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Recent trend in rulings of the court of justice of the EU might sideline the EU Interest and Royalties Directive. Opening a new gap for international tax optimization?

The recent rulings of the Court of Justice of the EU confirming the recognition of a doctrine of free movement of capital stipulated by primary law of the EU gives chance to tax planners that these rulings might override some of the objectives and provisions of the EU Interest and Royalties Directive. This means that certain part of the EU Interest and Royalties Directive might be legally inconsistent with the Treaty of the functioning of the EU, which is regarded as a part of unofficial constitution of the EU. Such conclusion could potentially lead to mass tax refunds and could give to tax planners some additional muscle with respect to tax optimization.

In April 2014, the Court of Justice of the EU (C -190/12)[1] confirmed the existence and determined, to a relevant extent, the scope of EU doctrine of free movement of capital contained in the Article 63 (Within the framework of the provisions set out in this Chapter, all restrictions on the movement of capital between Member States and between Member States and third countries shall be prohibited) and following of the Treaty of the functioning of the EU (further only as “TFEU”).

This was the Polish case when a US investment fund applied for a refund of withholding tax paid on dividends derived from Polish companies, but the claim was not accepted by Polish tax authorities. Polish law says that investment funds are exempted from taxation if their registered office is in Poland, in another member state of the EU, or of European Economic Area, and they satisfy certain conditions. Therefore, non-EU, EEA investment funds (i.e. US investment funds) are not able to benefit from such exemption even if they satisfy the conditions required by Polish law applicable to EU or EEA investment funds.

The Court of Justice of the EU ruled that the US investment fund should be also entitled to benefit from such exemption relying on the free movement of capital principle under the Article 63 and following of the TFEU (further only as the “Polish case”).

In addition, the Court of Justice of the EU (C-101/05)[2] ruled in a similar Swedish case in which dividends were distributed to a parent company from Sweden from a subsidiary parked in Switzerland. These dividends were not subject to taxation in Sweden due to exemption. A Swedish public authority claimed that the provisions of the TFEU regarding free movement of capital are unclear with regard to the movement of capital between member states and third countries, in particular in the case of those third countries which oppose exchanging information for purposes of fiscal supervision (Articles 64 and following of the TFEU).

Therefore, as in the Polish case, the question at hand was not whether distribution of dividends falls within free movement of capital under the TFEU, but instead particular details were the subject matter (i.e. fiscal supervision, tax evasion, existence of restrictive rules prior 1994[3], etc.). The Court of Justice of the EU ruled that tax exemption in relation to non-EU states in respect of dividends distributed from non-EU states may be granted only if a company making such distribution is established in a non-EU state with which a taxation convention providing for the exchange of information has been concluded by a member state of the EU imposing the tax, where that exemption is subject to conditions compliance with which can be verified by the competent authorities of that member state of the EU only by obtaining information from the non-EU state of establishment of the distributing company (further only as the “Swedish case”).

These judgments (Polish and Swedish case) give solid grounds for non-EU investment funds (in principle for any other non-EU individuals or entities) to rely on such tax preferences granted to EU entities and therefore benefit from EU law[4]. Moreover, these judgments, including a few other recent rulings of the Court of Justice of the EU, provide sound arguments to believe that the principle of free movement capital could be used not only with respect to dividends, but applies to any other tax case where free movement of capital is at issue (e.g. interests) as the case may be.

Generally, the TFEU distinguishes between freedom of establishment and free movement of capital. The principle of freedom of establishment is contained in the Article 49 of the TFEU as follows: “Within the framework of the provisions set out below, restrictions on the freedom of establishment of nationals of a Member State in the territory of another Member State shall be prohibited. Such prohibition 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.” According to this, non-EU individuals and entities are not entitled to rely on this principle.

On the other hand, with regard to elimination of restrictions on capital movements, the abovementioned Article 63 of the TFEU (Within the framework of the provisions set out in this Chapter, all restrictions on the movement of capital between Member States and between Member States and third countries shall be prohibited) stipulates very explicitly its applicability with respect to third countries.

