European Union: ECJ Decision Offers Foreign Investors Chances To Claim Refunds Of German Dividend Withholding Taxes

Last Updated: 28 February 2012
Article by J.F. Daniel Weyde

The European Court of Justice decided on October 20, 2011 that Germany's tax treatment of outbound portfolio dividends infringes the free movement of capital under Article 56 of the EC Treaty (Art. 64 TFEU) and Article 40 of the EEA Agreement because withholding tax is imposed on outbound portfolio dividends while domestic dividends are effectively exempt from tax. The European Commission had already formally notified the Federal Republic of Germany on October 12, 2005 of its doubts regarding the compatibility of the German tax system with the free movement of capital. Because Germany had failed to timely amend its tax laws, the Commission brought action against the Federal Republic on July 23, 2009 (C-284/09).

Dividends distributed by German corporations to resident or non-resident shareholders are subject to 26.375% German withholding tax. However, the withholding tax is almost entirely refunded to domestic corporate shareholders. This is because they benefit from a 95% exemption of dividends from corporate income tax; the tax withheld is treated as a mere prepayment on the corporate income tax liability. (The exemption from municipal trade tax is only available for dividends paid to shareholders holding 15% or more in the distributing company at the beginning of the relevant calendar year). By contrast, non-resident corporate shareholders are generally not entitled to a comparable withholding tax refund. They only qualify for full exemption if they meet the minimum participation requirements of the EU Parent-Subsidiary Directive (i.e., 10%) or of a double taxation treaty that provides for 0% withholding tax. In general, portfolio dividends only entitle non-resident corporate shareholders to a partial refund of the withholding tax equal to the difference between the regular rate of 26.375% and the lower rate of 15 or 10%. Consequently, Germany effectively imposes corporate income tax on portfolio dividends received by non-resident corporations at a higher rate than on portfolio dividends received by resident corporations.

The European Commission considered the German system discriminatory and not in compliance with the free movement of capital. The Federal Republic of Germany mainly argued that the unequal treatment of outbound portfolio dividends does not violate EU law because (i) domestic dividends are taxed in two stages (at the corporate shareholder level and at the level of its final individual shareholder) and, consequently, outbound dividends should also be subject to the whole tax charge, (ii) Germany is entitled to safeguard its taxation rights with respect to German-source income and has concluded double taxation agreements with other EU Member States in order to allocate taxation rights, and (iii) domestic portfolio dividends are fully subject to a municipal trade tax (at rates between 7 and 17%) and, therefore, do not effectively benefit from a lower tax burden than outbound portfolio dividends.

The ECJ dismissed these arguments. In particular, the ECJ concluded that Germany's double taxation agreements do not provide for a full refund of German withholding tax and, moreover, German withholding tax can only be credited against a foreign tax if and to the extent the shareholder's country of residence actually imposes tax on German-source dividend income. Consequently, an unequal treatment of outbound portfolio dividends cannot be denied because of the existence of double taxation agreements. With respect to trade tax, the ECJ gave short shrift to the matter, emphasizing that the existence of unrelated advantages does not result in the compatibility with EU law of an unequal treatment restricting the free movement of capital. The ECJ also stated that, where a Member State has chosen to effectively exempt domestic portfolio dividends from tax, it cannot rely on the argument that there is a need to safeguard its taxation rights. Last but not least, the ECJ determined that the unequal treatment of outbound portfolio dividends cannot be justified due to the need to maintain a coherent tax system. The ECJ pointed out that domestic dividends, which are taxed in two stages, benefit from a tax break until they are distributed to the final individual shareholder while outbound portfolio dividends do not benefit from a postponed taxation.

As a consequence of the ECJ decision, EU/EEA corporate shareholders that have received outbound portfolio dividends net of German withholding tax should be generally entitled to claim an entire refund. Although the ECJ decision is silent on this point, corporate shareholders outside the EU may equally benefit from the decision since the free movement of capital can generally be also invoked by non-EU residents. However, non-EU corporate shareholders resident in a jurisdiction that does not sufficiently cooperate with Germany in tax matters may not be able to base refund claims on the ECJ decision.

Foreign investors should be advised that there is no guidance at which tax office they may claim a withholding tax refund based on the ECJ decision. There are reports that the Federal Central Tax Office (which is competent for refunds under the EU Directive and double taxation treaties) has declined its competence so that a filing with a local tax office may be necessary. It can be expected that the German tax authorities will deny claims for a refund if the filing is made after 4 years since the dividend distribution on the grounds of the statute of limitations.

Germany can be expected either to reduce the domestic withholding tax rate on outbound portfolio dividends (at least with respect to recipients resident in the EU or EEA) or, alternatively, repeal the current corporate income tax exemption for domestic portfolio dividends.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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