Court Rules Taxation of Foreign Investment Funds Violates EU Law

In a recently published decision, Germany’s Federal Fiscal Court (BFH) held that the imposition of withholding tax on dividends paid to EU-based investment funds — while exempting German funds — violates the free movement of capital principle under article 63 of the Treaty on the Functioning of the European Union. Based on the BFH decision, the withheld tax plus interest must be refunded to eligible nonresident funds taking into account the four-year statute of limitations period for assessments.

Background

Until the end of 2017, the tax treatment of investment funds in Germany depended on whether the fund was domestic or foreign. Domestic funds were exempt from tax but foreign funds were subject to a 26.37% withholding tax on German-source dividends that could be reduced under an applicable tax treaty. However, as from 2018, the government fundamentally revised the relevant rules in the Investment Tax Reform Act, taking into account EU law requirements. As a result of these changes, all investment funds became subject to the same taxation. Nevertheless, as the BFH decision shows, the previous legal situation continued to have an impact on foreign funds whose application for tax refunds has not yet been finalized.

In its decision issued on 13 March 2024, the BFH held, based primarily on a 2023 decision of the Court of Justice of the European Union (CJEU) that the exclusion of foreign investment funds from the provisions of section 11 of the Investment Tax Act (InvStG 2004), although the exemption was granted to domestic funds during the disputed years (2008 to 2013), violates the free movement of capital and is therefore in breach of EU law.

Facts of the Case

The case before the BFH involved a French investment fund that received distributions from German companies during the years 2008 – 2013 and on which capital gains tax was withheld and paid over to the German tax authorities. 

Based on the Germany-France tax treaty, the investment fund requested a refund of the tax paid in accordance with section 50d of the German Income Tax Act, so that the tax and solidarity surcharge (totaling 11.375% under the treaty) could be refunded; the fund also sought a refund of the remaining 15% tax and interest. The fund’s position was that a fund based in France is equivalent to a German investment corporation, which is tax-exempt so no capital gains tax should be due and the unequal treatment of domestic and foreign funds under Germany’s investment tax law is unjustified and therefore, a refund should be granted. Finally, the fund argued that the German capital gains tax could not be credited against French tax in accordance with the treaty because the fund was not taxed in France. 

The foreign fund was subject to limited corporate income tax liability with respect to its German investment income. According to the clear wording of section 11(1) of the Investment Tax Act (InvStG 2004), the income tax exemption was reserved for domestic funds or domestic investment stock corporations. Section 11(2), which also only applied to domestic funds, granted relief from withholding tax on distributions received. The tax authorities justified the legislative approach by the assumption that not all income was taxed at the level of the investors in the foreign investment funds. 

The tax authorities denied the refund request on the grounds that any discriminatory treatment under EU law was justified because of the need to maintain coherence of the German tax system (in this case, the tax exemption for the investment fund and taxation of the investor). The taxpayer then filed an appeal that eventually came before the BFH.

BFH Decision

In reaching its conclusion that Germany’s Investment Tax Act was incompatible with EU law during the years at issue, and therefore the investment fund is entitled to a refund of tax paid, the BFH made the following determinations:

• Resident funds are exempt from corporation tax and domestic capital gains tax, but not foreign public funds. This unequal tax treatment is likely to deter non-resident public funds from investing in German corporations and deter investors resident in Germany from using nonresident public funds for such investments. Citing the CJEU, the BFH noted this conclusion is not affected by the taxation of distributions at the level of the investor because German law does not make the exemption of domestic funds conditional on all income being taxed at the level of their investors.
• Based on CJEU jurisprudence, a foreign fund must be granted the same tax advantages under the Investment Tax Act 2004 as domestic funds. Since domestic funds do not ultimately have to pay tax on the dividends they receive, foreign funds must not be treated less favourably. The presumption that investors in a domestic investment fund are taxed on distributions is irrelevant.
• There was no systematic taxation of domestic investors in domestic funds without the possibility of an exemption. Again citing the CJEU, the BFH determined that the German legislation contained a fundamentally impermissible restriction on the free movement of capital that was not proportionate. As a less restrictive measure, the tax exemption could have been granted to foreign funds provided the investors were taxed. The BFH held there was no statutory basis for indirectly imposing a mandatory charge on the fund investors.
• In addition to a refund of tax withheld, the fund is entitled to 6% interest per annum. 

The BFH remanded the case to the lower court as the responsible body to determine the exact tax refund and interest amounts. The decision shows, that the previous legal situation continues to have an impact on foreign funds whose tax treatment has not yet been finalized due to the still pending numerous withholding tax relief requests. Further, the investment funds should review the previously made decisions regarding the tax withholding refunds regarding any possible impact.