Lankhorst-Hohorst GmbH v. Finanzamt Steinfurt (Case C-324/00)

Before the Court of Justice of the European

Communities (Fifth Chamber)

ECJ (5th Chamber) (Presiding, Wathelet (Rapporteur) P.C.; Timmernamns,

Edward, Jann and Rosas JJ.) Jean Mischo, Advocate General.

December 12, 2002

H1 Reference from Germany by the Finanzgericht (Finance Court) Muenster,

under Art.234 EC

H2 Establishment--taxation--German corporation tax law--interest on loan capital paid by resident subsidiary to non-resident parent company--direct taxation within national competence--requirement for compliance with EC law-- non-discrimination on nationality--different tax treatment depending on seat of parent company--exercise of freedom of establishment less attractive--contrary to Art.43 EC--possible grounds for justification--preventing tax evasion-- ensuring coherence of tax system--not justified--ensuring effectiveness of fiscal supervision--no evidence. H3 The appellant, a company whose registered office was in Germany, received a loan from its sole shareholder, another company whose registered office was in The Netherlands. Under Art.8(a) of German corporation law, repayment of loan capital would constitute a covert distribution of profits if obtained by a company subject to corporation tax from a shareholder not entitled to corporation tax credit. The Finance Office argued that the interest paid by the appellant fell within that category and should be taxed as such at a rate of 30 per cent. The appellant argued that the German provision was contrary to Art.43 EC as all non-resident shareholders were not entitled to corporation tax credit and, therefore, would have to be taxed at that rate. It was the consistency of the German law with Art.43 EC that formed the subject matter of the reference to the Court. *694 Held: National legislation contrary to Art.43 EC H4 (a) Although direct taxation fell within national competence, Member States should exercise that competence consistently with Community law. In particular,

they should avoid any discrimination on grounds of nationality. [26] Wielockx (C-80/94): [1995] E.C.R. I-2493; [1995] 3 C.M.L.R. 85; Asscher (C-107/94): [1996] E.C.R. I-3089; [1996] 3 C.M.L.R. 61; Royal Bank of Scotland (C-311/97): [1999] E.C.R. I-2651; [1999] 2 C.M.L.R. 973; Baars (C-251/98): [2000] E.C.R. I-2787; [2002] 1 C.M.L.R. 49; Joined Cases Metallgesellschaft (C-397/98 and 410/98): [2001] E.C.R. I-1727; [2001] 2 C.M.L.R. 32, followed. H5 (b) The German provision under review gave rise to a difference in treatment between resident subsidiary companies according to the seat of their parent company. If the latter was also resident and, hence, entitled to tax credit, interest paid on loan capital provided by the resident subsidiary would be treated as expenditure. If, however, it was non-resident, interest paid on loan capital provided by the resident subsidiary would be treated as a covert dividend at a rate of 30 per cent. Such a difference was, in principle, prohibited by Art.43 EC. This was because the German measure made it less attractive for companies established in other Member States to exercise freedom of establishment. In consequence, they might refrain from acquiring, creating or maintaining a subsidiary in the State which adopted that measure. [27]-[32] Possible grounds for justification not applicable to the measure in question H6 (a) The German measure would be justified by pressing reasons of public interest if it pursued a legitimate aim compatible with the EC Treaty in a manner which would ensure achievement of that aim and would not go beyond what was necessary for that purpose. [33] Futura Participations and Singer (C-250/95): [1997] E.C.R. I-2471; [1997] 3 C.M.L.R. 483; Verkooijen (C-35/98): [2000] ECR I-4071; [2002] 1 C.M.L.R. 48, followed. H7 (b) Reduction in tax revenue did not constitute an overriding reason in the public interest which might justify a measure which was in principle contrary to a fundamental freedom. [34]-[36] ICI (C-264/96): [1998] E.C.R. I-4695; [1998] 3 C.M.L.R. 293; Verkooijen (C-35/98): [2000] E.C.R. I-4071; [2002] 1 C.M.L.R. 4; Joined Cases Metallgesellschaft (C-397/98 and 410/98): [2001] E.C.R. I-1727; [2001] 2 C.M.L.R. 32; Saint-Gobain Zn (C-307/97): [1999] E.C.R. I-6161; [2001] 3 C.M.L.R. 34, followed. H8 (c) Tax evasion was neither a justification as the measure in question did not have the specific purpose of preventing wholly artificial arrangements designed to circumvent German tax legislation from attracting a tax benefit. Instead, it applied generally to any situation in *695 which the parent company had its seat, for whatever reason, outside Germany. Such a situation did not, of itself, entail a risk of tax evasion, since such a company would in any event be subject to the tax legislation of the State in which it was established. Indeed, according to the referring court, no abuse had been proved in the present case. [37]-[38] ICI (C-264/96): [1998] E.C.R. I-4695; [1998] 3 C.M.L.R. 293, followed. H9 (d) The need to ensure the coherence of the tax system might justify rules which restricted the free movement of persons. That had been held to be the case where the tax payer was one and the same person. In Bachmann and Commission v Belgium, for instance, there was a link between deductibility of

pension and life assurance contributions and taxation of the sums received under those insurance contracts. In such a case, the preservation of that link would have been necessary to safeguard the coherence of the relevant tax system. However, that was not the case as regards the German rule at issue. Indeed, there was no such link where the subsidiary of a non-resident parent company suffered less favourable tax treatment and the German Government had not pointed to any tax advantage to offset such treatment. [39]-[42] Bachmann (C-204/90): [1992] E.C.R. I-249; [1993] 1 C.M.L.R. 785; Commission v Belgium (C-300/90): [1992] E.C.R. I-305; [1993] 1 C.M.L.R. 785, distinguished. Wielockx (C-80/94): [1995] E.C.R. I-2493; [1995] 3 C.M.L.R. 85; Svensson and Gustavsson (C-484/93): [1995] E.C.R. I-3955; Eurowings Luftverkehrs (C-294/97): [1999] E.C.R. I-7447; [2001] 3 C.M.L.R. 64; Verkooijen (C-35/98): [2000] E.C.R. I-4071; [2002] 1 C.M.L.R. 4; Baars (C-251/98): [2000] E.C.R. I-2787; [2002] 1 C.M.L.R. 49, considered. H10 (e) The need to ensure effectiveness of fiscal supervision did not justify the German measure. This was because no argument had been put before the Court to show how the German rules classifying repayments of loan capital as a covert distribution of profits were of such a nature as to enable the German tax authorities to supervise the amount of taxable income. [43]-[44] H11 Representation W-D Plessing, T Jürgensen and G Mükker-Gatermann (in the oral proceedings only), acting as Agents, for the German Government. J. Molde, acting as Agent, for the Danish Government. J E Collins, acting as Agent, assisted by R Singh, Barrister, for the United Kingdom Government. R Lyal, acting as Agent, assisted by R Bierwagen, Rechtsanwalt, for the Commission of the European Communities. J Schirmer and J A Schirmer (in the oral proceedings only), Steuerberater. *696 H12 Cases referred to in the judgment: 1. Asscher (PH) v Staatssecretaris Van Financien (C-107/94), June 27, 1996: [1996] E.C.R. I-3089; [1996] 3 C.M.L.R. 61. 2. Baars v Inspecteur der Belastingdienst Particulieren/Ondernemingen (C-251/98): [2000] E.C.R. I-2787; [2002] 1 C.M.L.R. 49. 3. Bachmann v Belgium (C-204/90), January 28, 1992: [1992] E.C.R. I-249; [1993] 1 C.M.L.R. 785. 4. Commission of the European Communities v France (270/83): [1986] E.C.R. 273. 5. Commission of the European Communities v Belgium (C-300/90), January 28, 1992: [1992] E.C.R. I-305; [1993] 1 C.M.L.R. 785. 6. Compagnie de Saint-Gobain, Zweigniederlassung Deutschland v Finanzamt Aachen-Innestadt (C-307/97), September 21, 1999: [1999] E.C.R. I-6161; [2001] 3 C.M.L.R. 34. 7. Eurowings Luftverkehrs AG v Finanzamt Dortmund-Unna (C-294/97), October

