Test Claimants in Thin Cap Group Litigation v R & C Commissioners
| Jurisdiction | England & Wales |
| Judgment Date | 18 February 2011 |
| Neutral Citation | [2011] EWCA Civ 127 |
| Date | 18 February 2011 |
| Court | Court of Appeal (Civil Division) |
[2011] EWCA Civ 127.
Court of Appeal (Civil Division).
Arden, Rimer and Stanley Burnton L JJ.
David Ewart QC, Rupert Baldry QC and Sarah Ford (instructed by the Solicitor for HMRC) for the appellants.
Graham Aaronson QC, David Cavender QC and Laura Poots (instructed by Dorsey & Whitney (Europe) LLP) for the taxpayers.
The following cases were referred to in the judgment:
Amministrazione delle Finanze dello Stato v San Giorgio SpAECAS (Case 199/82) [1983] ECR 3595
Imperial Chemical Industries plc v ColmerECASTAX (Case C-264/96) [1998] BTC 304; [1998] ECR I-4695
Lankhorst-Hohorst GmbH v Finanzamt SteinfurtECASTAX (Case C-324/00) [2003] BTC 254; [2002] ECR I-11779
Marks & Spencer plc v Halsey (HMIT)ECASTAX (Case C-446/03) [2006] BTC 318; [2005] ECR I-10837
Oy AAECASTAX (Case C-231/05) [2011] BTC 150; [2007] ECR I-6373
Société de Gestion Industrielle SA (SGI) v BelgiumECASTAX (Case C-311/08) [2011] BTC 123
Test Claimants in the FII Group Litigation v IR CommrsECASTAX (Case C-446/04) [2008] BTC 222; [2006] ECR I-11753
Test Claimants in the FII Group Litigation v IR CommrsUNKTAXUNKTAX [2010] EWCA Civ 103; [2010] BTC 265 (CA); [2008] EWHC 2893 (Ch); [2009] BTC 443
Test Claimants in the Thin Cap Group Litigation v IR CommrsECASTAX (Case C-524/04) [2008] BTC 348; [2007] ECR I-2107
Woolwich Equitable Building Society v IR CommrsTAXELR [1992] BTC 470; [1993] AC 70
Corporation tax - Thin capitalisation - Tax avoidance - Freedom of establishment - Arm's length test - Discrimination - Justification - Loan interest paid to related company resident in another member state or in non-member country - National legislation on thin capitalisation giving rise to potential restriction on freedom of establishment - Whether thin cap legislation permissible under EU law if it affected transactions between related companies other than on arm's length terms - Whether thin cap legislation unlawfully infringed freedom of establishment if it affected genuine commercial transactions - HMRC's appeal allowed - Taxpayers' cross-appeal dismissed - Article 43 EC.
These were an appeal by HMRC and a cross-appeal by the taxpayers in proceedings which were part of group litigation concerning the UK rules on thin capitalisation.
Each of the taxpayers was a UK-resident company which was at least 75 per cent owned, directly or indirectly, by a non-resident parent company and had been granted a loan either by that parent company or by another non-resident company which was at least 75 per cent owned, directly or indirectly, by that parent company.
Following the judgment of the European Court of Justice (ECJ) in Lankhorst-Hohorst GmbH v Finanzamt Steinfurt (Case C-324/00) [2003] BTC 254; [2002] ECR I-11779, the taxpayers brought claims for restitution and/or compensation for the consequential tax disadvantages which they claimed to have suffered as a result of the application of the UK legislation, including, in particular, the additional corporation tax paid following the decision of the UK tax authorities to disallow interest paid as a deduction against their taxable profits and/or to limit such deductions, and the additional tax arising as a result of those companies having converted loans to equity. A group litigation order was made and the High Court referred questions to the ECJ for a preliminary ruling on the proper interpretation of art. 43 EC.
The ECJ ((Case C-524/04) [2008] BTC 348; [2007] ECR I-2107) ruled that the national provisions relating to thin capitalisation gave rise to a difference in treatment between resident borrowing companies according to whether or not the related lending company was established in the UK. Such legislation would be considered a restriction on freedom of establishment if it was capable of restricting the exercise of that freedom in one member state by companies established in another member state. It followed that the difference in treatment constituted a restriction on freedom of establishment which was permissible only if it was justified by overriding reasons of public interest and did not go beyond what was necessary to attain it. The question whether the restriction was justified depended on whether the rules allowed taxpayers, where a transaction did not satisfy the arm's length test set out in ICTA 1988, s. 209(2)(da), to produce evidence of the commercial justification for that transaction. In the light of that ruling, a number of issues in the test claims were directed to be tried.
