An article by Francis Fitzpatrick, Barrister, regarding recent decisions of the European Court of Justice and their implications for UK corporation tax
Published in the February 2001 issue of "Tax Adviser" KEY POINTS
- Recent decisions of the European Court of Justice have important implications for UK corporation tax
· The European Court is indirectly bringing about a degree of tax harmonisation
· The abolition of ACT and recent changes to group/consortium relief in FA 2000 were prompted by concerns over European law
· UK companies and even non-UK companies may have claims against the UK in respect of breaches of EC law
When the United Kingdom joined the European Community in 1972, no one imagined that in so doing the UK was ceding sovereignty over corporation tax to EC law. It was of course inherent in the system that EC law would have a big impact on indirect taxes such as VAT. VAT was after all based on the Sixth Directive. Corporation tax and other direct taxes however encapsulated the very idea of the sovereignty of Member States.
Switch forward 28 years and the UK is forced to: change its dividend taxation rules (by abolishing ACT); change its corporation tax group relief rules and capital gains tax group relief rules (in the Finance Act 2000) to accommodate EC law; and the government is facing claims for many millions of pounds in damages from companies who claim that the conflict between UK law and EC law has caused them loss and damage, and no-one knows where the next claim is coming from.
Amongst lawyers and academics within the EC, the question of tax harmonisation is the current hot topic with the European Commission taking a particular interest in direct tax cases from Member States.
Whilst the UK stands outside the Euro, and gasps of horror are heard from politicians of all sides at the very mention of the words a ‘federal European State’, tax harmonisation of a sort is occurring as a result of the developing case law of the European Court of Justice (‘the ECJ’). The principles underlying this development were all present in 1972, but now they are being taken seriously by the ECJ and by taxpayers and the results are, and are likely to continue to be, quite staggering.
The origin of these developments lies in the right to freedom of establishment guaranteed to nationals of Member States by Article 52 of the Treaty of Rome.
The right to freedom of establishment
Article 52 of the Treaty of the Rome (since renumbered Article 43 following the Treaty of Amsterdam) provides, so far as is relevant, that:
‘Within the framework of the provisions set out below, restrictions on the freedom of establishment of nationals of a Member State in the territory of another Member State shall be abolished by progressive stages in the course of the transitional period. Such progressive abolition shall also apply to restrictions on the setting up of agencies, branches or subsidiaries by nationals of any Member State established in the territory of any Member State.
Freedom of establishment shall include the right to take up and pursue activities as self-employed persons and to set up and manage undertakings, in particular, companies or firms ... under the conditions laid down for its nationals by the law of the country where such establishment is effected...’
The transitional period referred to expired in 1970 and since then the right of establishment has been directly applicable in Member States, in other words a person can rely on this right even if a Member State has not implemented it in its own domestic law. Article 58 (now Article 48 EC) confirms that this right applies to companies as it does to individual nationals of Member States.
The ECJ decided that this right to freedom of establishment was one of the fundamental rights granted by the Treaty of Rome and that it applied to all kinds of discrimination which hindered freedom of establishment, whether direct or indirect. It formulated a simple test - Article 52 required that similar situations be treated in the same way unless there was an objective justification for a difference in treatment.
So in principle if a Member State’s tax system was discriminatory and impeded or limited the right to freedom of establishment, this could amount to a breach of Article 52 unless the State could show an objective justification for the difference in treatment.
It was clear that there would be two questions in the tax field - when were two taxpayers in the same situation and what type of objective justification could a Member State rely on in the tax field?
When are two taxpayers similarly situated for the purposes of the right to freedom of establishment?
A resident company and a non-resident company will not normally be in the same position as regards corporation tax for the obvious reason that, normally, one will be within the scope of corporation tax and one will be outside the scope of corporation tax.
However a non-resident company may have a subsidiary company or a branch or agency in the UK which is on a similar footing to a UK company in that the subsidiary company and the branch or agency will, at least if the latter is trading within the UK, be subject to corporation tax at least on profits arising within the jurisdiction.
This indeed appears to be the test which the ECJ has adopted to decide whether two persons are in the same position as regards corporation tax. The ECJ has held that if a Member State taxes the profits of two companies on the same basis, then the Member State has in effect conceded that both companies are in the same position as regards corporation tax for the purposes of Article 52 (see for example Case 270/83 Commission of the European Communities v French Republic [1986] ECR 273, the ‘Avoir Fiscal case’). The ECJ has also held that the branch of a non-resident company trading in the UK through a branch or agency (so that the profits of the branch or agency are within the scope of corporation tax) and a UK company are similarly situated for this purpose even though the branch or agency is not subject to corporation tax on its worldwide profits (see for example Case C-311/97 Royal Bank of Scotland v Elliniko Dimosio (Greek State)).
What amounts to an objective justification for a difference in treatment in the tax field?
