“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”
“37. As regards more specifically the justification based on the risk of tax evasion, it is important to note that the legislation at issue here does not have the specific purpose of preventing wholly artificial arrangements, designed to circumvent German tax legislation, from attracting a tax benefit, but applies generally to any situation in which the parent company has its seat, for whatever reason, outside the Federal Republic of Germany. Such a situation does not, of itself, entail a risk of tax evasion, since such a company will in any event be subject to the tax legislation of the state in which it is established … .”
“(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 section 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, should be treated in the same way as if a security had been issued. So the scope of the paragraph extended to simple unsecured loans. … (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;”
“Where, owing to a special relationship between the payer and the recipient or between both of them and some other person, the amount of the interest paid, having regard to the debt-claim for which it is paid, exceeds the amount which would have been agreed upon by the payer and the recipient in the absence of such relationship, the provisions of this article shall apply only to the last-mentioned amount. In that case, the excess part of the payments shall remain taxable according to the law of each Contracting State, due regard being had to the other provisions of this Convention.”
“Where, owing to a special relationship between the payer and the person deriving the interest or between both of them and some other person, the amount of the interest exceeds for whatever reason the amount which would have been paid in the absence of such relationship, the provisions of this article shall apply only to the last-mentioned amount. In that case, the excess part of the payments shall remain taxable according to the law of each contracting state, due regard being had to the other provisions of this convention.”
“(a) the question whether the loan would have been made at all in the absence of the relationship, (b) the amount which the loan would have been in the absence of the relationship, and (c) the rate of interest and other terms which would have been agreed in the absence of the relationship.”
“(2) In the Corporation Tax Acts “distribution”, in relation to any company, means – … (da) any interest or other distribution out of assets of the company (“the issuing company”) in respect of securities issued by that company which are held by another company where – (i) the issuing company is a 75 per cent subsidiary of the other company or both are 75 per cent subsidiaries of a third company, and (ii) the whole or any part of the distribution represents an amount which would not have fallen to be paid to the other company if the companies had been companies between whom there was (apart from in respect of the securities in question) no relationship, arrangements or other connection (whether formal or informal), except so much, if any, of any such distribution as does not represent such an amount or as is a distribution by virtue of paragraph (d) above or an amount representing the principal secured by the securities;” … (da) any interest or other distribution out of assets of the company (“the issuing company”) in respect of securities issued by that company which are held by another company where – (i) the issuing company is a 75 per cent subsidiary of the other company or both are 75 per cent subsidiaries of a third company, and (ii) the whole or any part of the distribution represents an amount which would not have fallen to be paid to the other company if the companies had been companies between whom there was (apart from in respect of the securities in question) no relationship, arrangements or other connection (whether formal or informal), except so much, if any, of any such distribution as does not represent such an amount or as is a distribution by virtue of paragraph (d) above or an amount representing the principal secured by the securities;”
“Repayments in respect of loan capital which a company limited by shares subject to unlimited taxation has obtained from a shareholder not entitled to corporation tax credit which had a substantial holding in its share or nominal capital at any point in the financial year shall be regarded as a covert distribution of profits … (2) where repayment calculated as a fraction of the capital is agreed and the loan capital is more than three times the shareholder’s proportional equity capital at any point in the financial year, save where the company limited by shares could have obtained the loan capital from a third party under otherwise similar circumstances or the loan capital constitutes borrowing to finance normal banking transactions … ”
“33. It must still be established whether a national measure such as that in Paragraph 8a(1) … pursues a legitimate aim which is compatible with the Treaty and is justified by pressing reasons of public interest. In that event, it must also be such as to ensure achievement of the aim in question and not go beyond what is necessary for that purpose … 34. First, the German, Danish and United Kingdom Governments and the Commission submit that the national measure at issue in the main proceedings is intended to combat tax evasion in the form of the use of “thin capitalisation” or “hidden equity capitalisation”
“92. The answer to Questions 1 and 3 must therefore be that Article 43 EC precludes legislation of a Member State which restricts the ability of a resident company to deduct, for tax purposes, interest on loan finance granted by a direct or indirect parent company which is resident in another Member State or by a company which is resident in another Member State and is controlled by such a parent company, without imposing that restriction on a resident company which has been granted loan finance by a company which is also resident, unless, first, that legislation provides for a consideration of objective and verifiable elements which make it possible to identify the existence of a purely artificial arrangement, entered into for tax reasons alone, and allows taxpayers to produce, if appropriate and without being subject to undue administrative constraints, evidence as to the commercial justification for the transaction in question and, secondly, where it is established that such an arrangement exists, such legislation treats that interest as a distribution only in so far as it exceeds what would have been agreed upon at arm’s length.”