26, 1999: [1999] E.C.R. I-7447; [2001] 3 C.M.L.R. 64. 8. Futura Participations SA v Administration des Contributions (C-250/95), May 15, 1997: [1997] E.C.R. I-2471; [1997] 3 C.M.L.R. 483. 9. Imperial Chemical Industries Plc (ICI) v Kenneth Hall Colmer (H.M. Inspector of Taxes) (C-264/96), July 16, 1998: [1998] E.C.R. I-4695; [1998] 3 C.M.L.R. 293. 10. Metallgesellschaft v Commissioners of Inland Revenue and H.M. Attorney General (C 397 & 410/98), March 8, 2001: [2001] E.C.R. I-1727; [2001] 2 C.M.L.R. 32. 11. Royal Bank of Scotland Plc v Elliniko Dimosio (Greece) (C-311/97), April 29, 1999: [1999] E.C.R. I-2651; [1999] 2 C.M.L.R. 973. 12. Staatssecretaris Van Financien v Verkooijen (C-35/98), June 6, 2000: [2000] ECR I-4071; [2002] 1 C.M.L.R. 48. 13. Svensson and Gustavsson (C-484/93), November 14, 1995: [1995] E.C.R. I-3955. 14. Wielockx v Inspecteur der Directe Belastingen (C-80/94), August 11, 1995: [1995] E.C.R. I-2493; [1995] 3 C.M.L.R. 85. H13 Further cases cited by the Advocate General: 15. Amministrazione delle Finanze dello Stato v Simmenthal SpA (No.2) (106/77), March 9, 1978: [1978] E.C.R. 629; [1978] 3 C.M.L.R. 263. 16. Bautiaa and Société Française Maritime (C 197 & 252/94), February 13, 1996: [1996] E.C.R. I-505. *697 17. Centros Ltd v Erhvervs-og Selskabsstyrelsen (C-212/97), March 9, 1999: [1999] E.C.R. I-1459; [1999] 2 C.M.L.R. 551. 18. Commission of the European Communities v Italy (48/71), July 13, 1972: [1972] E.C.R. 529. 19. Gilly v Directeur des Services Fiscaux du Bas-Rhin (C-336/96), May 12, 1998: [1998] E.C.R. I-2793; [1998] 3 C.M.L.R. 607. 20. Ministerio Publico v Epson Europe BV (C-375/98), June 8, 2000: [2000] E.C.R. I-4243; [2002] 3 C.M.L.R. 4.

Opinion of Advocate General Mischo [FN1] FN1 Delivered on September 26, 2002. AG1 The Finanzgericht (Finance Court) Münster, Germany, asks the Court to interpret Art.43 EC in a case in which, under German tax legislation, repayment of interest by a subsidiary established in Germany to its parent company whose corporate seat is in the Netherlands was reclassified as a covert distribution of profits.

I --The national legal framework

AG2 The Körperschaftsteuergesetz (Law on Corporation Tax, hereinafter the "KStG"), in para.8a(1) (capital borrowed from shareholders) of the version in force from 1996 to 1998, provides as follows: Repayments in respect of loan capital which a company limited by shares subject to unlimited taxation has obtained from a shareholder not entitled to corporation tax credit which had a substantial holding in its share or nominal capital at any point in the financial year shall be regarded as a covert distribution of profits ... 2. where repayment calculated as a fraction of the capital is agreed and the loan capital is more than three times the shareholder's proportional equity capital at any point in the financial year, save where the company limited by shares could have obtained the loan capital from a third party under otherwise similar circumstances or the loan capital constitutes borrowing to finance normal banking transactions. ... AG3 According to para.51 of the KStG: Exclusion of entitlement to tax credit and offsetting of corporation tax If the shareholder is not liable to tax on receipts within the meaning of Heads 1 to 3 of para.20(1) or Head 2a of para.20(2) or if, under Head 1 or 2 of para.50(1), those receipts are not included in the taxable amount, there can be no tax credit or offsetting of corporation tax under Head 3 of para.36(2) of the Einkommensteuergesetz (Law on Income Tax).

*698 II --The facts AG4 Lankhorst-Hohorst GmbH (hereinafter "Lankhorst-Hohorst"), a limited liability company incorporated under German law, whose registered office is in Rheine, Germany, is engaged in the sale of boating equipment, goods for watersports, leisure and craft items, leisure and work clothing, furnishings, hardware and similar goods. In August 1996 it increased its share capital to 2,000,000 DM. AG5 Lankhorst-Hohorst's sole shareholder is Lankhorst-Hohorst BV (hereinafter "LH BV"), which has its registered office in the Netherlands, at Sneek. The sole shareholder in the latter is the, likewise Dutch, company Lankhorst Taselaar BV (hereinafter "LT BV"), whose registered office is in Lelystad, the Netherlands. AG6 By agreement of December 1, 1996, LT BV granted Lankhorst-Hohorst a loan of 3,000,000 DM, repayable over 10 years in annual instalments of 300,000 DM from October 1, 1998. The variable interest rate was 4.5 per cent until the end of 1997. Interest was payable at the end of the year. LT BV thus received interest of 135,000 DM in 1997, and then 109,695 DM in 1998. AG7 The loan was intended as a substitute for capital. It was accompanied by a "Patronatserklärung" (letter of support) under which LT BV would waive repayment of the loan if third party creditors made claims against Lankhorst-Horhorst. AG8 The loan enabled Lankhorst-Hohorst to reduce its borrowing from AMRO-Bank Münster from 3,702,453.59 DM to 911,174.70 DM and therefore to reduce its interest burden. AG9 For 1996, 1997 and 1998, the plaintiff's balance sheet showed a deficit not

covered by equity capital. For 1998 this was DEM 1 503 165, the final balance being 428,21 DM. AG10 In its corporation tax assessment notices for 1997 and 1998, of June 28, 1999, the tax authorities treated the interest paid to LT BV as a distribution of profits within the meaning of para.8a of the KStG and taxed it as such at the rate of 30 per cent (under Head 3 of para.27(1) of the KStG). AG11 According to the referring court, the exception in the second sentence of para.8a(1) of the KStG, for cases where the company in question could have obtained the loan capital from a third party under identical terms, could not apply. In view of the plaintiff's excessive indebtedness and its inability to provide security, it could not in fact have obtained a similar loan (granted without security and with a letter of support) from any third party. AG12 By a decision of February 14, 2000, the tax authorities rejected the objection lodged by the plaintiff against the corporation tax assessment notices. AG13 In support of its action before the referring court, Lankhorst-Hohorst states that the grant of the loan by the Netherlands shareholder was a rescue attempt by it and that the interest paid to that *699 shareholder could not be classified as a covert distribution of profits. It argues, further, that para.8a of the KStG is discriminatory in view of the treatment it affords German shareholders who are entitled to the tax credit (unlike LH BV and LT BV which have their corporate seats in the Netherlands) and, consequently, contrary to Community law and to Art.43 EC in particular. AG14 Lankhorst-Hohorst adds that it is necessary to have regard to the spirit and purpose of para.8a of the KStG, which is to prevent evasion of tax payable on the assets of companies limited by shares. In the present case, however, the loan was granted with the sole objective of minimising Lankhorst-Hohorst's costs and it enabled it to make significant savings on bank interest. The plaintiff points out in that regard, that, before modification of the bank loan, the interest was twice as high as that thereafter payable to LT BV. This is accordingly not a case in which a shareholder which is not entitled to deduct the tax paid by its subsidiaries is seeking to circumvent tax on true distributions of profits by authorising payments of interest to itself. AG15 The Finanzamt Steinfurt (Steinfurt Tax Office) recognises that application of para.8a of the KStG could exacerbate the situation of firms and companies in difficulties. However, the clear wording of the provision, in its view, precludes any other interpretation in the light of its spirit and purpose. In that connection, the referring court likewise accepts that the wording of the paragraph does not suggest that, in addition to the factual requirements, there must also be evasion in order for the provision to apply. AG16 The tax authorities take the view that para.8a of the KStG does not conflict with the Community principle of non-discrimination. Many countries have provisions with a similar objective, primarily in relation to abuse in specific cases, based on the proportion of equity capital to debt capital. AG17 The Finanzamt states that the distinction made in para.8a of the KStG between those who are entitled to the tax credit and those who are not does not entail covert discrimination on the basis of nationality since para.51 in