Article 56 of the Treaty (now Article 46) allows a derogation from the right to freedom of establishment on the grounds of public policy, public security or public health.
The normal complaint which a Member State might be expected to raise is that equal treatment might give rise to tax avoidance. However, this avenue is closed. The ECJ has held that considerations of a purely economic nature such as the diminution of revenue by reason of there being an increased scope for legitimate tax avoidance is not a matter of overriding general interest which may be relied upon to justify unequal treatment which is contrary to Article 52 (see Case C-264/96 ICI v Colmer [1998] STC 874 at para.28).
Another might be that if equal treatment of the resident subsidiary of a non-resident parent and the resident subsidiary of a resident parent were allowed, then the resident subsidiary of the non-resident might be in a better position than the resident subsidiary of the resident parent. This defence also is not available. The ECJ has held that differences in treatment cannot be justified by any advantages which the subsidiary of a non-resident might enjoy as Article 52 prohibits all discrimination no matter how limited (see the Avoir Fiscal case above).
Nor can a Member State say that it will only extend equal treatment to the subsidiary of a non-resident if the non-resident’s State agrees to grant a reciprocal advantage under, for example, a double tax treaty (see Avoir Fiscal at para.26).
The only basis for justifying discrimination which has enjoyed any degree of success is that discrimination is justified on the basis of the need to preserve the cohesion of the national tax system. This defence has so far been successful on one occasion and has otherwise failed. It has a very limited scope.
The defence of fiscal cohesion
The one instance in which the defence succeeded was in respect of a provision of Belgian law which gave rise to two cases - Case C-204/90 Bachman v Belgium [1992] ECR I-249 and Case C-300/90 EC Commission v Belgium [1992] ECR I-305. Belgian law made the deductibility against income tax of sickness and pension contributions conditional on those contributions being paid to a company in Belgium. Whilst this provision was found to infringe Article 49 of the Treaty on free movement of workers, the infringement was found to be justified on the ground that there was a direct link between the deductibility of the contributions and the liability of the insurer to deduct tax on sums paid pursuant to sickness or pension contracts. If sums paid to companies outside Belgium were deductible, Belgium would not be able to levy tax on those insurers when payments were made under the sickness and pension contracts. The cohesion of Belgium’s tax system required that the deductibility of contributions be matched by the ability to tax the eventual payments. There was a direct link as the loss of revenue from tax deductions given to the assured was offset by the taxation of sums paid by the insurer to the insured.
Whilst the defence succeeded in this case, the ECJ was careful to point out that any such restriction on Community rights had to be proportionate, in other words the measures adopted must be the least restrictive possible. Furthermore whilst the defence has predictably been raised by Member States in every case where their direct tax systems are threatened, it has failed in every subsequent case (of which there have been at least seven - see for example Svennson [1995] ECR I-3955, and Wielockx [1995] ECR I-2493).
The Advocate General in his Opinion in the Metallgesellschaft/Hoechst cases (which involve a challenge to the now abolished ACT system in the UK) considered that the true scope of the defence was only in circumstances where there was a direct, fundamental and organic link between the tax and exemption in question, and would normally only apply where there was a real and substantial risk that extending equal treatment would potentially facilitate tax evasion in both of the Member States concerned (Advocate-General Fennelly in Joined Cases C-397/98 and C-410/98 12 September 2000).
Unless there is a very significant change in the approach of the ECJ, the occasions on which the defence of fiscal cohesion is likely to apply are likely to be very rare.
The consequences for UK corporation tax
The abolition of the ACT regime
The ACT regime notoriously limited the right to make a group income election to wholly UK resident groups, so that the resident subsidiary of a non-resident parent resident in another Member State could not make a group income election and thus had to pay ACT when it paid dividends to its parent, and so, as compared to the resident subsidiary of a resident parent, had to pay its corporation tax early. In short, a resident subsidiary of a non-resident parent (resident in another EC state) was treated less favourably than a resident subsidiary of a resident parent purely on the basis of where its parent was incorporated.
The decision of the ECJ in the Metallgesellschaft/Hoechst cases as to whether this amounted to discrimination and as to whether, if it did, it could be justified on the grounds of fiscal cohesion, is expected in the early part of this year. The Opinion of the Advocate General referred to above (which is a non-binding legal opinion prepared for the ECJ) has come out in the taxpayer’s favour.
It is likely that this apparent incompatibility with EC law is at least one of the reasons why the government decided to abolish the ACT regime.
Consortium relief
Prior to the decision of the ECJ in Colmer v ICI (referred to above), to qualify as a consortium company a company had to be UK resident and had to be owned as to at least 75 per cent of its capital by UK resident companies. In the light of the decision of the ECJ, the Revenue accepted that a resident company could be a consortium company provided that 75 per cent of its capital was owned by companies resident within the Member States of the EC (see IR Press Release of 26 February 1999).
However prior to FA 2000, the Revenue maintained that no consortium relief was available to a non-resident company carrying on a trade in the UK through a branch or agency.
