By Anno Rainer, Jan Roels and Véronique Parmentier

The European Court of Justice (ECJ) ruled on 17 January 2008 that the freedom of establishment principle of the EC Treaty precludes the reclassification of interest paid by a Belgian company to its nonresident parent that is a director of the Belgian subsidiary (Case C-105/07, N.V. Lammers & Van Cleeff).

Facts

The case involves a Belgian company that paid interest to its Dutch resident parent company in assessment years 1996 and 1997. At the time, the parent company was a member of the Belgian company’s board of directors. Because the loan granted by the Dutch resident parent exceeded the paid-up capital of the Belgian subsidiary at the end of the relevant taxable periods, increased by the taxable reserves of the company at the beginning of the periods, the interest on the excessive part of the loan paid by the Belgian subsidiary to its Dutch-incorporated director was reclassified as a dividend under article 18 of the Belgian Income Tax Code. As a result, the interest could not be deducted from the taxable base of the Belgian company. The Belgian subsidiary appealed the decision of the Belgian tax authorities to reclassify the interest and disallow the deduction on the grounds that the interest would not have been so reclassified had it been paid to a director subject to Belgian corporate income tax.

Article 18, designed to prevent the thin capitalization of Belgian resident companies, addresses situations where interest is paid to nonresident corporate directors. Interest is reclassified as a dividend to the extent (1) a loan exceeds the sum of the paid-up capital and the taxable reserves at the beginning of the taxable period, or (2) the interest paid on the loan exceeds an arm’s length rate. Under the first alternative, no reclassification will be made if the interest is paid to a director that is a Belgian company.

ECJ Decision

The ECJ first noted that the Belgian legislation provides for a difference in treatment of resident subsidiaries depending on whether the parent company has its seat in Belgium, thus making subsidiaries of a nonresident parent company subject to a tax treatment that is less favorable than the treatment granted to subsidiaries of a Belgian parent company. Referring to the Test claimants in the thin cap group litigation case, the ECJ held that this difference in treatment conflicts with the freedom of establishment principle because it makes it less attractive for companies established in another Member State to exercise that freedom, with the result that they may refrain from managing a company in a Member State that has such a measure, or even refrain from acquiring, creating or maintaining a subsidiary in that Member State. The Court concluded that making the tax treatment depend on whether a director is resident or nonresident restricts the freedom of establishment.

It follows from the Test claimants in the thin cap group litigation decision that such a restriction may be justified only where it applies to wholly artificial arrangements. The mere granting of a loan is not the basis for a general presumption of an abusive practice.

The ECJ acknowledges that, while the Belgian measure at issue is designed to combat abusive practices, it goes beyond what is necessary to attain that objective because the rule brings within its scope situations that cannot be regarded as purely artificial arrangements, i.e. the rule also applies where interest does not exceed an arm’s length amount.

Preliminary Comments

The ECJ decided the N.V. Lammers & Van Cleeff case without an oral hearing and without a formal opinion from the ECJ Advocate General.

As noted above, interest may be reclassified under article 18 of the Belgium Income Tax Code to the extent: (1) the interest-bearing loan amount exceeds the sum of the paid-up capital and the taxable reserves; or (2) the interest rate exceeds the market rate. The ECJ ruled that the first part of the rules is precluded by the freedom of establishment principle; it did not have to rule on whether the second part is incompatible with the freedom of establishment. Under the Belgian rules, the deduction of excess interest would be disallowed at the level of the paying company in a purely domestic situation - whether there is a difference in treatment at the level of the recipient of reclassified/disallowed interest would have to be determined based on the particular facts of the case.

It is worth noting that the N.V. Lammers & Van Cleeff case involves a loan granted by an EU parent of a Belgian resident company. Based on the ECJ’s position in the Test claimants in the thin cap group litigation case, it is doubtful whether the basic freedoms of the EC or the EEA treaties could be relied on where either the parent entity or the financing entity granting the loan to the Belgian company resides outside the EU/EEA. However, it may be possible to make arguments based on the nondiscrimination provision of an applicable tax treaty or other bilateral treaty concluded between Belgium and the third country or on the nondiscrimination provision in the Belgian Constitution. A careful analysis of the facts would be required.

In addition, although N.V. Lammers & Van Cleeff concerns only the nondeductibility for tax purposes of the reclassified interest, the reclassification mechanism in article 18 of the Belgian Income Tax Code entails a switch from the rules governing interest withholding tax to the rules applicable to dividends. From a Belgian perspective, the latter may be disadvantageous where the recipient of the interest does not have a (direct) shareholding in the Belgian paying company because the standard dividend withholding tax rate is 25% and (partial) relief as foreseen by the EC Parent-Subsidiary Directive or an applicable tax treaty might not be available in these circumstances.

In the past, the Belgian legislator and the tax authorities have been slow to react to ECJ decisions against Belgian tax rules. Taxpayers that have claims similar to those at issue in N.V. Lammers & Van Cleeff should consider initiating court proceedings if their claims have been pending before the tax authorities for more than six months to potentially obtain expedited treatment of their claim. If such a claim is upheld in court, recent changes to Belgian law provide that courts must award lump sum compensation for lawyers’ fees to taxpayers.

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