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Making the most of EC law

Category Technical Articles
AuthorTechnical Department
Adam Craig explains how to approach UK tax claims based on EC law. Adam Craig is an international tax adviser specialising in EC law and tax treaty interpretation. He leads the EU Tax Group of Deloitte & Touche in the UK, and is on the executive of the Deloitte & Touche EU group. This article appeared in the December 2002 issue of Tax Adviser.
For most people European law is something they associate with human rights, metric martyrs and the shape of vegetables. For those involved in tax, however, claims under European Community law (EC law) are becoming an essential element of tax strategy that can provide significant improvements to a group’s tax position – both to cashflow and to the reporting position in the accounts.

The basics
Before delving into specifics and case law, it is worth clearing up a few common misconceptions about European law.

Maybe the first area of confusion is where this law comes from and the widely held belief that this is a ‘them’ and ‘us’ situation with ‘European’ law on one side and United Kingdom (UK) law on the other.

This is not foreign law; EC law is UK law. Rights and remedies created by EC (European Community) treaties and legislation can have legal effect in the UK without any further enactment. These rights and remedies are called ‘enforceable community rights’. Some of those rights extend to European Economic Area (EEA) and European Union (EU) applicant countries.

Secondly, UK courts must take judicial notice of the decisions and opinions of the European Court of Justice (ECJ). As a result, ECJ case law is also UK case law – even if the opinions are not published in English! In other words, the rights and remedies interpreted by the ECJ or the Advocate-General in cases such as Lankhorst-Hohorst (Germany – Case (C-324/00)), Walter Schmid (Austria – Case (C-516/99)) and Bosal Holdings (Netherlands – Case (C-200/98)) exist in UK law.

Furthermore, the exercise of rights conferred by EC law should be available on the same terms as they are available to nationals under national law. European Community nationals should not have to guess what procedure to apply or be forced to litigate to be able to enjoy their rights.

The jargon

Finally, a few pointers on terminology. Many sources of European law are relevant for tax advisers. This article focuses only on EC law, not EU law.

To understand how EC law fits into EU law, it helps to know that the EU has three pillars. The EC is the first pillar and is given legal personality by the EC treaty (of Rome, as updated). The single market freedoms referred to below, and the ECJ which interprets them, are created by the EC treaty.

The second and third pillars were added by the EU treaty (of Maastricht) – they aim to increase intergovernmental cooperation in common foreign and security policy and justice and home affairs. They involve EC institutions, but remain largely outside the EC legal structure.

Both the EC and EU treaties are substantially revised and updated by the treaties of Amsterdam and Nice.

It is not wrong to talk about EU law, but for the kind of claims discussed here it is usually more precise to talk in terms of EC law.

The ECJ currently staffed by 15 judges - one judge per member state - rules on the interpretation and application of EC law. The judges are assisted by eight Advocates-General, who are completely impartial and independent. Their role is to make reasoned submissions in open court on cases which require their involvement. Their opinions are usually, but not always, followed by the ECJ after a delay of three to six months.

Starting a claim
The starting point for a claim under EC law is a difference in treatment between nationals and non-nationals or residents and non-residents, which restricts an enforceable community right.

‘ … although direct taxation is a matter for the member states, they must, nevertheless, exercise their taxation powers consistently with community law.’:Compagnie de St Gobain ZN (C-307/97 para. 57).

As soon as you have that difference in treatment, it is up to the member state responsible to justify it – from this point of view member states are guilty until proved innocent rather than the other way round.

Enforceable community rights include: non-discrimination, freedom of establishment, the freedom to provide services and the free movement of capital and payments. Justifications of restrictions of such rights include public security and public health; they do not include loss of revenue for national governments; they could, in the right circumstances, include cohesion of national tax systems or the need to ensure the adequacy of fiscal supervision.

The result is that even though there is very little formal corporate tax harmonisation in the EU, companies can still make tax claims and high court claims based on EC law. Three cases serve to highlight the scope and opportunities for such claims. All three were heard in 2002 and represent current thinking in their area.

Tax free foreign source dividends

The Walter Schmid (C-516/99) case

Walter is an Austrian individual with dividend income from both Austrian and German shares. His Austrian shares suffer a 25 per cent withholding tax, after which there is no more tax to pay. His German shares, however, are taxed in Austria at his upper rate of income tax, which is 50 per cent. He appealed against his 1997 income tax assessment requesting that dividends from his German shares be taxed at 25 per cent.