Therefore, in order to find out whether a particular tax case should receive protection from the EU law, a distinction must be made between two basic EU principles: (i) freedom of establishment (Article 49 and following of the TFEU) and (ii) free movement of capital (Article 63 and following of the TFEU).

In case that the extent to which the holdings confer their owner definite influence over the decisions of the companies concerned and allow it to determine their activities, principle of freedom of establishment applies[5]. For that reason, if shareholding of a non-EU holder enables it to substantially influence the management and control of an EU company, distribution of dividends from this EU company to this non-EU holder should not be subject to protection from either Article 49 of the TFEU (Freedom of establishment) or of Article 63 of the TFEU (Free movement of capital).

It follows from above that holdings in a company which are not acquired with a view to the establishment or maintenance of lasting and direct economic links between the shareholder and that company and do not allow the holder to participate effectively in the management of that company or in its control cannot, in this connection, be regarded as direct investments and thus subject to Article 49 of the TFEU (Freedom of establishment).[6] Therefore, a non-EU holder receiving dividends from an EU company should be able to rely on Article 63 of the TFEU (Free movement of capital) if its shareholding in the EU company is not regarded as direct investment.

It therefore follows from this that as long as a financial instrument at issue does not, by its nature, constitute a direct investment tool, such instrument should be viewed in relation to free movement of capital under the Article 63 of the TFEU.

According to the OECD Benchmark Definition of Foreign Direct Investment[7]“A direct investment is a category of cross-border investment made by a resident in one economy (the direct investor) with the objective of establishing a lasting interest in an enterprise (the direct investment enterprise) that is resident in an economy other than that of the direct investor. The motivation of the direct investor is a strategic long-term relationship with the direct investment enterprise to ensure a significant degree of influence by the direct investor in the management of the direct investment enterprise. The “lasting interest” is evidenced when the direct investor owns at least 10% of the voting power of the direct investment enterprise. The same threshold is also used in the Glossary of foreign direct investment terms of the International Monetary Fund: “A direct investment relationship is created when an enterprise resident in one economy owns 10 percent or more of the ordinary shares or voting power for an incorporated enterprise, or the equivalent for an unincorporated enterprise, that is resident in another economy“[8]

Likewise, this follows also from the ruling of the Court of Justice of the EU (C-446/04) pursuant to which, if a resident company receives from another resident company dividends exempted from taxation and the same state levies corporation tax on dividends which a resident company receives from a non-resident company in which it holds less than 10% of the voting rights, without granting the company receiving the dividends a tax credit for the tax actually paid by the company making the distribution in the state in which the latter is resident, it is regarded as being contrary to the Article 63 of the TFEU (former Article 56) restriction on capital movements (i.e. portfolio investments).[9]

In addition to this, International Monetary Fund stipulates that apart from income on equity (e.g. dividends) income on debt (e.g. interests) should be regarded as a direct investment income if there is this relevant holding.[10]  Definition of direct investment used by International Monetary Funds has been implemented into domestic laws of various countries including Slovak Republic or Czech Republic.

Summarizing the above, any investment in an EU resident (equity of debt) where an investor is not a holder having more than 10% of shareholding in the EU resident should be subject to Article 63 of the TFEU (Free movement of capital).

Generally speaking, measures such as different treatment of non-EU residents and EU residents with respect to capital movements discourage non-EU residents from making investments in the EU[11]. Although, authors Terra and Wattel suggest, the history of integration in this sphere shows that Member States defend their direct tax sovereignty “as if it were their virginity,”[12] it must be noted that while indeed direct taxation falls within the competence of member states of the EU, domestic measures must be in line with EU basic freedoms such as free movement of capital.[13]

Based on the above, the whole area of direct taxation (not only dividends as confirmed in cases[14]) should be able to enjoy protection under the Article 63 of the TFEU (Free movement of capital). It follows from the above that taxation of interests in the EU should not result in restrictions on capital movements as well. 

