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Luiss Libera Università Internazionale degli Studi Sociali Guido Carli

CERADI Centro di ricerca per il diritto d’impresa

European and International Tax Moot Court Competition - 2005/2006

Memorandum for the applicant Memorandum for the defendant

Francesca Vitale Emanuela Cocco Andrea Sciarrillo Coordinamento della ricerca: Alessio Persiani e Federico Rasi Direzione della ricerca: Giuseppe Melis ed Eugenio Ruggiero

Marzo 2006

© Luiss Guido Carli. La riproduzione è autorizzata con indicazione della fonte o come altrimenti specificato. Qualora sia richiesta un’autorizzazione preliminare per la riproduzione o l’impiego di informazioni testuali e multimediali, tale autorizzazione annulla e sostituisce quella generale di cui sopra, indicando esplicitamente ogni altra restrizione

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Il presente lavoro nasce dalla partecipazione dell’Università Luiss Guido Carli alla European and

International Tax Moot Court Competition organizzata dalla European Tax College Foundation di

Lovanio.

Si tratta di una competizione che simula un processo, in cui le delegazioni di alcune università

europee ed americane si affrontano su uno specifico tema di diritto tributario internazionale e/o

comunitario.

Simulando un’udienza dinanzi alla Corte di Giustizia delle Comunità Europee in sede di rinvio

preliminare ex art. 234 Trattato CE, le differenti squadre hanno proceduto, in questa edizione, alla

redazione di un ricorso per illustrare le posizioni sia della parte ricorrente, sia di quella resistente, in

merito alla conformità al diritto comunitario di un ipotetico trattato contro la doppia imposizione

stipulato da una Stato Membro con uno Stato terzo contenente una clausola di limitazione dei

benefici (c.d. LOB clause).

I paragrafi 12 e 13 del Memorandum for the applicant ed i paragrafi 12 e 13 del Memorandum for

the defendant sono stati redatti dal dott. Andrea Sciarrillo. I restanti paragrafi del Memorandum for

the applicant sono stati redatti dalla dott.ssa Emanuela Cocco. I restanti paragrafi del Memorandum

for the defendant sono stati redatti dalla dott.ssa Francesca Vitale.

Il dott. Alessio Persiani ed il dott. Federico Rasi hanno assistito gli studenti nella preparazione dei

lavori e nella successiva fase orale.

I lavori sono stati diretti dal Prof. Giuseppe Melis e dal Dott. Eugenio Ruggiero quali team coach

della delegazione LUISS.

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MEMORANDUM FOR THE APPLICANT

TABLE OF CONTENTS

I. LIST OF SOURCES..............................................................................................................................9

II. STATEMENT OF FACTS...................................................................................................................13

III. ISSUES..........................................................................................................................................18

IV. ARGUMENTS.................................................................................................................................22

1. GENERAL REMARKS ON THE METHOD..............................................................................................22

PART A: STATE A-US TAX TREATY AND THE FREEDOM OF ESTABLISHMENT......................................24

2. THE EC TREATY DEFINITION OF THE RIGHT OF ESTABLISHMENT.....................................................24

2.1. APPLICABILITY OF THE RIGHT OF ESTABLISHMENT........................................................... 25

3. THE LOB PROVISIONS OF ART. 20, (1) (a) (i), OF STATE A-US TAX TREATY AND THE RESTRICTION

TO THE RIGHT OF ESTABLISHMENT.......................................................................................................26

3.1. THE RESTRICTION TO THE RIGHT OF ESTABLISHMENT IS NOT JUSTIFIED............................ 27

3.1.1. COHERENCE OF THE NATIONAL TAX SYSTEM......................................................28

3.1.2. PREVENTION OF TAX EVASION AND TAX REVENUE REDUCTION..........................29

3.1.3. THE PRINCIPLE OF PROPORTIONALITY................................................................29

4. ART. 20, (1) (a) (i), CONSTITUTES A BREACH OF EC LAW IN RELATION TO THE FREEDOM OF

ESTABLISHMENT..................................................................................................................................30

PART B: STATE A-US TAX TREATY AND THE FREE MOVEMENT OF CAPITAL.......................................32

5. THE SCOPE OF APPLICATION OF THE FREEDOM OF CAPITAL MOVEMENTS.........................................32

5.1. APPLICABILITY OF THE FREE MOVEMENT OF CAPITAL.......................................................32

6. THE LOB PROVISIONS OF ART. 20, (1) (a) (ii), OF STATE A-US TAX TREATY AND THE RESTRICTION

TO THE FREE MOVEMENT OF CAPITAL..................................................................................................33

6.1. THE RESTRICTION TO THE FREE MOVEMENT OF CAPITAL IS NOT JUSTIFIED........................34

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6.1.2. PREVENTION OF TAX EVASION AND TAX REVENUE LOSS.....................................35


7. ART. 20, (1) (a) (ii), CONSTITUTES A BREACH OF EC LAW IN RELATION TO THE FREE MOVEMENT OF

CAPITAL...............................................................................................................................................35

8. THE FREE MOVEMENT OF CAPITAL IN RELATION TO THIRD COUNTRIES............................................37

8.1. APPLICABILITY OF THE FREE MOVEMENT OF CAPITAL IN RELATION TO THIRD

COUNTRIES..........................................................................................................................................37

9. RESTRICTION TO THE FREE MOVEMENT OF CAPITAL IN RELATION TO THIRD COUNTRIES..................38

PART C: THE MEMBER STATES’ EXTERNAL TAX TREATY-MAKING POWER.........................................39

10. EXTERNAL TAX TREATY-MAKING POWER IN THE AREA OF DIRECT TAXATION...............................39

11. CONCLUSIONS................................................................................................................................40

PART D: STATE A’S LIABILITY FOR THE BREACH OF EC LAW..............................................................42

12. THE CONDITIONS FOR MEMBER STATES’ LIABILITY.......................................................................42

12.1. ARTICLES 43 AND 56 ECT CONFER RIGHTS ON INDIVIDUALS..........................................43

12.2. THE “SUFFICIENTLY SERIOUS BREACH” TEST..................................................................44

12.3. THE LINK OF CAUSATION.................................................................................................45

13. ASSESSMENT OF DAMAGES............................................................................................................46

V. ANNEXES........................................................................................................................................47

VI. LIST OF ABBREVIATIONS..............................................................................................................50

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MEMORANDUM FOR THE DEFENDANT

TABLE OF CONTENTS

I. LIST OF SOURCES............................................................................................................................52

II. STATEMENT OF FACTS..................................................................................................................59

III. ISSUES..........................................................................................................................................64

IV. ARGUMENTS.................................................................................................................................68

1. GENERAL REMARKS ON THE METHOD.............................................................................................68

PART A: THE MEMBER STATES’ EXTERNAL TAX TREATY-MAKING POWER.......................................71

2. THE COMMUNITY EXTERNAL POWERS............................................................................................71

3. MEMBER STATES RETAIN THEIR EXCLUSIVE TREATY-MAKING POWER IN THE AREA OF DIRECT

TAXATION...........................................................................................................................................72

3.1. IN SUBSIDIARY ORDER: MEMBER STATE A HAS THE EXCLUSIVE POWER TO NEGOTIATE

THE A-US TAX TREATY……………………………………………….................................. 74

3.2. STATE A HAD THE EXCLUSIVE POWER TO NEGOTIATE THE LOB CLAUSE IN THE STATE A-

US TREATY.............................................................................................................................75

PART B: COMPATIBILITY OF THE STATE A–US TAX TREATY WITH THE EC TREATY AND THE

FUNDAMENTAL FREEDOMS................................................................................................................77

4. THE LOB CLAUSE IS COMPATIBLE WITH THE NON-DISCRIMINATION PRINCIPLE…………………77

5. THE LOB CLAUSE IS COMPATIBLE WITH THE FREEDOM OF ESTABLISHMENT.................................78

5.1. THE EC TREATY DEFINITION OF THE RIGHT OF ESTABLISHMENT ……………………….78

5.2 APPLICABILITY OF THE RIGHT OF ESTABLISHMENT………………………………………79

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6. THE LOB PROVISIONS OF ART. 20, (1) (A) (I), OF STATE A-US TAX TREATY DO NOT CONSTITUTE

A RESTRICTION TO THE RIGHT OF ESTABLISHMENT............................................................................81

6.1. IN SUBSIDIARY ORDER: THE ASSERTED RESTRICTION TO THE FREE MOVEMENT OF CAPITAL

IS NOT JUSTIFIED.....................................................................................................................82


6.1.2. PREVENTION OF TAX EVASION AND TAX REVENUE LOSS.....................................84


7. ART. 20, (1) (A) (I), DOES NOT CONSTITUTE A BREACH OF EC LAW IN RELATION TO THE FREEDOM

OF ESTABLISHMENT............................................................................................................................85

8. THE FREEDOM OF CAPITAL MOVEMENT DOES NOT APPLY TO THE LOB

CLAUSES.............................................................................................................................................85

8.1. IN SUBSIDIARY ORDER: THE LOB PROVISIONS OF STATE A-US TAX TREATY DO NOT

RESTRICT THE FREE MOVEMENT OF CAPITAL........................................................................86

8.2. THE RESTRICTION TO THE FREE MOVEMENT OF CAPITAL IS JUSTIFIED………………..87

9. ART. 20, (1) (A) (II), DOES NOT CONSTITUTE A BREACH OF EC LAW IN RELATION TO THE FREE

MOVEMENT OF CAPITAL....................................................................................................................88

PART C. THE FREE MOVEMENT OF CAPITAL IN RELATION TO THIRD COUNTRIES.............................89

10. THE FREEDOM OF CAPITAL MOVEMENT WITH THIRD COUNTRIES HAS A NARROWER SCOPE

EXTERNAL TAX TREATY-MAKING POWER IN THE AREA OF DIRECT TAXATION....................................89

10.1 THE LOB CLAUSE IS COMPATIBLE WITH THE FREE MOVEMENT OF CAPITAL WITH THIRD

COUNTRIES…………………………………………………………………………………...90

11. CONCLUSIONS................................................................................................................................91

PART D: THE ISSUE OF STATE A’S LIABILITY FOR THE BREACH OF EC LAW.......................................93

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12. THE CONDITIONS FOR MEMBER STATES’ LIABILITY.......................................................................94

12.1. DIRECT EFFECT OF ARTICLES 43 AND 56 ECT……………............................................94

12.2. THE “SUFFICIENTLY SERIOUS BREACH” TEST.................................................................. 94

12.3. THE LINK OF CAUSATION.................................................................................................98

13. QUESTIONS ABOUT THE ASSESSMENT OF DAMAGES.......................................................................98

V.

ANNEXES..........................................................................................................................................100

VI. LIST OF ABBREVIATIONS...........................................................................................................103

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European Tax Moot Court Competition 2005/2006

MEMORANDUM FOR THE APPLICANT

Registration number: E/001

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I. LIST OF SOURCES

Scholars

BECKER H.-THOMMES O., Treaty shopping and EC Law, Critical notes to Article 28 of the New

German-US Double Taxation Convention, in European taxation, 1991, p. 173.

CLARK B., The limitation on benefits clause under an open sky, in European taxation, 2003, p. 22.

CRAIG A., Open your eyes: what the “Open Skies” cases could mean for the US Tax Treaties with

the EU Member States, in Tax Bulletin, 2003, p. 63.

DAHLBERG M., New tax Treat between Sweden and the US raises questions about Treaty

shopping, in Intertax, 1997, p. 295.

DOYLE H., Is Article 26 of the Netherlands-United States Tax Treaty compatible with EC Law?, in

European taxation, 1995, p. 14.

HILSON C., The role of discretion in EC law on non-contractual liability, in Common market law

review, 2005, p. 689 and ff.

HINNEKENS L., Compatibility of Bilateral Tax Treaties with European Community Law.

Application of the Rules, in EC Tax Review, 1995, p. 202.

HINNEKENS L., Compatibility of Bilateral Tax Treaties with European Community Law. The

Rules, in EC Tax Review, 1994, p. 146

HINNEKENS L., The search for framework conditions of the fundamental EC Treaty principles as

applied by the European Court to Member States’ direct taxation, in EC Tax Review, 2002, p. 112.

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MALHERBE J. – DELATTRE O., Compatibility of Limitation on Benefits provisions with EC Law,

in European taxation, 1996, p. 12.

MARTIN-JIMENEZ A. J., EC Law and Clauses on “Limitation on benefits” in Treaties with the

US after Maastricht and the US-Netherlands Tax Treaty, in EC Tax Review, 1995, p. 78.

PANAYI C., Ships and taxes: does the case of Commission v. Netherlands have tax implications?,

in EC tax review, 2005, p. 97.

PISTONE P., Towards European international tax law, in EC Tax Review, 2005, p.4.

RIENKS S., An EU view on the New Protocol to the Tax Treaty between the US and the

Netherlands, in Intertax, 2004, p. 567.

STAHL K., Free movement of capital between Member States and third countries, in EC Tax

Review, 2004, p. 47.

TERRA B.J.M. – WATTEL P.J., European tax law, The Hague, 2005, p. 48.

TRIDIMAS T., Liability for breach of Community law: growing up and mellowing down?, in

Common market law review, 2001, p. 301.

VAN DEN HURK H., Is the ability of the Member States to conclude tax treaties chained up?, in

EC Tax Review, 2004, p. 17.

European Court of Justice jurisprudence

European Court of Justice, judgment in case 26/62, Van Gend en Loos.

European Court of Justice, judgement in case C-22/70, AETR.

European Court of Justice, judgement in case C-2/74, Reyners.

European Court of Justice, judgment in case C-55/75, Balkan-Import.

European Court of Justice, judgment in case C-33/76, Rewe.

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European Court of Justice, judgement in case C-45/76, Comet.

European Court of Justice, judgment in case C-52/81, Werner Faust.

European Court of Justice, judgement in case C-270/83, Avoir Fiscal.

European Court of Justice, judgment in case C-236/84, Hauptzollamt Dusseldorf.

European Court of Justice, judgement in case C-81/87, Daily Mail.

European Court of Justice, judgement in case C-175/88, Biehl.

European Court of Justice, judgement in joined cases C-6/90 and C-9/90, Francovich and Bonifaci

v. Italy.

European Court of Justice, judgement in case C-204/90, Bachmann.

European Court of Justice, judgement in joined cases C-46/93 and C-48/93, Brasserie du Pêcheur v.

Germany and R. v. Secretary of State for Transport, ex parte Factortame.

European Court of Justice, judgement in case C-279/93, Schumacker.

European Court of Justice, judgement in joined cases C-358/93 and C-416/93, Bordessa.

European Court of Justice, judgement in case C-5/94, The Queen v. Ministry of Agriculture,

Fisheries and Food ex parte Hedley Lomas (Ireland) Ltd.

European Court of Justice, judgement in case C-80/94, Wielockx.

European Court of Justice, judgement in case C-107/94, Asscher.

European Court of Justice, judgement in joined cases C-163/94, C-165/94 and C-250/94, Sanz de

Lera.

European Court of Justice, judgement in joined cases C-178/94, C-179/94, C-188/94, C-189/94, C-

190/94, Dillenkofer and others v. Germany.

European Court of Justice, judgement in case C-484/94, Svensson and Gustavvson.

European Court of Justice, judgement in case C-127/95, Norbrook Laboratories Limited v. Ministry

of Agriculture.

European Court of Justice, judgement in case C-250/95, Futura Participations SA and Singer.

European Court of Justice, judgement in case C-264/96, Imperial Chemical Industries.

European Court of Justice, judgement in case C-319/96, Brinkmann Tabakfabriken GmbH v.

Skatteministeriet.

European Court of Justice, judgement in case C-140/97, Rechberger and Greindl v. Austria.

European Court of Justice, judgement in case C-212/97, Centros.

European Court of Justice, judgment in case C-222/97, Trummer and Mayer.

European Court of Justice, judgement in case C-311/97, Royal Bank of Scotland.

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European Court of Justice, judgement in case C-424/97, Salomone Haim v. Kassenzahnärtzliche

Vereinigung Nordrhein (Haim II).

European Court of Justice, judgement in case C-35/98, Verkooijen.

European Court of Justice, judgement in case C-251/98, Baars.

European Court of Justice, judgement in joined cases C-397/98 and C-410/98, Metallgesellschaft.

European Court of Justice, judgment in case C-464/98, Stefan.

European Court of Justice, judgement in case C-466/98, Commission v. United Kingdom.

European Court of Justice, judgement in case C-467/98, Commission v. Denmark.

European Court of Justice, judgement in case C-468/98, Commission v. Sweden.

European Court of Justice, judgement in case C-469/98, Commission v. Finland.

European Court of Justice, judgement in case C-466/98, Commission v. Belgium.

European Court of Justice, judgement in case C-472/98, Commission v. Luxembourg.

European Court of Justice, judgement in case C-475/98,Commission v. Austria.

European Court of Justice, judgement in case C-476/98, Commission v. Germany.

European Court of Justice, judgement in case C-55/00, Gottardo.

European Court of Justice, judgement in case C-324/00, Lankhorst-Hohorst.

European Court of Justice, judgement in case C-168/01, Bosal Holding.

European Court of Justice, judgement in case C-319/02, Manninen.

Opinions of the European Court of Justice

Opinion of the European Court of Justice 2/91.



Opinions of Advocate General

Opinion of Advocate General Mischo in case C-436/00, X and Y.

Opinion of Advocate General Tizzano in case C-516/99, Schmid.

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II. STATEMENT OF FACTS

EUA SE (“EUA”) is a privately held company, incorporated as a Societas Europaea

and resident for tax purposes in EU Member State A. EUA was, until December 31, 2000,

held by a holding company EUAHOLD SE (“EUAHOLD”), incorporated as a Societas

Europaea and resident for tax purposes in EU Member State A.

EUAHOLD was owned until December 31, 2000, by three individuals, resident for

tax purposes in EU Member State A.

EUA manufactures and sells highly sophisticated technical devices, used in the

military, medical and heavy industry sectors, to allow testing of materials in situations

where such testing is normally very hard to perform. It is very profitable and employs

worldwide about 3000 workers and employees. It sells all of its products throughout the

world through fully owned subsidiaries incorporated abroad (in the US, Europe, and Latin

America), such as USCO INC.

USCO INC. (“USCO”) is a privately held company, incorporated and resident for

tax purposes in the United States of America. It was incorporated in 1985 and fully

owned until December 31, 2000 by EUA.

USCO manufactures and sells the same product range as EUA for the US market. It

employs about 500 workers and employees and is very profitable.

There is currently no, nor ever was, any financing by EUA of the activities of

USCO, given USCO’s high level of profitability. EUA never repatriated dividends from

USCO, but preferred to accumulate earnings in the US and use USCO shareholders’ funds

for further expansion in the US, and not to pay or defer US withholding taxes on

dividends, which otherwise would have been due in the US at the rate of 5%, if dividends

were repatriated to EUA.

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The three individual shareholders of EUAHOLD resident in EU Member State A

equally preferred that no dividends were paid from USCO to EUA, awaiting the possible

sale of EUA by EUAHOLD, which under the national tax legislation of EU Member State

A (subject to certain conditions being met) would result in a tax free capital gain for

EUAHOLD.

EUAHOLD sold all of its shares in EUA to EUB SE (“EUB”), effective January

1, 2001 and realized a considerable tax free capital gain in EUA.

EUB is a privately held company, incorporated as a Societas Europaea in 1980 and

resident for tax purposes in EU Member State B. It is held by five individuals, who are

resident for tax purposes in EU Member State B.

The EUB group was, until the purchase of the EUA group (effective January 1,

2001), a major competitor of the EUA group. The EUB group is active in the same

industry sectors and manufactures and sells similar, but not identical, products

worldwide.

EUB acts both as the top holding and headquarter of the group and also runs

manufacturing and sales operations in EU Member State B. EUB has many subsidiaries

outside EU Member State B.

As indicated above, effective January 1, 2001, EUB bought all shares of EUA from

EUAHOLD.

Early 2001, EUB lent funds to EUA (through a registered bond issued by EUB

and subscribed by EUA), allowing EUA to incorporate new sales companies in

China, Malaysia and Hong Kong.

EUB preferred EUA to act as its top holding and headquarters for the EUA group

products, rather than directly owning the new Asia-Pacific sales entities in China,

Malaysia and Hong Kong (selling only EUA products). At the same time, interest paid by

EUA to EUB was deductible against the manufacturing and sales profits of EUA and was

not subject to withholding taxes in EU Member State A.

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The interest paid to EUB by EUA exceeds on a yearly basis more than 50% of

the gross income of EUA.

Prior to the acquisition of EUA effective January 1, 2001, EUB owned a sizeable

subsidiary in the US, USEUB, which manufactures a range of products similar to the

products of EUA, but specifically sold to the telecom industry. USEUB is loss-making for

tax purposes.

In order to obtain a de facto tax consolidation in the US, USEUB has been

absorbed by, and merged into USCO, effective January 1, 2001. After the merger,

USCO operates two different business units in one single company USCO.