“74. In order for a restriction on the freedom of establishment to be justified on the ground of prevention of abusive practices, the specific objective of such a restriction must be to prevent conduct involving the creation of wholly artificial arrangements which do not reflect economic reality, with a view to escaping the tax normally due on the profits generated by activities carried out on national territory (Cadbury Schweppes and Cadbury Schweppes Overseas, paragraph 55). 75. Like the practices referred to in paragraph 49 of the judgment in Marks & Spencer, which involved arranging transfers of losses incurred within a group of companies to companies established in the Member States which applied the highest rates of taxation and in which the tax value of those losses was therefore the greatest, the type of conduct described in the preceding paragraph is such as to undermine the right of the Member States to exercise their tax jurisdiction in relation to the activities carried out in their territory and thus to jeopardise a balanced allocation between Member States of the power to impose taxes (Cadbury Schweppes and Cadbury Schweppes Overseas, paragraph 56). 76. As the United Kingdom Government observes, national legislation such as the legislation at issue in the main proceedings is targeted at the practice of thin capitalisation, under which a group of companies will seek to reduce the taxation of profits made by one of its subsidiaries by electing to fund that subsidiary by way of loan capital, rather than equity capital, thereby allowing that subsidiary to transfer profits to a parent company in the form of interest which is deductible in the calculation of its taxable profits, and not in the form of non-deductible dividends. Where the parent company is resident in a State in which the rate of tax is lower than that which applies in the State in which its subsidiary is resident, the tax liability may thus be transferred to a State which has a lower tax rate. 77. By providing that that interest is to be treated as a distribution, such legislation is able to prevent practices the sole purpose of which is to avoid the tax that would normally be payable on profits generated by activities undertaken in the national territory. It follows that such legislation is an appropriate means of attaining the objective underlying its adoption.”
“79. As the Court held in paragraph 37 of its judgment in Lankhorst-Hohorst, that requirement is not met by national legislation which does not have the specific purpose of preventing wholly artificial arrangements designed to circumvent that legislation, but applies generally to any situation in which the parent company has its seat, for whatever reason, in another Member State. 80. By contrast, legislation of a Member State may be justified by the need to combat abusive practices where it provides that interest paid by a resident subsidiary to a non-resident parent company is to be treated as a distribution only if, and in so far as, it exceeds what those companies would have agreed upon on an arm’s length basis, that is to say, the commercial terms which those parties would have accepted if they had not formed part of the same group of companies. 81. The fact that a resident company has been granted a loan by a non-resident company on terms which do not correspond to those which would have been agreed upon at arm’s length constitutes, for the Member State in which the borrowing company is resident, an objective element which can be independently verified in order to determine whether the transaction in question represents, in whole or in part, a purely artificial arrangement, the essential purpose of which is to circumvent the tax legislation of that Member State. In that regard, the question is whether, had there been an arm’s length relationship between the companies concerned, the loan would not have been granted or would have been granted for a different amount or at a different rate of interest. 82. As the Advocate General stated at point 67 of his Opinion, national legislation which provides for a consideration of objective and verifiable elements in order to determine whether a transaction represents a purely artificial arrangement, entered into for tax reasons alone, is to be considered as not going beyond what is necessary to prevent abusive practices where, in the first place, on each occasion on which the existence of such an arrangement cannot be ruled out, the taxpayer is given an opportunity, without being subject to undue administrative constraints, to provide evidence of any commercial justification that there may have been for that arrangement. 83. In order for such legislation to remain compatible with the principle of proportionality, it is necessary, in the second place, that, where the consideration of those elements leads to the conclusion that the transaction in question represents a purely artificial arrangement without any underlying commercial justification, the re-characterisation of interest paid as a distribution is limited to the proportion of that interest which exceeds what would have been agreed had the relationship between the parties or between those parties and a third party been one at arm’s length.”
