European Union tax: ECJ finds restrictions of former German imputation system may be justified

The European Court of Justice (ECJ) issued its decision in Glaxo Wellcome (C-182/08) on 17 September 2009, a case referred by the German Federal Tax Court (BFH) for a preliminary ruling on the compatibility of a German tax rule under the old "full imputation system" (abolished in 2000/2001) that blocked foreign shareholders from indirectly obtaining a tax credit for German corporate income tax paid by a subsidiary. The rule denied resident companies the tax deductibility of write downs of shareholdings in German corporations that were acquired from nonresident shareholders to the extent the write downs did not exceed the "blocked amount" (the difference between the acquisition costs and the nominal value of the holding) and were caused solely by the distribution of profits.

Before the Glaxo Wellcome case, taxpayers employing tax planning arrangements with complex restructurings challenged the rule based on German domestic provisions, but the BFH rejected the arguments with a broad interpretation of the provision. The BFH did not refer these cases to the ECJ since they only involved third (i.e. non-EU) country situations and the BFH concluded that only the freedom of establishment principle in the EC Treaty was at issue (which only applies to intra-EU situations). Glaxo Wellcome, however, involved a restructuring after an acquisition of shares in a German corporation from a U.K. shareholder, with the rules in question (as interpreted by the BFH in prior cases) serving to reduce the basis of the assets because the German taxpayer had acquired shares from a nonresident (that was not entitled to an imputation credit).

While the BFH rejected the taxpayer's arguments under domestic tax law, the taxpayer argued the German provision constituted an infringement of the fundamental freedoms in the EC Treaty (and the case was referred to the ECJ).

The ECJ reasoned (somewhat surprisingly) that the relevant freedom at issue was the free movement of capital (despite a 100% shareholding having been acquired). The ECJ stated that the purpose of the German legislation was "to prevent nonresident shareholders from obtaining an undue tax advantage directly through the sale of shares with the sole objective of obtaining that advantage, and not with the objective of exercising the freedom of establishment." Although the Court's decision may seem to conflict with some of its other decisions (e.g. the Aberdeen or FII GLO cases, where the ECJ took the actual shareholding into consideration in determining which fundamental freedom was at issue), the contradiction is less than it appears because the acquisition of the shareholding in a resident corporation by a German resident would not be directly covered by the freedom of establishment due to the absence of a cross-border element.

The ECJ concluded that the German provision constitutes a restriction of the free movement of capital, but the restriction "can be justified by the need to maintain a balanced allocation of the power to impose taxes between the Member States" and to prevent "wholly artificial arrangements which do not reflect economic reality and whose only purpose is to obtain a tax advantage." However, this possible justification still has to meet the proportionality test, i.e. the legislation must "not go beyond what is necessary to attain the objectives thus pursued." Although the Court stated that it is for the national courts to determine whether or not the proportionality test is met by the domestic rules in question, the ECJ did indicate that the fact that the rule disregarded that a purchaser may be willing to buy shares for a purchase price exceeding their nominal value for other reasons than the potential future tax credit and that the rule did not give the taxpayer a right to prove that the arrangement was not motivated by unduly obtaining a tax advantage may give rise to concerns regarding the proportionality of the rule.