beskattning av internationella...
TRANSCRIPT
INTE RNAT I ONE L LA HANDE L SHÖG SKOLAN HÖGSKOLAN I JÖNKÖPING
B e s k a t t n i n g a v I n t e r n a t i o n e l l a P o r t f ö l j e r - Juridisk Analys -
Magisteruppsats inom internationell skatterätt
Författare: Stefan Palm
Handledare: Juan José Nieto Montero,
João Félix Pinto Nogueira samt
Ulrika Rosander.
Jönköping Januari 2009
JÖNKÖP I NG INT ERNA T I ONAL BU S IN E S S SCHOOL JÖNKÖPING UNIVERSITY
Taxing International Portfolios - Legal Analysis -
Thesis in international tax law
Author: Stefan Palm
Tutors: Juan José Nieto Montero,
João Félix Pinto Nogueira and
Ulrika Rosander.
Jönköping January 2009
i
Magisteruppsats inom internationell skatterätt
Titel: Beskattning av Internationella Portföljer
– Juridisk analys
Författare: Stefan Palm
Handledare: Juan José Nieto Montero,
João Félix Pinto Nogueira samt
Ulrika Rosander
Datum: 2009-01-15
Ämnesord: Internationell skatterätt, Utdelning, Kapital beskatt-ning, Europeisk beskattning, Portfölj inkomst.
_______________________________________________
Sammanfattning
Magisteruppsatsen är inriktad på utvecklingen inom beskattnings neutraliteten inom områ-
det direkt beskattning för portfölj inkomst inom EG-rätten. Frågan är av stor betydelse ef-
tersom den juridiska behörigheten inom EU är otydlig och eftersom den internationella
skatterätten är ett komplext område, påverkar den även portföljer. Problemet är ofta be-
skrivet i termer om dubbel beskattning och det är av särskilt intresse för denna uppsats att
undersöka hur en portfölj är påverkad av gränsöverskridande investeringar som har relatino
till EU.
Termen portföljinkomst är på den internationella arenan använd med stor variation och
somliga länder använder sig inte av en speciell beskattning för portföljinkomst. EU har ing-
en positiv integration som kan bygga upp en skattelagstiftning och därmed försvinner dess
möjlighet att bestämma hur portföljinkomst skall beskattas. EG-domstolen har istället en
exklusiv möjlighet att ruinera den hantering av skatt som är orättvis enligt den fundamenta-
la fria rörligheten för capital i EG förordningen. Problemet med en brist på positiv integra-
tion inom EU gör det svårare att harmonisera skattesystem till ett. Länder är rädda för att
förlora makten över sin viktiga finansieringskälla och problem finns även utanför unionen
då CIN och CEN används olika. En använding av dem gemensamt verkar idagsläget vara
en utopi.
ii
För att ge en lättnad inom dubbelbeskattningen är bilaterala metoder i använding. Ofta an-
vänds dock unilaterala metoder. Båda erbjuder Credit-metoden (Avräkningsmetoden), Ex-
empt-metoden (Friställningsmetoden) och Deduction-metoden (Avdragsmetoden).
EG-domstolen har i sina mål favoriserat Credit-metoden, vilken ser ut att vara samma me-
tod som används inom Direktiv, såsom Sparande direktivet om informations utbyte samt i
enighet med doktrin.
Problemen på området är svåra p.g.a. att en osäkerhet uppkommer för de investeringar
som skulle störa den globala handeln och en skatteplanering om inte t.o.m. skattemissbruk
skulle kunna uppkomma, som gör att en trend införs och orsakar allvarliga konsekvenser
för en av de största ekonomiska motorerna i världen; aktiemarknaden. G20 mötet har i sin
“Declaration summit on financial markets and the world economy” från den 15 november 2008 be-
slutat bl.a. att på medellång sikt fortsätta med sitt arbete inom organ såsom OECD att för-
stärka ett informationsutbyte om skatt sinsemellan och vidare att stora konsekvenser skall
utövas vid brist av detta. Bestämmelsen ger en praktisk insyn på skattens betydelse inom ett
gott skattesystem för att utveckla en global ekonomisk välfärd.
iii
Master’s Thesis in International Tax Law
Title: Taxing International Portfolios – Legal Analysis
Author: Stefan Palm
Tutors: Juan José Nieto Montero,
João Félix Pinto Nogueira and
Ulrika Rosander
Date: 2009-01-15
Keywords: International taxation, Dividends, Capital taxation,
European taxation, Portfolio income. ______________________________________________________
Abstract
The thesis is concentrating on the development of tax neutrality in the area of direct taxa-
tion of portfolio income within the EC Law. The question is of great importance as the ju-
ridical powers of the EU are unclear and as the international tax law is a complexed area, it
does affect portfolios. The problem is often described in terms of double taxation and it is
of special interest for this paper to see how a portfolio is affected by cross-border invest-
ments with relation to the European Union.
The term portfolio income is on the international area widely used and not all countries are
using a special taxation of portfolio income. The EU has no positive integration to build a
tax legislative platform and thereby to decide how portfolio income should be taxed. In-
stead has the ECJ an exclusive possibility to destroy tax treatments which are unfair due to
the fundamental free movement of capital in the ECT.
Problems in regard to the lack of positive integration for the EU makes it harder to unify
the union into one tax system. Countries are afraid of loosing their important source of fi-
nancing the state and the two generally used methods of CIN and CEN are used in differ-
ent countries, even outside the union. To use them synchronised seems today to be a
utopy.
iv
To relieve the double taxation, are often bilateral methods used, and sometimes unilateral
methods. Both of them are using the Credit method, Exemption method and Deduction
method. The ECJ has in its case law favoured the Credit method, which seems to be the
same method used by the Directives, such as the Savings Tax Directive about information
exchange and in accordance with the doctrine.
The problems in the area are difficult as an uncertainty appears for the investments which
could interfere the global trade and a tax planning, if not even tax abuse could appear mak-
ing a movement which would have severe consequences for one of the biggest economical
engines in the world; the stockmarket. The G20 meeting has with its ‘Declaration summit on
financial markets and the world economy’ from the 15th November 2008 decided among other
things, to continue the work within organisations such as the OECD decided to, among
other things, strengthen the exchange of information on taxes on a middle-long time
schedule and to give severe consequences if this will be nonchalanced. This decision shows
how the importance of taxes on a practical view of the importance of developing a good
tax system to get into an economical global wealth.
v
Table of Contents
Appearances .................................................................................. 1
Thank you... .................................................................................... 1
1 Introduction .............................................................................. 3 1.1 Background ........................................................................................ 3 1.2 Purpose .............................................................................................. 4 1.3 Method and Material ........................................................................... 5 1.4 Disposition .......................................................................................... 5
2 Guidelines for a Good Tax System of Portfolio Income ........ 5 2.1 Territorial Tax System and Worldwide Tax System ............................ 6 2.2 More Guidelines ................................................................................. 7
2.2.1 Capital Import Neutrality (CIN) .................................................... 8 2.2.2 Capital Export Neutrality (CEN) ................................................... 9 2.2.3 CIN v. CEN .................................................................................. 9 2.2.4 Critics ........................................................................................ 10
2.3 The Issue ......................................................................................... 10
3 Portfolio Holding and the EC law .......................................... 13 3.1 Portfolio Income ............................................................................... 15 3.2 Portfolio Taxes ................................................................................. 17 3.3 No Capital Gain Tax ......................................................................... 20 3.4 A Jurisdiction’s Right to Tax Portfolio Income Under International
Law ....................................................................................................... ......................................................................................................... 21
3.5 The EU and International Capital ..................................................... 21 3.5.1 Free Movement of Capital ......................................................... 22
3.5.1.1 Free Movement of Capital and Portfolio Investments ............................. 23 3.5.1.2 Free Movement of Capital in Relation to other Fundamental Freedoms 24
4 Taxation of International Portfolio Holding .......................... 25 4.1 Portfolio Holders ............................................................................... 25
4.1.1 Individual ................................................................................... 26 4.1.2 Entity ......................................................................................... 26
4.2 Internal Approach ............................................................................. 27 4.2.1 The Unilateral Methods ............................................................. 27
4.2.1.1 Foreign Tax Credit Method ...................................................................... 28 4.2.1.2 Exemption Method ................................................................................... 30 4.2.1.3 Deduction Method .................................................................................... 32 4.2.1.4 Conclusion ............................................................................................... 33
4.3 International Approach ..................................................................... 34 4.3.1 Double Tax Treaties (DTT) ........................................................ 34
4.3.1.1 The OECD Model .................................................................................... 36 4.3.1.2 The U.N. Model ........................................................................................ 39 4.3.1.3 The U.S. Model ........................................................................................ 42 4.3.1.4 Do We Need DTT? .................................................................................. 43 4.3.1.5 The Relation Between Tax Treaties and the ECT ................................... 44 4.3.1.6 Conclusion ............................................................................................... 47
vi
4.4 European Approach ......................................................................... 48 4.4.1 Positive Integration .................................................................... 49
4.4.1.1 Savings Directive ..................................................................................... 49 4.4.1.2 Exchange of Information Directive ........................................................... 53
4.4.2 Negative Integration .................................................................. 55 4.4.2.1 Case-Law ................................................................................................. 55 4.4.2.1.1 How does the EC law deal with Double Taxation for Inbound _________Dividends of Portfolio Investment? ....................................................... 56 4.4.2.1.2 Capital Gains on Ordinary Shares ........................................................ 63
4.4.3 Conclusion ................................................................................ 64
5 Summary ................................................................................. 65
References ................................................................................... 68
1
Appearances
ECJ European Court of Justice.
ECT Treaty of the European Community.
EC law European Community Law.
EU European Union.
IBFD International Bureau of Fiscal Documentation.
MS Memberstate of the European Union.
OECD Model OECD Model Tax Convention on Income and on Capital; July 2008.
UN Model United Nations Model Tax Convention between Developed and Developing Countries; 2001.
US United States of America.
US Model United States Model Income Tax Convention; November 2006.
Thank you...
‘The hardest thing in the world to understand is the income tax.’ -Albert Einstein
The day has come when the accomplishment is done. The period of my thesis will always
be close to my heart, as it has been a time I consider to be similar with the ‘Camino de Santi-
ago’ with many curious crossings, each leading to cotter and reaching closer to the goal.
The camino1 has thus also given some blisters, as the long journey has had a heavy back-
pack, regardless of up-hill or down-hill. The information has been like a mountain to get
through. Sometimes has it been relatively the same or not necessary, and sometimes has it
been a real test.
The fact that the camino was having crossings is stimulating as there still is much out there
to discover, and it would be fascinating to try another way in the future from the camino.
The camino resulted in stimulating my passion for finance and law. The law is always there
by your side as it is like a world, with its own language, its own culture and its own history
and future. The Finance is fascinating as we are on a daily basis impacted by it, and we no-
tise it especially in these times of regression in the world economy.
1 Spanish for ‘patch’.
2
My decision to walk the camino, have been done by my passion to the subjects of financial
law, but I wouldn’t have reach the destination Santiago de Compostela, if not for the peo-
ple I’ve met on my patch.
I want to thank especially João, a light in the dark and a friend, for all from intelligent
stimulation to help with ordering good coffee in Spain.
Thanks to prof. Nieto and Ulrika Rosander who made it possible to write this thesis at
both the universities and to get this paper accredited.
I want also to give special thanks to Mireya as I wouldn’t be in Spain if not for you. An in-
telligent woman with an optimistic mind and stubborness and who gave stability and love.
Finally, I want to thank my beloved family, for being there despite the miles between us.
And once I was back in Sweden, all the help I got there.
I wouldn’t deliver my best without all of your support, thank you.
January 2009, Stockholm
Stefan Palm
3
1 Introduction
‘Taxes are what we pay for a civilized society’2
1.1 Background
Since the first known taxation in 1200 B.C Egypt, has the evolution sharply increased.3 In
present, there is a sophisticated global financial market, meaning a more complex tax sys-
tem.
By the fact of an era of enormous exchange of information channelized mainly through the
Internet the World has became even more global. Our physical boundaries are decreasing
as we are more united, by for instance the European Union, making impact on the national
jurisdictions.
The Global Financial Markets are in fact the biggest engines in an economy which is having
its own life and is impacting more and more people and governments, from a regional level
to an international level. Nowaday it is especially remarkable by the effects of the crisis
bloomed out from the U.S subprime loan system.
The Players4 in the financial markets are the financial institutions also known as banks,
pension funds, investment funds other financial companies. To the term of players should
also individual investors be added as it has became significantly easier to participate and to
get information in the market. The majority of the players are trying to maximize the eco-
nomical-wealth as well as offer investments to a risk which their clients can handle, mean-
ing in fact a bigger wealth of our richness in savings and pension funds. The impact to a
single person’s life is from an economical-wealth point of view, with a mild term, huge.
Nowaday, when it comes to the size of the pensions funds it is an actual topic for people
retirering as the difference in for instance: a person retirering this year in the UK that has a
pensions fund exclusively invested in the national index has seen a drop in the lifetime sav-
ings with 32 %5 in comparison with have been retired one year earlier. In Sweden, Spain
2 p. 1 Adams.
3 p. 6 Adams.
4 The term player is used as it refers to actually be taking a part of the market while a participant may be an observer without being “in’ the market.
5 http://uk.finance.yahoo.com/q?s=^FTSE [2008-10-14]
4
and Poland the drop has been 35 %6, 23 %7 and 46 %8 respectively. The people are getting
major in age9 and are facing tops and bottoms in their life long savings.
With the introduction to the Euro, the EU has started to debate the desirability and feasi-
bility of more co-operation in the field of capital income.10 With a more united economic
policy it could be more safe, by less risk, to invest capital and more alternatives could open
up for investments. However the market will look like, will the capital market be accompa-
nied by a tax system.
The present tax system is designed by a business income instead of a portfolio income per-
spective, at least in the US, and as the legislators haven’t thaught much about taxing portfo-
lio income.11 One of the fundamental questions appearing, is how the taxation should func-
tion in the financial market, and further if it is fulfilling its purpose?
1.2 Purpose
The paper will concentrate on the recent development within the European Union: be-
tween the MS and its relation to third countries with respect to portfolio holdings.
The matter is dealing with Neutrality for portfolio holdings which are on an international
level and appearing as a double taxation, by the later it is meant that an affection of at least
one jurisdiction’s tax rules will be existing. The view will be from the perspective of a resi-
dent country. The Neutrality will be presented by the used methods, from a theoretical ap-
proach in Guidelines and in practise by uni- and bilateral methods. The Neutrality will fur-
ther be analized in relation to the EC law.
This paper does not consider any issue on permanent establishment and it is not entering
in-depth any national tax system nor explaining the roles within the financial markets.
6 http://di.se/ [2008-10-14]
7 http://www.bolsamadrid.es/esp/bolsamadrid/publicacion/estadisticas/key_200710.pdf [2008-10-14]
8 http://www.gpw.pl/wykresy/wykres.asp?ticker=WIG20&BW=r [2008-10-14]
9 2007 World Development Indicators.
10 p. 1 in the conclusion of Cnossen (2000).
11 p. 229 Graetz (2004).
5
The essay is on an international area of tax law with a delimitation from inter-governmental
legislation of money laundry, bank regulations as well as to Civil law.
1.3 Method and Material
The paper is following the hierarchy of legal sources where the statutory legislation is fol-
lowed by preparatory acts, case law and finally doctrine. The method for the mentioned
material in use is also known as traditional legal methodology12.
