ECJ – Recent Developments in Direct Taxation 2014

I. S. 184Introduction

On 10 April 2014, the ECJ issued its decision in C-190/12 Emerging Markets Series of DFA Investment Trust Company (hereinafter: Emerging Markets) case. This article aims at assessing this judgment and examining the impact it may have on the application of corporate income tax law in Poland and other Member States with regard to relations with third countries.

The case was instigated through a preliminary question from the Regional Administrative Court in Bydgoszcz, concerning Polish CIT regulations which exclude from the scope of a general income tax exemption investment funds established in third countries and the compatibility of those provisions with EU law – the free movement of capital in particular.

II. Facts and Applicable Law

Emerging Markets Series of DFA Investment Trust Company, a US investment vehicle, invested in private equity in Poland. It yielded dividend income which was subject to withholding tax in Poland at a 19 % tax rate, and reduced to 15 % under Article 11 Sec. 2b of the tax treaty between Poland and the USA.

The fund applied to the Polish tax authorities on 20 December 2010 for a tax refund, claiming that withholding tax on dividends paid out by Polish companies violated the free movement of capital. This application was not approved by the tax authorities so the fund lodged a complaint to the WSA in Bydgoszcz, which decided to refer the case to the ECJ.

Under Article 6 Sec. 1 item 10 of the Corporate Income Tax Act investment funds governed by the provisions of the Investment Fund Act of 27 May 2004 are exempt from tax. This is a general tax exemption, it covers all income of the fund. According to Article 1 of the Investment Fund Act, it applies to the establishment and operation of investment funds having their seat in Poland and sets out principles for carrying out activities in Poland by foreign investment funds and management companies. Under Article 2 Sec. 7 and Sec. 9 of the IF Act, a foreign investment fund is defined as an open investment fund or an investment company S. 185with a seat in another EU Member State carrying out an activity in accordance with the Community law on the rules of collective investment in securities.

The exemption applied to investment funds established both in Poland and in other EU Member States. However, since the regulations were not clear and the tax authorities tended to limit the scope of the exemption to Polish investment funds, the European Commission instigated an infringement procedure against Poland in response to which Poland has amended its legislation.

That being so, all investment vehicles established in third countries are now outside the scope of the exemption.

The right to free movement of capital applies not only to the capital flows between Member States but also in relations with third countries (i.e. non-Member States). Under a literal interpretation of Article 63 TFEU, the principle of the free movement of capital may not be applied any differently with respect to relations with third countries than in purely intra-EU situations. What is more, under Article 64 TFEU the free movement of capital with regard to third countries is restricted by the Treaty (the standstill clause and others), which itself differentiates between intra-EU and third-country situations. As such, additional distinctions may not be made under a literal interpretation of Article 63 TFEU.

The WSA in Bydgoszcz, hearing the case, applied to the ECJ for a preliminary ruling asking the Court the following questions:

III. The ECJ Decision

The ECJ in its decision of 10 April 2014 firstly settled that potential discriminatory taxation of third-country investment schemes should be assessed in the light of the principle of free movement of capital (Article 63 TFEU) thus not the freedom of establishment. The Court also decided that the free movement of capital precludes Polish CIT legislation which leaves non-EU investment funds outside the general tax exemption but only when there is a legal basis for exchange of information which would enable the national tax authorities to verify information provided by the taxpayer concerning the conditions for its formation and the conduct of its business. The ECJ stated that such a verification procedure should focus on the determination of whether a non-EU investment scheme operates within a regulatory framework equivalent to that of the European Union.

IV. Comments

A. Freedom of Establishment vs. Free Movement of Capital

Answering the first preliminary question, the ECJ dealt with the issue of identification of the legal character of the alleged violation of EU law. The Court determined whether the compatibility of Article 6(1)(10) of the CIT Act with EU law should be examined from the perspective of the freedom of establishment or the free movement of capital. The Polish Government argued that the tax treatment of dividends paid out to investment funds should be examined in the light of the freedom of establishment – restricted to intra-EU situations.

