The 2006 Year in Review and the Challenges for 2007

Transcription

1 The 2006 Year in Review and the Challenges for 2007 Winner: 2006 Editor s Merit Award

2 The 2006 Year in Review and the Challenges for 2007 Table of Contents Introduction 1 Simon Whitehead Who Will Be the Winners in the Thin-Cap Debate? 2 Simon Whitehead What s Your Motive? 7 Simon Whitehead Dividend Taxation in the Spotlight 10 Liesl Fichardt Cross Border Group Relief: The Next Generation 12 Simon Whitehead Controlled Foreign Companies Legislation and the Abuse of Law 16 Mitchell Moss and George Gillham VAT and Supplies: When is a Supply Not a Supply? 23 Mitchell Moss Group Litigation and the European Court of Justice 26 Simon Whitehead A Balancing Act? The FII Group Litigation (Part One) 31 Liesl Fichardt, Chris Morgan (KPMG) and Jonathan Bridges (KPMG)

3 The 2006 Year in Review and the Challenges for Introduction Simon Whitehead The second half of 2006 again produced considerable developments in European law with claimants represented by Dorsey setting the pace. June ended with the delivery of the delayed opinion of the Advocate General in the Thin Cap GLO, favourable for at least a large part of the claimants, followed by the surprising alacrity of the judgment in Cadbury Schweppes in mid September produced within 4 months of its Advocate General s opinion. Mercurial speed by ECJ standards. Interestingly the ECJ appeared to depart here from a perceived trend towards complicated and indecisive rulings to reproduce the refreshingly simple and straight forward style of guidance reminiscent of its approach from the late 1990s. Even more interesting then was the reaction of the Chancellor proposing in retrospective changes to the CFC rules, an interpretation of that judgment so ingenious and recondite that I can recall no commentator seeing it coming. Yet more interesting still will be to hear how the Revenue s Counsel will try to shoe-horn the judgment into that illfitting explanation in the depressingly inevitable litigation to follow. October gave us a 4:1 taxpayer win from the House of Lords in DMG giving tax payers with court based damages (or restitution claims) an ability to bring claims going back in effect to 1973 or at least the subsequent commencement of the legislation under challenge. Coupled with the direction of the Lords in Autologic in 2005 this gave to tax payers vastly longer time limits than might be available through statutory appeal routes. The strategy of the Revenue in linking the issue of the available limitation in the claims in all the GLOs to the DMG case seemed in this decision to backfire. Their reaction came in December not in arguments seeking to distinguish the remaining cases from DMG but rather an admission to the contrary followed by further proposed retrospective changes to shorten the time period of existing claims. Like the previous iterations the legality of these proposed attempts will be the subject of the Court s scrutiny in the FII GLO. December saw a flurry of activity with three significant judgments from the ECJ. In ACT Class 4 the Court appears to have concluded that while French and German parent companies must look to their home states for redress from inequalities in the alleviation of economic double taxation upon dividend flows from the UK before 1999, parent companies from other Member States will have valid claims directly against the UK. This comes as good news to about a quarter of claimants in ACT class 4 and all in class 2. The FII judgment while substantially favourable for taxpayers unfortunately provided only partial answers to the questions referred to the court. In particular the issue of the validity of the UK s dividend taxation system for holdings over 10% has been delayed by the direction of the ECJ that the national court establish whether or not the curious assertion of the UK at the oral hearing that UK companies can only use reliefs to reduce their effective rate of tax in highly exceptional circumstances is in fact correct. The year then ended with the judgment in Denkavit exposing all types of withholding tax on intra-community payments to challenge. As always Dorsey lawyers have published extensively in the leading journals including Tax Notes International, Tax Journal, Taxation, International Tax Review, De Voil Indirect Tax Intelligence, BNA International and EC Tax Journal. Our articles from July to December 2006 are reproduced in this volume. As we move into 2007 Les Allen and I are immensely pleased to be accompanied by two new tax partners, Liesl Fichardt and Mitch Moss, both promoted from Special Counsel promises to be an interesting and challenging year with judgments still awaited from the Court of Appeal in Marks & Spencer v- Halsey, the House of Lords in Sempra Metals and the ECJ in the Thin Cap GLO. We have hearings already listed before the Lords in March in the Depreciation in Stock case and ACT class 3. ACT class 2 returns to the High Court in February with the ACT class 4 and FII cases awaiting national court listings and the CFC and Dividend case expecting its turn before the ECJ. The team and I remain immensely proud to be serving our clients in such important and exhilarating litigation.

4 2 The 2006 Year in Review and the Challenges for 2007 Who Will Be the Winners in the Thin-Cap Debate? Simon Whitehead Originally appeared in the September 2006 edition of International Tax Review. Reprinted with permission. The opinion in the Thin Cap Group Litigation case at the ECJ considers that the relevant UK provisions before 2004 could be discriminatory. Simon Whitehead of Dorsey & Whitney analyzes the reasoning and suggests who should take encouragement from it. Continuing his tour de force of European corporation tax provisions, on June 29, Advocate-General Geelhoed delivered his fifth opinion to the European Court of Justice (ECJ) on the topic since February. Turning from the UK, Belgian and French dividend taxation provisions considered by him in ACT Class IV (C-374/04), the FII Group Litigation (C-446/04), Kerckhaert Morres (C- 513/04) and Denkavit (C170/05), he ventured into the area of thin capitalization and transfer pricing with his opinion in the Thin Cap Group Litigation (C-524/04) commenting on both the previous and current UK rules. At the moment, the rulings of the full chamber of the ECJ seem to take between eight and 11 months after the opinion to be delivered. What then are the implications for the future, both for domestic and crossborder transfer pricing, and for current claims if this opinion is followed by the court? Change of tack? Commentators have already discussed the basic approach of this Advocate General to the taxation of cross-border transactions recommended in these previous four opinions. Those opinions dealt with the treatment of a dividend payment from one member state of the community to a parent company or shareholder in another. A distinction needs to be drawn, AG Geelhoed believes, between the source state where income is earned and the home state where the entity or persons controlling that enterprise reside. Where funds flow from a subsidiary to its parent across a border within the community, to AG Geelhoed the greater obligation to ensure that the tax treatment of the cross-border movement is not disadvantaged, when compared with a domestic one, lies with the home state where it exercises worldwide taxing jurisdiction over its residents. The only obligation he believes should be imposed on the source state is to ensure equal treatment with an identical domestic payment only when the source state actually taxes the non-resident recipient. As others have observed, this thesis when applied in practice produces incongruous results. By employing a credit system for alleviating the economic double taxation of shareholders upon dividends paid internally but no system at all for alleviating it when paid from a UK subsidiary to its French parent the UK did not (arguably) tax the French company and therefore in the ACT Class IV case AG Geelhoed believes the UK s ACT provisions in that circumstance might pass muster. In the Denkavit case, the French imposed withholding tax on payments from a French subsidiary to its Dutch parent but not to a French one. Although exactly the same result was produced (that is, greater alleviation of economic double taxation internally than cross-border) because the form of the French provisions (arguably) entailed a tax on the foreigner it was, he believes, an unlawful means of producing the same result. Given that approach, one might have expected this Advocate General to see thin capitalization and transferpricing rules as beyond the grasp of community law. In theory they are intended to enable the source state to tax profits earned there by restricting the ability of economic operators to divert them to other jurisdictions by way of excess interest deductions or the provision of goods, rights and services between group members on uncommercial terms. Provided the source state does so by a method which does not involve taxing the non-resident, according to the theory of AG Geelhoed, should it not be permitted to do so? But of course the ECJ has already told us, in the Lankhorst-Hohorst case (C324/00), that thincapitalization rules are restrictions which can offend community law even where no tax is imposed by the source state on the non-resident lender. This then needs to be added to the list of cases which challenge the home/source state distinction advocated by AG Geelhoed. Indeed this distinction does not feature in his opinion in the Thin Cap Group Litigation which instead seems to follow a line reminiscent of the opinion of AG Leger in the Cadbury Schweppes case (C-196/04). The approach to thin capitalization and transfer pricing In Cadbury Schweppes AG Leger saw controlled foreign company provisions as discriminatory restrictions on

5 The 2006 Year in Review and the Challenges for Who Will Be the Winners in the Thin-Cap Debate? community freedoms to establish in other member states, even if the only reason for doing so was to benefit from a more advantageous tax regime. However he accepted that that restriction could be justified by the objective of preventing groups from transferring their profits across the community to suit their convenience. He reconciled these considerations by his conclusion that CFC provisions could be permitted if they did not consider the motive for the establishment in the other state but only limited their effect to wholly artificial arrangements where the CFC was not genuinely established in that other member state. A similar approach has been adopted by AG Geelhoed in the thin-capitalization context. He considers the UK thin-capitalization rules before 2004 to be a discriminatory restriction on the freedom of establishment but agrees that they could be justified by the objective of preventing the diversion of profits, via excess interest deductions, from the state where they were earned to another member state. He reconciles these considerations by suggesting that in addition to an arm s-length test, lawful thin-capitalization (and transfer pricing) provisions must possess two features (paragraphs 67 and 69). First, the provisions must enable the taxpayer to show that even where the transaction was not at arm s length it was still for genuine commercial reasons : there was some other explanation other than the mere attainment of tax advantages. Second, it is essential that the provisions ensure via the terms of double tax conventions that where interest is disallowed as excessive, there is a corresponding adjustment in the lender s home jurisdiction so that the lender is not taxed on the receipt where the borrower does not receive a deduction for the payment. Whether the UK provisions have these features is a matter the Advocate General would leave to the national court, here the High Court, to determine. It is questionable that the UK provisions, before 2004, have either. If a taxpayer fails the arm s length test there seems no discretionary provision or the like to permit HM Revenue and Customs (HMRC) to allow the deduction even if the motive of the taxpayer was not abusive. There seems nothing in the UK provisions to suggest that the disallowance of a deduction is dependent on a corresponding adjustment at the other end. These though are matters he would prefer the national court to address. Furthermore, the issue of what would amount to a genuine commercial reason for the loan is left in general terms described as not a wholly artificial construct aimed at abusing and circumventing national tax legislation (paragraph 63), although he uses the example of the Lankhorst-Hohorst case (lending to a failing subsidiary to prevent insolvency) and indicates at several points that he believes only exceptional cases would qualify but without explaining why. No comment is made on whether or not the two main test cases so qualify. In both the lending was to make very substantial acquisitions. In both the tax rate of the lending company was comparable with or higher to the UK. In one, debt was preferred to equity to retain flexibility before a restructuring of the acquired entities and a refinancing to achieve lower overall rates. In the other, the loan was actually on arm s length terms but fell foul of the thincapitalization provisions when a subsequent acquisition of a loss-making group with its own debt issues affected the ratios. Whether these are genuine commercial reasons is also left to the national court. EU parented groups The opinion offers encouragement to taxpayers in three notable areas. The first is for those entirely UK resident groups now dealing with the 2004 changes and their imposition of transfer pricing both on debt and generally between UK-resident group members. To the Advocate General the objective of thin capitalization provisions (preventing the diversion of profits from the state where they were earned) is entirely irrelevant where the lender is also resident in the same member state. It is regrettable he feels that member states such as the UK and Germany believed it prudent to extend such provisions domestically as well, where no risks of such diversion could possibly arise (paragraphs 68 and 84). The second encouragement is given to those groups parented within the EU with possible claims under the pre-2004 rules. To the Advocate General, provided the common parent of the UK borrower and the lender is an EU resident then their community rights are engaged where

6 4 The 2006 Year in Review and the Challenges for 2007 Who Will Be the Winners in the Thin-Cap Debate? thin-capitalization provisions apply, irrespective of whether the lender itself is an EU resident or not. If the national court finds that the UK provisions do not enable genuine commercial transactions beyond arm s-length terms to avoid thin-capitalization restrictions and, additionally, those restrictions will only apply where there is a corresponding adjustment in the other state, then presumably the UK restriction will be precluded in all such circumstances. If the national court does find that the UK provisions can be invested with those conditions, then such groups should still be encouraged where the motivation was not a wholly artificial arrangement or, in any event, where no adjustment was made at the other end. The third concerns the types of recovery. This is a rather esoteric point but one of potentially great significance. It dwells on the difference between repayment (or restitution) claims and damages claims. It is accepted that in community law once there has been a finding that community law has been breached the member state is then required to compensate the taxpayer where its claim is for a repayment. However, where the taxpayer s claim amounts to damages (classically, loss of profit caused by the precluded restriction on its trade) still further conditions, as set out in Brasserie du Pecheur and Factortame [1996] ECR , must be met before the taxpayer is entitled to compensation. HMRC had argued that only in circumstances where there had been an actual interest disallowance was the taxpayer s claim a repayment claim for the corporation tax actually paid as a result. Otherwise the taxpayer s claim, HMRC contended, was a damages claim which did not meet those Factortame conditions. In other words, where instead of paying the corporation tax liability resulting from the disallowance, the taxpayer had used other reliefs to shelter the liability or where the group had converted debt to equity, or made loans interest free or at reduced interest rates, HMRC had contended these were damages claims which did not meet the criteria for compensation. The Advocate General disagrees, contending that in those and other similar circumstances the claims are indeed repayment claims which should entitle the taxpayer to recovery. Thus where expecting a thincapitalization disallowance the group invested equity where it would otherwise have preferred debt, the corporation tax resulting from the fact that the borrower s profits were higher because it did not pay interest (as the fund was equity not debt), should be recoverable. HMRC has maintained that these types of claims can only be brought in the High Court as part of the current group litigation process, which of course remains open to new participants. Third-country claimants While however generally positive for groups parented in the EU, the Advocate General s remarks do not help those groups parented outside the EU, even where the lending came from a finance company based in the EU. However AG Geelhoed reaches this result through a means not present in the court s existing case law. It will therefore be interesting to see if he is followed in this regard, particularly for EU based loans. His conclusion derives from his approach to the interaction of three community rights, the freedom of establishment (article 43), the freedom to provide services (article 49) and the free movement of capital and payments (article 56). All three could apply in the circumstance of loans to a UK subsidiary. The adverse tax treatment of interest payments could inhibit the establishment of subsidiaries in the UK (article 43). Similarly this could impede the provision of the loan from the financial services company if the interest was treated adversely for tax purposes (articles 49 and 56). The point is, however, that transactions involving third countries can only invoke the third provision, article 56. In circumstances where all three could operate which one can be relied on? There is much in the community case law to say that it shouldn t really matter: that both articles 43 and 56 stand together, neither excluding the operation of the other. The express derogations to article 56 actually refer to provisions concerning establishment (article 57(1)) which would be incongruous otherwise. AG Stix Hackl in her recent opinion in Fidium Finanz (C- 452/04) certainly sees a loan as both the provision of services and a movement of capital, not ever seeking to suggest that one construction excludes reliance on the other. Article 50 explicitly provides that article 43 takes precedence over article 49. There is no similar provision in relation to the interaction of articles 43 and 56.