As a rule, primary law of the EU (i.e. TFEU) determines the legal framework within which secondary law adopted by the EU institutions is implemented. This implies that for example EU regulations or EU directives must not be in contradiction to primary law of the EU (i.e. TFEU).

Under the EU Interest and Royalties Directive, interest arising in a member state of the EU should be exempt from any taxes imposed on those in that member state, whether by deduction at source or by assessment, provided that the beneficial owner of the interests is a company of another member state of the EU or a permanent establishment situated in another member state of the EU of a company of a member state of the EU. Such exemption applies only if a company which is the payer, or a company whose permanent establishment is treated as the payer, of interests is an associated company of the company which is the beneficial owner, or whose permanent establishment is treated as the beneficial owner, of that interests. A company is considered as an associated company to a second company in the following cases:

  • the first company has a direct minimum holding of 25 % in the capital of the second company; the first company is a parent company,
  • the second company has a direct minimum holding of 25 % in the capital of the first company; the first company is a subsidiary, or
  • a third company has a direct minimum holding of 25 % both in the capital of the first company and in the capital of the second company; the first and the second companies are sister companies.

Assume that an EU investor has purchased bonds of or has provided a loan to its EU associated company and for the sake of exemption, the EU investor fulfills all criteria stipulated by the EU Interest and Royalties Directive. Under this, a distribution of interests from this EU associated company to the EU investor should be exempted from taxation at source (i.e. in a country of the distributing EU associated company).

Assume that a non-EU investor (further only as “Non-EU investor”) has purchased bonds of or has provided a loan to its EU associated company (further only as “EU Associated Company”) and for the sake of exemption, the Non-EU investor fulfills all material criteria stipulated by the EU Interest and Royalties Directive apart from being an EU resident. Under this, a distribution of interests from the EU Associated Company to the Non-EU investor should not be exempted from taxation at source (i.e. in a country of the distributing EU associated company).

The EU Interest and Royalties Directive very clearly lays down that, as a rule, the Non-EU investor cannot rely on the EU Interest and Royalties Directive when it comes to taxation of interests. However, the Non-EU investor is discriminated based on the Article 63 of the TFEU (Free movement of capital) if its investment in its EU Associated Company is not regarded as direct investment, meaning that the Non-EU investor does not own 10 percent or more of the ordinary shares or voting power in its EU associated company. Can this happen?

Pursuant to the EU Interest and Royalties Directive, tax preference (tax exemption) applies in the following cases:

  • an investor has a direct minimum holding of 25 % in the capital of a company in which it invests;
  • a company in which an investor invests has a direct minimum holding of 25 % in the capital of the investor, or
  • a third company has a direct minimum holding of 25 % both in the capital of an investor and in the capital of a company in which the investor invests.

As regards the first case, if the Non-EU investor has a holding of more than 25% in the EU Associated Company, it would be regarded as a direct investment relationship subject to the Article 49 of the TFEU (Freedom of establishment) and therefore not protected by the Article 63 of the TFEU (Free movement of capital).

As regards the second case, it follows from the definition of the International Monetary Fund that a direct investment relationship is created also oppositely; i.e. a company is owned by 10% or more by another company[15]. Therefore, if the Non-EU investor is owned by 25% or more by its EU Associated Company, it is a direct investment relationship subject to the Article 49 of the TFEU (Freedom of establishment) and therefore not protected by the Article 63 of the TFEU (Free movement of capital).

As regards the third case, it follows from the definition of the International Monetary Fund that a direct investment relationship is created also with respect to sister companies[16]. Therefore, if the Non-EU investor is owned by 25% or more by a company which has a direct minimum holding of 25 % or more in the EU Associated Company, it is a direct investment relationship subject to the Article 49 of the TFEU (Freedom of establishment) and therefore not protected by the Article 63 of the TFEU (Free movement of capital).

