Advance Corporation Tax - Stake Your Claim

JONATHAN LEVY and ANDY WATTERS of Ernst & Young explain the group litigation arising from the Hoechst case.

THE INLAND REVENUE has been served with a number of High Court claims for substantial amounts of restitution following the decision of the European Court of Justice in the Hoechst and Metallgesellschaft cases – C-397/98, C-410/98. These claims raise a number of difficult issues which the United Kingdom courts will have to determine. Given the size of the claims and the principles involved, the forthcoming litigation is of importance for both the Inland Revenue and claimant taxpayers.

The Hoechst decision

On 17 November 1998 the European Court of Justice received two referrals from the High Court of Justice under Article 177 of the European Community Treaty on the interpretation of Articles 6, 52 and 58. From 1974 to 1995 Hoechst UK Limited paid dividends to its German parent company, Hoechst AG. Under the United Kingdom taxation régime in operation at the time, the existence of a non-United Kingdom parent meant Hoechst UK was not eligible to make a group income election. Hoechst UK was therefore obliged to deduct advance corporation tax on the dividends paid to its parent and account for that tax to the Inland Revenue. Hoechst finally brought proceedings before the United Kingdom courts, complaining that it had suffered a cash flow disadvantage in comparison with the subsidiaries of parent companies resident in the United Kingdom for whom a group income election was available under section 247, Taxes Act 1988. Such an election was available only to companies, one of which owned at least 51 per cent of the other and both of which were resident in the United Kingdom.

Hoechst's claim was that the inability of its United Kingdom subsidiary to make a group income election, because its parent was resident in Germany, was incompatible with the freedom of establishment guaranteed by Articles 52 and 58 of the European Community Treaty. Hoechst argued that denying the possibility of making a group income election would deter non-United Kingdom companies from establishing subsidiaries in the United Kingdom.

The advance corporation tax system

In order to arrive at its decision, the European Court of Justice had to analyse the United Kingdom advance corporation tax system as it applied during the time dividends were paid by Hoechst UK to its parent company. This will be familiar ground to most readers but, to rehearse it briefly, advance corporation tax applied in the United Kingdom from its introduction in 1972, under section 84, Finance Act 1972, until its abolition in section 31, Finance Act 1998. Under section 14, Taxes Act 1988 where a company resident in the United Kingdom made a 'qualifying distribution' it was liable to pay an amount of advance corporation tax. 'Qualifying distribution' included the payment of a dividend as an income distribution by a company to its shareholders. The legislation provided that advance corporation tax should be payable at a rate fixed by fraction I divided by 100-I, where I is the percentage at which income tax at the lower rate which is charged for the year of assessment beginning on 6 April in the financial year in question.

Under section 13, Taxes Act 1988, a company was required to make a return, broadly for each quarter, and advance corporation tax had to be paid within fourteen days of the end of that quarter

In principle, advance corporation tax paid during an accounting period could be set off against the paying company's corporation tax liability for the accounting period in question or, alternatively, transferred to its subsidiaries, which could then set it off against the mainstream corporation tax to which they were liable (sections 239 and 240, Taxes Act 1988). The effect of payment of advance corporation tax was, therefore, to advance the date of payment of corporation tax which would otherwise be due by a period varying from eight-and-a-half months, in the case of a distribution made on the last day of the accounting period, to one year and five-and-a-half months where a distribution was made on the first day of an accounting period. Where no corporation tax was payable in respect of the period in question, perhaps because the company had made a loss, advance corporation tax would be unused.

Tax credits

Section 231, Taxes Act 1988 provided for tax credits to be granted to the United Kingdom recipients of qualifying distributions by a United Kingdom resident company. Under section 208, the dividends received by one United Kingdom company from another were not generally subject to corporation tax in the recipients' hands. The sum paid, together with tax thereon, was known as franked investment income.

Franked investment income could be used to frank the receiving company's own distributions paid in the accounting period when the franked investment income was received, in accordance with section 241, Taxes Act 1988. Hence, advance corporation tax was not payable on such distributions.

The position for non-residents, however, was different. Under section 233, tax credits were not granted to a non-resident unless specifically provided for by the terms of any relevant double taxation convention.