7 The 2006 Year in Review and the Challenges for Who Will Be the Winners in the Thin-Cap Debate? Establishment favoured AG Geelhoed takes a contrary view. Relying on the Baars case, he invites the court to depart from this approach and ask itself which freedom seems more directly invoked. As thin-capitalization provisions require a 75% common holding they only arise in the circumstance of the establishment of a subsidiary. Accordingly he concludes that the freedom of establishment is the relevant treaty provision and it trumps the rest. As thirdcountry circumstances are only relevant if article 56 applies, the imposition of thin-capitalization provisions where the common parent is non-eu resident does not engage community rights. This conclusion would exclude from compensation all UK borrowers where the common parent is not resident in the EU unless the lender was an EU resident which invested sufficient equity in the borrower to invoke its own right to establish. It is noteworthy that AG Geelhoed has previously proposed this same argument - that article 43 trumps article 56 - in Reisch (C-515/99) where it was not followed by the court. What to do now? An Advocate General s opinion is not binding on the Court. It represents advice to the ECJ on a possible legal solution to the questions referred to it. Nevertheless, certainly for EU parented groups the opinion would seem to offer encouragement both substantively and also in relation to the types of recovery available going well beyond the simple disallowance of interest deductions. To illustrate the scope of possible recovery, consider the following example. A German parented group wishes to make an acquisition through its top-tier UK subsidiary. It would prefer to fund the investment with a loan, at a commercial rate, from its Swiss financing company as it intends after the acquisition to restructure the group. The prospect that the acquired assets might then need to be transferred to another group member as part of the restructure makes a loan a more flexible form of financing than the investment of additional equity. However, other companies in the UK sub-group are loss-making and the group s advisers anticipate that as a result HMRC would regard any loan as exceeding arm s-length terms. Instead then, the German parent invests the necessary funding as equity in the top UK subsidiary. Although profitable for the next couple of years, that subsidiary is able to shelter some of its tax liabilities through the surrender of losses from its own subsidiaries until those subsidiaries themselves return to profit. Safe from recharacterization It is suggested that this is a type of circumstance where although the arm s-length test might not be met, the commercial motivation for the loan should mean that, in the Advocate General s opinion, the interest should have been safe from recharacterization. To the Advocate General it is also irrelevant that the lender is resident outside the EU. But no loan was ever made. How then is the group worse off as a result? The top UK subsidiary s taxable profits were of course higher because it lacked the interest deductions which would have come with servicing the loan. Its subsidiaries paid more tax when they returned to profit as a result of surrendering reliefs to their parent which would not have been necessary had the parent incurred those interest deductions and thus had lower tax liabilities to shelter. As a wholly-owned subsidiary, increasing the equity in the top UK subsidiary means the German parent has received no return on its additional investment. The German Revenue might also perhaps regard this as over-capitalization and seek to impute deemed interest receipts. As there was no interest to deduct, it might be considered that the types of claims described above would fall beyond the scope of what might be regarded as normal tax liabilities capable of appeal through the statutory route. Yet to the Advocate General, while the claims of the German parent deriving from the lack of a return on its money might be damages claims (and subject to certain conditions before they might be recoverable) those of the top UK subsidiary and its subsidiaries amount to repayment claims recoverable as a matter of right. The UK subgroup has paid (and HMRC has received) more tax, earlier as a direct result of non-compatible provisions.

8 6 The 2006 Year in Review and the Challenges for 2007 Who Will Be the Winners in the Thin-Cap Debate? View supported Advocate-General Geelhoed is also not alone in advocating such an approach. In C-470/04 N, AG Kokott also extends the scope of repayment claims in that case not only to the refund of a security required under the Dutch exit tax provisions (considered incompatible with community law following C-9/02 de Lasteyrie) but also to the bank fees and missed interest caused by raising the security (paragraphs 128 to 130). The example illustrates some of the claims which are the subject of the Thin Cap Group Litigation from which this reference to the ECJ of course derives and which, arguably, are uniquely the province of the High Court and beyond the scope of the statutory appeal mechanism. Some 17 company groups already participate in that litigation, which remains open to others.

9 The 2006 Year in Review and the Challenges for What s Your Motive? Simon Whitehead Originally appeared in the September 21, 2006, edition of Taxation. Reprinted with permission. Simon Whitehead considers the future of the motive test in the controlled foreign company legislation. The European Court s decision delivered on Tuesday, 12 July in the Cadbury Schweppes case (Cadbury Schweppes plc v CIR (and related appeals) Case C- 196/04) goes some way to answering the questions left by the Advocate General s opinion received in May (see Taxation, I I May 2006, page 153). On its face, the ruling produces the result regarding the compatibility with community law of the UK s controlled foreign company (CFC) provisions which the Advocate General had recommended, namely that the case should return to the Special Commissioners for an assessment of whether the motive test can be applied in a way compliant with community law. Yet the Court s approach to the issue would seem to allow far less scope for the uncertainty feared by the leading commentators mentioned in the Taxation report. For those unfamiliar with the case, perhaps I can reproduce the short summary that appeared in the Taxation news item referred to above. Cadbury Schweppes had two subsidiaries resident in the Republic of Ireland, which were subject to a 10% rate of tax. HMRC issued assessments claiming that the controlled foreign companies legislation in TA 1988, ss 747 to 756 applied. Cadbury appealed, saying that the application of the controlled foreign companies legislation breached Articles 43EC,49EC and 56EC of the EC Treaty (freedom of establishment). The Special Commissioners referred the case to the European Court of justice for a ruling on whether those articles precluded national tax legislation which provides in specified circumstances for the imposition of a charge upon a company resident in that Member State in respect of the profits of a subsidiary company resident in another Member State and subject to a lower level of taxation. The CFC rules and community rights The CFC provisions (see TA 1988, s 747 et seq.) impose a charge to tax on a parent company to equalise a lower effective tax rate of a subsidiary for, so the theory goes, the purpose of preventing the diversion of profits to States where they would be taxed more advantageously. To the Advocate General it is not an abuse of community rights to establish a subsidiary in another EU Member State for an avowed tax motive (opinion paragraph 40). CFC provisions will, he believes, produce a tax differential contrary to community law - a UK resident parent is never taxed on its UK subsidiary s profits (paragraph 81). Of course, TA 1988, s 748 provides some particular exemptions to the CFC charge and, in addition, provides that if those do not apply, exemption may be achieved under a motive test (see below) if tax reduction was not the main purpose of the transaction. Here the uncertainty crept into the opinion, there are circumstances where the restriction on the exercise of the right to establish a subsidiary in a low tax jurisdiction might be justified. The community right being exercised in these circumstances was the right of establishment. Establishment requires conducting a genuine commercial activity - e.g. through a branch, agency, subsidiary - in the other community Member State (opinion paragraph 106). If the CFC was not genuinely established in the other Member State, but was rather a wholly artificial arrangement aimed at circumventing national law (paragraph 108), then imposing a CFC charge on the parent to prevent the diversion of profits from UK tax by this means, would be permissible. TA 1988, s 748(3) motive test Notwithstanding that none of paragraphs (a) to (e) of subsection (I) above applies to an accounting period of a controlled foreign company, no apportionment under section 747(3) falls to be made as regards that accounting period if it is the case that: (a) in so far as any of the transactions the results of which are reflected in the profits arising in that accounting period, or any two or more transactions taken together, the results of at least one of which are so reflected, achieved a reduction in United Kingdom tax, either the reduction so achieved was minimal or it

10 8 The 2006 Year in Review and the Challenges for 2007 What s Your Motive? was not the main purpose or one of the main purposes of that transaction or, as the case may be, of those transactions taken together to achieve that reduction; and (b) it was not the main reason or, as the case may be, one of the main reasons for the company s existence in that accounting period to achieve a reduction in United Kingdom tax by a diversion of profits from the United Kingdom; and Part IV of Schedule 25 shall have effect with respect to the preceding provisions of this subsection. The exemptions As mentioned above, the UK CFC provisions permit numerous exemptions. To the Advocate General these protected some genuine establishments from attracting a CFC charge.that a subsidiary distributes most of its profits back to the UK (the acceptable distribution policy or ADP exemption in s 748(1)(a)) indicates that the structure does not seek to avoid UK tax. That a subsidiary conducts certain activities (the exempt activities test in s 748(1)(b)), like manufacturing, in its state of residence indicates a genuine presence there. But these exemptions do not protect all genuine establishments (paragraph 144). It remains to be seen whether the motive test is capable of application to ensure (on proof from the taxpayer) that the balance of genuinely established enterprises not falling under the other exemptions are also excluded from attracting a CFC charge by the motive test. In other words, does the motive test ensure that the provisions will only ever apply to wholly artificial arrangements (paragraphs )? This is a question that the Advocate General wishes referred back to the national court (the Special Commissioners). To determine whether or not an establishment was a wholly artificial arrangement, the Advocate General postulated a three-limb test (paragraph I 11). It was this test in particular which led commentators to see issues of interpretation. His test required, first, the subsidiary to have the degree of physical presence in the low tax state such as staff, premises and equipment necessary for its services. Secondly, the nature of its activities had to be genuine ; namely, the establishment s staff were competent to perform the services. Finally, the subsidiary s services had to be of economic value. The ECJ s approach How then has the European Court tightened the approach from that recommended by its Advocate General? It has certainly followed the path he laid for it. The Court concludes that the fact that a company is established in a Member State solely for the purpose of benefiting from more favourable tax arrangements does not in itself suffice to constitute an abuse of community rights (paragraphs 36-8). The CFC legislation constitutes a restriction on the freedom of establishment by imposing an additional level of taxation on a resident company on the basis of the level of tax upon its controlled entities (paragraphs 43-5, 46):... any advantage resulting from the low taxation to which a subsidiary established in a Member State other than the one in which the parent company was incorporated is subject cannot by itself authorise that Member State to offset that advantage by less favourable tax treatment of the parent company..: (paragraph 49). The Court does deal more directly than the Advocate General in responding to possible justifications offered in the Special Commissioners referring order. It is irrelevant, for example, that the imposition of a CFC charge has the same tax effect as if the activity was conducted in and taxed in the UK (paragraph 45). The parent is still made subject to tax upon the profits of another entity. Next, the Court like the Advocate General then accepts that that restriction can be justified where the national legislation pursues the specific objective... to prevent conduct involving the creation of wholly artificial arrangements which do not reflect economic reality, with a view to escaping the tax normally due on the profits generated by activities carried out on national territory (paragraph 55). The exemptions in the CFC legislation identify circumstances, such as the distribution of 90% of the subsidiary s profits, where a wholly artificial arrangement for tax purposes would be excluded.

