Strained Relations

FINTAN CLANCY examines the relationship between European Union law and United Kingdom dividend taxation.

THE TREATY OF Rome, signed in 1957, had as one of its aims the creation of establishing a single market within the European Union. Discrimination between businesses and people on the basis of nationality is incompatible with this aim, and the Treaty of Rome protects fundamental freedoms as specific examples of prohibited discrimination. These are: free movement of capital and payments, persons (including the right of establishment), and the freedom to provide services.

The European Union Member States have not harmonised their direct tax law (and may never do so), and in recent years the European Court of Justice has been called upon to enforce the general anti-discrimination rules contained in the Treaty in a tax context. European Union law should apply to domestic tax law because tax systems can constitute an incentive or disincentive to investment, carrying on a business, or moving from place to place within the European Union.

This article will be a practical review for United Kingdom companies which own shares in European Union corporates. It will examine how some United Kingdom rules may have to be modified to become consistent with the concept of fundamental freedom and to comply with the recent case law developed by the European Court of Justice.

Dividends

Section 208, Taxes Act 1988 exempts dividends paid by one United Kingdom resident company to another from United Kingdom corporation tax (the exemption method of taxing dividends). Dividends paid by a non-United Kingdom resident company are, however, charged to tax under Schedule D, Case V as income from 'possessions out of the United Kingdom' with credit for withholding tax and, sometimes, underlying tax (the credit method of taxing dividends). This has the practical result that United Kingdom resident companies holding shares in European Union, but non-United Kingdom, resident companies can be liable to United Kingdom corporation tax on dividends paid by those companies. Since Finance Act 2000, the use of a mixer company has been effectively eliminated by the new double taxation relief rules so that a tax charge is more likely for corporate groups.

In addition, a more onerous compliance burden is imposed in respect of dividends paid by a non-United Kingdom resident company under the double taxation relief rules. It is understood that an exemption method for United Kingdom companies receiving non-United Kingdom dividends was considered as part of the process leading to the introduction of onshore pooling, but was rejected.

To determine whether this rejection of exemption method is consistent with the requirements of European Union law, three questions must be answered.

Is there discrimination?

In a European Union context, discrimination means treating persons in the same situation differently, or treating people in different situations in the same way. As a European Union, but non-United Kingdom, resident company will usually be subject to the domestic tax laws of its state of residence in the same way that a United Kingdom resident company is subject to United Kingdom tax law, from a European Union perspective it will be in the same objective situation as a United Kingdom resident company. The corporate seat or place of incorporation serves to link the company with a Member State in the same way that nationality links an individual with a Member State (see Royal Bank of Scotland plc v Greece (Case C-311/97) [2000] STC 733).

In addition, the United Kingdom applies the exemption method to United Kingdom dividends, but the credit method to non-United Kingdom dividends which, prima facie, constitutes discrimination. Article 4(1) of the Parent-Subsidiary Directive (90/435) provides that the Member State of the investing company must apply either an exemption or credit method in respect of profits distributed by a subsidiary to a parent. Although the directive provides that either approach may be used, it should not be viewed as allowing discrimination. Indeed, Recital 3 states that one aim of the directive is to harmonise tax laws of Member States that are 'generally less advantageous than those applicable to parent companies and subsidiaries of the same Member State'.

Is there a restriction or hindrance of a fundamental freedom?

The second question is whether this discrimination constitutes a restriction on the exercise of a fundamental freedom or makes the exercise of a fundamental freedom less attractive. Subjecting dividends from a company resident outside the United Kingdom to tax, while exempting those from United Kingdom resident companies from tax, makes establishing the operations of a United Kingdom company in other Member States less attractive. Similarly, it operates to restrict the free movement of capital, as a United Kingdom resident corporate investor will be in a better tax position by investing in a United Kingdom resident company when compared with a non-United Kingdom resident company. This problem will be particularly acute in the case of a portfolio investor if it holds less than ten per cent of the other company and cannot obtain credit for underlying tax on the dividend.

In Verkooijen (Case C-35/98), the European Court of Justice considered a Dutch tax provision which exempted from tax certain dividends received from Dutch (but not other European Union) resident companies. The European Court held that the provisions breached the free movement of capital provisions by constituting an obstacle to raising capital in the Netherlands on the basis that foreign dividends received less favourable tax treatment than Dutch dividends: 'It follows that to make the grant of a tax advantage, such as the dividend exemption relating to taxation of the income of natural persons who are shareholders, subject to the condition that the dividends that are paid by companies established within the national territories constitutes' a prohibited restriction on capital movements.

Is the restrictive discrimination capable of justification?