1.4 Disposition
In chapter 2 is a statical approach taken where Guidelines are presented for a good tax sys-
tem with respect to portfolio income. The reader will obtain a theoretical understanding of
the complex issue.
In chapter 3 will the portfolio holding be defined from an international tax law perspective
and how the EC tax law is situated in relation to the portfolio holding.
The analizing part of how the modern EC tax law is dealing with the taxation of the port-
folio holding is made in chapter 4.
The final chapter 5 will give the author’s conclusion and a summary of the thesis.
2 Guidelines for a Good Tax System of Portfolio In-come
Taxes are present in our lifes and impacting us and our wealth. We cannot avoid the fact
according to the saying that taxes are as sure as death.13 As we cannot avoid them, the ques-
tion arises of what then the tax is for. The main function of a tax could be understood as
12 Swedish term; Rättsdogmatisk metod.
13 Benjamin Franklin, 1706-1790.
6
the need to finance the public administration.14 This financing is regulated, and the regula-
tion of the taxes can be considered to follow guidelines.
The guidelines intend to establish a good tax system for portfolio income.15 A good tax sys-
tem, has at least the following characteristics – Equity, Legal effectiveness and Economic
efficiency. 16
The first characteristic: Equity, is distinguished between vertical and horizontal equity. The
later addresses fair tax base and the earlier addresses a fair distribution of income after tax.
Within international taxation does specific aspects such as the inter-individual equity and
inter-national equity also excist. The inter-individual equity is understood to determine the
tax treatment in the country of residence.17 The inter-nation equity on the other hand, es-
tablishes the right for the source country to receive a fair share of the tax revenue.18
The second characteristic: Legal effectiveness, regards the validity of a norm by correct leg-
islation and an obey of the society.19
In this paper does an Economic efficiency refer to that taxation should not be influencing
an economic decision for a portfolio holder, planning to make an investment, it should be
indifferent both in the portfolio holders own country and a foreign country. By this it is
meant that the taxation should be as neutral as possible: a principle of Neutrality.20
2.1 Territorial Tax System and Worldwide Tax System
In theory, there excists two common basic types of a national tax system: a Territorial Tax
System and a Worldwide Tax System.21 A jurisdiction is positioned towards one of them
depending on its political goals of achievement with their tax.
14 IBFD International Tax Glossary; ‘Tax’.
15 p. 1 McIntyre.
16 p. 25 Juusela.
17 p. 12 Panayi.
18 p. 25 Juusela.
19 Ibid.
20 p. 25 Juusela.
21 p. 109 European Parlament.
7
The Territorial Tax System is based on taxation of income derived within the national ju-
risdiction, irrespective of the residence of the taxpayer.22 This system relies on the funda-
mental principle of source. It allocates the tax jurisdiction over income by letting the coun-
try tax income having source in its jurisdiction. This regardless of the residence of the tax-
payer. The tax system is also referred to as the principle of limited taxation.23
In the Worldwide Tax System, the worldwide income is taxed of individuals and entities,
regardless of where the income derives from.24 This system relies on the fundamental prin-
ciple of residence. Another popular name is the principle of unlimited taxation for this tax sys-
tem.25 It considers the resident taxpayer as a subject26 to tax on her27 worldwide income and
treating the non-residents as subjects to tax on domestic-source income.
The basic types of national tax systems are in practise different from theory as there is no
country having a pure system of any of the mentioned types and is either a mixture or
comes in hybrid forms.28 All tax systems have though features allowing them to be charac-
terised as either one of the types. Both the systems are set as a framework for making Neu-
trality and Equity.29 Sofar only equity has been described and below it is described how the
neutrality exists in the systems.
2.2 More Guidelines
It is assumed that the fundamental goal of international income tax policy is to advance
worldwide economic efficiency and that tax should be neutral.30As tax equity relates pri-
22 Ibid.
23 p. 2 Panayi.
24 Ibid.
25 p. 3 Panayi.
26 The definition of a tax subject is described in chapter 2.3.
27 By the lack of a neutral word for ‘his’ and ‘her’ should the reader understand in the following that both terms could be used.
28 p. 14, Staff of the Joint Committee on Taxation.
29 p. 4 Cnossen.
30 p. 6 Panayi.
8
marily to the relationship of taxpayers to each other, neutrality refers to the relationship be-
tween the taxpayer and the State.31
With respect to the operation of residence taxation in general, and the relief of double taxa-
tion in particular, it should be noted that the traditional debate is formed in terms of capi-
tal-export neutrality (CEN) and capital-import neutrality (CIN). They are established for
fulfilling the purpose that economic decision should be made without regard of the tax
consequences. In other words, the mentioned concept of economic efficiency.
A country’s net flow of capital is making a country to either a net capital importer or a net
capital exporter. Therefore, all countries in the world are either CIN or CEN, depending
on if the cash flow is exported or imported to a country. Both the CIN and CEN focuses
on world welfare by promoting free movement of capital.32
2.2.1 Capital Import Neutrality (CIN)33
CIN focuses on the impact of tax on imported capital to one country from another.
The objective of CIN is to ensure that the total tax imposed on investment returns in a
given country is the same irrespective of the residence of the portfolio holder34. CIN there-
fore advocates equalizing the tax imposed on all investors, from whichever country they
may be. By the lack of concentration on the portfolio holder, I suppose by the term resi-
dence which is widely used, it also means that an exclusion is made from nationality.
CIN is attained when the total tax imposed on foreign investments by the portfolio
holder’s country of residence and the capital-importing country equals the tax imposed on
domestic investments, in other words the tax the capital importing country imposes on its
residents' investments at home. For instance should, a tax burden of 30 % should rest on a
portfolio holder’s income, whether (s)he is resident or not.
31 p. 23 Rohatgi.
32 p. 23 Ibid.
33 para. 5 European parlament.
34 The term ‘investor’ should be understood to include speculator or other player in the financial markets.
9
On an international area could CIN be achieved if: all countries imposed an identical rate
of taxation on source principle and exempt35 residents from tax on their income produced
abroad.
2.2.2 Capital Export Neutrality (CEN)36
CEN is developed within the OECD and it concentrates on the tax subject.37 The portfolio
holder is subject to the same tax level on capital income, regardless of the country in which
income is earned. According to this method, will a resident have the same tax choice when
(s)he chooses an investment generating income from abroad or being domestic. The in-
come could be taxed with for instance 30 % on her total income from the investment.
The Neutrality via CEN could be achieved on an international level if all countries were us-
ing a taxation on their residents and taxing their worldwide income.
2.2.3 CIN v. CEN
As different interest exists, either CIN or CEN occurs in a jurisdiction. When it comes to
choosing an approach, should the jurisdiction in question, observe the effects of CIN and
CEN respectively.
Jurisdictions are, despite the lack of evidence, afraid of using CIN as it could diminish the
national tax base. For multinational companies would CIN be preferred as it establishes a
better international competition.
CEN on the other hand, seems to be more favoured by academics as distortion in the loca-
tion of investments are thought to be more costly than distortions in the allocation of sav-
ings.38
35 See 4.2.1.2.
36 para. 5 European Parlament.
37 Sheppard.
38 p. 12 Panayi.
10
It could however be possible for CIN and CEN to co-exist if the tax base and the marginal
effective tax rates on capital income would be identical around the world’s jurisdictions, but
this seems to be an utopy, or atleast in present, unreachable because of the different goals
with taxation.39
2.2.4 Critics
As long as it doesn’t excist a completely harmonised global tax system, a full neutrality un-
der both CIN and CEN are not achievable, and that is why a pure form of CIN or CEN
doesn’t exist.40 Using both CIN and CEN in one jurisdiction is also impossible as the re-
quired measures would conflict with each other because CEN favours worldwide taxation
while CIN encourages a territorial tax system.41 Not using neither one of the methods
would not fulfill the fundamental purpose of neutrality, which would ultimately lead to a
lack of a good tax system.
The pure forms of CIN and CEN are constituting a dilemma of how to approach neutrality
in international taxation. In practise are the pure forms of CIN and CEN however rarely
used. Countries follow a combination of CIN and CEN principles depending on their
overall economic policy, of which tax is one of the components.42
2.3 The Issue
The central issue in this paper is the issue due to Double taxation. One of the two forms of
the issue appear when jurisdictions are overlapping one another because of different na-
tional tax laws.43
The overlap arise as an economic activity connects jurisdictions. This means that one and
the same person44 becomes taxed more than once for the same income arisen from the
39 p. 227 Graetz (2004) and p.12 Panayi.
40 p. 227 Graetz (2004).
41 Ibid.
42 Ibid.
43 See for instance p. 1683 Avi-Yonah.
11
same period.45 The collision appears because of different definitions of the principles in the
domestic law.
An observant reader can distinguish three key components of a tax transaction which con-
nects the jurisdictions to find a tax liability:
Tax subject. The identity of the taxpayer, or a person’s relationship to the taxed object that
creates a tax liability:
Tax object. The identity of the subject matter, or the facts that cause the tax liability: and
Connecting factor. There must be a ‘reasonable connection’ between the taxing powers of the
State, and the taxpayer or the transaction. Without a connecting factor between either the
taxpayer or the business activity and the tax jurisdiction, a State cannot levy its tax.46
The collision can for instance occour when a non-resident brings a foreign-source income
to a country where (s)he is having a citizenship. The worst scenario would lead to a tax li-
ability in three different countries on condition that all the three principles would be in
use.47 The mentioned issue is labelled as juridical double taxation or international double taxation
due to its nature. 48
An efford has been made to address specificly the issue. The OECD defines international
double taxation as:
‘[T]he imposition of comparable taxes in two (or more) States on the same taxpayer in respect of the same
subject matter and for identical periods.’ 49
UN defines a double taxation as ‘the imposition of similar taxes in two or more States on the same
taxpayer in respect of the same base.’50
44 By person in this sentence it is referred to any subject on whom a tax burden can rest, including entities.
45 para. 169 European Parlament.
46 p. 16 Rohatgi.
47 The problem can also appear as one country can use more than one of the principles.
48 para. 169 European Parlament.
49 para. 1 OECD Model.
50 para. 2 UN Model.
12
The wording informs that a double taxation can appear also when more than two jurisdic-
tions claim their right to the tax: a ‘multi-taxation’ can occour, though it has the same char-
acteristics as a double taxation. The definitions are similar to each other but the UN defini-
tion is more general as it doesn’t mention anything about the period. However shouldn’t
any greater importance be given as both definitions are used for the same purpose in prac-
tise.
The juridical double taxation occours on an international level as the tax issue is involving
at least two jurisdictions. A national level can also appear when one and the same nation
uses more than one of the mentioned principles from the guidelines. For instance by re-
gional taxes that are taxing the same income levied from one region to another, where the
taxpayer is resident, despite being in the same nation. This issue is referred to as legal iden-
tity of subject.51
Another tax problem of importance is labelled as economical double taxation. It refers to a
double tax on the same income in the hands of different persons. It excists for instance in
situations such as between husband and wife, partnership and partners, company and
shareholder as well as parent and subsidiary.52 An economical double taxation occours
more often on national level but international cases can excist in situations such as, when
the company and the owner are residents in different States, or when one country taxes a
legal entity as such, whereas the other country disregards the entity for tax purposes and
taxes the income in the hands of the resident owner.53
It is possible to refer to the economic double taxation issue as to an economic identity of
subject.54
A country would gain from avoiding a double taxation as each country gets its share of tax
revenues, the bilateral and multilateral trade grows and the overall tax collection also in-
creases as a result of which both countries tend to benefit. It would however be unfair for
the taxpayer to have a double taxation as it would be an obstacle for investments abroad, as
51 p. 15 Rohatgi.
52 Ibid.
53 p. 86 Barenfeld.
54 p. 15 Rohatgi.
13
investors would keep the investment in the jurisdiction and moreover damage the relation
with a specific country. Therefore is any double taxation prohibited.
Despite it being by policy prohibited does the OECD also finding it ‘scarcely necessary to stress
the importance of removing the obstacles that double taxation presents to the development of economic rela-
tions between countries’.55 By working with these issues a hope is to reach a bit in what is
known as the principle of tax harmonization.56
3 Portfolio Holding and the EC law
As this study concentrates on portfolios, of importance is the definition of it. In present,
there is no universal definition of a portfolio, and the definition may vary in the different
jurisdictions. Due to its nature it is also difficult to give an effective definition.
In this paper the portfolio will therefore be defined as a flow of Dividends from holdings
by an investment in a limited number of shares, and other securities. Securities are the fi-
nancial instruments that are negotiable and has a recognised financial worth.
Shares are as well defined on a domestic law area, and might be simplified explained as an
ownership in a company, a stock. Shares are equal per value and bear equal rights and obli-
gations. They lead to the possibility to make a participation and a right to vote on decisions
during shareholder meetings. They do also entitle to profits which means to get Dividends
which is connected to the invested capital. Further, it is a proportionate share of the pro-
ceeds upon liquidation and subordination to creditors, which would be referred as the
mentioned obligation.57
To get ownership in a company an investment must be done with either own capital or by
loan, where the previous is known as equity capital while the later is labelled as debt capital.
The distinction between equity capital and debt capital is of important value to recognise as
equity capital is subject to tax and the later is not. In this paper will therefore only equity
55 para. 1 OECD Model.
56 p. 6 McIntyre; For more info about tax harmonization see for instance “European Community Law on the free movement of capital and EMU’ by Sidek Mohamed IBSN: 9041111530.
57 IBFD International Tax Glossary; ‘Equity capital’.
14
capital be of consideration as it is a tax object. To note is as well that difficulties to qualifi-
cate capital do however appear be the complexity of rules of qualification of capital.58
Most frequent in portfolio holding is the investment in shares and therefore the focus will
be on them. Shares can come in two forms: ordinary shares that are equity capital and pre-
ferred shares, where the alter are in the category of hybrid financial instruments59.
Some jurisdictions have made an approach to distinguish between direct investments and pas-
sive investments for finding a definition on the category of the capital. A portfolio investment,
which is the opposite of a direct investment, does not own a controlling interest in a for-
eign entity. The ECJ defines a portfolio investment as owning less than 10 % of all the
votes in a company.60 Further, ECJ has developed its definition about a portfolio by the
Golden Share case61, where it finds a portfolio investment to ‘mak[e] a financial investment
without any intention to influence the management and control of the undertaking62‘. The ECJ has not
clearly specified if a small stake held as a portfolio investment enables the shareholder to
effectively participate in the management but it has referred to the domestic courts to rule
on this issue.63 A critical reader should not be misslead by the ECJ’s definition of a portfo-
lio as the court may only rule in the given case, and the definition should not be considered
to be absolute. The definition is of value as different tax rules are implemented depending
on the nature of the investment and therefore needs to be distinguished. A refinition
should also be defined between trading income and portfolio income, as the earlier is a
form of a business income and subject for all its financial activity, in other words on a
mark-to-market-basis.64
To further understand the complexity of a portfolio, the reader should understand two of
the characteristics of a portfolio, starting with the mobility. It can be seen that the goal of a
portfolio is to make a financial investment, and develope a wealth. A portfolio holder can
sell its shares when being unhappy with the company’s business decision.65 By selling the
58 p. 105 Mintz (2004).
59 International Tax Glossary; ‘Hybrid financial instrument’.
60 C- 446/04 – FII Group; and p. 1581 Graetz (2007).
61 C- 282 and 283/04 – Commission v. Netherlands.
62 European Law term for entity.
63 C- 101/05 – ‘A’ case.
64 p. 106 Mintz.