conjunction with para.5 of the KStG (on exemption from corporation tax) also excludes several categories of German taxable persons from entitlement to the tax credit. AG18 Lastly, according to the Finanzamt, the principle of once-only taxation and the coherence of the German tax system justify applying para.8a of the KStG in the circumstances of the main proceedings. AG19 The Finanzgericht Münster, citing the case law of the Court of Justice, [FN2] expresses doubts as to whether para.8a of the KStG is compatible with Art.43 EC. It draws attention to the fact that, according to the case law of this Court, a national of a Member State *700 who has a holding in the capital of a company established in another Member State which gives him definite influence over the company's decisions and allows him to determine its activities is exercising his right of establishment. [FN3] FN2 See, in particular Commission v France (C-270/83): [1986] E.C.R. 273; Royal Bank of Scotland (C-311/97): [1999] E.C.R. I-2651; [1999] 2 C.M.L.R. 973; and Eurowings Luftverkehrs (C-294/97): [1999] E.C.R. I-7447; [2001] 3 C.M.L.R. 64. FN3 Baars (C-251/98): [2000] E.C.R. I-2787; [2002] 1 C.M.L.R. 49. AG20 According to the referring court, there is infringement of the right to freedom of establishment where the different tax treatment of a subsidiary is based solely and without further objective justification on the fact that its sole shareholder, the parent company, has its corporate seat in a different Member State from that in which the subsidiary is established. AG21 It observes, in that connection, that the rule in para.8a of the KStG is not linked directly to nationality but to whether the taxable person enjoys the tax credit. Legal persons not entitled to tax credit are essentially, under the KStG, German corporations which are exempt from corporation tax and foreign shareholders who do not have their holding in the capital of a German limited company in the form of German operating assets. AG22 Under those circumstances, a shareholder established in a different Member State is systematically subject to the rule in para.8a of the KStG whereas, of shareholders established in Germany, only a clearly defined category of taxable persons is exempt from corporation tax and is not, in consequence, entitled to the tax credit (that is to say, as a general rule, corporations governed by public law and those carrying on business in a specific field and performing tasks which should be encouraged). The latter category of corporations is not, it believes, in a position comparable to that of the plaintiff's parent company. AG23 As regards the justification for applying para.8a of the KStG, the referring court points out that a party can only rely on considerations relating to the coherence of the tax system where there is a direct link between a fiscal advantage accorded, on the one hand, and taxation, on the other, in respect of the same taxable person. [FN4] There is, in its view, no such link in the present

case. FN4 Judgment of the Bundesfinanzhof of December 30, 1996, I B 61/96, Bunderssteuerblatt Part II 1997, p.466, and Eurowings Luftverkehrs, cited above.

III --The question referred for a preliminary ruling AG24 In view of the foregoing, the Finanzgericht Münster, by order of August 21, 2000, stayed the proceedings and, under Art.234 EC, referred the following question to the Court of Justice for a preliminary ruling: Is the requirement of freedom of establishment for nationals of a Member State in the territory of another Member State laid down in Art.43 of the Treaty of November 10, 1997 establishing the European Community to be interpreted as precluding the national rule contained in para.8a of the German Körperschaftsteuergesetz?

*701 IV --Analysis

A --Application of Art.43 EC in the present case AG25 It is necessary to examine, first of all, whether Art.43 EC applies to a case such as that now under consideration. AG26 The plaintiff argues that the arrangements established by Head 2 of para.8a(1) of the KStG have the effect, essentially, of taxing subsidiaries differently according to whether their parent company is resident or not. AG27 The Court of Justice examined this issue at length in its judgment in Metallgesellschaft. [FN5] The Court ruled as follows: 37 It should be remembered that, according to settled case law, although direct taxation falls within their competence, Member States must nonetheless exercise that competence consistently with Community law and avoid any discrimination on grounds of nationality. [FN6] ... FN5 Metallgesellschaft (C 397 & 410/98): [2001] E.C.R. I-1727; [2001] 2 C.M.L.R. 32. FN6 Wielockx (C-80/94): [1995] E.C.R. I-2493; [1995] 3 C.M.L.R. 85, para. [16]; Asscher (C-107/94): [1996] E.C.R. I-3089; [1996] 3 C.M.L.R. 61, para. [36]; Royal Bank of Scotland, cited above, para.[19]; and Baars, cited above, para.[17]. 41 Art.52 of the [EC Treaty (now, after amendment, Art.43 EC)] constitutes one of the fundamental provisions of Community law and has been directly applicable in the Member States since the end of the transitional period. Under that provision, freedom of establishment for nationals of one Member State within the territory of another Member State includes the right to take up and pursue activities as self-employed persons and to set up and manage undertakings under the conditions laid down for its own nationals by the law of the country

where such establishment is effected. The abolition of restrictions on freedom of establishment also applies to restrictions on the setting up of agencies, branches or subsidiaries by nationals of any Member State established in the territory of another Member State. [FN7] FN7 Commission v France, cited above, para.[13]; and Royal Bank of Scotland, cited above, para.[22]. 42 Freedom of establishment thus defined includes, pursuant to Art.58 of the Treaty, the right of companies or firms formed in accordance with the law of a Member State and having their registered office, central administration or principal place of business within the Community, to pursue their activities in the Member State concerned through a branch or agency. [FN8] With regard to companies, it should be noted in this context that it is their corporate seat in the above sense that serves as the connecting factor with the legal system of a particular State, like nationality in the case of natural persons. [FN9] Acceptance of the proposition that the Member State in which a company seeks to establish itself may freely apply to it a different treatment solely by reason of the fact that its corporate seat is situated in another Member State would thus deprive Art.52 of all meaning. [FN10] FN8 ICI (C-264/96): [1998] E.C.R. I-4695; [1998] 3 C.M.L.R. 293 *702 , para.[20], and the case law cited therein; and Saint-Gobain Zn (C-307/97): [1999] E.C.R. I-6161; [2001] 3 C.M.L.R. 34, para.[34]. FN9 ICI, cited above, para.[20], and the case law cited therein; and Saint-Gobain Zn, cited above, para.[35]. FN10 Commission v France, cited above, para.[18]. AG28 Specifically, it is therefore necessary to examine whether, as was the case in Metallgesellschaft [FN11] for subsidiaries established in the United Kingdom, subsidiaries established in Germany are treated differently according to whether or not their parent company has its corporate seat in Germany. FN11 Para.43.

The existence of a difference of treatment arising from the criterion used in Head 2 of para.8a(1) of the KStG

AG29 It emerges from reading the provision at issue, that is to say, Head 2 of para.8a(1) of the KStG, and from the commentary by the referring court, that it applies only to remuneration in respect of the loan capital which a company limited by shares subject to unlimited taxation, in the instant case, Lankhorst-Hohorst, has obtained "from a shareholder not entitled to corporation tax credit". AG30 The referring court states that those shareholders which are not entitled to the tax credit "are essentially, under Art.51 of the KStG, German corporations

which are exempt from corporation tax and foreign shareholders who do not have their holding in the capital of a German limited company in the form of German operating assets". AG31 According to the German Government, the fact that a significant number of German taxpayers are also excluded from the right to the tax credit proves that the criterion based on entitlement to the tax credit is not discriminatory. AG32 This argument is not, however, compelling. AG33 As the referring court, Lankhorst-Hohorst and the Commission rightly point out, the category of German undertakings which are not entitled to the tax credit is not an appropriate reference group for making a comparison with foreign taxpayers who are not, as a general rule, entitled to it. Undertakings in the first group are in fact intrinsically different from those which, like the plaintiff's parent company, are involved in commercial activities and operate with a view to a profit. AG34 The undertakings comparable to the latter are, in contrast, resident parent companies which are involved in commercial activities. The comparison should therefore be with their treatment and that of their subsidiaries. AG35 Already in the Eurowings Luftverkehrs case, cited above, the German Government put forward an argument similar to the one it is now advancing in this case. It then asserted that the contested obligation on the lessee to make add-backs to the taxable amount for trade tax applied wherever the lessor was not liable to that trade tax, whether he was established in Germany or in another Member State. [FN12] FN12 Para.25. AG36 The Court of Justice, however, rejected that argument and stated as follows: *703 35 In that regard, it is to be noted that in the main action the obligation to make the add-backs provided for in para.8(7) and para.12(2) of the [Gewerbesteuergesetz] is always applicable for German undertakings leasing goods from lessors established in another Member State, since the latter are never liable to pay the trade tax, whereas that obligation does not apply, in most cases, for German undertakings leasing goods from lessors established in Germany, the latter being generally liable to the tax, save in the rare instances mentioned in paras 25 to 27 of this judgment. 36 The legislation at issue in the main case therefore establishes tax rules which differ, in the large majority of cases, according to whether the provider of the services is established in Germany or in another Member State. AG37 In the present case, likewise, the legislation at issue in the main proceedings amounts to the establishment of different tax rules according to whether the parent company, that is to say, the shareholder in the subsidiary, is established in Germany or in another Member State. AG38 Head 2 of Art.8a(1) of the KStG, therefore, invariably applies, ratione personae, where a resident subsidiary such as Lankhorst-Hohorst has obtained loan capital from its non-resident parent company, whereas that is not true, under