As a consequence of the merger, EUB now owns 66% of USCO and EUA owns

34% of the shares of USCO.

In May 2002, the annual general meeting of shareholders of USCO decided to pay a

high amount as dividend to its shareholders EUA and EUB.

A 5% withholding tax (as provided in the Tax Treaties concluded between the US

and both EU Member State A and EU Member State B for direct shareholdings of least

10% ) was withheld and paid to the US Treasury on both the dividends paid to EUA and

to EUB.

In September of 2002 EUA decided to pay and paid an interim dividend, for about

the same amount it received from USCO, to EUB. No withholding tax was withheld on

this dividend, based on the EC Parent-Subsidiary Directive and EU Member State A’s

internal tax law.

EUB used the dividend it received as a direct shareholder of USCO in May 2002 and

the interim dividend received from EUA in September 2002 to partly reimburse the debt

it engaged into to acquire EUA.

Upon audit by the US Internal Revenue Service (“IRS”) in 2005, the reduction

of the standard dividend withholding tax from 30% to the 5% Tax Treaty rate, as

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provided by the EU Member State A–US Tax Treaty, was disallowed by the IRS for

the dividend paid by USCO to EUA.

According to the IRS, the withholding tax on the dividend could not be reduced to

5%, since EUA did not meet the requirements laid down in the “limitation on benefits”

Article of the EU Member State A-US Tax Treaty (Article 20). Hence USCO was

assessed an additional 25 % dividend withholding tax. Late interests and penalties were

applied and assessed as well on USCO.

The reduction of the withholding tax from 30% to 5% on the dividend paid by

USCO directly to EUB was not challenged by the IRS, since, in the view of the IRS, it

was made in accordance with the stipulations of the EU Member State B-US Tax Treaty

(in particular Article 25).

USCO charged and was reimbursed by EUA, the 25% additional US

withholding taxes (not the US penalties and US interest).

Having reviewed the stipulations of the EU member State A-US and EU Member

State B-US Tax Treaties, USCO, EUA and EUB concluded that the IRS rightly applied

both Tax Treaties and decided not to litigate in the US.

So, EUA and EUB decided to file a claim for damages before the civil court, i.e. the

Tribunal of First Instance of city Z (in EU Member State A, where EUA has its legal seat)

against EU Member State A.

The Tribunal of First Instance agreed and judicially acknowledged with EUA’s and

EUB’s position on these points and allowed the case to be heard.

The civil law claims were based on the argument that EU Member State A breached

EC law, in the way it agreed on a limitation on benefits clause in its Tax Treaty with the

US. As a result, EUA (directly and indirectly) and its parent EUB (indirectly) suffered a

financial loss.

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• A first claim was filed by EUA and called for damages to be paid by EU

Member State A, equal to the amount of the additional US withholding tax

(25%).

• In addition, both EUA and EUB claimed payment of the amount of US

penalties and US late interest paid by USCO, which both shareholders of

USCO suffered indirectly, proportionally to their shareholdings in USCO as

a result of the alleged breach of EC law by EU Member State A.

• EUA further claimed interest on the amount of the additional US

withholding taxes of 25%.

• Finally, EUA and EUB claimed interest on the amount of US penalties and

US late interest paid by USCO, which both shareholders of USCO suffered

indirectly, proportionally to their shareholdings in USCO.

The Tribunal of First Instance of city Z in EU Member State A stayed the

proceedings and referred the following request for a preliminary ruling on the basis of

Article 234 EC Treaty to the European Court of Justice in Luxembourg.

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III. ISSUES

The present case involves many juridical questions and topics that can be summarised as follows:

PART A: STATE A-US TAX TREATY AND THE FREEDOM OF ESTABLISHMENT.

1. The notion of right of establishment according to Art. 43 of the EC Treaty.

1.1. Scope of the right of establishment.

1.2. Contents of the right of establishment.

1.3. Relationships between the right of establishment and the free movement of capital.

1.3.1. Definition of “direct investments” provided by the directive n. 88/361/EEC.

1.3.2. The close relationship of these investments with the right of establishment

according to the explanatory notes to the Annex I of the directive n. 88/361/EEC.

1.4. Application of this definition to the right of State B residents to set up and manage an

undertaking and to invest in a business continuation in other Member States.

1.4.1. EUB owns 100% shares of EUA and at any rate a controlling interest in a

company of another Member State is covered by the right of establishment.

2. LOB provisions and the right of establishment.

2.1. The principle of equal treatment.

2.1.1. LOB provisions on the basis of the place of residence of the controlling

shareholders in the company claiming Tax Treaty benefits are prohibited if they

affect companies with EU shareholders unfavourably as compared to companies with

domestic shareholders.

2.2. Analysis of possible justifications to this restriction and their unacceptability.

2.2.1. Coherence of the national tax system.

2.2.2. Prevention of tax evasion.

2.2.3. Tax revenue reduction.

2.2.4. The principle of proportionality.

2.3. The LOB provisions of State A-US Tax Treaty constitute a breach of EC Law in

relation to the right of establishment.

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PART B: STATE A-US TAX TREATY AND THE FREE MOVEMENT OF CAPITAL.

3. The free movement of capital according to Title III Chapter 4 of the EC Treaty.

3.1. Scope of this freedom.

3.1.1. The nomenclature provided by Annex I of the Directive 88/361/EEC.

3.1.2. Distinction between the free movement of capital and the right of

establishment.

3.1.3. Definition of “operations to repay credits or loans” provided by the directive

n. 88/361/EEC.

3.2. Application of the free movement of capital to the interest paid by EUA to EUB for a

loan granted in 2001.

4. LOB provisions and the free movement of capital.

4.1. Restrictions regarding the free movement of capital also includes restrictions in the form

of tax rules.

4.2. The LOB provisions at issue restrict the freedom of capital movements under two

different aspects:

• in respect of companies resident in State A, that cannot freely use their capital to

meet liabilities for interest and royalties;

• in respect of residents of other Member States, who will find obstacles in the

allocation of capital under the form of loans to State A residents.

4.3. Analysis of possible justifications to this restriction and their unacceptability.


4.3.2. Prevention of tax evasion.

4.3.3. Tax revenue reduction.


4.4. The LOB provisions of State A-US Tax Treaty constitute a breach of EC Law in

relation to the free movement of capital.

5. The free movement of capital in relation to third countries.

5.1. Scope of this freedom.

5.1.2. Purposes and objectives pursued.

5.2. Application of the free movement of capital in relation to third countries to dividends

paid by USCO to EUA and EUB.

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6. LOB provisions and the free movement of capital in relation to third countries.

6.1. The LOB provisions at issue restrict the free movement of capital in relation to third

countries because they make the direct way from the US to State B preferable to the

alternative transfer US-State A-State B.

6.2. The previously analysed justifications can neither be accepted for this restriction.

6.3. The LOB provisions of State A-US Tax Treaty constitute a breach of EC Law for as

concerns the free movement of capital in relation to third countries.

PART C: THE MEMBER STATES’ EXTERNAL TAX TREATIES MAKING POWER.

7. The EC Treaty confers both internal and external powers on the Community.

7.1. Art. 281 EC Treaty and the “implied powers doctrine”.

7.2. External Tax Treaties’ making power in the area of direct taxation.

7.2.1. The objectives that the Community must pursue do not expressly include direct

taxation.

7.2.2. The possibility to include direct taxation in the “approximation of the laws of

Member States”.

7.3. The adoption by the Community of common rules in the area of direct taxation and the

consequent external powers acquired in the same fields.

8. The EC Member States have no power to negotiate the rules concerning the dividend withholding

tax, as this area is covered by the Parent-Subsidiary directive.

8.1. State A had no power to conclude the Tax Treaty with the US.

8.2. The conclusion of such a Treaty by State A constitutes a breach of EC Law.

PART D: STATE A’S LIABILITY FOR BREACH OF EC LAW.

9. The conditions for Member States’ liability.

9.1. The “Francovich doctrine” and the Member States’ liability for the payment of the

damages that the violation of their Community law obligations has caused to individuals.

9.2. The obligation to nullify the unlawful consequences of a breach of Community law is

implied by the principle of effectiveness of EC rules.

21

9.3. Member States’ liability for infringement on EC law also arises when the national

legislator is responsible for the breach in question.

9.4. Comparison between Member States’ liability and Community’s liability according to

Art. 288 EC Treaty.

10. The general requirements to be fulfilled in order to qualify for compensation.

• The violated rule of law must confer rights on individuals;

• The breach must be sufficiently serious;

• There must be a direct causal link between the breach of the obligation resting on the State

and the damage sustained by the injured parties.

10.1. Check of the fulfilment of these requirements in the case at issue.

10.2. The requirements are all fulfilled.

11. State A must be held liable for compensation.

11.1. Assessment of damages and amount of compensation.

22

IV. ARGUMENTS

1. GENERAL REMARKS ON THE METHOD

The analysis of the compatibility with EC law of the LOB provisions contained into Art. 20

of State A-US Tax Treaty is strictly connected to the analysis of the concepts of right of

establishment and free movement of capital, which have to be investigated under different points of

view.

With regard to the right of establishment, which is granted only to EU citizens, we will have

to understand if the investments addressed to set up and manage undertakings or to invest in a

business continuation in other Member States can be considered as strictly and directly related to

the right of establishment. This question deserves a positive solution; in particular, as a controlling

interest in a company of another Member State is at any rate included in this category of

investments, we will demonstrate that the provisions at issue restrict the right of establishment and

that this restriction is not justified.

With regard to the free movement of capital, we will have to determine the operations

covered by this freedom, and in particular if loans and related interest are included or not. This

question deserves a positive solution; in particular, as the provisions at issue limit the freedom of a

company to use its gross income to pay interest on loans, we will demonstrate that they restrict the

free movement of capital and that this restriction is not justified.

Once assessed the applicability of the free movement of capital also to third States, we will

show that the provisions at issue constitute a breach of EC law even on this point, with special

attention to the withholding tax on dividends paid by a US subsidiary to EU companies located in

two different Member States.

We will demonstrate that each restriction to the right of establishment and the free

movement of capital provided by the LOB provisions at issue fails the proportionality test; we will

also show how this is confirmed by the fact that another Member State, that has also concluded a

Tax Treaty with the US containing an LOB clause, provided for less restrictive measures which

would imply the LOB not to apply to a situation comparable to the case at issue.

In the last part of the Memorandum we will deal with Member States’ external Tax Treaty-

making power. In fact, although we have already demonstrated that the LOB provisions at issue

constitute a breach of EC law under different aspects, it is important to check if Member States still

23

have the power to conclude a Tax Treaty such as the one in which the EC law incompatible

provisions are included. We believe that the answer is negative; in fact, the Community, by

adopting common rules in the area of direct taxation and thus exercising its internal powers in this

field, has by now obtained external powers in the negotiating and conclusion of Tax Treaties with

third States.

Finally, we will demonstrate State A’s liability for the breach of EC law and determine the

amount of compensation for damages.

24

PART A: STATE A-US TAX TREATY AND THE FREEDOM OF ESTABLISHMENT

2. THE EC TREATY DEFINITION OF THE RIGHT OF ESTABLISHMENT

The provisions regarding the right of establishment are stated in Title III, Chapter 2 ECT.

According to Art. 43, par. 1, ECT “restrictions on the freedom of establishment of nationals of a

Member State in the territory of another Member State shall be prohibited. Such prohibition shall

also apply to restrictions on the setting-up of agencies, branches or subsidiaries by nationals of any

Member State established in the territory of any Member State”. Besides, pursuant to Art. 43, par.

2, ECT, the right of establishment includes “the right to take up and pursue activities as self-

employed persons and to set up and manage undertakings, in particular companies or firms within

the meaning of the second paragraph of Article 48, under the conditions laid down for its own

nationals by the law of the country where such establishment is effected”1.

The application of the freedom of establishment is granted only in the EU area, and, in

particular, to EU citizens. This is perfectly in line with the ECT principles: in particular, Art. 2

ECT, fixing the objectives and purposes of the Community, limits their scope of application

“throughout the Community”. This is also confirmed by the ECJ case-law which affirmed that

“there exists no general principle obliging the Community, in its external relations, to accord to

non-member countries equal treatment in all respects”2.

Even if the investments sustained in order to establish and maintain an undertaking or a

subsidiary in another Member State are strictly related to the Chapter 2 provisions, we have to

realize that they are also mentioned in relation with the EC Treaty rules ensuring the free movement

of capital. In particular, the wide definition of capital provided by annex I of the Council Directive

n. 88/361/EEC3, mentioning the “operations carried out by any natural or legal person”, explicitly

includes the direct investments related to the “establishment and extension of branches or new

undertakings belonging solely to the person providing the capital”. So it is important to analyse the

1 If, pursuant to Art. 43, par. 2, ECT the establishment of an undertaking occurs, we have a “primary establishment”, as the citizen, deciding to transfer his economic activity in another EU Member State, loses any bound with the former Member State; if, pursuant to Art. 43, par. 1, ECT a citizen decides to set up an agency, a branch or a subsidiary, we have a “secondary establishment” as a bound with its Member State is maintained.

2 This statement was referred to the application of the non-discrimination principle stated by Art. 12 ECT. See European Court of Justice, judgment in case C-236/84, Hauptzollamt Dusseldorf. See also European Court of Justice, judgment in case C-55/75, Balkan-Import; European Court of Justice, judgment in case C-52/81, Werner Faust.

3 For the applicability of this definition also after the ECT modifications due to the Maastricht Treaty see European Court of Justice, judgment in case C-222/97, Trummer and Mayer; European Court of Justice, judgment in case C-464/98, Stefan.

25

relationships between the provisions concerning the right of establishment and the ones related to

capital movements. It is possible to assume that if an economic operator is merely making a

portfolio investment, the free movement of capital applies, whereas the right of establishment is

involved if the economic operator is actually investing in a business continuation or start-up

abroad4.

2.1. APPLICABILITY OF THE RIGHT OF ESTABLISHMENT

First of all the present case requires to check if the activity carried out by EUA, as concerns

the application of the LOB article contained in the Member State A-US tax Treaty, is covered by

the freedom of establishment. This question deserves a positive solution.

EUA is a subsidiary, established in the territory of State A, totally owned by EUB, which is

held by five individuals resident for tax purposes in Member State B. Anyway, it is not important

that EUA is held by individuals resident in State B (i.e. a State different from the one where the

company is located), because Art. 43, par. 1, ECT only requires the nationality of “any Member

State”. In fact, the freedom of establishment is related to all EU citizens and “it is by essence

capable of being directly invoked by nationals of all the other Member States”5.

This specific situation, as regards the right of State B residents to set up and manage an

undertaking and to invest in a business continuation in other Member States, is covered by the right

of establishment. EUB owns 100% shares of EUA, having definite influence over the subsidiary’s

decisions and activities. The Court itself has pointed out that at any rate a controlling interest in a

company of another Member State is covered by the right of establishment6.

We also said before that this freedom is granted only in the EU area and in particular to EU

citizens. However, although the Tax Treaty is concluded by State A with the US, the LOB clause

contained in it is indeed included in the scope of Art. 43 ECT as the discriminatory effects are

produced against residents of other Member States who control companies located in State A. The

ECJ itself specified that “all companies established in a Member State within the meaning of Article

4 TERRA B.J.M. – WATTEL P.J., European tax law, The Hague, 2005, p. 48. 5 European Court of Justice, judgement in case C-2/74, Reyners, par. 25. 6 European Court of Justice, judgement in case C-251/98, Baars, par. 22: “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 and allows him to determine its activities is exercising his right of establishment”. See also: European Court of Justice, judgement in case C-279/93, Schumacker; European Court of Justice, judgement in case C-264/96, Imperial Chemical Industries; European Court of Justice, judgement in case C-35/98, Verkooijen; European Court of Justice, judgement in case C-324/00, Lankhorst-Hohorst; European Court of Justice, judgement in case C-168/01, Bosal Holding.

26

52 (now Art. 43) of the Treaty are covered by that provision, even if their business in that State

consists of services directed to non-member countries”7.

3. THE LOB PROVISIONS OF ART. 20, (1) (a) (i), OF STATE A-US TAX TREATY AND THE

RESTRICTION TO THE RIGHT OF ESTABLISHMENT

Once assessed the applicability of the freedom of establishment, it is necessary to check if the

LOB provisions of Art. 20 of the Member State A-US Tax Treaty are compatible with this freedom.

The answer is negative.

The LOB provisions of Art. 20, (1) (a) (i), require at least a 50% level of resident

shareholding for a company resident in State A to be entitled to the benefits of the Tax Treaty8.

EUA cannot benefit by the reduction of the standard dividend withholding tax from 30% to the 5%

Tax Treaty rate for the dividend paid by USCO, because it is fully held by individuals resident in

State B.

According to the ECT provisions on the freedom of establishment, the same rules applicable

to the citizens of a Member State must also be applied to the citizens of another Member State

deciding to set up an undertaking, an agency, a branch or a subsidiary in the first mentioned

Member State. By including in the Tax Treaty an LOB provision which discriminates on the basis

of residence, State A breached Art. 43 ECT, because such a provision restricts the freedom of

establishment of a resident of another EU Member State wishing to establish itself in State A by

setting up a subsidiary in the territory of that State and, meanwhile, discriminates against those

companies having their seat in State A but owned or controlled by residents of other Member

States.

The fundamental principle of equal treatment requires that all Member States grant nationals

of other Member States the same advantages as those which their own nationals enjoy according to

a bilateral agreement concluded with a third country, unless they can provide objective

justifications9. The rules regarding equality of treatment forbid not only overt discrimination by

7 European Court of Justice, judgement in case C-475/98, Commission v. Austria, par. 134. 8 In particular, Art. 20, (1) (a) (i), states that “a person which is a resident of a Contracting State and derives

dividends, interest or royalties from the other Contracting State shall not be entitled [...] to relief from taxation in that other Contracting State unless more than 50 percent of the beneficial interest in such person (or in the case of a company, more than 50 percent of the number of shares of each class of the company’s shares) is owned, directly or indirectly, by one or more individual residents of one of the Contracting States, one of the Contracting States or its political subdivisions or local authorities, or citizens of the United States.

9 European Court of Justice, judgement in case C-55/00, Gottardo, par. 34.

27

reason of nationality, but all covert forms of discrimination which, by the application of other

criteria of differentiation, definitely lead to the same result10.

This statement is confirmed by the ECJ’s decision in the Open skies litigation11. On that

occasion the ECJ stated that various Member States had infringed Art. 43 ECT by concluding with

the US “open skies” agreements containing the so called “nationality clause”, providing for the

Contracting States the right to exclude certain airlines from the benefits of the agreement if they

were owned or controlled by nationals of other States. Even if related to a non-tax matter, the

“nationality clause” in question can be compared to the “resident shareholder test” contained in Art.

20, (1) (a) (i), of Member State A-US Tax Treaty, since both clauses discriminate against non-

residents by denying them the Treaty benefits recognised to residents. Moreover, the ECJ’s

judgement in the Open skies cases shows that Member States may not restrict the rights of residents

of another Member State, even if the Treaty is concluded with a third country, such as the US, and

even if the said Treaty concerns an area which is primarily the responsibility of the Member States,

such as aviation rights or direct taxation, as in the present case12.

The EC Treaty freedoms are unconditional and may therefore not be made dependent on

bilateral Tax Treaty negotiation results13. Consequently, LOB provisions on the basis of the place of

residence of the controlling shareholders in the company claiming Tax Treaty benefits are

prohibited if they affect companies with EU shareholders unfavourably as compared to companies

with domestic shareholders14.

3.1. THE RESTRICTION TO THE RIGHT OF ESTABLISHMENT IS NOT JUSTIFIED

The restriction provided by Art. 20, (1) (a) (i), cannot be justified through any of the

possible grounds of justification set out in Art. 46 ECT: public order, public security and public

health. The reduction of the withholding tax paid by USCO to the US Treasury on the dividends

distributed to EUA does not imply any sufficiently serious threat affecting one of the fundamental

10 CRAIG A., Open your eyes: what the “Open Skies” cases could mean for the US Tax Treaties with the EU

Member States, in Tax Bulletin, 2003, p. 63. 11 European Court of Justice, judgements in cases: C-466/98, Commission v. United Kingdom; C-467/98,

Commission v. Denmark; C-468/98, Commission v. Sweden; C-469/98, Commission v. Finland; C-471/98, Commission v. Belgium; C-472/98, Commission v. Luxembourg; C-475/98, Commission v. Austria; C-476/98, Commission v. Germany.

12 CLARK B., The limitation on benefits clause under an open sky, in European taxation, 2003, p. 22. 13 European Court of Justice, judgement in case C-270/83, Avoir Fiscal: “the rights conferred by Article 52 [now

Art. 43] of the Treaty are unconditional and a Member State cannot make respect for them subject to the contents of an agreement concluded with another Member State”.

14 See MARTIN-JIMENEZ A.J., EC Law and Clauses on “Limitation on Benefits” in Treaties with the US after Maastricht and the US-Netherlands Tax Treaty, in EC Tax Review, 1995, p. 81.

