A Landmark Decision on Capital Gains Tax Refunds

In a landmark decision delivered on March 13, 2024, the German Bundesfinanzhof (Federal Fiscal Court) ruled in favor of foreign investment funds, determining that they are entitled to refunds on capital gains tax withheld on German dividends from 2004 to 2017. This ruling has far-reaching implications for the European investment landscape and the principles of non-discrimination and equal treatment within the European Union.

Upholding the Free Movement of Capital

The core of the court’s decision rests on the principle of the free movement of capital, as enshrined in Article 63 of the Treaty on the Functioning of the European Union (TFEU). The Federal Fiscal Court, drawing on case law from the European Court of Justice (ECJ), ruled that foreign funds must be granted the same tax advantages as those provided to domestic funds under Section 11 of the Investment Tax Act 2004. The decision underscores that since domestic funds do not pay tax on the dividends they receive, treating foreign funds less favorably constitutes a violation of the free movement of capital.

The court dismissed arguments based on the coherence of tax law, noting that the differential tax treatment of investors was irrelevant to the assessment of discrimination. The German authorities claimed that the differential treatment was necessary to maintain the internal coherence of the tax framework, suggesting that tax exemptions for domestic funds were linked to the tax treatment of investors in the funds and the overall coherence of the system. However, the BFH found no direct compensatory relationship between the tax exemptions granted to domestic funds and specific tax burdens imposed on investors in the funds.

This lack of direct connection meant that granting similar tax exemptions to foreign funds would not disrupt the coherence of the German tax system. Moreover, the court's rejection of this coherence argument aligned with the European Court of Justice (ECJ) ruling in case C-537/20, which established that tax coherence cannot justify different treatment unless a direct and compensatory relationship between exemptions and burdens is demonstrated.

The BFH further determined that the restrictions on foreign funds were not proportionate, as denying them tax exemptions was more restrictive than necessary and less restrictive alternatives could achieve the same objectives without infringing on the principle of the free movement of capital. Consequently, the court concluded that the capital gains tax paid by foreign funds on dividend distributions must be refunded, aligning German tax practices with EU law requirements.

Historical Context and Competency Issues

The case traces its roots to the historical treatment of withholding tax (WHT) in Germany. Until 2018, German tax law imposed a WHT of 26.375% on dividends distributed to non-resident investment funds, while resident investment funds could receive dividends free of WHT by providing an exemption certificate known as "Nichtveranlagungsbescheinigung."

Even when double tax treaties applied, foreign funds were subject to a final WHT of 15%. This long-standing disparity underscored the unequal treatment of foreign and domestic funds, prompting legal challenges. Further complicating the matter was a lack of clear rules regarding which tax authorities were competent to handle WHT reclaims filed by foreign investment funds based on EU law. This ambiguity led to refusals by German tax offices to issue decisions, effectively putting WHT reclaims on hold until June 2021, when the Central Tax Authority (BZSt) was designated as the responsible body for processing these applications.

Interest on Refunds and the Path Forward

The German Federal Fiscal Court’s judgment also addressed the timing and calculation of interest on refunded amounts. The court determined that interest would accrue at a rate of 0.5% per month, which equates to an annual interest rate of 6%. This substantial interest rate is particularly significant when applied to tax refunds dating back many years. The accumulation of interest over such extended periods can result in considerable sums, dramatically increasing the financial impact of these refunds on the German tax authorities. For instance, on a withheld tax amount of €1 million, a 6% annual interest over a decade could add up to €600,000, making the total refund amount substantially larger. For refunds related to years before 2012, interest begins to accumulate six months after the refund application is filed. For more recent years, interest accrues from the date the tax was withheld. This nuanced approach to interest calculation ensures that foreign funds are adequately compensated for the period during which their capital was unjustly taxed.

While the court's decision is a significant step towards resolving these long-standing issues, further proceedings are required. The matter has been referred back to the Hessian Finance Court for detailed calculations of refund interest and verification of dividend information. Although the process may take some time, it marks a critical step towards ensuring that the German tax authorities comply with EU law, ultimately paving the way for the processing of refund applications by the Federal Central Tax Office (BZSt).

Broader EU Scrutiny and the L-Fund Case

This ruling by the German Federal Fiscal Court reflects a broader EU-wide scrutiny on member states' tax practices. The European Commission recently initiated an infringement procedure against the Netherlands, challenging its tax practices as discriminatory towards foreign investment funds. This infringement action underscores the EU's commitment to the free movement of capital and highlights ongoing tensions between national tax policies and EU regulations. By targeting discriminatory practices that disadvantage foreign funds, the EU is making clear its intention to enforce a fair investment environment across its member states.

The decision in this case parallels the “L-Fund” case, where the German Federal Fiscal Court also ruled in favor of foreign funds. In the L-Fund case, a Luxembourg real estate fund was found to have been unjustly taxed by Germany on income from German real estate, while similar German funds were exempt. The court determined that this differential treatment was discriminatory and violated the free movement of capital.

Both cases involve the application of EU law principles to ensure that foreign funds are not treated less favorably than domestic funds. These decisions collectively highlight the need for member states to align their tax practices with EU principles to prevent discrimination and ensure fair treatment for all investment funds, whether domestic or foreign.

Implications and Future Outlook

The March 13th ruling by the German Federal Fiscal Court is a decisive moment in the ongoing evolution of EU tax law. It reinforces the free movement of capital and the rights of foreign investors, ensuring that the economic benefits of investment across borders are not undermined by discriminatory tax practices. By affirming the principle that foreign funds must be treated equally under tax laws, the Bundesfinanzhof has sent a clear message about the importance of adherence to EU principles. Such consistent legal interpretations reinforce the EU’s commitment to ensuring a level playing field for all investment funds, irrespective of their origin.