the same circumstances, for a resident subsidiary which has received loan capital from its resident parent company. AG39 The German Government's reference at the hearing to a worked example submitted by it at the request of the Court does not refute that finding. AG40 Basing itself on that example, the German Government asserted that a resident subsidiary which had obtained loan capital from a resident shareholder could likewise be subject to reclassification of the remuneration on that capital as a distribution of dividends. AG41 It is appropriate, nonetheless, to reproduce the German Government's accompanying commentary to the worked example, which states as follows: It should be recalled that in the main action the lender, which, through a wholly-owned subsidiary, indirectly controls the borrower, provided a letter of support (Patronatserklärung) for the loan, waiving repayment if third party creditors made claims against the borrower. The loan was therefore intended as a substitute for capital. Wherever a shareholder declares that he wishes to be taken into account for the purposes of his claim only after satisfaction of all the undertaking's creditors and,--until the crisis is averted--not before but only at the same time as calls by its co-shareholders for repayment of their contributions, [FN13] the loan commitment should not be entered as a liability in the trading and tax accounts of the lender in the form of loan capital. The loan is converted into equity capital. If, in the main action, the terms of the letter of support are to be interpreted in that way, then the tax treatment, in a situation with no foreign element, is as follows (as shown by an example): [worked example]. FN13 See judgment of the Bundesgerichtshof of January 8, 2001, Part II, ZR 88/89 DStR pp.175, 176. AG42 *704 That commentary shows that reclassification, in the worked example, is based fundamentally on there being a "Patronatserklärung" (the Bundesgerichtshof uses the expression "Rangrücktrittserklärung"). However, such a prerequisite for reclassification is quite different from the requirements set out in Head 2 of para.8a(1) of the KStG, which attaches no importance to the presence of a "Patronatserklärung". AG43 Even though, in the present case, Lankhorst-Hohorst did obtain such a letter from its parent company, the fact remains that it was subject to reclassification, not by reason of that "Patronatserklärung", but on the basis of Head 2 of para.8a(1) of the KStG. AG44 Since subsidiaries in the same position as Lankhorst-Hohorst, but whose parent company is resident, cannot be subject to such a reclassification--the provision in issue not applying to them--the German Government cannot claim that Lankhorst-Hohorst received the same treatment as those subsidiaries. AG45 Having therefore established that there is a difference of treatment, it is necessary now to examine its consequences. It seems to me beyond doubt that the difference operates solely to the detriment of a resident subsidiary which has obtained loan capital from a non-resident parent company.

AG46 I note that it follows from the order for reference that, as the result of application of Head 2 of para.8a(1) of the KStG, the interest paid by Lankhorst-Hohorst was taxed as a covert payment of dividends at a rate of 30 per cent. AG47 It is apparent, conversely, from information provided at the hearing by counsel for Lankhorst-Hohorst and not disputed by the German Government, that, where there is no reclassification, earnings derived from loan interest are taxed in the hands of the resident parent company which receives that interest. AG48 The result is therefore that, if the requirements for the application of Head 2 of para.8a(1) of the KStG are satisfied, a subsidiary which has obtained loan capital from a non-resident parent company is subject to taxation in respect of the interest in question, whereas a subsidiary which has obtained loan capital from a resident parent company is not. AG49 Furthermore, according to the explanation given by the referring court, where a shareholder is entitled to the tax credit, the tax on the distribution of dividends is set against its personal income tax. That is not so where the shareholder is not entitled to a tax credit, which, as has already been seen, is invariably the position with shareholders resident abroad. AG50 The German Government, moreover, confirmed at the hearing that, by operation of the tax credit, the amount of tax payable at the level of the Federal budget is zero for a group consisting of a resident parent company and resident subsidiary. Conversely, if the parent company is *705 non-resident, the tax paid by the subsidiary on the distribution of dividends represents, according to the German Government, a final charge. AG51 That difference of treatment linked to entitlement to the tax credit, even if one takes the view that it affects the position of the non-resident parent company (in the present case, LT BV) rather than that of the subsidiary (Lankhorst-Hohorst), is likewise liable to infringe Art.43 EC. AG52 As the referring court rightly points out with reference to the Baars judgment, a national of a Member State who has a holding in the capital of a company established in another Member State which gives him definite influence over the company's decisions is exercising his right of establishment. That is indisputably true of LT BV which holds 100 per cent of the capital in Lankhorst-Hohorst. AG53 Lastly, unlike the German Government, I am of the view that freedom of financing is in fact more restricted as regards the options for financing the resident subsidiary of a non-resident parent company than as regards the options for financing the resident subsidiary of a resident parent company. AG54 The German Government maintains, on that point, that the loan to which Head 2 of para.8a(1) of the KStG relates nonetheless remains loan capital and is not reclassified as equity capital. AG55 Be that as it may, the fact remains that such financing is treated, from a fiscal point of view, as a capital contribution. AG56 The effect of Head 2 of para.8a(1) of the KStG is, consequently, such that, if the requirements for application of that provision are satisfied, a non-resident parent company can no longer usefully opt to finance its subsidiary by using loan

capital. Its freedom of financing is therefore, in practice, more limited than that of a resident parent company.

Existence of an overriding requirement of general interest justifying the difference of treatment

AG57 Since it seems to me to have been established that the second sentence of para.8a(1) of the KStG does give rise to a difference of treatment, whether to the detriment of the resident subsidiary of a non-resident parent company or of the non-resident parent company itself, it is necessary to examine whether there is an overriding requirement of general interest which justifies that difference. [FN14] FN14 See, in particular, Futura Participations and Singer (C-250/95): [1997] E.C.R. I-2471; [1997] 3 C.M.L.R. 483, para.[26]; and Verkooijen (C-35/98): [2000] E.C.R. I-4071; [2002] 1 C.M.L.R. 48, para.[43]. AG58 The referring court describes the purpose of that provision as being "to prevent shareholders not entitled to the tax credit from circumventing the once only imposition of corporation tax on distributed profits intended by the law by endowing a company limited by shares with loan capital rather than equity capital". AG59 More particularly, the German, United Kingdom and Danish *706 Governments and the Commission submit that the provision in question is a rule adopted to combat under-capitalisation ("thin capitalisation"). AG60 The Danish Government states that such rules were adopted in a series of countries, both inside and outside the European Union, as economies become increasingly internationalised and as the need to prevent tax avoidance makes itself increasingly felt. AG61 That Government submits that by their very nature the rules on thin capitalisation only relate, in fact, to cross-border transactions. In the situation of a transaction between two fully-taxable domestic companies, the tax-deductible interest expense of one company will be equal to the earnings from taxable interest of the other and the net result will be fiscally neutral for the group. It is only where the transactions take place between companies having their registered offices in different countries that the tax debt can be transferred from one country to another. AG62 Accordingly, in the view of the Danish Government, in the event of an injection of funds by a parent company into a subsidiary in the form of a capital loan instead of a capital contribution, the profits of the subsidiary are transferred to the parent company in the form of deductible interest instead of non-deductible dividends. If the two companies are in different countries, the tax debt can in that way be transferred from one country to another at the will of the parties to the transaction. AG63 The governments which lodged observations are thus in agreement that, since the rules on thin capitalisation are intended to prevent the arbitrary transfer of the tax debt from one country to another and to ensure that the tax is charged

in the place where the profit was actually made, there can be no finding of discrimination between the tax arrangements applicable to cross-border operations and those applicable to domestic operations. AG64 Those same governments refer to Art.9 of the model convention drawn up by the Organisation for Economic Cooperation and Development (hereinafter the "OECD model convention") for the prevention of double taxation. [FN15] That article provides for the add-back *707 of profits for tax purposes, where transactions take place between associated enterprises (parent company and subsidiaries or companies under common control) on other than market terms (the "arm's length principle"). FN15 According to Art.9 of the OECD model convention, 1. Where (a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or (b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State, and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly. 2. Where a Contracting State includes in the profits of an enterprise of that State-- and taxes accordingly--profits on which an enterprise of the other Contracting State has been charged to tax in that other State and the profits so included are profits which would have accrued to the enterprise of that first-mentioned State if the conditions made between the two enterprises had been those which would have been made between independent enterprises, then that other State shall make an appropriate adjustment to the amount of the tax charged therein on those profits. In determining such adjustment, due regard shall be had to the other provisions of this Convention and the competent authorities of the Contracting States shall if necessary consult each other. AG65 According to the German Government, Head 2 of para.8a(1) of the KStG is the embodiment of that principle, primarily in the field of returns which are independent of the profits and turnover of the company. AG66 The Commission also believes that the difference of treatment deriving from para.8a of the KStG can be justified by its purpose, which is to ensure the taxation of profits in Germany in the case of undertakings not entitled to a tax credit and accordingly the correct allocation of the right to tax and the related tax revenue. In other terms, it is a matter of preventing thin capitalisation abuses, by preventing the covert distribution of dividends in the form of interest, which reduces the annual results of the subsidiary and thereby diminishes the tax revenue of the relevant Member State. AG67 However, according to the Commission, the rule in para.8a of the KStG must also comply with the principle of proportionality. The Commission points out