11 The 2006 Year in Review and the Challenges for What s Your Motive? However, they do not identify them all. To ensure that the UK regime is proportionate, it is necessary that there be some saving provision which excludes CFCs reflecting an economic reality despite a tax motive (paragraph 65). It is for the national court therefore to determine whether the motive test is sufficient to ensure that only wholly artificial arrangements are so caught. However, it is then in circumscribing those conditions where an arrangement will be wholly artificial that the Court would seem to give more accurate guidance than its Advocate General. First, there is no talk in the Court s ruling that the burden is on the taxpayer to prove that its subsidiary is genuinely established (paragraph 67). Secondly, the Court seems to adopt only the first limb of the Advocate General s test for identifying a wholly artificial arrangement, namely its physical presence in the other State (paragraph 67). Gone are the more abstract criteria of the genuine nature of the activity and its economic value. But most useful is the guidance it would seem to offer as to where the dividing line exists between a genuine and a wholly artificial establishment. It would seem from their comments that the Court is looking to cases where there is a fairly high level of abuse: If checking those factors leads to the finding that the CFC is a fictitious establishment not carrying out any genuine economic activity in the territory of the host Member State, the creation of that CFC must be regarded as having the characteristics of a wholly artificial arrangement. That could be so in particular in the case of a letterbox or front subsidiary (paragraph 68). The next step So the question now returns to the Special Commissioners to determine whether the motive test can act as an exemption to protect from attracting a CFC charge anything else which is not a wholly artificial arrangement and which does not fall under the other exemptions from attracting a CFC charge. If it can, the UK s provisions will be compatible with community law; if it cannot, they will be contrary to community law (paragraphs 72 to 4). Two observations arise in this context from the Court s conclusion that whether an entity is a wholly artificial arrangement is to be determined from reference to its physical presence in the other jurisdiction. The first is that if the subsidiary is not actually resident in the other jurisdiction, its management is conducted from the UK, its establishment in the other State is fictitious and it carries out no economic activities there, will it not be a UK resident taxpayer anyway? That it is a CFC in the first place and therefore tax resident beyond the UK might seem to imply a sufficient level of establishment to meet the Court s test for exemption. The second observation is that the Court s test focuses on physical establishment. The motive test does not. As the European Court records, the second limb of the motive test will be failed if - had the CFC or any related company established outside the United Kingdom not existed - the receipts would have been received by, and been taxable in the hands of, a United Kingdom resident (paragraph 11). This is not qualified by the degree of establishment in the other jurisdiction. This point can perhaps be tested in the following way. Assume a wholly-owned subsidiary of a UK parent is set up in a low tax jurisdiction to conduct financial services which could easily be conducted from the UK. It is there to save tax, pure and simple. Assume it fails all the exemptions including the motive test. The European Court s conclusion at this stage of the investigation would be neutral. The parent may or may not permissibly be the subject of a CFC charge calculated on the subsidiary s profits. It depends on whether the subsidiary lacks the requisite degree of establishment in the other state. Now assume that that financing company owns an office block and employs 2,000 local staff in that low tax state. It is certainly no letterbox or front and logically has that requisite level of presence in spades. The Court would now, arguably, say that the parent could not permissibly be charged upon the subsidiary s profits. Yet if the subsidiary failed the motive test without the office block and the large payroll bill, it is difficult to see how the motive test would produce a different result with those factors inserted. If the motive test cannot apply to exclude all remaining genuine establishments from the ambit of the charge, the Court s conclusion is that the UK s provisions will be contrary to community law.

12 10 The 2006 Year in Review and the Challenges for 2007 Divident Taxation in the Spotlight Liesl Fichardt Originally appeared in the October 16, 2006, edition of The Tax Journal. Reprinted with permission. In a recent press release the EU Commission called on certain European Union Member States to end discriminatory taxation of dividends. The UK dividend taxation regime has also not escaped scrutiny. In his article in The Tax Journal (Issue 854, 25 September 2006), Stephen Edge listed the taxation of foreign dividend income in the UK as one reason for the UK not being the most favoured holding company jurisdiction. In an earlier issue (Issue 850, 14 August 2006), Sara Luder pointed out that the current inbound dividend regime requires a great amount of management time, which does not strengthen the UK s position as an attractive financial centre. In April 2006 Advocate- General Geelhoed, in his Opinion in the Franked Investment Income Group Litigation (FII GLO) case (C-446/04), concluded that ICTA 1988, s 208, which provides for an exemption from tax for UK domesticsource dividends but no similar exemption in respect of foreign-source dividends, was in breach of Articles 43 and 56 of the EC Treaty. Chris Morgan commented on aspects of that Opinion in his article in The Tax Journal, Issue 838, 22 May Can the current UK regime of taxation of foreignsource dividends, coupled with a credit system, survive this attention and a potential judgment in favour of the claimants in the pending FII GLO? Will the credit system be retained but salvaged by attempts to make it compliant with community law (that is, levelling down, as with the thin capitalisation rules)? In that case the UK may be even less attractive as a jurisdiction for holding companies. Is the introduction of an exemption system in respect of inbound dividends not perhaps the only viable option, especially if one is to have regard to the UK s current status as a holding centre in comparison with those of other EU Member States and a desire for harmonisation of dividend taxation within the EU? Dividend taxation in other EU Member States Most holding company jurisdictions now apply a dividend exemption system for qualifying dividend income received from foreign subsidiaries. In France, Germany, Italy and Belgium, 95% of dividend income is exempted. To this extent, there is harmonisation of foreign source dividend taxation within the EU. In Gibraltar, dividend income is fully taxed and there is no tax credit, because the corporate income tax rate is 0%. The UK stands alone in that foreign dividend income is fully taxed but a credit is applied, as more fully discussed below. Some holding company regimes grant a dividend withholding tax credit where the dividend income from a foreign subsidiary is distributed. A tax credit for withholding tax on dividend income from a Swiss participation is given in Malta, Italy, Portugal and the UK. In relation to a French and German participation, a credit is granted in Malta and the UK. In the case of outbound dividends, most holding jurisdictions levy a withholding tax on dividends distributed to non-resident shareholders of the holding company jurisdiction. A rate of between 15% and 30% is applied. No dividend withholding tax is levied in Cyprus, Gibraltar and Greece. It is also not levied in the UK. In July 2006 the EU Commission requested various Member States to end discriminatory taxation of dividends. The request was targeted at both inbound and outbound dividend taxation. Regarding outbound dividends, the Commission asked Belgium, Spain, Italy, Luxembourg, The Netherlands and Portugal to end discriminatory taxation of outbound dividends in the hands of non-resident corporate shareholders. In these countries, due to a withholding tax charge on outbound dividends only, the relevant taxes legislation result in a more onerous taxation of outbound dividends, as opposed to dividends paid domestically. Dividend taxation in the UK In the UK, although outbound dividends do not attract withholding tax, inbound dividend income is subject to corporation tax. Where the UK holding company receives foreign-source dividend income as well as dividend income from a domestic source, it is exempt from tax only in respect of domestic-source dividends. Section 208 permits an exemption from tax for UK domestic-source dividends but no similar exemption in respect of foreignsource dividends. To the extent, however, that the source state has levied tax in its jurisdiction in respect of the dividends, the

13 The 2006 Year in Review and the Challenges for Divident Taxation in the Spotlight UK scheme permits a credit so as to relieve potential economic double taxation. Therefore, in the case of the recipient UK company holding less than 10% of the voting power of the foreign-source company paying the dividend (also referred to as `portfolio holdings ), a credit is given for the withholding tax levied by the source state on the dividends. In the case of a UK company which directly or indirectly controls not less than 10% of the voting power of the company paying the dividend, a credit is also given for the underlying foreign corporation tax on the profits out of which the dividends were paid. The impact of the UK credit system In principle, insofar as the credit system seeks to relieve economic double taxation, it serves its humble purpose. In the FII GLO Advocate-General Geelhoed unsurprisingly had no difficulty with the application of a credit system of double economic taxation relief per se if considered in the light of the provisions of the EC Treaty which protect the freedom of establishment (Article 43) and the free flow of capital (Article 56). The relevant question, however, is whether the application in the UK of an exemption system for domestic-source dividends and a credit system for foreign-source dividends has the effect of treating foreign-source dividends and domestic-source dividends differently. In circumstances where foreign-source dividends are treated less favourably than domestic-source dividends, the EC Treaty is breached, concluded Advocate General Geelhoed. In the case of portfolio holdings credit is given for the foreign withholding tax levied on foreign dividends and not for underlying foreign corporation tax. This results in less favourable treatment of foreign-source income falling within its tax jurisdiction than of equivalent domestic-source income. Even with non-portfolio holdings differential treatment between foreign-source dividends, applying a credit system, and domesticsource dividends, applying an exemption system, can arise in certain circumstances. One example is where the UK distributing subsidiary pays a lower net rate of corporation tax than the standard UK rate (as a result of UK exemptions and benefits). In these circumstances it would appear that the provisions of the EC treaty are breached. The credit system requires the company to track the underlying profits out of which dividends are paid and calculate the tax on such profits according to UK tax principles so as to determine the maximum tax credit permitted. The process of collection and recalculation could be complex, especially where profits are distributed through intermediary companies. These difficulties, of course, do not arise in the context of an exemption system. Can the credit system be salvaged? It is not easy to find good reasons for retaining the credit system. Does the tax collected on foreign-source income justify the difficulties (including management time) occasioned by the credit system? It has been suggested that it does not. It is hard to conclude that the credit system, if retained in the UK, could be remoulded so as to eliminate any differential treatment and to make it EU compliant. Chris Morgan pithily referred to the possibility of withdrawing the domestic exemption and taxing all dividends as the nightmare scenario. It is certainly one way of retaining the credit system and making the UK even less attractive as a holding company location. The UK finds itself in a lonely position, retaining as it does taxation of inbound dividends coupled with a credit system. Has the time not arrived to move on, as other Member States have, to a more simplified and attractive exemption system? Some form of exemption system may go a long way towards achieving harmonisation of dividend taxation within the EU. It may go even further to secure the UK s position as a primary holding company jurisdiction. It is, however, never easy to lay down the structure of a new system if a balance is sought to be achieved between the interests of the taxpayer and those of the Exchequer. Is it perhaps unlikely that we will see a system which exempts foreign-source dividend income and grants relief for the cost of funding investments abroad that generate the dividend income? Is a dividend exemption system married to interest allocation rules more likely? Under those rules the deduction of interest on borrowings relating to the funding of overseas investments which generate non-taxable dividend income may be limited. But only time will tell. What is clear is that the current regime is unlikely to escape the spotlight.

14 12 The 2006 Year in Review and the Challenges for 2007 Cross Border Group Relief: The Next Generation, Tax Notes International Simon Whitehead Originally appeared in the September 25, 2006, edition of Tax Notes International. Reprinted with permission. Much international attention has been given to the European Court of Justice ruling in the Marks and Spencer case (C-470/04 Marks and Spencer plc v. Halsey, Doc , 2005 WTD ), in which a U.K. parent company claimed group relief against its profits for the losses incurred by its French, German, and Belgian subsidiaries. On its face, the case might be assumed to have purely European relevance, dealing as it does with rights available under the EC treaty only to European Community nationals. However, double taxation conventions (DTCs) usually grant to nonresidents subsidiaries rights to treatment like those offered to the subsidiaries of U.K. residents. Can those rights under DTCs provide non-european parented groups similar entitlements to the cross-border transfer of losses between their European subsidiaries? A number of multinational groups have raised that argument. Marks & Spencer The Marks and Spencer case concerned the U.K. s group relief provisions that enabled companies under common ownership within a company group to surrender losses between them to offset profits in the same accounting period, thus enabling the group to pay tax on an aggregated basis. The intention of the provisions, however, was that only the losses of U.K. taxpayers would be available for that purpose. For accounting periods preceding April 1, 2000, both the surrendering and receiving companies had to be U.K. residents. For subsequent accounting periods, the companies did not need to be U.K. residents, but the losses (and of course the profits) had to come from a U.K. trade. A further restriction though not the subject of the Marks and Spencer case required the common parent company, for accounting periods before April 1, 2000, also to be a U.K. resident, although that was relaxed following the ECJ s decision in ICI v. Colmer in 1998 to include parents resident within the EC. The Marks and Spencer case concerned a cessation of trade. In 2001 the group ceased trading in continental Europe. It sought to offset losses it had suffered in those jurisdictions from 1998 to 2001 against corresponding profits of the U.K. parent through group relief. The case focused on three subsidiaries in France, Germany, and Belgium. The French subsidiary had been sold to a third party, while the other two remained in existence, carrying forward their losses, but without any trade to generate profits to apply them against. In those circumstances, had the subsidiaries been resident in the U.K. (or after April 1, 2000, traded in the U.K.), those losses would have been available for group relief. The taxpayer argued that excluding the losses on the basis that they were incurred by nonresident subsidiaries was contrary to the rights available under the EC treaty. In its ruling last December, the ECJ held that while it might generally be permissible to restrict U.K. group relief to losses incurred by or in the U.K., the restriction in the U.K. system went too far. It lacked any mechanism to permit cross-border surrender of a nonresident loss when the taxpayer could demonstrate that the possibilities available to use the loss in past, present, or future accounting periods in the state where the loss was incurred had been exhausted. DTCs What that ruling means for the validity of the U.K. s group relief provisions and how the ruling is to be interpreted are subjects of ongoing litigation, described below. To the U.K. Revenue, however, it is critical that the common parent between the U.K. profitmaking subsidiary and the surrendering company resident in the other EU member state be itself a U.K. resident. While there might be circumstances when the loss of, say, a French subsidiary could be offset against the profits of a U.K. subsidiary of a common U.K. parent, the U.K. Revenue contend that any such right is immediately lost when the common parent is itself French or U.S. or Japanese or whatever. The ECJ, dealing with the circumstances of the Marks and Spencer case itself, offers no view. But can the Revenue s interpretation be right? Most DTCs with the U.K. include a nondiscrimination article (NDA) similar to article 24 of the OECD model. Article 24(5) of the OECD model prevents an enterprise of a contracting state (that is, the U.K.) whose capital is wholly or partly owned or controlled, directly or indirectly, by residents of the other contracting state (for example, the U.S.) from being subject to other or more burdensome taxation or connected requirements than that to which other similar enterprises of that contracting state (the U.K.) would be subject.