The TFEU does not provide a clear answer in this respect. The Court admitted that the tax treatment of dividends may be potentially covered both by Article 49 TFEU (freedom of establishment) and Article 63 TFEU (free movement of capiS. 187tal). The ECJ ruled that it is the purpose of the legislation which should decide which freedom should be applied (paragraph 25 of the Emerging Markets decision). The exemption stipulated by Article 6(1)(10) of the CIT Act is not exclusively available for dividends paid out of shares which allow exerting definite influence on the decisions of the company. Therefore limiting the scope of the exemption to Polish and EU based investment funds should be viewed as a potential violation of the free movement of capital – irrespective of the size of the investment of the fund in a Polish company. According to the ECJ, the facts of a given case are here irrelevant – what matters is only the purpose and scope of the domestic legislation.

The approach taken by the ECJ in the case at hand goes beyond the traditional “influence test” under which if a person holds a shareholding in a company situated in another Member State which gives him a “definite influence” over that company’s decisions then such a situation should be examined in the light of the principle of freedom of establishment.

We agree that the purpose but also the consequences (effects) of the particular regulation at issue should be seen as a decisive criterion giving primacy to one particular freedom in each respective case. It should be noted that where the provision in question refers simultaneously to the free movement of capital and to the freedom of establishment, the question to be considered is which freedom is affected to the largest extent by the application of that measure. It should not be forgotten that investment vehicles acquire shares in other companies in order to invest capital on behalf of their investors (acting as intermediaries only), not to carry on business activity through subsidiaries. Thus, hindering such an activity endangers the free movement of capital to a greater extent than it hinders the freedom of establishment.

B. Comparability test

The ECJ identified that different treatment of third-country investment funds may discourage them from investing in Poland which, as a consequence, leads to the limitation of free movement of capital. However, such a limitation would violate Article 63 TFEU only if EU investment funds and non-EU investment schemes were in a comparable situation. That being so, the Court had to find a relevant comparator which could be used in order to examine the comparability of the taxpayers.

S. 188The German Government claimed that the effects of a limitation of the free movement of capital may be neutralized where an investor is able to deduct tax paid by an investment vehicle from its own tax. The Court rejected that argument explaining that Article 6(1)(10) of the CIT Act does not make the general tax exemption dependent on the legal situation of the investor. The only differentiating criterion used by the Polish legislator is based on the place of residence. Thus, according to the ECJ, one should examine the comparability of the situation of investment vehicles not the investors. What is more, it has to be pointed out that investors in a given investment scheme (EU or third-country based), who apply for the exemption, may originate from different jurisdictions (they may just as easily be e.g. Polish residents). Normally it would be very difficult to determine whether individual investors of a fund are exempt or subject to tax.

The Governments of Poland, Germany, Spain, France, Italy and Finland along with the European Commission and the regional Administrative Court in Bydgoszcz argued that the principal difference between EU and third-country investment schemes comes down to the fact that EU funds are subject to uniform regulation on formation and functioning of investment vehicles – i.e. the Directive 85/611 of 20 December 1985 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS). Third-country schemes are not bound by the regulatory requirements set forth in that legal Act therefore, they are not in a comparable situation to EU based investment vehicles.

The ECJ rightly rejected this argumentation, nonetheless its reasoning has some weak points in this respect. The Court underlined the fact, already mentioned, that under Article 6(1)(10) of the CIT Act the exemption from tax is dependent only on the residence requirement. In other words, according to the Court, granting the general tax exemption is not linked to being subject to the regulatory system of the European Union. That being so, the regulatory framework the fund operates within cannot be taken into account when determining the comparability of third-country investment vehicles.

However, it has to be noted that Article 6(1)(10) of the CIT Act does not exempt any investment scheme registered in Poland but only those investment funds which are governed by the provisions of the Investment Fund Act of 27 May 2004. Consequently, by way of the reference to the Investment Fund Act, the CIT Act makes the exemption dependent on being subject to certain regulatory requirements which, in principle, are derived from the EU secondary legislation on collective investment schemes.

