Withholding taxes on gross payments of interest contrary to EU law

The ECJ has held that the levying of withholding tax on payments of interest from a Portuguese borrower to an Irish bank was contrary to the freedom to provide services: Auto Estradas do Litoral SA (Brisal) v Fazenda Publica (ECJ, 13 July 2016). The imposition of withholding tax amounted to taxing a non-resident lender on a gross basis, whereas resident lenders were taxed on a net basis, after deduction of expenses.

Whilst the ECJ confirmed that the imposition of a withholding tax on payments of interest to a non-resident financial institution is not per se contrary to the fundamental freedoms, the court held that unless the non-resident is able to deduct business expenses directly related to the lending activity then the withholding tax would be disproportionate and contrary to EU law. As such, the decision potentially has very wide ramifications for the application of withholding taxes, not only on interest, but on other payments subject to withholding taxes such as royalties.

Background

The case involved payments of interest from a Portuguese borrower, Brisal, to a syndicate of banks, including an Irish bank, KBC Finance. Brisal was obliged to withhold tax at 15% from its payment of interest to KBC Finance (reduced from 20% by the terms of the Portuguese/Irish double tax treaty). Brisal and KBC brought an appeal against the Portuguese authorities claiming that the withholding tax levied was contrary to the freedom to provide services. They pointed out that no withholding tax applied to the payment of interest from a Portuguese borrower to a Portuguese lender and as such the withholding tax was discriminatory. The Portuguese authorities argued that the levying of a withholding tax to payments to non-residents was not in itself an infringement of the fundamental freedoms and pointed to the earlier ECJ decision in Truck Center.

In that case, the ECJ held that a 15% withholding tax imposed by Belgium on interest payments from a Belgian borrower to an associated company located in Luxembourg did not constitute a restriction on the freedom of establishment or the free movement of capital. In particular, the ECJ pointed out that both resident and non-resident recipients were taxed on the interest and the withholding tax simply operated as a different method of taxation. In addition, the ECJ suggested that since the withholding tax was at a significantly lower rate than domestic corporate income tax, it could not be said that there was necessarily any advantage for Belgian resident lenders.

ECJ decision

The ECJ first confirmed that it is clear from earlier caselaw that the application of a withholding tax, as a method of taxation, to non-residents, whilst constituting a restriction on the freedom to provide services, may be justified by the need to ensure the effective collection of tax. However, as well as being justified, the restriction must not go beyond what is necessary to attain the objective pursued (effective taxation).

As regards the deduction of business expenses, the ECJ noted again that it had already held that resident and non-resident service providers are in a comparable position for the purposes of applying the discrimination caselaw. As such, Article 49 precludes national tax legislation which as a general rule takes into account gross income when taxing non-residents when residents are taxed on a net basis, after deduction of expenses.

On this point, the ECJ rejected Portugal’s argument that, in relation to financial services, it is “impossible to establish any characteristic link between costs incurred and interest income received”. There was no reason to treat banking services any differently to any other service. The granting of a loan will give rise to a range of business expenses, such as travel and legal or tax advice, where it is relatively easy to establish a direct link to the lending. As regards financing costs and other general expenses, whilst it may be more difficult to establish a direct link with a given loan, that does not justify taxation on a gross basis. It was simply necessary for the taxpayer to provide proof as to the direct expenses and the fraction of general expenses which may be regarded as directly related to the loan.

Finally, the ECJ rejected Portugal’s arguments that the restriction could be justified by other overriding reasons. In particular, the fact that the withholding tax rate was lower than the main rate of tax could not justify the restriction. The ECJ stated that it had repeatedly held that unfavourable tax treatment contrary to a fundamental freedom cannot be regarded as compatible with EU law because of the potential existence of other advantages.

Comment

If the decision of the ECJ in this case comes as a surprise, it is really only because it is in such contrast to the earlier, controversial Truck Center decision. In particular, the ECJ in that case seemed to go out of its way to endorse a pragmatic approach which upheld international tax practice. Indeed, contrary to the statements in Brisal, the ECJ in Truck Center specifically referred to the fact that the lower rate of withholding tax meant that it would not be said that there was in fact any restriction. As such, it is especially disappointing that the ECJ has made no effort to distinguish or explain its earlier decision in Truck Center. In fact, the ECJ entirely failed to refer to Truck Center in its legal analysis of the Brisal case.

Nevertheless, it can be pointed out that in Brisal, the withholding tax was applied in relation to a bank, whose trade was in lending transactions. As such, the deduction of expenses was clearly more relevant in this context than in relation to loan between associated companies, not involving a lending trade. Arguably, therefore, Truck Center should be regarded as involving a case where there were no expenses to set off, such that the point simply never arose.

Of course, the levying of withholding tax based on the recipient’s net position would place the person responsible for making the withholding in an impossible position. On that point, the court noted that provided the recipient is authorised to claim its right to a deduction directly from the tax authorities after the withholding tax has been levied, claiming a repayment of a fraction of the tax deducted at source, that situation can be avoided. As such, what is required by EU law is a mechanism for a recipient to reclaim tax overpaid, where the imposition of a fixed rate of withholding tax results in excess tax being levied. (Whether this needs to be compared to the domestic tax rate on the net income in order to first determine if excessive tax has been deducted is, however, unclear.)

Finally, it should be noted that there is nothing in the judgment that limits it to withholding tax paid on interest. It appears that, where the recipient has incurred relevant business expenses, it should equally apply to other forms of withholding tax, including withholding tax applied to royalty payments.

For further analysis on the impact of the decision on UK withholding taxes, see “UK withholding tax on interest paid to EU recipients contrary to EU law due to Brisal case”.