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3.3 EC Interest and Royalties Directive


Taxation of cross-border interest and royalty payments in the European Union   

On 3 June 2003 the Council adopted Directive 2003/49/EC on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States (the “I+R” Directive). The purpose of the I+R Directive is  to eliminate withholding tax obstacles in the area of cross-border interest and royalty payments within a group of companies, on an equal footing with domestic payments, by eliminating  double taxation
and cash-flow disadvantages by abolishing:   

  • withholding taxes on royalty payments arising in a Member State, and
  • withholding taxes on interest payments arising in a Member State.  

For the purposes of the Directive:

  • the term ‘interest’ means income from debt-claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor’s profits, and in particular, income
    from securities and income from bonds or debentures, including
    premiums and prizes attaching to such securities, bonds or debentures;
    penalty charges for late payment shall not be regarded as
  • the term ‘royalties’ means payments of any kind received as a
    consideration for the use of, or the right to use, any copyright of
    literary, artistic or scientific work, including cinematograph films
    and software, any patent, trade mark, design or model, plan, secret
    formula or process, or for information concerning industrial, commercial
    or scientific experience; payments for the use of, or the right
    to use, industrial, commercial or scientific equipment shall be regarded
    as royalties.


By taxing the beneficial owner in the Member States of residence – in the case of PEs, in the MS
where they are located – it is guaranteed that such income is taxed in the same
jurisdiction where the related expenditure is deductable (i.e., the cost of raising
capital in the case of interest income, and research and development expenditure in
the case of royalties).   

These interest and royalty payments shall be exempt from any taxes in that State provided that the beneficial owner of the payment is a company or permanent establishment in another Member State.   

Directive 2003/49/EEC   

Directive 2003/49/EEC that entered into force on 1 January 2004 is designed to eliminate taxes levied at source on payments of interest and royalties between associated companies of different Member States. Taxes levied at source, either by deduction (i.e. withholding taxes) or by assessment, in Member States on interest and royalties paid to companies resident in other Member States can create problems for companies engaged in cross-border business. In particular, such taxes can involve time-consuming formalities, result in cash flow losses and sometimes lead to double taxation. Associated companies must have cross-shareholdings of at least 25%.   

The Directive is designed to relieve double taxation but not to facilitate non-taxation. The Directive therefore includes provisions to ensure that Member States are not precluded from taking steps to combat fraud or abuse. Such steps could include denying companies the benefits of the Directive.   

Transitional arrangements were provided for Greece and Portugal for both interest and royalties and for Spain for royalties in order to alleviate the immediate budgetary impact of the Directive on those countries. Under these arrangements, Greece and Portugal did not apply the Directive until 1 January 2005 and Spain did not apply the Directive to royalty payments until that same date. Subsequently, Greece and Portugal, for a transitional period of eight years, were allowed to apply a withholding tax on payments of interest or royalties that did not should exceed 10% during the first four years and 5% during the final four years. Spain, during a transitional period of six years starting on the same date of 1 January 2005, were authorised to apply a rate of tax on payments of royalties that did not should exceed 10%.   

A number of Member States do not at present levy withholding tax on outbound interest payments (with a further
two MS granting broad exemptions), and a few Member States do not levy withholding tax on
royalty payments (an exception, in the case of one Member State, for patent royalties).
It should be noted in this context that the Directive is relevant even for those Member States that
do not levy withholding taxes (or tax by assessment) on interest or royalty payments,
inasmuch as Articles 4 and 5 limit the discretion of all Member States to recharacterise interest
or royalty payments as profit distributions and levy taxes thereon.   

‘Beneficial owner’

The Directive request that (Article 1(4)) a company of a Member State shall be treated as the beneficial owner of interest or royalties only if it receives those payments for its own benefit and not as an intermediary, such as an agent, trustee or authorised signatory, for some other person.   

It also states that (Article 1(5)) a permanent establishment shall be treated as the beneficial owner of interest or royalties in the following cases:   

  • if the debt-claim, right or use of information in respect of which interest or royalty payments arise is effectively connected with that permanent establishment; and 
  • if the interest or royalty payments represent income in respect of which that permanent establishment is subject in the Member State in which it is situated to one of the taxes mentioned in Article 3(a). 

The beneficial ownership condition aims at ensuring that relief under the Directive is
not wrongfully obtained through the artificial interposition of an intermediary.
While there are differences of wording between the beneficial ownership criteria for
companies and PEs, respectively, the key difference lies in the reference to
“…income in respect of which that permanent establishment is subject…to one of the
taxes…”. The Directive here makes explicit that the payments as such must be taxed
in the hands of the beneficial owner.   