Moreover, the ECJ itself admits that it is important when measuring the comparability of EU and third-country investment funds, to determine the content of S. 189regulations under which the investment vehicles are formed and under which they carry out investment activity. The Court, analysing the admissibility of restricting free movement of capital, examined the effectiveness of fiscal supervision and noted that the availability of an effective mechanism for exchange of information for tax authorities is essential for verifying whether third-country investment vehicles are subject to “conditions for their formation and operation, in order to determine that they operate within aregulatory framework equivalent to that of the European Union” (see our further analysis of that issue). Leaving non-EU investment funds outside the exemption under Article 6(1)(10) of the CIT Act indeed comes down to the lack of Polish residence of those taxpayers (a US investment fund cannot claim that it fulfills the other requirements set forth in the Investment Fund Act – as it would never meet the residence condition) but regulatory issues cannot be ignored.

At the same time, the ECJ emphasizes, which has to be welcomed, that denying non-EU investment funds the general tax exemption on the grounds that those vehicles are not subject to EU UCITS regulations would deprive the free movement of capital principle of its effet utile. In practice it would mean excluding all non-EU investment funds from the exemption since being subject to EU regulations is naturally linked to having a registered seat in the territory of a EU Member State.

We are of the opinion that EU and third-country investment funds do not have to be identical in respect of their legal construction and the legal environment they function in, to be found comparable. The ECJ noted that non-EU investment funds should operate within a similar regulatory framework. In our view one should also examine the scope of activity, economic nature and the purpose of functioning of such institutions. Typically investment funds are all based on a similar concept. They act as an intermediary between a target investment and the investors. In other words, the investment schemes manage their investments on behalf of the investors. The idea of the investment fund is based on pooling the resources from a number of individual investors and re-investing them on the market through professional fund management. Whether those circumstances are present should be examined from the perspective of the law of the given Member State.

C. S. 190Justification of Different Treatment

1. General Remarks

Concluding that third-country investment funds might be in a comparable situation opens up discussion on whether limiting the free movement of capital with respect to such taxpayers by a Member State may be justified by an overriding reason in the public interest. One could point out a few of the justifications most frequently invoked in the ECJ decisions but in the case at hand the most obvious ones which should be analysed are: effectiveness of fiscal supervision, cohesion of the tax system, prevention of tax abuse and the balanced allocation of taxing rights.

2. Effectiveness of Fiscal Supervision

The Court in the Emerging Markets case came to the conclusion that a central element of an analysis with regard to the effectiveness of fiscal supervision is to examine whether there is a legal basis for the tax authorities of a source state to verify whether a non-EU investment fund carries out an investment activity within a regulatory framework equivalent to that of the European Union. The ECJ admitted that in relations between Member States it should go without saying that a taxpayer should be allowed to prove that it fulfils equivalent requirements provided by the source Member State, in its country of residence. At the same time, the Court correctly notes that the free movement of capital between Member States and third countries is exercised in a different legal context. In our view this should translate into the principle, according to which the taxpayer may present evidence of the comparability of its situation with EU based investment funds but there has to be a legal basis to enable verification of this evidence by the tax authorities. Such a mechanism is also reasonable when taking into consideration the need to prevent tax abuse.

Leaving aside the Mutual Assistance Directive 77/799 which does not apply to fiscal cooperation with third countries, one should take into account other possible instruments for the exchange of information. The ECJ in the case at hand underlined that it c could not be ruled out that the Polish tax authorities were not equipped with any instruments which could effectively guarantee the possibility to verify documentation provided by the taxpayer. This assumption was made on S. 191the basis of the existence of both the tax treaty between Poland and the USA and the Strasbourg Convention on Mutual Administrative Assistance in Tax Matters of 25 January 1988 (hereinafter: the Mutual Administrative Assistance Convention). The Court, however, did not elaborate on this issue and left the problem of examining whether those instruments were sufficient for fiscal supervision to the national courts.