28

interests of society; therefore, there is no direct link between a hypothetical threat to public policy

and generalized discrimination against companies held by individuals who are not resident in a

Contracting State.

However, it is also necessary to verify the possible applicability of the other justifications

accepted by the Court under its rule of reason for different or restrictive tax treatment of cross-

border situations as compared to similar domestic situations, and in particular the need to protect the

coherence of the national tax system, the need to avoid tax evasion and the need to avoid the

reduction of tax revenues.

3.1.1. COHERENCE OF THE NATIONAL TAX SYSTEM

It must be pointed out that fiscal coherence has often been invoked by Member States as a

valid reason to justify discriminating treatments and restrictions to the freedom of establishment,

but it was accepted only in the Bachmann case15, when the limited deduction of insurance

contributions paid to Belgian companies was justified through the connection between contributions

and money paid by insurance companies in force of their contracts, in the way that taxes levied on

pensions and capital paid by insurance companies were to compensate the deduction of contribution

from the taxable income.

From the analysis of case-law, it is possible to assume that the fiscal coherence as a reason

for discriminating against non-residents can be accepted only if there is a “direct link” between the

tax deferral and the later realization of the tax claim: that link between the tax benefit and

subsequent taxation must be immediate, it must exist within the same tax and it must concern the

same taxpayer and the same contract.

These requirements are not met in the present case: the LOB provisions of Art. 20, (1) (a)

(i), discriminate against EUA in respect of another company located in the same State but with less

than 50% of foreign shareholders, without giving a corresponding benefit to it. Allowing similar

fiscal restrictions to cross-border economic activity on the basis of tax coherence within one

jurisdiction would mean fragmentizing the internal market into several national tax markets,

permitting undesirable tax fences along internal borders16.

15 European Court of Justice, judgement in case C-204/90, Bachmann. On the same day the Court delivered

judgement in the infringement proceedings brought by the Commission against Belgium under Art. 169 ECT on largely the same issues (case C-300/90, Commission v. Belgium). The issue of fiscal coherence was invoked also in other cases, such as Svensson-Gustavvson (C-484/93), Asscher (C-107/94), ICI (C-264/96), Baars (C-251/98), Verkooijen (C-35/98) and Metallgesellschaft (C-397/98 and C-410/98), but was always rejected.

16 TERRA B.J.M.-WATTEL P.J., European tax law, quot., p. 120.

29

3.1.2. PREVENTION OF TAX EVASION AND TAX REVENUE REDUCTION

The aim to avoid tax evasion is often invoked by Member State to justify restrictions. The

ECJ stated that this aim can be achieved in different ways without discrimination. In the recent

Lankhorst-Hohorst17 judgement, for example, a situation in which the parent company had its seat

outside the State involved, was considered not entailing itself 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.

Since tax evasion can be fought in non discriminatory ways, it has been never accepted by the

Court. The possibility itself to find a different method to reach the same result implies that the

measure is discriminatory; for example the access to the procedure of exchange of information is an

alternative and non-restrictive measure that States can adopt18. The purpose of the provisions at

issue could be also to prevent the reduction of tax revenues by State A. However, the Court has

never accepted this justification, stating that tax revenues are a problem to be dealt with by each

State in a merely internal context19.

3.1.3. THE PRINCIPLE OF PROPORTIONALITY

Furthermore, it is necessary to point out that the restriction provided by Art. 20, (1) (a) (i), is

not proportional to the purpose pursued.

In fact, following the evolution of the Court’s jurisprudence, a restriction is justified only if it

complies with the principle of proportionality: it means that a measure must be appropriate,

necessary and proportionate for attaining an objective compatible with the ECT20, without going

beyond what is necessary to attain it21. In other words, the Court states that a national provision

introducing a distinction in the tax treatment of two comparable cases in order to achieve a certain

result is discriminatory even when the same result could be reached in a different and less restrictive

way. The provisions of Art. 20, (1) (a) (i), do not comply with the principle of proportionality,

17 European Court of Justice, judgement in case Lankhorst-Hohorst, quot. 18 European Court of Justice, judgement in case C-250/95, Futura Participations SA and Singer; European Court

of Justice, judgement in case C-81/87, Daily Mail; European Court of Justice, judgement in case Imperial Chemical Industries, quot.

19 See, for example, European Court of Justice, judgement in case Imperial Chemical Industries, quot.; European Court of Justice, judgement in case Verkooijen, quot.; European Court of Justice, judgement in case Lankhorst-Hohorst, quot.

20 Opinion of Advocate General Mischo in case C-436/00, X and Y; Opinion of Advocate General Tizzano in case C-516/99, Schmid.

21 European Court of Justice, judgement in case Commission v. Belgium, quot.

30

because they are too restrictive and such a restriction is not necessary to ensure the avoidance of

treaty shopping.

This is confirmed by the fact that State B also provided for an LOB clause in its Tax Treaty

with the US, but this clause is less restrictive than the one accepted by State A and provides for

more possibilities for the LOB not to apply. As regards more specifically the right of establishment,

Art. 25, (1) (c) (iii) (B), of State B-US Tax Treaty requires, for a company resident in State B to be

entitled to treaty benefits, at least 70% of the aggregate vote and value of the shares to be owned by

five or fewer companies that are residents in the US or in EU Member States, and not only in State

B22.

4. ART. 20, (1) (a) (i), CONSTITUTES A BREACH OF EC LAW IN RELATION TO THE FREEDOM OF

ESTABLISHMENT

We have demonstrated that State A breached EC law in the way it negotiated an LOB clause

providing for an infringement on the freedom of establishment that has no justifications.

The inclusion of such a clause in the bilateral agreement between State A and the US seems

rather to be due to economic considerations, because its main purpose is to exclude from Tax Treaty

benefits those companies belonging to non-residents of the Contracting States. The ECJ arrived to

the same conclusion in the judgement of the “nationality clause” included in the “open skies”

agreement between Denmark and the US23.

If a resident of another Member State invests in the company of State A which has agreed to

an LOB provision in the Treaty with the US, or if it purchases the shares of this company, the latter

will lose its reduction in the withholding rate on US dividends. Its profitability will decrease as will

the value of its shares24. But, accordingly to ECT, nationals of all countries of the EU are granted

the freedom to create and manage companies in every Member State under the conditions set by

such States for their own nationals. The ECT does not refer directly to discrimination based on

22 In particular, Art. 25, (1) (c) (iii) (B), states that a company resident in EU Member State B shall be entitled to

all the benefits of the Convention if “at least 70 percent of the aggregate vote and value of all its shares is owned, directly or indirectly, by five or fewer companies that are residents of the United States or of Member States of the European Communities, the principal class of shares of which are substantially and regularly traded on one or more recognized stock exchanges”.

23 European Court of Justice, judgement in Commission v. Denmark, quot., par. 116: “a clause such as that on the ownership and control of airlines would seem rather to be justified by economic considerations which are not covered by Article 56 [now Art. 46] of the Treaty and which have to do with the fact that the parties to the agreement refuse to extend the commercial benefits to airlines belonging to nationals of countries with which no “open skies” agreement has been concluded”

24 MALHERBE J. – DELATTRE O., Compatibility of Limitation on Benefits provisions with EC Law, in European taxation, 1996, p. 12.

31

residence, but, since the Biehl case25, the Court has ruled that discrimination on the grounds of

residence can under certain circumstances be regarded as discrimination on the grounds of

nationality. Consequently, in any case, individual Treaty provisions may not discriminate against

residents of other Member States when executing their unconditional rights under the ECT26.

This means that the conditions laid down for State A’s own nationals should apply for EUA

even though the company is owned by persons resident in another Member State. By taking into

consideration “persons residents in other Member States” the LOB clause in question would be

more at ease with EC Law27. Hence Art. 20, (1) (a) (i), would be compatible with Art. 43 ECT if

reformulated as following: “more than 50 percent of the beneficial interest in such person (or in the

case of a company, more than 50 percent of the number of shares of each class of the company’s

shares) is owned, directly or indirectly, by one or more individual residents of one of the

Contracting States, one of the Contracting States or its political subdivisions or local

authorities,[or of another Member State], or citizens of the United States”.

25 European Court of Justice, judgement in case C-175/88, Biehl. 26 BECKER H.-THOMMES O., Treaty shopping and EC Law – Critical notes to Article 28 of the New German-

US Double Taxation Convention, in European taxation, 1991, p. 173. 27 DAHLBERG M., New tax Treat between Sweden and the US raises questions about Treaty shopping, in

Intertax, 1997, p. 295.

32

PART B: STATE A-US TAX TREATY AND THE FREE MOVEMENT OF CAPITAL

5. THE SCOPE OF APPLICATION OF THE FREEDOM OF CAPITAL MOVEMENTS

The provisions regarding the free movement of capital are stated in Title III, Chapter 4 ECT.

According to Art. 56, par. 1, “all restrictions on the movement of capital between Member States

and between Member States and third countries shall be prohibited”. A similar rule concerning the

payments is provided by the par. 2, affirming that “all restriction on the movement of payments

between Member States and between Member States and third countries shall be prohibited” 28.

Article 56 ECT states the general principle of the free movement of capital and payments without

specifying the actual content of “capital and payments movement”. In order to determine its scope,

the ECJ stated the applicability of Council Directive n. 88/361/EEC for the implementation of

former Article 67 of the ECT29. Art. 1 of this Directive clearly states that Member States shall

abolish restrictions on capital movements taking place between Community residents. The

nomenclature provided by Annex I of the Directive summarises the capital movements as referred

to in Art. 1 of the Directive and indicates which transactions constitute a capital movement.

In many cases there exists a very subtle distinction between the free movement of capital and

the right of establishment. Generally, it is possible to assume that the free movement of capital

covers any operation which does not imply a long-lasting and continuous use of capital, so that

investments aiming to acquire a controlling interest in a company are not included.

5.1. APPLICABILITY OF THE FREE MOVEMENT OF CAPITAL

The present case requires to check if the activity carried out by EUA falls within the scope of

application of the free movement of capital. This question deserves a positive solution.

We said before that the free movement of capital covers any operation which does not imply a

long-lasting and continuous use of capital, so that investments aiming to acquire a controlling

interest in a company are not included. Anyway, in the wide definition of capital provided by the

said nomenclature, it is possible to find an hypothesis relevant to the present case. In particular, the

28 It is important to realize that the extension of the liberalization of capital movements to third states took place

through the Maastricht Treaty. In fact, the previous provisions on the subject were stated by Art. 7 of the directive 88/361/EEC, which affirmed that “in their treatment of transfers in respect of movements of capital to or from third countries, the Member States shall endeavour to attain the same degree of liberalization as that which applies to operations with residents of other Member States…”.

29 European Court of Justice, judgement in case Trummer and Mayer, quot.; European Court of Justice, judgement in case Stefan, quot..

33

nomenclature, mentioning the “operations to repay credits or loans”, makes the freedom of capital

movement apply to the relationship between EUA and EUB without taking into account the

controlling interest of the parent in the subsidiary.

In fact, in 2001 EUB lent funds to EUA allowing it to incorporate new sales companies

abroad. As a consequence of that loan EUA pays to EUB an interest that exceeds on a yearly basis

more than 50% of the gross income of EUA. This interest constitutes a capital flow from State A to

State B.

6. THE LOB PROVISIONS OF ART. 20, (1) (a) (ii), OF STATE A-US TAX TREATY AND THE

RESTRICTION TO THE FREE MOVEMENT OF CAPITAL

Once assessed the applicability of the free movement of capital, it is necessary to check if the

LOB provisions of Art. 20 of State A-US Tax Treaty are compatible with this freedom. The answer

is negative.

The LOB provisions of Art. 20, (1) (a) (ii), require less than 50% of the gross income to be

used to meet liabilities for interest or royalties to non-residents for a company resident in State A to

be entitled to the benefits of the Tax Treaty30. EUA cannot benefit by the reduction of the standard

dividend withholding tax from 30% to the 5% Tax Treaty rate for the dividend paid by USCO,

because the interest due to EUB for the loan granted in 2001 exceeds on a yearly basis more than

50% of its gross income. The requirements of Art. 20, (1) (a) (ii), are not met, because more than

50% of the gross income of EUA is transferred to State B residents.

Art. 56 EC Treaty forbids any restriction to capital movements, so that any measure which is

able to dissuade EU citizens from enjoying the benefits deriving from this freedom constitutes a

breach of EC law. The ECJ has found in a large number of cases that the prohibition against

restrictions regarding the free movement of capital also includes restrictions in the form of tax

rules31. In the Schumacker case32 the ECJ made it clear that Member States must comply with

European law even when exercising the powers retained at the national level, such as direct

taxation.

30 In particular, Art. 20, (1) (a) (ii), states that “a person which is a resident of a Contracting State and derives dividends, interest or royalties from the other Contracting State shall not be entitled [...] to relief from taxation in that other Contracting State unless more than 50 percent of the gross income of such person is not used, directly or indirectly, to meet liabilities for interest or royalties to persons who are not residents of one of the Contracting States, one of the Contracting States or its political subdivisions or local authorities, or citizens of the United States”.

31 European Court of Justice, judgement in case Futura Singer, quot.; European Court of Justice, judgement in case C-212/97, Centros; European Court of Justice, judgement in case Baars, quot.; European Court of Justice, judgement in case Verkooijen, quot.; European Court of Justice, judgement in case Imperial Chemical Industries, quot.

32 European Court of Justice, judgement in case Schumacker, quot., par. 21.

34

The LOB provisions of Art. 20, (1) (a) (ii) have the effect of restricting the free movement of

capital. If the same loan had been granted to EUA by State A residents the LOB clause would not

have applied. Hence the provisions at issue restrict the freedom of capital movements under two

different aspects: firstly, in respect of companies resident in State A, that cannot freely use their

capital to meet liabilities for interest and royalties; secondly, in respect of residents of other

Member States, who will find obstacles in the allocation of capital under the form of loans to State

A residents, who will prefer domestic loans in order to avoid the application of the LOB clause.

6.1. THE RESTRICTION TO THE FREE MOVEMENT OF CAPITAL IS NOT JUSTIFIED

Member States providing for a restriction to the free movement of capital have to demonstrate

that the measure is capable of protecting the national interest as described in arts. 57 and 58 ECT.

Tax rules which hinder the free movement may still be accepted if the rules are justified by

overriding requirements of public interest, such as the coherence of the national tax system, the

prevention of tax evasion and the prevention of tax revenues reduction. Anyway, the balance

between the Community interest to secure the free movement and the Member States’ interest to

protect their tax bases has regularly turned out to the detriment of the latter33. In addition, the

measure has to comply with the principle of proportionality34.


According to settled case-law, fiscal coherence as a reason for discriminating against non-residents

can be accepted only if that there is a “direct link” between the tax advantage granted and the

offsetting of that advantage by a fiscal levy, both of which related to the same tax35. Through it, the

ECJ assures symmetry in the tax field: a restriction can be accepted if the following disadvantage

for the taxpayer is directly linked to an advantage for another one36.

These requirements are not met in the present case: the LOB provisions of Art. 20, (1) (a)

(ii) discriminate against EUA in respect of another company located in the same State that pays the

same interest to State A residents without giving a corresponding benefit to it.

33 STAHL K., Free movement of capital between Member States and third countries, in EC Tax Review, 2004, p. 47.

34 See HINNEKENS L., Compatibility of Bilateral Tax Treaties with European Community Law – Application of the Rules, in EC Tax Review, 1995, p. 202.

35 European Court of Justice, judgement in case Bachmann, quot.; European Court of Justice, judgement in case Verkooijen, quot. European Court of Justice, judgement in case Bosal Holding, quot.

36 European Court of Justice, judgement in case Bosal, quot.: “Where there is no such direct link, because, for example, one is dealing with different taxes or the tax treatment of different taxpayers, the argument based on the coherence of the tax system cannot be relied upon”.

35

6.1.2. PREVENTION OF TAX EVASION AND TAX REVENUE LOSS

The aim to avoid tax evasion has never been accepted by the ECJ, because it can be reached

without discrimination. As said before in respect of restrictions to the right of establishment, the

access to the procedure of exchange of information could be an alternative and non-restrictive

measure that States can adopt37. State A cannot invoke the prevention of tax revenue reduction,

because tax revenues are a problem to be dealt with by each State in a merely internal context38.


Finally, it is necessary to point out that the restriction provided by Art. 20, (1) (a) (ii) is not

proportional to the prevention of treaty shopping.

This is confirmed by the fact that State B also provided for an LOB clause in Art. 25 of its

Tax Treaty with the US, but this clause is less restrictive than the one accepted by State A and

provides for more possibilities for the LOB not to apply. As regards more specifically the free

movement of capital, Art. 25, (5) (a) (iii) of State B-US Tax Treaty requires, for a company resident

in State B to be entitled to Treaty benefits, less than 70% of the gross income to be used to make

deductible payments to non-qualified persons and less than 30% of such gross income to be used to

make deductible payments to persons that are neither qualified persons nor residents of Member

States39.

7. ART. 20, (1) (a) (ii), CONSTITUTES A BREACH OF EC LAW IN RELATION TO THE FREE

MOVEMENT OF CAPITAL

We have demonstrated that State A breached EC law in the way it negotiated an LOB clause,

infringing, without any justification, the rules on the free movement of capital.

The fact that more than 50% of the gross income is used by EUA to pay the interest to EUB

does not minimally affect the domestic context of State A. It only aims to prevent that tax benefits

37 European Court of Justice, judgements in case Futura Participations SA and Singer, quot.; European Court of Justice, judgement in case Daily Mail, quot.; European Court of Justice, judgement in case Imperial Chemical Industries, quot.

38 See, for example, European Court of Justice, judgement in case Imperial Chemical Industries, quot.; European Court of Justice, judgement in case Verkooijen, quot.; European Court of Justice, judgement in case Lankhorst-Hohorst, quot.

39 In particular, Art. 2, (5) (a) (iii), states that a person resident in EU Member State B meets the base reduction test if “ (A) less than 70% of such gross income is used, directly or indirectly, to make deductible payments to persons that are not qualified persons; and (B) less than 30 percent of such gross income is used, directly or indirectly, to make deductible payments to persons that are neither qualified persons nor residents of Member States of the European Communities”.

36

are indirectly enjoyed by non-residents. Such a restriction has the effect of according advantages to

a person resident of a Contracting State only if the gross income of such person follows a certain

destination.

Pursuant to Art. 56 ECT, the limitation should not exist with respect to all EU residents, and

not only to residents of State A. It is settled case-law that discrimination arises through the

application of different rules to comparable situations or the application of the same rules to

different situations40. The fact that the Tax Treaty in question does not grant to EUA the same

benefits it would grant to it if the same amount of its gross income were used to meet liabilities for

interest or royalties to residents, is discriminatory, because EUA is in a comparable situation with a

company transferring the same amount of capital to residents.

Even though the EC Treaty has an express carve-out regarding taxation matters, in principle

erga omnes liberalization applies even to tax matters in so far as the movement of capital and

payments is concerned41. Clauses limiting the entitlement to Treaty benefits to any EU national

have to be removed from all existing conventions, together with other provisions that hinder

national treatment in respect of cross-border situations, including the levying of different

withholding taxes from that which are applicable in a purely domestic context42.

This means that the conditions laid down for State A’s own nationals should apply for EUA

even though the company transfers most of its gross income to another Member State. By taking

into consideration “persons residents in other Member States” the LOB clause in question would be

more at ease with EC Law43. Hence Art. 20, (1) (a) (ii) would be compatible with Art. 56 of the

ECT if reformulated as following: “more than 50 percent of the gross income of such person is not

used, directly or indirectly, to meet liabilities for interest or royalties to persons who are not

residents of one of the Contracting States, one of the Contracting States or its political subdivisions

or local authorities,[or of another Member State], or citizens of the United States”.

40 European Court of Justice, judgement in case Schumacker, quot., par. 30; European Court of Justice, judgement in case C-80/94, Wielockx, par. 17; European Court of Justice, judgement in case C-107/94, Asscher, par. 40.

41 PANAYI C., Ships and taxes: does the case of Commission v. Netherlands have tax implications?, in EC tax review, 2005, p. 97.

42 PISTONE P., Towards European international tax law, in EC Tax Review, 2005, p.4. 43 DAHLBERG M., New tax Treat between Sweden and the US raises questions about Treaty shopping, quot., p.

295.

37

8. THE FREE MOVEMENT OF CAPITAL IN RELATION TO THIRD COUNTRIES

The free movement of capital provided by Art. 56, par.1, ECT also applies towards third

countries44, since this provision prescribes that “all restrictions on the movement of capital between

Member States and between Member States and third countries shall be prohibited”.

The freedom of capital movements in and out of the EU is just as far-reaching as the freedom

of capital movements between Member States45. This interpretation is confirmed by the ECJ’s

judgement in the Sanz de Lera case46, when the Court applied the same principles developed in the

Bordessa case47, concerning free capital movement within the EU, and by this means clearly

recognized the lack of differences in the application of the freedom of capital movements in an

internal context or towards third countries.