Group income

Section 247, Taxes Act 1988 enabled a company receiving dividends from another company, where the paying company was a 51 per cent subsidiary of the other, to make a joint election for the dividends to be paid gross and without deduction of advance corporation tax. The effect of section 247 was that the subsidiary did not pay advance corporation tax on any dividends it paid to its parent company and, correspondingly, the parent company would not be entitled to a tax credit which could be used to frank the payment of any subsequent dividend. Only a United Kingdom resident subsidiary and parent company could, however, make a group income election under section 247. The effect was that a United Kingdom subsidiary would enjoy a cash flow advantage over a fellow United Kingdom subsidiary with a non-United Kingdom resident parent, in that it might elect advance corporation tax not to be paid on the payment of the dividend to its parent. The obligation of both companies to pay corporation tax within nine months of the accounting period, however, remained. Payment of corporation tax was, therefore, postponed rather than avoided.

Hoechst's case

Hoechst argued before the European Court of Justice that the cash flow advantage arising to United Kingdom subsidiaries discriminated against the ability of European Union companies to establish themselves in the United Kingdom. The argument in particular was that Hoechst's right of establishment under Article 52 of the European Community Treaty had been breached.

In Hoechst the European Court of Justice acknowledged the difference in tax treatment and said:

The Government's position

The United Kingdom argued that, where the group income election applied to a United Kingdom subsidiary paying dividends to a United Kingdom parent, that parent would be required to pay advance corporation tax when it made a distribution to its own shareholders. The obligation to pay advance corporation tax was, therefore, transferred from the subsidiary to the parent company. By contrast, a non-United Kingdom resident parent had no obligation to pay advance corporation tax. The 'symmetry' of the advance corporation tax was thus broken.

The United Kingdom Government also argued that the refusal to grant a resident subsidiary of a non-resident parent the right to make a group income election was justified by the need to preserve the cohesion of the United Kingdom's tax system.

The European Court of Justice had little difficulty in dismissing these arguments. The Court noted that advance corporation tax was in no sense a tax on dividends but was rather an advance payment of corporation tax. The subsidiary of the non-resident European Union parent would not, therefore, avoid paying any tax in the United Kingdom on profits distributed by way of dividends. As a result, the subsidiary of a United Kingdom parent which could postpone payment of corporation tax under section 247 would enjoy a significant cash flow advantage.

The European Court of Justice also ruled that the fact that a non-resident parent company would not be subject to advance corporation tax, when it in turn paid out dividends, could not justify denying its United Kingdom subsidiary the same exemption when paying dividends to its parent.

The Court also held:

Finally, the European Court of Justice dismissed an argument by the United Kingdom Government based on the cohesion of the United Kingdom tax system, which argument was based on the European Court of Justice decision in Bachmann and Commission v Belgium, case C-204/90.

Restitution

The second issue in Hoechst was whether European law would give rise to a restitutionary right for a United Kingdom resident subsidiary of a non-resident parent to claim a sum of money by way of interest on the advance corporation tax which the subsidiary paid, on the basis that national law did not allow it to make a group income election.

The United Kingdom argued, on this point, that a breach of Community law would require the breach to be remedied not through restitution but through an action brought against the State for damages for loss occasioned by its breach of Community law. The United Kingdom Government cited European authority to the effect that in the case of damages arising out of breach of a directive, Community law does not require a Member State to pay a sum equivalent to interest on a sum paid late. The United Kingdom Government argued therefore that Community law did not require interest to be paid in respect of the loss of use of a sum of money for a certain period on account of the advanced levying of a tax contrary to Community law.

The United Kingdom Government also argued that, even if Hoechst's claim could be treated as one for restitution, interest on such claims could not be upheld because, under English law, entitlement to interest depended on whether or not proceedings were commenced before payment of the sum on which interest is claimed; whereas in this case the principal sum had of course been repaid (by way of set-off for the advance corporation tax against corporation tax), before any action for restitution was commenced.

The European Court of Justice, however, rejected these arguments, holding that, subject to time limits provided for by the national laws of Member states, restitution should be granted to the claimants.

The group litigation order

Following the Hoechst decision by the European Court of Justice, the Revenue has been served with a number of claims which fall within three classes. These are:

Class 1 which comprises claims brought by members of groups of companies where:

Class 2 which comprises claims brought by members of groups of companies where:

Class 3 which comprises claims brought by members of groups of companies where:

The Revenue applied to the High Court of Justice on 15 October 2001 for a group litigation order under the Civil Procedure Rules 1998, Part 19. Under the Civil Procedure Rules, the courts may make a group litigation order where there are, or are likely to be, a number of claims giving rise to group litigation order issues. A group litigation order will arise, for example, in the handling of claims by a court involving multiple parties giving rise to common or related issues of fact or law, which may be assisted by unified procedures.

