Rewrite confusion

KEY POINTS

• Defining ‘qualifying distribution’.
• Purpose of the rewrite programme.
• Complying with EU legislation.
• Overpayment relief claims and TMA 1970, Sch 1AB.
• Ambit of ITTOIA 2005, s 399.

When the taxation treatment of dividends was rewritten by ITTOIA 2005 it appears that, unbeknown to anybody at the time, the taxation treatment of foreign dividends was changed under UK law. The effect is that individuals and trusts who have received foreign dividends, certainly until the tax credit on foreign dividends was introduced in 2008, have overpaid tax.

Income Tax (Trading and Other Income) Act 2005, s 399 is an obscure provision of the tax legislation which says that where a person receives a qualifying distribution which does not carry a tax credit, he is treated as having paid income tax at the dividend ordinary rate of 10%.

This income tax can be offset against the taxpayer’s liability to tax, but is not repayable. Unlike a tax credit there is no grossing up and the taxpayer is taxed on the net distribution.

This means that for individuals who were paying tax at the higher rate, which for dividends was 32.5%, s 399 treatment is more favourable than a tax credit, because their higher rate tax liability is 22.5%.

This is the difference between 32.5% and 10% as distinct from 25% which is the effective additional tax after taking account of the grossing up of the tax credit.

Not just UK companies

The term ‘qualifying distribution’ was defined in TA 1988, s 14(1) for the relevant periods as meaning any distribution other than a distribution within s 209(2)(c).

However, there is nothing in this definition which confines the term to distributions from UK companies. The charge, now repealed, to advance corporation tax under s 14(1) was only imposed on UK companies that made qualifying distributions.

The predecessor provision to ITTOIA 2005, s 399 was TA 1988, s 233. This was contained in Part VI of TA 1988 which constituted the supplementary provisions to Schedule F. Only UK distributions were charged under Schedule F and foreign dividends were charged under Schedule D Case V. One of the objectives of ITTOIA was to remove the schedule base of taxation.

Section 399 forms part of chapter 3 of Part 4 to ITTOIA, which contains in s 383 the charge to tax on dividends and other distributions from UK companies.

This chapter prior to the FA 2008 changes was headed ‘Dividends etc. from UK resident companies etc’. Can it therefore be said that as s 399 is incorporated into chapter 3 it only applies to qualifying distributions from UK companies? It is helpful to look at s 382, which sets out the contents of the chapter. This states:

‘This chapter also makes provision about tax credits, tax being treated as paid and reliefs available in respect of certain distributions which applies whether or not the distributions are otherwise dealt with under this chapter (see sections 397 to 401).’

Odd traits

This appears to make clear that it does not matter that the distribution is taxed as a foreign dividend under chapter 4. There are some other pointers. Why does s 397 refer to distribution from UK companies but s 399 does not? While the first ‘etc.’ in the heading of chapter 3 must refer to other distributions what is the purpose of the second ‘etc.’?

It is also interesting to observe that when the tax credit for foreign dividends was introduced in 2008, this was done by inserting s 397A to C into chapter 3.

The heading of the chapter was changed to read ‘Dividends etc. from UK resident companies etc. and tax credits etc. in respect of certain distributions’. No change was made to s 382 and the use of the term ‘certain distributions’ both in the new heading and in s 382(2) suggests that this term encompasses distributions by both UK and non-UK companies.

The rewrite programme was not intended to change the law except in minor ways, and these were detailed in an annex to the explanatory notes to the Bill laid before Parliament.

It could therefore be argued that the new legislation should be interpreted in a way which is consistent with the old legislation and a significant change in the law should not be introduced by the back door.

This raises an important issue over the interpretation of rewrite legislation that has not been tested in the courts. Should re-write legislation be interpreted on a standalone basis and how much reference should be given to the previous legislation?

If constant reference has to be made to the previous legislation, does this defeat the purposes of the rewrite and do the courts have a role in correcting mistakes?

Discriminatory legislation

There is the argument that UK law is discriminatory against foreign dividends and this is contrary to the EU principle of freedom of establishment. The treatment of advance corporation tax and corporate dividends in the UK has been the subject of much litigation in the European and UK courts.

The treatment of dividends received by a Finnish individual was considered by the European Court of Justice in Manninen (Case C-319/02) [2004] STC 1444.

Claims have been made that UK law is discriminatory in denying a tax credit for foreign dividends. HMRC have resisted such claims generally, although they now accept that claims can be made but only in respect of dividends from a very limited number of countries. See Revenue and Customs Brief 38/10, ‘Finnish, Greek and Irish dividends’.

European Communities Act 1972, s 2(1) gives effect to EU obligations in UK laws and s 2(2) imposes an obligation to construe other legislation in a manner which is consistent with EU obligations. If, therefore, a UK court has a choice of interpretations, it should construe the law in a manner which is most consistent with EU law.