Unless it is justified, a discriminatory restriction on a fundamental freedom is prohibited. Justifications can be found in treaty and case law. In the case of freedom of establishment, Article 46 of the Treaty states that Member States may provide 'special treatment for foreign nationals on grounds of public policy, public security or public health'. It is unlikely, however, that any of these could apply to a tax case.

For free movement of capital payments, an additional Treaty justification is available; this is the right of Member States to distinguish between taxpayers who are not in the same situation with regard to their place of residence. In Verkooijen (a capital and payments case), the European Court of Justice held that discrimination based on place of residence could be justified provided that such distinctions 'could be justified by overriding reasons in the general interest' but continued 'the reduction in tax revenue cannot be regarded as an overriding reason in the public interest which may be relied on to justify a measure which is in principle contrary to a fundamental freedom'.

In direct tax cases based on the fundamental freedoms, once discrimination has been established, the only justification the European Court has accepted is the principle of 'coherence of the tax system' (see Bachmann v Belgium (Case C-204/90) [1994] STC 855). To establish this justification, the Member State must show that the discrimination is necessary in order to safeguard the coherence of the tax system in question. This analysis can be applied to section 208, Taxes Act 1988 as follows:

• The exemption is not dependent on any tax being charged in the United Kingdom. For example, a dividend may be paid by a company from a profit arising on the exempt sale of a substantial shareholding. In addition, dividends are paid out of accounting and not taxable profits which suffer varying effective tax rates: the United Kingdom tax system is not coherent in this sense.
• There are two different taxpayers (the paying and receiving company), so the direct link relating to the same tax and the same taxpayer cannot be established (see Baars (Case C-251/98)).

The United Kingdom could argue that section 208 is merely a method of granting double tax relief within the United Kingdom, equivalent to the new double taxation relief taxes in Chapter II, Part XVIII of the Taxes Act 1988. This argument does not seem to be correct, as the exemption and credit methods are not equivalent. The administrative burden of the double taxation relief rules, particularly since Finance Act 2000, is onerous; investors holding less than ten per cent of the dividend paying company cannot take advantage of the double taxation relief rules; and section 208 is not dependent on any tax being paid by the dividend-paying company, so that the profits may suffer either a higher or lower effective tax rate.

It is, therefore, probably unlikely that the United Kingdom can justify the discrimination inherent in section 208, and that the section should be read as referring to dividends from any company resident in a Member State of the European Union.

Controlled foreign companies

If dividends from European Union, but non-United Kingdom, companies were to be exempt from corporation tax, one can anticipate that the Inland Revenue could seek to charge the profits of the subsidiary to tax under the controlled foreign companies legislation. With credit for underlying tax, this could have substantially the same effect as taxing the dividend. The payment of a suitable dividend by the non-United Kingdom company usually prevents a controlled foreign companies charge if the dividend is 'taken into account in computing the [United Kingdom resident's] income for corporation tax purposes' (paragraph 2(1A) of Schedule 25 to the Taxes Act 1988). If section 208 were to apply to that dividend, however, it would not be so taken into account.

The application of controlled foreign companies legislation in these circumstances would be vulnerable to a challenge under European Union law. First, under section 747(1)(a), Taxes Act 1988, the rules do not apply to companies resident in the United Kingdom, and this may constitute unjustifiable discrimination based on place of residence of the payer. In addition, the structure of the legislation seems to have the effect of undermining the single market. The exempt activities test specifically brings companies which provide group financial wholesale services and group dealing in goods within the controlled foreign companies rules, targeting United Kingdom companies wishing for legitimate economic reasons to consolidate their European Union-wide financial activities or purchasing activities into a single entity. The motive test may exclude the operation of the rules, but this is dependent on a subjective assessment of the reasons for locating in another European Union country; a concept alien to the right of establishment.

Excluded countries

The excluded countries regulations (SI 1998 No 3081) contain a list of countries to which the controlled foreign companies rules do not apply (in Part I of Schedule 2) and countries to which the controlled foreign companies rules can apply in certain circumstances (in Part II of Schedule 2). If a country is not on either list, the rules are potentially applicable in all circumstances. All European Union countries are currently either on Part I or Part II and no European Union country is unlisted. The fact that a country is on Part II of the list probably constitutes discrimination between companies resident in a Part II territory and those resident in a Part I territory. The United Kingdom might seek to justify the difference in treatment on the basis that most of the tax régimes referred to in Part II of the list are themselves discriminatory between residents and non-residents of the particular country in question. In effect, the United Kingdom would be attempting to use its tax system to retaliate against allegedly unfair tax competition in breach of Article 3(1)(c) of the Treaty. Furthermore, in Eurowings (Case C-284/97), the European Court of Justice held that tax advantages in one Member State 'cannot be used by another Member State to justify less favourable treatment in tax matters'.