Once the group litigation order is made, a group register is established in which the claims managed under that order will be entered. The order will also specify the group litigation order issues and identify the claims managed as a group under that order and will specify which court, called the 'Management Court', will manage the claims of the group register.

The effect of the group litigation order is that, where a judgment or an order is given or made in relation to one or more group litigation order issues, the judgment or order is binding on all of the parties on the group register at the time the judgment or order is given (unless the court otherwise directs).

Class 1 Issues

Even though the European Court of Justice has given judgment in favour of Hoechst, there are still a number of issues for the High Court to decide. The first question is how far back in time claims can be made. In the Hoechst case claims went back until 1973. The Inland Revenue will no doubt argue, however, that under national legislation the time limit for making claims should be curtailed. The answers to whether claimants can go back further than six years may in turn depend on the difference between 'restitution' and 'damages'. A claim for damages is based on principles set out by the European Court of Justice in Francovich v Italy, Case C-6, 9/90, [1991] ECR I-5357. Such a claim would have a limitation period of six years from the date on which the cause of action accrued – see section 2, Limitation Act 1980.

A claim for restitution would be on the basis that the early use of money by way of advance corporation tax constituted a financial benefit obtained unlawfully by the United Kingdom. In this respect, the European Court of Justice has consistently held that Member States must reimburse taxes levied in breach of Community law.

Under United Kingdom law, there are two possible bases for a restitution claim. Firstly, the sums demanded and paid by way of advance corporation tax were simply ultra vires. The limitation period for restitution based on ultra vires is again six years.

Secondly, it could be argued that the payments were made under a mistake of law. If payments were made under a mistake of law, then it is possible that section 32(1)(c), Limitation Act 1980 extends the six-year period to the date on which the claimant discovered or ought to have discovered his mistake. The date of discovery in this case, it would be argued, is March 2001 when the European Court of Justice gave its judgment in Hoechst .

Until comparatively recently, money paid under a mistake as to the general law, or as to the legal effect of the circumstances under which is paid, but with full knowledge of the facts, was irrecoverable. The position was changed in Kleinwort Benson Limited v Lincoln City Council [1983] 3 WLR 1095. In that case the House of Lords held that the general bar to a restitutionary claim of money paid under a mistake of law should no longer be maintained as part of English law. There is, therefore, a general right to recover money paid under a mistake, whether of fact or law.

The House of Lords held that retention of money is prima facie unjust in circumstances where the payer paid over money because he believed that he was obliged to do so and then subsequently discovered that he was not in fact liable. In this case, counsel considered that there was a further issue as to whether when taxes are paid they might be paid under a mistake of law. However, counsel considered that there was a mistake of law here, namely that a section 247, Taxes Act 1988 election could not be made by the subsidiary.

In Kleinwort Benson the House of Lords rejected a submission that restitution is barred where the payee believes that he was entitled to the money. However, the House of Lords left open the issue of whether a defence of 'settled understanding of the law' could be used in public cases as opposed to private cases. It is possible, therefore, that the Revenue may argue that restitution based on mistake of law is barred because it was the settled understanding of the law that advance corporation tax could be levied on dividends paid by subsidiaries of non-resident parent companies.

Overall, it seems clear that claimants have an argument that they are entitled to restitution going back more than six years and/or a claim to damages.

The next question concerns appropriate rate of interest. It is likely that claims will be made at a 'commercial' rate, perhaps LIBOR or LIBOR plus 1 per cent as a reasonable rate of interest that should have arisen on advance corporation tax paid early during the years in issue. It is also worth noting that interest may also be claimed on that sum under ordinary United Kingdom principles relating to litigation. This will effectively amount to interest upon interest and it would be prudent to expect the United Kingdom courts to be cautious about awarding such interest under section 35(A), Supreme Court Act 1981.

The next issue that arises is the correct treatment of cases of surplus advance corporation tax. It would appear that a claim may be made for repayment of the advance corporation tax together with interest thereon. As a result, if the advance corporation tax was not in fact offset against mainstream corporation tax, there may be a valid claim for the surplus.

Finally, there is the position if advance corporation tax is suffered by a sub-subsidiary. It would appear that claims may be made on the basis that there would have been a group income election but for the inability for the parent company to make such an election with the ultimate, foreign parent. It will no doubt be necessary to produce evidence that this would have been the case.

