UK: European Imperative

Summary: Volume 150, No 3888 19 December 2002

Date originally published: 19/12/2002

EUROPEAN UNION LAW relating to direct taxation is constantly developing. However, as the Member States seem unable to agree common rules to determine either the tax base or a single rate of corporation tax, legislation is almost wholly absent from the process of change. In October 2001, the European Union Commission issued a working paper on ‘Company Taxation in the Internal Market’ which sought to identify (with the ultimate aim of eliminating) the differences in determining the corporate tax base in Member States and the main tax provisions that hamper cross-border economic activity within the single market, but there has been little legislative change as a result.

The main driver of the change is the case law of the European Court of Justice. The European Court operates exclusively in favour of the taxpayer as it has the power to disapply domestic tax law, but not to levy tax. In an earlier article, ‘Strained Relations’, Taxation, 26 September 2002 at pages 695 to 698, I discussed whether United Kingdom companies should be exempt from United Kingdom corporation tax on dividends received from European Union resident companies and whether the controlled foreign companies legislation is applicable to such companies. This article will discuss two further developments in European Union law relating to direct taxation: thin capitalisation and the ability of the United Kingdom to rely on the ‘coherence of the tax system’ doctrine.

To recap, the European Community Treaty prohibits discrimination by the Member States based on nationality. Specific examples of the prohibition on discrimination are the fundamental freedoms:

• the freedom of establishment;
• the free movement of goods and workers;
• the free movement of capital and payments; and
• the freedom to provide services.

A domestic tax provision that operates as a discriminatory restriction on a fundamental freedom is invalid unless the relevant Member State can justify the restriction. Justifications exist in the Treaty, but none has been successfully argued in a direct tax case. The only justification that has been successfully argued in a direct tax case is the ‘coherence of the tax system’ in Bachmann (Case C-204/90).

On 26 September 2002, Advocate General Mischo published his Opinion in the Lankhorst case (Case C-324/00). The Opinion is not binding and the European Court of Justice is free to disagree with it, but rarely does. The case involved the German thin capitalisation provisions which can have the effect of re-characterising interest payments between related parties as distributions. The German rules do not apply to interest paid to a company subject to German corporation tax in respect of that interest or to arm’s length loans. The rules are similar in effect to section 209(2)(da) and the second limb of section 212(3), Taxes Act 1988, but the German rules have the additional exclusion that they do not apply where the debt:equity ratio is less than 3:1.

The facts of the case were that Lankhorst-Hohorst GmbH, a German incorporated and resident company, received a loan from a related company, Lankhorst Tasalaar BV, a Dutch incorporated and resident company. GmbH ran into financial difficulties with the result that it became thinly capitalised and the German revenue authorities sought to re-characterise the interest paid to BV as a distribution which would give rise to a withholding tax of 30 per cent. GmbH challenged the decision, inter alia, on the basis that the German thin capitalisation rules constituted a breach of Article 43 of the Treaty, namely the freedom of establishment.

Germany argued that its thin capitalisation rules did not amount to discrimination based on nationality because only companies which are subject to German corporation tax benefited from the intra-German exemption. Certain non-German entities could be subject to German corporation tax and many German entities were not, thus the exemption applied irrespective of nationality. The Advocate General noted that a similar argument had been rejected by the European Court of Justice in Eurowings case (Case C-294/97). In that case, the European Court held that companies subject to corporation tax in one Member State were in the same objective position as those subject to corporation tax in another. To treat persons in the same objective position differently amounted to discrimination.

As an aside, Advocate General Albert did not rely on this element of Eurowings in giving his Opinion in Bosal (Case C-168/01, 24 September 2001), where a Dutch tax provision denying deductibility for finance costs arising on the acquisition of a participation in a subsidiary not subject to Dutch tax was considered to be incompatible with the freedom of establishment. Had Advocate General Albert relied on Eurowings, his decision that discrimination existed may have been more logical and easier to follow.

Having found discrimination to be present, the Advocate General considered whether it was restrictive of a fundamental freedom. Under the German thin capitalisation rules, a thinly capitalised German resident company paying interest to its non-resident affiliate was taxed more highly than a thinly capitalised German resident company paying interest to its German resident affiliate. On this basis, the discrimination clearly restricted the right of a non-German lender to establish outside Germany.

