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Back door tax harmonisation Back  
The European Court of Justice in the Lankhorst-Hohorst case has ruled that Germany’s thin capitalisation rule is contrary to EU law on a number of counts. The thin capitalisation rule denies a deduction for interest expense of a company where it is paid to a foreign associated company, or in some cases paid to a third party on foot of group guarantees, and where the debt equity ratio exceeds a benchmark level. Such rules are common worldwide although Ireland does not have such a rule.
The thinking behind a thin capitalisation rule is that a foreign owner of a local subsidiary has the freedom to structure matters so that he takes out profits either by way of interest on borrowings, or by way of dividend. Typically interest is a deductible expense, and dividends are not. The thinking is that if interest and dividends are interchangeable at the shareholder’s choice, there should be some restrictions on the deductibility of interest to mirror the non-deductibility of the dividends.
The challenge to the rule was not on the basis of the logic behind it but on the basis of European law, which provides for freedom of establishment.
The court concluded that a difference between the deductibility of interest by resident subsidiary companies according to the seat of their parent company constituted an obstacle to the freedom of establishment. It said ‘- - the tax measure in question makes it less attractive for companies established in other member states to exercise freedom of establishment and they may, in consequence, refrain from acquiring, creating or maintaining a subsidiary in the state which adopts that measure’.
In other words, if a company wishes to have a German subsidiary and the deductibility of interest in that subsidiary will depend on whether its parent is resident in Germany, or in another EU member state, the freedom of the parent company to be situate where it will has been interfered with. The freedom of non-German companies to create subsidiaries in Germany while retaining their foreign residence has been interfered with. That is illegal.
Interestingly, the German thin capitalisation rule was not a black and white rule that distinguished between interest paid to non-resident parents, as opposed to resident parents. A small category of German holding companies also suffered the disadvantage that interest paid to them was denied a deduction in the tax computation of the paying subsidiary. However the court was content to proceed on the basis that the vast majority of German parent companies did not suffer this disadvantage, whereas almost every foreign holding company did suffer (at least potentially) this disadvantage.
The usual justifications for the discriminatory treatment were trotted forward and blown away by the court. The court rejected the defence that German tax revenues would be adversely impacted if foreign investors were allowed to structure their investments as loans rather than share capital. It said such an argument does not justify a measure, which is in principle contrary to a fundamental freedom. It also rejected the argument that the discrimination was in the interests of combating tax evasion. This was simple to counter, since the measure clearly had nothing to do with tax evasion. Even if it had been concerned with tax evasion there would be a need that the countervailing measure be proportionate to the risk, and a blanket discrimination against non-residents was hardly a proportionate response.

There are straightforward and immediate implications. German subsidiaries that have suffered a denial of a deduction for interest paid to foreign group members by reason of the thin capitalisation rule should now seek to reopen their tax assessments and demand refunds of tax accordingly. Any Irish companies with German subsidiaries should review the position.
The significance of the case however goes far beyond the possibility that some German companies will get some tax refunds. The truth is that thin capitalisation rules are part of a suite of tax rules almost universally applied to cross border transactions in Europe. Other tax measures which are part of that suite include controlled foreign company legislation (CFC). Such legislation seeks to tax in the home country the profits of an overseas subsidiary in certain circumstances, typically where it is taxed at a lower rate abroad than it would be if it were located in the home country. Ireland has had experience of a toughening up of UK CFC legislation as it applies to Ireland, in the recent past. If thin capitalisation legislation that discriminates between a resident EU parent and non resident EU parent is illegal, then it is highly likely that controlled foreign company legislation is also contrary to EU law.
Transfer pricing legislation exists in most EU states on the basis that it applies only to cross border transactions with connected parties, but not to transactions between connected parties all of whom are resident in the local state. Once again, on the logic of the thin capitalisation case such an approach must be open to question. In this case there may be some stronger defence than in the thin capitalisation case, but not much more. Ireland is expected to introduce transfer-pricing legislation by 2004 at latest.
Some EU member states (including the UK and Ireland) do not tax dividends and other profit distributions between resident companies, but do tax such distributions of profits when received locally from a country resident in another EU member state. Typically credit will be granted for foreign taxes, but not in all cases. This situation must also now look threatened by the thin capitalisation ruling. and other decisions of the ECJ.
Ireland has a number of tax measures that can cause income arising to persons resident in other EU member states to be taxed as if it was income received by an Irish resident, thus discouraging an Irish resident from making certain investments abroad. Similarly capital gains arising to persons resident in other EU member states can be attributed to Irish persons (including companies) under various parts of the tax code, once again discouraging foreign investment. These rules must now look suspect. The normal reasons advanced for such rules eg countering tax evasion, clearly won’t wash before the ECJ since in the vast majority of instances in which the rules apply there is no tax evasion involved, nor any requirement that there should be for the sections to apply.
Lankhorst-Hohorst is likely to be a name that will be remembered for a long time. It is a Dutch group carrying on a trade in boating equipment, water sports and leisure equipment, and in hardware. Its advertising agency could hardly have hoped to achieve the ‘name recognition’ it now has.

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