Brisal, a Portuguese resident company manages a large highway in Portugal and earns revenue from the associated tolls. In 2004 the company entered into a financing arrangement with a large number of financial institutions, in particular the co-litigant in this case KBC Finance Ireland (an Irish resident company). The financing amounted to €262m, so was presumably related to the construction of the highway itself.
Interest is deemed to be 'sourced' from the country in which the debtor is situated. Thus, tax is levied on the creditor even if it is non-resident. There is of course a tax collection issue with trying to collect tax from non-residents, either because it's harder to legally enforce tax laws offshore or because non-residents in many cases may not even be aware of their foreign tax obligations. This is why interest withholding taxes exist - to ensure the debtor withholds tax on the interest before it leaves the country.
The Transactions
Between 2005 and 2007 Brisal paid €350,000 in interest to KBC, withholding around €60,000 of that for withholding tax purposes. The withholding tax rate in Portugal for non-resident companies in receipt of interest is 20% of their 'gross' income, which appears lower than the 25% rate of tax charged to resident companies on their 'net income'. However, as no deductions can be made on 'gross income' the flat 20% tax actually works out worse for all non-resident companies with a profit margin of less than 80% (basically every large company on the planet).
The Argument
KBC were not asking the Portuguese government to let it have the resident rate of tax inclusive of deductions, rather it argued for the allowance of deductions on its lower withholding tax rate of 20%. The basis for its argument is that allowing resident companies to deduct expenses from their interest income whilst not allowing the same deductions for non-resident companies amounts to tax discrimination - prohibited under the EUs principle of freedom of movement of services - because discrimination runs contrary to the very essence of 'freedom'.
The basis for tax discrimination has been set out in previous ECJ decisions. For example in The Commission v Spain it was held that charging non-residents absurdly higher inheritance tax amounted to tax discrimination and thus unjustly interfered with the free movement of capital within the EU.
The Law
Article 56 of the TFEU provides for freedom of movement of services within the union:
"restrictions on freedom to provide services within the Union shall be prohibited in respect of nationals of Member States who are established in a Member State other than that of the person for whom the services are intended."
KBC contend that disallowing deductions for withholding tax in a system where resident companies are allowed to deduct expenses in relation to the same type of income is discrimination contrary to the spirit of free movement of services.
Note that when these transactions occurred in 2005, Article 56 TFEU was found under Article 49 of the previous TEC agreement (thus the decision below refers to Article 49).
The Decision
The ECJ ruled in favour of KBC and Brisal, ruling that deductions should be allowed against withholding taxes where it would prevent discrimination against non-residents.
"Article 49 EC precludes national legislation, such as that at issue in the main proceedings, which, as a general rule, taxes non-resident financial institutions on the interest income received within the Member State concerned without giving them the opportunity to deduct business expenses directly related to the activity in question, whereas such an opportunity is given to resident financial institutions."
With regard to Portugal's argument that the more favourable tax rate to non-residents justifies the restriction on deductions, the ECJ said:
"the Court has 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."
Notes
Case [2016] EUECJ C-18/15: http://www.bailii.org/eu/cases/EUECJ/2016/C1815.html
Treaties
Treaty on the Functioning of the European Union
Article 49 of the TEC
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