It is important to note that the free movement of capital within the EU is necessary for the

proper functioning of the monetary union, whereas the purpose of the free movement of capital

towards third countries is different: it aims to attract into the EU area foreign investors. Anyway,

this objective is perfectly in line with Community principles, because capital from third countries

strengthens the common market, so that it is desirable to make its flow easier.

8.1. APPLICABILITY OF THE FREE MOVEMENT OF CAPITAL IN RELATION TO THIRD COUNTRIES

In the present case, USCO is a company resident for tax purposes in the US, but it is owned

for the 66% by EUB and for the 34% by EUA; consequently, the dividends are definitely paid by

USCO to EU residents. Hence the free movement of capital between Member States and third

countries applies to the relationship between USCO, on the one hand, and EUB and EUA, on the

other hand. As we know that EUA is fully owned by EUB, we can simplify our analysis by

focusing our attention on the movement of capital between the US and Member State B.

44 A “third country” is one that is not included both in the EC Treaty and in the EEA Agreement, which includes

EC Member States and Iceland, Liechtenstein, Norway and Switzerland. These treaties grant the freedom of capital movements both among EC Member States or EEA Member States, and towards third countries. See also European Court of Justice, judgement in case C-452/01, Ospelt.

45 STAHL K., Free movement of capital between Member States and third countries, quot., p. 47. 46 European Court of Justice, judgement in joined cases C-163/94, C-165/94 and C-250/94, Sanz de Lera. More

specifically, the issue in that case was whether it was consistent with the provisions on free capital movements to require authorisation and/or a declaration in advance as a condition for exporting money from the country. It was decided that a requirement for authorisation was not consistent with free capital movement provisions but that a claim on declaration could be accepted.

47 European Court of Justice, judgement in joined cases C-358/93 and C-416/93, Bordessa. It should be noted that this case did not concern the Treaty provisions on the free movement of capital but the provisions in Directive 88/361/EEC.

38

There is a certain amount of capital flowing from the US to State B under the form of

dividend. This flow takes two different ways: a first part is transferred directly from the US to

Member State B, applying a 5% withholding tax as provided by the State B-US Tax Treaty; a

second part is transferred only indirectly to State B, since it flows through Member State A before

reaching State B. This “double passage” implies that the taxation of the latter dividend is regulated

by the different rules provided by the State A-US Tax Treaty. Pursuant to this Treaty the reduction

of the standard dividend withholding tax from 30% to the 5% is not allowed, because of the

requirements provided by the LOB clause of Art. 20, so a 30% withholding tax is levied on the

dividend paid to EUA. This situation shows an infringement on the free movement of capital in

relation to third States, because the same amount of capital cannot freely flow within the EU: in

fact, the direct way from the US to State B is preferable to the alternative transfer US-State A-State

B, since the latter encounters the restriction created by a disadvantageous taxation.

9. RESTRICTION TO THE FREE MOVEMENT OF CAPITAL IN RELATION TO THIRD COUNTRIES

However, there is no objective difference between the dividend paid by USCO to EUB and

the dividend paid by USCO to EUA. The two companies are in a comparable situation and,

according to the general principle, require the application of the same rules48. In this sense the LOB

clause contained in State A-US Tax Treaty is incompatible with the provisions of Art. 56 ECT, not

only in relation to capital movements between Member States, but also in relation to capital

movements between Member States and third countries.

The restriction is not justified for the same reasons explained before with regard to free

movement of capital between Member States49.

48 See HINNEKENS L., Compatibility of Bilateral Tax Treaties with European Community Law – Application of

the Rules, quot., p. 202; HINNEKENS L., The search for framework conditions of the fundamental EC Treaty principles as applied by the European Court to Member States’ direct taxation, in EC Tax Review, 2002, p. 112.

49 See paragraph 7.1 of this Memorandum.

39

PART C: THE MEMBER STATES’ EXTERNAL TAX TREATY-MAKING POWER

10. EXTERNAL TAX TREATY-MAKING POWER IN THE AREA OF DIRECT TAXATION

Although we have already demonstrated that the LOB provisions at issue constitute a breach

of EC law under different aspects, it is important to check if Member States still have the power to

conclude a Tax Treaty such as the one in which the EC law incompatible provisions are included.

We believe that the answer is negative.

The ECT confers not only internal powers on the Community, but in certain specific areas it

also confers it external powers50. In fact, Art. 281 ECT gives the Community the legal capacity to

negotiate and enter into agreements with third States not only where the Treaty expressly confers

them, but also when they are implied by the fact that expressly conferred powers cannot effectively

be exercised without such “implied powers”51. The AETR case52 and several opinions53 handed

down by the ECJ, show that whenever EC law confers internal powers on the Community in order

to achieve an objective, the Community is also competent to conclude international agreements

necessary to achieve the same objective, even in the absence of a specific Treaty provision

conferring such competence. Moreover, the Court held that, where the exercise by the Community

of internal powers to achieve the aims of the ECT leads to the adoption of common rules, the

separate Member States no longer have the power to conclude their own agreements with third

States on the subject matter already covered by EC law, if such agreements with third States could

jeopardize the full effectiveness of the common rules54.

Notwithstanding direct taxation is not explicitly mentioned as an objective of the Community,

Art. 3, lett. h), ECT mentions “the approximation of the laws of Member States”: it includes direct

taxation55. In the Opinion of the Court 2/9156 the ECJ repeated the essence of the AETR judgement

and went a little further: Member States cannot conclude agreements that could affect Community

50 External powers are powers concerning relations with third States. 51 TERRA B.J.M. - WATTEL P.J., European tax law, quot., p. 191. 52 European Court of Justice, judgement in case C-22/70, AETR. 53 Opinions of the European Court of Justice 2/91, 2/92 and 1/94. 54 European Court of Justice, judgement in case AETR, quot: “to the extent to which the Community rules are

promulgated for the attainment of the objectives of the Treaty, the Member States cannot, outside the framework of the Community institutions, assume obligations which might affect those rules or alter their scope”.

55 VAN DEN HURK H., Is the ability of the Member States to conclude tax treaties chained up?, in EC Tax Review, 2004, p. 17. This conclusion is confirmed by Art. 94 EC Treaty, which constitutes the juridical base for harmonization of direct taxation in all Member States.

56 In that case, the Commission asked the ECJ for advice regarding the question of who (the Community or the separate Member States) was competent to conclude a Treaty concerning the safe use of chemicals at work.

40

rules without consulting the Community institutions. In order to strengthen this belief throughout

the Community area, the Court57 has always referred to Art. 10 ECT, establishing the principle of

Community loyalty, which prescribes Member States to ease the task of the Community for all

areas cohering to the objectives of the Treaty.

So the question arises whether the Community, adopting common rules58 in specific areas of

direct taxation and thus exercising its internal powers in these fields, has obtained external powers

in these fields of the negotiation and conclusion of Tax Treaties with third States59. The answer

should be positive. In fact, if the Community is internally competent, this competence becomes

implicitly external if it is necessary for the execution of the internal one and, consequently, Member

States have no more power to autonomously conclude agreements in the areas where the

Community has acted.

Thus, the Community has acquired, by virtue of the adoption of said Directives, the

competence to negotiate, with regard to these areas, Tax Treaties with third countries. With regard

to the case at issue, the EC Member States had not the competence to negotiate the rules concerning

the dividend withholding tax, as this area is covered by the Parent-Subsidiary directive60. And this

breach of EC law hinders “the approximation of the laws of Member States”, which is one of the

objectives the Community must pursue61.

11. CONCLUSIONS

In relation to all the above mentioned conclusions, the LOB provisions of Art. 20 of State A-

US Tax Treaty are incompatible with EC law. In particular, they infringe on:

• Art. 43 EC Treaty, for as concerns the right of establishment of all EU citizens in the

Community area;

• Art. 56 EC Treaty, for as concerns the free movement of capital between Member States;

57 See, for example: European Court of Justice, judgement in case Wielockx, quot., par. 16; European Court of

Justice, judgement in case Imperial Chemical Industries, quot., par. 19; European Court of Justice, judgement in case C-311/97, Royal Bank of Scotland, par. 19; European Court of Justice, judgement in case C-319/02, Manninen, par. 19.

58 Such as the Parent-Subsidiary Directive, the Merger Directive, the Interest and Royalty Directive, the Interest Savings Directive and the Mutual Assistance Directives.

59 TERRA B.J.M.-WATTEL P.J., European tax law, quot., p. 192. 60 HINNEKENS L., Compatibility of Bilateral Tax Treaties with European Community Law. The Rules, in EC

Tax Review, 1994, p. 146; see also RIENKS S., An EU view on the New Protocol to the Tax Treaty between the US and the Netherlands, in Intertax, 2004, p. 567.

61 DOYLE H., Is Article 26 of the Netherlands-United States Tax Treaty compatible with EC Law?, in European taxation, 1995, p. 14.

41

• Art. 56 EC Treaty, for as concerns the free movement of capital between Member States

and third States.

Anyway, we believe that State A had no power to conclude a Tax Treaty with the US,

because the Community, by adopting common rules in the area of direct taxation and thus

exercising its internal powers in this field, has by now obtained external powers in the negotiating

and conclusion of Tax Treaties with third States.

42

PART D: STATE A’S LIABILITY FOR THE BREACH OF EC LAW

12. THE CONDITIONS FOR MEMBER STATES’ LIABILITY

In case the Court should hold that State A breached EC law in the way it negotiated its Tax

Treaty with the US as it relates to the LOB article, the State A’s liability for damages sustained by

EUA and EUB must be assessed and, should it be ascertained, the amount of losses that need

compensation must be determined.

In the Francovich and Bonifaci v. Italy62 case the ECJ introduced the principle, established as

“inherent in the system of the Treaty”63, that the Member States can be held liable in the payment of

the damages that the violation of their Community law obligations has caused to individuals. The

Court relied on Art. 10 ECT: among the measures that Member States are required to take in order

to ensure fulfilment of their obligations under Community law, the ECJ also identified the

“obligation to nullify the unlawful consequences of a breach of Community law”64, in accordance

with the principle of effectiveness of EC rules65. The so-called “Francovich doctrine” has been

further elaborated by the ECJ in the joined cases Brasserie du Pêcheur and Factortame66, in which

the Court held that Member States’ liability for infringement on EC law also arises when the

national legislator was responsible for the breach in question67.

Stating the universality of the right to reparation, the ECJ set out the requirements necessary

for a State being held liable for compensation. The Court drew a parallel with Art. 288 ECT, so that

the conditions under which a State is held liable may not differ from those applicable to the liability

of the Community itself in comparable situations. Moreover, it was determined that if Member

States acted in an area in which they hold broad powers, similar to the powers of Community

institutions in the enforcement of EC policies, then the conditions of liability are applicable to

Member States in the same way they apply to the Community institutions.

On this model, the ECJ subsequently formulated the general requirements to be fulfilled in

order to qualify for compensation:

62 European Court of Justice, judgement in joined cases C-6/90 and C-9/90, Francovich and Bonifaci v. Italy. 63 Id. par. 35. 64 Id. par. 36. 65 Pursuant to it, in the enforcement of EC law, Member States must no render practically impossible the

exercise of rights conferred by Community law. See, on this point, European Court of Justice, judgment in case C-33/76, Rewe; European Court of Justice, judgement in case C-45/76, Comet.

66 European Court of Justice, judgement in joined cases C-46/93 and C-48/93, Brasserie du Pêcheur v. Germany and R. v. Secretary of State for Transport, ex parte Factortame.

67 The Francovich judgement dealt with the failure of Italian government to implement a Directive, so that the default of Member States to enforce Community law was concerned.

43

1) the violated rule of law must confer rights on individuals;

2) the breach must be sufficiently serious;

3) there must be a direct causal link between the breach of the obligation resting on the State

and the damage sustained by the injured parties68.

In order to evaluate the liability of Member State A for damage caused to EUB group, it is

opportune to examine the three criteria separately, and consider whether each condition is satisfied

in the instant case.

12.1. ARTICLES 43 AND 56 ECT CONFER RIGHTS ON INDIVIDUALS

The freedom of establishment and the free movement of capital are two of the four

fundamental freedoms on which the ECT is founded: the latter is expressly designated as such,

while the former is part of the free movement of persons69. Since the wording of these provisions

indisputably shows that they do aim to grant rights to individuals, the fulfilment of the first

condition depends on whether or not Articles 43 and 56 ECT are provided with direct effect, so that

they confer rights directly upon individuals, without interposition by national governments. In Van

Gend en Loos70 the Court developed the concept of direct applicability of Community provisions

which are sufficiently precise, clear an unconditional, without prior transformation into national

law. As properly observed, a provision is in principle clear, precise and unconditional enough if the

national administration or court can decide the case before it on the basis of that provision without

assuming legislative competences, i.e. without having to make political or policy choices71. If

regulations have direct effect by definition72 and directives may have it if they meet the

abovementioned conditions, then a fortiori such a qualification must not be denied to ECT rules

under the same conditions; and undoubtedly the rules laid down in Articles 43 and 56 ECT fulfil the

requirements set out in Van Gend en Loos, as they clearly enounce the content of the two freedoms

with sufficient precision, and directly bind Member States to recognize the rights granted to

individuals. The effectiveness and priority of EC law could not be preserved if the fundamental

68 See e.g. European Court of Justice, judgement in joined cases C-178/94, C-179/94, C-188/94, C-189/94, C-

190/94, Dillenkofer and others v. Germany, par. 20-21; European Court of Justice, judgement in case C-140/97, Rechberger and Greindl v. Austria, par. 21; European Court of Justice, judgement in case C-424/97, Salomone Haim v. Kassenzahnärtzliche Vereinigung Nordrhein (Haim II), par. 36; European Court of Justice, judgement in case C-127/95, Norbrook Laboratories Limited v. Ministry of Agriculture, par. 107.

69 VAN DEN HURK H., Is the ability of the Member States to conclude tax treaties chained up?, quot., p. 29-30. 70 European Court of Justice, judgment in case 26/62, Van Gend en Loos. 71 TERRA B.J.M.-WATTEL P.J., European tax law, quot., p. 172. 72 See Art. 249 ECT.

44

freedoms, crucial for the creation and the maintenance of a common market, were deemed not to be

directly applicable.

Consequently, we have to conclude that the rules of EC law breached by State A are intended

to confer rights directly enforceable by individuals, so that the first condition of State liability is

satisfied.

12.2. THE “SUFFICIENTLY SERIOUS BREACH” TEST

In order to give rise to liability, a breach of Community law must be sufficiently serious. For

this to be established, a Member State must have manifestly and gravely disregarded the limits on

the exercise of its discretionary powers73. According to the ECJ, the margin of discretion enjoyed

by the Member State is in an inverse relationship with the likelihood of establishing a serious

breach. The less the margin of discretion left to the national authorities by the EC rules, the easier it

would be to establish that a breach of those rules is serious74. Besides, in Hedley Lomas75 the Court

held that, where a Member State has no discretion, or where its discretion is considerably reduced,

the mere infringement of Community law may be sufficient to establish the existence of a serious

breach76. In Brasserie du Pêcheur the ECJ laid down further guidelines to be taken into account in

order to determine whether the threshold of seriousness has been reached77. Among these, suffice it

to recall the clarity and the precision of the rule breached and, particularly, the existence of a

judgement finding the infringement in question to be established, which makes ex se the breach

sufficiently serious78.

In the instance, the rules of EC law infringed by State A are considerably clear and precise, as

it has been demonstrated above and, since the clarity of the relevant Community law is the core

factor in order to determine how much discretion the Member State had in issuing its legal acts79, it

follows that the discretion enjoyed by the State in this case was extremely limited, or none at all.

73 European Court of Justice, judgement in case Brasserie du Pêcheur, quot., par. 55. 74 See TRIDIMAS T., Liability for breach of Community law: growing up and mellowing down?, in Common

market law review, 2001, p. 310-311. 75 European Court of Justice, judgement in case C-5/94, The Queen v. Ministry of Agriculture, Fisheries and

Food ex parte Hedley Lomas (Ireland) Ltd. 76 Id., par. 28. See also European Court of Justice, judgements in Dillenkofer, quot., par. 25; Norbrook, quot.,

par. 109. 77 European Court of Justice, judgement in Brasserie, quot., paras. 56-57. 78 The other criteria are: whether the infringement and the damage caused was intentional or involuntary;

whether any error of law was excusable or inexcusable; the fact that the position taken by a Community institution may have contributed towards the omission; the adoption or retention of national measures or practices contrary to Community law.

79 See in this sense HILSON C., The role of discretion in EC law on non-contractual liability, in Common market law review, 2005, p. 689 and ff.

45

According to Hedley Lomas ruling80, this circumstance is sufficient to ascertain that a serious

breach of EC law was committed by State A. Even if it should be proved that a margin of discretion

still remained, and thus a complete test is necessary, the conclusion would not be different.

In the Gottardo case81 the ECJ ruled that the free movement of persons requires the Member

States not to limit the benefits of a bilateral treaty they conclude with a third State to only their own

nationals82. What is more, in the Open Skies judgements83 the Court disqualified the “nationality

clause”, contained in the bilateral agreements of eight Member States with the United States, which

is similar, mutatis mutandis, to the resident shareholder test in the LOB clause of Art. 20 of State

A-US Tax Treaty: both requirements restrict the benefits of the agreements predominantly to

residents of the contracting States84.

After the abovementioned rulings, it is undisputable that the breach of EC law perpetrated by

State A must be considered sufficiently serious, and thus the second condition of liability is also

met.

12.3. THE LINK OF CAUSATION

Finally, as regards the requirement of the direct causal link between the breach and the

damage, a case by case approach has always been adopted by the ECJ85. In the instant case, what

must be established is the existence of a primary link of causation between State A’s agreeing on

the LOB clause and the financial loss suffered by EUA and EUB, i.e. the amount of the additional

US withholding tax (25%) charged to EUA and the amount of US penalties and late interests paid

by USCO86.

The correct reasoning is the following: if State A had not agreed on that LOB clause, would

EUA and EUB have sustained such damage87? And the answer could not be other than a point-black

80 European Court of Justice, judgement in case Hedley Lomas, quot. 81 European Court of Justice, judgement in case Gottardo, quot. 82 The case concerned Mrs. Gottardo, of Italian origin, but through her marriage of French nationality, who had

worked in Italy, Switzerland and France, paying social security contributions in all three States, and later applying for an Italian pension. To reach the pension rights threshold, she needed her Swiss employment period to be counted as well. The Italian-Swiss treaty provided for such inclusion only for nationals. The Court held that Art. 39 ECT required Italy, when calculating the required employment period for the grant of an Italian pension, to include the Swiss employment period irrespective of the nationality of Mrs. Gottardo, as long as it was an EU nationality.

83 European Court of Justice, judgement in cases Open skies, quot. 84 CLARK B., The Limitation on Benefits Clause Under an Open Sky, quot., p. 22. 85 See European Court of Justice, judgement in case C-319/96, Brinkmann Tabakfabriken GmbH v.

Skatteministeriet, par. 29; European Court of Justice, judgement in case Rechberger, quot., paras. 74 and ff. 86 Which both shareholders of USCO, EUA and EUB, suffered proportionally to their shareholding. 87 I.e.: would USCO have been assessed an additional 25% dividend withholding tax, along with late interests

and penalties, by the US Internal Revenue Service?

46

no. In fact, in its tax audit the IRS rightly applied Art. 20 and concluded that EUA did not meet the

requirements laid down in it: had the LOB clause been formulated in a non discriminatory way,

there would have been no space for litigation in the US. And this means that, in the absence of

exceptional or unforeseeable events that broke the chain of causation, State A’s infringement must

be considered the proximate cause of the loss suffered by EUA and EUB.

13. ASSESSMENT OF DAMAGES

Since all conditions of State’s liability are fulfilled, State A must be held liable for

compensation.

As concerns the amount of compensation, the basic principle is that the compensation must be

effective with respect to the damage suffered so that the actual protection of the injured parties’

rights is assured88. It derives that State A must be condemned to reimburse the additional US

withholding taxes plus penalties and late interests applied by the IRS.

In addition, as settled case-law states that compensation has to cover not only the damage but

also the loss of profits89, there is no reason to doubt that the payment of interests on the amount of

assessed damages is also due by State A.

88 VAN DEN HURK H., Is the ability of the Member States to conclude tax treaties chained up, quot., p. 29. 89 See European Court of Justice, judgement in case Francovich, quot., par. 46: “[…] a Member State is required

to make good loss and damage caused to individuals […]”.

47

V. ANNEXES

Up to 31st Dec 2000 As from 1st Jan 2001B

USCO inc.

USA

A

EUA Se

EUAHOLD Se

Mr. X Mr. Y Mr. Z

EUB Se

Mr. J Mr. K

Mr. W

Mr. I Mr. V

EUA Se

USCO inc.