65 p. 539 Graetz (2003).
15
holding does the movement lead to volatility66 in the market which is influenced by the
portfolio holder’s accepted level of risk.67 In economic science is risk divided into positive
and negative risk, where the positive risk leads to unexpected profits and negative to unex-
pected loss. Both are co-existing with each other. The risk is upcoming because of a lack of
information or misunderstood information. Mobility in cross border situations involves
different jurisdictions and their tax rules, which gives good opportunities for tax planning.
According to an economic study, has the mexican financial crisis had a connection between
a country’s financial and currency vulnerability and the composition of its capital inflows.68
This fact shows the importance portfolios make in the economy.
The second characteristic for a portfolio is the liquidity. The term is from the economic sci-
ence, however does it affect the rules of taxation as they are concentrating on the amount
the portfolio is holding onto. The liquidity is referring to the amount of capital the portfo-
lio is having for investing, and that amount is not stabile due to the consequences of in-
vestment. Because of this characteristic it is more complex to grab the solid definition of
the capital within the portfolio.
3.1 Portfolio Income
In tax policy is the fundamental concept of income necessary to be defined as it is on the
income that a tax is based. From an economical aspect, and the adopted definition for
IBFD, can income be defined as the algebraic sum of ‘(1) the market value of rights exercised in
consumption and (2) the change in the value of the store of property rights between the beginning and end of
the period in question’.69
Another approach to define an income is as an in rem-tax, which means that a tax is attrib-
uted to specific items which could be included in the tax base, such as for instance ordinary
shares.
66 Economic term for a change of value of a financial instrument within a specific time horizon.
67 p. 549 and 552 Graetz (2003).
68 p. 553 Graetz (2003).
69 National tax systems are in practice a bit modified from this formula. ‘The Federal Income Tax’ H. Simons 1921.
16
As the portfolio investment is in this paper a holding of shares, they tend to generate tax-
able income. This income is labelled as Dividends.
Dividends. The OECD Model70 defines Dividends in art. 10 as ‘[...]the residual definition includes
income from other corporate rights than in general tax law, such as income from shares in the country of dis-
tribution’. The income is therefore coming from shares, jouissance shares or jouissance
rights, mining shares or founder’s shares. Also other rights, not being debt claims, partici-
pating in profits are included. Further on are other corporate rights that are subject to the
same tax treatment, such as income from shares under the laws of the State of residence of
the company making the distribution included. By the wording of the definition ‘other corpo-
rate rights’ the distinctive elements to classify a payment on hybrid financial instruments
seems to be targeted. Further, derivative financial instruments and financial instruments
who are not characterised as debt capital seems to be captured.
Dividends in the OECD and UN Model, could also be understood by using three parts ac-
cording to Helminen.71 The first two parts of the term are autonomous, meaning that they
have to be interpreted by the art 3(2) of the relevant Model. The article is referring to the
law of the State which is applying the treaty if the context does not otherwise require. The
third part of the definition refers to the definition of the law of the source country. This
would mean that a domestic definition of Dividends not necessary would be the same in
the source country as in the home country, which would constitute a loophole to try to
classificate the income to Dividends, if it was preferable by the portfolio holder. The US
Model treats Dividends differently. It treats Dividends broadly and flexibly, with intention
to cover all arrangements that yield a return on an equity investment in a corporation as de-
termined under the tax law of the State of source, as well as arrangements that might be
developed in the future. It includes income from shares and other income not treated as
debt under the law of the source State.72
70 Explained in 4.3.1.1.
71 p. 49 Helminen (2007).
72 art. 10 U.S Model; p. 420 Christians.
17
3.2 Portfolio Taxes
As shares are defined as income from Dividends, it makes it to a tax object. When an in-
vestment is done in a foreign company, in a source country, by a resident of another juris-
diction, the income can consequently be object to a withholding tax. This constitutes an is-
sue in a cross-border situation.
Withholding tax. The tax is made by a withheld amount from the source country where it is
deducted from income. The tax may be provisional or final. If it is provisional it will be
credited against the taxpayer’s final tax liability. If it is final, no subsequent adjustments will
be made. The rates of withholding tax are frequently reduced by double tax treaties.73 Some
jurisdictions distinguish between withholding tax on resident and on non-resident. As an
example of a withholding tax on Dividends for a foreign portfolio holding in an investment
fund situation could be when an investment fund declares a Dividend of 100 % of their
share on its 50 000 shares of stock, giving a total of € 5 000 000 which is reportable as in-
come by the shareholders. Of this amount could for instance 80 % be paid out to the
shareholders while the rest-over of 20 % to be taken as tax. It would give the amount of €
4 000 000 to the shareholders and € 1 000 000 to be withheld for taxes. The aim in a cross-
border situation of Withholding tax is to avoid double non-taxation, or tax avoidance.74
The problem with the tax occurs when a portfolio holder that is obliged to file a tax return
within a specific period has to do this in both the country of residence and the country of
source whom require a tax return and no information exchange or, if misunderstanding oc-
curs, the portfolio holder would be taxed in both countries for the same income. Another
problem would occur if the shareholder level taxation does not exist in the country of resi-
dence of the shareholder. (S)he would be treated in another way than other residents it its
jurisdiction.
The tax can also be considered as a corporate tax which affects the shareholder. It consti-
tutes an economic double taxation as the corporate tax income is taxed at both the corpo-
rate level and can be taxed in the hands of the shareholder if not a relief would be estab-
lished.
73 IBFD International Tax Glossary; ‘withholding tax’. Read chapter 4.3 to understand double tax treaties.
74 By double non-taxation it is meant that no country is taxing the income. Tax avoidance refers to a behav-iour aimed at reducing tax liability which falls short of tax evasion. The behaviour refers often to illegal measures, while double non-taxation is a consequence of a lack of rules, not a cause of the investor.
18
Another tax that appears with respect to shares is the Capital Gains tax (CGT).
CGT. The tax occurs in the wording of art. 13(2) in OECD Model and is defined as: ‘[g]ains
from the alienation of movable property forming part of the business property of a permanent establishment
which an enterprise of a Contracting State has in the other Contracting State, including such gains from the
alienation of such a permanent establishment, may be taxed in that other State.’75
The wording of CGT in the US Model76 is slightly different, but is not of value for this pa-
per.
The OECD seems to be using the term ‘alienation’ for a wider scope than just ‘sale’.77 An ex-
change is included in the term alienation.
The function of the tax is however that CGT is levied only when the asset is resulting in a
gain when realised on alienation of the asset and not on accrual basis. This means that the
tax is not exclusive for shares and further it can also occur on the taxation of trading in-
come78. The definition of gain depends on the entitled Contracting State’s domestic defini-
tion of gain in its tax law. By recognising Capital Gains and capital losses it follows the
principle of realization.79 The tax follows this principle because of two reasons. First, it
would otherwise violate the principle of ability-to-pay. Secondly, some assets, such as
shares from not stock-listed companies are difficult to value as no market price exists.
The tax rate of CGT may be different depending on who is the taxpayer as well as special
rules may be implied on the period of the holding. Jurisdictions may define a long-term
capital holding and when it is disposed for CGT it may be more favourably taxed by a re-
duced rate in comparison to short-term Capital Gains which may be taxed as ordinary in-
come.
For example does the USA, tax its individuals who are disposal to long-term CGT at a
lower tax rate of 20 %. France reduces the rate to 15 % for company tax payers. In Italy it
is possible for a corporate taxpayer who have held a holding for a minimum period of three
75 The wording of the US Model is in general the same and the difference is without any value in this study; p._249 Avery Jones.
76 art. 13 US model.
77 p. 249 Avery Jones et al.
78 Business tax for financial intermediation dealing with derivatives, financial instruments and hybrid financial instruments.
79 p. 83 Barenfeld.
19
years, to spread the gain over a period of five years. In Denmark it exists a possibility to ex-
empt the gain on shares when the holding period is over three years.80
To give an example, under the terms of a double taxation treaty, can the country where the
tax is levied deduct its share of the tax first. The country of residence could then levy its tax
and person A would be required to pay the balance due. For instance, if a share is sold with
a net Capital Gain of € 100 000 in a country where CGT is levied at 20 % for all tax payers,
the liability for CGT in this country would be € 20 000. As person A is resident in the UK,
(s)he may also be liable for British CGT at 40 %, € 40 000. However, as (s)he has already
paid CGT in the source-country, (s)he may only be liable for € 20 00081 in the UK. Person
A may also be able to deduct CGT allowances.82
A holding does not always result in a gain, in fact it is said that investors do face losses. In
the taxation of Capital Gain, it may exist special rules leaving a possibility to carry-over
capital losses to make the tax more fair. Is so can the tax be offset against present and fu-
ture Capital Gains. The function of the rules on capital losses depends on the jurisdiction
but it can give the possibility of ‘saving’ the loss for future gains and some jurisdiction al-
low a reduction from past gains. An example would be that person A made a € 100 000
gain in the fiscal year 2006 but may reduce this with € 50 000 because of losses in the fiscal
year of 2007. A total amount of € 50 000 would then be taxable with a tax rate of for in-
stance 20 %.
The explained CGT is in practise used in different forms, for instance are the Common
Law systems separating capital from income, while other systems such as the Continental
Law systems sees the capital as a part of an income.83 A hybrid system in the EU is the
‘Dual income tax system’84 which separates the gains which are instead added to income
from capital and are subject to capital income tax. The OECD is aware of how the tax oc-
curs and has offered jurisdictions the choise to have the OECD’s approach to distinguish
between CGT and capital. The tax is by OECD Model discerned from capital: Art.13 and
22 OECD Model. Art. 22 OECD Model applies to taxes on capital from the possession or
80 pp. 254-255 Rohatgi (2005).
81 €40,000 - €20,000.
82 Built on the example given from http://www.obeliskfinance.eu/news22/Double_Taxation_Explained.
83 p. 220 Avery Jones et al.
84 Exists between Denmark, Finland, Iceland, Norway and Sweden.
20
ownership of capital, and not the income or the gains from capital.85 The US Model ex-
cludes capital since there are no federal capital taxes in the US.86
3.3 No Capital Gain Tax
A country not using a capital income tax do so of a number of reasons. First, a host coun-
try that excempts capital income may find that it is difficult to impose taxes on income ac-
cruing to non-residents when neighbouring countries continue to asses an income tax. For
instance, would foreigners from neighbouring countries prefer to earn capital income in the
host country rather than other forms of compensation to avoid paying taxes to both the
host and home countries, in other words the country of source and the country of resi-
dence.
Second, some capital exporting countries could allow their taxpayers to claim a credit for
withholding taxes paid to foreign governments against the taxes in the state of residence.87
Many jurisdictions have chosen not to have any Capital Gain tax, and where it exists, is a
tax subject often levied with a lower effective rate than the income tax on Dividends. As a
result of this bias in favour of retentions, equity funds may be ‘trapped’ within particular
companies rather than allocated between companies in the most efficient manner by finan-
cial markets, according to the investment opportunities that the company face.
Taxation on Dividends doesn’t frequently appear as Dividends, received by financial insti-
tutions from other companies, already have been subject to tax when a company distributes
income from after-tax profits. An additional tax on Dividend income of financial institu-
tions would result in a double taxation of income.88
85 p. 174 Rohatgi.
86 Ibid.
87 p. 14 Mintz (1992).
88 p. 103 Mintz.
21
3.4 A Jurisdiction’s Right to Tax Portfolio Income Under In-ternational Law
There is no established international law which can interfere in a nations sovereign right to
tax income which accrues, arises or is being received on its territory. The tax subject has
not signed any physically existing agreement between her and the country, instead the
agreement exists by conclusive action89 which means that by living or making business in a
jurisdiction, the person has accepted to be taxed by that jurisdiction.
As a consequence of the right, is a ground laid for a double taxation as countries have the
possibility to tax income on the basis of the established principles of residence and source.
Due to the consequences, jurisdictions are observing the present principles and are trying
to solve the matter by negotiated agreements90.
3.5 The EU and International Capital
International tax law is claimed not to be an autonomous area of law, as nations try to ne-
gotiate and harmonize their taxation with respect to each others tax systems and laws. As
tax law is a sovereign right it therefore also is a national law, but since many european
countries have entered the EU some of the sovereign rights have been given to the supra-
national jurisdiction.91 Although direct taxation92 falls within the competence of each
Member State, Member States must none the less exercise that competence consistently
with EC law.93
In this paper is the term EC law used instead of EU Law as the author considers the EU to
be built on three pillars where the first pillar is the oldest pillar by the established ECT. The
ECT has been updated to the present Treaty of Nice, but however will it be referred to the
ECT as the Treaty of Nice has not changed the established case law and use of the rules
which will be discussed below.
89 Swedish term; ’Konkludent handling’.
90 Double tax agreements, will be discussed in 4.3.1.
91 Direct effect is given to the EU law which overruns the national laws.
92 A tax which is directly paid to the government, contrary to an indirect tax such as VAT.
93 C- 422/01 – Skandia v. Ola Ramsted, para. 25.
22
3.5.1 Free Movement of Capital
The EU has by the ECT established four fundamental freedoms which makes the heart of
an internal market94. The internal market makes the MS come closer and erases the physical
borders. This is done by integrating and opening up for competition within European fi-
nancial markets and services. One of the four freedoms is the free movement of capital which is
presented by art. 56-60 ECT. The freedom had a full liberalisation in 1988 by the Directive
88/361/EEC, where the effect came into force in 1990. The liberalisation of capital
movements has accompanied the development of EMU. In present has the Lissabon
Treaty, which is under debate of integration, presented the freedom under its art. 63-66
ECT. Art. 56 ECT has the wording:
‘(1). Within the framework of the provisions set out in this Chapter, all restrictions on the movement of
capital between Member States and between Member States and third countries shall be prohibited.
(2). Within the framework of the provisions set out in this Chapter, all restrictions on payments between
Member States and between Member States and third countries shall be prohibited.’
The article has in its formulation included third-countries, meaning countries whom are not
members of the EU. The analyzing reader would find the question how is it possible to or-
der another nation to have the fundamental freedom of the EU without entering such an
agreement?
The answer is art. 57, 59 and 60 ECT, whom present specific restrictions, safeguard meas-
ures and sanctions in respect of third countries. To further make the fundamental rights
possible to work in practise, bilateral and multilateral agreements between EU and the
third-countries are negotiated on continual basis. 95
A recent case96 has shown how the EC law interprets the freedom with respect to third
countries. The legal background informs of a Swedish individual A, who owned shares in a
parent company X, a resident of Switzerland. X considered distributing a Dividend to A in
the form of shares in its subsidiaries. Under Swedish rules, income tax is levied on such a
94 Some documents from the EU is using the wording ‘single market’, instead of internal market, as in the ECT. They should however be considered of being synonymous with each other.
95 Term for describing an agreement between two parties, in this case, two jurisdictions. The term multilateral, would signify an agreement between more than two parties.
96 C- 101/05 – ‘A’ case.
23
distribution if parent company, among other conditions, is not established in a State within
the EEA or in a State with which Sweden has concluded a taxation convention that con-
tains a provision on exchange of information. The ECJ has clarified the art. 56(1) ECT of
being clear and unconditional, which gives a direct effect for the claimer, and with no im-
plementation requirement, leading to a relevant rule in the domestic law. The court has
ruled the Swedish tax authorities to not be able to use the Directive 77/799/EEC with a
third country, but referred to the exchange of information clause in the bilateral tax agree-
ment between the countries and to interpret it on a domestic level as the ECJ is not com-
petent to interpret it itself. The outcome of this case shows both the relevance of the free
movement of capital, with limitation to Directives, but also that the ECJ is using Model
conventions and that its clause of exchange of information could supplement the lack of
EC Directives. More of this will hence be discussed in chapter 4.