that the rule prescribes the proportion of loan capital to equity capital and makes an exception where loan capital could also have been made available by an unconnected third party on the same conditions. AG68 However, the Commission refers to the risk of double taxation in this case: the German undertaking is subject to German corporation tax on profits distributed whilst the foreign shareholder still has to declare in the Netherlands, as earnings, amounts it has received in the form of interest. In the view of the Commission, a Member State which classifies an interest payment as a covert distribution of profits must also ensure that there is liaison on the matter with the State in which the parent company is registered, so that a corresponding adjustment can be made. In the absence of any such adjustment, the risk of double taxation cannot be ruled out. AG69 The Commission submits that, in the present case, Art.9(2) of the OECD model convention may afford the outline of a solution. In its view, the model convention, whilst consistent with the principle of proportionality, ensures the correct sharing of the right to tax, on the one hand, and the tax revenue of the Member States involved, on the other. AG70 What should one make of those arguments? AG71 The question is what is the true purpose of rules on thin *708 capitalisation, of which, according to the interveners, Head 2 of para.8a(1) of the KStG is one. AG72 Is the purpose to protect, in general terms, the financial soundness of a subsidiary by compelling it to have sufficient equity capital? AG73 That is what the German Government is suggesting in asserting that "a shareholder wishing to rescue its company must inject supplementary equity capital. Loan capital would, moreover, be economically damaging to the undertaking at such a juncture. Any new interest-bearing loan creates new costs for the company, which even further exacerbate its financial situation". AG74 It seems clear to me, however, that protecting the financial soundness of subsidiaries is not the true purpose of the tax legislation at issue in the main proceedings. Were that the purpose, the thin capitalisation rule would also have to apply to the subsidiaries of a resident parent company, which is not the case. AG75 The real purpose of the thin capitalisation rule in the form of Head 2 of para.8a(1) of the KStG is therefore to prevent Germany from losing a portion of its revenue in the form of taxation, owing to the use by the taxpayer (or its shareholder) of a financing mechanism which is not in itself prohibited. AG76 That purpose is confirmed not only by the explanations of the referring court and those expounded by the interveners, but also by academic commentary on Head 2 of para.8a(1) of the KStG and on the thin capitalisation rules in general. [FN16] FN16 See, in particular, Menck, in Blümich, Einkommensteuer-Körperschaftsteuer-Gewerbesteuer. Kommentar, KStG s.8a(2): "Bei Steuerausländern soll die Einmalerfassung des in Deutschland erwirtschafteten Gewinns gewährleistet bleiben und damit die deutsche Besteurerungshoheit gegenüber dem Ausland zur Geltung gebracht warden", and Sommerhalder,

R.A., "Approaches to Thin Capitalisation", European Taxation, 1996, p.82, 82: "The expression thin capitalisation is commonly used to describe a situation where the proportion of debt to equity exceeds certain limits and thin capitalisation legislation is a tool used by tax authorities to prevent what they regard as a leakage of tax revenues as a consequence of the way in which a corporation is financed". Sometimes, the mere title is eloquent. See, e.g., Hey, F.E.F., "To Stop Revenue Loss, Germany Reconsiders Thin Capitalisation Rules", Journal of International Taxation (1993) at p.264. AG77 It does not seem to me, however, that such an objective can amount, in the context of Art.43 EC, to an overriding requirement of general interest justifying a difference of treatment. AG78 It is settled case law that "diminution of tax revenue cannot be regarded as a matter of overriding general interest which may be relied upon in order to justify a measure which is, in principle, contrary to a fundamental freedom". [FN17] FN17 Metallgesellschaft, cited above, para.[59] of the judgment. See also the judgments in ICI, cited above, para.[28], and Verkooijen, cited above, para.[59]. AG79 The fact that the thin capitalisation rules supposedly comply with *709 Art.9 of the OECD model convention does not, in my view, alter the position. AG80 Indeed, assuming that such compliance were established, [FN18] it must still be pointed out that the fact that the rules are consistent with the provisions of the OECD model convention does not also mean that they comply with Art.43 EC. Neither the provisions nor the objectives of the OECD model convention, on the one hand, or of the EC Treaty, on the other, are in fact the same. FN18 See, however, for a negative view as regards compliance with certain provisions of the OECD model convention, Knobbe-Keuk, B., "Wieder einmal ein Entwurf zu § 8a KStG--Wiederauflage einer Regelung zur Gesellschaftfremdfinanzierung im Standortssicherungsgesetz", Der Betreib (1993) at pp.60, 63-65, and Meilicke, W., "Zur Vereinbarkeit des § 8a mit dem gemeinschaftrechlichen Diskriminierungsverbot", Steuerrecht (2000) at pp.748, 748. AG81 Admittedly, nothing precludes an interpretation of the EC Treaty, so far as possible, in accordance with an OECD model convention. [FN19] However, I take the view that it is not possible to do so in the present case, always assuming that a provision such as Head 2 of para.8a(1) of the KStG does comply with Art.9 of the OECD model convention. FN19 See, e.g., Gilly (C-336/96): [1998] E.C.R. I-2793; [1998] 3 C.M.L.R. 607, para.[31]. AG82 Article 43 EC does not, admittedly, prevent Member States from taxing profits generated in their territories and in that sense does not affect their

jurisdiction in relation to fiscal policy. However, it establishes a restriction on that freedom in that it cannot be exercised in a way which gives rise to discrimination. That is an inescapable fact, irrespective of anything which the provisions of the OECD model convention may permit. AG83 The German and the United Kingdom Governments also consider that Head 2 of para.8a(1) of the KStG is justified by the overriding requirement of general interest consisting of the need to ensure the coherence of the applicable tax systems. [FN20] FN20 Bachmann (C-204/90): [1992] E.C.R. I-249; [1993] 1 C.M.L.R. 785, para. [21]; Commission v Belgium (C-300/90): [1992] E.C.R. I-305; [1993] 1 C.M.L.R. 785, para.[14]; Baars, cited above, para.[37]; and Metallgesellschaft, cited above, para.[67]. AG84 In that connection, however, it must be pointed out, as did the referring court, that the Court of Justice has stated that such an overriding requirement exists only if the fiscal coherence is "established in relation to one and the same person by a strict correlation" between a tax advantage and unfavourable tax treatment. [FN21] FN21 Wielockx, cited above, para.[24]. See also Svensson and Gustavsson (C-484/93): [1995] E.C.R. I-3955, para.[18]; Eurowings Luftverkehrs, cited above, para.[42]; and Baars, cited above, para.[40]. AG85 The German Government does not indicate what tax advantage offsets the unfavourable tax treatment of the subsidiary of a non-resident parent company to which Head 2 of para.8a(1) of the KStG applies. AG86 I therefore do not find that a rule such as the provision at issue here is *710 justified by a need to preserve the coherence of the applicable tax systems. AG87 The German Government also submits that the rule in para.8a of the KStG is justified as a measure intended to combat abuse. AG88 It refers, in that regard, to para.24 of the Centros judgment, [FN22] which states that ... according to the case law of the Court a Member State is entitled to take measures designed to prevent certain of its nationals from attempting, under cover of the rights created by the Treaty, improperly to circumvent their national legislation or to prevent individuals from improperly or fraudulently taking advantage of provisions of Community law ... FN22 Centros (C-212/97): [1999] E.C.R. I-1459; [1999] 2 C.M.L.R. 551. AG89 It is necessary, however, to point out in that connection that the tax legislation at issue in the main proceedings covers, generally, any situation in which the parent company is, for any reason whatsoever, established outside Germany. Such a finding was sufficient for the Court to reject the argument based on the risk of tax avoidance put forward by the United Kingdom

