Sita UK Ltd v Greater Manchester Waste Disposal Authority

JurisdictionEngland & Wales
JudgeLord Justice Stanley Burnton,Lord Justice Rimer,Lady Justice Arden,Lord Justice Elias
Judgment Date24 February 2011
Neutral Citation[2011] EWCA Civ 156
Docket NumberCase Nos: A3/2010/0214 & 0215,Case No: A3/2010/0907
CourtCourt of Appeal (Civil Division)
Date24 February 2011
Between
Test Claimants in the Thin Cap Group Litigation
Claimants, Appellants and Respondents
and
Commissioners for Her Majesty's Revenue and Customs
Defendants, Appellants and Respondents

Mr Justice Henderson

Before: Lady Justice Arden

Andlord Justice Rimer

and

Lord Justice Stanley Burnton

Case Nos: A3/2010/0214 & 0215

IN THE HIGH COURT OF JUSTICE

COURT OF APPEAL (CIVIL DIVISION)

ON APPEAL FROM THE HIGH COURT OF JUSTICE

CHANCERY DIVISION

David Ewart QC, Rupert Baldry QC and Sarah Ford (instructed by the Solicitor for HMRC) for the Appellant Defendants

Graham Aaronson QC, David Cavender QC and Laura Poots) (instructed by Dorsey & Whitney (Europe) LLP) for the Respondent Claimants

Hearing dates: 18, 19, 20, 21 October 2010

Lord Justice Stanley Burnton

Lord Justice Stanley Burnton:

Introduction

1

On 17 November 2009, Henderson J gave judgment on preliminary issues in claims made by the Test Claimants in the Thin Cap Litigation against the Commissioners for Her Majesty's Revenue and Customs (to whom I shall refer as "the Revenue"). His judgment is reported on BAILII and at [2010] STC 301. Both the Claimants and the Revenue have appealed against those of his decisions that were adverse to their respective cases.

2

As in the case of The Test Claimants in the Franked Investment Income Group Litigation v The Revenue [2010] EWCA Civ 103, the Claimants in the present case contend that provisions of UK corporate tax legislation (in the present case, those in force until 2004) were incompatible with a fundamental freedom conferred by the EC Treaty. In that case too the judge at first instance was Henderson J. As in that case, his judgment in the present case is careful, clear and detailed. I express my admiration and gratitude for it, and I have been able to incorporate much of it in my judgment.

What is "thin cap" legislation?

3

"Thin cap" is an abbreviation of "thin capitalisation". Like transfer pricing legislation, thin cap legislation seeks to address what the Revenue considers to be transfers of profits, and therefore transfers of tax bases, from this jurisdiction to another. The subject was explained by Advocate General Geelhoed in the reference for a preliminary ruling in the present case to the Court of Justice of the European Communities ("the ECJ"):

3. There are two principal means of corporate finance: debt and equity finance. Many Member States draw a distinction in the direct tax treatment of these two forms of finance. In the case of debt finance, companies are generally permitted to deduct interest payments on loans for the purpose of calculating their taxable profits (i.e., pre-tax), on the basis that this constitutes current expenditure incurred for the pursuit of the business activities. In the case of equity finance, however, companies are not permitted to deduct distributions paid to shareholders from their pre-tax profits; rather, dividends are paid from taxed earnings.

4. This difference in tax treatment means that, in the context of a corporate group, it may be advantageous for a parent company to finance one of the group members by means of loans rather than equity. The tax incentive to do so is particularly evident if the subsidiary is located in a relatively "high-tax" jurisdiction, while the parent company (or indeed an intermediate group company which provides the loan) is located in a lower-tax jurisdiction. In such circumstances, what is in substance equity investment may be presented in the form of debt in order to obtain a more favourable tax treatment. This phenomenon is termed "thin capitalisation". By thus manipulating the manner in which capital is provided, a parent company can effectively choose where it wishes profits to be taxed.

