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

Author:Dr. J.F. Weyde
Profession:Cleary Gottlieb Steen & Hamilton

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...

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