Code of conduct

The United Kingdom could also argue that the code of conduct between Member States allows Member States to combat avoidance and evasion of tax and the motive test is aimed at remedying non-avoidance cases from the controlled foreign companies rules. It should be noted, however, that this is a political agreement between Member States and is not binding in law. Furthermore, it is an agreement between Member States and cannot be viewed as restricting substantive rights of individuals and companies granted by the Treaty. Alternatively, the United Kingdom could argue that the controlled foreign companies code as a whole is capable of objective justification as it is proportional to the objective to be achieved. The objective to be achieved is to prevent tax avoidance by moving activities from the United Kingdom to another jurisdiction, thus reducing the United Kingdom tax base. As stated above, the Verkooijen case clarifies that this is not an acceptable justification for discrimination. Furthermore, the right to establish anywhere within the European Union is one of the fundamental freedoms, so that legislation whose aim is to restrict that right must be scrutinised carefully.

Proportionate

On a narrower point, the United Kingdom could argue that the motive test makes controlled foreign companies legislation proportionate to the objective to be achieved as it excludes 'good' companies from the rules. As the controlled foreign companies test imposes additional compliance burdens on United Kingdom companies, i.e. they must compute the profits of the alleged controlled foreign company under United Kingdom rules and determine whether the lower level of tax test is satisfied, rather than merely relying on the accounts; this may not be accepted by the European Court of Justice. Further, the European Court has not accepted any justifications in any direct tax case once discrimination has been found to exist, except in the Bachmann case. On balance, therefore, it seems that these arguments would not hold up.

Irish companies

Ignoring the ten per cent tax rate that may be grandfathered in certain circumstances until 2010, Irish companies will, from 2003 be taxed at 12.5 per cent on trading income and 25 per cent on non-trading income. An Inland Revenue press release on 23 July 2002 suggests that Ireland may be removed from Part II of the excluded countries list because of the fall in Irish corporation tax rates. As a result, Irish companies that do not benefit from any special tax exemptions in Ireland could be subject to the United Kingdom controlled foreign companies rules. Subject to the other exemptions in the rules applying, it would therefore seem likely that the United Kingdom could levy a controlled foreign companies charge in respect of Irish trading companies owned by United Kingdom resident companies.

It is interesting to note that the Eurowings case involved German tax discrimination against an Irish company on the basis that it was subject to the ten per cent tax rate. As the 12.5 per cent rate is itself compliant with European Union law (the Commission has accepted that this is so), it seems that the action proposed in the Inland Revenue press release is an example of unjustifiable discrimination.

Government's dilemma

The United Kingdom tax code relating to dividends does not stand up to European Union scrutiny. It is likely that the exemption method for dividends should be applied to all European Union dividends and that the controlled foreign companies rules should not apply to European Union companies. This will present the Government with a more difficult policy decision than that arising from ICI v Colmer Case C-264/96 [1998] STC 874. There, the Government extended the application of non-discrimination principles to all companies worldwide. Because the tax reliefs in that case were effectively limited to United Kingdom resident companies and United Kingdom branches, it was unlikely that there is a significant reduction in the tax yield. If section 208, Taxes Act 1988 extends to dividends paid by any European Union resident company and the controlled foreign companies rules do not apply to such companies, the potential loss of United Kingdom tax revenue is large.

The Revenue would have to decide whether to preserve this preferential treatment in relation to European Union countries or extend the treatment to all countries worldwide, further reducing the tax yield. Conceivably, it could exempt dividends from all companies wherever resident, but preserve the controlled foreign companies rules in relation to non-European Union countries. Alternatively it could tax intra-United Kingdom dividends but extend the double taxation relief rules, creating a huge administrative burden.

United Kingdom resident companies which have been taxed on dividends received from European Union resident companies will no doubt be considering whether they should submit similar claims to recover that tax. United Kingdom headed multinational groups probably operated mixer companies until recently and may not have significant tax to be reclaimed. Portfolio investors may, however, be able to reclaim significant tax. Taxpayers should be aware that the normal United Kingdom time limits apply to such claims.

Following the decision in Hoechst AG and another v Commissioners of Inland Revenue and Attorney General (Case C-410/98) [2001] STC 452, a large number of United Kingdom companies or their European Union parents have submitted claims against the Revenue for advance corporation tax that should not have been paid. It is anticipated that the United Kingdom Government may be obliged to refund significant tax. In addition, there are several other aspects of United Kingdom tax law which may be incompatible with European Union law and could lead to further large refunds of tax.

Fintan Clancy ATII is a tax lawyer working in the London office of Skadden, Arps, Slate, Meaher & Flom LLP. He is qualified as a solicitor in Ireland.

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