15 The 2006 Year in Review and the Challenges for Cross Border Group Relief: The Next Generation, Tax Notes International The potential impact of an NDA on the analysis is perhaps easiest seen in the following example. A U.K. subsidiary (subject to a corporation tax rate of 30 percent) makes profits of 100 in each of years 1 and 2. A French subsidiary in the same group makes a loss of 100 in year 1, which, for purposes of the illustration, meets the criteria for a cross-border surrender described in the Marks and Spencer ruling. If the common parent of the subsidiaries is U.K. resident, the U.K. subsidiary can accept the surrender of the French loss. It pays no tax in year 1 and tax of 30 in year 2. If the common parent becomes, say, a U.S. resident, the U.K. subsidiary cannot receive the loss. Its tax bill over the two years is doubled. One U.K. subsidiary in identical circumstances has a higher tax bill than the other. The only distinction between them is the residence of their parent. Is that not more burdensome taxation of an enterprise owned in the U.S. than another similar enterprise, in breach of the NDA? If so, the net effect is the extension of the same rights available in the Marks and Spencer context to company groups with European subsidiaries, provided the parent is resident in a country whose DTC with the U.K. incorporates something similar to the model NDA. The ACT Class 3 Case The argument, of course, relies on an interpretation of another similar enterprise for purposes of the NDA. That issue is the subject of the ACT Class 3 group litigation (sometimes referred to by the test cases, NEC Semiconductors or Bush Boake Allen, Doc , 2006 WTD 22-6). (For prior coverage, see Tax Notes Int l, Feb. 13, 2006, p. 511.) For years the U.K. Revenue had argued that the other similar enterprise to determine the comparison required by the NDA was not the U.K. subsidiary of a U.K. resident, but the U.K. subsidiary of a company resident in a third country. If the U.K. treated the U.K. subsidiary of a U.S. parent no worse than that of another third country, then the U.S. parented group, they maintained, had no complaint even if the subsidiaries of U.K. parents were given preferential treatment. That approach was challenged by the impact of the rights available to taxpayers under the EC treaty. The single market can enable U.K. subsidiaries of parents in other EU member states to exercise rights in many regards akin to those enjoyed by U.K. subsidiaries parented in the U.K. For the Revenue s interpretation to work, it required the U.K. Revenue to be permitted to pick the third-country comparator to exclude the 25 EU member states, or indeed any others to which it gave a better deal hardly a palatable qualification. The ACT Class 3 case involved precisely those circumstances. The ACT system required a U.K. subsidiary to pay advance corporation tax when paying a dividend to its parent. If the parent was U.K. resident, the obligation to pay ACT could be moved from the subsidiary to its parent if the parent then distributed that receipt to its shareholders. If the company was the subsidiary of a nonresident, that option did not exist. In every circumstance, it had to pay ACT. In 2001, however, in the Hoechst case (C-398/98 and 410/98 Hoechst and Metallgesellschaft), the ECJ found the distinction incompatible with the EC treaty. The taxpayers in the ACT Class 3 case contend that the ACT system also offended the NDA when the parent was resident beyond the EU (specifically in the U.S., Japan, or Switzerland) by imposing on a U.K. subsidiary from those countries distributing profits to its parents the requirement to pay a (temporary) tax, which the U.K. subsidiary of a U.K. parent could avoid. In those circumstances, if the U.K. sought to assert that the other similar enterprise was the U.K. subsidiary of a third-country parent, it met the inevitable retort that, as a result of the Hoechst ruling, if that parent was German or, at that time, from some 13 other countries, the claimant was still worse off in comparison. That produced an ingenious development of the argument. At the commencement of the ACT Class 3 case, the third country comparator was abandoned by the Revenue in exchange for a subtle replacement. The effect of the ability to avoid the payment of ACT at the subsidiary level was not that ACT was ignored, but that the obligation to pay ACT was transferred to the U.K. parent company should it ever distribute those receipts to its own shareholders. How could the treatment of a U.K. subsidiary of a U.S. parent then ever be compared to a U.K. subsidiary of a U.K. parent? Only in the latter

16 14 The 2006 Year in Review and the Challenges for 2007 Cross Border Group Relief: The Next Generation, Tax Notes International would an additional liability to U.K. tax fall on the parent were its subsidiary to avoid the payment of ACT. No comparison, they say, is possible at all. Ergo ACT falls beyond the grasp of the NDA. Of course, on closer examination that merely replaces a parent comparator based on U.K. residence with one based on a liability to U.K. tax although an answer that better suits the occasion, it is hardly a major departure. It is a distinction that convinced neither the High Court nor the Court of Appeal, both concluding, consistent with the taxpayer s argument, that the proper comparison was to be drawn with the U.K. subsidiary of a U.K. parent who could have avoided the payment of ACT. That issue has now moved to the House of Lords, the ultimate domestic level of appeal. Transferred to the context of group relief, however, the Revenue s replacement argument offers up an interesting conundrum. Whatever the result in the House of Lords, how does the Revenue s argument help them in relation to group relief? A French subsidiary can sometimes surrender its loss to a U.K. sister company when the common parent is U.K. resident. Yet the U.K. tax liabilities of all companies remain unaltered if the parent becomes a U.S. resident. The Revenue s approach to the NDA adopted for the context of ACT would seem to work against them when it comes to group relief whether or not the state of the law is overturned on further appeal. The Next Stage Of course, an issue has been sidelined in the above discussion. In the Marks and Spencer case, the ECJ concluded that cross-border group relief should be permitted in some circumstances. What does that mean? Following the ECJ s ruling, the Marks and Spencer case has returned to the U.K. domestic courts and is awaiting hearing before the Court of Appeal, the second-highest appellate tribunal. Three fundamental issues remain. The first is whether that conclusion means the entire U.K. group relief system is incompatible with EC law. The ECJ has ruled that group relief systems that generally prohibit the surrender of a nonresident loss will be compatible with European community law if they at least permit the surrender of nonresident losses that cannot be used in the local jurisdiction where they were incurred. That, however, does not come close to describing the U.K. system, which does not generally prohibit the surrender of a nonresident loss save in some circumstances, but rather always prohibits the nonresident surrender even in those circumstances. If national provisions cannot be read compatibly with EC law, then under standard EC principles the restriction to EC rights must be disapplied. That might entitle the cross-border surrender of losses whether or not they meet the requirement that they cannot be used in the local jurisdiction. Beyond that question, two others arise. If it is necessary to show that the loss cannot be used locally, what does that mean? Can a loss not be used locally when, in the context of Marks and Spencer s German and Belgian losses, they are being carried forward but there is no trade to produce profits against which they could be used? Second, at what moment must the taxpayer demonstrate that the possibilities for local use of a loss have been exhausted? In the context of a failing business, management might well not decide in the first year of losses to cease trading. Commonly, some opportunity might be given to trade out of the difficulties before the situation was deemed hopeless. It might then be practically impossible for the taxpayer to demonstrate that the loss was beyond possible local use in the year in which it was incurred rather than at some later time when the position became clearer. Current Claims Those are the issues before the Court of Appeal in the Marks and Spencer case. It will be considering them on an expedited basis toward the end of the year. While those developments are awaited, opportunities exist for claimants with current claims. Particularly if the court were to conclude that the restriction within the UK provisions prohibiting EU cross border loss surrenders is precluded under the application of community law so that that restriction should simply be disapplied, then the more complex questions about the nature of the cross-border loss may become academic. Over 30 multinational groups parented beyond the U.K. have already brought claims as part of classes 2 and 3 of the loss relief group litigation in the English High

17 The 2006 Year in Review and the Challenges for Cross Border Group Relief: The Next Generation, Tax Notes International Court seeking the relief of nonresident European losses against the profits of U.K. subsidiaries. They raise a variety of claims and arguments, including reliance on NDAs in the manner described above. Their claims concern not only the recovery of U.K. tax that might otherwise have been offset, but numerous other tax consequences, such as compensation for the use of other U.K. relief against those liabilities that might otherwise have been carried forward or put to alternative use had the group been able to shelter the liability against the foreign loss. Also, a further eight groups in Class 4 of that litigation have claims that explore the other restriction in the U.K. system not investigated in Marks and Spencer. As mentioned at the outset, the requirement for accounting periods before April 1, 2000, that the common parent of the surrendering and receiving U.K. subsidiaries be itself a U.K. company was relaxed following the ECJ s decision in ICI v. Colmer to include parents resident within the EC. Thus for accounting periods before April 2000, two U.K. subsidiaries owned by a resident of the U.K. or any of the other then 14 EU member states could surrender losses between them. Those same subsidiaries could not surrender losses if their common parent was resident in the U.S. or Japan. Is that not also contrary to the NDAs?

18 16 The 2006 Year in Review and the Challenges for 2007 Controlled Foreign Companies Legislation and the Abuse of Law Mitchell Moss and George Gillham Originally appeared in the December 2006 edition of Tax Planning International Review. Reprinted with permission. Until February 21, 2006, when the decision in Halifax plc and others v Commissioners of Customs and Excise 1 was made, many U.K. tax commentators argued that there wasn t a concept of abuse of rights applying to U.K. tax. The instinctive reaction of a British lawyer, brought up on the common law, is that a doctrine of abuse of rights is anathema. We understand the principles of individual rights, of governments whose powers are subordinated to those rights, and of an independent judiciary to declare and uphold those rights. That we should be told that we cannot exercise our rights abusively is a contradiction in terms. However in the United Kingdom we do speak of conditional or limited rights. I have a right (liberty) of free speech. If I incite someone to violence I can be indicted. So the right of free speech is not unlimited but is subject to restrictions. If I do incite someone to violence, we would not say that I have abused my right of free speech; merely that I had no right to do so in the first place. This is a matter of the extent of rights, not their abuse; I could only enjoy an unlimited right of free speech if my right takes priority over, for example, the right of someone else not to be defamed. The Concept of Motive in U.K. Tax Avoidance The classic English case on motive is Bradford Corporation v Pickles, 2 especially the comments of Lord Halsbury, the Lord Chancellor LC: If it was a lawful act, however ill the motive might be, he had a right to do it. If it was an unlawful act, however good his motive might be, he would have no right to do it. Motives and intentions in such a question as is now before your Lordships seem to be absolutely irrelevant. 3 It is clear from many United Kingdom (U.K.) authorities dealing with tax planning or tax avoidance that the motive of the taxpayer is irrelevant. The law was set out in IRC v The Duke of Westminster 4 in As Lord Tomlin said in a famous passage: Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax. 5 Although the precise scope of the Duke of Westminster principle is now subject to the doctrine in Ramsay (WT). Ltd v the Inland Revenue Commissioners, 6 it was in general approved by Lord Wilberforce in that case. And it is now firmly established that the Ramsay principle itself is simply a rule of statutory construction and cannot be used to undermine rights (or immunities) clearly conferred by a statute or to impose duties which the statute does not impose. The Abuse of Rights Principle in E.U. Law In E.U. tax law, by contrast to U.K. law, it is now clear that there is a principle of abuse of rights. Customs relied heavily in the Halifax case (of which more later) on Emsland-Stärke 7 as laying down a general principle of abuse of rights in EC law. This case turned on the interpretation of Commission Regulation 2730/79, laying down common detailed rules for the application of the system of export refunds, on agricultural products. The case thus concerned a right granted by EC law. Emsland-Stärke exported to Switzerland several consignments of a product based on potato starch. On an application by Emsland-Stärke, the HZA (the German Customs Office) granted the company an export refund. Immediately after their release for home use in Switzerland, the exported consignments were transported back to Germany unaltered, and by the same means of transport, under an external community transit procedure and were released for home use on payment of the relevant import duties. There appears to have been no real argument that abuse of rights was not in point, the main argument being that Germany could no longer claw back the refund. Some U.K. commentators have argued that the real reason that the court found against Emsland is that the regulation gave no right to an export refund if there

19 The 2006 Year in Review and the Challenges for Controlled Foreign Companies Legislation and the Abuse of Law was no intention to put the goods exported into free circulation outside the EC. While this was perhaps a tenable interpretation at the time that the judgment was released, the authors respectfully submit that it is no longer tenable. The Court quoted the three-element test suggested by the Commission covering objective, subjective, and procedural law elements; but it then formulated its own: A finding of an abuse requires, first, a combination of objective circumstances in which, despite formal observance of the conditions laid down by the Community rules, the purpose of those rules has not been achieved. It requires, second, a subjective element consisting in the intention to obtain an advantage from the Community rules by creating artificially the conditions laid down for obtaining it. The existence of that subjective element can be established, inter alia, by evidence of collusion between the Community exporter receiving the refunds and the importer of the goods in the non-member country. 8 This judge-made doctrine, which appeared nowhere in the treaties, has also received legislative form in some areas.regulation 2988/95/EC on the protection of the European Communities financial interests, Article 4(3), refers to: the obtaining of an advantage contrary to the objectives of the Community law applicable. One should also make mention of Council Directive 2003/49/EC, the interest and royalties directive, which is clearly a political prefiguring of the Court s recent attitude. Article 5 (Fraud and abuse) reads: 1. This Directive shall not preclude the application of domestic or agreement-based provisions required for the prevention of fraud or abuse. 2. 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. The Halifax Case The case of Halifax 9 has placed the abuse of law/ abuse of rights doctrine centrally on the stage for taxes governed by European law. Halifax plc was building four call centres. Had it contracted directly with the builders, it would have incurred a large amount of irrecoverable input tax (Halifax is a bank and therefore limited in its rights of VAT recovery). Instead, Halifax interposed two subsidiary companies between it and the third party builders and through a combination of carefully timed payments, prepayments and grants of interests in land achieved a situation where, under a literal application of the U.K. VAT legislation, the vast majority of the VAT charged by the builders was recoverable by the subsidiaries. The U.K. tax authorities argued that the structure was ineffective on the basis that transactions motivated by tax avoidance were not supplies for the purposes of VAT and therefore did not give rise to a right to recover input tax. The taxpayer appealed to the U.K. VAT Tribunal which found in favour of the tax authorities. This decision was later quashed by the High Court and remitted to the Tribunal which made a reference to the ECJ. The reference dealt with two broad issues: firstly whether the existence of a supply could be affected by the motive of the party making it, and secondly whether the doctrine of abuse of rights meant that the taxpayer was not entitled to recover its input tax. Both the Advocate General and the ECJ swiftly dismissed the first question; whether or not an activity constituted a supply could not be affected by the motivation of the person carrying out that activity. If the activity met the objective criteria for being a supply, i.e., the provision of goods or services in return for consideration, then the fact that it was carried out as part of a structure designed to reduce the taxpayer s tax burden was irrelevant.

