Justifying restrictions on the free movement of capital involving third countries

The circumstances in which a Member State might justify restrictions on the free movement of capital based on the need to prevent “wholly artificial arrangements” have been considered by the ECJ.

The ECJ has handed down its judgment in X GmbH v Finanzamt Stuttgart (Case C-135/17) (ECJ, 26 February 2019) concerning the scope of the free movement of capital involving third countries. In doing so, the court has clarified its earlier case law on the meaning of “wholly artificial arrangements” and the opportunities that a Member State must provide to a taxpayer to rebut any suggestion that particular arrangements fall into that category.

Perhaps most significantly, the decision suggests a wider scope for justifications of restrictions in the context of the free movement of capital and third countries. This may well be significant when considering other BEPS related anti-avoidance provisions, such as the UK’s diverted profits tax.


The case involved a German company, X, which held 30% of the shares in a Swiss company, Y. Y acquired certain debts from a third German company, Z and received funding from X by way of a loan. The German tax authorities sought to assess X on a pro rata share of Y’s income on the basis that Y was a CFC of X and that it was, accordingly, taxable on the income from the passive activities of Y.

X sought to resist the assessment on the basis that the German CFC provisions, which only applied to companies established in third countries, where contrary to the free movement of capital.

Standstill clause

The ECJ first had to consider the relevance of the standstill clause in Article 64 of the TFEU. This provision protects restrictions that were in place on 31 December 1993. In particular, the German court’s referred questions to the ECJ concerning whether the German tax authorities could still rely on the German CFC rules in this case (which had existed in December 1993) given that they had undergone amendments in the meantime.

The ECJ first held that an extension of the application of the CFC rules from holdings of 10% to 1% did not prevent the German tax authorities continuing to rely on the provisions. Although the rules were widened, that did not prejudice the application of the standstill clause in this case. The German tax authorities could have applied those provisions in December 1993 to X’s 30% shareholding and so the standstill clause was effective. It didn’t matter that those rules had been extended to cover “portfolio” investments post-1993.

The ECJ also had to consider the impact of changes “on account of the adoption of a law which entered into force but was replaced before ever being applied in practice, by legislation that is essentially identical to that applicable on 31 December 1993”. On this issue, the ECJ held that December 1993 restrictions are not prejudiced simply because a Member State enacts restrictions after that date which are identical to the previous restrictions or which made those restrictions less stringent. However, it was essentially a question for the domestic courts to determine whether the pre-31 December 1993 provisions had continued to exist at all times since then. If the amending legislation had been deferred and had been repealed before becoming effective, that would not affect the operation of the standstill clause. However, if the changes did become applicable, then that would interrupt the continued existence of the rules, even if they were repealed shortly afterwards and even if, on account of that repeal, the tax authorities ultimately did not apply those rules to collect tax.

Restriction on free movement of capital?

Given the uncertainty over the application of the standstill clause, it was appropriate for the court also to consider whether the rules in this case amounted to an illegal restriction on the free movement of capital in any case. Unsurprisingly, the court held that the CFC rules requiring the taxation of a German company on the pro rata share of the profits of a foreign subsidiary was, in principle, a restriction on the free movement of capital. Therefore, the question was whether these CFC rules could be justified by reason of the fact that they were intended to “prevent or offset the transfer of (passive) income… to States with a low tax rate”.

The court reiterated that both the need to prevent tax avoidance or evasion and indeed the need to guarantee effective fiscal supervision may constitute overriding reasons in the public interest capable of justifying restrictions on the fundamental freedoms. In this context, the court noted that it had held that measures restricting the fundamental freedoms may be justified when “designed specifically to prevent conduct that consists of creating wholly artificial arrangements” (Cadbury Schweppes (Case C196/04)). Whilst the court in Cadbury Schweppes focussed on the nature of the establishment in determining whether there were “wholly artificial arrangements”, the ECJ suggested that, in the context of free movement of capital, a wider set of consideration may be appropriate, “since the artificial creation of the conditions required in order to escape taxation in a Member State improperly or enjoy a tax advantage in that Member State improperly can take several forms as regards cross-border movements of capital”. The Court suggested that indications of a wholly artificial arrangement might involve an assessment of “the commercial justification of acquiring shares in a company that does not pursue any economic activities of its own. However, that concept is also capable of covering, in the context of the free movement of capital, any scheme which has as its primary objective or one of its primary objectives the artificial transfer of the profits made by way of activities carried out in the territory of a Member State to third countries with a low tax rate.”

However, in this case, it was clear that the legislation could not be regarded as “designed solely” to prevent such artificial schemes. The rules applied automatically and did not give taxpayers an opportunity to show the arrangements were not artificial. Although a low tax rate or the passive nature of the income can be indicators of tax avoidance, they are not sufficient grounds to find that the acquisition of shares constitutes an artificial scheme. In order for such rules to be proportionate, the taxpayer must be given an opportunity to provide evidence of commercial justification for the transaction.

Finally, however, the court noted that, in situations involving third countries, the obligation of a Member State “to give a taxable person the opportunity to produce evidence demonstrating any commercial justification for its shareholding in a company established in a third country, it is apparent from the Court’s case-law that the existence of such an obligation must be assessed according to the availability of administrative and legislative measures permitting, if necessary, the accuracy of such evidence to be verified”. Accordingly, it was again up to the domestic German courts to assess whether there were any treaty obligations between Germany and Switzerland which would genuinely empower the German tax authorities to verify the accuracy of information provided on the Swiss company, Y. If no such provisions exist, then it would not be contrary to the free movement of capital in this context to apply the German CFC legislation.


The decision of the ECJ provides further guidance on the extent to which Member State may apply anti-avoidance rules aimed at profit-shifting to low-tax jurisdictions. In the context of the free movement of capital, the court has suggested that an extended meaning be given to “wholly artificial arrangements”. In particular, the decision that the phrase “could also cover any scheme which has as its primary objective or one of its primary objectives the artificial transfer of profits made by way of activities carried out in the territory of a Member State to third countries with a low tax rate” may well be significant for the application of wider anti-BEPS legislation, including the UK’s diverted profits tax.

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