With the exception of Italy, Denmark and Sweden, all EU member states apply either the EET or the TEE system to pension taxation. EET means that the pension contributions are ‘exempt’, that is the contributions are deductible from the taxable income, the investment results of the fund itself are also exempt, and the pension benefits are taxed.

In the same way, TEE means that the pension contributions are not deductible from the taxable income, they are taxed, the investment results of the fund are exempt, and the pension benefits are exempt from taxation.

What the EET and the TEE system have in common is that the investment results of the pension funds themselves are exempt from taxation. They do not pay corporation tax or income tax on their income. However, many member states reserve this exemption to their own pension funds and do not apply it to pension funds in other member states. It is now becoming increasingly clear that such difference in treatment, only based on the location of the pension fund, is contrary to the principles of the internal market.

The higher taxation of the foreign pension funds is the result of the levying of withholding taxes on dividend and interest payments by the source state. The member states which exempt their pension funds from corporation and income tax often provide for exemption at source of the withholding tax on dividend and interest paid to domestic pension funds.

In most member states where there is no such exemption at source there is a refund procedure, by which the pension fund can claim back the withholding tax from the local tax authorities. However, in most cases, foreign pension funds do not qualify for the relief at source or the refund procedure. The result is that the source member state levies a higher tax on interest or dividends paid to foreign funds than on those paid to domestic funds.

This analysis may also concern the group of the ETT states (Italy, Denmark and Sweden). They exempt the pension contributions, but levy a tax on a fund’s investment results, and also tax the pension benefits. To the extent that the withholding taxes on outbound dividends and interest in these member states are higher than the second T, that is the tax on the investment results of the domestic funds, they may, like the EET and TEE member states that exempt their funds, levy more tax on foreign funds than on domestic funds.

According to the complaint by the EFRP and PriceWaterhouseCooper (PWC), 17 member states levy a higher tax on dividends paid to foreign pension funds: the Czech Republic, Denmark, Germany, Estonia, Spain, France, Italy, Latvia, Lithuania, Hungary, The Netherlands, Austria, Poland, Portugal, Slovenia, Finland and Sweden. Nine member states levy a higher tax on interest paid to foreign funds: Czech Republic, Germany, France, Lithuania, Austria, Poland, Portugal, Slovenia and the UK.

The analysis of the impact of EU law seems to be relatively straightforward. It starts with a ruling by the ECJ in the case of Mr Verkooijen, who lived in the Netherlands and received some dividends from another member states. Dividends paid by a company in another member states to a resident of the member states concerned are called inbound dividends. Domestic dividends are dividends paid by a company of a member states to a shareholder in the same member states. Outbound dividends are dividends paid by a company of the member states concerned to a shareholder in another member states. The Netherlands exempted the first thousand guilders of the received dividends, but only for domestic dividends. The exemption did not apply to inbound dividends. The ECJ ruled that this was contrary to the free movement of capital, as guaranteed by the EC Treaty.

On the basis of the Verkooijen judgement, the EC issued a communication in December 2003 on the taxation of dividends received by individuals, drawing two clear conclusions: inbound dividends cannot be taxed higher than domestic dividends, and outbound dividends cannot be taxed higher than domestic dividends. These conclusions can probably also be applied to dividends received by companies or other legal entities, such as pension funds.

Concerning interest payments the commission has already sent a reasoned opinion to Portugal, for taxing outbound interest paid to foreign banks higher than interest paid to domestic banks. The EFTA court has ruled that the EEA agreement, which extends the internal market of the EC Treaty to the three EFTA states, and thus contains the same freedoms as the EC Treaty, forbids rules such as in Norway, where a withholding of tax was levied on outbound dividends paid to companies, whereas domestic dividends were exempt.

The case law of the ECJ and the dividend communication by the EC have already resulted in more than 20 complaints and requests for preliminary rulings from national judges to the ECJ concerning inbound and outbound dividends. The EFRP and PWC complaints bring this number to over 40.

The EFRP and PWC launched their complaints in December 2005. According to its internal rules, after receiving a complaint the EC has one year to either close the case, if it concludes that there is no infringement, or to send a so-called ‘letter of formal notice’ to the member states concerned.

The member state has two months to reply. If the reply is negative and the commission remains of the opinion that there is an infringement, it will send a so-called ‘reasoned opinion’ to the member state. Again the member state has two months to reply. If the member state is still not prepared to change its legislation and the commission still thinks that there is an infringement, it will refer the member state to the ECJ. The complaints procedure can be started by anyone.

Furthermore it is worth noting that the complaints procedure is form-free and cost-free; the only really essential part of a complaint is a quote of the national provisions which are thought to be not in conformity with the EC Treaty. The complaints procedure has proved of great benefit to the EC to help it to find unjustified obstacles to the internal market.

There are signals from the pension fund industry that many funds in many member states are now formally filing procedures with local tax authorities in the source states, on the levying of withholding taxes, if they think that they have to pay more tax than local funds.

The financial stakes are high, as cross-border intra-EU investments account for an important share of the total investments of European pension funds. If the complaints by the EFRP and PWC are judged to be well founded the net income for European pension funds from cross-border intra-EU dividends and interest may go up by between 11-33%, on the basis of the fact that the withholding tax rates under attack vary between 10-25%.

If a member state has to choose how to eliminate the difference in treatment between domestic and foreign pension funds, it can of course make two choices. It can either extend the exemption to the pension funds in the other EU and EEA states, or it can start to tax its own pension funds. In many member states pension funds are struggling to maintain the proper balance between assets and liabilities. Politicians may find it difficult to disturb this balance by starting to tax the investment results of their pension funds.

Finally, it is interesting to note that what applies to pension funds to a large extent may also apply to investment funds. Many member states have special tax regimes for their domestic investments funds, which often result in no or very low taxation on their investment income. As with pension funds, there may be member states which, by levying withholding taxes on dividends and interest paid to foreign investment funds, subject these funds to higher taxation than their domestic investment funds.

Peter Schonewille works in the unit dealing with direct tax infringement cases at the Directorate-General Taxation and Customs Union of the European Commission in Brussels and at the CompetenceCentre for Pension Research at Tilburg University. His article does not necessarily reflect the opinion of the European Commission. E-mail: peter.schonewille@cec.eu.int