As for Article 23 of the tax treaty between Poland and the USA of 8 October 1974 it should be noted that that treaty contains only a narrow exchange of information clause. It enables the competent authorities of both contracting states to exchange the information necessary for carrying out the provisions of the treaty or to prevent fraud or for the administration of statutory provisions concerning taxes to which the treaty applies. That instrument may not be sufficient for a proper verification of the information submitted by the taxpayer in the light of requirements set forth by the Emerging Markets decision in this respect.

Information provided by US residents to the Polish tax authorities may however, be verified under Article 4 of the Convention on Mutual Administrative Assistance in Tax Matters which (in its original wording) obliges the parties to the treaty to exchange any information that is foreseeably relevant to 1) the assessment and collection of tax, and the recovery and enforcement of tax claims, and 2) the prosecution before an administrative authority or the initiation of prosecution before a judicial body. The possibility of invoking the Mutual Administrative Assistance Convention as a legal ground for effective exchange of information as understood by the ECJ in the Emerging Markets case has already been approved by Polish administrative courts.

In two decisions of 3 June 2014 (II FSK 1284/12 and II FSK 1702/12) the Supreme Administrative Court took the position that the Mutual Administrative Assistance Convention could serve as a legal ground for effective exchange of information for the purposes of verification of the status of US investment funds. In that situation different treatment of non-EU investment schemes cannot be justified.

The Regional Administrative Court in Bydgoszcz (the referring court) in its decisions of 3,4, 11 and 30 June 2014 (I SA/Bd 479-489/14), repeating the reasoning expressed by the ECJ in the Emerging Markets decision, added that an examination of the effectiveness of mechanisms for exchange of information in the case at hand should have been carried out by the tax authorities and it repealed their decision which referred the case back to the administrative stage.

S. 192One should also mention the decision of the Regional Administrative Court in Wrocław of 2 June 2014 (I SA/Wr 113/14) which ruled in favour of the tax authorities. It has to be noted, however, that the case heard by that court pertained to a company registered in Switzerland and concerned a different legal basis for tax exemption (Article 22 and 22b of the CIT Act). It is interesting, though, as it examines the effectiveness of exchange of information instruments as mechanisms used by tax authorities in order to verify the fulfilment of domestic requirements for tax exemption of dividends. Moreover, the court invoked the Emerging Markets decision in its reasoning in this respect. The WSA in Wrocław explained that in the case of the Swiss registered taxpayers, tax exemption of dividends could not be granted as, in 2011 – when the Swiss company derived income from Polish sources, there was no effective legal ground for fiscal supervision on which the Polish tax authorities could rely. The Regional Administrative Court in Wrocław examined the treaty concluded between Poland and Switzerland and came to the conclusion that a so called “narrow” clause of exchange of information, which was in force at that time, did not allow the tax authorities to verify information provided by the taxpayer which was required by law in order for the taxpayer to apply for the exemption.

3. Cohesion of the Tax System

During the proceedings in the Emerging Markets case, the Polish Government claimed that different treatment of non-EU investment schemes may be justified by the need to preserve the cohesion of Polish tax system. It was argued that the tax exemption provided by Article 6(1)(10) of the CIT Act is directly linked to the taxation of profit distributions made by investment funds in favour of unitholders.

The established case law of the ECJ, in order to legitimize limitation of fundamental freedoms by the cohesion of tax system, requires demonstrating a direct link between tax benefits and the tax burden, i.e. the benefits and tax burdens should pertain to the same taxpayer and the same tax.

It is thought, however, that the ECJ should examine how a particular tax benefit affects the same taxpayer (such a tax does not have to be imposed directly on that taxpayer and it does not have to bear the same name). In other words, the whole economic framework within which the taxpayer operates should be examined. That position was taken by German Government in the proceedings before the ECJ in the Emerging Markets case.

S. 193In the opinion of the ECJ, which should be applauded, Article 6(1)(10) of the CIT Act does not make the general tax exemption of the investment fund conditional on taxation of profit distributions to the unitholders of the fund in any way. Tax exemption does not compensate the imposing of tax on an individual investor (there is no direct link between those two elements).