100%

100%

100%

34%

Shares in EUA

EUB Se

USEUB (USEUB)

Group Structure

66%

48

Intra Group Dividends

Interest: - deductible for EUA - no withholding tax exceeds

50% of the gross income of EUA

EUB Se

EUA Se

Loan Interest

USCO inc.

66% 34%

32,3 % 62,7 %

32,3 %

Dividends: - 34% from USCO to EUA - 66% from USCO to EUB - 5% withholding tax when

distributed by USCO to EUA

B

A

USA

- 5% withholding tax when distributed by USCO to EUB

- no withholding tax when distributed by EUA

49

IRS Tax Audit

EUB Se

EUA Se

USCO inc.

66% 32,3 %

34%

32,3 %

62,7 %

USA

BUSA-B Treaty applies

USA

AUSA-A Treaty does not apply

8,5%

8,5% + (late interests + penalties)

IRS

Penalties: - 8,5% (25% of 34) from USCO to US

IRS - Late interests and penalties on the

additional 25% - 8,5% reimbursed by EUA to USCO

Dividends: - 34% from USCO to EUA - 66% from USCO to EUB - 5% withholding tax when distributed

by USCO to EUB - 30% withholding tax when distributed

by USCO to EUA - no withholding tax when distributed by

EUA

50

VI. LIST OF ABBREVIATIONS

Art. Article ECJ European Court of Justice EC Law European Community Law ECT European Community Treaty EU European Union IRS Internal Revenue Service LOB Limitation On Benefits US United States of America

51

European Tax Moot Court Competition 2005/2006

MEMORANDUM FOR THE DEFENDANT

Registration number: E/001

52

I. LIST OF SOURCES

Scholars

AVERY JONES, J. F., Flows of capital between the EU and third countries and the consequences

of disharmony in European international tax law, in EC Tax Review 1998/2 p. 97

BAKER, P., Double Taxation Conventions and International Tax Law, 2nd edition, Sweet &

Maxwell, London 1994, p. 59-60.

BRAEDON, C., The Limitation on Benefits Clause under an open Sky, in European Taxation,

January 2003, p. 22.

DE CEULAER, S., Community Most-Favoured-Nation Treatment: One Step Closer to the

Multilateralization of Income Tax Treaties in the European Union?, in Bulletin 2003 p. 496.

DOURADO, A. P., From the Saint-Gobain to the Metallgesellschaft case: scope of non-

discrimination of permanent establishments in the EC Treaty and the most-favoured-nation clause

in EC Member States tax treaties, in EC Tax Review 2002/3 pp. 151

HILSON C., The role of discretion in EC law on non-contractual liability, in Common Market

Law Review, 2001, p. 692.

HINNEKENS, L., Compatibility of Bilateral Tax Treaties with European Community Law. The

Rules, in EC Tax Review, 1994/4, p. 146

HINNEKENS, L., Compatibility of Bilateral Tax Treaties with European Community Law –

Application of the Rules, in EC Tax Review, 1995/4, p. 202.

HINNEKENS, L., European Court goes for robust tax principles for treaty freedoms. What about

reasonable exceptions and balances?, in EC Tax Review, 2004/2, p. 66.

53

KEMMEREN, E., The termination of the ‘most favoured nation clause’ dispute in tax treaty law

and the necessity of a Euro Model Tax Convention, in EC Tax Review 1997/3, p.146.

KOFLER, G.W., European Taxation under an “Open Sky: LoB Clauses in Tax Treaties Between

the US and EU Member States, in Tax Notes International, 2004, p. 78

MEUSSEN, G., The Advocate General’s Opinion in the “D” Case: Most-Favoured-Nation

Treatment and the Free Movement of Capital, in European Taxation 2005 p.54.

MOHAMED, S., European Community law on the Free Movement of Capital and the EMU,

Kluwer, 1999, p. 217.

PANAYI, C., Open Skies for European Tax?, in British Tax Review, 2003, p. 194.

PETKOVA, S., Treaty Shopping. The Perspective of National Regulators, in European Taxation,

2004, 543.

RIENKS, S., An EU view on the New Protocol to the Tax Treaty between the US and the

Netherlands, in Intertax, 2004, p. 567.

SMIT, D., Capital movements and direct taxation: the effect of the non-discrimination principles, in

EC Tax Review, 2005/3, p. 129.

STAHL, K., Free movement of capital between Member States and third countries, in EC Tax

Review, 2004/2, p. 52.

TERRA, B.J.M. and WATTEL, P.J., European Tax Law, The Hague, 2005.

TRIDIMAS T., Liability for breach of Community law: growing up and mellowing down?, in

Common market law review, 2001, p. 310.

54

VAN DER HURK, H., Is the ability of the Member States to conclude tax treaties chained up?, in

EC Tax Review, 2004, p. 17.

VAN DER LINDE, R., Some thoughts on most-favoured-nation treatment within the European

Community legal order in pursuance of the D case, in EC Tax Review 2004/1 p.12.

VAN UNNIK, D., and M. BOUDESTEYN, New US-Dutch Treaty and the Treaty of Rome, in EC

Tax Review, 1993/2, p. 106.

VOGEL, K., Problems of a Most-Favoured-Nation Clause in Intra-EU Treaty law, in EC Tax

Review 1995/4 p.264.

WASSERMEYER, F., Does the EC Treaty Force the Member States to Conclude a Multilateral

Tax Treaty?, in Multilateral Tax Treaties, in New Developments in International Tax Law, Kluwer

Law International, 1998, p. 18.

WEBER, D. and SPIERTS, E., The “D Case”: Most-Favoured-Nation Treatment and

Compensation of Legal Costs before the European Court of Justice, in European Taxation 2004 p.

65.

WEBER, D., Most-Favoured-Nation Treatment under Tax Treaties Rejected in the European

Community: Background and Analysis of the D case, in Intertax, 10/2005, p. 440.

55

European Court of Justice jurisprudence

Judgment of 5 February 1963 in case C-26/62, Van Gend en Loos

Judgment of 31 March 1971, in case C-22/70, AETR

Judgment of 21 June 1974, in case C-2/74, Reyners

Judgment of 22 January 1976, in case C-55/75, Balkan-Import

Judgment of 11/11/1981,in case C-203/80, Casati

Judgment of 28 October 1982, in case C-52/81, Werner Faust

Judgment of 24 June 1986, in case C-236/84, Hauptzollamt Dusseldorf

Judgment of 19 November 1991 in joined cases C-6/90 and C-9/90, Francovich and Bonifaci v.

Italy

Judgement of 28 January 1992, in case C-204/90, Bachmann

Judgment of 14 February 1995, C-279/93, Finanzamt Koeln-Altstadt v. Roland Schumacker

Judgment of 11 August 1995, in case C-80/94, Wielockx

Judgment of 14 November 1995, in case (C-484/93), Svensson-Gustavvson

Judgment of 5 March 1996 in joined cases C-46/93 and C-48/93, Brasserie du pêcheur v. Germany

and R. v. Secretary of State for Transport, ex parte Factortame

Judgement of 23 May 1996 in case C-5/94, The Queen v. Ministry of Agriculture, Fisheries and

Food ex parte Hedley Lomas (Ireland) Ltd

56

Judgment of 27 June 1996, in case C-107/94, Asscher

Judgement of 15 May 1997 in case C-250/95, Futura Participations SA and Singer

Judgment of 8 October 1996 in joined cases C-178/94, C-179/94, C-188/94, C-189/94, C-190/94,

Dillenkofer and others v. Germany

Judgement of 2 April 1998 in case C-127/95, Norbrook Laboratories Limited v. Ministry of

Agriculture

Judgment of 12 May 1998, in case C-336/96, Gilly

Judgment of 16 July 1998, in case C-264/96, Imperial Chemical Industries

Judgment of 27 September 1998 in case 235/87, Matteucci

Judgment of 16 March 1999, in case C-222/97, Trummer and Mayer

Judgment of 15 June 1999 in case C-140/97, Rechberger and Greindl v. Austria

Judgment of 21 September 1999 in Case C-307/97, Compagnie de Saint-Gobain

Judgment of 13 April 2000, in case C-251/98, Baars

Judgment of 6 June 2000, in case C-35/98, Verkooijen

Judgment of 15 June 2000 in case C-319/96, Brinkmann Tabakfabriken GmbH v. Skatteministeriet

Judgment of 4 July 2000 in case C-424/97, Salomone Haim v. Kassenzahnärtzliche Vereinigung

Nordrhein (Haim II)

Judgment of 11 January 2001, in case C-464/98, Stefan

57

Judgment of 8 March 2001in joined cases C-397/98 and C-410/98, Metallgesellschaft and Hoechst

Judgment of 15 January 2002, in case C-55/2000, Gottardo

Judgment of 28 January 2002, in case C-300/90, Commission v. Belgium

Judgments of 5 November 2002, in joined cases: C-466/98, Commission v. United Kingdom; C-

471/98, Commission v. Belgium; C-467/98, Commission v. Denmark; C-468/98, Commission v.

Sweden; C-469/98, Commission v. Finland; C-472/98, Commission v. Luxembourg; C-

475/98,Commission v. Austria; C-476/98, Commission v. Germany, cd. “Open skies”

Judgment of 12 December 2002, in case C-324/00, Lankhorst-Hohorst

Judgment of 18 September 2003, in case C-168/01, Bosal Holding

Judgement of 23 September 2003, in case C-452/01, Ospelt and Schlössle Weissenberg

Judgment of 11 March 2004 in Case C-9/02, de Lasteyrie du Saillant

Judgment of 5 July 2005 in case C-376/03, D case

Opinions of the European Court of Justice





58

Opinions of Advocate General

Opinion of Advocate General Mischo in case C-436/00, X and Y.

Opinion of Advocate General Tizzano in case C-516/99, Schmid.

Opinion of Advocate General Kokott of 18 March 2004 in case C- 319/02, Manninen.

Opinion of Advocate General D. Ruiz-Arabo Colomer of 24 October 2004

European Community Legislation

Council Directive 77/799/EEC, the Mutual Assistance Directive

Council Directive 88/361/EEC of 24 June 1988 for the implementation of Article 67 of the Treaty

Council Directive 90/435/EEC of 23 July 1990, Parent-Subsidiary Directive

Council Directive 90/434/EEC of 23 July 1990, Merger Directive

Council Directive 2003/48/EC of 3 June 2003, Interest Savings Directive

Council Directive 2003/49/EC of 3 June 2003, Interest and Royalty Directive

Other documents

Council Decision (2004/911/EC) of 2 June 2004.

EU Commission, DG Taxation and Customs Union, Working Document of 9 June 2005, DOC (05)

2306.

59

II. STATEMENT OF FACTS

EUA SE (“EUA”) is a privately held company, incorporated as a Societas Europaea

and resident for tax purposes in EU Member State A. EUA was, until December 31, 2000,

held by a holding company EUAHOLD SE (“EUAHOLD”), incorporated as a Societas

Europaea and resident for tax purposes in EU Member State A.

EUAHOLD was owned until December 31, 2000, by three individuals, resident for

tax purposes in EU Member State A.

EUA manufactures and sells highly sophisticated technical devices, used in the

military, medical and heavy industry sectors, to allow testing of materials in situations

where such testing is normally very hard to perform. It is very profitable and employs

worldwide about 3000 workers and employees. It sells all of its products throughout the

world through fully owned subsidiaries incorporated abroad (in the US, Europe, and Latin

America), such as USCO INC.

USCO INC. (“USCO”) is a privately held company, incorporated and resident for

tax purposes in the United States of America. It was incorporated in 1985 and fully

owned until December 31, 2000 by EUA.

USCO manufactures and sells the same product range as EUA for the US market. It

employs about 500 workers and employees and is very profitable.

There is currently no, nor ever was, any financing by EUA of the activities of

USCO, given USCO’s high level of profitability. EUA never repatriated dividends from

USCO, but preferred to accumulate earnings in the US and use USCO shareholders’ funds

for further expansion in the US, and not to pay or defer US withholding taxes on

dividends, which otherwise would have been due in the US at the rate of 5%, if dividends

were repatriated to EUA.

60

The three individual shareholders of EUAHOLD resident in EU Member State A

equally preferred that no dividends were paid from USCO to EUA, awaiting the possible

sale of EUA by EUAHOLD, which under the national tax legislation of EU Member State

A (subject to certain conditions being met) would result in a tax free capital gain for

EUAHOLD.

EUAHOLD sold all of its shares in EUA to EUB SE (“EUB”), effective January

1, 2001 and realized a considerable tax free capital gain in EUA.

EUB is a privately held company, incorporated as a Societas Europaea in 1980 and

resident for tax purposes in EU Member State B. It is held by five individuals, who are

resident for tax purposes in EU Member State B.

The EUB group was, until the purchase of the EUA group (effective January 1,

2001), a major competitor of the EUA group. The EUB group is active in the same

industry sectors and manufactures and sells similar, but not identical, products

worldwide.

EUB acts both as the top holding and headquarter of the group and also runs

manufacturing and sales operations in EU Member State B. EUB has many subsidiaries

outside EU Member State B.

As indicated above, effective January 1, 2001, EUB bought all shares of EUA from

EUAHOLD.

Early 2001, EUB lent funds to EUA (through a registered bond issued by EUB

and subscribed by EUA), allowing EUA to incorporate new sales companies in

China, Malaysia and Hong Kong.

EUB preferred EUA to act as its top holding and headquarters for the EUA group

products, rather than directly owning the new Asia-Pacific sales entities in China,

Malaysia and Hong Kong (selling only EUA products). At the same time, interest paid by

EUA to EUB was deductible against the manufacturing and sales profits of EUA and was

not subject to withholding taxes in EU Member State A.

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The interest paid to EUB by EUA exceeds on a yearly basis more than 50% of

the gross income of EUA.

Prior to the acquisition of EUA effective January 1, 2001, EUB owned a sizeable

subsidiary in the US, USEUB, which manufactures a range of products similar to the

products of EUA, but specifically sold to the telecom industry. USEUB is loss-making for

tax purposes.

In order to obtain a de facto tax consolidation in the US, USEUB has been

absorbed by, and merged into USCO, effective January 1, 2001. After the merger,

USCO operates two different business units in one single company USCO.

As a consequence of the merger, EUB now owns 66% of USCO and EUA owns

34% of the shares of USCO.

In May 2002, the annual general meeting of shareholders of USCO decided to pay a

high amount as dividend to its shareholders EUA and EUB.

A 5% withholding tax (as provided in the Tax Treaties concluded between the US

and both EU Member State A and EU Member State B for direct shareholdings of least

10% ) was withheld and paid to the US Treasury on both the dividends paid to EUA and

to EUB.

In September of 2002 EUA decided to pay and paid an interim dividend, for about

the same amount it received from USCO, to EUB. No withholding tax was withheld on

this dividend, based on the EC Parent-Subsidiary Directive and EU Member State A’s

internal tax law.

EUB used the dividend it received as a direct shareholder of USCO in May 2002 and

the interim dividend received from EUA in September 2002 to partly reimburse the debt

it engaged into to acquire EUA.

Upon audit by the US Internal Revenue Service (“IRS”) in 2005, the reduction

of the standard dividend withholding tax from 30% to the 5% Tax Treaty rate, as

62

provided by the EU Member State A–US Tax Treaty, was disallowed by the IRS for

the dividend paid by USCO to EUA.

According to the IRS, the withholding tax on the dividend could not be reduced to

5%, since EUA did not meet the requirements laid down in the “limitation on benefits”

Article of the EU Member State A-US Tax Treaty (Article 20). Hence USCO was

assessed an additional 25 % dividend withholding tax. Late interests and penalties were

applied and assessed as well on USCO.

The reduction of the withholding tax from 30% to 5% on the dividend paid by

USCO directly to EUB was not challenged by the IRS, since, in the view of the IRS, it

was made in accordance with the stipulations of the EU Member State B-US Tax Treaty

(in particular Article 25).

USCO charged and was reimbursed by EUA, the 25% additional US

withholding taxes (not the US penalties and US interest).

Having reviewed the stipulations of the EU member State A-US and EU Member

State B-US Tax Treaties, USCO, EUA and EUB concluded that the IRS rightly applied

both Tax Treaties and decided not to litigate in the US.

So, EUA and EUB decided to file a claim for damages before the civil court, i.e. the

Tribunal of First Instance of city Z (in EU Member State A, where EUA has its legal seat)

against EU Member State A.

The Tribunal of First Instance agreed and judicially acknowledged with EUA’s and

EUB’s position on these points and allowed the case to be heard.

The civil law claims were based on the argument that EU Member State A breached

EC law, in the way it agreed on a limitation on benefits clause in its Tax Treaty with the

US. As a result, EUA (directly and indirectly) and its parent EUB (indirectly) suffered a

financial loss.

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• A first claim was filed by EUA and called for damages to be paid by EU

Member State A, equal to the amount of the additional US withholding tax

(25%).

• In addition, both EUA and EUB claimed payment of the amount of US

penalties and US late interest paid by USCO, which both shareholders of

USCO suffered indirectly, proportionally to their shareholdings in USCO as

a result of the alleged breach of EC law by EU Member State A.

• EUA further claimed interest on the amount of the additional US

withholding taxes of 25%.

• Finally, EUA and EUB claimed interest on the amount of US penalties and

US late interest paid by USCO, which both shareholders of USCO suffered

indirectly, proportionally to their shareholdings in USCO.

The Tribunal of First Instance of city Z in EU Member State A stayed the

proceedings and referred the following request for a preliminary ruling on the basis of

Article 234 EC Treaty to the European Court of Justice in Luxembourg.

64

III. ISSUES

The present case involves many juridical questions and topics that can be summarised as follows:

PART A: THE MEMBER STATES’ EXTERNAL TAX TREATY-MAKING POWER

1. The EC Treaty confers only limited external powers on the Community.

1.1. The Community has also limited powers when necessary to effectively pursue an

objective set out by the EC Treaty (“implied powers doctrine”).

1.2. The objectives the Community must pursue do not expressly include direct taxation.

1.3. The Community has no external power in the field of direct taxes.

2. Member States retain their exclusive treaty-making power in the area of direct taxation

2.1. State A had the exclusive power to conclude the Tax Treaty with the US, since the

adoption by the Community of common rules in the area of direct taxation does not imply

that the Community acquired external powers in the same field.

2.2. The conclusion of such a treaty by State A does not constitute a breach of EC Law.

3. In subsidiary order: State A had the exclusive power to negotiate the LOB clause in the State A-

US Treaty

3.1 Even if the Community had limited (implied) external powers in the area of direct

taxation, they would not concern the negotiation of LOB clauses.

3.2. The LOB clauses have a general anti-abuse purpose. They are functional to the

prevention of double taxation, which is a general objective of the Community.

3.3. The EC Member States’ power to negotiate LOB clauses is not infringed by the Parent-

Subsidiary directive, since DTCs cover a much wider area and have a specific different

purpose.

65

PART B: COMPATIBILITY OF THE STATE A–US TAX TREATY WITH THE EC TREATY AND THE

FUNDAMENTAL FREEDOMS

4. The LOB clause is compatible with the Non-Discrimination Principle laid out by Art. 12 EC

Treaty.

4.1 The non discrimination principle does not apply to tax treaties: Member States are free to

allocate taxation powers, which is the core content of the Double Taxation Conventions.

4.2. Moreover, the non-discrimination principle does not imply that objectively different

situations should be treated in the same manner.

4.2.1. Residents and non-residents are not, in principle, in a comparable situation.

5. The LOB clause is compatible with the Freedom of Establishment

5.1. The EC Treaty definition of the right of establishment (Art. 43).

5.1.1. Scope of the right of establishment.

5.2. The right of establishment does not apply to LOB questioned in the present case.

5.2.1. The freedom of establishment only applies to companies and individuals

resident within the EU.

5.2.2. The freedom of establishment does not apply to a LOB clause set out by a

Treaty with a third country, as in the present case.

5.3. The LOB provisions of Art. 20, (1) (a) (i), of State A-US Tax Treaty do not constitute a

restriction to the right of establishment.

5.3.1. The Open skies doctrine does not apply, since it concerns a non-tax case and a

different type of clause (nationality clause).

6. In Subsidiary Order: the asserted restriction to the free movement of capital is justified

6.1 The asserted restriction is justified on the grounds of (international) public order.

6.2. The asserted restriction is justified also under all the possible justifications accepted by

the ECJ under its rule of reason.


6.2.2. Prevention of tax evasion and tax revenue loss.


66

7. State A-US Tax Treaty and the free movement of capital.

7.1. The free movement of capital according to Title III Chapter 4 of the EC Treaty.

7.1.1. Scope of this freedom.

7.1.2. The nomenclature provided by Annex I of the Directive 88/361/EEC

7.1.3. Annex I does not apply to the present case: the free movement of capital only

applies to non-related companies.

7.2. The free movement of capital does not apply to the interest paid by EUA to EUB for a

loan granted in 2001.

7.2.1. The 2001 loan is only a covert form of establishment.

7.3. The freedom of capital movement does not apply to the LOB clause set out by the State

A-US Treaty.