20 18 The 2006 Year in Review and the Challenges for 2007 Controlled Foreign Companies Legislation and the Abuse of Law However, according to the Advocate General, tax law should not become a sort of legal Wild-West in which virtually every sort of opportunistic behaviour has to be tolerated so long as it conforms with a strict formalistic interpretation of the relevant tax provisions and the legislature has not expressly taken measures to prevent such behaviour (paragraph 76). The Grand Chamber of the ECJ, echoing the Advocate General, held that the principle of prohibiting abusive practices (the principle formerly known as abuse of law) applied to VAT. Although taxpayers are generally entitled to structure their affairs so as to minimise their tax liability (paragraph 73 of the ECJ judgment), this is not the case where there are abusive practices. Abusive practices exist only if: formal application of the conditions laid down by the relevant provisions of the Sixth Directive and the national legislation transposing it result in the accrual of a tax advantage the grant of which would be contrary to the purpose of those provisions; and it is apparent from a number of objective factors that the essential aim of the transactions concerned is to obtain a tax advantage. Although the ECJ held that it was for the national court to determine whether the conditions were met, this did not prevent it holding that, in the case of Halifax, both conditions were clearly met (thereby rather limiting the role of the national court). Once the national court has detected an abusive practice, it must redefine the transactions involved so as to re-establish the situation that would have prevailed in the absence of the transactions constituting that abusive practice (paragraph 98). The first condition set out by the ECJ poses philosophical and epistemological issues which will be returned to below. The second raises more practical questions. The ECJ set the bar rather high in stating that the prohibition of abuse is not relevant where the economic activity carried out may have some explanation other than the mere attainment of tax advantages (paragraph 75). This appears to say that any commercial reason for the transactions in question would be sufficient to prevent there being an abusive practice. In the case of Emsland-Stärke, this is a fairly easy test to apply. The transactions in question are the export and re-import of the potato starch. Clearly, this served no economic purpose in itself and was done solely in order to generate the entitlement to the export refund. Without the refund, it would not have been necessary to carry out those transactions in a different way; rather, it is inconceivable that they would have been carried out at all. The case of Halifax is different. Halifax was building call centres to be used for the purposes of its business. The transactions concerned were supplies of construction services. If the transactions complained of by the U.K. tax authorities did not take place, Halifax would have had to find other means to procure the building of its call centres. Regarded at a global level, this appears to be the permissible minimisation of tax liabilities referred to by the ECJ in its judgment. It is only when the analysis is carried out in respect of individual transactions, rather than the overall structure, that the test laid out by the ECJ can possibly be satisfied. This suggests a potentially wide application for the principle of abuse. In most tax planning structures, there will be one or more component steps that would not be carried out, or would be carried out in a different way, were it not for the tax planning. A forensic approach to identifying the transactions in respect of which one must identify the essential abusive aim may lead to the strict test having a very wide application. It will be interesting to watch how the case law in this area develops. The ECJ referred to the second test as based on objective factors. The reason for this is that in answering the first question, the court had made clear that the motive of taxpayers was irrelevant. However, it is difficult to see in practice how the test can truly be objective. If, objectively, there can be no motive for a transaction other than gaining a tax advantage, it follows that gaining that advantage must also have been the subjective intention of the taxpayer (unless the taxpayer is wholly irrational). Thus, in that case, the subjective and

21 The 2006 Year in Review and the Challenges for Controlled Foreign Companies Legislation and the Abuse of Law objective coincide. However, the converse is not true. If, objectively, there are acceptable reasons for carrying out a transaction, that does not mean that the actual taxpayer s intention was acceptable; it may have been motivated solely by tax avoidance. The true intention in such a case can only be determined subjectively. The authors wonder whether the intention of the ECJ was to disapply the abuse principle where a taxpayer is able to point to genuine commercial reasons for carrying out the transactions in question that someone else might have, but he did not. In Halifax, the point had been conceded by the taxpayer before the Tribunal; in other cases, it may well be that a degree of subjectivity will creep back into the test. The authors now return to the philosophical issues raised by the first test. As is frequently the case with decisions of the European Court, the judgment is somewhat laconic and the intellectual underpinning is to be found in the Opinion of the Advocate General. A key point made by the Advocate General is that the principle is one of interpretation. Therefore, it does not need to be enacted either in Community legislation or in the legislation of Member States. Member States, including their courts, are obliged to apply the principle of prohibiting abusive practices in interpreting both Community law and national law that implements Community law. In essence, this means that there is a principle of interpretation that may require the clear words of a law to be taken to mean their exact opposite (although Halifax is perhaps more complicated, the position in Emsland- Stärke is stark). The Advocate General does not shy away from this conclusion. He stated at paragraph 71 that: one must conclude that a person who relies upon the literal meaning of a Community law provision to claim a right that runs counter to its purposes does not deserve to have that right upheld. In such circumstances, the legal provision at issue must be interpreted, contrary to its literal meaning, as actually not conferring the right and at paragraph 79 that: If this interpretation entails any kind of derogation, it will be only from the text of the rule, not from the rule itself, which comprises more than its literal element [emphasis added] The concept of a law having a richer existence outside of, and apparently inconsistent with, the statute that created it (and presumably unknowable in its fullness by mere humans) is one that would have been familiar to Plato. 10 Plato believed that objects in the real world were pale copies of archetypal forms; we can recognise a variety of animals as dogs because they all possess attributes of the form dog. The metaphysical form is the epitome of beauty and perfection. Objects in the physical world bear the same relation to their form as shadows dancing on the wall of a cave to the objects outside casting the shadow. This is a philosophical theory that has few supporters today. What does it mean to have a perfect form that cannot be perceived by humans? How can forms interact with the material world if limited to an existence on the metaphysical plane? Similar questions apply in relation to the rules identified by the Advocate General. Where is the abstract rule and how are we to know and apply it? How is this a helpful aid to legal construction? There is also the question of the application of this decision in the courts of the Member States. It is one thing to apply the specific decision of the ECJ in Halifax, it is another to apply the test in other cases without a clear and specific direction from the ECJ. It is hard to imagine an English Chancery court judge having much sympathy with the submission that clear words in a statute should be ignored in favour of contrary words to be deduced from the statute s metaphysical parent. Leaving aside the esoteric realm and returning to practical matters, it is likely that tax authorities will be seeking to rely on the concept of abuse as both sword and shield (i.e., to attack what they perceive as unacceptable tax planning and to deter such things from happening). For taxpayers, it is advisable to make a contemporaneous written record of the commercial reasons for each transaction that involves some tax

22 20 The 2006 Year in Review and the Challenges for 2007 Controlled Foreign Companies Legislation and the Abuse of Law structuring, which can be used to demonstrate this to the tax authorities in any future negotiations or dispute. It may also be worth documenting possible alternative methods of undertaking the transaction in question which it is thought would be less vulnerable to challenge (and would be the next best alternative tax efficient outcome for the taxpayer). Although the courts in each Member State can apply the ECJ guidance in Halifax and re-characterise as they see fit, given that this would be a contemporaneous record, it should carry some weight with the court and may assist the taxpayer in arguing for its preferred re-characterisation. The Cadbury Schweppes Case Like a number of other E.U. countries, the United Kingdom has implemented CFC legislation. The CFC legislation is designed to tax a U.K. resident parent company on undistributed profits of subsidiaries resident in lower tax jurisdictions. A jurisdiction is a lower tax jurisdiction if its tax rate is less than 75 percent of the U.K. s tax rate. There are a number of exemptions from the CFC legislation including a distribution of profits exemption, a trading exemption, and the motive test. Cadbury Schweppes Plc is incorporated and resident in the United Kingdom. It is the parent company of a group of companies including two indirect 100 percent subsidiaries incorporated with unlimited liability in Ireland and agreed (for the purposes of this case only) to be resident in Ireland, Cadbury Schweppes Treasury Services (CSTS) and Cadbury Schweppes Treasury International (CSTI). CSTS and CSTI were subject to a tax rate of 10 percent within the International Financial Services Centre in Dublin. CSTS and CSTI raised finance and provided that finance to subsidiaries in the PLC worldwide group. HM Revenue & Customs ( HMRC ) sought to apply the CFC legislation to the profits of these companies. Cadbury appealed to the Special Commissioners who referred the case to the ECJ in the following terms: Do Articles 43, 49 and 56 of the EC Treaty preclude national tax legislation which provides, in specified circumstances, for the imposition of a charge upon a company resident in that Member State in respect of the profits of a subsidiary company resident in another Member State and subject to a lower level of taxation? 11 In the Cadbury Schweppes case (as in the ACT IV, 12 FII, 13 and Thin Cap 14 GLOs) HMRC argued the abuse of rights principle before the ECJ. The decision in Cadbury Schweppes 15 was delivered on September 12, In their decision the ECJ addressed the abuse of rights point first. The Court concluded that while Treaty rights must not be used to circumvent legislation or facilitate fraud, if a legal person establishes itself in a Member State to take advantage of lower taxes, that does not of itself constitute abuse. The carve-out allowing for CFC rules in the case of wholly artificial arrangements imposed a very high threshold for abuse before CFC rules could apply. The establishment would have to be fictitious; it would have to carry on no genuine economic activity 16 in particular, it would have to be akin to a letterbox or front company. If it had premises, staff and equipment, it would have genuine economic substance. It is also important that the Court commented that, just because the economic activity could just as well be carried on in the home state, that does not mean that the overseas operation is artificial. 17 The reasons which motivated a company in question to locate itself in a more tax advantageous environment cannot affect the conclusion of whether it has genuine economic substance or not. The judgment makes reference to the settled case law under which a Member State may not restrict the right of a company to exercise the freedom of establishment for fiscal reasons. 18 The fact that none of the exceptions apply and that the intention is to obtain tax relief is still not sufficient to conclude that a company is a wholly artificial arrangement. 19 How do you test the legislation if a company does not come within the exemptions and a charge under the U.K. legislation in principle applies? The ECJ seems to be saying if a company is not within an exemption, but is nevertheless exercising its E.U. freedoms, the legislation falls to be disapplied.

23 The 2006 Year in Review and the Challenges for Controlled Foreign Companies Legislation and the Abuse of Law Conclusions In the past, tax law, in the United Kingdom at least, did have some resemblance to the legal Wild West identified by the Advocate General in Halifax. The courts took a strict interpretation of the law and were morally neutral as to tax planning. However, the Wild West has been in the process of being tamed for many years now. The U.K. courts have taken a far more purposive view of legislative interpretation and, unsurprisingly, tend to find that Parliament did not intend the laws to be circumscribed by eagle-eyed professional advisers spotting loopholes. This trait is even more pronounced in VAT and other tax cases where European law is relevant. In the past, the accepted view of both practitioners and courts was that the taxpayer could rely on U.K. law if it failed properly to implement European directives. This is no longer the case; the courts have shown themselves increasingly ready to read words into U.K. statutes to meet the requirements of European law (see IDT Card Services Ltd v HM Commissioners of Revenue & Customs 20 ). Part of this development can be traced to the implementation of the ECHR into U.K. law and the strong purposive construction required by the Human Rights Act which the House of Lords has said is the same test as applies to construing domestic law in light of EC law requirements. At one level, the principle of abuse of law is simply a further example of this. However, it goes significantly further in elevating purpose above construction. Where there is an abuse, it does not matter what the law says; the courts are obliged to enforce what it ought to have said. This is a new proposition and a somewhat worrying one, at least for a common law practitioner. Legislation that is badly written can now be rescued by the courts. One hopes that this does not lead to more bad legislation, with the need for the executive and legislature to check and consider the consequences reduced by the comfort blanket of the principle of abuse of law thrown by the courts. But this is not going so far as to say that legislation that is incompatible with European law (i.e., that can t be read in a compatible way) can be rescued by the courts. Such legislation will fall to be disapplied. The Cadbury Schweppes judgment shows that the ECJ regards some elements of European law as so important as effectively not to be capable of being abused. In other words, some of the written laws (such as freedom of establishment) are of such fundamental importance that they eclipse the unseen and different but perfect metaphysical forms of the law. The stream of cases that are sure to follow over the coming years will help to show whether abuse of rights has a broad application as in Halifax or a limited application as in Cadbury Schweppes. However the law develops, it is clear that the best defence to an attack on the basis of abuse of law will be the ability to demonstrate a genuine commercial purpose for one s actions. Taxpayers will be well advised to bear this in mind when deciding how to structure their affairs. 1 Halifax plc and others v Commissioners of Customs and Excise, (Case C-255/02); [2006] STC Bradford Corporation v Pickles [1895] AC Ibid at IRC v The Duke of Westminster [1936] AC 1 5 Ibid at 19 6 W. T. Ramsay Ltd. v. Inland Revenue Commissioners, Eilbeck (Inspector of Taxes) v. Rawling [1982] A.C Emsland-Stärke v Hauptzollant Hamburg-Jonas (Case C- 110/99) 8 Ibid at paras 52 & 53 9 Halifax plc and others v Commissioners of Customs and Excise, (Case C-255/02); [2006] STC And probably also to Josef K, the protagonist of Kafka s The Trial, in his frenzied and unsuccessful attempt to determine the nature of the laws under which he was accused. 11 Special Commissioners, Reference of June 6, Test Claimants in Class IV of the ACT Group Litigation (Pirelli, Essilor and Sony); Test Claimants in Class IV of the ACT Group Litigation (BMW) v Commissioners of Inland Revenue (Case C- 374/04) 13 Test Claimants in the FII Group Litigation v Commissioners of Inland Revenue (Case C-446/04)