The Advocate General then considered the possible justifications, including those submitted by the United Kingdom and Danish governments and the European Commission. The Danish government observed that thin capitalisation rules were necessary, in the light of the internationalisation of finance, to prevent fiscal evasion: if thin capitalisation rules did not exist, it would be possible to extract tax free profits from one jurisdiction to another. Furthermore, thin capitalisation rules were merely a concrete expression of Article 9 of the Organisation for Economic Co-operation and Development Model Double Taxation Convention which imposed the arm’s length principle for transactions between affiliated enterprises.

Unusually, the European Commission submitted observations in favour of the domestic law. It noted that the difference in treatment under the German thin capitalisation rules could be justified by the principle of proportionality as a means of preventing fiscal abuse. The Commission also observed that there was a risk of double taxation if interest was not deductible for the payer but taxable for the recipient. The Commission suggested that Article 9 of the Model Convention could be the solution to this problem.

To answer these observations, the Advocate General first posed the question of what was the purpose of the German thin capitalisation rules. He found that their purpose was to avoid the loss of tax revenue to the German state as a result of a financing technique which was not forbidden under general law. This objective was, in effect, the preservation of the tax base which can never ‘be regarded as a matter of overriding general interest which can be relied upon in order to justify’ a discriminatory restriction on a fundamental freedom. (See ICI v Colmer (Case - C264/96), [1998] STC 867 at page 892.)

The Bachmann coherence of the tax system argument was rejected for the usual reason that the discrimination must relate to the same person by way of a rigorous correlation between the fiscal advantage and the unfavourable fiscal treatment. (Baars Case C-251/98). As will be seen below, the scope of this doctrine has been further reduced by the European Court of Justice in Danner (Case C-136/00).

Finally, the German government argued that a Member State ‘is entitled to take measures designed to prevent certain of its nationals from attempting, under cover of the rights created by the treaty, improperly to circumvent their national legislation or to prevent individuals from improperly or fraudulently taking advantages of provisions of Community law’. (See Centros Case C-212/97.) While this argument was accepted by the Advocate General in principle, it was rejected in this case because establishing a company outside Germany does not necessarily involve fiscal evasion (see ICI v Colmer [1998] STC 874). It seems, therefore that this justification is available to European Union revenue authorities, but only if the domestic legislation applies exclusively to avoidance cases. Furthermore, any contested domestic rule must not operate as a disguised restriction on a fundamental freedom and must be proportional to the objective to be achieved.

As the Advocate General found for the taxpayer, it is assumed that the German government will appeal. The European Court is not bound to accept the Advocate General’s Opinion, but does so in most cases. In this case, the Advocate General’s Opinion is consistent with European Court of Justice case law and, in my view, will be upheld.

Once a discriminatory restriction on a fundamental freedom is present, the Member States may attempt to justify it to retain it as part of domestic law. The only justification which has been accepted in a direct tax case is the ‘coherence of the tax system’ in Bachmann. In Danner (Case C-136/00), the European Court of Justice narrowed this justification significantly.

Mr Danner, a resident of Finland, sought to make additional voluntary contributions to a non-Finnish pension fund. Finnish tax legislation restricted the deductibility of such contributions in the case of non-Finnish pension plans. The Finnish state did not dispute that the national legislation operated as a restriction on the freedom of non-Finnish pension funds to provide services to Finnish residents, but sought to justify the discrimination.

Although the facts were quite similar to the Bachmann case, the European Court of Justice chose not to follow the ‘coherence of the tax system’ doctrine. It held that ‘where, as a result of double-taxation conventions like those which follow the [Organisation for Economic Co-operation and Development] model ... fiscal cohesion is no longer established in relation to one and the same person by strict correlation between the deductible contributions and the taxation of pensions but is shifted to another level, that of the reciprocity of the rules applicable in the Contracting States …’.

The United Kingdom has concluded a double taxation convention with each of the other 14 Member States of the European Union and with each of the ten applicant states. Accordingly, the United Kingdom may not argue that a discriminatory restriction on a fundamental freedom contained in United Kingdom law can be justified on the basis of the coherence of the tax system doctrine.

The ability of the current United Kingdom corporation taxation system to raise revenue from the United Kingdom corporate sector has been significantly undermined by recent judgments handed down by the European Court of Justice, particularly if the opinion of the Advocate General in Lankhorst is upheld, and Verkooijen (Case C-35/98) is extended from individuals to corporations as expected. If the judgments are applied in the United Kingdom, the United Kingdom will not (except possibly in cases of tax avoidance):

• be able to tax dividends received from European Union resident companies;
• be able to operate the controlled foreign companies legislation against European Union subsidiaries or, possibly, the transfer pricing rules; or
• be able to operate the thin capitalisation rules for interest paid to European Union resident companies or European Union permanent establishments.