The IBFD survey continue: “Member States have adopted different approaches in respect of the
beneficial ownership criteria. With regard to companies, some Member States have chosen not
to transpose the Article 1(4) definition at all, others have relied on domestic
definitions, and yet another group of Member States have transposed it with deviations. As
regards Permanent Establishments (PEs), some Member States have chosen either not to transpose Article 1(5) at all, or to
transpose it with national variations.
Those differences of approach could lead to relief being denied in one Member State, but being
granted, in identical circumstances, in another. Notwithstanding comments from
some Member States to the effect that this issue is essentially one of case-by-case assessment,
the fact remains that the term as used in the context of the Directive is one of
Community law. Its interpretation must be uniform throughout the Community. The
co-existence of 27 potentially different interpretations would undermine the
effectiveness of the Directive.”

PE – ‘Tax-deductible expense’  

According to the Directive, where a permanent establishment of a company of a Member
State is treated as the payer, or as the beneficial owner, of interest or
royalties, no other part of the company shall be treated as the payer, or
as the beneficial owner, of that interest or those royalties for the purposes
of this Article.  This  shall apply only if the company which is the payer, or
the company whose permanent establishment is treated as the payer, of
interest or royalties is an associated company of the company which is
the beneficial owner, or whose permanent establishment is treated as the
beneficial owner, of that interest or those royalties.  

This will not apply where interest or royalties are paid by
or to a permanent establishment situated in a third State of a company
of a Member State and the business of the company is wholly or partly
carried on through that permanent establishment.  

Nothing in the Directiva may prevent a Member State from taking
interest or royalties received by its companies, by permanent establishments
of its companies or by permanent establishments situated in that
State into account when applying its tax law.  

In the case of payments made by PEs, the obligation of the source State to refrain
from taxing is made conditional on such payments being a tax-deductible expense for
the payer.
It is clear from the context that the purpose of the ‘tax-deductibility’ requirement is to
ensure that the benefits of the Directive accrue only in respect of those payments that
represent expenses which are attributable to the PE. However, on its wording the
provision would also apply to cases where deduction is denied on other grounds.   

Holding period  

Member States have the option (Article 1(10) of not applying this Directive
to a company of another Member State or to a permanent establishment
of a company of another Member State in circumstances
where the conditions set out in Article 3(b) have not been maintained
for an uninterrupted period of at least two years.  

Article 3(b) states that a company is an ‘associated company’ of a second company if, at least:  

  • the first company has a direct minimum holding of 25 % in the capital of the second company, or
  • the second company has a direct minimum holding of 25 % in the capital of the first company, or
  • a third company has a direct minimum holding of 25 % both in the capital of the first company and in the capital of the second company.

Holdings must involve only companies resident in Community territory.  However, Member States shall have the option of replacing the criterion of a minimum holding in the capital with that of a minimum holding of voting rights;  

A number of the Member States have availed themselves of this option provided for by the Directive (Article 1(10)), according to the IBFD survey, ” to impose a minimum holding period as a condition for enjoying the
benefits of the Directive. A fiew Member States require this
condition to be satisfied at the time of payment, with no possibility for a subsequent
fulfilment of the condition to be taken into account retroactively.”   

“The latter requirement appears to be inconsistent with the purpose of the Directive in
general and of Article 1(10) in particular, and with the relevant ECJ case law. In the
Denkavit case, concerning the holding period option provided for by Article 3(2) of
the Parent-Subsidiary Directive, the Court found that as a derogation from the
principle of exemption from withholding taxes laid down by that Directive, the
holding period option was to be interpreted strictly.” The court noted aswell that the
provision was “aimed in particular at counteracting abuse whereby holdings
are taken in the capital of companies for the sole purpose of benefiting from the tax
advantages available and which are not intended to be lasting”.   

As in the case of Article 3(2) of the Parent-Subsidiary Directive, Article
1(10) of the I+R Directive, according to the IBFD Survey, “constitutes a derogation from the principle of exemption from withholding
taxes, and is therefore to be interpreted strictly. It also shares the same purpose as
Article 3(2), i.e. to counteract abusive enjoyment of the benefits of the Directive
through temporary, purely tax-motivated holdings. That purpose is achieved if the
holding is maintained for the required minimum period, regardless of whether that
period has already come to an end at the time of payment or whether it comes to an
end only at some later time, such as the date on which an application for relief is

Place of effective management
A few Member States, according to the IBFD survey, “appear to require, as a condition for granting exemption,
that the company receiving a payment should be subject to corporation tax in the Member States
in which it has its place of effective management. This could lead to a denial of the
benefits of the Directive in a situation where, for instance, both the Member States in which the
company is incorporated and that in which it has its place of effective management
rely, in their domestic legislation, on the place of incorporation as the relevant factor
for determining tax residence.”   