3.5.1.1 Free Movement of Capital and Portfolio Investments
As art. 56 ECT is applicable for the free movement of capital the question arises whether
portfolio investments by a resident of one MS in shares in a corporation, with a permanent
establishment in another MS, and the returns on these investments can be qualified as
movement of capital.
One of the earliest cases related to a pure ruling in the area of direct taxation and with re-
spect to the free movement of capital is the case of Verkooijen97. Mr. Verkooijen who was
a resident of the Netherlands, was refused exemption from income tax for share Dividends
from a foreign resident company: established in Belgium. According to Dutch law, 1000
NLG per individual was exempt, if the source country for the Dividends was the Nether-
lands.
As the ECT was not during the process in force, the Directive 88/361/EEC et al was used,
to implement the establishing of the free movement of capital by art 67 EC. As the court
didn’t find any guidance of a definition of capital in the ECT, it sought for guidance in the
Annex I of the Directive.98
97 C- 35/98 – Verkooijen.
98 Ibid, para. 20-21.
24
The ECJ founded that the Dividends and the returns was governed by the Directive and
receipted as ‘presupposes participation in new or existing undertakings’.99
The court had to be clearer with the definition as the company paying the Dividends was
resident in another MS. A clearer definition of the Dividends came by linking them to the
‘acquisition ... of foreign securities dealt in on a stock exchange’ and was thus ‘indissociable from a capital
movement.’100 The outcome showed a connection between: Dividends and returns and the
free movement of capital101, as well as its position within the area of direct taxation as ‘al-
though direct taxation falls within [...] competence, the MS’s must none the less exercise that competence
consistently with community law’.102
3.5.1.2 Free Movement of Capital in Relation to other Fundamental Freedoms
As the free movement of capital is a part of the internal market it is co-existing with other
fundamental freedoms, but how would the legal value be of the free movement of capital
in a conflict with another free movement?
In the year 2006 did the ECJ give a controversial judgement in relation to the question:
The company Fidium Finanz103, resident in Switzerland, wished to offer credit via their
website to residents in Germany. According to German law did a prohibition lay on grant-
ing credits as the company was not having a permanent establishment in the territory of
Germany. Fidium Finanz turned to the ECJ as it considered the situation to be in breach of
art. 56 ECT. The court found both the free movement of capital and the free movement of
services to be applicable in the case. Due to the applicable articles, only the article 56 estab-
lishing the free movement of capital was considered to extend the fundamental freedom to
jurisdictions not being MS. The court decided that the case must be treated with accor-
dance to the rules of free movement of services as the movement of capital should be con-
99 para. 27-30.
100 Ibid.
101 para. 30.
102 C- 279/93 – Schumacker, para. 21.
103 C- 452/04 – Fidium Finanz, para 16.
25
sidered as ‘an inevitable consequence of the restriction imposed on the provision of services’.104 The deci-
sion shows that in conflict with other freedoms then the free movement of capital has to
surrender. Fidium Finanz did not win the case as it was not entitled to have any ECT
rights.
The case has got huge critics as the court did not judge in the given question if the prohibi-
tion was fair due to art. 56 ECT, instead it answered which treaty was most affected, and by
only focusing on that freedom, exluding the other which also seems strange as only the free
movement of capital appears in the ECT between MS and non-MS. Finally has the critics
been pointed of the lack, from the ECJ, of considerating art. 57(1) ECT:
‘The provisions of Article 56 [the free movement of capital] shall be without prejudice to the application to
third countries of any restrictions which exist on 31st of December 93 under national or Community law
adopted in respect of the movement of capital to or from non-member countries involving direct investment--
including in real estate--establishment, the provision of financial services or the admission of securities to
capital markets’.
4 Taxation of International Portfolio Holding
4.1 Portfolio Holders105
Different forms of a portfolio holding exist as different tax rules106 and consequently dif-
ferent tax treatment occurs, depending on who is the tax subject and which jurisdictions
are involved. The reader should not be ignorant of this as it is highly relevant for financial
decision-making and market behaviour how the personal income and corporate income tax
systems are regulated.107
104 Ibid, para. 48-49.
105 The word investor is also used in this paper which is synonymous to portfolio holder.
106 For instance personal income vs. corporate income.
107 p. 103 Mintz.
26
4.1.1 Individual
The holder of a portfolio is a natural person who has legal capacity. A natural person can
be subject to among other taxes: personal capital tax, specificaly to a shareholder level taxa-
tion, instead of a corporate taxation.
A portfolio is established when person A, who owns less than 10 % shares directly in com-
pany Y. The requirement for the holder is that (s)he must be a natural person who is a tax-
payer and subject of personal income tax.
An alternative would be if person A owns shares in an investment fund, which then pur-
chases shares in company Y. In general, it is common that investment funds are established
as partnerships.108 In many jurisdictions is a partnership considered to be a transparent entity,
which is not subject to strict rules and are therefore more flexible than other companies.109
The profit from such a company is often taxed among the partners, and the partners them-
selves can be liable for the tax based on their property and family circumstances.110
A person who chooses to have the holding via an invetstment fund, would be considered
as a holder as (s)he invests and owns assets which are in the portfolio. The positive apect
of having a holding via an investment fund can be a possibility to reduce taxation of Divi-
dends, conversion of income from a progressive to nominal tax, Dividend averaging, ad-
vanced banking facilities such as bank secrecy, and reducing Capital Gains tax among oth-
ers.111
4.1.2 Entity
The tax subject for a portfolio income could also be a company. Company X could own
the limited number of 10 % shares in company Y. As company X is a taxpayer, it is subject
to corporate income tax.
108 p. 218 Schaffner.
109 About partnerships, see for instance more about Schaffner or Barenfeld.
110 p. 218 Schaffner.
111 p. 257 Romano.
27
To observe is that in the given examples, is company Y considered to be a tax subject in a
jurisdiction, but it doesn’t thereby mean it also is a legal entity. A jurisdiction could for in-
stance treat a partnership to be liable to tax despite not having the definition as a legal en-
tity.
4.2 Internal Approach
As the issue of double taxation occurs, it is possible for a country to give a relief for juridi-
cal double taxation by avoiding, or atleast reducing, the tax by making a more fair taxation
of the income of the portfolio holder. This internal approach is made by a jurisdiction’s
chosen unilateral methods which are considered to be a part of anti-avoidance rules. Those
rules exist as countries hope to reduce double taxation. On the flipside of the coin, coun-
tries do also hope to eliminate double non-taxation which is seen as unfair to other inves-
tors as a tax which should be paid but is not, violates the concept of neutrality.
The rules leads tax authorities to keep an eye on the domestic and world-wite tax revenues.
If they would not be aware of it, tax avoidance would accur. To prevent this phenomenon,
jurisdictions have implemented laws regulating anti-tax-avoidance. For instance laws on
CFC112, Transfer Pricing and Thin capitalisation. In this paper do the mentioned rules fall
out of the scope, but another possibility to regulate this phenomenon is by double tax trea-
ties.113
4.2.1 The Unilateral Methods
Unilateral methods are set up to give a relief from the effects of juridical double taxation
on the basis of domestic legislation for its residents. It is a unilateral method as a conse-
quence of not having any treaty on double taxation with another country that is claiming a
right to tax. The methods are correlated to the mentioned concepts of neutrality.114
112 Shortening for Controlled Foreign Corporation.
113 p. 5 Rohatgi (2005).
114 Sheppard.
28
Most of the Capital exporting countries have passed the unilateral methods of anti-
avoidance rules and the two first methods, which are presented below, are used by most of
the OECD countries, as they theoretically could solve the issue of double taxation.115
4.2.1.1 Foreign Tax Credit Method
Foreign-source income earned by residents can be taxed by the home country116 with a
credit given for withholding and corporate income taxes levied by the host country.117 The
amount of the foreign tax credit can be subject to one or more limitations, referred to as a
foreign tax credit limitation.118 The method takes one out of two forms, labelled as full credit
and ordinary credit.
With the previous form, the home country allows a deduction from its domestic tax of the
amount equal to the tax paid in the other State and later taxing the amount that the foreign
tax do not tax. The later form, gives a maximum deduction which is restricted to the ap-
propriate proportion of its own tax.119 The ordinary credit method is intended to apply also
for a State which follows the Exemption method but to give a credit some modification
can be relevant.120
An example of the forms are set in the table 1.1
Ordinary Credit Full Credit Foreign taxable income 100 € 100 € - Foreign tax of 30 % -30 € -30 € - Domestic 35 % world-wide tax
-5 € [35-30] 0 €
= Total tax burden 35 € 30 € = After tax result 65 € 70 €
Table 1.1
115 p. 8 Mintz (1992).
116 Country of Residence.
117 p. 8 Mintz (1992).
118 para. 73 OECD Commentary.
119 para. 57 OECD Commentary and p. 178 Molenaar.
120 para. 58 OECD Commentary.
29
For the countries using the credit method, the full tax credit method gives the taxpayer the
best result as (s)he will keep more money. It also seems to be having a close connection to
the mentioned concept of CEN as the total tax burden after the full tax credit is equal to
the tax that would be due if the income were earned in the home country only.121
Policymakers use this method to encourage cross-boarder trading.122 Further, can countries
using the credit method, choose to not refund taxes if their taxpayers pay foreign taxes at a
rate higher than the domestic rate.123 US is for instance a country using the credit
method.124
According to Rohatgi125 are the advantages with the credit method such as:
• It is capital export neutral, i.e. it treats all taxpayers in the residence State on the
same tax basis:
• It allows the deduction of foreign losses of permanent establishment in the home
country:
• It discourages the transfer of assets or income to low-tax countries or tax havens:
and
• It is easy to apply since the tax authority giving the tax credit, computes the amount
under its own laws and does not have to consider the foreing tax system.
Rohatgi has also provided disadvantages such as:
• The taxpayer always pays the greater of foreign and domestic taxes:
• It could lead to excess foreign tax credits that may not be useful:
• It eliminates the tax relief and incentives given in the source State, unless the resi-
dence State spares the tax. In other words doesn’t it eliminate by itself double taxa-
tion:
• It makes the export of capital less attractive: and
• It is complicated and can be time-consuming.
121 p. 178 Molenaar.
122 p. 228 Graetz (2004).
123_http://goliath.ecnext.com/coms2/gi_0199-2147645/Relief-from-international-double-taxation.html (2008-11-12).
124 art. 23 US Model.
125 p. 71 Rohatgi (2005).
30
4.2.1.2 Exemption Method
The second approach to relief double taxation is the Exemption method which could be
seen to fulfill the concept of CIN as it is up to the capital importing country to decide the
tax burden.
The exemption can take form in two ways, either as exemption with progression or full exemp-
tion.126 The previous lets the home country take into account the excempted foreign source-
income when calculating the amount of tax on the remaining domestic income. Therefore
the domestic income is taxed at the rate of worldwide income. The effect of exemption
with progression can be a reduction of losses if the income is negative which otherwise
would be available as carry-forward. The later, concentrates on its own domestic source in-
come and omits the foreign income from its taxation.127
Table 1.2 illustrates the effect of the forms of the method:
Exemption with_progression
Full exemption
Foreign taxable income 100 € 100 €
- Foreign tax 30 % -30 € -30 €
Domestic income 100 € 50 €
- Domestic tax with 35 % if total income >101 €
-35 € 0 €
- Domestic tax with 25 % if total income <100 €
0 € -25 €
= Total tax burden 65 € [30+35] 55 € [30+25]
= Total after tax 135 € [100+100-65] 145 € [100+100-55]
Table_1.2
Table 1.2 could be understood that a resident taxpayer who has received a foreign-source
income, could be taxed on a more favourable way if the investment is done in a low-tax ju-
risdiction and the home country is using a full exemption. As inequity appears in the situa-
tion, have countries made restrictions which prevents taxpayers from (1) improperly treat-
ing income earned in tax-haven countries as derived from exempt countries and (2) artifi-
126 For instance OECD Model 23A.
127 p. 175 Molenaar.
31
cially shifting deductions from exempt countries to income earned in a tax-haven coun-
try.128
The full exemption is usually the most advantageous for eliminating double taxation, in
comparison with the exemption with progression. This as it reduces the taxation of the
resident by being exempted on the highest tax rate in the marginal taxation. The exemption
with progression would be more limited as only the average tax rate on the domestic in-
come would be affected.129
The exemption with progression method is moreover favoured by especially MS as re-
ceived Dividends would be exempt from tax and taken into account when computing the
tax on the other income.130
Although the OECD Model and the U.N. Model sanction the Exemption method, the
method would not conform the objectives of fairness and economic efficiency if foreign
taxes are lower than domestic taxes.131
According to Graetz, Molenaar, Rohatgi and Terra, are the advantages of the method the
following:132
• It is capital import neutral, meaning it treats all taxpayers in the source State on the
same tax basis:
• A foreign loss could by the exemption with progression be offset against other do-
mestic income which would reduce the taxation:133
• It recognises fully the tax benefits granted by the source State: and
• It is the least complex administratively, and consequently can be accompanied with
other anti-avoidance rules:134
• It avoids dealing with two tax authorities:
• It eliminates actual and potential double taxation:
128 http://www.aicpa.org/pubs/taxadv/online/oct2002/clinic5.htm (2008-11-06).
129 p. 177 Molenaar.
130 para. 52 OECD Commentary.
131 art. 23A in both the UN and OECD Models.
132 p. 71 Rohatgi (2005).
133 p. 177 Molenaar.
134 p. 121 Terra.
32
• No cost for bringing money back to the home country: and 135
• It encourages resident taxpayers to invest abroad in countries with lower tax
rates.136
Further, does Rohatgi provide that the disadvantages of the method as137:
• It reduces the tax revenues due to the State of residence:
• The source State may deny certain allowance or deductions:
• The losses of the permanenet establishment may be disallowed by the residence
State:
• It requires detailed financial statements if exemption is given with progression: and
• It encourages the use of low-tax countries or tax havens as source or residence
States.
4.2.1.3 Deduction Method
The deduction method is known to be the least effective method of providing relief of
double taxation.138 The table 1.3 illustrates the function of the method.
Deduction
Foreign taxable income 100 €
- Foreign tax 30 % - 30 €
Domestic worldwide tax 35 % - 24,50 €
[0,35 x (100€-30€)]
Total tax burden 54,50 €
[24,50 € + 30 €]
After tax result 45,50 €
Table 1.3
135 p. 2 Graetz (2004).
136 See 2.2.1 as it describes the guideline CIN.
137 p. 71 Rohatgi (2005).
138 http://www.aicpa.org/pubs/taxadv/online/oct2002/clinic5.htm (2008-11-06).
33
As a result, choosing a foreign tax deduction still leaves a tax burden substantially higher
than the € 35 in tax that would be paid if A would have earned the entire € 100 (35 % x 100
€) in the home country. An obvious favour of domestic investment occours and the
method is not in harmony with the principle of neutrality. 139
4.2.1.4 Conclusion
Depending on what goal a country has, it can manipulate which actions an investor would
consider, for instance could reliefs be given for investments in stocks from the UK. Inves-
tors would thereby invest in the UK and give a better political relationship with the country
as it maintains a financing for UK companies. It would also redirect investments from one
country to the UK for instance. A jurisdiction such as the US could also for instance decide
that it needs commodities from Canada, the taxation when buying those would be more
beneficial with a relief. On the other hand could also an approach be done for letting capi-
tal stay within the country and develop its own well-being.
