By Etienne Genot and Marie-Charlotte Mahieu

In a wide-reaching decision, the European Court of Justice (ECJ) ruled on 10 May 2012 that foreign investment funds that invest in French companies should not be liable to withholding tax on dividends. Currently, French investment funds are exempt from French tax on dividends received from a French company, while foreign funds are subject to a 30% withholding tax (25% before 1 January 2012), unless the tax rate is reduced under an applicable tax treaty.

The ECJ held that the discriminatory treatment of dividends paid to foreign investment funds violates the free movement of capital principle under the Treaty on the Functioning of the EU (TFEU) and that the discrimination cannot be justified in either an EU or a third country context. The Court also said there is no reason to apply a temporal limitation on the effects of its decision.

This is a significant victory for investment funds, and the expected cost of the decision to the French tax authorities is in excess of approximately EUR 4 billion. The decision also will have implications for similar challenges against several other EU member states by portfolio investors, such as investment funds, pension funds and charities investing in those other member states.

Background

The case originally arose after the ECJ issued its 2009 decision in the Finnish Aberdeen case, in which it held that EU member states could not levy withholding tax on dividends paid to nonresident investment funds while exempting domestic investment funds from such tax. Following this ruling, many nonresident investment funds sought to recover French dividend withholding tax on the basis that the French law also is contrary to EU law.

In 2010, there were 10 “test” cases before the Administrative Lower Court of Montreuil on the tax treatment of French-source dividends paid to Belgian, German, Spanish and U.S. investment funds. However, because of the number of withholding tax reclaims that were pending before French administrative courts at the time (about 2,500 of them, totaling approximately EUR 4 billion), the Lower Court referred the case to France’s Supreme Administrative Court (SAC).

In 2011, the SAC issued an opinion on some of the issues raised by the cases, but requested a preliminary ruling from the ECJ on whether the different tax treatment of French-source dividends paid to French investment funds and investment funds established in other EU member states and in non-EU countries is compatible with the TFEU, and whether the existence of discrimination must be determined at the level of the fund, the investors or globally.

As regards dividends paid to non-EU funds, the SAC opined that the different treatment may violate the free movement of capital principle. The SAC also stated that the argument of the French tax authorities that the different treatment could be justified by the government’s inability to conduct efficient tax audits outside the EU could not be sustained where the country in which the investment fund was established had concluded a tax treaty with France containing a mutual assistance clause.

The issues before the ECJ were whether foreign investment funds are sufficiently comparable to French investment funds to be treated in the same way (i.e. as tax-exempt), whether non-EEA funds should be entitled to the same benefit and if so, whether there is a justification for the imposition of a higher tax burden on these funds. Given the potential amount of the claims at stake, the French tax authorities asked the ECJ to consider blocking further claims by applying a temporal limitation.

ECJ decision

The ECJ ruled that the French rules are incompatible with the free movement of capital principle and that the tax treatment of the investors does not need to be taken into account in comparing the treatment of French and non-French investment funds. Accordingly, French and foreign investment funds are in comparable situations and the existing differential treatment violates EU law.

The ECJ also rejected France’s request to limit the temporal effects of its decision to claims filed with the French tax authorities before 10 May 2012. Claims can therefore now be filed in accordance with the standard French statute of limitations. Under these rules, an ECJ decision indicating that French law is not in conformity with EU law is regarded as a new “event” allowing a claim to be made to recover undue taxes paid as from 1 January of the third year preceding the ECJ decision. Thus, taxpayers can file claims to recover tax paid on or after 1 January 2009.

While the ECJ did not specifically rule on investment funds established outside the EU, but clearly rejected the justification based on the efficiency of tax audits, the ECJ did indicate that the mere fact that France would be unable to conduct efficient tax audits outside the EU cannot justify the different treatment even when the country in which the investment fund is established has not concluded a tax treaty with France that includes mutual assistance provisions. Consequently, non-EU funds now have an opportunity to seek the recovery of withholding tax paid.

Next steps

Based on the decision of the ECJ and the 2011 opinion issued by France’s SAC, the Administrative Lower Court of Montreuil will rule on the 10 test cases before the other pending claims are addressed. The French government is likely to amend the withholding tax rules to align the tax treatment of resident and nonresident investment funds in respect of French-source dividends.

Taxpayers have several courses of action to consider:

• Nonresident investment funds that already have filed protective claims covering the period from 1 January 2009 are expected to bring their cases to the French courts.
• Non-French investment funds (whether within or outside the EU) with French dividend income should consider reclaiming French withholding tax paid as from 1 January 2009 if they have not already done so. Particular attention should be paid to supporting documentation.
• Non-French portfolio investors (whether within or outside the EU) should assess the viability of EU claims across all EU markets and protect claims that have a legitimate basis and value.