“66. On this point [i.e. the question of proportionality], it is my view that, depending on its formulation and application, legislation aimed at avoiding thin capitalisation may in principle be a proportionate anti-abuse measure. It is true that the idea that companies have the right to structure their affairs as they wish means that, in principle, they should be allowed to finance their subsidiaries by equity or debt means. However, this possibility reaches its limit when the company’s choice amounts to abuse of law. It seems to me that the arm’s length principle, accepted by international tax law as the appropriate means of avoiding artificial manipulation of cross-border transactions, is in principle a valid starting point for assessing whether a transaction is abusive or not. To use the reasoning of the Court developed in the indirect tax sphere and other non-tax spheres, the arm’s length test represents in this context an objective factor by which it can be assessed whether the essential aim of the transaction concerned is to obtain a tax advantage. Moreover, it is in my view valid, and indeed to be encouraged, for Member States to set out certain reasonable criteria against which they will assess compliance of a transaction with the arm’s length principle, and in case of non-compliance with these criteria for them to presume that the transaction is abusive, subject to proof to the contrary. The setting out of such criteria is, to my eyes, in the interests of legal certainty for taxpayers, as well as workability for tax authorities. This approach is to be contrasted for example, with the use of a single fixed criterion to be applied in all cases – such as a fixed debt-equity ratio – which does not allow other circumstances to be taken into account. 67. However, the formulation and application in practice of such a test must also satisfy the requirements of proportionality. This means in my view that: (1) It must be possible for a taxpayer to show that, although the terms of its transaction were not arm’s length, there were nonetheless genuine commercial reasons for the transaction other than obtaining a tax advantage. In other words, as the Court noted in its Halifax judgment, “the prohibition of abuse is not relevant where the economic activity carried out may have some explanation other than the mere attainment of tax advantages” [Halifax Plc v Customs and Excise Commissioners (Case C-255/02 )[2006] Ch.387 , paragraphs 74 and 75]. An example that comes to mind is the situation on the facts in Lankhorst-Hohorst, where the purpose of the loan, as accepted by the Court, was a rescue attempt of the subsidiary via minimising the subsidiary’s expenses and achieving savings on bank interest charges. One could imagine, however, that similar situations (i.e., where a transaction was not concluded on arm’s length terms, but was nonetheless made non-abusively and not purely to obtain a tax advantage) would be relatively exceptional; (2) If such commercial reasons are put forward by the taxpayer, their validity should be assessed on a case-by-case basis to see if the transactions should be seen as wholly artificial [and] designed purely to gain a tax advantage; (3) The information required to be provided by the taxpayer in order to rebut the presumption should not be disproportionate or mean that it is excessively difficult or impossible to do so; (4) In cases where the payments are found to be abusive (disguised distributions) in the above sense, only the excess part of the payments over what would have been agreed on arm’s length terms should be re-characterised as a distribution and taxed in the subsidiary’s state of residence accordingly; and (5) The result of such examination must be subject to judicial review.” (1) It must be possible for a taxpayer to show that, although the terms of its transaction were not arm’s length, there were nonetheless genuine commercial reasons for the transaction other than obtaining a tax advantage. In other words, as the Court noted in its Halifax judgment, “the prohibition of abuse is not relevant where the economic activity carried out may have some explanation other than the mere attainment of tax advantages” [Halifax Plc v Customs and Excise Commissioners (Case C-255/02 )[2006] Ch.387 , paragraphs 74 and 75]. An example that comes to mind is the situation on the facts in Lankhorst-Hohorst, where the purpose of the loan, as accepted by the Court, was a rescue attempt of the subsidiary via minimising the subsidiary’s expenses and achieving savings on bank interest charges. One could imagine, however, that similar situations (i.e., where a transaction was not concluded on arm’s length terms, but was nonetheless made non-abusively and not purely to obtain a tax advantage) would be relatively exceptional; (2) If such commercial reasons are put forward by the taxpayer, their validity should be assessed on a case-by-case basis to see if the transactions should be seen as wholly artificial [and] designed purely to gain a tax advantage; (3) The information required to be provided by the taxpayer in order to rebut the presumption should not be disproportionate or mean that it is excessively difficult or impossible to do so; (4) In cases where the payments are found to be abusive (disguised distributions) in the above sense, only the excess part of the payments over what would have been agreed on arm’s length terms should be re-characterised as a distribution and taxed in the subsidiary’s state of residence accordingly; and (5) The result of such examination must be subject to judicial review.”
