Thin capitalisation rules are intended to prevent the arbitrary transfer of the tax debt
from one country to another and to ensure that the tax is charged in the country where
the profit is actually made. The rules operate by imposing an “arm’s length” rate of
interest, and disallowing for tax purposes any interest paid in excess of this. They also
apply to companies whose capital structure is disproportionately biased towards loan
capital rather than equity. The whole of the relevant interest charge is disallowed
when such fat debt financing is found to occur.
Transfer pricing rules are similar to these thin capitalisation rules in imposing arm’s
length prices on cross-border transactions within a group. The application of transfer
pricing rules solely to non-domestic transactions could be considered discriminatory
and contrary to EC law.
The question arising in the case of Lankhorst-Hohorst GmbH v Finanzamt Steinfurt
was whether subsidiaries established in Germany were treated differently depending
on whether or not their parent company had its corporate seat in Germany.22 The
German company Lankhorst-Hohorst's sole shareholder was Lankhorst-Hohorst BV,
which had its registered office in the Netherlands. The sole shareholder in Lankhorst-
Hohorst BV was Lankhorst Taselaar BV, whose registered office was also in the
Netherlands. The Netherlands (grand)parent company granted a loan to Lankhorst-
Hohorst in Germany and the dispute concerned the interest paid by the German
company on foot of this loan.
The German tax authorities treated the interest paid to the Dutch company as a
distribution of profits and taxed it as such. The German provisions were not directly
linked to nationality, but to whether the taxable person enjoyed a tax credit.
Lankhorst-Hohorst argued that the loan by the Dutch shareholder was a rescue
attempt by it and that the interest paid to that shareholder could not be classified as a
covert distribution of profits. It argued that the German provisions were
discriminatory and consequently contrary to Article 43 in view of the treatment they
afforded to German shareholders who were entitled to a tax credit (unlike the
companies in the case, which had their corporate seats in the Netherlands).
The ECJ found that difference in treatment between resident subsidiary companies
according to the seat of their parent company constituted an obstacle to the freedom of
establishment which was, in principle, prohibited by Article 43. The tax measure in
question made it less attractive for companies established in other Member States to
exercise freedom of establishment and they may in consequence have refrained from
acquiring, creating or maintaining a subsidiary in the State which adopted that
measure.
The German government, supported by the Danish and UK governments and the
European Commission, sought to justify the measure on the basis that it was intended
to combat tax evasion in the form of ‘thin capitalisation’ or ‘hidden equity
capitalisation’. The ECJ again pointed out that a reduction in tax revenue did not
constitute an overriding reason in the public interest which could justify a measure
contrary to a fundamental freedom. It noted that the legislation in question did not
22 (Case C-324/00) [2002] ECR I-11779.
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