5. Many States, viewing thin capitalisation as abusive, have implemented measures aimed at countering this abuse. These measures typically provide for loans which fulfil certain criteria to be regarded for tax purposes as disguised equity capital. This means that interest payments are recharacterised as profit distributions, so the subsidiary cannot deduct all or part of the interest payment from its taxable income, and the payment is subject to any applicable rules on dividend taxation.

4

For present purposes, two forms of tax avoidance may be regarded as paradigms. The first is appropriately referred to as thin cap, and is that referred to in the extract from the Advocate General's opinion cited above. The second paradigm involves a loan by the parent company (or another non-UK subsidiary) of an appropriate amount, but setting a rate of interest in excess of that which would be agreed between unconnected parties. By setting and paying an excessive interest rate, the profits of the subsidiary are excessively reduced. The aim of thin cap legislation would be to treat the interest as if it were payable at a reasonable rate, and to disallow the excess as a deduction from the gross profits of the subsidiary.

5

Abuses of the kind referred to above have long been recognised, and not surprisingly thin cap legislation is common internationally. However, abuse in the sense of deliberate evasion of tax is not the only possible object of thin cap legislation. Another is the regulation and preservation of the national tax base. In this connection, it is useful to refer to Article 9 of the OECD Model Convention with respect to Taxes on Income and Capital:

ASSOCIATED ENTERPRISES

1. Where

a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or

b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State,

and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.

6

It can be seen that Article 9 is not confined to deliberately abusive transactions. It applies a simple arm's length test to transactions between related companies. This test, commonly found in national legislation, was clearly regarded as appropriate by the 33 Member States of the OECD.

7

The difficulty in framing thin cap legislation within the EU is that the problem it seems to address is generally confined to international groups of companies. Generally, for a UK parent to set an excessive interest rate on its lending to its UK subsidiary will be tax neutral. In principle, the excessive interest received by the parent will be taxed in its hands at the same rate as it would have been had it not been payable by the subsidiary and had therefore not been taken into account in assessing its taxable profits. (For present purposes, I leave out of account the possibility that the parent has allowances or accumulated losses that it can set against its profits.) If, however, the excessive interest is payable to a foreign company, without appropriate thin cap legislation the consequence is that the UK tax base is reduced by the amount of that excess. It is therefore generally pointless to extend thin cap legislation domestically, and to do so imposes unnecessary administrative burdens on domestic companies and on the Revenue. However, if the legislation is confined to international transfers, it is necessarily discriminatory, and there is a risk of it being held unlawfully to interfere with a basic freedom conferred by the EC Treaty, and specifically Articles 43, 49 and 56. The cases in which the ECJ has considered thin cap legislation highlight the tension, if not the inconsistency, between national jurisdiction over direct taxation and EC Treaty freedoms, at least once those freedoms are interpreted as prohibiting unjustified differential tax treatment of national and foreign EU companies.

The UK tax rules

8

The UK tax rules were helpfully summarised by Henderson J in his judgment.

The rules applicable until 1995

18. Prior to their amendment by the Finance Act 1995, the main relevant domestic provisions were contained in s.209(2) of the Income and Corporation Taxes Act 1988 ( ICTA).

19. Section 209(2)(d) provided that any interest paid by a company on a loan which represented more than a reasonable commercial return on the loan was to be regarded as a distribution of profits to the extent that it exceeded such return. The provision was in the following terms:

"(2) In the Corporation Tax Acts 'distribution', in relation to any company, means –

(d) any interest or other distribution out of assets of the company in respect of securities of the company, where they are securities under which the consideration given by the company for the use of the principal thereby secured represents more than a reasonable commercial return for the use of that principal, except so much, if any, of any such distribution as represents that principal and so much as represents a reasonable commercial return for the use of that principal."

"Security" was defined in s.254(1) as including securities not creating or evidencing a charge on assets, and it was also provided that interest paid by a company on money advanced without the issue of a security for the advance, or other consideration given by a company for the use of money so advanced,...

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