24 22 The 2006 Year in Review and the Challenges for 2007 Controlled Foreign Companies Legislation and the Abuse of Law 14 Test Claimants in the Thin Cap Group Litigation v Commissioners of Inland Revenue (Case C-524/04) 15 Cadbury Schweppes plc v Commissioners of Inland Revenue (Case C-196/04) 16 Ibid at para HMRC has seized on this economic activity concept in designing the new net economic value CFC test announced in the Pre- Budget Report on December 6, This article does not aim to address the new rules but time will tell whether HMRC have got hold of the right end of the stick. 18 Eurowings Luftverkehrs AG v Finanzamt Dortmund-Unna, (C- 294/97) 19 Cadbury Schweppes plc v Commissioners of Inland Revenue (Case C-196/04) at para The Commissioners for Her Majesty s Revenue and Customs (formerly known as the Commissioners for Customs and Excise) v IDT Card Services Ireland Ltd [2006] EWCA Civ 29

25 The 2006 Year in Review and the Challenges for VAT and Supplies: When Is a Supply Not a Supply? Mitchell Moss Originally appeared in the December 2006 edition of De Voils Indirect Tax Intelligence. Reprinted with permission. VAT can be a somewhat curious tax. It is, according to the Court of Appeal: a kind of fiscal theme park in which factual and legal realities are suspended or inverted (Royal & Sun Alliance Insurance Group plc v C & E Comrs [2001] STC 1476, para 54). After more than 30 years, it is still a tax obsessed with why heated pastries are hot, with two Tribunal decisions within two months this year reaching opposite conclusions (Ainsleys of Leeds Ltd (2006) Decision and Jannicke Wallace t/a The Cornish Pasty (2006) Decision 19793). The recent High Court decision of MBNA Europe Bank Limited v HM Revenue & Customs [2006] EWHC 2326 (MBNA) has thrown up another curious phenomena the case of the disappearing supply 1. The core of the MBNA decision is that where a bank assigns debts to a special purpose vehicle set up to carry out a securitisation, the assignments of the debts do not constitute supplies. They are in theory capable of constituting supplies but belong to the exceptional class of transactions which look prima facie like a supply, but which lose that character when viewed in their context (paragraph 102). At first blush, this is a peculiar concept. If something looks like a supply, that must be because it has the characteristics of a supply. In the physical sciences, having the requisite characteristics of a particular group is both necessary and sufficient to belong to that group. For example, the characteristics of a mammal are being warm-blooded, vertebrate, (females) secreting milk to feed their young, and having a four-chambered heart (please do not write in if I have omitted one or more of your favourite mammalian characteristics). Any creature that has all of these characteristics is a mammal. The class of mammals includes humans, whales, bats and rodents. This is a pretty disparate group (it is hard to imagine the social occasion that could happily include them all). Yet there is no question of a creature which looks prima facie like a mammal being disqualified from membership because of where or how it lives (i.e., its context). This certainty in the physical sciences is reflected in VAT law by the principle of legal certainty applied by the European Court according to which predictability and consistency are virtues to be borne in mind when construing legislation (save, post-halifax, in the case of abuse where the underlying law of which the written text is merely a pale shadow may require the written text to be stood on its head). That the judge in MBNA was troubled by this apparent absence of legal certainty is made clear at paragraphs 107 and 108 of the judgment, where he sets out the factors that gave him considerable pause for thought. Ultimately, Mr Justice Briggs overcame his concerns at creating a new class of exception to the general rule that the provision of goods or services for consideration is a supply on the basis that this new class was consistent with the existing classes. The existing exceptions to the general rule set out by the judge are: the sale of currency to a foreign exchange dealer to obtain an exchange service; the assignment of debts to a factor to obtain a factoring service; and the assignment of property to a lender as security for a loan. The common factor identified by the judge between these situations and the assignment of debts as part of the securitisation process is that they all constitute compliance with a necessary condition for the supply of the service by the transferee to the transferor. There are also other situations where the provision of goods or services does not constitute the making of a supply. The most common of these is the making of payment; it is the generalised form of the foreign exchange exception set out by the judge. Where a business pays for a supply, it is either providing goods if the payment is in cash or a service of payment if carried out by some other means. However, payment does not constitute a supply (even though there is nothing in the legislation which specifically prevents it from constituting one). Tenants typically have obligations to keep their leased property tidy and in good order. In some leases, the tenant

26 24 The 2006 Year in Review and the Challenges for 2007 VAT and Supplies: When Is a Supply Not a Supply? will have an obligation to decorate and/or refurbish the property on a periodic basis. Plainly, cleaning and decorating can constitute the making of supplies, but not when carried out by a tenant. Indeed, almost every commercial contract will place a series of obligations on the recipient of the supply in addition to payment (for example warranties, indemnities, and non-compete clauses). Typically, none of these obligations will amount to the making of supplies. There is a practical reason why activities such as those set out above cannot constitute supplies. This is the impossibility of VAT accounting in such a world. If every transaction constituted multiple supplies made by both parties, chaos would ensue. There would need to be a mechanism for apportioning consideration between the various elements. If a tenant pays rental of 10,000 but also provides a service of keeping the property in good repair, then the total value of the supply or supplies provided by the landlord must be in excess of the 10,000 in order to balance the monetary and non-monetary consideration provided by the tenant. The values of all the non-core supplies would need to be determined so that proper invoices could be issued. The single/multiple supply questions that would be generated would be sufficient to make a VAT lawyer drool and business despair. In short, the whole VAT system would be unworkable. Having established a practical reason why the concept of a supply needs to be kept in check, it is necessary to find a principled underpinning for this. The concept of exceptions to the general rule as set out by the judge is, with respect, not the ideal candidate. If all of the activities set out above constitute exceptions to the general rule, then the general rule is beginning to look far from general, since one or more of these nonsupplies are likely to accompany every supply. In fact, the general rule as stated by the judge is not really a general rule at all. This is explicitly recognised by Mr Justice Briggs earlier in his judgment (paragraph 15ff). He cites Article 6 of the Sixth Directive, which states that supply of services shall mean any transaction which does not constitute a supply of goods. He then states that [r]ead literally, paragraph 1 of Article 6 would appear to mean that any transaction of any kind (other than a supply of goods) constitutes a supply of services, although pursuant to Article 2 it will only be subject to VAT if effected for consideration. As will appear however, paragraph 1 of Article 6 has not been interpreted with that degree of remorseless logic. Its apparently limitless breadth is circumscribed by reference to the essential nature and purpose of VAT, for which point the judge found support in the Opinion of the Advocate-General in Kretztechnik AG v Finanzamt Linz [2005] STC 118 (the case that held that share issues are not supplies). It is in this inherent limitation on the concept of a supply that the solution to the apparent paradox of limitless exceptions to a general rule can be found. Essentially, in the view of the writer, in order for the provision of services for consideration to constitute a supply, those services must have an independent existence. This immediately eliminates payment for a supply as a candidate for itself being a supply; it is inherently parasitical to the supply for which it is payment. This formulation also properly leaves as supplies both sides of a barter transaction. Although each is payment for the other, each also has an independent existence and purpose of its own. If I provide legal services to a builder in exchange for the builder providing me with construction services, we both have made a supply with an independent existence and purpose. The two supplies are fully independent activities; they are joined together solely by an agreement of both parties to accept the provision of the supply to them in lieu of payment in money by their customer. This analysis explains why the assignment of an interest in property to a lender as security for a loan is not a supply. It is inconceivable that the assignment would take place without the loan; the assignment is not a separate activity but rather it is part of the architecture of the supply of the loan. The same applies to the obligations of tenants to keep property in good repair or to refurbish. No person would enter into such an undertaking without enjoying the rights of tenancy (although the practical compliance with such obligations entails cleaning and decorating, the obligations themselves are very different

27 The 2006 Year in Review and the Challenges for VAT and Supplies: When Is a Supply Not a Supply? from the terms on which cleaners and decorators would contract to provide services). The assignment of debts is more of a borderline case. The ECJ has held that the assignment of debts to a debt factor is not a supply (Finanzamt Gross Gerau v MKG Kraftfahzeuge Factory GmbH [2003] STC 951). In MBNA, the High Court has held that the same applies to debts assigned as part of a securitisation. However, the assignment of debts in return for consideration can be a genuine and independent commercial and economic activity. The issue in these cases is whether the particular assignment under consideration is made in such a way that, taking into account all of the relevant circumstances, it would not be made were it not for some activity being carried out for the assignor by the recipient of the assignment. The High Court in MBNA appears to have been swayed by the fact that the securitisation structure had been carefully and specifically designed to achieve its purpose of providing lower cost funding; was operated under very detailed contracts; and was carried out precisely in accordance with those contracts. Taken together, these factors persuaded the court that the assignments were too intrinsically bound up in the securitisation to have the necessary independent existence to constitute supplies in their own right. This analysis has some similarities to the single/multiple supply debate. That is concerned with whether one or more parts of an overall supply so dominate other parts that they lose their independent fiscal identity. A useful metaphor for this test is whether one element of the supply exerts a sufficient gravitational pull to hold other elements in its orbit. Similarly, one can see the test outlined above as whether one supply has a sufficient gravitational pull to draw an activity carried out by the recipient of that supply into its orbit thereby denying that second activity the status of an independent supply. I would end on a note of caution. It would be nice to think that identifying a test would make it easy to determine where the border between activities that do, and activities that do not, constitute supplies lies. In the world of VAT, this may be unlikely to be the case. Since the ECJ set out its classic summary of the single/multiple test in Card Protection Plan Ltd v C & E Comrs [1999] STC 270, the issue has been before the domestic courts with great frequency and no apparent ultimate resolution. Unfortunately, knowing the question is not the same as knowing the answer and it is likely that there will be many more cases such as MBNA before the boundary between activities that are and are not supplies is clearly established. 1 The detail of this decision and its impact for securitisations was covered in some detail by Peter Jenkins in his excellent article The VAT Treatment of Credit Card Securitisations (Tax Journal, Issue 857, October 2006) and the writer does not intend to cover the same ground.

28 26 The 2006 Year in Review and the Challenges for 2007 Group Litigation and the European Court of Justice Simon Whitehead 1 Originally appeared in The EC Tax Journal, October Reprinted with permission. Those who keep track of the diary of the European Court of Justice (ECJ) or the Commission s website will have noticed the entry over 2004 and 2005 of a number of pending cases identified only as the Claimants in certain group litigation v Commissioners of Inland Revenue. The United Kingdom national courts, specifically the High Court of England and Wales, have now referred questions in 4 such cases 2 to the ECJ with others possibly to follow. Two have been the subject of opinions with one awaited all from Advocate General Geelhoed 3. The fourth awaits hearing 4. As the names suggest these cases are representative litigation where test cases have been selected by the national court through which answers are sought to questions relevant to the resolution of a number of other similar claims. In consequence the questions referred to the ECJ are longer and perhaps more elaborate than the norm. This article seeks to provide an overview and summary of the issues raised in this litigation and an update of their progress and the possible further references to the ECJ as part of this process. What is Group Litigation? The connecting feature of these group litigation actions, and there are now 7 proceeding through UK courts, is that they involve taxpayers seeking compensation from the effects of tax provisions or their application said to be contrary to community law or the terms of double taxation conventions. Their genesis lies in C997/98 and C-410/98 Hoechst and Metallgesellschaft. UK subsidiaries of German parent companies faced with a liability to advance corporation tax (ACT) upon the payment of a dividend, in circumstances where the UK subsidiary of a UK parent company could have avoided that liability, sought to contest those provisions not by using the statutory system for appealing a relevant decision of their tax inspector but rather by seeking compensation for the imposition and payment of the ACT as a claim in restitution or damages through the civil courts. Group litigation is a process in the UK only available in the context of court proceedings. It enables the court to manage multiple claims which raise similar issues of fact or law by drawing them together and selecting from them representative cases through which these common issues can be determined. Only in the context of social security is any similar procedure available under the statutory tribunal system for tax appeals 5 where the process of the assessment by inspectors of individual returns makes marshalling like claims difficult, although not impossible. 6 The Common Issues The first notable feature of the group litigation actions therefore is that although they have tax as their subject, they are in fact claims for restitution or damages seeking relief from the consequences of compliance with taxation provisions said to be incompatible with community law. As such they encounter similar defences from the Revenue reflected in virtually identical questions among those referred to the ECJ. The taxpayers contend that they have suffered loss in a number of ways as the result of the allegedly unlawful provisions. The payment of the unlawful tax is only the most obvious. Where an unlawful tax liability was incurred the taxpayer may instead have utilised reliefs to shelter that liability which reliefs might otherwise have been carried forward or put to alternate use. Thus the taxpayer s complaint is not that it paid an unlawful tax but rather that it made other lawful tax payments in later years which it would not have incurred had it not been required to manage the unlawful imposts in earlier years. Taken to another level of abstraction, the relief which sheltered the allegedly unlawful tax may have been surrendered to the taxpayer by another company in the group who would otherwise have been able to carry it forward. Here the claim becomes that not of the company which suffered the unlawful tax but of its sister: by using its relief in Year 1 to offset an unlawful tax liability of Company A, Company B paid a higher (lawful) tax bill in Year 2 against which that relief would have been available. Another example appears in the context of the Thin Cap Group Litigation. Believing the thin capitalization rules of the UK to be lawful, companies may have taken measures which had the effect of increasing the corporation tax liability of the UK borrowing company in a cross border group such as converting some debt to equity or structuring a loan as interest free or not