The judge held that the relevant UK provisions were consistent with the arm's length test envisaged by the European Court of Justice. However, the thin cap legislation was incompatible with art. 43 as the provisions were not proportionate to achieving the purpose of preventing abusive tax avoidance, as they did not allow for a separate defence of commercial justification ([2009] EWHC 2908 (Ch); [2009] BTC 754).
HMRC appealed, contending that the thin cap legislation was permissible under Community law if it affected transactions between related companies that were other than on arm's length terms even if those transactions were commercially justified. The taxpayers argued that the failure of the UK legislation to permit a commercial justification of transactions that were not on arm's length terms infringed art. 43. The taxpayers also submitted that, when applying the arm's length test to a subsidiary within a group of companies, the UK legislation failed to take into account the fact that the subsidiary was within that group. That submission involved a challenge to the finding of Henderson J that the UK provisions were consistent with the arm's length test envisaged by the ECJ.
Held, allowing HMRC's appeal and dismissing the taxpayers' cross-appeal (Arden LJ dissenting in part):
1. It was clear from the case-law of the ECJ that the objectives of ensuring the balanced allocation between member states of the power to tax, together with the prevention of tax avoidance, might justify legislation that would otherwise be an unlawful interference with the freedom of establishment guaranteed by art. 43, and that the application of an arm's length test was appropriate and sufficient for that purpose. It was a proportionate measure to achieve those objectives. The taxpayers' contention that thin cap legislation could be justified only if it was confined to abusive or sham transactions had to be rejected. Legislation that involved the application of the arm's length test, as embodied in art. 9 of the OECD Model Convention, did not unlawfully interfere with art. 43 EC, provided the taxpayer was given an adequate opportunity to present his case to the tax authority that the transaction in question was on arm's length terms, and could challenge the decision of the tax authority before the national court, and, secondly, that the effect of the legislation was limited to those aspects of the advantage conferred by the taxpayer company that did not satisfy that test. There was no doubt that the UK legislation satisfied all of those requirements. It applied the arm's length test; it did not disallow any interest that would have been payable under a transaction on arm's length terms; the taxpayer was given an adequate opportunity to present its case, and it had recourse to the courts if dissatisfied with the decision of the Revenue. (Oy AA (Case C-231/05) [2011] BTC 150; [2007] ECR I-6373 and Societe de Gestion Industrielle SA (SGI) v Belgium (Case C-311/08) [2011] BTC 123 applied.)
2. It was not open to the taxpayers, in the light of the ECJ's judgment in the instant case, to argue that the UK legislation did not provide an appropriate objective test based on the arm's length principle. The ECJ was clearly aware of the effect of the UK legislation. There was nothing in the judgment of the ECJ to suggest that UK legislation might be incompatible because of its failure to take into account a subsidiary's membership of a non-UK group of companies. The only matters left open in the judgment (as clarified by the judgments in Oy AA and SGI) were whether UK law gave an adequate opportunity to the taxpayer to present his case, and whether it had access to the courts if dissatisfied with the Revenue's ruling. Nor was the UK arm's length test more stringent than the OECD test.
3. The decision of Henderson J was inconsistent with the judgments of the ECJ in Oy AA and SGI, and with the judgment of the ECJ in the instant case, as explained and applied in those judgments. The commercial justification that the taxpayer companies could have put forward for their transactions was that their terms were those which would have been agreed between unconnected parties. Since that was the test applied by the UK legislation, the fact that the taxpayer could not put forward some other commercial justification did not render the UK legislation incompatible with their or their parent companies' freedom of establishment. The taxpayers' transactions in issue did not satisfy the arm's length test, and the UK thin cap legislation was appropriately and lawfully applied to them.
4. (Per Arden LJ) The ECJ had not cast doubt on its decision in Lankhorst-Hohorst which appeared to hold that a domestic rule which did not permit the deduction of interest paid by a resident subsidiary on a loan made by its non-resident parent other than on arm's length terms, in circumstances where interest on a similar loan by a resident parent company would be deductible, was contrary to European Union law if the loan could be shown to be capable of commercial justification. The facts of Lankhorst-Hohorst appeared to show that there could be transactions that were not at arm's length that could not be described as abusive and that the taxpayer had to be given an opportunity to show that, even though the terms were not such as would have been agreed between parties at arm's length, they were...
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