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ECJ Ruling Upsets Thin Capitalisation Rules

by Ulrika Lomas,, Brussels

18 December 2002

A recent judgement by the European Court of Justice has thrown 'thin capitalisation' rules into doubt in many EU member states. Such rules set out maximum ratios of debt to equity capitalisation, seeking to prevent a company from financing a cross-border subsidiary with debt rather than equity, and thus escaping withholding tax normally levied on dividend distributions by remitting profits in the form of loan interest or repayments.

In the case which has just been decided, a German company, Lankhorst-Hohorst, had been capitalised through loans by its Dutch parent. The company argued that far from being a ploy to avoid German taxes, the loans were a vitally needed support to its failing German subsidiary. The ECJ agreed, and rejected arguments put forward by the German, British and Danish governments, as well as by the European Commission, that the loan-based capitalisation structure was illegal.

The Court said that the German law against thin capitalisation was contrary to the EU Treaty because it constrained the principle of freedom of establishment, and discriminated against foreign companies which might not be able to obtain tax credits under participation exemption rules. The EU's 'parent/subsidiary' directive would normally allow an EU parent to bypass withholding taxes, whereas in many cases a foreign parent would not be able to have such privileged treatment and would have to pay the withholding tax. The thin capitalisation rules would therefore disadvantage non-EU companies as against EU ones. Of course that's exactly what they're intended to do, although nobody admits it, so the ECJ has once again looked straight through national protectionist rule-making to the intent of the underlying treaty.

The Court said: 'The legislation at issue here does not have the specific purpose of preventing wholly artificial arrangements, designed to circumvent tax legislation, from attracting a tax benefit, but applies generally to any situation in which the parent company has a seat outside the Federal Republic of Germany.' In other words, if the intent of the German law had been restricted just to preventing tax avoidance, the Court might have allowed its operation; but because the law is quite general, it has to be struck down.

Most EU member states have legislation equivalent to the German rules, and will now have to change it. In the UK, Ernst & Young told the FT: 'In our view the case is clearly applicable to UK thin capitalisation rules. The UK government will be obliged to amend its legislation to ensure compatibility with this decision.'

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