The European Court of Justice (ECJ) has now ruled as of May 10, 2012, on the tax discrimination alleged by nine institutions over withholding tax levied on foreign investors in French equities compared with domestic funds which are exempt. Withholding tax is levied at up to 25% on dividends paid out to investors by equity issuers, but where investors from different countries are not taxed at the same level, it is considered to be contrary to the Free Movement of Capital across the European Union.

As if the incoming French president did not have enough issues to contend with, the French Government could be facing actions for up to EUR20Bn in tax reclaims by foreign investors – and EUR5Bn of that may be crossing the channel to the UK.

The battle is not yet over of course, as foreign funds will likely have to prove that they are sufficiently similar to the tax-exempt French domestic funds in order to be treated the same way. Another option available to the French Government may be to solve the discrimination by taxing the domestic funds the same way as the foreign investors – this is not without precedent and may even be a vote winner in France if it can be sold as a tax on banks and bankers rather than the end investor.

On the positive side for claimants, the ECJ have refused to apply a temporal limit to the claims, so past discriminated investors can also take action going forward.

As far as securities lending is concerned, this could have a dramatic effect on one of the most lucrative markets in Europe. Dividend arbitrage, or yield enhancement as it is often known, involves the lending of equities over dividend periods from a fund that suffers withholding tax to one that does not. The enhancement to the dividend is then shared between the funds rather than paid as tax to the relevant tax authority. Without funds being discriminated on the basis of tax, there is no trade.

If this ruling is upheld and indeed enforced, as similar rulings have previously been in Sweden and Spain, then this is yet another downward pressure on earnings in an already embattled market and potentially sets a further precedent for other countries to follow.