Section 399 is clearly discriminatory, if it is only applied to UK dividends, and this would compel the court to interpret it in a way which was not discriminatory.

Although Parliament may not have intended to change the law in 2005, it can be argued that it should have done and this would allow the courts to give relief for foreign dividends. This could be used to trump any arguments about the general interpretation of rewrite legislation.

Availability of tax credits

For the three years from 2005/06 to 2007/08 no tax credit was available on any foreign dividends and s 399 can apply to all dividends for these years. In 2008 the tax credit was introduced for minority dividends so s 399 can no longer apply to these dividends.

Dividends where the taxpayer’s holding was 10% or more of the company did not qualify for the tax credit for 2008/09 and dividends from offshore funds were also denied a tax credit. For 2008/09 it is therefore possible to claim s 399 treatment on these dividends.

Ironically, taxpayers will be better off claiming s 399 treatment than they will be claiming a tax credit, because of the lack of grossing up. In 2009 the rules changed again so that majority shareholdings qualify for the tax credit where there is an appropriate double taxation treaty.

Dividends from offshore funds now qualify for the tax credit, though dividends from non-equity funds are now classified as interest.

Time constraints

Unless the tax return has not been submitted, taxpayers will not be able to amend their tax return for 2008/09 or earlier years. If a tax return is under enquiry the taxpayer may be able to seek to amend his return.

The route to recovery of tax will be an overpayment claim under the provisions of TMA 1970, Sch 1AB, which came into effect last year to replace TMA 1970, s 33. The time limit for making overpayment claims was reduced to four years. The year 2005/06 is now out of time and 2006/07 will expire on 5 April 2011.

Under Sch 1AB para 2 there are a number of cases where overpayment relief claims are prevented. Case G is the most pertinent here. This denies a repayment claim where the amount paid is excessive by reason of a mistake in calculating the claimant’s liability to income tax and the liability was calculated in accordance with the practice prevailing generally at the time.

This point was discovered after the introduction of the FA 2008 changes and the tax returns would have been submitted when the taxpayer and his agent were ignorant of the fact that s 399 could apply. There is an issue as to whether a prevailing practice exists where a taxpayer has not thought of an application of law, which had not previously been considered.

There is a neater and sharper argument as to why case G does not apply. Is there actually a mistake in computing the taxpayer’s liability to tax?

Let us say that a taxpayer has a foreign dividend of £10,000 and pays tax at the dividend higher rate of 32.5%. His liability to tax when the tax return was submitted was £3,250. If he claims s 399, his liability to tax remains at £3,250.

What we have discovered is that withholding tax of £1,000 has been overlooked and should be brought into account. If he has already paid £3,250, the total amount he is regarded as paying is £4,250 and he should be repaid £1,000 of the tax he has already paid.

Although tax treated as paid under s 399 is not repayable, if the taxpayer has paid tax or has had tax deducted under PAYE or another provision, he should be entitled to a repayment of the tax paid or deducted.

The distinction between the tax for which one is liable and the tax which one pays is something which most tax practitioners will be familiar. Chapter 3 of Part 2 of the Income Tax Act 2007 sets out how a person’s income tax liability is calculated.

If one follows through these rules one will note that tax credits and any tax withheld or treated as paid does not enter into the calculation of income tax liability. There is therefore a very good argument that case G does not apply to a claim in relation to s 399.

The amount potentially overpaid by most taxpayers should be 10% of the foreign dividend shown on their tax return. If the foreign dividend has suffered foreign withholding tax, this should not affect the repayment.

Credit should be available for the foreign tax suffered. In the unlikely event that the taxpayer suffered a 32.5% withholding of foreign tax, there is nothing to prevent the tax treated as paid being offset against the tax on other sources of income.

Potential litigation

The author of this article discovered this point about s 399 towards the end of 2008. A number of tax counsel opinions have been obtained on the matter and have endorsed the analysis. The clients of many leading firms have made claims on this basis over the past two years.

HMRC have generally confused the claims with Manninen and only recently have they given a considered response. This takes the view that s 399 only applies to distributions from UK companies.

The reasons given by HMRC are not impressive: they fail to give proper analysis to the chapter and fail to take into account the EU dimension.

There are indications that HMRC are digging in their heels and want to litigate. There is commercial sense for HMRC in delaying; the ability to recover tax in respect of 2006/07 will expire on 5 April 2011, while claims in respect of 2007/08 will expire on 5 April 2012.

It is unlikely that even if the matter proceeds immediately to litigation that any case will be heard and decided by the tribunal before that date. Since it would raise significant issues over the interpretation of the rewrite legislation, the litigation could go to the Supreme Court.

Issue: 4290 / Categories: Comment & Analysis , Tax Law Rewrite