It is likely that the Revenue’s and the European Court’s view of the meaning of tax avoidance will differ. For example, locating a group treasury, purchasing or finance function in, say, Ireland may be considered to be tax avoidance by the Revenue, but is likely to be regarded by the European Court as a legitimate exercise of the freedom of establishment and a natural consequence of the single market. It should be noted that the Revenue, as an organ of the state, is under a positive duty to uphold European Union law.

As a result of these developments, United Kingdom multi-national groups will have significant scope to extract profit from the United Kingdom to other European Union countries which tax at a lower tax rate.

On a narrow point, United Kingdom groups currently using European Union based finance companies should consider resisting the application of the United Kingdom thin capitalisation rules, and seek a refund of tax previously paid under these rules. United Kingdom companies with a calendar year-end should consider submitting an amended return for 2001 prior to 31 December 2002 to avoid being time-barred.

On a wider point, United Kingdom groups should consider a restructuring to maximise the benefits of these developments in European Union law.

European Union law has undermined the ability of the current United Kingdom corporation tax system effectively to raise revenue from European Union wide groups.

To reform the United Kingdom corporation tax system to make it compliant with European Union law, but also to raise taxes from the multi-national sector, it seems that there are several approaches that the United Kingdom Revenue could adopt.

First, the United Kingdom could do nothing and accept that profits may be extracted by way of unlimited interest deduction from United Kingdom companies or sheltered in controlled foreign companies. This would significantly reduce the corporate tax take, while the United Kingdom Government’s stated plan is to increase public spending and a budget deficit is looming.

Secondly, the United Kingdom could adopt a strict source basis of taxation, i.e. abolish the residence rule and subject all United Kingdom source income and gains to tax. Interest deductibility could be restricted to the extent that the borrowing was incurred to generate United Kingdom taxable profits. This is the approach that Hong Kong takes, but it is out of step with the approach of the other members of the Organisation for Economic Co-operation and Development. In addition, it does not completely answer European Union concerns.

Thirdly, the United Kingdom could adopt a civil law approach, i.e., exempt profits from non-United Kingdom permanent establishments and non-United Kingdom resident companies. This would not, however, solve the fundamental problem with the thin capitalisation rules.

Finally, the United Kingdom could expand thin capitalisation, transfer pricing and the Schedule D, Case V charge on dividends to all intra-United Kingdom transactions and companies. To avoid a vastly increased compliance burden for United Kingdom corporate groups, this should be introduced together with a true consolidation system for the United Kingdom resident companies and United Kingdom permanent establishments of an European Union corporate group. The transfer pricing, thin capitalisation and dividend taxation rules would apply only to non-consolidated United Kingdom companies, as consolidated United Kingdom entities would be treated as a single entity. Although this would increase the compliance burden for non-group transactions that are solely within the United Kingdom, it may not result in an excessive compliance burden for United Kingdom groups. European Union companies should also be excluded from the controlled foreign companies régime. Furthermore, the rules relating to which entities can be consolidated would have to operate in a non-discriminatory manner.

Recently, the Revenue published a paper on reform of the United Kingdom tax system, which focussed on the tax treatment of capital assets, rationalisation of the schedular system and the differences between trading and investment companies. With the fundamental problems highlighted above in relation to the maintenance of the tax base in the United Kingdom, it seems that this paper is akin to rearranging the deckchairs on the Titanic. The Revenue should instead focus on how it can maintain an effective corporate tax system in the light of European Union law developments.

Immediately prior to publication of this article, the European Court of Justice handed down its judgment in the Lankhorst case. As expected, it found that the German thin capitalisation rules breached the right of establishment and were not capable of being justified. Accordingly, corporate groups now have the ability to extract profits from the United Kingdom by way of interest charges and locate those profits in taxed European Union subsidiaries which are subject to a lower level of taxation.

Historically, Netherlands or Luxembourg finance companies have often been used and I anticipate that this will continue to be the case. It is important, however, to note that the European Court emphasised that, as a matter of fact, there was no tax avoidance present in the Lankhorst case. Thus, the Inland Revenue could argue, based on the Centros case, that anti-avoidance legislation (such as the ‘unallowable purpose’ test in paragraph 13 of Schedule 9 to the Finance Act 1996) can apply to deny interest deductibility. The onus would, however, be on the Inland Revenue to show that tax avoidance exists as opposed to the legitimate exercise of an European Union Treaty right, such as the right of establishment.