7.4. In Subsidiary Order: the restriction to the free movement of capital is justified under all

the possible justifications accepted by the ECJ under its rule of reason.

PART C. THE FREE MOVEMENT OF CAPITAL IN RELATION TO THIRD COUNTRIES

8. The LOB clause does not infringe the free movement of capital in relation with third countries

8.1. The Freedom of Capital Movement also applies, in principle, to capital movements with

third countries.

8.2. However, the freedom of capital movements with third countries has a narrower scope.

8.2.1 The free movement of capital with third countries may be limited only to

physical and direct restrictions.

8.2.2 EC law does not require Member State to apply a Most Favourite Nation clause

in their relations with third countries (D case).

8.2.3. Would the LOB clause at issue restrict the free movement of capital with third

countries, a Most Favoured Nation treatment would apply.

8.3. The LOB clause is compatible with the free movement of capital with third countries.

PART D: THE ISSUE OF STATE A’S LIABILITY FOR THE BREACH OF EC LAW

9. The conditions for Member States’ liability.

67

9.1. The “Francovich doctrine” and the Member States’ liability for the payment of the

damages that the violation of their Community law obligations has caused to individuals.

10. The general requirements to be fulfilled in order to qualify for compensation.

• The violated rule of law must confer rights on individuals;

• The breach must be sufficiently serious;

• There must be a direct causal link between the breach of the obligation resting on the State


10.1. Check of the fulfilment of these requirements in the case at issue.

10.2. The requirements are not fulfilled.

11. State A can not be held liable for compensation.

11.1. Assessment of damages is not possible: no compensation is due.

68

IV. ARGUMENTS

1. GENERAL REMARKS ON THE METHOD

This paper basically aims to demonstrate (1) the compatibility of the LOB provisions set out

by Art. 20 of the State A-US Tax Treaty (hereinafter: the A-US TT) with EC law – and, in

particular, with the fundamental freedoms of establishment and movement of capital -, and (2) the

lack of State A’s responsibility for having agreed to the above-mentioned LOB clause.

As a preliminary remark, we submit that there are no legal grounds for assessing Member

State A’s liability in negotiating the LOB Article in the A-US TT. In the lack of substantial

harmonisation in the field of direct taxes, MS retain exclusive external tax treaty-making power.

This assumption is indirectly confirmed by Art. 293 ECT, which confers exclusively on the MS the

power to negotiate international agreements aiming at reducing double taxation within the

Community.

Should the Court fail to accept this argument, nonetheless we contend that EU Member State

A did not breach EC law in the way it negotiated its tax treaty with the US as it

relates to the limitation of benefits article.

The fundamental freedoms should apply to prevent discrimination in, for example, the tax

treaty between A and B, where the A government had excluded a company resident in B from the

benefits of the treaty if nationals of another Member State (C) substantially own it. The right of the

US, in its tax treaty with A, is beyond the scope of the fundamental freedoms. The Open Skies

doctrine is not applicable to the present case, as it refers to a non comparable clause (the nationality

clause) and is not applicable to tax matters.

Should the Court not uphold this argument, nonetheless State A did not breach EC law with

reference to the freedom of establishment.

In fact, the investments addressed to set up and manage undertakings or to invest in a

business continuation in other MS can not be considered as strictly and directly related to the right

69

of establishment. This freedom, incidentally, is granted only to EU citizens, and therefore does not

apply to companies established in the US.

Nor did Member State A breach EC law as far as the free movement of capital is concerned.

In fact, the definition of “capital movement” does not include a controlling interest in a company of

another Member State. The payment of loan-related interest from EUA to EUB is not relevant:

although falling prima facie within the scope of Art. 56, the 2001 loan from EUA to EUB may be

deemed a covert form of establishment.

We also contend that the potential breach of EC law by EU Member State A is

not impacted by the fact that other EU Member States, e.g. EU Member State B,

provided for different and more extensive provisions on limitations of benefits in tax

treaties with the US.

In other words, the Most Favoured Nation (MFN) doctrine90 does not apply to tax treaties,

as expressly stated by the ECJ in the late D case91. In fact, it is hardly possible to understand how a

90 The possibility to apply the MFN doctrine to direct tax matters has been debated for a long time by EU scholars. We shall remember, among others, AVERY JONES, J. F., Flows of capital between the EU and third countries and the consequences of disharmony in European international tax law, in EC Tax Review 1998/2 p. 97; DE CEULAER, S., Community Most-Favoured-Nation Treatment: One Step Closer to the Multilateralization of Income Tax Treaties in the European Union?, in Bulletin 2003 p. 496f; DOURADO, A. P., From the Saint-Gobain to the Metallgesellschaft case: scope of non-discrimination of permanent establishments in the EC Treaty and the most-favoured-nation clause in EC Member States tax treaties, in EC Tax Review 2002/3 pp. 151ff and 156; HINNEKENS, L., Compatibility of Bilateral Tax Treaties with European Community Law. The Rules, in EC Tax Review 1994/4 pp.152ff ; idem, Compatibility of Bilateral Tax Treaties with European Community Law – Applications of the Rules, in EC Tax Review 1995/4 pp. 210ff; TERRA, B. J. M., and WATTEL, P., European Tax Law, The Hague, 2005; VAN DER LINDE, R., Some thoughts on most-favoured-nation treatment within the European Community legal order in pursuance of the D case in EC Tax Review 2004/1 pp.12 and 17; VOGEL, K., Problems of a Most-Favoured-Nation Clause in Intra-EU Treaty law, in EC Tax Review 1995/4 pp.264f. The ECJ had the opportunity of giving its opinion on it in the joined cases Metallgesellschaft and Hoechst (Judgement of the Court 8 March 2001, Joined Cases C-397/98 and C-410/98), but it did not address the issue. Although similar problems arose in the Schumacker case, in its decision the ECJ did not need to address the matter either (cf. WEBER and SPIERTS, The “D Case”: Most-Favoured-Nation Treatment and Compensation of Legal Costs before the European Court of Justice, in European Taxation, 2004, p. 67). Some scholars (E. KEMMEREN, The termination of the ‘most favoured nation clause’ dispute in tax treaty law and the necessity of a Euro Model Tax Convention, EC Tax Review 1997/3, pp.146ff and 152) argued that the non applicability of the MFN doctrine under the ECT had already been implicitly decided by the ECJ in the Bachmann case (Judgement of the Court of 28 January 1992, Case C-204/90) where the ECJ stated: “It is true that bilateral conventions exist between certain Member States, allowing the deduction for tax purposes of contributions paid in a contracting State other than that in which the advantage is granted, and recognizing the power of a single State to tax sums payable by insurers under the contracts concluded with them. However, such a solution is possible only [emphasis added] by means of such conventions or by the adoption by the Council of the necessary coordination or harmonization measures” (para. 26). 91 Judgment of 5 July 2005, case C-376/03, D case.

70

legitimate exercise of sovereignty of a Member State – the negotiation and endorsement of

legitimate clauses of a tax treaty – could impact on a non-legitimate behaviour of another Member

State.

Furthermore, we submit that the insertion of clauses like the limitation of

benefits article of the EU Member State A-US tax treaty is fully compatible with the

free movement of capital with third countries.

With regard to the free movement of capital in relation to third States, we will show that the

provisions at issue do not constitute a breach of EC law, due to the fact that EC law does not

provide for a full liberalisation of capital movements with third countries.

In subsidiary order, we submit that every potential restriction of the right of establishment

and the free movement of capital provided by the LOB provisions set out by Art. 20 A-US TT is

justified, respectively, under the criteria (fiscal cohesion, prevention of tax evasion, proportionality)

mostly accepted by the ECJ, and under Art. 58 ECT.

Finally, we contend that, shall the Court hold that State A breached EC law insofar as it

negotiated the LOB clause contained in the State A–US Treaty, nonetheless it has no liability for

the breach of EC law and therefore no compensation for damages is due.

71

PART A: THE MEMBER STATES’ EXTERNAL TAX TREATY-MAKING POWER

2. THE COMMUNITY EXTERNAL POWERS

It is not subject to dispute that the Community can negotiate and enter into international

agreements92. The ECT contains a number of provisions which confer on the Community external

powers93 in specific areas.

Besides these “explicit” external powers, it is now widely accepted that the Community has

“implicit” external powers94. The AETR case95 and several opinions96 handed down by the ECJ

show that whenever EC law confers internal powers on the Community in order to achieve an

objective, the Community is also competent to conclude those international agreements which

prove to be necessary to achieve the same objective (“in foro interno, in foro externo” doctrine).

Moreover, the Court held that, where the exercise by the Community of internal powers leads

to the adoption of common rules, MS’ power to conclude their own agreements with third States

may be limited, if such agreements could jeopardise the full effectiveness of the common rules97.

It follows that the Community has an exclusive external competence in the areas in which:

(a) the power to negotiate with third States is expressly conferred on its institutions; or

(b) it has included in its internal legislative acts provisions that deal with the treatment of

citizens of third countries98.

The Community may also have a limited external competence in certain specific areas. This

competence, however, arises if, and only if, any of these conditions is met:

(c) the exercise of external powers is strictly necessary to fulfil an objective expressly stated

in the Treaties; or

92 Art. 281 ECT expressly confers on the Community the legal capacity to do so. 93 External powers are powers concerning relations with third States. 94 TERRA B.J.M. - WATTEL P.J., European tax law, quot., p. 191. 95 European Court of Justice, judgement in case C-22/70, AETR. 96 Opinions of the European Court of Justice 2/91, 2/92 and 1/94. 97 European Court of Justice, judgement in case AETR, quot: “to the extent to which the Community rules are promulgated for the attainment of the objectives of the Treaty, the Member States cannot, outside the framework of the Community institutions, assume obligations which might affect those rules or alter their scope”. 98 Opinion 1/94 para.95; VAN DER HURK H., Is the ability of the Member States to conclude tax treaties chained up?, in EC Tax Review, 2004, p.21.

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(d) action has been conducted by the institutions of the Community in the framework of the

Treaties (i.e., enactment of Regulations or Directives) with regard to a particular issue99.

3. MEMBER STATES RETAIN THEIR EXCLUSIVE TREATY-MAKING POWER IN THE AREA OF

DIRECT TAXATION

As far as direct taxes are concerned, no doubts arise with respect to exclusive external

competence: the ECT contains no specific provisions enabling the EU to conclude international

treaties in the field of direct taxation (and, above all, Double Taxation Conventions, hereinafter:

DTCs).

This assumption is indirectly confirmed by the provisions laid out in Art. 293 ECT100,

according to which:

“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”.

With reference to a presumed “limited” Community external competence in the field of direct

taxes, it must be observed what follows.

Direct taxation is not explicitly mentioned as an objective of the Community. In the AETR

judgment the ECJ clearly limited the possibility for the Community to interfere with MS’ external

powers to those areas falling within the scope of Art. 3 ECT101: therefore, the EU should have no

external power in the field of direct taxation102.

A question may arise only on whether the Community, by adopting common rules (the so-

called “Tax Directives”)103 - and thus exercising its internal powers - in specific areas of direct

taxation, has derived external powers in these fields104.

99 See also VAN DER HURK H., quot., p. 24. 100 Art. 293 ECT is the only Article of the ECT expressly referred to direct taxation. 101 Which indicates, for the purposes set out in Article 2 ECT, the activities of the Community. 102 Many authors support this view. Concede that WASSERMEYER, F., Does the EC Treaty Force the Member States to Conclude a Multilateral Tax Treaty?, in Multilateral Tax Treaties, New Developments in International Tax Law, Kluwer Law International, 1998, p. 18- 103 Namely, the Parent-Subsidiary Directive, the Merger Directive, the Interest and Royalty Directive, the Interest Savings Directive and the Mutual Assistance Directives.

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With regard to the present case, one may argue that the EC MS had not the competence to

negotiate the rules concerning the dividend withholding tax, as this area is covered by the Parent-

Subsidiary directive105.

This argument can not be accepted106.

In fact, tax treaties have a much wider scope than just a specific directive. Moreover, the

Parent-Subsidiary Directive is limited to purely internal solutions, and does not impinge on external

relations.

DTCs basically aim at apportioning income between two States, with a view to eliminating

double taxation. And, as the ECJ ruled:

“... in the absence of unifying or harmonising measures adopted in the Community ... the

Member States are at liberty, in the framework of bilateral agreements concluded in order to

prevent double taxation, to determine the connecting factors for the purposes of allocating

powers of taxation.107”.

In addition, the very extent of the EU competence in the field of direct taxes is uncertain.

Since the ECT contains no specific provisions on the subject, the power to enact the Tax Directives

had to be justified as implied by Art. 94 ECT108. It would be quite peculiar that an “implied”

internal power could be effectively be exercised only through an “implicit” external power.

104 TERRA B.J.M.-WATTEL P.J., European tax law, quot., p. 192. 105 HINNEKENS L., Compatibility of Bilateral Tax Treaties with European Community Law. The Rules, in EC Tax Review, 1994, quot., p. 146; see also RIENKS S., An EU view on the New Protocol to the Tax Treaty between the US and the Netherlands, in Intertax, 2004, p. 567. 106 VAN DER HURK H., quot., p. 17. This conclusion is confirmed by Art. 94 EC Treaty, which constitutes the juridical basis for the harmonisation of direct taxation in all Member States. 107 Judgment of the Court of 21 September 1999, Case C-307/97 (Compagnie de Saint-Gobain), point 56. See also Judgment of the Court of 12 May 1998, Case C-336/96 (Gilly), point 24. 108 “The Council shall, acting unanimously on a proposal from the Commission and after consulting the European 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”.

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There are also textual arguments which may lead to conclude that DTCs cannot be affected by

EC law. Art. 7, para. 2, Parent-Subsidiary Directive, supports this statement109, even though its

meaning is not completely clear110.

DTCs provisions are left unprejudiced also by some recent Agreements signed by the

Community with third States in the field of the taxation of savings – covered by the Council

Directive 2003/48/EC111.

The arguments proposed lead to the conclusion that the so called “in foro interno, in foro

externo” doctrine has not been positively accepted by EC law.

3.1. IN SUBSIDIARY ORDER: MEMBER STATE A HAS THE EXCLUSIVE POWER TO NEGOTIATE THE

A-US TAX TREATY

Shall this Court hold that the Community has a limited external power in the field of direct

taxation, nevertheless State A had an exclusive power to negotiate the A-US TT.

It is true that, in case of treaties concluded after the entry into force of ECT112, MS are under

an obligation – set out by Art. 10 ECT – to abstain from any measure which could jeopardise the

attainment of the objectives of this Treaty113.

However, it can be argued that DTCs are, by their very purpose – avoiding double taxation

on income and capital –, per se in accordance with the ECT and its objectives. 109 Art. 7, para. 1, EC Directive 90/435 reads as follows “This Directive shall not affect the application of domestic or agreement-based provisions designed to eliminate or lessen economic double taxation of dividends, in particular provisions relating to the payment of tax credits to the recipients of dividends”. 110 BAKER, P., Double Taxation Conventions and International Tax Law, 2nd

edition, Sweet & Maxwell, London

1994, p. 59-60. 111 Council Decision (2004/911/EC) of 2 June 2004. 112 The State A – US Treaty was concluded after the entry into force of the ECT. Art. 307 ECT, governing conflicts between Community law and bilateral tax agreements between a Member State and a third country concluded before the entry into force of the ECT, does not apply to it. It may be interesting to remember that the first paragraph of this Article provides that “the rights and obligations arising from agreements concluded before [the entry into force of the Treaty (EC or Accession)] between one or more Member States on the one hand, and one or more third countries on the other, shall not be affected by the provisions of this Treaty.” 113 See Judgment of 27 September 1998 on Case 235/87 (Matteucci): “Article [10] of the Treaty provides that Member States must take all appropriate measures, whether general or particular, to ensure fulfilment of the obligations arising out of the Treaty. If, therefore, the application of a provision of Community law is liable to be impeded by a measure adopted pursuant to the implementation of a bilateral agreement, even where that agreement falls outside the field of application of the Treaty, every Member State is under a duty to facilitate the application of that provision and, to that end, to assist every other Member State which is under an obligation under Community law.”

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Moreover, Art. 10 does not apply to a bilateral agreement concluded by a Member State and

a non-Member State. The obligation to take appropriate measures to ensure fulfilment of the ECT

may only be referred to a Member State. The solidarity obligation, therefore, can not apply to a

relationship in which the required action is on the side of the contracting non-Member State, the

Member State being a passive party.

Furthermore, we must consider that the contracting Member State can not be bound by the

solidarity obligation if the third State – as in the present case - can always take unilateral action

which produces the same effect as that of the EC-incompatible tax treaty. It would be non-

sensical114.

3.2 STATE A HAD THE EXCLUSIVE POWER TO NEGOTIATE THE LOB CLAUSE IN THE STATE A-

US TREATY

Shall the Court reject these arguments, nonetheless we contend that MS retain an exclusive

power to negotiate LOB clauses.

Indeed, whenever the Community has a limited competence to interfere with a Member

State’s external treaty-making power, it can act only if, and insofar as, the external competence is

necessary for the correct exercise of the internal competence115.

In other words, the measures must not only lie within the scope of enacted Community

legislation, but the criteria effectiveness and necessity have to be met. The criterion effectiveness

signifies that the Community is competent if the internal power can be exercised effectively only

together with the external competence116. The necessity criterion implies that the power only exists

if an international agreement is necessary for the specific realisation and this could not be reached

by other means, for instance, by a regulation.

Neither of these criteria is met in the present case.

114 This argument is well analysed by D. VAN UNNIK and M. BOUDESTEYN, New US-Dutch Treaty and the Treaty of Rome, in EC Tax Review, 1993/2, p. 106. 115 As expressly recognised by VAN DER HURK H., quot., p. 24. 116 Opinions 1/76 and 1/94 para.89

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The purpose of the LOB clause in tax treaties is to restrict the benefits of the treaty solely to

residents of the two contracting States.

They do not attain specifically to the taxation of dividends or to any other specific topic

covered by the Tax Directives. They only attain to the determination of the connecting factors for

the purposes of allocating powers of taxation. Therefore, MS are free to negotiate them, as

recognised implicitly by the ECJ117.

117 Judgment of the Court of 21 September 1999 (Compagnie de Saint-Gobain), and of 12 May 1998, (Gilly), quot.

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PART B: COMPATIBILITY OF THE STATE A–US TAX TREATY WITH THE EC TREATY AND

THE FUNDAMENTAL FREEDOMS

4 THE LOB CLAUSE IS COMPATIBLE WITH THE NON-DISCRIMINATION PRINCIPLE

Shall the Court hold that the Community may interfere with the negotiation of a DTC such

as the State A–US Treaty, our contention would be that the LOB provision it contains does not

violate EC law.

More specifically, the LOB clause does not breach any of the fundamental freedoms, nor

does it violate the non-discrimination principle, as argued in the following paragraphs.

It is widely accepted that DTCs have a much wider scope than that of the Tax Directives

(see above).

The MS thus have sovereign power to determine the connecting factors bringing taxpayers

within their respective powers of taxation. The factor connecting a taxpayer to a tax system may

vary. Even nationality can, according to the Court, be used for the allocation of taxation powers

without necessarily constituting discrimination within the meaning of the Treaty:

“... such differentiation cannot be regarded as constituting discrimination prohibited under

Article [39] of the Treaty. It flows, in the absence of any unifying or harmonising measures

adopted in the Community context under, in particular, the second indent of Article [293] of

the Treaty, from the contracting parties' competence to define the criteria for allocating

their powers of taxation as between themselves, with a view to eliminating double

taxation118”.

Such allocation may result in tax disparities disadvantageous to Community citizens

exercising their freedoms under the Treaty, but these disparities are not necessarily discrimination

within the meaning of Community law119. The non-discrimination principle set out by Art. 12 ECT

118 Case C-336/96 (Gilly), point 30. 119 In certain cases these disparities may constitute measures restricting exercise of the freedoms – obstacles which, without being genuinely discriminatory (since they apply equal treatment to nationals of the country concerned and of other Member States), impede the exercise of a fundamental freedom or make the exercise of that freedom less

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does have a very broad scope. However, it does not imply that objectively different situation should

be treated in the same manner. This Court has repeatedly affirmed that residents and non-residents

are not, in principle, in a comparable situation120.

Because of the lack of Community harmonisation, the taxation system varies among MS and

Community commitments do not oblige the MS to allow taxpayers to make use of one of the basic

freedoms in order to benefit from the most favourable possible scheme121, as expressly recognised

even by the EU Commission122.

The existing network of tax treaties should achieve the objective, explicitly specified in the

ECT, of avoiding double taxation. This means that the ECT presumes that DTCs are consistent with

EC law if they are on the whole structured to prevent double taxation of income.

5. THE LOB CLAUSE IS COMPATIBLE WITH THE FREEDOM OF ESTABLISHMENT

5.1 THE EC TREATY DEFINITION OF THE RIGHT OF ESTABLISHMENT

The provisions regarding the right of establishment are set out in Title III, Chapter 2, ECT.

