Recovery of Spanish withholding taxes by foreign hedge funds

Update: For details of the appeal to the Spanish Supreme Court, see “Spanish Supreme Court to rule in hedge fund withholding tax cases”.

In a further development relating to the interaction of the Spanish non-resident income tax rules (NRIT) and the non-discrimination principle under EU law as applicable to dividend withholding taxes, the second highest court in Spain (the 'Audiencia Nacional') has held that alternative investment funds located within the EU are, in appropriate cases, able to obtain a refund of Spanish dividend withholding tax levied on their Spanish holdings.

The decision highlights the fact that it is not only EU UCITS, but also EU based alternative investment funds which are comparable to Spanish alternative investment funds which may benefit from the lower 1% rate of income tax and be entitled to recover any excess withholding taxes levied in Spain. Both EU based hedge funds and also non-EU based hedge funds which have suffered excess Spanish withholding tax on portfolio dividends should consider whether they are entitled to claim a refund, particularly bearing in mind the general four year statute of limitations period under Spanish tax laws.

Background

Historically, the Spanish NRIT has imposed withholding taxes at rates up to 21% (currently 19%) on the distribution of dividends to shareholders based outside Spain, whereas comparable Spanish funds may easily recover any excess withholding tax and end up being taxed only at the 1% corporate tax rate applicable to domestic hedge funds.

However, a series of European decisions concerning the compatibility of withholding taxes levied on cross-border portfolio dividends (including the Santander, Fokus Bank and later Fidelity Funds cases) have called into question the compatibility of cross-border withholding taxes on funds. As a result, in 2011 the NRIT rules were amended to provide an equivalent right to be taxed at a 1% rate under NRIT rules on dividends paid to EU and EEA based UCITS, provided that they were comparable to Spanish investment funds which benefited from the 1% rate, thus allowing easy dividend WHT recovery by the aforementioned UCITS.

This change did not affect the rates of withholding tax applicable to funds based outside the EU. However a 2019 decision of the Spanish Supreme Court concerning the levying of the withholding tax on dividends paid to a US regulated fund held that the NRIT rules were in breach of the freedom of capital movement (which applies not only to intra-EU movements of capital but also movements between EU member states and third countries) to the extent that they did not extend to non-EU investment funds. According to this decision, provided that the non-EU based fund is comparable to a qualifying Spanish fund or EU UCITS entitled to the lower 1% rate of dividend income tax and provided that the Spanish tax authorities are able to verify the information provided to them (such as pursuant to exchange of information clause in a double tax treaty), then it would be contrary to the free movement of capital to apply higher rates of NRIT to the non-EU fund.

Extension to EU based hedge funds

The Audiencia Nacional has now extended the application of these earlier cases to EU based alternative investment funds or hedge funds in its ruling of 30 July 2021. The court held that since the Spanish NRIT rules did not contain any method for a foreign fund to reclaim withholding tax, then the rules were contrary to the free movement of capital and should be disapplied.

The court rejected the arguments of the Spanish tax authorities that since the EU based funds may be entitled to a foreign tax credit under the relevant double tax treaty, there was no discrimination.

As a result, the court held that the EU based alternative investment funds were entitled to a refund of the excess withholding tax levied together with interest.

Comment

The decision has been appealed to the Supreme Court by the Spanish tax authorities as it actually included dissenting votes from two of the judges belonging to the court, creating some level of uncertainty as to the specific comparability requirements which may finally be required for foreign alternative investment funds to qualify for withholding tax refunds (probably the most critical being the one concerning the minimum number of investors). Nevertheless, the decision definitely constitutes a further positive step towards the recognition of EU law principles in this context.

The decision extends further the ability of foreign funds to recover excess withholding taxes suffered on their Spanish portfolio investments. It is now clear that not only are EU based UCITS entitled to the same treatment as Spanish funds, but so are EU based hedge funds and also non-EU based funds which are comparable to EU UCITS. On the basis of the developing case law, it seems equally likely that this principle will also be extended to non-EU based hedge funds provided that they can show that they are comparable to Spanish hedge funds and that they are based in a treaty jurisdiction with an appropriate exchange of information provision with Spain.

If you have suffered Spanish withholding tax on portfolio dividends then you should consider whether this decision may entitle you to a refund. Our Spanish tax team, which has been involved in a number of these developments at the highest levels (including landmark cases at the Spanish Supreme Court) and has advised a number of AMIF clients on the recovery of withholding taxes, can advise you on the position.