Government in the ICI case. [FN23] FN23 Para.[26] of the judgment. AG90 Thus, according to the Court of Justice, "... the establishment of a company outside the United Kingdom does not, of itself, necessarily entail tax avoidance, since that company will in any event be subject to the tax legislation of the State of establishment". [FN24] FN24 Ibid. See, also, Metallgesellschaft, cited above, para.[57]. AG91 The fact that the provision at issue "does not have the specific purpose of preventing wholly artificial arrangements, set up to circumvent [the] tax legislation" [FN25] of Germany is, moreover, confirmed by the facts of the present case. FN25 ICI, cited above, para.[26] of the judgment. AG92 The provision at issue here applies to a situation in which, according to the findings of the referring court itself, there was no abuse, since the loan was made "to prevent financial disaster on the part of the plaintiff and to reduce the burden of loan interest arising from banking commitments". AG93 Additionally, as pointed out above, a resident parent company, as a result of the tax credit, can set the tax on the distribution of dividends against its personal income tax, which a non-resident parent company is not able to do. AG94 That gives rise, in economic terms, to a higher tax charge for the group of a non-resident parent company than for the group of a resident parent company, which cannot be ascribed merely to a concern to combat tax avoidance. [FN26] FN26 Similar considerations led the Court of Justice to reject the argument based on the risk of tax avoidance in Metallgesellschaft, cited above, para. [58] of the judgment. AG95 I therefore take the view that the need to combat tax avoidance does *711 not, in the present case, constitute an overriding requirement of general interest justifying the difference of treatment deriving from a rule such as the provision at issue. AG96 Lastly, it is necessary to examine the argument put forward by the United Kingdom Government in Futura Participations and Singer, in which the Court of Justice held, in para.31, that ... the effectiveness of fiscal supervision constitutes an overriding requirement of general interest capable of justifying a restriction on the exercise of fundamental freedoms guaranteed by the Treaty .... AG97 It suffices, however, in that regard, to note that the present case does not concern tax supervision in the true sense, as distinct from the situation in the Futura Participations and Singer case, which related to the requirement that the

taxpayer keep accounts in compliance with certain rules in the Member State in which tax is to be charged so that the tax authorities of that Member State can ascertain the amount of taxable income. AG98 Having regard to the foregoing, I am therefore of the view that there is no overriding requirement of general interest justifying the difference of treatment deriving from a rule such as the provision at issue. Such a rule is therefore, in my view, contrary to Art.43 EC. AG99 It falls to the German authorities to determine whether the provision in issue should be replaced by, e.g., a provision extending to subsidiaries with a resident parent company the rules on the reclassification of interest as dividends. [FN27] In the meantime, however, the provision at issue cannot be applied. [FN28] FN27 See Scheffler, W., "Der Einfluss der Steuerreform auf die Finanzierung von deutschen Kapitalgesellschaften", Steuerrecht (2000) at pp.2441, 2447. FN28 See, in particular, Commission v Italy (48/71): [1972] E.C.R. 529, paras [6]-[8]; and Simmenthal (106/77): [1978] E.C.R. 629; [1978] 3 C.M.L.R. 263, para.[17].

B --Application of Directive 90/435 AG100 In response to a question from the Court of Justice, the parties gave their views on the relevance which Council Directive 90/435 of July 23, 1990 on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States [FN29] may have for resolution of the dispute in the main proceedings. FN29 [1990] O.J. L225/6. AG101 The Danish Government states that, were this an instance of an overt distribution of dividends, that distribution would, by virtue of Art.5(1) of Directive 90/435, be exempt from withholding tax. Accordingly, a covert distribution should receive the same treatment. AG102 In contrast, the German Government, the United Kingdom Government and the Commission consider that Art.5(1) of Directive *712 90/435 does not relate to the tax at issue. In their view, that tax is not a withholding tax but normal taxation of the profits of the subsidiary, in the form of corporation tax. AG103 The Commission further adds that to hold in any other way would have the effect of totally prohibiting any so-called "thin capitalisation" rules. The Commission believes that such rules are a useful tool in achieving fair taxation. AG104 Neither of those two arguments that Directive 90/435 should not apply is, however, convincing. AG105 The fact that, under German tax legislation, the present case concerns a tax on the profits of the subsidiary, in the form of corporation tax, does not also mean that Directive 90/435 does not apply. AG106 As the Court of Justice held in AthinaÏki Zythopoiia, [FN30]

26 [I]n order to determine whether the taxation of distributed profits pursuant to the Greek legislation at issue in the main proceedings falls within the scope of Art.5(1) of the directive, it is necessary, first, to refer to the wording of that provision. The term withholding tax contained in it is not limited to certain specific types of national taxation. [FN31] FN30 (C-294/99): [2001] E.C.R. I-6797. FN31 See Epson Europe (C-375/98): [2000] E.C.R. I-4243; [2002] 3 C.M.L.R. 4, para.[22]. 27 Second, it is settled case law that the nature of a tax, duty or charge must be determined by the Court, under Community law, according to the objective characteristics by which it is levied, irrespective of its classification under national law. [FN32] FN32 See, in particular, Joined Cases Bautiaa and Société Française Maritime (C-197/94) and (C-252/94): [1996] E.C.R. I-505, para.[39]. AG107 By the same token, in my view the fact that classification of the tax at issue as a withholding tax within the meaning of Art.5(1) of Directive 90/435 would, as the Commission claims, have the effect of completely prohibiting any "thin capitalisation" rules does not preclude such a classification. AG108 Article 5(1) of Directive 90/435 does not provide for any exceptions allowing non-application of that provision in order to protect the "thin capitalisation" rules. AG109 I endorse the Danish view that Art.5(1) of Directive 90/435 does apply to the tax at issue. AG110 It seems to me that the considerations which led the Court of Justice, in the AthinaÏki Zythopoiia case, cited above, to classify the tax at issue in the main proceedings as a withholding tax are present in this case also. AG111 Specifically, the Court of Justice held that "... the chargeable event for the taxation at issue in the main proceedings ... is the payment of dividends. In addition, the amount of tax is directly related to the size of the distribution". [FN33] FN33 AthinaÏki Zythopoiia *713 , cited above, para.[28]. AG112 Further, according to the Court, ... [t]he taxation relates to income which is taxed only in the event of a distribution of dividends and up to the limit of the dividends paid. That is shown by the fact (inter alia) that, as the applicant in the main proceedings and the Commission have pointed out, the increase in the basic taxable amount generated, in accordance with Art.106(2) and (3) of the Income Tax Code, by the distribution of profits cannot be offset by the subsidiary using negative income from previous tax years, contrary to the fiscal principle enabling losses to be carried forward

which is nevertheless laid down in Greek law. [FN34] FN34 Ibid., para.[29]. AG113 In the instant case, the event giving rise to the taxation is likewise the payment of (covert) dividends and the amount of taxation is directly related to the size of the distribution. AG114 Moreover, as can be inferred from the order for reference, Lankhorst-Hohorst was not able to offset, against losses from previous years, the increase in its basic taxable amount resulting from the application of Head 2 of para.8a(1) of the KStG. AG115 The Commission further suggests that Head 2 of para.8a(1) of the KStG could fall within the exception in Art.1(2) of Directive 90/435, according to which that directive "... shall not preclude the application of domestic or agreement-based provisions required for the prevention of fraud or abuse". AG116 That argument cannot, however, be accepted. AG117 If, as indicated above, Head 2 of para.8a(1) of the KStG and the difference of treatment deriving from that provision are not justified by an overriding requirement of general interest consisting of the need to combat tax avoidance, it necessarily follows that the same provision cannot be found to be justified by the need to combat fraud and abuse, as permitted by Art.1(2) of Directive 90/435. AG118 The inevitable conclusion is, therefore, in my view, that Directive 90/435 does not apply to the tax at issue. AG119 That said, I take the view that, even if Germany exempted from withholding tax the covert distribution of profits within the meaning of Head 2 of para.8a(1) of the KStG, that would not necessarily remove the discrimination for the purposes of Art.43 EC. AG120 Where, e.g., the subsidiary of a non-resident parent company is not authorised to deduct, from its total taxable amount, interest paid to its parent company as an expense under the same conditions as the subsidiary of a resident parent company, there could still be discrimination even if there were no withholding of tax.

