Many EU member states tax foreign pension funds more heavily than domestic funds. The European Commission has set the first formal step to end this discrimination with its letter of formal notice to the Czech Republic, Denmark, Spain, Lithuania, the Netherlands, Poland, Portugal, Slovenia and Sweden.

The nine formal notices are the first reaction by the Commission to the complaints which the European Federation for Retirement Provision and PricewaterhouseCoopers filed on 18 member states in December 2005. The Commission announced that it is still examining the situation in other member states, so more formal notices may follow.

"The European pension industry has complained about higher taxation of pension funds if they exercise their rights under the EC Treaty to invest across the border," said EU Taxation and Customs Commissioner László Kovács on 7 May. "The Commission is taking these complaints seriously and has decided to start formal enquiries".

The nine cases all concern the same issue: higher taxation of foreign pension funds resulting from the levying of withholding taxes on dividend and interest payments. Most member states exempt their domestic pension funds from any corporation and/or income tax. In addition, they usually provide for exemption at source of any withholding tax on dividend and interest paid to domestic pension funds.

Where there is no such exemption at source they normally apply a refund procedure, by which the pension fund can claim back the withholding tax. However, foreign pension funds may not qualify for the relief at source or the refund procedure. The result may be that the source state levies a higher tax on interest or dividends paid to foreign funds than on those paid to domestic funds.

According to the Commission, the higher taxation of foreign pension funds is a restriction of the free movement of capital as protected by the EC Treaty and the EEA Agreement. The cases thereby also concern pension funds located in the EEA/EFTA countries, investing in EU Member states, which coincides with these countries' implementation of the IORP Directive.

There is little doubt that the European Court of Justice (ECJ), if the cases were to arrive there, would rule against member states' higher taxation of foreign pension funds. In the Denkavit case, Case C-170/05 of 14 December 2006, the ECJ ruled that the EC Treaty did not allow France to levy a higher (withholding) tax on dividends paid to a company in
the Netherlands than to a French company.

France tried to justify its higher taxation of the outbound dividend by claiming that it would be compensated by the Netherlands, as the French-Dutch bilateral tax convention provided that the Netherlands would give a tax credit for the French withholding tax. This is the so-called two-country approach, whereby the effect of a discriminatory measure is assessed by looking both at the country of source of the income and the country of residence of the taxpayer.

The court applied this two country approach and found that in the circumstances of the case there was actually no credit given by the Netherlands: the same tax convention also provided that the credit would be limited to the tax that the Netherlands levied themselves on the dividend. Since the Netherlands exempted the French dividend under their participation exemption rules the French discrimination was not compensated for by a Dutch credit and France had to pay back the withholding tax that it had levied on the outbound dividend.

It is unlikely that the two country approach could save the member states currently levying higher taxes on outbound dividend and interest payments to pension funds established elsewhere in EU member states or in the EEA/EFTA countries. The very large majority of the member states have the EET or TEE system (EET means that the pension contributions are exempt, that is the contributions are deductible from the taxable income, the investment results of the fund itself are also exempt, and the pension benefits are taxed).

Under the EET and TEE systems there is no taxation of the investment results of the funds. If the state of residence of the pension fund does not levy any tax on the investment results of the fund itself, it cannot give a credit for any foreign withholding tax levied on dividends and interest paid to the fund. As in the Denkavit case, the discrimination of the foreign fund by the source state cannot be justified by a credit in the residence state, as there will not be such credit.

After receiving a letter of formal notice a member state has two months to reply. If the reply is negative and the Commission concludes that there is an infringement, it will send a so-called reasoned opinion to the member state, asking it to modify its legislation within two months.

If the member state is still not prepared to change its legislation and the Commission still thinks that there is an infringement, the Commission will refer the Member State to the ECJ, which on simple cases takes around two years to deliver a judgement.

In practice most infringement procedures are resolved without a ruling by the ECJ. If the member states agree that the Commission is right they change their legislation and the Commission closes the procedure. Some member states have already changed their legislation without even awaiting the opening of the procedure by the Commission. Hungary has abolished its withholding taxes altogether.

Since 6 April 2006 the UK has granted foreign pension funds the same exemptions as it grants to its domestic pension funds.

The only thing the foreign fund needs to do is to register itself via a simple two page form (APSS 100), which can be found on: http://www.hmrc.gov.uk/PENSIONSCHEMES/registration.htm. The exemption also applies to income from real estate.

The Netherlands eliminated the discrimination as of 1 January 2007, albeit only for pension funds in the EU. Pension funds established elsewhere in the EU can now apply for a refund procedure for the Dutch withholding tax on dividends on the same basis as Dutch pension funds.

The financial consequences of these infringement procedures are potentially large. The pension funds in the EU manage an estimated €3trn. Much of this money may be invested in the member state of the pension fund, or outside the EU in, for instance, the US or Japan. In these cases there is no impact.

But in many cases the investments may have been made in bonds or shares issued in other member states. In those cases any withholding taxes on the interest and dividends, with rates varying between 10% and 25%, may have been levied contrary to the EC Treaty.

Eliminating the discrimination of pension funds established in other member states will make the single market more efficient, raise the net returns of EU pension funds and make the EU a better place for pension investments.

 

Peter Schonewille works in the unit dealing with direct tax infringement cases at the directorate-general taxation and customs union of the European Commission in Brussels and at the CompetenceCentre for Pension Research of Tilburg University in the Netherlands. His article is written on a personal basis. E-mail: peter.schonewille@cec.eu.int

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