However, in some countries (e.g. Slovak Republic or Czech Republic), the definition of direct investment does not refer to the second or third case and therefore it remains questionable how this would be ruled by the Court of Justice of the EU if it takes place.

Assume that there is a US investor buying bonds of its sister company (its associated company according to the EU Interest and Royalties Directive) situated in the Czech Republic. The transaction is driven solely by economic needs and based on the arm´s length principle. The Czech company pays interests to the US investor. If instead of the US investor, an EU investor would be in place, the interests thus paid to the EU investor would be exempted from withholding tax in the Czech Republic based on the EU Interest and Royalties Directive[17]. Can the US investor appeal for application of the Article 63 of the TFEU (Free movement of capital)?

As in the Polish case, if this would be confirmed by the Court of Justice of the EU favorable to tax planners, attempts for tax refund on behalf of non-EU investors might follow thereafter[18]. If confirmed by the Court of Justice of the EU in favor of non-EU investors, it would likely open up a new opportunity for international tax structuring and eventually attract foreign investments into the EU. After all, this would be in line with the objective of the principle free movement of capital already upheld by the Court of Justice of the EU since the measures such as different treatment of non-EU residents and EU residents with respect to capital movements discourage non-EU from making investments in the EU.[19]


[1] Judgment of the Court (First Chamber) of 10 April 2014 (C -190/12): Emerging Markets Series of DFA Investment Trust Company v Dyrektor Izby Skarbowej w Bydgoszczy.
[2] Judgment of the Court (Grand Chamber) of 18 December 2007 (C-101/05): Skatteverket v A.
[3] The conditions for free movement of capital qualification are laid down in the Articles 64 and following of the TFEU.
[4] If they satisfy other conditions.
[5] Paragraph 81 of the Judgment of the Court (Grand Chamber) of 12 December 2006 (C -446/04): Test Claimants in the FII Group Litigation v Commissioners of Inland Revenue
[6] Paragraph 196 of the Judgment of the Court (Grand Chamber) of 12 December 2006 (C -446/04): Test Claimants in the FII Group Litigation v Commissioners of Inland Revenue
[7] 16 May 2014. Available online: [link]
[8] 16 May 2014. Available online: https://www.imf.org/external/np/sta/di/glossary.pdf
[9] Paragraph 74 of the Judgment of the Court (Grand Chamber) of 12 December 2006 (C-446/04): Test Claimants in the FII Group Litigation v Commissioners of Inland Revenue
[10]16 May 2014. Available online: https://www.imf.org/external/np/sta/di/glossary.pdf
[11] Paragraph 40 of the Judgment of the Court (Grand Chamber) of 18 December 2007 (C -101/05): Skatteverket v A.
[12] TERRA, B., WATTEL, P. 2012: European Tax Law. p. 249
[13] Joined Cases C -338/11 to C-347/11: Santander Asset Management SGIIC SA and other v Ministre du Budget, des Comptes publics, de la Fonction publique et de la Réforme de l’État or  C-155/09: European Commission v Hellenic Republic or others.
[14] Case C -190/12: Emerging Markets Series of DFA Investment Trust Company v Dyrektor Izby Skarbowej w Bydgoszczy, Case C-513/04: Mark Kerckhaert, Bernadette Morres v Belgische Staat, Case C-292/04: Wienand Meilicke, Heidi Christa Weyde, Marina Stöffler v Finanamt Bonn-Innenstadt, or Case C-319/02: Petri Manninen.
[15] 16 May 2014. Available online: http://stats.oecd.org/glossary/detail.asp?ID=2092
[16] 16 May 2014. Available online: http://stats.oecd.org/glossary/detail.asp?ID=2092
[17] If relevant material conditions would be fulfilled.
[18] This is about to happen with respect to the Polish case.
[19] Paragraph 40 of the Judgment of the Court (Grand Chamber) of 18 December 2007 (C -101/05): Skatteverket v A.

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