Class 2 issues

All the issues in Class 1 above will arise for Class 2 claims but in addition there is the issue where advance corporation tax is fully set off, as to whether payment of partial tax credit to the parent eliminates any discrimination under European Community law. In the Hoechst case the Revenue had contended that the granting of any partial tax credit under the terms of a double taxation convention would cure any discrimination suffered by the subsidiary. This contention was, however, dismissed by the European Court of Justice. It remains to be seen whether the United Kingdom courts accept the European Court of Justice's reasoning in this respect. A similar issue arises where advance corporation tax is not fully set off.

The Inland Revenue will, no doubt, argue that the United Kingdom court should offset at least a portion of the tax credit granted to the parent against any loss suffered by the subsidiary. There is even perhaps a possibility that the Revenue may argue that the advance corporation tax refund should be clawed back in its entirety from the parent. It is considered that there are no legal grounds for such a conclusion, but courts can be unpredictable.

It would appear, however, that there is an increased risk of the tax credit being recoverable where surplus advance corporation tax forms part of the sums paid by way of restitution or damages. This is because, under these circumstances, no corporation tax was payable and it is possible that the Revenue may argue no tax credit should therefore be granted to the parent. It is still considered, however, that there is no legal mechanism for the Revenue to recover such credit.

Class 3 issues

Class 3 is the most difficult of the three areas. Class 3 claims depend not on European Community law but on anti-discrimination provisions in a double taxation convention. Under such a claim, a United Kingdom subsidiary would claim for restitution or damages in respect of the loss of the advance corporation tax paid early when compared to a United Kingdom subsidiary of a United Kingdom parent who could make a group income election.

A number of complex issues arise. Firstly, it would appear that the standard anti-discrimination articles clearly provide for a comparison between, say, a United States owned United Kingdom subsidiary and a United Kingdom owned United Kingdom subsidiary. It would appear, however, that the Revenue will contend that the true comparison should be between a United States owned United Kingdom subsidiary and another foreign owned United Kingdom subsidiary.

Where advance corporation tax is fully set off, the question arises of whether payment of partial tax credit to the parent means that there is no discrimination. It is considered that this is not the case because the standard non-discrimination article directs attention to the position of the subsidiary.

If advance corporation tax is not fully set off, again the question arises of whether payment of partial tax credit to the parent means that there is no discrimination. Again, it is considered that the discrimination is not removed because the discrimination is suffered by the subsidiary.

An important issue is whether a payment of restitution/damages to the subsidiary means that any tax credit paid to the parent is recoverable by the Revenue. As for Class 2, it is considered that the answer should be in the negative, as the credit reflects payment of corporation tax and not early payment of advance corporation tax. Here the discrimination is that the subsidiary was not treated on the basis that it could pay dividends under a group income election.

The position may be different, however, where surplus advance corporation tax formed part of the sums paid by way of restitution or damages. Under these circumstances, it is arguable that the parent should not have been entitled to a credit in the first place. Again as for Class 2, however, it is considered that there is no legal mechanism for the Revenue to claw back any credit.

The next issue is whether the parent itself can claim an entitlement to a tax credit on the basis of the non-discrimination article in the double taxation convention. Under some treaties, this would not be possible – see the United States/United Kingdom Treaty, but the drafting of others made such a claim possible – see, for example, the United Kingdom/Swiss double taxation convention.

It is considered likely that the Revenue will argue that a section 788, Taxes Act 1988 claim could and should have been made by claimants within the time limits stipulated under section 42, Taxes Management Act 1970. As a result, any claims which are outside of these time limits (effectively six years) will, on this argument, fail for being out of time.

A final possibility is that claimants may make a claim under Article 14 and Article 1 of the First Protocol of the European Convention of Human Rights, such a claim being brought by virtue of the 1998 Human Rights Act.

Conclusion

The group litigation raises a number of complex questions which will no doubt try the ingenuity of the courts in the months to come. It seems clear, however, that, unless claims are properly made and claimants duly entered on the High Court group litigation order register, there is a danger that potential claimants will not benefit from any awards made by the United Kingdom courts following the Hoechst decision. It is important, therefore, that claimants are aware of this fact.

Jonathan Levy and Andy Watters are both senior consultants in Ernst & Young's Tax Risk Management Group.

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