In the opinion of the IBFD, “there is no support in the text of the Directive for imposing one tax residence
criterion in preference to another. If the company is resident in one MS only, it
matters not whether the criterion applied by the MS of residence is the place of
incorporation or the place of effective management. If the company is dual resident,
the tie-breaker rule of the relevant DTC will usually determine residence on basis of
the ‘place of effective management’ criterion.” In this situation, it may be
the case that the company would be “subject to one of the following
taxes without being exempt” [Article 3(a)(iii)] in the country in which the company has
its place of effective management. A position that could conceivably be challenged on the grounds that in a case where a PE is the
recipient of an interest or royalty payment it should suffice that the company is subject to tax in the MS
of the PE on profits attributable to the latter.   

Subject-to-tax requirements
While most MS appear to apply a ‘subjective’ subject-to-tax requirement – i.e. it
applies to the company as such, rather than to the specific interest or royalty payment
– some MS require that the payment itself should be subject to tax (an ‘objective’
subject-to-tax requirement).
According to the IBFD survey, “one MS requires that the company should not have an
option of being exempt. That MS furthermore requires that the company should be
subject, in its MS of residence, to a tax that is of the same or similar character as the
income tax in the first MS.” In this case, “there is no support in the Directive for either requirement. On the contrary, the
conditions of Article 3(a) are exhaustive, thus leaving no scope to impose further
conditions and restrictions.”   

‘Associated company’: Holding threshold and Companies ‘involved’   

In general, Member States had not relaxed the 25% direct minimum holding
threshold, although at least one Member States accepts indirect holdings. However, several Member States had
choose to move from a ‘capital’ criterion to a ‘voting rights’ criterion, or allowed the
alternative use of either criterion.   

The IBFD survey found that “one MS requires that both criteria, ‘capital’ and ‘voting
rights’, be satisfied simultaneously. There is no support in the Directive for such a
dual requirement.”   

It also noted that another Member State “has extended the scope of relief available under the Directive by dispensing
with the requirement that the common parent in the situation described in Article
3(b)(iii) should be EU-resident. MS can be more generous than the Directive.”

PE – Definition
The definition of a PE is clearly modelled on that of Article 5 of the OECD MTC,
but without reproducing the list of examples and exceptions contained in Articles
5(2) to 5(7).
The fact that the Directive’s definition differs somewhat from that of Article 2(2) of
the Parent-Subsidiary Directive, and that neither definition reproduces exactly
Article 5 of the OECD MTC, may create a situation of legal uncertainty, in particular
concerning the situation of dependent agent PEs.
When implementing the Directive most MS have chosen to rely on the general PE
definition contained in their respective domestic tax legislations. However, five MS
have introduced a specific definition for the purpose of implementing the Directive.   

Exclusion of payments as interest or royalties   

The Directive states (Article 4(2)) that, where, by reason of a special relationship between the payer and the beneficial owner of interest or royalties, or between one of them and some other person, the amount of the interest or royalties exceeds the amount which would have been agreed by the payer and the beneficial owner in the absence of such a relationship, the provisions of this Directive should apply only to the latter amount, if any. 


Accordint to the IBFD, this Article 4(2) “is a transfer pricing provision. As is clear from the commentary on the
Article contained in COM (1998) 67 final, it is also intended to be a thin
capitalisation provision. The commentary also argues that any amount reclassified as
a profit distribution should be granted the benefits of the Parent-Subsidiary
Directive” (Cf. the opinion of AG Mischo of 26.9.2002 in Case C-324/00 Lankhorst-Hohorst.)
The survey also found that “one MS would deny the benefits of the Parent-Subsidiary
Directive for interest and royalty payments reclassified as hidden profit distributions,
on the grounds that under domestic case-law such distributions cannot be regarded as
12 dividends. However, that MS finds itself unable to charge withholding tax if there is
a DTC, since the dividend Article of the DTC would not apply.”  This is not clear. In its reservation on Article 10(3) of the OECD MTC, this same Member State
reserves “the right to amplify the definition of dividends in paragraph 3 so as to cover all income
subjected to the taxation treatment of distributions”. A payment will not allways qualify
as a ‘dividend’ under the domestic law of that MS in order to be considered a ‘dividend’ when applying
Article 10(3).   