In January 2002, the Advocate-General of the ECJ agreed that the Austrian measure was a restriction on the free movement of capital.

The UK rules are not dissimilar from those in Austria. United Kingdom resident individuals and companies are taxed in the UK at different rates depending on whether their dividend income is UK source or foreign source. Indeed, a UK holding company is only taxed on its foreign source dividend income. Following Walter Schmid this appears to be a restriction on the free movement of capital. United Kingdom holding companies should consider claims that foreign source dividends should be exempt from tax.

There was an unfortunate twist in Walter’s particular case. The ECJ returned the case to the referring tribunal on a technicality (the Austrian court was part of the tax inspectorate and not an independent court). So although there was a strong recommendation on how to decide the case the ECJ did not deliver the solution.

Fortunately for UK claimants, there is other supporting case law. But procedure and tactics will be crucial for a successful claim.

Cross-border loss relief

The Bosal Holdings (C-200/98) Case

Bosal is a Dutch company that borrowed money in 1993 to finance shareholdings in companies established outside the Netherlands, but within the EU. Bosal claimed a tax deduction for the loan interest, but this deduction was denied under Dutch law. Essentially, a Dutch company only gets a tax deduction if the subsidiary has a source of income in the Netherlands: the subsidiary must be a Dutch company or a foreign company with a Dutch branch.

‘When ascertaining profits, profits from a participating interest and costs associated with a participating interest, are left out of account, unless these costs serve directly to achieve the profit taxable in the Netherlands (exemption for participating interests).’
(Article 13 (1) Dutch Corporation Tax Act 1969)

The case ended up before the Dutch Supreme Court, which referred two questions to the ECJ before which Bosal, the Netherlands, the UK and the European Commission were all represented.

1. ‘Does [the freedom of establishment] or any other provision of community law, prevent a member state from permitting a parent company subject to taxation in that member state from deducting costs connected with a participating interest held by it, only if the subsidiary concerned achieves a profit that is taxable in the member state where the parent company is established?
2. Does it make a difference … if the member state concerned takes account of the costs in question when taxing the subsidiary in the event of the subsidiary but not the parent company being subject to tax on its profits in that member state?’
(Dutch Supreme Court referral to ECJ in Bosal Holdings (C-200/98))

In their submission before the Advocate-General in July 2002 the Netherlands argued that the difference in treatment arose from a disparity between national tax systems, but was not precluded by the Treaty of Rome. The costs of a foreign investment fell ‘between the dock and the side of the ship’, as the Dutch saying goes. If the difference in treatment was an obstacle to the single market, then it was justified by the need to protect the Dutch tax base and preserve the cohesion of the Dutch system.

The UK government supported the Dutch government. It argued that the Dutch system is fair because there is a direct link between the deductibility of costs and whether the profits are taxable in the Netherlands. Bosal was asking for a ‘double whammy’ by asking the Dutch government to forego levying a tax on gains and also forego taxing profits by allowing deductions.

The Advocate-General rejected the idea that a country should be able to point to the way a subsidiary company is taxed in order to justify the way it taxes a parent. In his view the cohesion principle can only justify a restriction if there is one taxpayer and a direct link between the granting of a tax advantage and the off-setting of this advantage by a tax charge. It makes no difference if the member state concerned, in the event of the subsidiary and not the parent company being subject to profits tax in that member state, takes these costs into account when taxing the subsidiary.

‘The Dutch government links a tax advantage to the parent company in the form of the deductibility of participating costs with the possibility of a tax charge on the subsidiary. In the view of the Dutch and UK governments, this linkage establishes the cohesion of the system. However, this seems to overlook that parent companies and subsidiaries – unlike branch offices or permanent establishments – are mutually different legal persons each with their own legal personality. They are subject to separate taxation.’
(Advocate General opinion Bosal Holdings (C-200/98 para. 63–64))


For accounting periods ending after 31 March 2000, UK loss relief rules require claiming and surrendering companies to have a source of trading income in the UK (ICTA 1998, s. 403). These are very similar to the provisions affecting Bosal Holdings – little wonder then that the UK government intervened to support the Dutch government at the ECJ hearing.

