The European Court of Justice recently issued a judgment in six cases concerning the application of the Interest and Royalty Directive (Joined Cases C-115/16, C-118/16, C-119/16 and C-299/16) and the Parent-Subsidiary Directive (Joined Cases C-116/16 and C-117/16). The ECJ ruled that member states must deny the benefits granted under these two directives if there is an abuse of rights. An abuse of rights would occur if a 'conduit company' claimed the benefits of these directives. The ECJ provided guidance on when a conduit company may exist. These six judgments significantly limit the ability of non-EU investors to obtain benefits under the two directives through the use of EU companies established - in the Netherlands or Luxembourg, for example - if the only function of those companies is to pass on interest and dividends to non-EU persons. Investors should review whether any EU company they use is at risk of being deemed a 'conduit company'. In the Netherlands, these judgments raise the question of whether the minimum substance requirements that apply as a safe harbour against a claim of abuse of rights are in line with EU law and can therefore be maintained in the future.

The facts In short, each of the six cases decided by the ECJ concerned Danish resident entities either paying interest or distributing dividends to their direct parent companies resident in Luxembourg, Cyprus or Sweden. The Danish entities claimed the withholding tax exemption for these payments as provided for by the Interest and Royalty Directive and the Parent-Subsidiary Directive (the "EU Directives"). The Danish tax authorities denied this exemption. They argued that the direct parent companies did not qualify as the beneficial owner of the payments, and the withholding tax exemption should consequently be denied. In this context, the High Court of Eastern Denmark requested a preliminary ruling concerning the application of the concept of abuse of rights under the EU Directives. Obligation for Member States to refuse benefits in case of an abuse of right In its judgment, the ECJ confirmed that, as a general principle of EU law, taxpayers cannot receive the tax advantages provided for by EU law if the transactions are carried out for abusive or fraudulent ends. In those cases, member states must refuse to grant such benefits, irrespective of whether the member state's domestic law or tax treaties provide for a refusal. The use of conduit companies in principle constitutes an abuse of right The ECJ reiterated previous case law decisions and determined that an abuse of rights requires two elements to be present. First, it must be established that based on a combination of objective circumstances, the purpose of the relevant EU rules (in this case the EU Directives) is not met, even though all conditions have been formally met. Second, there must have been an intention to obtain an advantage granted under EU rules through an artificial arrangement. According to the ECJ, these two elements, which embody abuse of rights, are present if an EU resident conduit company is interposed between the company that pays the dividends or interest and the company which is to be regarded as the beneficial owner if, as a result of the interposition of that company, payment of tax on those dividends or interest is avoided. Taxpayers should be allowed to file counter evidence. Even though tax avoidance is a concern if the beneficial owners are established outside the EU, the ECJ explicitly highlights that tax avoidance can also occur if the beneficial owners are EU based but do not qualify for the benefits of the EU Directives, for example, if they are tax exempt or lack the required legal form(s) covered by the directives. Guidance for identifying conduit companies The ECJ gives additional guidance as to when a conduit company may be considered to exist. First, the ECJ points to the fact that all (or almost all) of the interest / dividends upon receipt is quickly passed on to a company that is not entitled to the benefits of the EU Directives. The passing on of income to a third party may be established by contractual arrangements as well as ‘in substance’. Furthermore, a company may also qualify as a conduit company according to the ECJ, if it has no economic activity other than the passing through of (passive) income to other (conduit) companies. Whether a company has no other economic activity, should be assessed by having regard to: the management of the company, its balance sheet, the structure of the costs / expenditures actually incurred, the staff that are employed and the premises and equipment used. Finally, the ECJ ruled that the existence of a conduit company can be identified by: the contracts between group companies, the way in which intra-group transactions are financed, the valuation of intermediary companies' equity and the conduit companies' inability to have economic use of the income received. The latter factor suggests that a company may be considered to act as a conduit company if it is not the beneficial owner of the income. In the joined cases dealing with the application of the Interest and Royalty Directive, the ECJ defined 'beneficial owner' as the entity which actually benefits economically from the interest and, accordingly, has the power to freely determine how it is used. Although the Parent Subsidiary Directive does not contain a specific reference to the term beneficial owner, this does not preclude the denial of benefits under the directive if the recipient of a dividend is not the beneficial owner. The ECJ also ruled that the closeness in time of the establishment of a structure to a change in tax laws can indicate the existence of a conduit company. Finally, the ECJ noted that the fact that the company that is the beneficial owner of the income is established in a jurisdiction that has a tax treaty with the Member State in which the payor of the income is resident, pursuant to which the income would also be exempt from tax, can, but does not in itself lead to the conclusion that there is no abuse of right. The burden of proving an abuse of rights rests with the tax authorities of the member state in which the exemption from tax is claimed. They have to establish that a company is merely a conduit company; they do not, however, have to identify the actual beneficial owner(s) of the income. The cases decided by the ECJ dealt with the application of the Parent Subsidiary Directive prior to the amendment thereof in 2015 through Council Directive (EU) 2015/121, which introduced a common minimum anti-abuse rule in the directive. There is no doubt in our view that the holdings of the ECJ in these cases equally apply under the amended Parent Subsidiary Directive. Implications of the ECJ judgment on the use of conduit companies Investors that are based outside the EU often structure investments into EU member states through an EU holding or finance company. The most popular jurisdictions for the establishment of such holding or finance companies are Luxembourg and the Netherlands, but other jurisdictions such as Cyprus, Malta or even Ireland, Spain and the UK are also frequently used. If these holding or finance companies qualify as conduit companies as defined by the ECJ, member states will have to deny the application of an exemption from withholding tax under the EU Directives on the interest, royalties and dividends paid to these companies. This will cause a significant increase in the tax burden on the repatriation of earnings from the EU. The risk of a denial of benefits under the EU Directives may be significant for non-EU based investors who must distribute the proceeds from their investments to their investors immediately after realisation, for example, private equity funds. Non-EU investors, private equity funds and others, will have to review their structures with a view to determining whether their EU holding or finance companies could be at risk of being deemed conduit companies as defined by the ECJ that could lose the benefits of the EU Directives. In the Netherlands, EU based holding companies with non-EU shareholders are entitled to an exemption from Dutch dividend withholding tax for dividends distributed on shares in Dutch companies. This would not apply if the main purpose (or one of the main purposes) for holding the shares is to avoid Dutch dividend withholding tax for the ultimate investors (the Dutch implementation of Council Directive (EU) 2015/121). There are several situations in which the anti-abuse clause will not apply pursuant to safe harbor rules. For example, a Luxembourg holding company that is held by a non-treaty based investor that is engaged in an active trade or business, will be granted an exemption from Dutch withholding tax if the EU holding company meets certain minimum substance requirements. Without going into detail on these minimum substance requirements, a company that satisfies these requirements could still be considered a conduit company to which the benefit of a withholding tax exemption should be denied under the fairly broad set of indications given by the ECJ. The question arises whether these safe harbors in the future will continue to apply given the ECJ's requirement upon member states to deny the benefits of the EU Directives if an abuse of rights exists as defined by the court.