“84. In the present case, the documents before the Court show that, prior to the amendments made in 1995, the legislation in force in the United Kingdom provided that interest paid by a resident subsidiary in respect of a loan granted by a non-resident parent company was treated, in its entirety, as a distribution, with no assessment of whether the loan satisfied a relevant criterion, such as that of being granted at arm’s length, and without that subsidiary being given any opportunity to provide evidence as to any valid commercial justifications there may have been for the loan. 85. However, those documents also show that that legislation did not apply in cases involving a DTC which prevented the application of those rules and thus ensured that the interest in question was allowed as a deduction for tax purposes, provided that the rate of interest did not exceed what would have been agreed upon on an arm’s length basis. Under such a DTC, only that proportion of the interest which exceeded what would have been paid on an arm’s length basis was treated as a distribution. 86. Whilst a tax regime such as the regime which arises, in cases to which they apply, under the DTCs concluded by the United Kingdom appears initially to be based on a consideration of objective and verifiable elements which make it possible to determine whether a purely artificial arrangement, entered into for tax reasons alone, is involved, it is for the national court to determine, should it be established that the claimants in the main proceedings benefited from such a regime, whether that regime gave them an opportunity, if their transactions did not satisfy the conditions laid down under the DTC in order to assess their compatibility with the arm’s length criterion, to provide evidence as to any commercial justification there may have been for the transactions, without being subject to any undue administrative constraints. 87. The same applies to the national provisions in force after the legislative amendments introduced in 1995 and 1998. It is a matter of agreement that, under those provisions, it is only interest which exceeds what would be paid on an arm’s length basis that falls to be re-characterised as a distribution. Whilst, at first sight, the criteria laid down by those provisions appear to require a consideration of objective and verifiable elements in order to determine whether a purely artificial arrangement, entered into for tax reasons alone, is involved, it is for the national court to determine whether those provisions allow taxpayers, where the transaction does not satisfy the arm’s length criterion, to produce evidence of the commercial justifications for that transaction, under the conditions referred to in the preceding paragraph.”
“To my mind the extension of the exceptions to the CFC legislation for which counsel for HMRC contends is as permissible as either of those which found favour in [Ghaidan v Mendoza[2004] UKHL 30 ,[2004] 2 AC 557 and Revenue and Customs Commissioners v IDT Card Services Ireland Ltd[2006] EWCA Civ 29 ,[2006] STC 1252 ]. It does not alter the impact on other CFCs which are not excepted by any other exception. Certainly it provides an additional exception but, as counsel for HMRC submitted, the grain or thrust of the legislation recognises that the wide net cast by section 747(3) is intended to be narrowed by section 748. Further the terms of various exceptions were not intended to be either mutually exclusive or immutable as the ability to amend the conditions contained in various parts of Schedule 25 and the terms of para (e) of section 748(1) show.”
“70. However, the question of retro-activity is relevant to the question of the burden of proof since, as Mr Schlosser points out, claimants who know that they will have to establish certain facts are more likely to ensure that they have specific evidence of those facts than are those who do not. 71. To compile and retain such evidence may be a cumbersome task in situations such as the present, so that a trader might feel justified in not carrying it out if there were no current or foreseeable need to do so in order to be able to obtain reimbursement of any tax which he considered to be clearly incompatible with Community law and the imposition of which he knew caused him a loss. In particular, retail price calculations may not have taken the amount of tax specifically and separately into account if the trader did not expect to have to provide proof of his loss.”
“the essential difference between the two versions put forward by each party is whether the limitation on the freedom of establishment constituted by the justification found by the ECJ to be permissible is to be read into it so as to restrict the class of person who, in the words of Lord Walker of Gestingthorpe in [Fleming (trading as Bodycraft) v Revenue and Customs Commissioners[2008] UKHL 2 ,[2008] 1 WLR 195 ] at [49], “are so circumstanced that the offending provisions must not be invoked against them, either in particular cases or at all.””