The ECJ completes its deliberations in December 2002. If it confirms the opinion of the Advocate-General, as it normally does, then the Inland Revenue can expect a flood of claims from UK companies for cross-border loss-relief, tax-free foreign source dividends, capital gains deferral and other tax advantages normally reserved for the parents of UK groups.

Already a number of major multinationals are beginning to take seriously the possibility of a UK company claiming loss-relief for the losses of EU resident companies in the same group, based on EC law or tax treaty non-discrimination. A major UK retailer will have its claim heard before the Special Commissioners in November 2002. The decision and arguments in Bosal Holdings can only be helpful to its case.

For most groups the next step is relatively simple: for group relief claims which are still in time under UK principles, consider filing an amended tax return showing a cross-border loss relief claim. For earlier periods, a High Court claim is most likely to be required, but it should be possible to obtain a stay in proceedings until there is a decision in the pending case.

Thin capitalisation

The Lankhorst-Hohorst (C-324/00)Case

Lankhorst-Hohorst is a loss making German company with very little equity, that borrowed money from its Dutch grandparent, Lankhorst-Taselaar. German thin capitalisation rules prevented a tax deduction for interest on this loan outside a fixed ratio of debt to equity. Had the loan been from a German company, there would have been no disallowance.

The governments of Germany, Denmark and the UK argued that thin capitalisation provisions prevent the arbitrary transfer of the tax liability from one country to another and ensure taxation at the point at which the profit has actually accrued. All three governments referred to Organisation for Economic Cooperation and Development (OECD) Model Tax Convention Art. 9 which provides for add backs for tax purposes where transactions between associated enterprises are not made at arm’s length.

The Advocate-General was unmoved, dismissed the relevance of the OECD model treaty because it has different objectives from the EC treaty, and declared the current German thin capitalisation provisions unenforceable.

‘The true objective of the thin capitalisation rule … is to prevent Germany from losing a certain amount of tax revenue through the use by the taxpayer (or its shareholder) of a financing technique which in itself is not prohibited … Such an objective does not appear to me, however, within the context of [the freedom of establishment], to constitute an overriding reason of general interest to justify a difference in treatment.’ (Advocate General’s opinion Lankhorst-Hohorst (C-324/00 para. s 76-77).)

This is much more than a German thin capitalisation case, and for the moment at least, it threatens the whole operation of thin capitalisation legislation in the EU.

For example, UK rules restrict European groups by treating UK-UK debt differently from UK-EU debt on the basis of the nationality of the lender. Furthermore, foreign group companies are excluded when calculating gearing and interest cover for the purposes of applying thin capitalisation rules and the Revenue even holds back treaty clearance when thin capitalisation ratios are exceeded.

The final decision in this case is due within the next couple of months. If the Advocate-General’s opinion is upheld there will almost certainly be amendments to national rules to protect the domestic tax base. Indeed even the Advocate-General specifically noted the potential remedy of applying thin capitalisation rules to intra-Germany loans, if it wished to continue to restrict interest deductions in thinly capitalised companies.

‘It is for the German authorities to assess whether the impugned legislation should be replaced, for example, by a provision that extends the rules on the re-classification of interest as dividends to subsidiaries having a resident parent company. Until such time, however, the legislation at issue cannot be applied.’
(Advocate General’s opinion Lankhorst-Hohorst (C-324/00 para. 99))

However, in the meantime, UK groups that have suffered a thin capitalisation restriction in any EU country – including the UK – should re-evaluate their position as a matter of urgency.

Similarly, groups which have suffered a transfer pricing adjustment or controlled foreign company (CFC) assessment should evaluate whether to make a claim.

Don’t just wait and see
Together, these three examples demonstrate that national tax advantages must be opened up to nationals of other EU member states under EC law – that subsidiaries cannot be treated differently based on the seat of the parent and parents cannot be treated differently based on the seat of the subsidiary.

For those working in tax this is an obvious area for action. Opportunities under EC law need to be taken when they arise – and before time limits kick in to restrict claims. Companies should act now to systematically identify all possible claims in the worldwide group and take the necessary steps to secure their position.

Technical Department
020 7235 9381

December 2002 by


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