According to Art. 43, para. 1, ECT:

“restrictions on the freedom of establishment of nationals of a Member State in the territory

of another Member State shall be prohibited. Such prohibition shall also apply to restrictions

on the setting-up of agencies, branches or subsidiaries by nationals of any Member State

established in the territory of any Member State”.

attractive; see, for example, the Court’s judgment of 11 March 2004 on Case C-9/02 (de Lasteyrie du Saillant), points 42-44. However, such obstacles may be justified by “pressing reasons of public interest”. See inter alia the Court’s judgment of 15 May 1997 on Case C-250/95 (Futura), point 31. 120 See also the recent Judgment of 5 July 2005, D case, where the ECJ expressly rejected a similar arguments brought up by the Advocate General D. Ruiz-Arabo Colomer in his opinion of 24 October 2004. 121 “... the object of a convention ... is simply to prevent the same income from being taxed in each of the two States. It is not to ensure that the tax to which the taxpayer is subject in one State is no higher than that to which he or she would be subject in the other. (Case C-366/96, Gilly, op. cit., point 46). 20 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; Article 293, second indent, EC Treaty. See also D case, quot. 122 EU Commission, DG Taxation and Customs Union, Working Document of 9 June 2005, DOC (05) 2306.

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Besides, pursuant to Art. 43, para. 2, ECT, the right of establishment includes:

“the right to take up and pursue activities as self-employed persons and to set up and manage

undertakings, in particular companies or firms within the meaning of the second paragraph of

Article 48, under the conditions laid down for its own nationals by the law of the country

where such establishment is effected”123.

It is not subject to dispute that the freedom of establishment only applies within the EU area,

and, in particular, to EU citizens. This is consistent with the ECT principles: in particular, Art. 2

ECT, in outlining the objectives and purposes of the Community, specifies that they shall be applied

only “throughout the Community”. The ECJ confirmed this interpretation, by stating that “there

exists no general principle obliging the Community, in its external relations, to accord to non-

member countries equal treatment in all respects”124.

5.2 APPLICABILITY OF THE RIGHT OF ESTABLISHMENT

It is important to assess whether the activity carried out by EUA, as concerns the application

of the LOB article contained in the Member State A-US TT, is covered by the freedom of

establishment. This question deserves a negative answer.

EUA is a subsidiary, established in the territory of State A, totally owned by EUB. EUA is

held by five individuals resident for tax purposes in Member State B, but this is not relevant since

Art. 43, para. 1, ECT only requires the nationality of “any Member State”125.

There is little doubt that this specific situation, as regards the right of State B residents to set

up and manage an undertaking and to invest in a business continuation in other MS, is covered by

the right of establishment. EUB owns 100% shares of EUA, and has therefore control over the

123 If, pursuant to Art. 43, para. 2, ECT the establishment of an undertaking occurs, we have a “primary establishment”, as the citizen, deciding to transfer his economic activity in another EU Member State, loses any bound with the former Member State; if, pursuant to Art. 43, para. 1, ECT a citizen decides to set up an agency, a branch or a subsidiary, we have a “secondary establishment” as a bound with its Member State is maintained. 124 This statement was referred to the application of the non-discrimination principle stated by Art. 12 ECT. See European Court of Justice, judgment in case C-236/84, Hauptzollamt Dusseldorf. See also European Court of Justice, judgment in case C-55/75, Balkan-Import; European Court of Justice, judgment in case C-52/81, Werner Faust. 125In fact, the freedom of establishment is related to all EU citizens and “it is by essence capable of being directly invoked by nationals of all the other Member States”: European Court of Justice, judgement in case C-2/74, Reyners, para. 25.

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subsidiary’s decisions and activities. The Court itself has pointed out that at any rate a controlling

interest in a company of another Member State is covered by the right of establishment126.

However, as we already pointed out, the freedom of establishment is granted only in the EU

area and in particular to EU citizens.

As a consequence, it does not apply to the provisions laid out in the A–US TT, included the

LOB clause set out in Art. 20.

The ECJ doctrine according to which “all companies established in a Member State within the

meaning of Article 52 (now Art. 43) of the Treaty are covered by that provision, even if their

business in that State consists of services directed to non-member countries”127 does not apply to

the present case.

In fact, the ECJ merely intended to include “all companies established in a Member State”,

regardless of their activity, within the scope of Art. 43 ECT. This statement suggests us noting as

regards the MS’ power to allocate their taxation rights with a non-Member State, nor does it

impinge on the relationship between companies established in the EU and companies established

outside the EU.

The freedom of establishment should apply to prevent discrimination in, for example, the tax

treaty between A and B, where the A government may exclude a B company from the benefits of

the treaty if Member State C nationals substantially own it. The right of the US, in its tax treaty with

A, is beyond the scope of the fundamental freedoms.

The judgement of the Court in the Open skies case merely indicates that the fact that a

company established in B is trading solely in a third state is not reason enough to exclude it from

the protection of Art. 52 of the EC Treaty or to justify any discriminatory treatment arising from the

126 European Court of Justice, judgement in case C-251/98, Baars, para. 22: “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 and allows him to determine its activities is exercising his right of establishment”. See also: European Court of Justice, judgement in case C-279/93, Schumacker; European Court of Justice, judgement in case C-264/96, Imperial Chemical Industries; European Court of Justice, judgement in case C-35/98, Verkooijen; European Court of Justice, judgement in case C-324/00, Lankhorst-Hohorst; European Court of Justice, judgement in case C-168/01, Bosal Holding. 127 European Court of Justice, judgement in Commission v. Austria, C-475/98, para. 134.

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operation of domestic B tax law or any of B’s tax treaties. Therefore, it does not provide any help in

solving the issues arising from the present case.

6. THE LOB PROVISIONS OF ART. 20, (1) (A) (I), OF STATE A-US TAX TREATY DO NOT

CONSTITUTE A RESTRICTION TO THE RIGHT OF ESTABLISHMENT

Shall the Court hold that Art. 43 applies to the State A–US TT, it is necessary to check if the

LOB provisions of Art. 20 of the A-US TT are compatible with this freedom. The answer should be

in the positive.

The LOB provisions of Art. 20, (1) (a) (i), require at least a 50% level of resident

shareholding for a company resident in State A to be entitled to the benefits of the Tax Treaty128.

EUA cannot benefit by the reduction of the standard dividend withholding tax from 30% to the 5%

Tax Treaty rate for the dividend paid by USCO, because it is fully held by individuals resident in

State B.

According to the ECT provisions on the freedom of establishment, the same rules applicable

to the citizens of a Member State must also be applied to the citizens of another Member State

deciding to set up an undertaking, an agency, a branch or a subsidiary in the first mentioned

Member State.

By including in the Tax Treaty Art. 20, however, State A did not breach Art. 43 ECT, because

such a provision has the mere function of allocating taxing powers between the two contracting

States.

Our contention is not infringed by the ECJ’s decision in the Open skies litigation129. On that

occasion the ECJ stated that various MS had infringed Art. 43 ECT by concluding with the US

“open skies” agreements containing the so called “nationality clause”, providing the Contracting

128 In particular, Art. 20, (1) (a) (i), states that “a person which is a resident of a Contracting State and derives dividends, interest or royalties from the other Contracting State shall not be entitled [...] to relief from taxation in that other Contracting State unless more than 50 percent of the beneficial interest in such person (or in the case of a company, more than 50 percent of the number of shares of each class of the company’s shares) is owned, directly or indirectly, by one or more individual residents of one of the Contracting States, one of the Contracting States or its political subdivisions or local authorities, or citizens of the United States”. 129 European Court of Justice, judgements in cases: C-466/98, Commission v. United Kingdom; C-467/98, Commission v. Denmark; C-468/98, Commission v. Sweden; C-469/98, Commission v. Finland; C-471/98, Commission v. Belgium; C-472/98, Commission v. Luxembourg; C-475/98, Commission v. Austria; C-476/98, Commission v. Germany.

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States with the right to exclude certain airlines from the benefits of the agreement if they were

owned or controlled by nationals of other States.

The “Open Skies doctrine” does not apply to the present case.

First of all, we must underline that it related to a non-tax case. Tax Treaties follow special

rules and principles, which set them aside from the other treaties, as recognised by the EU

Commission itself130. A principle applied in a non-tax matter can not be used in a tax matter.

In addition, the Open Skies judgement deals with an area (air fares and computerised

reservation systems) extensively covered by EC legislation. This is not the case for direct taxes131.

Moreover, it must be emphasised that the Open skies case concerns the nationality clause,

which can not be identified with the LOB clause. The latter, for example, has more far reaching

consequences132. We are quite surprised by the Applicant’s contention according to which the Open

Skies doctrine is applicable to the present case, because the LOB clause “can be compared” (sic!) to

the nationality clause. We “can” do many things, however this does not imply they are the right

things to be done. The legitimacy of a “comparison” between the two clauses must be positively

demonstrated by the Party who claims it.

In addition, should this comparison be demonstrated, the same Party should also

demonstrate why, and to what extent, a principle expressly laid out for a clause is applicable also to

another clause, which is not identical, but – we need to stress it again - only “comparable”.

6.1. IN SUBSIDIARY ORDER: THE ASSERTED RESTRICTION TO THE RIGHT OF ESTABLISHMENT IS

JUSTIFIED

Should this Court hold that Art. 20, (1) (a) (i) State A–US TT restricts the freedom of

establishment granted by Art. 43 ECT, nonetheless this restriction would be justified.

130 EU Commission, DG Taxation and Customs Union, Working Document of 9 June 2005, quot. 131 G.W. KOFLER, European Taxation under an “Open Sky: LoB Clauses in Tax Treaties Between the US and EU Member States, in Tax Notes International, 2004, p. 78; C. PANAYI, Open Skies for European Tax?, in British Tax Review, 2003, p. 194. 132 BRAEDON, C., The Limitation on Benefits Clause under an open Sky, European Taxation, January 2003, pp. 22-26, at 26.

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Firstly, it can be justified pursuant to Art. 46 ECT., under the grounds of public order133.

Art. 20 is, in fact, part of an international treaty. The obligation to abide by treaties is a customary

rule generally accepted under international law (pacta sunt servanda). Should EC law allow MS to

unilaterally modify a treaty provisions, international public order would be violated.

The restriction shall also be justified under all of the other justifications accepted by the

Court under its rule of reason, and, in particular, (a) the need to protect the coherence of the

national tax system, (b) the need to avoid tax evasion and (c) the need to avoid the reduction of tax

revenues.


The Court accepted fiscal coherence as a valid reason to justify discriminating treatments

and restrictions to the freedom of establishment in the Bachmann case134, when the limited

deduction of insurance contributions paid to Belgian companies was justified through the

connection between contributions and money paid by insurance companies in force of their

contracts. As a consequence, taxes levied on pensions and capital paid by insurance companies were

to compensate the deduction of contribution from the taxable income.

As explained above, LOB clauses do not concern the exercise of taxation, but the allocation

of taxing powers. Their coherence must therefore be assessed only within the applicable DTC.

In other words, when referred to DTCs, the condition of fiscal cohesion becomes a condition

of reciprocity.

A tax treaty comes into existence through a process of give and take. The negotiation of Art.

20 A-US TT arguably implied reciprocal concessions by the two contracting States. Invalidating

that clause would hinder the balance of reciprocity of the Treaty, and, therefore, its internal

coherence.

133 A “European fiscal public order exception” is accepted also by HINNEKENS, L., European Court goes for robust tax principles for treaty freedoms. What about reasonable exceptions and balances?, in EC Tax Review, 2004/2, p. 66. 134 European Court of Justice, judgement in case C-204/90, Bachmann. On the same day the Court delivered judgement in the infringement proceedings brought by the Commission against Belgium under Art. 169 ECT on largely the same issues (case C-300/90, Commission v. Belgium). The issue of fiscal coherence was invoked also in other cases, such as Svensson-Gustavvson (C-484/93), Asscher (C-107/94), ICI (C-264/96), Baars (C-251/98), Verkooijen (C-35/98) and Metallgesellschaft (C-397/98 and C-410/98), but was always rejected.

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This argument was substantially accepted by the ECJ in the Gottardo judgment135, where the

Court held that:

“Disturbing the balance and reciprocity of a bilateral international convention concluded

between a Member State and a non-member country may, it is true, constitute an objective

justification for the refusal by a Member State party to that convention to extend to nationals

of other Member States the advantages which its own nationals derive from that

convention”.

6.1.2. PREVENTION OF TAX EVASION AND TAX REVENUE REDUCTION

The aim of avoiding tax evasion may constitute a justification for the restriction of a

fundamental freedom.

It is out of dispute that the LOB clauses basically aim at avoiding tax evasion and revenue

reduction. They are essentially anti-abuse clauses, and, as such, have been effectively used for more

than thirty years to avoid treaty shopping136.

It can not be argued seriously that they do not pursue the objective of preventing tax evasion

sub specie of treaty shopping practices.


Furthermore, it is necessary to point out that the restriction provided by Art. 20, (1) (a) (i), is

proportional to the purpose pursued.

The ECJ believes a restriction to be justified only if it complies with the principle of

proportionality: this signifies that a measure must be appropriate, necessary and proportionate to the

attainment of an objective compatible with the ECT137, without going beyond what is necessary138.

135 Judgment 15 January 20002, case C-55/2000, ECTR I-413. 136 Treaty shopping it is still a threat because of the lack of harmonisation: the Community can not ask Member State to pay the consequences of its inactivity. On treaty shopping, see, among others, PETKOVA, S., Treaty Shopping. The Perspective of National Regulators, in European Taxation, 2004, 543f. 137 Opinion of Advocate General Mischo in case C-436/00, X and Y; Opinion of Advocate General Tizzano in case C-516/99, Schmid. 138 European Court of Justice, judgement in case Commission v. Belgium, quot.

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The provisions of Art. 20, (1) (a) (i), comply with the principle of proportionality, because

they are not overly restrictive and such a restriction is under every respect necessary to ensure the

avoidance of treaty shopping.

This assumption is not hindered by the fact that State B also provided for an LOB clause in its

Tax Treaty with the US, and this clause is less restrictive than the one accepted by State A and

provides for more possibilities for the LOB not to apply.

As already mentioned, EC law does not require the application of a MFN treatment139.

Bilateral agreements remain subject to the principle of reciprocity.

7. ART. 20, (1) (A) (I), DOES NOT CONSTITUTE A BREACH OF EC LAW IN RELATION TO THE

FREEDOM OF ESTABLISHMENT

Our contention would be that State A did not infringe the freedom of establishment granted

by the ECT in the way it negotiated an LOB clause.

The conclusions endorsed by the ECJ with regard to the “nationality clause” included in the

“open skies” agreement between Denmark and the US140 are not applicable to the present case.

Nor does the freedom of establishment apply to residents of third countries.

8. THE FREEDOM OF CAPITAL MOVEMENT DOES NOT APPLY TO THE LOB CLAUSES

The investments sustained in order to establish and maintain an undertaking or a subsidiary in

another Member State are expressly included in the provisions regarding the freedom of

establishment.

139 D case, quot. 140 European Court of Justice, judgement in Commission v. Denmark, quot., para. 116: “a clause such as that on the ownership and control of airlines would seem rather to be justified by economic considerations which are not covered by Article 56 [now Art. 46] of the Treaty and which have to do with the fact that the parties to the agreement refuse to extend the commercial benefits to airlines belonging to nationals of countries with which no “open skies” agreement has been concluded”

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It is true that they are also mentioned in relation with the EC Treaty rules ensuring the free

movement of capital. In particular, the wide definition of capital provided for by Annex I of the

Council Directive n. 88/361/EEC141, in mentioning the “operations carried out by any natural or

legal person”, explicitly includes the direct investments related to the “establishment and extension

of branches or new undertakings belonging solely to the person providing the capital”.

However, in the present case the free movement of capital does not apply as EUA and EUB

are related companies. In fact, in the mentioned Annex I it is clearly stated that the free movement

of capital covers merely the transactions between independent companies.

It can not be ignored that Annex I of the 1988 Directive includes “operations to repay credits

or loans” and that in 2001 EUB lent funds to EUA allowing it to incorporate new sales companies

abroad. As a consequence of that loan, EUA pays to EUB an interest that exceeds on a yearly basis

50% of the gross income of EUA. This interest constitutes a capital flow from State A to State B142.

However, it is clear that the 2001 loan was only created in order to allow EUA establish some

non-EU subsidiaries. As a consequence the interest paid by EUA to EUB is only a form of long-

lasting participation to the capital of a non-autonomous company. It must be regarded as part of

relationship existing between the two companies, which as submitted above, must be seen as

covered by the freedom of establishment.

8.1. IN SUBSIDIARY ORDER: THE LOB PROVISIONS OF STATE A-US TAX TREATY DO NOT

RESTRICT THE FREE MOVEMENT OF CAPITAL

Shall the Court hold the applicability of the free movement of capital to the LOB clause, it is

necessary to check if the LOB provisions of Art. 20 of A-US TT are compatible with this freedom.

The answer should be in the positive.

First of all, Art. 56 EC Treaty forbids any restriction to capital movements, which is able to

dissuade EU citizens from enjoying the benefits deriving from this freedom. 141 For the applicability of this definition also after the ECT modifications due to the Maastricht Treaty see European Court of Justice, judgment in case C-222/97, Trummer and Mayer; European Court of Justice, judgment in case C-464/98, Stefan. 142 See Annexes.

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Moreover, it must be pointed out that the LOB provisions of Art. 20, (1) (a) (ii) does not have

the effect of restricting the free movement of capital within the EU. As part of a bilateral agreement

with a third country, in fact, its effects must be assessed only within the framework of the A-US TT,

and therefore with reference to the free capital movement towards third countries.

The LOB provisions of Art. 20, (1) (a) (ii), require less than 50% of the gross income to be

used to meet liabilities for interest or royalties to non-residents for a company resident in State A to

be entitled to the benefits of the Tax Treaty143. EUA cannot benefit by the reduction of the standard

dividend withholding tax from 30% to the 5% Tax Treaty rate for the dividend paid by USCO,

because the interest due to EUB for the loan granted in 2001 exceeds on a yearly basis more than

50% of its gross income. The requirements of Art. 20, (1) (a) (ii), are not met, because more than

50% of the gross income of EUA is transferred to State B residents.

The analysis of the factual background supports the arguments explained above. In fact, the

LOB provision effectively impinges only on the freedom of establishment and not on the freedom

of capital movements.

8.2. THE RESTRICTION TO THE FREE MOVEMENT OF CAPITAL IS JUSTIFIED

Shall the Court hold that the LOB clause restricts the freedom of capital movement,

nonetheless this restriction is justified under Arts. 57 and 58 ECT.

Tax rules which hinder the free movement may still be accepted if they are justified by

overriding requirements of public interest, such as (a) the coherence of the national tax system, (b)

the prevention of tax evasion and (c) the prevention of tax revenues reduction. In addition, the

measures have to comply with the principle of proportionality144.

143 In particular, Art. 20, (1) (a) (ii), states that “a person which is a resident of a Contracting State and derives dividends, interest or royalties from the other Contracting State shall not be entitled [...] to relief from taxation in that other Contracting State unless more than 50 percent of the gross income of such person is not used, directly or indirectly, to meet liabilities for interest or royalties to persons who are not residents of one of the Contracting States, one of the Contracting States or its political subdivisions or local authorities, or citizens of the United States”. 144 See HINNEKENS L., Compatibility of Bilateral Tax Treaties with European Community Law – Application of the Rules, in EC Tax Review, 1995, quot., p. 202.

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We have already showed, with reference to the freedom of establishment, that these

justification are applicable to the present case. The arguments developed in para. 6.1. shall apply

also to justify the potential restrictions caused by Art. 20 A-US TT to the free movement of capital.

With regard to the application of the freedom of capital movement in the field of direct taxes,

potential restrictions should be also evaluated under Art. 58 ECT145.

Taxpayers resident in Member States are not in same situation as taxpayers of non-Member

States146, and LOB clauses are essentially anti-abuse provisions.

9. ART. 20, (1) (A) (II), DOES NOT CONSTITUTE A BREACH OF EC LAW IN RELATION TO THE FREE

MOVEMENT OF CAPITAL

We submit to this Court that State A did not breach Art. 56 ECT in the way it negotiated an

LOB clause. Shall the Court fail to uphold this submission, we contend that the restriction was

nonetheless justified under Art. 58 ECT.

In fact, the transactions between EUA and EUB must be seen as functional to long-lasting

investments in non-EU countries (establishments).

145 “The provisions of Article 56 shall be without prejudice to the right of Member States: (a) to apply the relevant provisions of their tax law which distinguish between taxpayers who are not in the same situation with regard to their place of residence or with regard to the place where their capital is invested; (b) to take all requisite measures to prevent infringements of national law and regulations, in particular in the field of taxation and the prudential supervision of financial institutions, or to lay down procedures for the declaration of capital movements for purposes of administrative or statistical information, or to take measures which are justified on grounds of public policy or public security”. 146 As regards capital movements to or form third countries and, more particularly, whether EC MS and third countries can be considered to be “in the same situation”, Art. 58 must be not interpreted in a restrictive manner. See Opinion of the Advocate General Kokott of 18 March 2004, in the Manninen case (C- 319/02); see also SMIT, D., Capital movements and direct taxation: the effect of the non-discrimination principles, in EC Tax Review, 2005/3, p. 129.