As for the given methods, it seems that for the tax planning for portfolio holders, the full
Exemption method has the most kind taxation, at least according to the examples given in
the cases above. The Exemption method seems also to be able to be used beneficiary in
cases of foreign losses as the foreign tax base could be used in the determination of the
domestic taxation and simply by affecting the progressive taxation, if it exist in the country
of resistence. The taxation could thereby give a softer taxation on the scale of progressivity
for the tax subject.
From the Credit method it could be argued that the second best option for an investor
would be the full credit approach as from the given example, it would be more beneficiary.
However this must be considered to apply with comparison to the situation which domes-
tic investors are in. When the tax rate is lower in a foreign jurisdiction compared with the
domestic rate, would the investor face an equal position with the other resident investors.
But if the foreign tax rate would be higher than the domestic, would the investor be equal
in the state of source, but unfairly taxed compared with domestic investors. This method is
thereby sensitive to tax rates and how they are applied to the tax base.
139 p. 17 Terra.
34
The less favoured method for an investor would be the Deduction method which leaves
the investor with a greater tax burden compared with domestic investors. Thereby is the
concept of equity weak and classificates the method to a ‘less good tax system’.
From a theoretical point of view could it further be understood that if a pure territorial tax
system would be existing on an international level, wouldn’t the methods be needed as no
jurisdictions would be minding about foreign income. The worldwide tax system however,
would need to exempt for reaching the best relief from double taxation. The same conclu-
sion has also Graetz came to.140
4.3 International Approach
Worldwide it is common that jurisdictions are using a relief for double taxation in their
domestic law: by unilateral methods. The unilateral metods are however bound to a certain
level of risk. The unilateral methods are not always successful with the objective as a coun-
try is not aware of what action is taken by the other State which the income is having a re-
lation to. The State would be in the risk of surrendering national revenue without obtaining
any guarantee that the income will be taxed anywhere. By this risk could the tax subject be
avoiding taxation and thereby getting a favourable situation by a double non-taxation.141 To
eliminate this risk, do jurisdictions have to enter into agreements on international level
regulating tax issues on a bilateral or multilateral basis. If an agreement exists between ju-
risdictions, it is preferred to use the agreement instead of a unilateral relief.142 These agree-
ments are labelled as Double tax treaties and are as mentioned before also included in anti
avoidance rules.
4.3.1 Double Tax Treaties (DTT)
An issue within international tax law, and of relevance for portfolio holdings, is the agree-
ments established by DTTs. A treaty is an international agreement concluded between ju-
140 p. 13 Graetz (2001).
141 p. 17 Terra.
142 Ibid.
35
risdictions in written form and governed by international law, whether embodied in a single
instrument or more.143 The Vienna Convention on the Law of Treaties, enforced on 27th of
January 1980, carries out the obligation of ensuring that treaties, including tax treaties, have
the force of domestic law.144 Therefore will an agreement between nations be of legal value.
In present are around 2000 bilateral DTTs in use, making them of interest to study.
A DTT is one of the solutions to avoid or reduce the consequence of being taxed more
than once. Initially was the idea of a bilateral DTT to be a temporary solution145, hence it
still exists today and its aim is to eliminate or mitigate the incidence of double taxation by
sharing the revenues arising out of the international transactions by the two Contracting
States with accordance to the agreement. Treaties use to allocate taxing jurisdiction of the
relevant item of income on the source or resident country or both. They stipulate the
maximum tax rate on the income and thereby provide relief from double taxation. Most
DTTs do not impose tax, instead they aim to limit the tax which otherwise would be im-
posed by the State. Another positive character of a DTT is its possibility to eliminate tax
avoidance, exchange of information and determining dispute resolution mechanisms.146
DTT could also be understood to be established because of a ‘desir[e] to clarify, standardize,
and confirm the fiscal situation of taxpayers who are engaged in commercial [... and] financial [...] activities
in the countries through the application by all countries of common solution to identical cases of double taxa-
tion’.147
Because of the intention established between the parties of a Treaty, it is difficult to over-
ride a treaty with domestic laws. Nations should respect the treaty as it has been established
143 p. 27 Rohatgi (2005).
144 The Convention is not having a retroactive effect but because of its essentially codification of existing norms of customary international law on treaties, it is considered to be binding on all jurisdictions, regard-less if they have signed for convention or not, and applicable to both past and future treaties. The result of this means that a convention does not have to be specifically incorporated in the domestic law: p. 17 Ro-hatgi (2005).
145 p. 25 Panayi.
146 p. 104 McIntyre (2002).
147 para. 2 introduction to the OECD Model.
36
by the principle of pacta sunt servanda.148 The possibility to override a treaty could however
be existent, if the domestic law approves.149
Many of the DTT which are in force, have been established by guidance of a Model. A
Model can be seen as a set out from forms of treaties used as a basis for negotiation be-
tween nations. They are not binding in and of themselves and they are often accompanied
by commentaries or technical explanations that aid in their interpretation.150 In present
there are three major Models of DTTs established. These Models are the United Nations
Model Double Taxation Convention between Developed and Developing Countries (UN Model), the
OECD Model Tax Convention on Income and on Capital (OECD Model), and the United States
Model Income Tax Convention (US Model). They have in common to be dealing exclusively
with direct taxation.151
4.3.1.1 The OECD Model
The OECD Model is the most widely used Model for DTTs and it is established by OECD
Committee on Fiscal Affairs and accompanied with commentaries. The latest issue of the
Model is from August 2008. The Model is dealing with juridical double taxation152 and is
having its primary objective to rely on the residence principle, meaning that the country of
residence is having superior right, over the country of source, to tax items such as Divi-
dends and interest first. Capital Gain is though exclusively taxed in the country of resi-
dence.153 The approach leads to a favour for jurisdictions using CEN, which in practise are
industrialised countries, and also the majority of the MS.
The fact that the country of residence is having the first possibility to tax doesn’t eliminate
a double taxation unless the State of residence allows an exemption or a foreign tax credit
148 art. 26 Vienna Convention.
149 p. 34 Rohatgi (2005).
150 For instance Introduction to the commentary on the United Nations Double Taxation Convention para-graph 35.
151 p. 74 Rohatgi (2005).
152 In the presenting of OECD, UN and US Models, the wording double taxation refers to international ju-ridical taxation, meaning that the economic double taxation is excluded.
153 p. 70 Barenfeld.
37
method. The Model is offering these reliefs of double taxation in article 23 A154 and B155 re-
spectively. As these reliefs are exclusively for juridical double taxation, is the economic
double taxation appearing to be an unresolved issue on a domestic level.156 Hence, it could
be an option for countries to regulate economic double taxation by a Mutual Agreement
Procedure (MAP) with accordance to art. 25(3) OECD Model.
The Model could be easily omitted if a difference between non-residents and residents
would exist by more taxes, or taxes with more burden for the non-residents. This is regu-
lated by art. 24 OECD Model which is stating that ‘[n]ationals of a Contracting State shall not be
subjected in the other Contracting State to any taxation or any requirement connected therewith, which is
other or more burdensome than the taxation and connected requirements to which nationals of that other
State in the same circumstances, in particular with respect to residence, are or may be subjected... This pro-
vision shall, notwithstanding the provisions of Article 1, also apply to persons who are not residents of one
or both of the Contracting States.’157 The term ‘national’ should be understood as ‘resident’, as a
pure nationality approach would lead to discrimination.158
To fulfill the goal of the Model an exchange of information is established in art. 26 OECD
Model. The establishment of the article is necessary to allow a State to conduct a tax inves-
tigation in another State, as it is prohibited to conduct a tax investigation in another State
without its consent.159 The competent authorities of each State are entitled to inform the
other State’s authorities, with confidential information about a taxpayer.160 Hence, there ex-
ists no obligation for the involved jurisdictions to inform the taxpayer.
The exchange of information is allowed mainly through three modes: on request, sponta-
neously and automatically, but other possibilities exist as well.161 The mode is up to the
competent authorities of the Contracting State to mutually decide.162 The most popular
154 Exemption method.
155 Credit method.
156 p. 266 Couzin.
157 p. 552 Hattingh.
158 art. 24(1) OECD Model.
159 p. 185 Rohatgi (2005).
160 p. 186 Rohatgi (2005).
161 OECD Commentary: art. 26, para. 19.10.
162 p. 186 Rohatgi (2005).
38
mode is the automatic mode, which has the benefits of enabling the other treaty partner to
enforce the tax laws of the other State, and to identify persons not entitle to the reduced
withholding tax rates under the relevant treaty.163 Complementary to that article is art. 26(5)
OECD Model, added in 2005, which opens up for bank secrecy laws of a State related to
banks, other financial institutions, nominees, agents and fiduciaries to issue needed infor-
mation and additionally the ownership interests in a person.164
Since 2003 is an amendment made in art. 13(4) OECD Model which grants the source tax-
ing rights on gains derived from the sale of shares in companies deriving over 50 % of their
value from immovable property in that State.165 This is not included in the other treaties
and therefore shouldn’t portfolio holdings in these companies be taxed in the home state.
The Capital Gain can be in conflict with art. 21 OECD Model. The OECD has during re-
vision been dealing with the issue by the question ‘which Article should apply when there is a
payment for property sold on annuity during the lifetime of the alienator and not on a fixed price. Are such
annuity payments, as far as they exceed costs, to be dealt with as a gain from the alienation of the property
or as ‘income not dealt with’ according to Article 21?’166 The OECD sees this problem as rare in
the practice and has not made any effort to solve it.167 Instead a tip is given to solve that
question by the MAP. Capital Gains are not applied to premiums and prices are attached to
bonds or debentures.
The confusion of the difference between art. 13 and 22 OECD Model about capital, could
be understood as art. 22 OECD Model applies to taxes on capital from the possession or
ownership of capital, and not the income or the gains from capital.168 The US Model does
however exclude capital since there are no federal capital taxes in the US.169
163 pp. 233-234 Rohatgi (2005).
164 OECD Commentary; art. 26, para 19.10.
165 p. 110 Rohatgi (2005).
166 para. 18 OECD Commentary.
167 Ibid.
168 p. 174 Rohatgi (2005).
169 Ibid.
39
4.3.1.2 The U.N. Model
As opposite to the OECD Model’s objective to levy taxes in the source country for the
taxation in the resident country, is the guideline from UN Model170 which is made by the
Ad hoc group of Experts on Tax Treaties between developed and developing countries. Its
latest issue is from 2001 and the Model is accompanied by commentaries. The Model does
as well deal with juridical double taxation and relies on the source principle and therefore
emphasizes the primacy of source based taxation. This means that the Model aims to estab-
lish neutrality via CIN. In practise does especially countries which are developing, benefit
from such taxation. For instance are transition countries in Eastern Europe using the UN
Model.171 The Model is younger than the OECD Model and therefore has the UN Model
recognised to find guidance in the OECD Model due to the experience in the field.172
However, do differences appear.
The UN Model differs as it has a broader view on taxation, it provides that ‘there is a need for
international and regional organisations to provide guidelines to facilitate conclusion of tax treaties with a
view to promote trade liberalisation and expansion as well as socio-economic growth.’173 The treaty is
therefore considered to be a tool for economic growth and not just an agreement for the
sharing of taxing rights.174 The objective of promoting economic growth is of mutual im-
portance and therefore justifies double non-taxation when countries give up their taxing
rights.175
Another difference is that the UN Model uses a tax sparing credit method as a policy mat-
ter, as it protects the objective best, where industrialised countries tend to use the Credit
method of treaty relief. A Tax sparing, which is also known as matching credit or credit for no-
tional tax, deals with foreign tax credit and it grants the source based countries tax notion-
ally borne on income of certain kind. In this cathegory places for instance Dividends. The
credit can be limited to the maximum source country tax which is permitted by the DTT.
The use of the method seems to encourage foreign investments.
170 Latest issue is from November 2001.
171 p. 74 Rohatgi (2005).
172 Introduction to the commentary on the United Nations Double Taxation Convention para 9.
173 para. 44 UN model and p.73 Rohatgi (2005).
174 p. 73 Rohatgi (2005).
175 p. 74 Rohatgi (2005).
40
The example from Toaze176 can explain how a practical approach for the tax sparing can
appear:
‘Assume that the income tax treaty between Canada and country B provides for a withholding tax rate of
up to 15 % on interest. Country B, in an effort to entice lenders to loan it, or its residents, funds at lower
than normal interest rates, decides to limit the withholding tax on interest to 5 %.’
Toaze continues the example by giving the conditions in the tax treaty:
‘The tax treaty between Canada and country B provides that where a Canadian resident receives interest
from a resident of country B, Canada shall grant a foreign tax credit equal to the amount of tax paid by
the Canadian resident to country B in respect of withholding tax on the interest. Further, the treaty provides
that the withholding tax paid by the Canadian recipient of the interest shall always be deemed to be equal
to 15 % of the gross amount of the interest (the tax-sparing provision). A Co, a Canadian-resident corpo-
ration, purchases bonds issued by a corporation in country B and receives an interest payment of $200,000.
A Co’s Canadian tax rate is 40 %. The[..] table [1.4] sets out the results to A Co under three scenarios:
first, where country B imposes withholding tax at the maximum treaty rate of 15 %: second, where tax is
imposed at 5 % without a tax-sparing provision: and third, where the 5 % rate applies and Canada pro-
vides tax sparing.
176 pp. 881-882 Toaze.
41
Table 1.4
With a 5 % withholding tax rate and no tax sparing, A Co pays, in total,the same amount of tax as it
would have paid in the base case. The key difference between the base case and a reduced withholding tax
rate without tax sparing is that the ratio of tax paid to country B and to Canada, respectively, is substan-
tially altered: where the rate of withholding is reduced, the tax forgone by country B is paid to Canada. For
A Co, when the 5 % withholding rate is combined with a tax-sparing provision, less tax is paid in total
and there is no increase in the amount of Canadian tax over that paid in the base case. In other words, the
intended benefit of the tax incentive to A Co is preserved. Absent the tax-sparing provision, the reduced
withholding tax rate provided by country B would result in (1) A Co’s paying less tax in country B and
more tax in Canada: (2) a consequential transfer of tax revenues from country B to the Canadian govern-
ment: and (3) the complete erosion of anybenefit to A Co associated with the reduced withholding rate of-
fered by country B.’177
Both the OECD and UN Models do not even go so far as to deal with the underlying
credit or participation exemption. Most treaties in practice addresses this issue, but they
generally avoid the issue of reconciling double taxation in corporation/shareholder taxation
177 pp. 881-882 Toaze.
42
as this is an unresolved issue at the domestic level in many countries, with the result that an
international consensus is impossible to reach.178
A non-discrimination article is used by the UN Model as it otherwise would be unfair to
tax subjects whom are not resident to give a more heavy tax burden.179 The possibility to
establish harmony on an international tax area would not exist if different taxes and tax
burdens would exist because of a discriminatory argument.