The IBFD survey states that “there is a need for further reflection regarding the tax treatment of excess amounts
of interest or royalties, whether or not reclassified as profit distributions. Depending
on the circumstances, there could conceivably also be a question of discrimination
vis-à-vis the treatment of similar domestic payments.
In this context it should be noted that the Court has found that the discriminatory
application of thin capitalisation provisions involving a fixed debt/equity ratio, with
no let-out clause, constitutes a disproportionate, and therefore unjustifiable,
restriction of the freedom of establishment.” Examples of this are the cases C-105/07 Lammers ( paragraph 32) and Case C-524/04 Thin Cap Group Litigation (paragraph 92)   

Fraud and abuse  

This Directive (Article 5) does not preclude the application of domestic or agreement-based provisions required for the prevention of fraud or abuse. Member States may, in the case of transactions for which the principal motive or one of the principal motives is tax evasion, tax avoidance or abuse, withdraw the benefits of this Directive or refuse to apply this Directive. 


Several Member States may use the Article 5 in orden to deny tax relief in cases
where the receiving company is controlled by a third-country resident.   

Article 3(b) requires that “holdings must involve only companies resident in
Community territory”. As the IBFD survey indicates, “the Directive does not however stipulate that a parent
company receiving an interest or royalty payment from its part – or wholly- owned
subsidiary must be controlled by an EU resident (or by a resident of a MS other than
that of the subsidiary) in order for the payment to qualify for relief.
Article 5 must moreover be interpreted in the light of the relevant ECJ anti-abuse
case-law, which requires anti-abuse measures to be appropriate and proportionate.” An example is judgment of 17.7.1997 in Case C-28/95 Leur-Bloem v Inspecteur der Belastingdienst/Ondernemingen Amsterdam 2 (paragraph 44).   

The IBFD continues: “Domestic legislation or a DTC provision that denies relief on the sole grounds that
the parent company is controlled by a third-country resident – or by one of its own
residents – is unlikely to meet the proportionality test,” because does not “have the
specific purpose of preventing wholly artificial arrangements”. An example os this is  judgment of 13.3.2007 in Case C-524/04 Test Claimants in the Thin Cap Group Litigation v Commissioners of Inland Revenue (paragraph 79).   

It should be recalled that the ‘beneficial owner’ condition of Article 1 is specifically
designed to tackle artificial conduit arrangements. It may therefore be doubted
whether a company that satisfied the ‘beneficial owner’ test, could be considered an
artificial conduit when applying Article 5.

Intra-company payments
The scope of the Directive is currently limited to payments between separate legal
entities. Thus, it does not cover the intra-company situation, for instance actual or
notional payments between a head office and a PE, or between two PEs of the same
In the context of the OECD work on the attribution of profits to PEs, the question has
arisen whether, under DTC, the source state (usually the state of the PE) would be
entitled to levy a withholding tax, or other form of taxation at source, on notional
interest or royalty payments to the head office or other PE of the same company.
The matter is still under debate, but some OECD countries have indicated that they
would be minded to impose a withholding tax on the above payments.
Taxation at source on intra-company payments would create disadvantages for crossborder
investment similar or identical to those that prompted the adoption of the
Directive. It would therefore seem appropriate to consider extending the scope of the
latter to cover such payments.   


1.The threshold:   

Article 3(b) of the Directive currently stipulates that ‘holdings’ within
the meaning of that provision should meet or exceed a threshold of 25% of capital or
voting rights. Under Article 3 of the Parent-Subsidiary Directive, which contains a
similar provision, the threshold for ‘holdings’ has gradually been reduced from 25%
to currently 10% of capital or voting rights (cf. also Article 7(2) of the
Merger Directive).
Thus, even though all three EC company tax directives share the aim of creating
conditions analogous to those of an internal market, a company group for the
purposes of the latter two directives remains something less than a company group
under the Interest and Royalties Directive, thereby increasing the planning and
compliance costs of companies involved in cross-border operations.
The difference between thresholds may produce incongruous results, for instance in
the context of a reclassification of an interest or royalty payment as a profit
distribution. An interest or royalty payment between companies associated through a
‘holding’ of at least 10%, but less than 25%, would not qualify for relief under the
Interest and Royalties Directive, but would qualify for relief under the Parent-
Subsidiary Directive if reclassified as a profit distribution.   

2.Indirect holdings:   

The scope of the Directive is currently limited to direct holdings,
while that of the Parent-Subsidiary Directive has no such limitation. Since both
directives share the same purpose – i.e. to eliminate double taxation – there is no
obvious justification for this difference.   

