Spanish Supreme Court decides first hedge fund withholding tax case

Spanish Supreme Court releases its first decision on hedge funds cases

This decision is a key milestone on the taxation of non-resident hedge funds on Spanish source dividends.

The Spanish Supreme Court has held that the Spanish rules for taxing non-resident hedge funds on Spanish source dividends are contrary to EU law. In particular, the Court has held that the rules are in breach of the principle of free movement of capital.

Non-resident funds which have suffered Spanish withholding taxes should now consider whether they may benefit from this decision and reclaim any overpaid Spanish withholding taxes.

Background

The case appealed to the Spanish Supreme Court concerns the taxation of a French hedge fund on Spanish source dividends. The French hedge fund was subject to tax at 15% (reduced from 19% under the Spain-France double tax treaty). This compares unfavourably, however, with a Spanish hedge fund which is only subject to taxation at 1% on Spanish source dividends.

Nevertheless, the Spanish regional court held that this situation was not contrary to EU law as the difference in taxation was based on the existence of objective differences between a French and Spanish hedge fund and, consequently, did not amount to illegal discrimination. Please see our previous publication concerning this and other related cases here: Spanish Supreme Court to rule in hedge fund withholding tax cases | Simmons & Simmons (simmons-simmons.com)

Analysis of the Supreme Court’s decision

In its decision released on 5 April 2023, the Supreme Court has followed a similar approach to the one taken in other similar cases (e.g. those concerning UCIT funds, insurance companies, sovereign funds or US investment funds) to confirm that the Spanish tax rules are contrary to the freedom of movement of capital in Article 63 of the Treaty on the Functioning of the European Union (TFEU) and there is no valid justification for the discriminatory treatment borne by non-resident hedge funds where such funds are comparable to Spanish funds. In this regard, the Supreme Court states that a non-resident hedge fund will be comparable with a Spanish hedge fund if:

• it is an open-ended entity. On this point, the Supreme Court has confirmed that any limitations on access to professional or qualified investors does not undermine its open-ended nature for these purposes.
• it has an authorisation to operate in its home country issued by the relevant domestic regulator equivalent to the Spanish regulator (in Spain the “Comisión Nacional del Mercado de Valores” or CNMV).
• It is managed by an entity authorised to operate under equivalent terms to those set out in the Alternative Investment Fund Managers Directive (Directive 2011/61/EU).

In contrast to the decision of the regional court, the Supreme Court has held that a degree of flexibility must be allowed with regard to the evidence that non-resident hedge funds must obtain to prove their comparable nature. Furthermore, the Supreme Court remarked that, since the Spanish regulations do not establish any specific rules as to how comparability should be evidenced, Spain cannot require disproportionate or extraordinarily means of evidence that can hardly ever be obtained. Moreover, if the Spanish Tax Administration has doubts about the documentation provided, it must initiate a procedure for the exchange of information with the jurisdiction of residence of the hedge fund.

Finally, the Supreme Court has confirmed that the restriction on the free movement of capital may only be deemed to be neutralised by the provisions of a double taxation treaty if the treaty allows the relevant hedge fund to completely deduct the excess of Spanish tax withheld. This confirmation is very welcome, and, in practice, the Spanish rules do not currently provide for the deduction of any excess tax withheld.

Comment

This decision is the first of several other Supreme Court cases that are expected to be released soon and can now be expected to follow the same approach.

It should be noted that, although the claimant in this case was a French hedge fund (and the remaining pending cases also concern EU-based hedge funds), due to the broad scope of the reasoning in this decision, not only non-EU hedge funds but also a wider range of non-resident investment vehicles which may be considered comparable with Spanish collective investment schemes should have strong arguments that they too should benefit from this case law as long as they are resident in a treaty jurisdiction for Spanish tax purposes.

Nonetheless, it should also be highlighted that the judgment includes dissenting votes from two judges of the Court, which expressed a position more in line with the regional court, suggesting that elements such as the minimum number of investors or minimum capital requirements should be considered when assessing comparability. As such, although it is more likely that the pending decisions will follow the reasoning of the Court in this case (especially if the composition of the Court does not change), there remains a risk that this minority position may be taken up in future judgments.

Any non-resident funds which have suffered Spanish withholding tax on portfolio dividends should now consider whether this decision may entitle them 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.