4.3.1.3 The U.S. Model
The third major Model is the U.S Model, which is used when the US is one of the Con-
tracting States. It is accompanied by technical explanation180 and has originally been pub-
lished by the US Department of the Treasury in 1976. In present is the issue of November
2006 in force. It might be seen as odd that an OECD member country has not adopted the
OECD Model, however has the OECD Model had a significant influence on all US in-
come tax treaties. Still there are though a couple of fundamental differences between the
OECD Model and the US Model.181 The objective of the US Model is the same as in the
OECD Model but a major contrast exists in the relief of double taxation. The US Model is
more limited as it only accepts the Credit method for avoidance of double taxation. It
would otherwise be in conflict with the US tax policy of providing that tax treaties should
not restrict the right of a State to tax its residents.182 As it only uses the Credit method, it
also excludes the tax sparring method from the UN Model. The argument has been to not
use the method neither as it would be against the CEN which USA is in favour of. Among
other arguments against the method is also a belief of the tax sparing to be ‘overrated’.183
To observe is also the addressee of the US Model. While the OECD and UN Models use a
territorial approach to define the addressees, does the US Model use a broader basis of
178 p. 266 Couzin.
179 art. 24 UN Model.
180 The function of technical explanation and the commentaries from UN and OECD Models should be con-sidered to be practically the same.
181 p. 270 Shannon III.
182 p. 280 Shannon III.
183 p. 887 Toaze.
43
resident. This is of great importance as a consequence for a US citizen which is resident in
another State, which is not a Contracting State, can claim treaty benefits of reduced taxa-
tion of Dividends and the exemption of interest, and thereby receive benefits from a MAP
and the non-discrimination clause of the US Model!184
According to the Model is a resident a person who has been recognised according to the
domestic state, to have her domicile, citizenship, residence or other similar criterias ful-
filled.185 The catalogue should be understood as insatured and thereby could other criterias
such as nationality be considered of a resident of a specific country. The article does also
cover the residence of partnerships, and therefore it impacts on investment funds. This
leads to less flexibility in cross-border joint ventures for an investment fund as it is more
regulated. In the other treaties which do not regulate partnerships is the contrast estab-
lished and therefore makes partnership considered to be ‘transparent’ tax subjects.186
The exchange of information is also presented in the Model by art. 26 and it is extended in
the US Model by administrative assistance, meaning that an obligation lays for the Con-
tracting State to make an effort to collect on behalf of the other Contracting State such
amounts as may be necessary to ensure that the treaty benefits do not insure to the benefits
of persons whom are not entitle thereto.
4.3.1.4 Do We Need DTT?
As mentioned before does it exist around 2000 DTTs in present. Estimately does the world
need totally 16 000 to fulfill the aim of a DTT. With the progress in presence will that
quantity be reached in the year of 2050.187 The DTTs which occur do reduce double taxa-
tion, but this means that they don’t reach the goal to eliminate the double taxation.
By the lack of 14 000 DTTs is the conclusion that the elimination of double taxation is
normally done by unilateral measures. The issue on the other hand with unilateral meas-
184 p. 273 Shannon III.
185 art. 1(1) US Model.
186 Their profits are determined at the level of the partnership, but the profits are then divided.
among the partners, and the partners themselves are liable for the tax based on their property and family circumstances; p. 1 Schaffner.
187 p. 620 Easson.
44
ures, though they are often similar to the methods used in DTT when they exist, is the way
to give a relief from something unknown. No guarantee does exist in such a situation that a
double non-taxation would occour by giving a relief.
DTTs do however provide that where one party to the treaty has made an adjustment that
causes profits to be taxed that have been taxed in the other State, that other State shall
make an ‘appropriate adjustment’.188 Such an adjustment is frequently arrived by the MAP
in Art. 25 OECD Model. It requires the competent authorities of the Contracting States to
make an efford to eliminate double taxation. Whilst it is true that the MAP does not always
succeed in eliminating double taxation, it could still give important benefits to investors in
some cases.
The alternatives to improve the present system of bilateral tax treaties could, according to
Avery Jones et al, could be189:
• To enter multilateral tax treaties:
• Be dealing with taxation in multilateral trade and investment treaties:
• To harmonize national tax laws: and
• Establish a Model tax law.
The academic discussion isn’t unioned in what would be the best, and rather sees problems
to strive for either one of them.190 The DTTs are not perfect, but as the assumption is that
DTTs should be replaced and the answer is unclear of what would be the optimal solution, a
passive, waiting approach is taken.
4.3.1.5 The Relation Between Tax Treaties and the ECT
The ECJ has in 1984 came to a judgement to interpret better the wording of art. 293 ECT.
It dealt with the relation that the tax treaties are having to the ECT:
‘Member States shall, so far as is necessary, enter into negotiations with each other with a view to securing
for the benefit of their nationals: ...
— the abolition of double taxation within the Community,...’
188 art. 9(2) OECD Model.
189 p. 620 Easson.
45
The case lays an obligation for MSs to have a good intention to enter into DTTs and
thereby to remove the obstacles that Double taxation presents as well as other problems
that arise within juridical double taxation.191 By the judgement of the case can a MS under-
stand that a legal value exists for DTTs within the EC law. However, does an issue arise
with a DTT in its relation to the ECT. In another formulation that would be: which legal
value does it have within the Union?
The ECJ has in numerous decision192 been in contact with DTTs and provided that ‘MS[s]
are at liberty, in the framework of (double tax agreements), to determine the connecting factors for the pur-
poses of allocating powers of taxation[...]’193, hence they are nevertheless bound by the superior
EC Treaty obligations.194 This principle has been affirmed in the case of Schumacker195 and
the Bouanich case.196 The case law has shown a clear impression of not making the EC law
subject to the provisions of the DTTs and their condition of reciprocity.
As the fiscal sovereignity still rests on MSs, it is up to them to conclude international con-
ventions in order to prevent double taxation, since ‘Community law, in its current State …, does
not lay down any general criteria for the attribution of areas of competence between the Member States in re-
lation to the elimination of double taxation within the Community’197 and since apart from the exist-
ing legislation, ‘no uniform or harmonization measure designed to eliminate double taxation has as yet
been adopted at Community law level’.198
It can be regarded as of legal value that Double tax agreements between nations do affect
the EC law.
190 Ibid.
191 art. 293 ECT and 137/84 – Mutsch, para. 1.
192 For instance Avoir fiscal, Thin Cap GLO and above mentioned A case.
193 C- 307/97 – Saint Gobain.
194 p. 5 of the Executive summary from European Parlament.
195 The Schumacker case was about an individual carrying income from a state he was not resident of. In that state he couldn’t claim the personal and family deductions he had in the resident state.
196 p. 2 Pistone.
197 C- 307/97 – Saint Gobain.
198 C- 513/04 – Keckhaert, para.22.
46
The ECJ has provided that ‘MS are at liberty, in the framework of (double tax agreements), to deter-
mine the connecting factors for the purposes of allocating powers of taxation...’199
As the MSs are using either UN Model or OECD Model between each other, and they are
bound by the ECT it is not difficult to understand the impact of the EC law on the treaties
within the EU, but when it comes to other Models such as the third major Model: the US
Model, the question arises as well how the power of the EC law is in relation to those
DTTs, once they are having a connection to the EU.
The US Model is using in its DTTs a Limitation on Benefits-clause (LOB) which is estab-
lished in art. 22 US Model.
Almost all MSs which have entered a DTT with the US, using the US Model, is containing
a LOB which could, despite differences between the treaties, be treated alike as it is having
the same characteristic. The clause is used by defining a person which should be excluded
as (s)he isn’t considered to be having any ‘real connection’ to a Contracting State. Accord-
ing to art. 22 US Model are for instance Trusts and some corporations200 included to the
clause and the aim of the clause is to omit tax abuse.
Giving an example made by Mason201 can the result of nationality discrimination by the
clause be shown by two similarly situated companies which both are established in the
US.’The first U.S. company is 100 % owned by Beneficiary, a British holding company wholly owned by
five British resident individuals. The second U.S. company is 100 % owned by Excluded, a different Brit-
ish holding company wholly owned by five German resident individuals’.
Mason continues and refers to the tax treaty: ‘Under Article 4 of the U.S.-U.K. tax treaty defining
residence, both Beneficiary and Excluded would be British residents and therefore ostensibly entitled to
treaty benefits, including the zero rate of withholding on Dividends paid by a corporation resident in the
United States to an 80 % corporate owner residing in the United States to exempt EU nationals from the
clause. In the example with Excluded and Beneficiary, the United Kingdom has no authority to require the
United States to extend the zero withholding rate to Dividends paid to Excluded. As a result, the only way
199 C- 307/97 – Saint Gobain, para. 56.
200 Potential players of the financial market and thereby investment funds.
201 pp. 77-78 Mason.
47
to compensate taxpayers for discrimination by the United States—but countenanced by an EU Member
State—may be to require the Member State to fully credit the U.S. tax.’202
By a violation of such a clause with the ECT on the ground of discrimination, would the act
clair203 override the DTT clause and finding it against the goal of European Union.204 This
would face serious consequences against the US interest and is considered as a hinder for
the US Model with Contracting States from the EU. According to Mason205 is it unclear
how to heal such a situation for protecting both Contracting States’ interests, however it
could not be done by a unilateral method as an uncertainty would appear of how the tax
subject would be treated because of different definition of the taxpayer.
4.3.1.6 Conclusion
The Models for negotiating a DTT are well developed and strive for not discriminating in-
vestors in cross-border investment situations. They are aiming to clarify the taxation for
those whom are addressed, but they cannot always fulfill this because of unclear defini-
tions. Even when the definition is given by a referring to a Contracting State’s law, it could
be misunderstood by the other State by differences in languages. A dramatic example
would be when one country defines an income as a Capital Gain while the Contracting
State defines the income as a Dividend. The person would be double taxed but the tax au-
thorities would in such a situation have a kind of a bona fides206 that it was the only justi-
fied part to tax a labelled income.
Further on, the question which Model should be laid as a ground for negotiating a DTT,
should be a sensitive matter for the involved countries, as both are willing to protect their
own interest. My guess is, as it occurs in most business situations, that the strongest party is
the winner. This issue would be even more of curiosity if the EU would be striving for
202 pp. 27-28 Mason.
203 Acte Clair is an EC law term for settled case law.
204 C- 270/83 – Avoir Fiscal.
205 pp. 77-78 Mason.
206 Swedish term; God tro.
48
making a multilateral Model based on a Model such as the OECD Model, in simularity to
the Scandinavian approach.207
If an approach would be taken to get away from DTTs, it would be to one of the alterna-
tives which has been criticized. The DTTs aren’t always effective as they do not always ful-
fill to eliminate double taxation. They rather make a complex body with different treatment
for an portfolio holder, depending on where the portfolio capital has been. This by itself
gives an uncertainty and manipulates the action of tax planning and in some cases even tax
abuse. The positive outcome such as the exchange of information is however a step in the
right direction when countries are computing the taxation they are having right to.
The ECJ has shown how the relation is between the EC law and DTT. An approach is
taken to defend the principles and goals of the EU but on the same time are the DTTs
used as a tool in the judgements of the ECJ. By speculating, maybe as the DTTs are pro-
tecting the EU principles and goals. The already existing DTTs could maybe also be used
by the ECJ to give EC law a clearer and stronger importance on the international area of
direct taxation as the treaties are already agreed between jurisdictions.
The LOB is a complexed problem in the EU as the present outcoming is an override of the
principle of nationality which in a way shows that the EC law is major over the US Law,
however it is important to keep in mind that the US Law is not exclusively relying on the
principle of nationality as it is a part of the body of defining an addressee in the US Trea-
ties.
4.4 European Approach
The European approach is built on an interaction between a legislative and a judicial inte-
gration. When the EU is not sovereign to establish rules in a field, such as direct taxation, is
the sovereignity in the hands of the MS. Hence is the sovereignity which is on a national
level, in some cases restricted because of the treaty establishing the internal market. These
restrictions are sometimes interfering with the established rules and therefore becomes a
judicial matter. The legislative integration is also known as positive integration while the judi-
cial integration is labelled as negative integration. As the EU treats the taxation of portfolio in-
207 p. 239 Rohatgi (2005).
49
come under direct taxation, it should be mentioned that the area is complex as a lack exists
on the positive integration. Consequently can the ECJ only interpret how principles and
freedoms of the ECT are affected as no laws of taxation can be against a non existing legis-
lative power of the EU.208
4.4.1 Positive Integration
The approach is refering to the approximation of national laws between MS through legis-
lative measures taken on the Community level.209 This means that it is dealing with the im-
pact of secondary community law on the taxation of portfolio holdings. Mainly is art. 94
ECT giving a legal basis in the area of direct taxes:
‘The Council shall, acting unanimously on a proposal from the Commission and after consulting the Euro-
pean Parliament and the Economic and Social Committee, issue Directives for the approximation of such
laws, regulations or administrative provisions of the Member States as directly affect the establishment or
functioning of the common market.’
This is also the explanation of why only Directives are established in the area of direct taxa-
tion when there are more secondary legislation recognised by the union.210 The article has
been practised and laid a legal basis for the Parent-Subsidiary Directive, the Mergers Direc-
tive, the Interest-Royalty Directive and the Savings Tax Directive. Of particular interest is
the Savings Tax Directive with respect to portfolio holdings because of the addressee.
4.4.1.1 Savings Directive
The European commission has on the 1st of July 2005 presented the EU Savings Tax Di-
rective (Savings Directive)211, which is in present in force by the issue from July 2005. The
Directive provides for strengthening the liberalization of capital movements within the EU
208 pp. 17-18 Terra.
209 p. 321 Viitala et al.
210 art. 249 ECT.
211 88/361/EEC.
50
and its relation with third countries.212 It is the unique Directive which exists with respect
to the personal taxation.
The aim of the Directive is to permit the MS where an individual is resident213, to tax their
savings income in the form of interest payments they obtain from foreign locations. This
goal is achieved by a system of automatic exchange of information, which is an administra-
tive co-operation mechanism contained in the Exchange of information-Directive214 and in the
Directive on Mutual Assistance for the recovery of claims215. The legal framework of the Directive
can also be illustrated by an example:
‘A beneficial owner, resident in [MS 1], receives an interest payment from a paying agent established in
[MS 2]. In [MS 2], the beneficial owner is only subject to limited tax liability: quite often, no source tax is
levied. The beneficial owner’s State of residence would tax the worldwide income, i.e. also the cross-border
interest income, but where this income remains unreported, no tax will be levied in any of the States in-
volved.’216
The outcoming double non-taxation would distort the capital movement between MS and
moreover would open up for a capital flight to non-MS.
The term interest payments217 rests on a similar definition to interest provided from art. 11(3) of
the OECD Model from 1977:
‘Interest paid or credited to an account, relating to debt claims of every kind, whether or not secured by
mortgage and whether or not carrying a right to participate in the debtor’s profits, and, in particular, income
from government securities and income from bonds or debentures, including premiums and prizes attaching
to such securities, bonds and debentures: penalty charges for late payments shall not be regarded as interest
payments.’
212 para. 510, Heidenbauer.
213 Country of residence is where the persons permanent adress is; Art 3(3).
214 77/799/EEC.
215 76/308/EEC.
216 Example from p. 150 Savings Directive article from Christians.
217 art. 6(1).
51
The term interest could in general be explained as being paid or credited to an account, relat-
ing to debt claims of every kind. The Savings Directive itself seems to aim to define the in-
terst in another way, by listing ‘interest’ in art. 6.218
The Directive aims to be used in one out of two ways for the MSs: an exchange of relevant
information219 or to apply a system of withholding taxation on cross-border interest pay-
ments, where the revenue would be shared between the relevant MSs.220
The first mentioned option gives a reporting obligation which enters into force once an in-
terest payment is made or received. To fulfill the information an identity must be given
about the beneficial owner221 and, as the information is based on an automatic mode it
must be exchanged at least once a year, within six months from the following end of the
tax year of the paying agent’s MS of establishment.222 After this process, does a MS have all
information needed to exercise its taxation.