3.Extension of the scope:   

While the elimination of inconsistencies in respect of
thresholds and direct/indirect holdings would represent a significant improvement on
the existing situation, it can be deduced from Article 8, read in conjunction with
recitals 2, 4 and 9, that it was the intention that the Directive should eventually
encompass unrelated undertakings, and that the current limitation to associated
undertakings should be seen only as an experimental first step. It is self-evident that
international double taxation, burdensome administrative formalities and cash-flow
problems, as cross-border obstacles to transactions between related companies, are
also present in the case of payments between unrelated parties.
As regards royalty payments, an extension of the scope of the Directive to unrelated
undertakings would be consonant with the Article 163 EC objective of
“…strengthening the scientific and technological bases of Community industry and
encouraging it to become more competitive at international level…”
It should also be noted that extending the scope would be consistent with Articles 11
and 12 of the OECD MTC, which make no distinction between related and unrelated

Commission Proposal   

In January 2004, the European Commission  made a proposal to broaden the scope of the I+R Directive. The changes would see the Directive cover a larger range of companies including the European Company and the European Co-operative Society. The proposal would also, at the request of the EU’s Council of Ministers, eliminate a loophole by providing that the Directive would not apply to companies that are exempt from tax on interest and royalties received. The proposal is in line with the Commission’s view that double taxation due simply to the cross-border nature of economic activity cannot be accepted, but that its elimination should not create opportunities for tax avoidance and evasion and neither should any greater co-ordination of Member States’ tax systems give rise to unintentional non-taxation.   

The main elements of the Commission’s proposal to improve the operation of the “Interest and Royalties” Directive are as follows:   

List of Entities covered by the Directive   

As in the case of the Parent / Subsidiary Directive and the Mergers Directive, the Commission proposal on the I+R Directive would update the list of companies to which the Directive applies to cover new, specified, legal entities, including certain co-operatives and non-capital based companies, mutual companies, savings banks, funds and associations with commercial activity. The new list would include the European Company and the European Co-operative Society twith the result that companies and co-operatives operating in more than one Member State will have the option of establishing themselves as single entities under Community law.   

As under the Merger and the Parent-Subsidiary Directives, the benefits of the I+R Directive are only granted to companies which are:   

•subject to corporate tax in the EU,
•tax resident in an EU Member State and
•of a type listed in the annex to the Directive.   

As the annex to the Directive only includes the types of companies existing in the 15 Member States that were already members of the EU before 1 May 2004, the types of companies in the new Member States have now been added by Council Directive 2004/66/EC of 26 April 2004 . In addition, the Council, on 29 April, adopted Directive 2004/76/EC, granting some of the new Member States transitional periods resulting in their not applying the provisions of the Directive immediately from the date of their accession.   

I fact, several Member States have chosen to extend the benefits of the Directive to payments from a
broader range of entities than those listed in the Annex, while maintaining the Annex
requirements in respect of the recipients of the payments.   

Transparent entities
Currently, it is conceivable that one or more of the entities listed in the Annex could be
regarded as fiscally transparent by a Member State other than that in which the entity is
registered or incorporated.
The Directive does not contain any provision allowing Member States to ‘look through’ nonresident
qualifying (i.e. that meet all of the criteria of Article 3)  entities. It follows that a Member State has no legal basis for refusing to
apply the Directive to a non-resident entity which meets the requirements of Article 3.
However, even if it were permissible to apply a look-through approach, the logic of
that approach would require the Member State in question to extend the benefits of the
Directive to the partner/shareholder. That view would be consistent with the position
taken in the OECD Partnership Report and the Commentary on Article 1 of the
Model Tax Convention (MTC).   

Tax Avoidance   

The proposal also would make it clear that Member States have to grant the benefits of the Interest and Royalties Directive only where the interest or royalty payment concerned is not exempt from corporate taxation in the hands of the beneficial owner. In particular, this addresses the situation of a company paying corporate tax but benefiting from a special national tax scheme exempting foreign interest or royalty payments received. In such a case the source state would not be obliged to exempt the payments from withholding tax. The Council of Ministers requested the exclusion of exempt companies from the scope of the Directive at the time of the Directive’s adoption in June 2003.   

It is of concern that such payments should not escape taxation. According to recital 3 Directive 2003/49/EEC,  those payments should “…be taxed once in a Member State.”   


The European Commission in June 2006 published a survey (the “IBFD survey”) on the implementation of the Directive. The survey carried out by the International Bureau of Fiscal Documentation (IBFD) aims to provide a comprehensive overview of the implementation of the Interest and Royalty Directive.