply a matter of time.

If you have any questions, please contact the authors of the article at gtln@deloitte.de or your regular Deloitte contact.