It should also be pointed out that distribution of profits earned by the fund to its participants (unitholders) is subject to tax in Poland irrespective of the place of residence of the investment fund. In such a situation the argument of the need to preserve the cohesion of the Polish tax system cannot be accepted.

4. Balanced Allocation of Taxing Rights and Safeguarding Tax Revenue

Referring to the argument based on the need to maintain a balanced allocation of taxing rights which was raised by the German Government during the proceedings in the Emerging Markets case, the ECJ invoked its earlier decisions and ruled that the need to safeguard the balanced allocation of taxing powers may be invoked by the Member States if a given domestic measure is aimed at preventing conduct that would jeopardize the right of that State to tax the activities carried on in its territory. The Court also underlined that its decisions in this respect are relevant also to cases where the argument of balanced allocation of taxing rights is examined in relation to third countries.

Nonetheless, that justification cannot legitimize the restriction in the case at hand as Poland has decided to exempt Polish investment schemes and treats non-resident (third-country investment vehicles) in a discriminatory way.

The German Government added that granting the exemption to residents of third countries would result in a loss of tax revenues in the situation where non-EU countries do not participate in a common market (which is created and maintained by fundamental freedoms – including the free movement of capital). The S. 194Court repeated its position, expressed in earlier decisions, that losing tax revenues cannot justify restrictions on fundamental freedoms. That principle applies both to relations with other Member States and to relations with third countries.

V. Conclusion

The ECJ in the case at hand, found the treatment of third-country investment funds under Article 6(1)(10) of the CIT Act to be discriminatory insofar as those investment vehicles operate within a regulatory framework equivalent to that of the European Union. This view consequently led to the conclusion that the restriction in question could be justified by the need to guarantee effective fiscal supervision but only where there is no legal basis for the Polish tax authorities to verify the status of the taxpayer in its state of residence.

In our opinion, the domestic tax administration in the Emerging Markets case had legal instruments which were appropriate to confirm the legal position of US investment funds under Article 4 of the Mutual Administrative Assistance Convention. In many cases, but this would have to be analysed separately, a broad exchange of information clause implemented in a tax treaty may play a similar role. What is important, though, is that it may so happen in respective proceedings that the tax administration of the state of residence of a taxpayer does not provide the Polish administration with the necessary information and documentation. In such a case the tax authorities would be able to reject the application for exemption. The “third-country context” would not require an EU Member State to accept information presented by a non-EU taxpayer if confirming such information would not actually be possible for the tax authorities in a given case. On the other hand it has to be underlined that this principle should not apply if the lack of exchange of information results from the inactivity of the Polish tax administration.

At present, the CIT Act lacks a general provision that would preserve the budget from tax abuse (there is no General Anti-Avoidance Rule in the Polish tax law system). The broad regulation of the principle of free movement of capital in the TFEU which also covers third countries may potentially create an opening for abusive application of Article 6(1)(10) of the CIT Act. We would therefore recommend implementing a specific anti-avoidance rule (SAAR) under which the tax authorities could deny the general tax exemption stemming from Article 6(1)(10) of the CIT Act to investment schemes which are predominantly established and maintained for tax avoidance purposes.

S. 195The ECJ ruling in the Emerging Markets case enables non-EU investment vehicles to apply for tax benefits which are accessible to Polish taxpayers under Article 6(1)(10) of the CIT Act. The ruling does not, however, amount to automatic grant of the exemption to non-EU investment vehicles. As we mentioned, it depends on the actual scope of the information received by the Polish tax administration relating to the comparability of those vehicles with EU investment undertakings. Moreover, it has to be borne in mind that if the free movement of capital principle has been extended to third countries and hence since it forms an element of EU primary law, the consequences of such regulation have to be accepted. Different treatment of non-EU taxpayers may only be permitted in relation to applying the “third-country context” (which is discussed in this paper) but arbitrary discrimination should be seen as a violation of the Treaty.