“I appreciated the overall commercial background to the Henlys transaction. However, the cost was clearly in the UK whereas there was no guarantee that the benefits and the profits therefrom would be received or taxable in the UK.”
“The acquisition of BRS Ltd with its accumulated losses had the effect of increasing the gearing of [VTB] on a consolidated basis and depressing its consolidated earnings relative to its interest payments. As a result, [VTB] on a consolidated basis fell outside the ratios which HMRC had permitted in the agreements reached in December 2000 and interest disallowances resulted.”
“If NRH had been seeking to borrow from an unconnected party, it is inconceivable that such a third party lender would not have taken into account the fact that it was the UK holding company for one of the world’s largest multinational corporations.”
“I think it was. It was a typical scheme where there was a legitimate commercial purpose and legitimate commercial transaction. A fully artificial scheme was grafted on to it. I didn’t realise it at first when I was dealing with it, but by the end of the case I thought that was what happened. You may not welcome that as a view, but I am afraid that’s what I thought.”
“40. … This was because these ratios were considered an approximation of the arm’s length borrowing capacity of most UK companies. They were a rule of thumb that had been developed over the years by Inspectors experienced in dealing with thin capitalisation cases and represented an average between the high and low ratios seen in independent companies. It was also the view of HMRC, again developed through experience and reviewing numbers of loan agreements between independent parties, that UK lenders would seek a debt to equity ratio of 1:1 or less from independent borrowers. In the event of a borrower getting into difficulties, a receiver might be expected to realise only 50% or less of the value of assets on a [company’s] balance sheet. In these circumstances, if a company was financed equally by borrowed funds and share capital, then the bank would be able to recover its money.”
“Cross-border finance is a wide subject, and we challenge not only abusive schemes, but also “genuine” group transactions which result in the UK interest draw being higher than it would otherwise be in a wholly arm’s length situation.”
“94. In that regard, it must be noted, first of all, that, as was stated in paragraph 61 of this judgment, national legislation such as the legislation at issue in the main proceedings which, in treating interest paid by a resident subsidiary to a parent company as a distribution, applies a difference in treatment between resident subsidiaries which is based on the place where their parent company has its seat, constitutes a restriction on freedom of establishment, since it makes it less attractive for companies established in other Member States to exercise freedom of establishment and they may, in consequence, refrain from acquiring, creating or maintaining a subsidiary in the Member State which adopts such a measure. 95. It follows that legislation of this kind constitutes a restriction on freedom of establishment which is prohibited, in principle, by Article 43 EC, both where a resident borrowing company is granted a loan by a company which is established in another Member State and has a direct or indirect holding in the capital of the borrowing company, conferring on it definite influence on the decisions of that company and allowing it to determine its activities, and where a borrowing company is granted a loan by another non-resident company which, irrespective of where it is resident, is itself controlled by a company which is resident in another Member State and which has, directly or indirectly, such a holding in the capital of the borrowing company.”
“The [present] case therefore confirms, if confirmation were needed, that FII represents the current, and carefully considered, jurisprudence of the ECJ on these topics.”
