In a judgment given in September 2004 (C-319/02) in the so-called Manninen case, the European Court of Justice (ECJ) concluded that the Finnish imputation credit ( avoir fiscal) system for dividend taxation was incompatible with the principle of free movement of capital within the European Union (EU). Even before the judgment, the Finnish Parliament decided to abolish the imputation credit system from the beginning of 2005. However, the judgment raises serious concerns over its possible retroactive effect.

The Finnish Imputation Credit System (avoir fiscal)

Since 1990, Finland has applied an imputation tax credit system to the taxation of dividends distributed by Finnish resident companies. A Finnish resident shareholder (or the Finnish permanent establishment of a foreign company) receiving dividends from a Finnish company has received an imputation tax credit equal to the tax paid by the distributing company on the distributed income. The imputation tax credit has been offset against the tax payable by the shareholder on the dividend. In practice, this has in many instances made the dividend tax free. A corresponding tax credit has not, with some minor exceptions, been available to non-resident shareholders nor to Finnish shareholders on distributions received from non-resident companies.

While the system has been administratively and fiscally effective, it has been criticised as being discriminatory and too technical and difficult.

The effects of the ECJ judgment

In the Manninen case, Mr Manninen had received dividends from a Swedish company. Those dividends were taxed in Finland but, as the distributing company was Swedish, Mr Manninen was not entitled to an imputation tax credit. This was held to be discriminative.

There is a fear that as a result of the judgment, the Finnish tax administration could be flooded with demands for rectification. Although the Finnish Minister of Finance has expressed some doubts about the retroactive effect of the current judgment, we believe, based on the wording of the judgment and a previous ECJ ruling (C-294/99), that the judgment will be held to have retroactive effect.

Finnish investors having experienced similar treatment as Mr Manninen could in 2004 potentially file an appeal concerning their taxation for the year 1998 and subsequent years. Furthermore, it could potentially be possible to go even as far back as 10 years by instigating a civil process based on unjust enrichment of the Finnish Government.

Whether or not Finnish companies are entitled to an imputation credit on portfolio dividends received from companies in other EU states is likely to be resolved in the near future. It is likely this question will also be decided in favour of the taxpayer. Another question is whether residents in other EU states having received Finnish dividends are entitled to Finnish imputation tax credit. One thing, though, is certain – the Manninen judgment is likely to be scrutinised with interest by tax subjects and tax authorities throughout the EU.

The reform of Finnish dividend taxation

As of the beginning of 2005, the imputation system will be replaced by a partial double taxation of distributed profits. The reform has been criticised for being a mishmash including tax exempt, partially tax exempt as well as fully-taxed dividends. Furthermore, taxable dividends are either capital income taxed at flat rates and/or earned income taxed at progressive tax rates for individuals. In addition, the rules still include double tax elements that have been considered problematical. However, every cloud has a silver lining – Finnish companies can, after the reform, distribute retained earnings to their Finnish resident shareholders out of tax-exempt income without today's supplementary taxation.

Some of Finland's double tax treaties include a provision making the favourable tax treatment of dividends contingent on the existence of the imputation credit system in Finland. Consequently, despite the reduction in the general withholding tax rate from 29% to 28%, the withholding tax rates applied will in many situations actually be increased. This will happen, for example, under the treaties with The Netherlands, Switzerland and Estonia.

Finnish listed companies have distributed large dividends in 2004 to maximise the benefit to their shareholders of the imputation credit system. Finnish investors are afraid to transfer their investments abroad and substantial tax planning keeps tax experts busy: dividends are likely to be replaced, for example by capital gains, interest and rent. Furthermore, share buy-backs as well as leveraged structures are expected to increase. However, Finnish dividend taxation may decrease the interest in IPOs in the future especially among family-owned corporations.

Individual shareholders

Generally, the tax treatment of dividends varies depending on whether the company distributing the dividends is a listed or unlisted company.

Dividends received from a listed Finnish or EU company or from a listed company residing in a tax treaty country are taxed as follows: 30% of the dividend is tax exempt and 70% is taxed at a flat rate of 28%. Under transitional rules, only 57% of the dividend is taxable income in 2005.

Dividends received from an unlisted Finnish or EU company or from an unlisted company residing in a tax treaty country are split into different in-come baskets, all of which are taxed differently. Dividends per share in excess of 9% of the net assets per share of the distributing company are tax exempt, except for the amount by which all such dividends received by the same shareholder the same year exceed A 90,000 (£61,470). Seventy percent of such excess amount is taxed as capital income at the rate of 28%. The balance is tax exempt.

A special tax relief applies if Finnish wealth tax is payable by the shareholder. Seventy percent of any dividends received in excess of the 9% threshold is subject to progressive tax with margin rates going as high as 56%. The balance (30%) is tax exempt. Under the transitional rules, only 57% of the excess dividends is taxable income in 2005.

The reason for this complex formula is a desire to ensure that the overall net taxation of dividends from unlisted companies will, in most situations, be similar to that applying in the same situation today. There is, however, one important exception, namely the 28% tax. Unless the net wealth tax relief applies under the new system the tax will be levied on any (currently untaxed) dividends not exceeding the 9% threshold but exceeding €90,000 per shareholder and year.

Finally, the tax on dividends received from companies from states not belonging to the EU or with which Finland has not entered into a double tax treaty will be taxed at progressive tax rates (currently in general at flat rates).

Corporate shareholders

Dividends received by corporate entities will normally not be taxed. However, 75% of dividends on shares accounted for as investment assets will be taxable. This will apply equally to domestic and foreign entities unless the distributing company is an entity to which the Parent-Subsidiary Directive applies and of whose share capital the recipient company owns directly at least 10%. Under the transitional rules, only 60% of the dividends is taxable income in the year 2005.

Additionally, dividends will be taxable if the distributing company is not resident in the EU. Whether tax will actually be levied will, in most cases, be established on the basis of the relevant Finnish tax treaty. Furthermore, even if the shares are not accounted for as investment assets, 75% of dividends received on shares in a listed company will be taxable if the recipient company is neither listed nor owns at least 10% of the distributing company. The balance (25%) is tax exempt. Under the transitional rules, only 60% of the dividends is taxable in 2005.

Gunnar Westerlund is a partner and Taru Taajamaa a tax specialist at Roschier Holmberg.