29 The 2006 Year in Review and the Challenges for Group Litigation and the European Court of Justice claiming interest as a deduction 7. The FII group litigation offers another 8. The ACT system permitted in certain circumstances, where what was known as a foreign income dividend or FID was paid, the recovery of ACT on the onward distribution of foreign sourced dividend income but without enabling the recipient shareholder to receive the same tax credit as would accompany a distribution of UK sourced income under the UK s imputation system. To maintain the attractiveness of their shares to UK resident investors, many UK public companies therefore enhanced the value of the dividend to its UK resident shareholders to compensate them in cash for the tax credit they would have received upon the distribution of UK income. That enhancement is claimed. A careful reading of the referred questions reveals the response of the Revenue to these claims. It is common ground that if a claim is restitutionary then the conditions for recovery applicable to Francovich (damages) claims do not apply. The claim must simply be repaid. The Revenue however contend that this characterisation applies only to the repayment of cash tax paid where the tax itself is found to contravene community law. Where reliefs were used to shelter that liability or the tax impost which was paid was lawful even though more lawful tax was paid as a consequence of managing the unlawful tax, as in the circumstances above, the Revenue contend that the claim is only in damages. Likewise the other examples given above are, they contend damages claims. Being damages claims they then maintain that two of the conditions for recovery are not met. The first is that the taxpayer s actions in managing the unlawful liability or in taking steps in reliance upon an expectation that the provisions were lawful, breaks the link between the unlawful provision and the loss. In consequence the breach of community law does not directly cause the loss. Secondly they contend that the breaches of community law occasioned by the UK s provisions, should the ECJ reach such a conclusion, are not sufficiently serious to entitle the claimants to compensation. For good measure in one of the GLOs, but curiously not others to which the issue might be relevant 9, the Revenue raise the argument that the claimants have failed to mitigate their loss. In addition to claims under community law, the Claimants also claim that aspects of the subject provisions offend the enforceable terms of double taxation conventions (DTCs). Thus the imposition of thin cap restrictions only on cross border groups breaches the non discrimination article of DTCs which incorporate terms similar to article 24(5) of the OECD model as the Conseil d Etat concluded in Andritz SA and Coreal Gestion 10. They argue that controlled foreign company (CFC) rules offend the allocation of taxing powers article (similar to article 7(1) of the model) again as the same court found in Schneider Electric 11. The Revenue contend in C-524/04 Thin Cap that taxpayers are obliged to complete any such challenges before they are entitled to pursue claims based on community rights. The ACT Group Litigation The earliest and largest of the group litigation orders (GLOs) is the ACT group litigation in which, at its height well over 200 company groups participated. Commenced in late 2001 on the application of the Revenue, the ACT GLO is divided into 4 classes. The feature common to the claims is that they are made by the UK subsidiaries of non resident parent companies who seek compensation for the imposition of ACT in circumstances where a UK subsidiary of a UK parent company could have avoided that liability. Although abolished in 1999, the ACT system has been so frequently the subject of references to the ECJ 12 that a description almost seems as redundant as the system itself. From 1972 until 1999 the UK operated a partial imputation system under which a UK resident shareholder received with a dividend from a UK resident company a tax credit equivalent to the basic rate of income tax. The company which paid the dividend was also liable to pay ACT at the same rate. It could then set the ACT against its subsequent corporation tax liability or, if insufficient, carry it forward, sometimes backward or surrender it to subsidiaries for application against their present or future corporation tax liabilities. The mischief with which the ACT GLO is concerned concentrates on the mechanism, known as a group income election, by which a company paying a dividend to a majority corporate shareholder might avoid an incidence of ACT, passing on the requirement to pay it should the recipient then distribute that income. This

30 28 The 2006 Year in Review and the Challenges for 2007 Group Litigation and the European Court of Justice enabled company groups to incur the ACT liability where it was most tax efficient to do so but was a mechanism only available to UK resident company groups. Although not specified in the GLO itself the distinctions drawn by the Revenue between claimants has in effect divided the claims into four classes. One distinction drawn is between cross border groups where the parent, resident in another EU Member State, received a tax credit under the terms of its double taxation convention with the UK upon the payment of dividends. Class 1 is claimants whose parents (mostly German or French resident) received no such credit. Although the Revenue accept that the Hoechst case is directly referable to such claimants, issues still remain to be resolved concerning the time period over which claims can be brought and the computation of interest. The test case for the former issue is of course the well known Deutsche Morgan Grenfell case which has had mixed results in the lower courts and was heard by the House of Lords in July and has been and is likely to be determined purely on the basis of national law uninfluenced by community law considerations. The latter issue does raise community law arguments. The claimants, successful so far before the lower courts, argue that the principle of effectiveness requires full reparation, namely, compensation to reflect the commercial losses suffered. In other words they wish the damages for the period they were out of pocket for the tax imposed in breach of community law to be calculated at the actual borrowing rates of the claimant and compounded in common with any normal commercial debt. The test case, Sempra Metals (the renamed Metallgesellschaft group) whose claim commenced this litigation in 1995, is to be heard in the House of Lords in November A reference to the ECJ is possible although neither party appears to have requested one at earlier levels, content for the domestic courts to answer these questions from the guidance already supplied 14. In contrast the claimants in class 2, for whom the Pirelli group is the test case, are the UK subsidiaries of parents resident in other Member States whose parents did receive credits under DTCs. This case asks, in effect, three questions. The first is whether the receipt of tax credits under DTCs was dependent upon the UK subsidiary paying ACT. No reference is made to ACT in the DTCs of course which entitle parent companies to credits on meeting various criteria associated only with the payment of a dividend. As DTCs deal with alleviating economic double taxation it might be logical therefore to associate the credit with the corporation tax on the underlying profits rather than with ACT which was intended only to operate as a temporary tax. Certainly the lower courts unanimously accepted that position but were reversed equally unanimously in February by the House of Lords 15. To the Lords the UK system recognized only one tax credit which was a credit only available when the company had paid ACT. This decision of the House of Lords now requires answers to the other two questions previously rendered irrelevant by the lower courts views on the first. How is compensation to the subsidiary for having paid ACT to be calculated if the parent s credit must be brought into account, and, how does the subsidiary show that it would have exercised a group income election had one been available? These questions have been remitted to the High Court and a hearing date is awaited. To the taxpayer the questions do raise important issues of community law which may produce a reference to the ECJ. In particular the claimants contend that the claims are restitutionary in nature and as such community law requires repayment without the precondition that the taxpayer show it would have acted differently had the legislation been compliant. To impose such an obligation to prove how taxpayers would have acted over 7 years ago in hypothetical circumstances, they argue, also breaches the principle of effectiveness. Class 3 comprises company groups parented outside the EU/EEA. They raise two claims. First that the denial of a group income election to a UK subsidiary of a parent resident, relevantly, in the USA, Japan or Switzerland imposes on that subsidiary other or more burdensome tax or requirements than another similar enterprise solely because its capital is owned in that other state thus offending the non discrimination article in the DTC. Next, for ACT liabilities which fell to be paid after 31st December 1993, they contend that this

31 The 2006 Year in Review and the Challenges for Group Litigation and the European Court of Justice differential system breaches article 56 EC. The first claim was unsuccessful before the High Court and the Court of Appeal 16. As to the latter the Court of Appeal have proposed to refer it to the ECJ for a preliminary ruling but only if the House of Lords refuse leave for further appeal. The decision of the Lords on whether or not to permit a further appeal is pending. Class 4 is of course the subject of the opinion of Advocate General Geelhoed of 26th February 2006 and judgment is awaited. Class 4, as the Advocate General s opinion makes clear, is not concerned with group income elections. The focus of the claim moves from the UK subsidiary to the parent. Where a subsidiary paid a dividend to its UK resident parent the parent received, in addition, a tax credit of in the most relevant years 25%. A Dutch resident parent received a 6.875% credit in like circumstances. A French parent received no credit at all. The reference asks whether a system producing those differential results offends community law. The Loss Relief GLO Around 70 company groups have brought claims within this GLO for compensation for the inability under the UK s group relief system to surrender the losses of non resident companies within the group to offset the profits of UK members. It has yet to be the subject of a reference to the ECJ for a predictable reason. It awaits further determination of the Marks and Spencer case. That case, a statutory tax appeal beyond the group litigation, has recommenced its process through the national courts following the ECJ s judgment last December. When the courts have resolved the issues deriving from that judgment it is likely that further issues of community law will arise in the claims within this GLO. Some of those issues are likely to have a relevance only to interpreting the functioning of the UK s group relief system in a cross border context. One such issue is how to compute the loss for surrender purposes. Of more general relevance are issues deriving from differing group structures. The Marks and Spencer case of course concerned the surrender of the losses of non resident subsidiaries to offset the parent s profits and the ECJ s judgment addressed that circumstance. Should it matter however if the UK profit making company is the subsidiary and the loss maker is the parent or even another subsidiary of a common non-resident EU parent? The Revenue certainly maintain in the context of that litigation that it does indeed matter. An interesting interaction here between community law and double taxation conventions is engaged in this litigation. Assume the circumstance of French and UK resident subsidiaries of a common UK resident parent and the French company is in a position to surrender a loss to its UK sister under the terms of the Marks and Spencer ruling. Now assume the same circumstances but where the common parent is in the USA. If the UK then denied group relief would it be imposing other or more burdensome tax or requirements upon the UK subsidiary whose capital was owned in the USA than upon an identical subsidiary of a UK parent? This question is asked in this litigation. The FII and FID GLOs The ACT system produced anomalies not just for non resident companies trading through subsidiaries in the UK but also in the reverse circumstances. The UK employs a credit system for alleviating double taxation upon non resident sourced dividend receipts (but an exemption system internally). While ACT was intended only as a temporary tax, it could be used only as a relief against corporation tax liabilities within the UK group. Where therefore a UK parented group earned its profits in non resident subsidiaries which repatriated them to the UK, the onward distribution of those profits to the group s shareholders produced ACT but to the extent that they were taxed at source the credit system took from the scope of available profits against which it could be utilized, the very profits which were distributed. This produced large amounts of long term surplus ACT for groups which traded largely outside the UK and the strange anomaly that the ACT system could only begin to produce in a cross border context a result akin to the domestic, if the group concerned chose to invest only in tax havens. The FID system introduced in 1994 offered some limited mechanism for the recovery of ACT on the distribution of foreign source profits but at the expense of the shareholders tax credit. In the FII GLO about 20 UK parented company groups challenge both the UK s differential system for the

32 30 The 2006 Year in Review and the Challenges for 2007 Group Litigation and the European Court of Justice taxation of dividend income and seek compensation for the incidence of surplus ACT together with other adverse tax effects (such as the example given above). Advocate General Geelhoed s opinion was delivered on 6th April and the Court s ruling is awaited. In the FID GLO over 30 institutional investors seek to reclaim the tax credit not received on the payment of dividends under the FID regime. They also seek for their dividend receipts from non resident companies credits equivalent to those which were available from UK companies in the absence of the FID system. That case currently remains with the UK courts and no doubt also awaits the ECJ s answer in the FII case. Thin Cap GLO Around 16 company groups have brought claims contending that they suffered a variety of tax disadvantages as the result of the operation of the UK s thin capitalisation rules on normal commercial transactions such as the provision of finance to make acquisitions or the investment of loans to shore up troubled businesses pending sale, and which were not motivated by the objective of profit stripping to which thin cap provisions are meant to be directed. For example, the main test cases involved loans from France and Sweden not usually recognized as low tax jurisdictions until the submissions of the Member States in this case. The same Advocate General, Geelhoed, delivered his opinion on 29 June 2006 and judgment is also pending. CFC and Dividend GLO Awaiting hearing before the ECJ is the reference in this GLO where a group of over 20 company groups challenge the compatibility with community law of the UK s CFC and dividend taxation systems. Much of this reference may be influenced by decisions in the FII and Cadbury Schweppes cases yet much will still remain, particularly concerning the compatibility of those regimes in third country contexts. No date for hearing has yet been given. Finally Although outside the context of corporate tax the ECJ s ruling in the Bond House case 17 has produced another GLO. While HM Revenue and Customs have refunded input VAT withheld pending that ruling on the grounds that the transactions were involved in a fraud to evade VAT, numerous mobile phone traders argue that that is not good enough. They seek Francovich damages on the grounds that withholding the VAT repayments caused them to suffer business losses which should be compensated. The case is in its infancy and it remains to be seen whether the UK courts believe it an issue they can answer themselves. 1 Partner, Dorsey & Whitney London 2 C-374/04 Test Claimants in class IV of the ACT Group Litigation v Commissioners of Inland Revenue; C-446/04 Test Claimants in the FII Group Litigation v Commissioners of Inland Revenue; C-524/04 Test Claimants in the Thin Cap Group Litigation v Commissioners of Inland Revenue; C-201/05 Test Claimants in the CFC and Dividend Group Litigation v Commissioners of Inland Revenue. 3 Opinions of Advocate General Geelhoed in C-374/04 (26th February 2006); C-446/04 (6 April 2006) and C-524/04 (18 May 2006). 4 C-201/05 5 viz reg 7A of the Special Commissioners (Jurisdiction and Procedure) Regulations A similar approach was adopted by the Special Commissioners in Mars and William Grant using their general power to regulate their procedure. 7 See questions 5 (b) to (d) in C-524/04: OJ C 57, at p 20 8 See question in 6(ix) in C-446/04: OJ C 6, at p26 9 It is raised in C-524/04 (question 10) but not others Andritz SA (30 December 2003); SARL Coreal Gestion (30 December 2003) 11 No Schneider Electric (28 June 2002). 12 It has been the subject of 4 references so far: the combined references in C-997/98 and C410/98 Hoechst and Metallgesellschaft; C-58/01 Oce van der Grinten; C-374/04 Test Claimants in class IV of the ACT Group Litigation v Commissioners of Inland Revenue; C446/04 Test Claimants in the FII Group Litigation v Commissioners of Inland Revenue 13 [2006] 2 WLR 103 : [2005] 3 All ER 1025 : [2005] STC [2006] QB 37 : [2005] 3 WLR 521 : [2005] STC [2006] 1 WLR 400 : [2006] 2 All ER 81 : [2006] STC [2006] STC Optigen Ltd (C-354/03), Fulcrum Electronics Ltd (C-355/03), Bond House Systems Ltd (C484/03) v Commissioners of Customs & Excise