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PART C. THE FREE MOVEMENT OF CAPITAL IN RELATION TO THIRD COUNTRIES

10. THE FREEDOM OF CAPITAL MOVEMENT WITH THIRD COUNTRIES HAS A NARROWER

SCOPE

As a matter of principle, the free movement of capital provided for by Art. 56, para.1, ECT

also applies towards third countries147, since this provision prescribes that “all restrictions on the

movement of capital between Member States and between Member States and third countries shall

be prohibited”.

The freedom of capital movements in and out of the EU has a narrower scope than the

freedom of capital movements in an internal context.

It is important to note that the free movement of capital within the EU is necessary for the

proper functioning of the monetary union, whereas the purpose of the free movement of capital

towards third countries is different: it aims to attract into the EU area foreign investors, an aim

which is not directly connected with the realization of a common market.

The liberalisation of capital movements towards third countries should be meant, in principle,

to only prohibit restrictions on the pure, physical transport of money across borders148. There is no

for the EU to unilaterally and in full scale extend the free movement of capital to third countries.

This can hardly have been the intention behind Arts. 56-58 ECT. What matters under an EU

perspective is only that EU citizens receive the same favourable treatment in third countries as

citizens of these countries receive in the EU - which can be better achieved by means of bilateral

agreements149.

147 A “third country” is one that is not included both in the EC Treaty and in the EEA Agreement, which includes EC Member States and Iceland, Liechtenstein, Norway and Switzerland. These treaties grant the freedom of capital movements both among EC Member States or EEA Member States, and towards third countries. See also European Court of Justice, judgement in case C-452/01, Ospelt. 148 MOHAMED, S., European Community law on the Free Movement of Capital and the EMU, Kluwer, 1999, p. 217. 149 STAHL, K., Free movement of capital between Member States and third countries, in EC Tax Review, 2004/2, p. 52.

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This submission may be also supported by a textual argument. In fact, Art. 56 ECT should be

read in conjunction with Art. 57, para. 2 ECT: the liberalisation of capital movements towards third

countries is dependant on the Council taking positive action and adopting common provisions150.

In addition, the ECJ recently held that horizontal discrimination between non-residents does

not violate EC law. As a consequence, EU citizens can not invoke the application of a MFN

treatment151.

10.1. THE LOB CLAUSE IS COMPATIBLE WITH THE FREE MOVEMENT OF CAPITAL WITH

THIRD COUNTRIES

EC law does not require the MS to negotiate their DTCs in such a manner that benefits

available to a contracting State under a DTC are available also to third – non-contracting – MS152.

EC law does not imply either the existence of something like a “Most Favourite Nation”

clause, i.e., it does not require member State to extend the benefits negotiated in a bilateral Treaty

with a third party to the bilateral agreements concluded with the other MS.

Non entitlement to treaty benefits is not a matter originated by the non-EU contracting State,

but rather a consequence of the treaty itself (Open skies). This impinges on treaties concluded with

third States, as a violation of the free movement of capitals (directly applicable to relations with

third countries).

150 Art. 57, para. 2, ECT reads as follows: “Whilst endeavouring to achieve the objective of free movement of capital between Member States and third countries to the greatest extent possible and without prejudice to the other chapters of this Treaty, the Council may, acting by a qualified majority on a proposal from the Commission, adopt measures on the movement of capital to or from third countries involving direct investment — including investment in real estate — establishment, the provision of financial services or the admission of securities to capital markets. Unanimity shall be required for measures under this paragraph which constitute a step back in Community law as regards the liberalisation of the movement of capital to or from third countries”. The argument is put forward by MOHAMED, S. quot. 151 This would also lead to unacceptable consequences for the negotiation of bilateral treaties by the EU Member States. In the words of G. MEUSSEN, “This would paralyse the Member States in negotiating a bilateral tax treaty, as they would feel the eyes of the other 23 Member States on their backs or sense that all of the other Member States were looking over their shoulders trying to ascertain what was being negotiated” (The Advocate General’s Opinion in the “D” Case: Most-Favoured-Nation Treatment and the Free Movement of Capital, in European Taxation 2005 p.54). 152 See Judgement 14 February 1995, C-279/93, Finanzamt Koeln-Altstadt v. Roland Schumacker, CER I-225.

91

The potential restriction would be justified for the same reasons explained before with regard

to free movement of capital between MS153.

The fact that the reciprocal rights and obligations in a tax treaty hold only for residents of one

of the contracting States is substantially an “inherent consequence” of bilateral tax treaties for the

avoidance of double taxation154.

The difference in treatment is justified because it is included in a DTC155, and as the ECJ

stated clearly in the D case, an advantage stemming from a treaty

“cannot be regarded as a benefit separable from the remainder of the Convention, but is an

integral part thereof and contributes to its overall balance”156.

If EC law required the MFN doctrine to apply to LOB clauses, we would have the paradox

that MS treaties would be downgraded to no-LOB standard, thus reaching the lowest level of

functional integrity of tax treaty law157.

11. CONCLUSIONS

In relation to all the above mentioned conclusions, the LOB provisions of Art. 20 of the State A-US

Tax Treaty are fully compatible with EC law. In particular, LOB clauses are compatible with EC

law for the following main reasons:

- there is no harmonisation of this area by the Community and therefore MS remain

free to negotiate as they like;

- EC law does not require MS to practice a MFN policy in their DTCs;

153 See paragraph 7.1 of this Memorandum. 154 See Judgment in the D case, paras. 59-63. 155 D. WEBER, Most-Favoured-Nation Treatment under Tax Treaties Rejected in the European Community: Background and Analysis of the D case, in Intertax, 10/2005, p. 440. 156 Judgement of 5 July 2005, quot, para. 157 This is the argument put forward by L. HINNEKENS, who correctly points out that the most attractive and “shoppable” treaties of Member States are those that do not contain a LOB Article (in EC Tax Review, 1995/4, p. 230).

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- the third countries (i.e. the United States) could achieve a similar outcome

unilaterally;

- there is no obligation under EC law to follow the aims of the EC Treaty where this

would be to the detriment of the residents of the MS158.

158 van UNNIK, D., and BOUDESTEIJN, M., The New US-Dutch Tax Treaty and the Treaty of Rome, in EC Tax Review 2 (1993), pp. 106-115, at 114.

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PART D: THE ISSUE OF STATE A’S LIABILITY FOR THE BREACH OF EC LAW

12. THE CONDITIONS FOR MEMBER STATES’ LIABILITY

Should the Court hold that State A breached EC law in negotiating its Tax Treaty with the US

as it relates to the LOB article, the issue of State A’s liability for damages suffered by EUA and

EUB must be examined.

We need to point out from the outset that it would be juridically incorrect to hold that MS’

liability is a ‘strict liability’.

In Francovich and Bonifaci v. Italy159, and subsequently in the joined cases Brasserie du

pêcheur and Factortame160, the ECJ ruled that the principle of MS’ liability for damages suffered

by individuals as a result of an infringement of Community law is “inherent in the system of the

Treaty”161. Nevertheless, such liability is not dependent on the violation of EC law per se, but only

arises on the basis of additional requirements, which must be all fulfilled in order to qualify for

compensation162:

1) the rule of law infringed must be intended to confer rights on individuals;

2) the breach must be sufficiently serious;

3) there must be a direct causal link between the breach of the obligation resting on the State


Our analysis will therefore focus on these conditions, in order to determine whether they are

fulfilled in the instant case.

159 European Court of Justice, judgement in joined cases C-6/90 and C-9/90, Francovich and Bonifaci v. Italy. 160 European Court of Justice, judgement in joined cases C-46/93 and C-48/93, Brasserie du pêcheur v. Germany and R. v. Secretary of State for Transport, ex parte Factortame. 161 European Court of Justice, judgement in Francovich, quot., par. 35. 162 See on this point European Court of Justice, judgements in Brasserie du pêcheur, quot.; European Court of Justice, judgement in joined cases C-178/94, C-179/94, C-188/94, C-189/94, C-190/94, Dillenkofer and others v. Germany, par. 20-21; European Court of Justice, judgement in case C-140/97, Rechberger and Greindl v. Austria, par. 21; European Court of Justice, judgement in case C-424/97, Salomone Haim v. Kassenzahnärtzliche Vereinigung Nordrhein (Haim II), par. 36; European Court of Justice, judgement in case C-127/95, Norbrook Laboratories Limited v. Ministry of Agriculture, par. 107.

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12.1. DIRECT EFFECT OF ARTICLES 43 AND 56 ECT

Once assumed that State A’s infringement consists in the violation of the freedom of

establishment or of the free movement of capital, in order to assess liability concerns we shall, first

of all, verify whether such rules confer rights on individuals. What must be determined is

essentially whether or not Articles 43 and 56 ECT have direct effect.

According to the ruling of the ECJ in Van Gend en Loos163, ECT provisions are directly

applicable provided that they are sufficiently precise, clear and unconditional. Whether the ECJ

alwayd recognized the direct applicability of Art. 43 ECT, some doubts may arise with respect to

Art. 56 ECT. It was widely recognized that, before the Directive 88/361/EEC, the freedom of

capital movements was not directly applicable164.

12.2 THE “SUFFICIENTLY SERIOUS BREACH” TEST

The second condition to check is far more significant. The assumed breach of EC law cannot

originate liability unless it is proved to be sufficiently serious.

The decisive test for finding that a breach of EC law is sufficiently serious is the manifest and

grave disregard of the limits on the exercise of the discretionary powers enjoyed by the State165.

According to the ECJ, the likelihood of establishing a serious breach is in an inverse relationship

with the measure of discretion enjoyed by the State: the less the margin of discretion left to the

national authorities by the EC rules, the easier would it be to establish that a breach of such rules is

serious166.

In addition to this criterion, in Brasserie du pêcheur the ECJ also set out further guidelines to

determine whether the threshold of seriousness has been reached: as far as the case in instance is

concerned, it is worth mentioning among them the clarity and the precision of the rule breached and

the consideration on whether the infringement and the damage was intentional or involuntary167.

163 European Court of Justice, judgment in case 26/62, Van Gend en Loos. 164 European Court of Justice, judgment of 11/11/1981,in case C-203/80, Casati. 165 European Court of Justice, judgement in case Brasserie du Pêcheur, quot., par. 55. 166 See TRIDIMAS T., Liability for breach of Community law: growing up and mellowing down?, in Common market law review, 2001, p. 310-311. 167 European Court of Justice, judgement in Brasserie, quot., paras. 56-57. The other criteria are the following: whether any error of law was excusable or inexcusable; the fact that the position taken by a Community institution may have

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More in detail, the so-called “Brasserie fault criteria”168 conveys a very precise rule: before

attaching liability to a violation of Community law, it must be ascertained that the Member State

had no reasonable justifications for acting not in a EC law-abiding way. And the reasonableness of

such justifications must be evaluated according to the factual circumstances, applying the criteria

derived from settled case-law as a uniform standard of judgment. This statement is borne out by the

holding of the ECJ in Haim II169, where the Court ruled that

“a mere infringement of Community law by a Member State may, but does not necessarily,

constitute a sufficiently serious breach”170, because “in order to determine whether such an

infringement of Community law constitutes a sufficiently serious breach, a national court

hearing a claim for reparation must take account of all the factors which characterize the

situation before it”171.

Furthermore, it needs to be stressed that the fault factors and the peculiarities of the single

cases must always be verified, irrespective of the wide or narrow measure of discretion enjoyed by

the State: the judgment of the ECJ in Haim II is clear in this sense, and amends the ambiguous

wording previously used by the Court in Hedley Lomas172.

In the present case, there are no grounds for claiming that State A manifestly and gravely

exceeded the limits of its discretionary powers.

First of all, it must be pointed out that the measure of discretion enjoyed by State A in the

implementation of the ECT rules under examination (Articles 43 and 56), as it specifically relates to

its tax-levying power, is considerably wide. In fact, as the ECJ ruled in Gilly173,

contributed toward the omission; the adoption or retention of national measures or practices contrary to Community law. In any event, a breach of Community law will be sufficiently serious if it has persisted despite a judgement of the Court which establishes the infringement on question. 168 HILSON C., The role of discretion in EC law on non-contractual liability, in Common Market Law Review, 2001, p. 692. 169 European Court of Justice, judgement in Haim II, quot. 170 European Court of Justice, judgement in Haim II, quot., par. 41. 171 European Court of Justice, judgement in Haim II, quot., par. 42. 172 European Court of Justice, judgement in case C-5/94, The Queen v. Ministry of Agriculture, Fisheries and Food ex parte Hedley Lomas (Ireland) Ltd, par. 28. The Court held that, where a Member State has no discretion, or where its discretion is considerably reduced, the mere infringement of Community law may be sufficient to establish the existence of a serious breach. 173 European Court of Justice, judgement in case C-336/96, Gilly.

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“the Member States are competent to determine the criteria for taxation on income and

wealth with a view to eliminating double taxation - by means, inter alia, of international

agreements174.

And, since the abolition of double taxation within the Community175 is one of the objectives

of the Treaty176, the definition of the criteria for allocating taxing powers between the States177 can

not be deemed to be in contrast with the fundamental freedoms of the common market, at least in

principle178.

With regard to the single clauses or connecting factors drawn up in order to prevent double

taxation, their compatibility with EC law might be questioned: however, no violation of Community

law occurs, as long as they are reasonable and proportionate to the object pursued.

As we already remembered179, the ECJ held in Gilly that, with regard to bilateral agreements,

a differentiation made on the basis of nationality180 “cannot be regarded as constituting a

discrimination prohibited” under ECT181.

In the present case, the LOB clause set out in Article 20 A-US TT is comparable, in principle,

to the one considered by the Court in Gilly.

The circumstance that the ECJ referred, in this ruling, to the free movement of workers is of

no relevance at all, since the spirit of the fundamental freedoms on which the Treaty of Rome is

founded is the same, all being aimed at eliminating any obstacles that hinder the creation and the

functioning of the common market.

174 European Court of Justice, judgement in Gilly, quot., par. 24. 175 The fact that the Tax Treaty has been concluded in the instance between Member State A and the United States makes no substantial difference, as we discuss the compatibility of such Treaty with Article 56 ECT, which also applies to third States. 176 As laid down in the second indent of Article 293 ECT. 177 Irrespective of whether both are Member States or only one is: in any event it would arise the problem of the compatibility with EC law of an (inter)national tax regime. 178 See European Court of Justice, judgement in Gilly, quot. 179 See para. 4. 180 Laid down in a tax treaty between France and Germany. 181 European Court of Justice, judgement in Gilly, quot., par. 30. The circumstance that Article 220 ECT is not provided with direct effect, as the Court has also stated in this judgement (para. 17), contributes to strengthening our view: it is not the Community that provides the criteria for the Member States to adopt in order to abolish double taxation, and enforces such provision with direct applicability, but it is up to the Member States to enter into negotiations “so far as is necessary” to prevent double taxation. Within this scope, Member States have wide discretion on the selection of means and methods (see para. 4 of the present Memorandum).

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Therefore, it cannot be seriously argued that State A “manifestly and gravely” exceeded the

limits of its discretionary powers in agreeing on the LOB clause of Article 20.

Moreover, should the Court find that including a LOB clause such as the one laid down in

Article 20 of State A-US TT does constitute a violation of Articles 43 or 56 ECT, and that State A

had not a considerable margin of discretion in that matter, nonetheless State A could not be held

liable of a “serious breach”.

The US usually include LOB clauses in the tax treaties they stipulate with third States,

whether or not Member of the EC182. It can be reasonably argued that no tax treaty with the US

would have been concluded at all, if State A had not agreed to the LOB clause laid down in Article

20. In other words, State A had no choice: no LOB clause would have meant no reductions of

withholding taxes for taxpayers carrying out a business activity taxable in the US. It is a mandatory

requirement of public interest that comprehensive tax treaties are concluded with the US183. The

functioning of the common market rather requires a good network of DTCs with the US than the

avoidance of possible but rather remote unequal treatment of non-residents at the cost of not having

a tax treaty at all.

Finally, it is worth demolishing the hackneyed argument, according to which after the

rendering of the Open Skies judgements184 a nationality clause such as the one contained in the LOB

provision of Article 20 results in a violation of the free movement of capital185.

As shown above, the situation taken into consideration by the Court in Open Skies was not

comparable to the instant case. Moreover under the guidance of the recent D case186 it must be

acknowledged that Articles 56 and 58 ECT do not preclude a Member State from according,

pursuant to a bilateral convention for the avoidance of double taxation, allowances on the basis of

nationality, without extending such allowances to residents of the other MS. 182 Furthermore, LOB clauses such as the one of Article 20 are based on the model conventions on income and wealth tax drawn up by the OECD (Organization for Economic Cooperation and Development), which has inspired many bilateral conventions between Member States in full compliance with EC law. 183 TERRA B.J.M.-WATTEL P.J., European tax law, The Hague, 2005, p. 197. 184 European Court of Justice, judgement in cases Open skies, quot. 185 So that there would have been a preceding judgement of the European Court of Justice establishing the infringement in question, with the consequence that State A would have committed a “serious breach” under the Brasserie formula (see note n. 72). 186 European Court of Justice, judgement in D case, quot.

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For all the reasons indicated above, State A did not commit a serious breach of Community

law, so that the second and decisive condition for State liability is not fulfilled.

12.3. THE LINK OF CAUSATION

We can now move to the third requirement to which State liability is subject: the causal link

between the breach and the damage.

It is necessary to verify the existence of a primary link of causation between State A’s

agreeing on the LOB clause and the financial loss suffered by EUA and EUB, i.e. the amount of the

additional US withholding tax (25%) charged to EUA and the amount of US penalties and late

interests paid by USCO187.

Of course, if State A had not agreed on that LOB clause, EUA and EUB would have not

suffered such a damage. But the ECJ held in several occasions188 that a direct causal link must be

established: the breach must have been the proximate cause of the damage.

In the instant case, the proximate cause of the loss suffered by EUB group appears to be the

US Internal Revenue Service tax audit, not State A’s infringement. In fact, the challenge made by

the IRS appears to be an event such as to break the chain of causation between the agreement to the

LOB clause and the damage.

Consequently, none of the conditions for State liability is satisfied in the instance.

13. QUESTIONS ABOUT THE ASSESSMENT OF DAMAGES

For all the reasons stated above, we conclude that State A must not be held liable for

compensation.

187 Which both shareholders of USCO, EUA and EUB, suffered proportionally to their shareholding. 188 See e.g. European Court of Justice, judgment in case C-319/96, Brinkmann Tabakfabriken GmbH v. Skatteministeriet; European Court of Justice, judgment in Rechberger, quot.

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Therefore, any question concerning the amount of damages should be dismissed: damages

need not to be paid by State A, not to the extent of the additional US withholding taxes, nor to the

amount of penalties, late interests and not in the least interests on damages.

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V. ANNEXES

Up to 31st Dec 2000 As from 1st Jan 2001B

USCO inc.

USA

A

EUA Se

EUAHOLD Se

Mr. X Mr. Y Mr. Z

EUB Se

Mr. J Mr. K

Mr. W

Mr. I Mr. V

EUA Se

USCO inc.

100%

100%

100%

34%

Shares in EUA

EUB Se

USEUB (USEUB)

Group Structure

66%

101

Intra Group Dividends

Interest: - deductible for EUA - no withholding tax exceeds

50% of the gross income of EUA

EUB Se

EUA Se

Loan Interest

USCO inc.

66% 34%

32,3 % 62,7 %

32,3 %

Dividends: - 34% from USCO to EUA - 66% from USCO to EUB - 5% withholding tax when

distributed by USCO to EUA

B

A

USA

- 5% withholding tax when distributed by USCO to EUB

- no withholding tax when distributed by EUA

102

IRS Tax Audit

EUB Se

EUA Se

USCO inc.

66% 32,3 %

34%

32,3 %

62,7 %

USA

BUSA-B Treaty applies

USA

AUSA-A Treaty does not apply

8,5%

8,5% + (late interests + penalties)

IRS

Penalties: - 8,5% (25% of 34) from USCO to US

IRS - Late interests and penalties on the

additional 25% - 8,5% reimbursed by EUA to USCO

Dividends: - 34% from USCO to EUA - 66% from USCO to EUB - 5% withholding tax when distributed

by USCO to EUB - 30% withholding tax when distributed

by USCO to EUA - no withholding tax when distributed by

EUA

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VI. LIST OF ABBREVIATIONS

A- US TT The Tax Treaty concluded between Member State A and the

US Art. Article DTCs Double Taxation Conventions ECJ European Court of Justice EC Law European Community Law ECT European Community Treaty EU European Union IRS Internal Revenue Service LOB Limitation On Benefits MS Member States US United States of America

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