The second option223 is, during the transitional period, decreasing the aim of the Directive
from reduced to merely ensuring minimum effective taxation of savings in the form of interest
payments. This leads to a possibility for the withholding tax to exist. In art. 14 is an inten-
tion provided to not levy an additional tax on cross-border interest income, and therefore
is a double taxation eliminated. This leads to an obligation for the country of residence to
use a full credit, refund or 75 % revenue on the withholding tax. The tax rate for withhold-
ing tax is progressive and is in present 15 % out of the amount of interest paid or credited.
Until the 1st of July 2011 will the tax rate reach 35 %. The idea is to make it less and less
attractive for the addressee to avoid reporting its income to the State of residence. The
withholding tax in the Directive can also have competition with other withholding taxes, by
for instance a debtor of the interest payment, who can be a resident of a third country
which is using a withholding tax.224 The Directive has obliged the other withholding tax to
218 para. 527 Heidenbauer.
219 art. 7.
220 art. 8.
221 Ibid.
222 art. 9.
223 Used by Austria, Belgium and Luxembourg because of conflict between exchange of information and the national bank secrecy legislations.
224 p. 158 Savings article from Christians.
52
be credited first in such a situation.225 The conflict between the Savings Directive and DTT
in question of withholding taxes with progressive tax rate is easily omitted between the MSs
as the Savings Directive is EC law and therefore gives preference to it than the DTT.
The Directive is addressed to individuals with exemption for individuals who have not
acted on behalf of herself and further it excludes all legal entities including offshore in-
vestment vechicles. This opens to the question one might ask: why would interest pay-
ments made to companies be excluded from the scope of the Directive?
That question has been asked to the Commission when reviewers where analysing the pre-
sented Directive. The answer from the Commission came to be ‘[that] there are many more
problems of tax evasion in the individual taxation area than in the company tax area. Companies are re-
quired to lodge annual tax returns and they are audited or are subject to the possibility of being audited on
a regular basis. As far as companies are concerned, non-taxation of interest payments is not the main prob-
lem for tax administrators. The issue is more that of tax avoidance through aggressive tax planning.’226
This must be considered as an error, especially with regard to the statement from McLure
that the Commissions opinion was ‘hopelessly naïve’227. However does it seem as, despite the
observation of the loophole, is it difficult to include legal entities if regarded how the pre-
sent Directive is formulated.228 The question arising is thereby if there is any intention to
close the loophole.
Though that the Directive is referring to interests in a broad definition it still has a limita-
tion, and according to a list published by the Government of Guernsey, is the excluding
among others of Dividends that are paid on ordinary or preferred shares.229 This fact can
mean that a lack of neutrality exists because of favouring other investment forms. A limited
impact for portfolio holders must thus be considered to exist as the Directive solely affects
individuals who keep money in foreign accounts, and it is even more limited for tax plan-
ning as the same income could be excluded by the fact that the interest could be entering a
225 Ibid.
226 Commission’s document ‘Savings Tax Proposal: Frequently Asked Questions’.
227 pp. 90 and 96 McLure.
228 p. 481 Jiménez Martín.
229 Related to portfolio holding, but not to the thesis is also the fact that returns on derivatives and structured products excluded as well.
53
legal entity such as an offshore investment fund and thereafter convirting the income to a
Dividend when it is paid out as an income to individuals.
By the automatic exchange of information, at least individuals holdings of interest could be
sure to not be double non taxed.230 The unanswered question is however still why other
savings are excluded.
4.4.1.2 Exchange of Information Directive
The Savings Directive is as mentioned earlier, made to strengthen the tax co-operation
made by the Council Directive 77/799/EEC of 19th of December 1977231 concerning the
Mutual Assistance in the Assessment of Taxes in the field of direct taxation (Exchange of
Information Directive). It was addressed for the MS to establish an efficient exchange of
information.232 The exchange of information should be in accordance with the common
principles and rules of the EC law and it aims to strengthen the collaboration between tax
administrations of the MS. The Directive was updated in 2004 to speed up the flow of in-
formation between MSs’ tax authorities. The exchange of information Directive has similar
rules to art. 26 of the OECD Model and to the Multilateral convention on Mutual Admin-
istrative Assistance in Tax Matters.
The difference between the Directive and art. 26 OECD Model is that the Directive is be-
tween many parties and has a wider scope of the definition of the addressee which makes
definitions like nationals and residents irrelevant. This means that the information regard-
ing to a resident or non-resident taxpayer of the EU may be exchanged, as long as the crite-
ria helpful is fulfilled. The taxes which are covered by the Directive are in a list of art 1(2)
and it covers all taxes on total income, on total capital, withholding tax and taxes on Capital
Gains among others.
230 p. 138 Panayi.
231 Latest issue in force is from 3rd June 2003.
232 Preamble of the Council Directive 77/799/EEC of 19th of December 1977.
54
The Directive merely covers taxes on gains from the alienation of movable and immovable
property in Art. 1(2).233 It is in principle providing for any information that may enabe na-
tional tax administrations to effect a correct assessment of taxes.
The transitional rules doesn’t exist in the Directive and therefore allows MS to get informa-
tion related to any tax year, independently on what tax year is in force. It is not relevant
when the entry into force of the Directive provision appeared neither. The Directive states
three modes of exchange of information, by request234, spontaneous235 and automatic.236
The same principles are used in the Savings Directive as that Directive is built on the Ex-
change of Information Directive.
In art 8(2) an ordre public is established if the exchange of information would be interfer-
ing the fundamental principles of the MS which is supposed to give the information.
Thereby is the outcome having the effect to be inhibited within the internal market but a
question occours in this context; is it possible for the information exchange agreements to
prevent underreporting and evasion?
It is not sure yet if bilateral actions through tax treaties could combat the underreporting
problem, but the OECD has suggested the countries to intensify the exchange of informa-
tion provisions in the tax treaties which are based on the OECD Model.237 However has it
been pointed out that additional problems could occur when foreign portfolio income is
earned outsiside the major developed countries.
Vito Tanzi238 has pointed out that obstacles created by language differences, along with the
resource burdens on information-providing countries of collecting and organizing the mas-
sive flow of information about individual investors, may limit the ability of international in-
formation exchange to prevent tax evasion on foreign portfolio income earned in tax ha-
vens and developing countries. Further has he observed that even if the authorities would
233 p. 164 Christians.
234 Art. 2.
235 Art. 4.
236 Art. 3.
237 pp. 582-586 Graetz (2003).
238 p. 88 Vito Tanzi.
55
have all the information needed, it still would be difficult to decide a taxation due to the
complex arrangements appearing in the financial markets.
4.4.2 Negative Integration
As long as no positive integration has been achieved in a certain matter which a country is
possessing sovereignity in, do MSs remain in general free to regulate that matter however
they wish. The limitation lays however in those matters that the ECT is having having an
exclusive sovereignity in, such as the free movement of capital.239 This limitation is labelled
as the negative integration. It integrates the MS through legally enforceable prohibitions on
measures that the MS violates, according to the ECT established internal market.240 The
negative integration can, because of the supremacy of the ECT, remove domestic and
treaty provisions when a conflict of interests appears.
The negative integration has a substantial body, made by case law. It exists due to a lack of
rules on the portfolio taxation through the positive integration. The only positive integra-
tion with respect to personal taxation is the mentioned Savings Directive and the Exchange
of Information Directive.
4.4.2.1 Case-Law
According to studies made by Michael Graetz, could a US investor, subject to the highest
US individual tax rate investing in a US company bore a total marginal tax burden of 58 %
on Dividend payments, while the same US investor paid a 40 % tax on Dividend payments
by a French company, 58 % on Dividends paid by a German company, 45 % on Dividends
paid by an Irish company, and 47 % on Dividends paid by a UK company.
Further, to achieve CEN has the EU to adopt similar country-specific tax policies as de-
scribed above for the US. Indeed, every country would have to tax its resident investors
differently depending on the country where investments are made. But varying the level of
239 See 4.4. Positive and negative integration.
240 p. 203 Viitala.
56
domestic taxation depending on the country where a resident invests would violate the free
movement of capital requirement of the ECT.241
As various different methods are in use for eliminating or relieving a double taxation, the
question arises of how to deal with taxation of Dividends within the EU. Before entering
the case does it have to be mentioned that cases involving inbound Dividends arise in
source countries and concern the possibility of discrimination based on the origin of in-
vestment. The inbound Dividends arise questions about capital export neutrality.242
4.4.2.1.1 How does the EC law deal with Double Taxation for Inbound __________.Dividends of Portfolio Investment?
The ECJ has ruled four cases so far involving foreign Dividends received by individuals
under tax systems which are designed to reduce double taxation. In each of the cases the
court held that the treatment of foreign Dividends had to be conformed to that of domes-
tic Dividends to satisfy the ECT.
In the mentioned case Verkooijen243, the ECJ provided a general prohibition of discrimi-
nating by restricting the established free movement of capital on the basis of residence or the
place where the capital is invested.244 This decision came on the fact that the court did an
analysis in the case and founded in the legislation history of the Netherlands a design which
reduced economic taxation of corporations and their shareholders, but the system also dis-
couraged to investment abroad as well as difficulties for foreign companies to raise capital
in the Netherlands. The conclusions about causality can be seen as incomplete as such con-
sequences must be the cumulative result of the tax situation in both the source and resi-
dence countries.
Netherlands argued for its protection of its interest, by support of the rule of reason245, that
it exist a need to preserve the cohesion of the Netherlands tax system. A cohesion can be a
241 p. 564 Graetz (2003).
242 p. 1591 Graetz (2007).
243 Mentioned in 3.5.1.1; Verkooijen.
244 para. 18.
245 Established in art. 58 ECT.
57
justification under the rule of reason for a different treatment, but in our case did the ECJ
deal the argument with a denial as a direct link between a grant to shareholders in one MS
and taxation on profits of companies in another MS doesn’t exist. The court founded it to
be two different taxes.246
For the Netherlands, did the decision mean an entitlement to an exemption when the na-
tional tax treatment provided for an exemption for domestic source Dividends.247
The case has met critics in doctrine as the qualification for discrimination in the principle
of free movement of capital is made solely by looking at the taxation of shareholders. A
taxation of the distributing corporations flow is completely ignored. Cross-border tax in-
centives who invest at home or abroad must depend on the corporate and shareholder tax
situations in both countries. This means that a restriction is made of taking into account
the income stream at the corporate level when setting the level of shareholder taxes.
The ECJ has treated another important case with respect to Dividends. As Verkooijen
treated the discrimination by exemption, the Lenz treated Dividends with restriction by the
difference in the tax rate.
Mrs Lenz248, who was a resident of Austria, received Dividends from the shares she owned
in a German company. According to the Austrian tax law did she became subject of nor-
mal Austrian individual income tax as she got refused the choice of having her Dividends
taxed under a final withholding tax249, or under a half rate scheme250. The later meant that
although the net Dividends where included in the taxable base of the shareholder, they are
taxed at only half of the normal progressive rate of max 50 %. The Dividend tax was
thereby creditable/refundable.251 To note in this case is that the benefits did not depend on
Austrian corporate taxes actually having been paid.
246 para. 58.
247 p. 226 Denys.
248 C- 315/02 – Lenz. 249 The Dividend tax withheld by the distributing company of 25 % of the gross Dividends would then not be followed by any net income tax in the hands of the shareholder.
250 Austrian term; ‘Halbsatzverfahren’.
251 p. 401 Terra.
58
Germany realised that it would get serious financial consequences if the ECJ decision
would be against Germany’s then present tax rules and added that Germany was entitled to
believe that its legislation was EU compliant by the principle outcoming from the Verkooi-
jen case. Germany therefore asked for a temporal limitation as it otherwise would lead to
claims for the retrospective adjustment of pay scales covering a period of years.
The Advocate General didn’t find evidence to this argument and the court outlawed the
award of temporal limitation to Germany because decisions relevant to the case were al-
ready resolved for another MS. The court added that only exceptionally, in application of
the general principle of legal certainty, may a limitation to the temporal effects of an inter-
pretation of EC law be alouded. More specificly did the court mention, in order to guaran-
tee the equal treatment of the MS and of other persons subject to EC law, thta it may only
do so in the actual judgment that provides this interpretation. In such a case it must be be-
fore the issue first comes to the ECJ to judge.
According to EC law, it exists a justification of hidden or covered discrimination by a so
called rule of reason.252 Austria tried to justify its actions by the mentioned rule with the ar-
gument that its method of relieving double taxation should not apply to foreign companies
from which no Austrian tax had been collected.253 ECJ stated that a double taxation may
occur for both companies in different MS, so therefore by treating them the same wouldn’t
be against the Austrian tax system, as a credit is recognized for domestic income. It is ob-
vious here that the court once again only did its discrimination test by a shareholder view,
without regard of company taxation.
The court came to the conclusion of a discrimination made on the same grounds as in Ver-
kooijen: by restricting the inbound Dividends and therefore favour domestic investments
and making it harder for foreign companies to raise capital. Once again, didn’t the court
find the same direct link which was refered to in Verkooijen and instead held that the tax
rate abroad was irrelevant because that other tax advantages could not offset the litigated dis-
advantages.
The court has by the case shown that any different treatment of foreign-source and domes-
tic income is unalouded between MSs. The intolerant view from the ECJ in the lack of
252 C- 315/02 – Lenz, para. 27.
253 Ibid, para. 28.
59
equality between Dividends, can be argued that the court accepts that Outbound flows of
cross-border income are not automatically to purely internal flows of income but that In-
bound flows of cross-border income are in principle to be treated as if they were domestic.
This view may be understood as the Court has realised how outbound income flows may
improperly erode the fair tax base share of a source State, but doesn’t see how different
treatment of inbound flows of income as compared to domestic flows could be explained
by the need to protect a balanced allocation of tax revenue between the source and the
residence State. If it is so, then the court has shown a primacy of the source principle over
the resident principle.254
The final two cases involved credit for Dividends which had been paid as corporate in-
come to the crediting country, but not for Dividends from another country.
In the case of Manninen255, had Finland converted its corporate tax into a withholding tax
on Dividends. This was made by distributing Dividends that had not borne a corporate tax
equal to the shareholder credit. This trigged a compensatory tax known as withholding tax.
The country imposed a tax of 29 % at both the corporate and shareholder level, but the law
gave only a full credit for the corporate tax to shareholders of domestic companies. Mr
Manninen, who was a resident of Finland, owned shares in a Swedish company and
claimed that Finland should allow him a full shareholder credit for the corporate taxes paid
to Sweden. The link between the tax advantage and the offsetting tax levy was in the Fin-
nish tax system at the time of the trial, designed with respect to the cohesion of the na-
tional tax system. This means that it had sence if a taxation is made by the same jurisdic-
tion, or what the jurisdiction had agreed with other jurisdictions. Such an agreement was
for instance made in a treaty, which resulted in a relief of double taxation. It seemed to
have been in accordance with art. 10 of the multilateral tax treaty256 between the Nordic
countries, which was stating that the relief couldn’t exceed a tax rate of 15 %.
254 p. 340 Terra.
