The court of justice of the European Union attempts to clarify the concept of tax avoidance

On February 26, 2019, the Court of Justice of the European Union (CJEU) handed down its judgments in the cases of T Danmark (ECLI:EU:C:2019:135) and N Luxembourg 1[1] (ECLI:EU:C:2019:134), which once again address the concept of abuse of rights as a legal basis for CJEU case law on tax avoidance, this time regarding the use of holding companies within investment holding structures.

In the two cases joined under the T Danmark judgment, the Court looks at the interpretation of Directive 90/435/EEC (the Parent-Subsidiary Directive) in its wording at the time the facts judged took place. Certain ultimate shareholders resident outside the European Union acquired a company with tax residence in Denmark and structured the investment through a chain of entities that included a holding company resident in an EU Member State (Luxembourg and Cyprus, in the two respective cases). The question was whether the dividends the Danish entity distributed to its ultimate investors through this intermediary holding company could be tax exempt under the Parent-Subsidiary Directive, or whether they would be taxed in Denmark due to application of the anti-abuse rule set out in article 1.2 of the Directive.

In the joined cases ruled on in the N Luxembourg 1 decision, which involved certain investments that were also analyzed in the other judgment, the Court looked at application of Directive 2003/49, on a common system of taxation applicable to interest and royalty payments, to a flow of interest payments derived from a chain of loans involving an intermediary lender in a Member State that directed the flow to ultimate lenders outside of the European Union. The CJEU was asked to interpret the anti-abuse rule set out in article 5 this Directive, in light of article 11 of the OECD Model Tax Convention.

Both judgments were issued as preliminary rulings based on requests submitted by the same Danish court. The Danish Government requested that these cases be heard by the Grand Chamber of the Court and suggested that the Court organize a joint hearing of all the cases. The Court granted the Danish Government’s requests. Undoubtedly, this procedural approach was aimed at highlighting the importance of the matters and laying the groundwork for a judgment that could qualify the CJEU’s previous case law. The Court constructed a common response in both cases, although certain additional aspects were present in the N Luxembourg 1 case. In that case, the Court alluded to the very meaning of the withholding on interest payments, which it claimed was consistent with the free movement of capital; however, the Court did not address when the expenses related with those interest payments would be deductible.

In essence, the CJEU answered the following question: When does the use of an intermediary company in a Member State other than the State of residence of the acquired entity or of the ultimate investors become an abuse of rights that warrants application of the corresponding anti-abuse rule?  The answer is structured into four different components.

Firstly, the CJEU defined the legal basis for understanding fraud or abuse to exist. To that end, the Court reiterated its prior case law on abuse of rights in taxation matters, beginning with the judgments of February 21, 2006 and September 12, 2006 in the Halifax and Cadbury Schweppes cases. The Court only specifies that the principle of prohibiting abusive practices is a general European Union law principle that can be applied even if the anti-abuse rule contained in a directive has not been explicitly transposed into national law, as it had already stated in its judgment of December 18, 2014 (Italmoda).

On the basis of this general principle, the CJEU analyzed whether, in light of its case law, such an abuse existed in the matters before it, focusing on whether an “artificial legal construction” exists (although, in the English version, it later refers to this as an “artificial arrangement” and, in the French, as “un montage artificiel” or artificial set-up). In order to know whether an artificial arrangement exists in the matters at hand, the Court looks at a series of indications, although it clearly leaves the final assessment in the hands of the national court that submitted the question for preliminary ruling. These indications center less on the substance of the intermediary company and more on the circumstances of the flow of dividend or interest payments. Accordingly, the Court considers whether the party is contractually or legally bound to pass the funds on to another party, or whether there are any other circumstances that evidence that the intermediary company, “in substance”, did not have the right to use and enjoy the funds it receives.

In this point, the CJEU, in accordance with the thinking of the referring court, examines, in both judgments, what would happen if the beneficial owner of the income were a resident of a third country with which the State of the first subsidiary had concluded a double tax convention that would also exempt the dividends or interest payments from withholding tax. The Court does not give a clear answer to this, overlooking the fact that the Parent-Subsidiary Directive does not address the concept of beneficial owner. Nevertheless, the Court notes that if the beneficial owner resides in a third country, the exemption can be refused, although if the result were the same in any case, the arrangement should not be thought of as having been created with a fraudulent or abusive aim. In the N Luxembourg 1 case, the Court looks more deeply at the idea of beneficial owner, which is in fact addressed in Directive 2003/49. For the Court, this EU law concept has the same meaning as given in article 11 of the OECD Model Tax Convention, although it adds that the exemption would still apply if the ultimate owner were resident in another Member State and met the requirements set out in the Directive.

Lastly, the CJEU addresses the question of the burden of proving the abuse of rights, stating that the tax authority has the task of establishing the existence of elements constituting abuse or fraud but not the task of identifying the beneficial owners of the dividends or interest payments for which the exemption is being refused.

These judgments are perhaps even more important because of what the Court does not expressly state. Indeed, the Court says nothing of the precedent set by its September 7, 2017 judgment in the Eqiom case (C-6/16) or of the Advocate General’s opinion in all these matters, which the Court shared in Eqiom but now distances itself from. In fact, when summarizing its case law, the Court does not even mention the Eqiom judgment, even though, in it, the Court insisted on avoiding general assumptions of fraud, on the fact that it is not feasible to understand the presence of ultimate shareholders resident outside the European Union to be an indication of fraud, and on the fact that placing an intermediary holding company in an EU Member State is consistent with the freedom of establishment. For these reasons, in the Opinion heard on March 1, 2018, the Advocate General had insisted on a “substance-over-form” approach for the holding entity as the only way to determine whether an artificial arrangement exists, given that in any other case the parent company would be the beneficial owner of the income (unless the structure was devised primarily for tax reasons or were tarnished by the location of the ultimate parents in certain territories).

Now, the CJEU apparently prefers to take a more cautious approach and focuses on the financial flow of the subject payments, without referring to the question of economic substance of the intermediary company located in the European Union. The Court seems to be moving closer to the concept of beneficial owner of the income within the meaning given in articles 10 and 11 of the OECD Model Tax Convention. What the CJEU possibly leaves unsaid is up to what point it will question structures such as those described, with the qualifications it has introduced into its case law.

[1] In joined cases C-116/16 and V-117/16, and in joined cases C-115/16, C-118/16, C-119/16 and C-299/16.