33 The 2006 Year in Review and the Challenges for A Balancing Act? The FII Group Litigation (Part One) Liesl Fichardt, in conjunction with Chris Morgan and Jonathan Bridges 1 Originally appeared in Tax Journal, January Reprinted with permission. This two-part article will give background to the judgment of the European Court of Justice (ECJ) in the Franked Investment Income Group Litigation Order (FII GLO) which was delivered on 12 December 2006, comment on the court s decision and look at the implications. Part one shall consider the key features of the decision and part two which will feature in the next issue of Tax Journal will deal with the impact of the judgment on UK taxpayers and the Government. The Interests at Stake It is not always easy to strike a balance between two competing forces. This is what the ECJ was called upon to do in the FII GLO. It had to consider the interests of UK corporate taxpayers, on the one hand, and on the other, those of the Exchequer, in relation to the freedom of establishment (article 43EC) and the free flow of capital (article 56 EC). In general, the conflicting interests arise in the context of the fiscal treatment of dividend income in the hands of UK corporate taxpayers under Schedule D Case V and section 208 ICTA 1988 ( the dividend provisions), as well as the old Advance Corporation Tax (ACT) regime (which was abolished in 1999). In particular the conflict arises to the extent that there is a difference in the UK tax treatment of foreign source dividend income and domestic source dividend income. The GLO Background The FII GLO was made by the UK High Court on 8 October That Court referred various questions for determination to the ECJ on 13 October The case was heard by the ECJ on 29 November A few months later, on 6 April 2006, the Advocate General delivered his preliminary opinion to the Court. The Advocate General s opinion is not binding on the Court. On 12 December 2006, the ECJ delivered its judgment. The Issues Two fundamental features of the taxation of dividend income in the UK are at the heart of the FII GLO. The first concerns the taxation of foreign source dividends under Schedule D Case V and section 208 ICTA ( the dividend provisions ). The second issue concerns specific features of the UK ACT regime, known as Franked Investment Income ( FII ) and Foreign Income Dividends ( FIDs ). As regards dividend taxation the UK seeks to reduce or limit double taxation by use of an exemption system for domestic source dividends and a credit system for cross-border dividends. In respect of the ACT regime, it sought to reduce double taxation by the use of an imputation system. (i) The Dividend Provisions The taxpayers contend that these provisions, which exempts only domestic source dividend income from taxation, breach the EC Treaty. The relevant provisions, it was argued, had the effect of treating UK parented companies receiving foreign source income less favourably than UK companies receiving domestic source income. The former, whether it had holdings in a foreign subsidiary of less than 10% ( portfolio holdings ) or at least 10% ( non-portfolio holdings ), was taxed on its dividend income, but the latter was not, which created a restriction on the freedom of establishment and the free flow of capital in the absence of any justification. (ii) The ACT provisions Under the ACT regime, a company resident in the United Kingdom which paid dividends to its shareholders was liable to pay ACT. That company could off set the ACT paid by it during a particular period against its mainstream corporation tax for that period (subject to certain restrictions). It could also carry back any surplus ACT to a previous accounting period, carry it forward to a later one, or surrender it to its subsidiaries which could utilise it in respect of their own corporation tax liability. Surplus ACT could not be surrendered to non-uk resident subsidiaries. UK group companies could also elect not to pay ACT under a group income election. (This formed the subject matter of the case of Metallgesellschaft and Others [2001] ECRI-1727, C- 397/98, C-410/98].) The ACT regime had different consequences depending on whether dividends received by the UK company (and distributed on by it to its own shareholders) were domestic source dividends or foreign source dividends. Only dividends subject to ACT paid by a UK resident company to another UK resident company gave rise to a tax credit in favour of the latter company equal to

34 32 The 2006 Year in Review and the Challenges for 2007 A Balancing Act? The FII Group Litigation (Part One) the amount of ACT paid by the distributing company. The sum of the total of the dividend distribution and the ACT was called a franked payment and constituted FII. The UK resident company was liable to pay ACT only in respect of the excess of its franked payments over its FII. As a result, ACT was paid only once in respect of dividends passing through UK groups of companies. In the case of foreign source dividends, no ACT was payable by the non-resident company and the payment did not give rise to a credit in favour of the UK recipient company. As a result, the UK company could also not treat such income as FII. The impact of the ACT regime on the UK company which received foreign source dividends was this: it could not treat its income as FII and was liable to pay ACT in respect of its onward dividend. In many cases it could not (fully) offset the ACT against its corporation tax because tax on the distributed profits had been paid abroad and its UK corporation tax was covered by corresponding double tax relief. Furthermore, it could not offset its surplus ACT by surrendering it to non-uk subsidiaries. As a result the ACT became in effect an absolute permanent tax instead of an advance payment of tax. In July 1994, a further feature of ACT was introduced. Where a UK company received dividends from a nonresident company, the UK company could elect to treat the dividend, which it paid to its own shareholders, as a foreign income dividend (FID). Although the UK company became liable to pay ACT in respect if the payment of the FID, it could claim repayment of it to the extent to which the FID matched foreign dividends received. An individual shareholder receiving an FID ceased to be entitled to a refundable tax credit on the dividend received. This also meant that tax exempt shareholders, such as pension funds, which received FIDs were not entitled to a repayment of the tax credit they would have received on an ordinary dividend. The FID structure therefore caused UK companies to pay enhanced FIDs to their shareholders to compensate them for the absence of a credit in respect of the dividends. Hence, the UK company was out of pocket, not only to the extent of the time value of the ACT paid and later reclaimed, but also due to enhanced dividends paid to its shareholders. In summary, the FII GLO concerns the tax liability arising on foreign source income by virtue of the dividend provisions; liability to pay ACT (under the ACT regime) with resultant surplus ACT arising which could not be off set or mitigated; and the cash flow cost of ACT paid and reclaimed later in respect of FIDs paid. There are also various ancillary issues dealing with reliefs which had been utilised or waived in order to mitigate the effect of the various provisions. The Claims The claimants claim repayment of all corporation tax paid by them on foreign EU dividend income as well as compensation for having used reliefs such as group relief - against the liability. Regarding the ACT regime they claim repayment of all ACT paid on distributions to their shareholders of foreign sourced dividends, to the extent to which the ACT remained surplus. In so far as the ACT was utilised, they claim the loss of use of money for the time between the payment of the ACT and the date on which the ACT was set-off against their mainstream corporation tax liability. With regard to the payments of FIDs, the claimants claim payment for the loss of use of the money paid as ACT between the date of payment of ACT and the date of its repayment. They also claim that they were liable to make enhanced payments to their shareholders so as to compensate them for the lack of any tax credit in their hands. The Approach of the Court The Court went to great lengths to explain its attempt to reconcile the conflicting interests at stake, the rights of the claimants to claim protection of the treaty freedoms, and the interests of the UK Government in protecting its tax base. It re-stated the principle that, although direct taxation falls within the competence of Member States, they must nevertheless exercise that competence consistently with community law. As a result, whatever the mechanism adopted, the freedoms guaranteed by the treaty preclude a Member State from treating foreign source dividends less favourably than domestic source dividends, unless such a difference in treatment concerns situations which are not objectively comparable, or is justified by overriding reasons in the general interest.

35 The 2006 Year in Review and the Challenges for A Balancing Act? The FII Group Litigation (Part One) The court has concluded that the UK was not prohibited from operating an exemption system for domestic source dividends and a credit/ imputation system for foreign source dividends. However, for an imputation system to be compatible with community law, it is necessary that the foreign sourced dividends not be subject in the UK to a higher rate of tax than the rate which applies to domestic source dividends. The UK is obliged to prevent foreign source dividends from being liable to a series of tax charges by off-setting the amount of tax paid by the non-resident company making the distribution against the amount of tax for which the recipient company is liable (up to the limit of the latter amount). This applies to both non-portfolio holdings and portfolio holdings. For companies holding less than 10% of the voting rights, the Court unequivocally concluded that the UK provisions breached the Treaty. It was held to be unacceptable for nationally source dividends to be exempt from corporation tax where foreign source dividends are subject to that tax and entitled to relief only as regards any withholding charge on those dividends in the source State. This is a clear victory for the claimants concerned. For non-portfolio holding companies, the Court formulated the test that the EC Treaty will not be breached in circumstances where (i) the tax rate applied to foreign source dividends is not higher than the rate applied to nationally source dividends and (ii) the tax credit is at least equal to the amount paid in the source State. At the oral hearing in Luxembourg the claimants argued (i) is not met because there are many cases where a UK source dividend has not been subject to tax at 30% - e.g. where the profits distributed were sheltered by group relief, capital allowances or the substantial shareholding exemption. HMRC argued this only occurs in exceptional cases. The ECJ has left it for the UK courts to determine whether this is the case or not. This issue therefore remains alive. The Court was firm in its view that the ACT provisions as well as the FID provisions breached the treaty. ACT was an advance payment of corporation tax and the provisions permitted a resident company which received dividends from another resident company to set off ACT paid by the latter against the amount of ACT for which the former was liable so avoiding double taxation. By contrast in the case of foreign source dividends the recipient was not entitled to make such a deduction despite the fact that the distributing company would have paid corporation tax abroad. As a result, in many of these claims, the claimants may claim for periods going back to This was indeed a substantial win for the claimants. The judgment agrees with the general proposition that the ACT system should have provided a mechanism to mitigate the incidence of surplus ACT against EU profits. The Court rejects explicitly the UK s submissions to the contrary and accepts the submissions of the claimants. However it then limits its final answer to the question specifically to the UK corporation tax on the UK branch profits of EU subsidiaries. It remains to be seen whether the High Court will conclude this also means ACT should have been able to have been offset directly against the EU profits of a subsidiary and, if so, how this should have worked in practice. There remain many unclear areas, including claims for the cashflow disadvantage arising from ACT reimbursed under the FID system but where the matching dividend originates from outside the EU. The Court has concluded that community law is also breached in those circumstances but has left the remaining question for the national court as to whether the FID system by introducing a new disadvantage (the absence of a shareholder s credit) was therefore qualitatively different from the previous system so that it is not protected by the exemption for legislation predating December 1993 under Article 57EC. The remainder of the issues, including whether the remedies are restitutionary or damages, were effectively left open and undecided.

36 34 The 2006 Year in Review and the Challenges for 2007 A Balancing Act? The FII Group Litigation (Part One) What Next? The Court has found in favour of the claimants on several important issues. On other issues, it has left it up to the UK Courts to perform the balancing act, in particular regarding the issue of dividend taxation in the case of non-portfolio holdings. The UK system of dividend taxation is extremely complex even after the abolition of ACT. The judgement gives some guidance on how the rules could be made EU compliant. Wouldn t it be a breath of fresh air if the Government took the opportunity to improve the competitiveness of the UK system by simply exempting all dividends? Alas, the reaction to the Cadbury Schweppes case demonstrates this may be too much to hope for! 1 Liesl Fichardt, Partner, Dorsey & Whitney Chris Morgan, Partner, Head of KPMG International Corporate Tax Group Jonathan Bridges, KPMG EU Tax Group

37 The 2006 Year in Review and the Challenges for Authors 21 Wilson Street London EC2M 2TD Tel +44 (0) Fax +44 (0) Simon Whitehead +44 (0) Dr. Simon Whitehead is a Partner at Dorsey & Whitney and the Dorsey Head of Trial for Europe. He specialises in claims by companies against the UK Inland Revenue for the recovery of damages and the repayment of taxes levied in breach of community law. He has practiced in the UK since 1991 and is also a qualified solicitor in Australia. He writes and speaks widely on UK & EU tax and litigation issues. Liesl Fichardt fichardt.liesl@dorsey.com +44 (0) A partner at Dorsey & Whitney, Liesl Fichardt offers a broad understanding of many areas of corporate tax law. She has advised various multi-national corporations on a range of international tax issues, including transfer pricing, thin capitalization, double tax treaty provisions, anti-avoidance and VAT. She has also advised on UK and SA corporate tax provisions. She is currently involved in the GLO litigation which is pending before the UK Courts and the European Court of Justice. Previously, as Chairperson of the South African Tax Board, she presided over contentious tax disputes. During 2004 she acted as a Judge of the High Court of South Africa. George Gillham gillham.george@dorsey.com +44 (0) An ex- fast stream Civil Servant, Inland Revenue Inspector and Policy Adviser on Corporation Tax Reform, George joined Dorsey and Whitney in 2004 as a Tax Adviser on UK and EU tax, including the series of high-profile Group Litigation Orders which Dorsey leads. He writes for BNA Inc. and reviews for Tax Journal. Mitchell Moss moss.mitchell@dorsey.com +44 (0) A partner in the tax practice of Dorsey s London office. Mitchell s practice is focused on VAT litigation and advisory work. His experience covers a wide variety of industries and clients, particularly financial services and the motor industry. He has successfully represented many clients in disputes with Customs and Excise at all levels of the judicial system.