255 C- 319/02.
256 The multilateral tax treaty between the Nordic countries is a modification with more parties than the bilat-eral treaties of two. Still, the treaty is as the majority of Double tax agreements, as it is based on the OECD model convention and it provides that the state of residence of the shareholder will grant a tax credit for the foreign withholding.
60
The court did an interpretation of art. 58 ECT, to see the compatability of the EC law and
the Finnish legislation and declared that the provision must be interpreted strictly. It de-
clared that it couldn’t be interpreted as any tax law making a distinction between taxpayers
by reference to the place where they invest their capital is automatically compatible with the
ECT.257
The ECJ found a restriction on the free movement of capital on the inbound Dividends on
the ground that a Finnish double taxation could be achieved not only on Finnish Dividends
but also if Finland would grant foreign credit for the corporate taxes which were paid to
other MS. By the established principle of obligating a MS to look into another MS’s corpo-
rate tax system, consequences arise of having the right of checking the tax rules related to
an individual case, which can only be possible by a tax dialogue established between the
source country and the country of residence. As a forced tax dialogue is decided, a MS
can’t excuse discrimination by relying that the reduction would be made in the other MS.
Therefore the country of residence needs to allow a full credit for the foreign source tax in-
stead of a limited ordinary tax credit.258
A justification couldn’t neither be found on the base of safeguarding the cohesion of a tax
system by the ECJ. The court provided that such a justification must be examined in the
light of the objective persued by the tax legislation in question. It added that even if that
tax legislation is based on a link between the tax advantage and the offsetting tax levy
which provided that the tax credit granted the shareholder a fully taxable in Finland, it had
to be calculated by reference to the corporation tax due from the company established in
that MS on the profits which it distributes. The conclusion was that such legislation didn’t
appear to be necessary in order to preserve the cohesion of the Finnish tax system.259
The court developed their decision by explaining that if the source country had relieved
double taxation with a Dividend deduction, Finland would have been under no obligation
to extend its imputation system to foreign Dividends from that country. On the other
hand, if the source country had a classic corporate shareholder economic double taxation
system, Finland would be required to provide a shareholder credit based on the tax rate in
that country.
257 para. 26
258 Lenz and Manninen.
61
The Manninen case forces MS which uses a full credit method, to credit any remaining Divi-
dend withholding tax on incoming Dividends from other MS.260 With a Credit method sys-
tem it is established an obligation of having a tax dialogue with the source country. A re-
striction to the principle is laid stating that if a source country do not use a Credit method,
and instead uses a Deduction method, then a residence country do not have any obligation
to start a tax dialogue. The case of Meilicke261, seems to confirm this principle as well as it
is extending it to EEA262 countries as the same reasoning to the imputation system was
given. As a consequence of the judgement of Manninen, UK, Germany, France and
Finland have turned down their Credit method system. Some thoughts related to both the case of Lenz and Manninen is that they show by order-
ing a full tax credit, although under specific circumstances, that it must be understood as
the ECJ favours a full tax credit system instead of a limited ordinary tax credit. This ap-
proach seems also to be harmonized with the Savings Directive which could be argued to
be as evidence of an development leading to a full credit approach used within the EC law.
It can also be stated that in general has the ECJ been eliminating gradually the withholding
taxes of cross-border Dividends within the EU regardless of the availability or the lack of
double tax treaty benefits. But this does not apply in relations to third countries.263
However not all unfavourable tax treatments of foreign Dividends are against the ECT. In
the case of Mr. and Mrs. Kerckhaert-Morres264 whom were residents of Belgium, were dis-
puting the compatibility of the Belgian rules, giving a deduction from the taxable basis of
foreign withholding tax, in relation to the EC law.
According to the claimers was a deduction, instead of a credit for foreign withholding tax,
bearing a higher tax burden on the foreign Dividends than on the domestic ones. The tax
authority treated the situation with accordance to the principles outcoming from the estab-
lished case law of Avoir Fiscal265. The ECJ had further to deal with the difference from ear-
259 para. 44.
260 p. 125 Terra.
261 C- 292/04.
262 MS of the EU together with Iceland and Norway.
263 p. 7 Kent.
264 C- 513/04.
265 C- 270/83.
62
lier cases, as the Belgian law did treat Dividends with different outcome, depending on the
establishment of the company.266 This difference was the reason why the court didn’t find
any discrimination and didn’t gave mr. and mrs. Kerckhaert-Morres right.
The ECJ informed by its ruling that discrimination could arise through the application of
different rules to comparable situations or the application of the same rule to different
situations. This was though not the case.267
The so far mentioned case law has been dealing with withholding tax on inbound Divi-
dends, but how is the EC law relating to third-country withholding tax? The court has had
the case of Orange268 to answer, among other questions, if a full credit or ordinary credit
should be used.
The legislative background of the case informs that the investment fund Orange Small Cap,
established in the Netherlands, invested in MSs and third countries. In 1997 and 1998 did
Orange receive Dividends which were subject to foreign withholding tax. With accordance
to Dutch tax law, was the investment fund not to be recognised as a tax subject and there-
fore not eligible to receive any relief from the involved DTTs. However did the Nether-
lands have unilateral relief in its domestic law. Under these rules did Orange entitle a relief,
although a limitation appeared:
‘The relief was reduced to the extent as the Dutch investment fund was held by foreign shareholders.‘269
This meant that a full credit was not available. The ECJ considered the limitation to be in
conflict with the free movement of capital as it was less attractive to invest in the invest-
ment fund. As the shareholders of the investment fund are in the same situation it wouldn’t
be justified to treat them different and therefore should they, whether being resident in the
MS or in a third state, be receiving a relief which is not reduced due to the limitation. The
court ruled under art. 56 ECT instead of art. 57 ECT with the reason that art. 57(1) ECT
is addressed to natural persons and legal entities whom are making a direct investment in-
stead of a portfolio investment, such as by an investment fund.
266 para. 16.
267 para. 19
268 C- 194/06.
269 para. 66.
63
4.4.2.1.2 Capital Gains on Ordinary Shares
With the same established laws on the fundamental freedom of capital and with respect to
the papers second tax: CGT, has the ECJ judged in two relatively new cases.
The case of ms. Bouanich270 shows the approach taken for the definition of CGT in the
DTT and the relief of double taxation.
Ms. Bouanich was a resident of France and received a shareholder’s payment from a com-
pany established in Sweden. This payment was connected to the repurchase of the shares
and the reduction of the company’s share capital. This was according to Swedish tax law
defined as a CGT which gave a possibility to deduct the price of acquisition and thereafter
be taxed at a rate of 30 %. The law did however define the same circumstances as Divi-
dends when the shareholder was not a resident of Sweden. For the situation, did the DTT
between Sweden and France apply, and after the interpretation of the OECD commentaries on
the OECD Model tax convention, were the rules about Dividends applicable. The DTT fixed
the tax rate to 15 % and permited a deduction corresponding to the nominal value of the
repurchased shares. The ECJ had an objective approach in the case and founded a less at-
tractive situation in comparison to resident shareholders of Sweden. Despite a lower fixed
tax rate established by the DTT. A deduction of the acquisition price of the shares was
considered to be in breach of the free movement of capital. The ECJ did also mention that
it was up to the Swedish Court of Appeal to judge if the established less attractive situation
was applicable for ms. Bouanich.
The last case which will be treated, deals with discrimination in the qualification to CGT.
The Grønfeldt case271 dealt with the German rules for individual CGT which changed in
the tax reform in 2000. The prior rules could simplified be understood to make Capital
Gains taxable if the participation amounted to at least 10 %. By the tax reform, this was
lowered to 1 %. The transitional rules could simply be explained to state that the new
threshold applied to domestic participations from 2002 and to foreign participations al-
ready from 2001. The claimant sold his around 2 % Danish participations in 2001 and was
taxed on that gain. The Hamburg Tax Court doubted if the different treatment of domestic
and foreign participations was in line with the free movement of capital and referred the
case to the ECJ.
270 C- 265/04. 271 C- 436/06.
64
The German government argued that the different treatment was during a transition phase,
for which a Member State has certain discretion. Under the imputation system, taxation of
corporate profits was at corporate level exclusively. This gave shareholders an credit in or-
der to avoid double taxation. In the new half inclusion system, taxation of corporate profits
was achieved by an interaction of tax at company and shareholder level, so that the 10 %
Capital Gain threshold had to be lowered. For the shareholder, the imputation system ap-
plied in 2001 to domestic Dividends but the new system was already applicable to foreign
Dividends. The ECJ commented that as the half inclusion system was introduced to abol-
ish discrimination between domestic and foreign investments, it could hardly be denied
that shareholders of domestic and foreign companies where in comparable situations.
The ECJ acknowledged that the argument of full tax on corporate profits explains why the
half inclusion system did not apply to shareholders of domestic corporations before 2002:
Since these were subject to the old rules in 2000, Dividends distributed in 2001 were still
taxed wholly at corporate level. However, this did not justify the treatment of shareholders
of foreign corporations in 2001. Here, the ‘full taxation’ at corporate level was not achieved
in any case, since the foreign corporation profits were taxed abroad. The ECJ accordingly
declared that the free movement of capital precludes such a rule as the German one.
The ECJ handed down its judgement on 18th December 2007 stating that different treat-
ment due to the place of investment deters taxpayers from investing in foreign corpora-
tions and constitutes an obstacle for the latter raising capital in Germany.
4.4.3 Conclusion
As it doesn’t exist any explicit fiscal sovereignity for the EC law, it is easy to understand the
ECJ, which is not having any stable rules to follow, how it acts in the situations when a tax
related case comes up. The court is not able to build up anything, as it is the role of the
positive integration. Instead it is destroying the actions which are in a breach with the es-
tablished goals for the EU. The tax matters are thereby ruled on general principles which
indirectly have consequences for the taxation. Further on can’t the rules from the ECJ be
understood as being applicable totally as it still is a national sovereignity how an individual
person would be treated in taxation. The decisions from the ECJ should not be in breach
but they should be considered to be as a part of the trial in the domestic court.
65
The ECJ has been following the principle of discrimination with respect to the fundamen-
tal freedoms, and in the case of portfolio holding, has especially the most useful rules came
from the free movement of capital. The analized judgements have been made on a ‘case by
case’ basis which makes it difficult to establish a doctrine of the test of discrimination. This
lead to a legal uncertainty and it would be useful for MSs to not be feeling lost. By this it is
also understood the need of a fiscal sovereignity in the EC law. However would this be a
sensitive question as a nation wouldn’t enjoy to be in the situation of not being able to pro-
vide itself.
For instance from the cases of Lenz and Mannien is it clear that a full tax credit method is
preferred before an ordinary credit method. With the same approach made by the Savings
Directive, it could be understood that the EC law with both the positive integration and
negative integration is uniformed on how to be using the methods for relieving double
taxation for portfolio holders.
The previously mentioned conclusion, that an Exemption method would be better than a
Credit method, doesn’t seem to be following the same line as the EC law. This should
mean that not exclusively the interest of the tax payer, but also the involved jurisdictions
need to be financed, is considered by the EC law. Which option is optimal for all involved
parts is however a pure economical topic.
Finally can it be argued that in general has the ECJ gradually been eliminating the withhold-
ing taxes of cross-border Dividends which are within the EU, regardless of the availability
or the lack of double tax treaty benefits. But this does not apply in relations to third coun-
tries. This conclusion is also drawed by Kent.272
5 Summary
Taxation is a great body, more than just a juridical issue, affected by political, social and
economic factors. Countries are protecting its interest and justifying their approach to tax
an income. This interest is sometimes crossing the jurisdiction leading to a situation which
272 p. 7 Kent.
66
can constitute a double taxation. The double taxation is not in the interest of the state nor
the tax subject and actions are taken to make it disappear.
The two frequent approaches are by an unilateral and by a bilateral approach. Both can be
using practically the same double tax reliefs, but the bilateral approach is a better way than
the unilateral method, as it also helps to omit double non-taxation. The issue starts with
double taxation and continues to how to eliminate it. The most frequently used way to deal
with this is by DTT. The question is however how effective this way is as other options ex-
ists, and it could be argued if we need any option at all. The DTT are a negiotiation and
hopefully a win-win situation for all involved parties. By the DTT it is further a possibility
to deal with an economic double taxation. This approach is however of small importance
and rarely used.
The EU is another great body, which is founded by the ECT, establishing fundamental
rights for the MSs. The fundamental rights are however sometimes violated and indirectly
are tax consequences elaborating. The EU is not having a strong positive integration and
the most established tax law in the EU is made by the ECJ. The court has accepted the
Models to help MSs to solve how a treatment of for instance Dividends could be in rela-
tion to the established free movement of capital. The DTTs do also constitute an exchange
of information which should be used more heavily as it is only through communication the
bilateral approach can be used. In relation to capital mobility is it even a bigger possibility
to widen opportunities for tax evation and avoidance which should stress developed coun-
tries to use an effective information exchange. The Savings Directive for instance is a good
start, but it is a question how it comes that it is not dealing with all savings. The possibility
to omit the Directive by tax planning is constituting a big loophole. The modes are though
functioning well and it doesn’t seem to be an issue, once they are in force.
A portfolio holder is in the given situation the most relevant ‘tax subject’ because of having
the greatest capital mobility. The portfolio holder is however often not having a definition
and when it exists it doesn’t mean it is having the same definition in another state. Tax
consequences arises which are making the legal uncertainty strong and with the ‘unsteady’
EC law in the area of direct taxation I wonder if it wouldn’t be useful to find an autonom
definition under DTT. The definition could also be existing on a European level if coun-
tries would give away their fiscal sovereignity to the positive integration. Such a sensitive
matter is difficult to be negotiating on.
67
The taxes which are appearing for portfolio holders are Capital Gains taxes and withhold-
ing tax made on Dividends.
I consider Capital Gains taxation as a need to exist for the fairness in a country, it would in
the long run be otherwise a goal for tax subjects to become subjects to exclusively tax-free
investments. However is the issue the principle of realization which with regard to present
macroeconomic health would be unfair itself. A person who for instance has bought a
stock with the hope to be holding it for a couple of years, has in the beginning of the bear-
ish stockmarket seen a decrease of the value, and perhaps forcing her to sell the stock. The
taxation in this situation could be with a higher rate because of a short term holding, the
same or non existent. To ‘punish’ a portfolio holder for the worldeconomy would be hard
and it doesn’t makes sense in comparison to pension funds who can be considered as tax
free subjects. The savings in pension funds and savings funds do have similarities as both
are a saving for the future.
To the withholding tax on the gross amount of income, has the ECJ in general founded it
to be a restriction to the internal market and thereby is a stable approach taken to eliminate
the phenomen.
The EU as a body has further shown its power in relation between countries having a
DTT. The three major Models, which are as negotiation forms, have either been accepted
because of an approach the ECJ finds fair, or been turned down due to discrimination by
the actions. The US have for instance to be careful with the, fundamental for the US
Model, definition on resident, and thereby the limitation on benefits.
The reduction in the risk of unintended use of the treaty by third state residents through
better use of the existing treaty restrictions and the development of additional provisions to
curb treaty shopping.
It cannot be overestimated how great importance the exchange of information is having
for a good tax system, including the neutrality and thereby in the situation of cross-bording
capital. The importance is existing in all the three major Models and further done, but in an
unsuccessful way, by the Savings Directive. The European approach is with consideration
to both act clair and positive integration striving to find a Credit method within the EU.
Hopefully is this approach the optimal one for all involved parties.
68
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