V --Conclusion AG121 Having regard to the foregoing considerations, I propose that the Court should reply to the Finanzgericht Münster as follows: Article 43 EC precludes application of a rule such as that *714 contained in Head 2 of para.8a(1) of the Körperschaftsteuergesetz (Law on Corporation Tax). JUDGMENT 1 By order of August 21, 2000, received at the Court on September 4, 2000, the Finanzgericht (Finance Court) Münster referred to the Court of Justice for a preliminary ruling under Art.234 EC a question on the interpretation of Art.43 EC. 2 That question was raised in proceedings brought by Lankhorst-Hohorst GmbH

(hereinafter "Lankhorst-Hohorst"), a company established in Rheine, Germany, against the Finanzamt Steinfurt, a German tax authority, concerning payment of corporation tax for 1997 and 1998. The national legislation 3 Paragraph 8a of the Körperschaftsteuergesetz (Law on corporation tax), in the version in force from 1996 to 1998 (hereinafter "the KStG"), is headed "Capital borrowed from shareholders". Paragraph 8a(1) provides as follows: Repayments in respect of loan capital which a company limited by shares subject to unlimited taxation has obtained from a shareholder not entitled to corporation tax credit which had a substantial holding in its share or nominal capital at any point in the financial year shall be regarded as a covert distribution of profits, ... 2. where repayment calculated as a fraction of the capital is agreed and the loan capital is more than three times the shareholder's proportional equity capital at any point in the financial year, save where the company limited by shares could have obtained the loan capital from a third party under otherwise similar circumstances or the loan capital constitutes borrowing to finance normal banking transactions. ... 4 It is apparent from the order for reference that there is no entitlement to corporation tax credit, first, for non-resident shareholders and, second, for corporations governed by German law which are exempt from corporation tax, namely legal persons governed by public law and those carrying on business in a specific field or performing tasks which should be encouraged. The main proceedings and the question referred for a preliminary ruling 5 Lankhorst-Hohorst sells boating equipment, goods for watersports, leisure and craft items, leisure and work clothing, furnishings, *715 hardware and similar goods. In August 1996 its share capital was increased to 2,000,000 DM. 6 The sole shareholder in Lankhorst-Hohorst is Lankhorst-Hohorst BV (hereinafter "LH BV"), which has its registered office in the Netherlands, at Sneek. The sole shareholder in LH BV is Lankhorst Taselaar BV (hereinafter "LT BV"), which also has its registered office in the Netherlands, at Lelystad. 7 By agreement of December 1, 1996 LT BV granted Lankhorst-Hohorst a loan of 3,000,000 DM, repayable over 10 years in annual instalments of 300,000 DM from October 1, 1998 (hereinafter "the loan"). The variable interest rate was four and a half per cent until the end of 1997. Interest was payable at the end of each year. LT BV received interest payments of 135,000 DM in 1997 and 109,695 DM in 1998. 8 The loan, which was intended as a substitute for capital, was accompanied by a Patronatserklärung (letter of support) under which LT BV waived repayment if third party creditors made claims against Lankhorst-Hohorst. 9 The loan enabled Lankhorst-Hohorst to reduce its bank borrowing from 3,702,453.59 DM to 911,174.70 DM and thus to reduce its interest charges. 10 For 1996, 1997 and 1998, the balance sheet of Lankhorst-Hohorst showed a

deficit not covered by equity capital; in 1998 it amounted to 1,503,165 DM. 11 In its corporation tax assessment notices of June 28, 1999, in respect of the years 1997 and 1998, the Finanzamt Steinfurt took the view that the interest paid to LT BV was equivalent to a covert distribution of profits within the meaning of para.[8]a of the KStG and taxed Lankhorst-Hohorst on them as such at the rate of 30 per cent. 12 According to the Finanzgericht, the exception laid down in para.[8]a (1), Head 2, of the KStG for cases in which the company in question could also have obtained the loan capital from a third party under identical terms could not apply in the main proceedings. Having regard to the over-indebtedness of Lankhorst-Hohorst and its inability to provide security, it could not in fact have obtained a similar loan from a third party, granted without security and covered by a Patronatserklärung. 13 By decision of February 14, 2000, the Finanzamt Steinfurt rejected as unfounded the objection lodged by Lankhorst-Hohorst against the corporation tax assessment notices. 14 In support of its action before the National Court, Lankhorst-Hohorst stated that the grant of the loan by LT BV constituted a rescue attempt and that the interest repayments could not be classified as a covert distribution of profits. It also submitted that para.[8]a of the KStG was discriminatory in the light of the treatment accorded to German shareholders, who are entitled to the tax credit, unlike companies such as LH BV and LT BV which have their registered *716 offices in the Netherlands. Consequently, para.[8]a infringed Community law and Art.43 EC in particular. 15 Lankhorst-Hohorst added that regard should be had to the purpose of para. [8]a of the KStG, which is to prevent tax evasion by companies limited by shares. In the present case, however, the loan was granted with the sole objective of minimising the expenses of Lankhorst-Hohorst and achieving significant savings in regard to bank interest charges. Lankhorst-Hohorst claimed in that regard that, prior to reduction of the bank loan, interest charges had been twice the amount subsequently paid to LT BV. This is accordingly not a case of a shareholder with no right to a tax credit seeking to avoid tax chargeable on true distributions of profits by arranging for the payment of interest to itself. 16 The Finanzamt Steinfurt submitted that the application of para.[8]a of the KStG may indeed exacerbate the situation of companies in difficulty, but the German legislature had taken that circumstance into account in providing for an exemption in the third sentence of para.[8]a, Head 2, of the KStG. That exemption is not, however, applicable in the present case. The Finanzamt also submitted that the wording of para.[8]a does not suggest that the existence of tax evasion is one of the conditions for its application, and the Finanzgericht has confirmed that submission. 17 Nevertheless, the Finanzamt submitted that para.[8]a of the KStG is not contrary to the Community principle of non-discrimination. Many countries have adopted provisions with a similar objective, particularly in order to combat abuses. 18 The Finanzamt also submitted that the distinction made in para.[8]a of the

KStG--between persons who are entitled to tax credit and those who are not-- does not entail disguised discrimination on the basis of nationality, since para.[5], relating to exemption from corporation tax, read together with para. [51] of the KStG, also excludes several categories of German taxpayers from entitlement to tax credit. 19 The Finanzamt contends in addition that the principle of once-only levy of national taxation and the coherence of the German tax system justify the application of para.[8]a of the KStG in the circumstances of the main proceedings. 20 The Finanzgericht Münster has expressed doubts, in the light of the case law of the Court of Justice, as to the compatibility of para.[8]a of the KStG with Art.43 EC. [FN35] It observes that, according to the case law of the Court, a national of a Member State who has a holding in the capital of a company established in another Member State which gives him a definite influence over the company's decisions is exercising his right of establishment. [FN36] FN35 See, inter alia, Commission v France (C-270/83): [1986] E.C.R. 273 *717 ; Royal Bank of Scotland (C-311/97): [1999] E.C.R. I-2651; [1999] 2 C.M.L.R. 973; and Eurowings Luftverkehrs (C-294/97): [1999] E.C.R. I-7447; [2001] 3 C.M.L.R. 64. FN36 Baars (C-251/98): [2000] E.C.R. I-2787; [2002] 1 C.M.L.R. 49. 21 According to the Finanzgericht, there is an infringement of the right of establishment where the less favourable tax treatment of a subsidiary is based solely on the fact that the parent company has its seat in a Member State other than that in which the subsidiary is established and there is no objective justification for such treatment. 22 The Finanzgericht observes in that regard that the rule in para.[8]a of the KStG is not directly linked to nationality, but to whether the taxable person enjoys a tax credit. 23 It states that, in those circumstances, a shareholder which has its seat outside Germany is systematically subject to the rule in para.[8]a of the KStG, whereas, of shareholders established in Germany, only a clearly defined category of taxable persons is exempt from corporation tax and, in consequence, is not entitled to the tax credit. However, the latter category of corporations is not in a position comparable to that of the parent company of Lankhorst-Hohorst. 24 As regards the justification for applying para.[8]a of the KStG, the Finanzgericht observes that considerations relating to the coherence of the tax system may be relied on only where there is a direct link between a fiscal advantage granted to a taxable person and the taxation of that same taxable person. [FN37] In the present case, it can discern no such link. FN37 Judgment of the Bundesfinanzhof of December 30, 1996, I B 61/96, BStBl. II 1997, 466, and Eurowings Luftverkehrs, cited above, para.[42].