The problem with this was that as a company trading through a branch or agency in the UK is in the same position as regards corporation tax on the profits and gains of the branch or agency as a resident company, the UK had in effect conceded that they were similarly situated for the purposes of Article 52 (now Article 43 EC). It is no answer to say that the non-resident could have incorporated a resident subsidiary to carry on the trade in the UK, as the right to freedom of establishment includes the right to establish via a corporate entity or via an unincorporated entity such as a branch or agency (see for example Case C 307/97Compagnie de Saint Gobain). Furthermore it would be very difficult to advance any fiscal cohesion defence as what is in issue is the ability of a resident subsidiary to surrender corporation tax losses to its parent which by reason of its branch or agency has a UK corporation tax liability. There is no scope for tax evasion, all that happens is that UK tax losses are set against UK taxable profits.
The Revenue denies that there was any such conflict, but nonetheless, FA 2000 changed the position for accounting periods ending after 31 March 2000, so that consortium relief is now available to a non-resident company carrying on a trade through a branch or agency in the UK. This does not however change the position for the past. Similar changes were made in respect of establishing entitlement to group relief.
Group relief for corporation tax on chargeable gains
Prior to FA 2000, no group relief in respect of chargeable gains was available to a non-resident trading in the UK through a branch or agency and it was not possible to establish a group relationship otherwise than through UK resident companies. The problem with this rule was that this resulted in discriminatory treatment of branches of non-residents and direct subsidiaries of non-residents as compared to resident subsidiaries of resident parents. There is no question of tax avoidance in extending the relief on a non-discriminatory basis as it is simple to provide (as FA 2000 has done by using the concept of a chargeable asset, being an asset which remains within the scope of UK corporation tax) that the assets which are transferred intra-group remain within the scope of UK corporation tax. Once again there seems little or no scope for any defence of fiscal cohesion.
The Revenue has denied that the rules were discriminatory, however FA 2000 changed the law to extend group relief in a non-discriminatory fashion - but only for the future..
Regardless of protestations to the contrary, the changes to consortium/group relief and chargeable gains group relief, at least as regards companies within the EC, were a case of jump or be pushed.
Practical implications
Notwithstanding the abolition of ACT and the changes in the law made by FA 2000, the UK was almost certainly in breach of EC law in respect of the former rules. The implication of this is that a company which suffered as a result of such breach has a remedy. In cases where years are still open and it is possible to appeal or to pursue an open appeal, the remedy is to pursue the appeal on the basis that UK law is overridden by EC law so that the offending statutory provisions must be read and given effect to in a manner consistent with EC law. In other cases, companies which have suffered as a result of the discriminatory nature of the old rules may have a remedy in damages for breach of EC law against the UK government, although in such cases it should be borne in mind that normal periods of limitation will apply and it is likely that a claimant will only be able to go back six years.
Double tax treaties and the six million dollar question
The six million dollar question of EC law at the moment for tax purposes is whether the so-called ‘most favoured nation’ argument or ‘MFN’ is right or not.
The MFN runs as follows: Assume that under a double tax treaty with one EC state (‘State One’), there is no provision for the repayment of a tax credit to a parent company resident in State One receiving a dividend from its subsidiary in the UK, but under a double tax treaty between the UK and another EC State (‘State Two’) there is such provision; is the UK, by reason of the less favourable treatment accorded to parents in State One as compared to parents in State Two, thereby discriminating contrary to Article 52 EC against the parent in State One and, if so, is the parent in State One entitled to be treated in the same manner as the parent in State Two, thus in effect rewriting the terms of the double tax treaty between the UK and State One?
If this argument is right, then it has fundamental implications for the system of tax treaties as separately negotiated exclusive agreements between member states of the EC, as it would in effect allow a resident of another State to ‘cherry-pick’ the most favourable provisions for it from all of the tax treaties concluded by the UK with, at least, other EC members.
So far, no definitive judgment has been forthcoming from the ECJ, but it seems only a matter of time before the ECJ has to face this issue square on.
Action Points
- If you have client companies which are members of an international group within the EC, e.g. with a non-resident parent in an EC country and a UK subsidiary or a non-resident company trading through a branch or agency in the UK, you should consider whether any member of the group may have suffered as a result of the type of discrimination described above;
· If members of a mixed resident group within the EC are better off as a result of the FA 2000 changes for international groups, it is worth considering whether they may have previously been discriminated against;
· Before determining an open appeal for previous years in the cases of a company which is a member of an international group, it is worth considering whether there might be a claim as a result of discrimination contrary to EC law which could be pursued via the statutory appeal procedure;
· If a company has a damages claim in respect of such discrimination, bear in mind that a six year limitation period may apply which would limit any claim to damages arising in the six years prior to a claim being issued.
Technical Department
020 7235 9381
February 2001 by Francis Fitzpatrick
