The Spanish Supreme Court, being the highest court of appeals, laid down two separate judgements regarding the withholding tax rate which is currently levied on foreign hedge funds, also referred to as alternative investment funds (“AIFs”) or non-harmonised funds, which are resident in the European Union. The Court confirmed that the disparity between the withholding tax rate levied on non-Spanish hedge funds and that levied on comparable Spanish hedge funds is contrary to the Free Movement of Capital in Article 63 of the Treaty on the Functioning of the European Union (TFEU).
These judgements are a welcome development not only due to the favourable ruling for foreign hedge funds who own Spanish listed shares, but also because of the Court’s clarification on the essential criteria which should be considered when assessing the comparability of foreign hedge funds to those which are resident in Spain.
Exploring the Background: Two Different Cases, Same Principles
On 5 April and 25 April 2023, the Spanish Supreme Court was tasked with deciding whether the current tax treatment of Spanish-sourced income paid to foreign hedge funds constituted a restriction on the free movement of capital. Both cases concerned withholding tax levied on dividends paid on Spanish-listed shares to AIFs resident in France and Germany respectively (“the foreign AIFs”) between 2011 and 2014.
The withholding tax rate which was levied on the dividends was 15% (after applying the relevant Double Tax Treaty (“DTT”) with Spain). This was contested by the foreign AIFs as being contrary to the principle of free movement of capital in that comparable Spanish hedge funds were only charged at 1% on similar Spanish dividends. The Spanish tax authority rejected both claims on the basis that, firstly, the foreign AIFs were not comparable to Spanish hedge funds and, secondly, the foreign AIFs did not produce a certificate issued by their relevant supervisory authority confirming that the requirements of Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 (UCITS Directive) were met.
The two cases were then ultimately brought before the Supreme Court.
Unpacking Key Takeaways from the Supreme Court’s Ruling
The three main considerations in both cases were:
- Whether the difference in tax treatment between foreign hedge funds and comparable resident hedge funds amounted to a restriction of free movement of capital;
- What the essential criteria should be when assessing comparability; and
- Whether the effects of the disparity in tax treatment could be neutralised.
As regards the discrimination
After citing previous case law (both of the Court of Justice of the European Union and of the Supreme Court itself) the Supreme Court found that the lack of any regulations in Spanish domestic laws concerning, firstly, the comparability criteria to be met in order for foreign hedge funds to receive the same tax treatment as those resident in Spain, and, secondly, the procedure for obtaining a refund of the excess withholding tax borne by foreign hedge funds in comparable situations, infringes upon the principle of free movement of capital guaranteed in Article 63 of the TFEU. The Supreme Court further found that the State could not provide justifiable reasoning for this discrimination.
As regards the comparability criteria
In its judgements, the Supreme Court emphasised the importance of certain comparability criteria and the irrelevance of others, thereby creating more certainty around the issue. The Court held that factors such as the number of unitholders in the fund, the liquidity of the units in the fund, and the minimum share capital were not relevant in comparing foreign hedge funds to Spanish hedge funds because, firstly, these requirements are not laid down by the tax legislation itself, but rather, reference is made to the authorisation legislation and, secondly, these factors are likely to be different across different territories.
The Court found, however, that the following criteria is essential when comparing foreign hedge funds to Spanish hedge funds:
- The hedge fund must raise external capital or resources from the “general public” (i.e. access should not be restricted for subjective reasons, such as employment with a particular company or membership of a specific group);
- The hedge fund must have a valid authorisation to operate in their country of residence, which authorisation is issued by the competent authority for the control and supervision of collective investment undertakings; and
- The hedge fund must be managed by a duly authorised AIF Manager in the terms required by Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers (AIFM Directive).
As regards neutralisation
Lastly, the Supreme Court confirmed that the only way in which the effects of the restriction of free movement of capital produced by the Spanish domestic tax laws can be neutralised is where the fund is able to obtain, through the provisions of a DTT, a foreign tax credit up to the amount of the difference in tax treatment resulting from such domestic laws. Where a fund is not subjected to tax in its own country of residence, a foreign tax credit would not be possible. Further, the taxation of the unitholders is irrelevant as Spanish domestic law does not limit taxation of the fund based on the taxation of the underlying unitholders.
Looking Ahead: The Impact on Foreign Hedge Funds/AIFs
These two cases confirm that foreign hedge funds/AIFs resident in the EU, which are comparable to Spanish hedge funds, are entitled to the favourable withholding tax rate of 1%, as opposed to 19% (or 15% if the DTT is applied). This is a key milestone on the taxation of non-resident hedge funds on Spanish source dividends. The comparability criteria laid down by the Court, as opposed to the criteria currently being implemented by the Spanish tax authority, makes access to this favourable withholding tax rate more viable.
WTax actively ensures that reclaims are filed in accordance with Spanish and EU law standards and constantly monitors feedback from the Spanish Tax Authority, whilst keeping abreast of any further developments..
For detailed information on the impact of the recent ruling we encourage you to promptly get in touch with WTax’s regional specialists.