25 In the circumstances, the Finanzgericht decided to stay proceedings and to refer the following question to the Court for a preliminary ruling: Is the requirement of freedom of establishment for nationals of a Member State in the territory of another Member State laid down in Art.43 of the Treaty of November 10, 1997 establishing the European Community to be interpreted as precluding the national rule contained in para.[8]a of the German Körperschaftsteuergesetz? Reply of the Court 26 It should be remembered that, according to settled case law, although direct taxation falls within their competence, Member States must nonetheless exercise that competence consistently with Community law and, in particular, avoid any discrimination on grounds of nationality. [FN38] FN38 Wielockx (C-80/94): [1995] E.C.R. I-2493; [1995] 3 C.M.L.R. 85, para. [16]; Asscher (C-107/94): [1996] E.C.R. I-3089; [1996] 3 C.M.L.R. 61, para. [36]; Royal Bank of Scotland, cited above, para.[19]; Baars, cited above, para.[17]; and Joined Cases Metallgesellschaft (C-397/98) and (C-410/98): [2001] E.C.R. I-1727; [2001] 2 C.M.L.R. 32, para.[37]. The existence of an obstacle to freedom of establishment 27 Article 8a(1), Head 2, of the KStG applies only to "repayments in respect of loan capital which a company limited by shares subject to *718 unlimited taxation has obtained from a shareholder not entitled to corporation tax credit". As regards the taxation of interest paid by subsidiary companies to their parent companies in return for loan capital, such a restriction introduces a difference in treatment between resident subsidiary companies according to whether or not their parent company has its seat in Germany. 28 In the large majority of cases, resident parent companies receive a tax credit, whereas, as a general rule, non-resident parent companies do not. As stated in para.[4] of this judgment, corporations incorporated under German law which are exempt from corporation tax and, consequently, not entitled to tax credit are essentially legal persons governed by public law and those carrying out business in a specific field or performing tasks which should be encouraged. The situation of a company such as the parent company of Lankhorst- Hohorst, which is carrying on a business for profit and is subject to corporation tax, cannot validly be compared to that of the latter category of corporations. 29 It is therefore apparent that, under Art.8a(1), Head 2, of the KStG, interest paid by a resident subsidiary on loan capital provided by a non-resident parent company is taxed as a covert dividend at a rate of 30 per cent, whereas, in the case of a resident subsidiary whose parent company is also resident and receives a tax credit, interest paid is treated as expenditure and not as a covert dividend. 30 In reply to a question put by the Court, the German Government stated that

the interest paid by a resident subsidiary to its, likewise resident, parent company on a loan of capital from the parent company is also treated for tax purposes as a covert dividend in a case where the parent company has issued a Patronatserklärung. 31 That fact is not, however, such as to affect the existence of a treatment which differs according to the seat of the parent company. The classification of an interest payment as the covert distribution of profits results, in the case of a resident company which has received a loan from a non-resident parent company, solely and directly from application of para.[8]a(1), Head 2, of the KStG, irrespective of whether or not a Patronatserklärung has been issued. 32 Such a difference in treatment between resident subsidiary companies according to the seat of their parent company constitutes an obstacle to the freedom of establishment which is, in principle, prohibited by Art.43 EC. The tax measure in question in the main proceedings makes it less attractive for companies established in other Member States to exercise freedom of establishment and they may, in consequence, refrain from acquiring, creating or maintaining a subsidiary in the State which adopts that measure. Justification for the obstacle to freedom of establishment 33 It must still be established whether a national measure such as that in para.[8]a(1), Head 2, of the KStG pursues a legitimate aim which is compatible with the Treaty and is justified by pressing reasons of public *719 interest. In that event, it must also be such as to ensure achievement of the aim in question and not go beyond what is necessary for that purpose. [FN39] FN39 See, in particular, Futura Participations and Singer (C-250/95): [1997] E.C.R. I-2471; [1997] 3 C.M.L.R. 483, para.[26]; and Verkooijen (C-35/98): [2000] E.C.R. I-4071; [2002] 1 C.M.L.R. 48, para.[43]. 34 First, the German, Danish and United Kingdom Governments and the Commission submit that the national measure at issue in the main proceedings is intended to combat tax evasion in the form of the use of "thin capitalisation" or "hidden equity capitalisation". All things being equal, it is more advantageous in terms of taxation to finance a subsidiary company through a loan than through capital contributions. In such a case, the profits of the subsidiary are transferred to the parent company in the form of interest, which is deductible in calculating the subsidiary's taxable profits, and not in the form of a non-deductible dividend. Where the subsidiary and the parent company have their seats in different countries, the tax debt is therefore likely to be transferred from one country to the other. 35 The Commission adds that para.[8]a(1), Head 2, of the KStG does indeed provide for an exception in the case of a company which proves that it could have obtained the loan capital from a third party on the same conditions, and fixes the permissible amount of loan capital in comparison with equity capital. However, the Commission points to the existence, in the present case, of a risk of double taxation since the German subsidiary is subject to German taxation on interest paid, whereas the non-resident parent company must still declare the

interest received as income in the Netherlands. The principle of proportionality requires that the two Member States in question reach an agreement in order to avoid double taxation. 36 It is settled law that reduction in tax revenue does not constitute an overriding reason in the public interest which may justify a measure which is in principle contrary to a fundamental freedom. [FN40] FN40 See ICI (C-264/96): [1998] E.C.R. I-4695; [1998] 3 C.M.L.R. 293, para. [28]; Verkooijen, cited above, para.[59]; Metallgesellschaft, cited above, para.[59]; and Saint-Gobain Zn (C-307/97): [1999] E.C.R. I-6161; [2001] 3 C.M.L.R. 34 , para.[51]. 37 As regards more specifically the justification based on the risk of tax evasion, it is important to note that the legislation at issue here does not have the specific purpose of preventing wholly artificial arrangements, designed to circumvent German tax legislation, from attracting a tax benefit, but applies generally to any situation in which the parent company has its seat, for whatever reason, outside Germany. Such a situation does not, of itself, entail a risk of tax evasion, since such a company will in any event be subject to the tax legislation of the State in which it is established. [FN41] FN41 See, to that effect, ICI, cited above, para.[26]. 38 Moreover, according to the findings of the National Court itself, no abuse has been proved in the present case, the loan having been made *720 in order to assist Lankhorst-Hohorst by reducing the interest burden resulting from its bank loan. Furthermore it is clear from the case file that Lankhorst-Hohorst made a loss in the 1996, 1997 and 1998 financial years and its loss largely exceeded the interest paid to LT BV. 39 Second, the German and United Kingdom Governments submit that para. [8]a(1), Head 2, of the KStG is also justified by the need to ensure the coherence of the applicable tax systems. More specifically, that provision is in accordance with the arm's length principle, which is internationally recognised and pursuant to which the conditions upon which loan capital is made available to a company must be compared with the conditions which the company could have obtained for such a loan from a third party. Article 9 of the Model Convention of the Organisation for Economic Cooperation and Development (OECD) reflects that concern in providing for inclusion in profits for tax purposes where transactions are concluded between linked companies on conditions which do not correspond to market conditions. 40 In Bachmann and in Commission v Belgium [FN42] the Court held that the need to ensure the coherence of the tax system may justify rules which restrict the free movement of persons. FN42 Bachmann (C-204/90): [1992] E.C.R. I-249; [1993] 1 C.M.L.R. 785; and Commission v Belgium (C-300/90): [1992] E.C.R. I-305; [1993] 1 C.M.L.R. 785.

41 However, that is not the case with the rules at issue here. 42 Although in Bachmann and Commission v Belgium [FN43], since the taxpayer was one and the same person, there was a direct link between deductibility of pension and life assurance contributions and taxation of the sums received under those insurance contracts and preservation of that link was necessary to safeguard the coherence of the relevant tax system, there is no such direct link where, as in the present case, the subsidiary of a non-resident parent company suffers less favourable tax treatment and the German Government has not pointed to any tax advantage to offset such treatment. [FN44] FN43 Cited above. FN44 See, to that effect, Wielockxcited above, para.[24]; Svensson and Gustavsson (C-484/93): [1995] E.C.R. I-3955, para.[18]; Eurowings Luftverkehrs, cited above, para.[42]; Verkooijen, cited above, paras [56]-[58], and Baars, cited above, para.[40]. 43 Third, the United Kingdom Government, referring to para.[31] of the judgment in Futura Participations and Singer, submits that the national measure at issue here could be justified by the concern to ensure the effectiveness of fiscal supervision. 44 It is enough to find in that regard that no argument has been put to the Court to show how the classification rules contained in para.[8]a (1), Head 2, of the KStG are of such a nature as to enable the German tax authorities to supervise the amount of taxable income. 45 Having regard to all the foregoing considerations, the answer to be given to the National Court must be that Art.43 EC is to be interpreted as precluding a measure such as that contained in para.[8]a(1), Head 2, of the KStG. *721 Costs 46 The costs incurred by the German, Danish and United Kingdom Governments and by the Commission, which have submitted observations to the Court, are not recoverable. Since these proceedings are, for the parties to the main proceedings, a step in the action pending before the National Court, the decision on costs is a matter for that court. R1 Order On those grounds, THE COURT (Fifth CHAMBER), in answer to the question referred to it by the Finanzgericht Münster by order of August 21, 2000, HEREBY RULES: Article 43 EC is to be interpreted as precluding a measure such as that contained in para.[8]a(1), Head 2, of the Körperschaftsteuergesetz (Law on corporation tax).

(c) Sweet & Maxwell Limited [2003] 2 C.M.L.R. 22 END OF DOCUMENT