“104. As I observed in my Opinion in the FII case, the Court has consistently held that the right to a refund of charges levied in a Member State in breach of rules of Community law is the consequence and complement of the rights conferred on individuals by Community provisions as interpreted by the Court. The Member State is therefore required in principle to repay charges levied in breach of Community law. In the absence of Community rules on the recovery of sums unduly paid, it is for the domestic legal system of each Member State to designate the courts and tribunals having jurisdiction and to lay down the detailed procedural rules governing actions for safeguarding rights which individuals derive from Community law, provided, first, that such rules are not less favourable than those governing similar domestic actions (principle of equivalence) and, second, that they do not render practically impossible or excessively difficult the exercise of rights conferred by Community law (principle of effectiveness). 105. The question raised in the present case is precisely the same as that raised in the FII case; namely whether the plaintiffs’ claims should be characterised as claims in restitution, damages or for an amount representing a benefit unduly denied. 106. In that case, I noted (with reference to the Metallgesellschaft case) that in principle, it is for the national court to decide how the various claims brought should be characterised under national law. However, this is subject to the condition that the characterisation should allow the Test Claimants an effective remedy in order to obtain reimbursement or reparation of the financial loss which they had sustained and from which the authorities of the Member State concerned had benefited as a result of the payment of the unlawfully levied tax. This obligation requires the national court, in characterising claims under national law, to take into account the fact that the conditions for damages as set out in Brasserie du Pêcheur may not be made out in a given case and, in such a situation, ensure that an effective remedy is nonetheless provided. 107. Applying this to the present case, it seems to me that the heads of relief put forward by the Test Claimants should be assessed under the principles set out in the Court’s case-law on recovery of charges unlawfully levied; that is, the UK should not profit and companies (or groups of companies) which have been required to pay the unlawful charge must not suffer loss as a result of the imposition of the charge. As such, in order that the remedy provided to the Test Claimants should be effective in obtaining reimbursement or reparation of the financial loss which they had sustained and from which the authorities of the Member State concerned had benefited, this relief should in my view extend to all direct consequences of the unlawful levying of tax. Prima facie, this would to my mind include: (1) repayment of unlawfully levied corporation tax (Question 5(a), (b), (c), (d)); (2) restoration of relief used to offset unlawfully levied corporation tax (Question 5(e)); and (3) repayment of un-utilised advance corporation tax paid on wrongly re-characterised distributions (Question 5(f)). I would emphasise, however, that it is for the national court to satisfy itself that the relief claimed was a direct consequence of the unlawful levy charged.”
“On the other hand, it is also clear, to my mind, that the test of causation for the recovery of consequential loss under the San Giorgio principle must be a strict one. The Advocate General used the phrase “direct consequences”, and the ECJ used the phrase “an inevitable consequence” (in French “une conséquence inévitable”). I do not regard these expressions as necessarily conflicting with each other, or as intended to provide an exhaustive definition. They reflect rather the need for a direct and unbroken causal link, and an approach to causation which is considerably more stringent than that applicable to a Factortame damages claim …”
“I only comment that, at a time when Community law is becoming increasingly important, it would be strange if the right of the citizen to recover overpaid charges were to be more restricted under domestic law than it is under European law.”
“115. While it has not gone so far as to rule out the possibility of a State being liable in less restrictive conditions on the basis of national law, the Court has held that there are three conditions under which a Member State will be liable to make reparation for loss and damage caused to individuals as a result of breaches of Community law for which it can be held responsible, namely that the rule of law infringed must be intended to confer rights on individuals, that the breach must be sufficiently serious, and that there must be a direct causal link between the breach of the obligation resting on the State and the loss or damage sustained by the injured parties …”
“… in particular as to whether, given the state of the case-law on the interpretation of the relevant Community provisions, the breach was excusable?”
“118. As regards the second condition, it should be pointed out, first, that a breach of Community law will be sufficiently serious where, in the exercise of its legislative power, a Member State has manifestly and gravely disregarded the limits on its discretion. Secondly, where, at the time when it committed the infringement, the Member State in question had only considerably reduced, or even no, discretion, the mere infringement of Community law may be sufficient to establish the existence of a sufficiently serious breach (Test Claimants in the FII Group Litigation, paragraph 212 and the case-law cited there). 119. In order to determine whether a breach of Community law is sufficiently serious, it is necessary to take account of all the factors which characterise the situation brought before the national court. Those factors include, in particular, the clarity and precision of the rule infringed, whether the infringement and the damage caused were intentional or involuntary, whether any error of law was excusable or inexcusable, and the fact that the position taken by a Community institution may have contributed to the adoption or maintenance of national measures or practices contrary to Community law (Test Claimants in the FII Group Litigation, paragraph 213 and the case-law cited there). 120. On any view, a breach of Community law will clearly be sufficiently serious if it has persisted despite a judgment finding the infringement in question to be established, or a preliminary ruling or settled case-law of the Court on the matter from which it is clear that the conduct in question constituted an infringement (Test Claimants in the FII Group Litigation, paragraph 214 and the case-law cited there). 121. In the present case, in order to determine whether a breach of Article 43 EC committed by the Member State concerned was sufficiently serious, the national court must take into account the fact that, in a field such as direct taxation, the consequences arising from the freedoms of movement guaranteed by the Treaty have been only gradually made clear, in particular by the principles identified by the Court since delivering judgment in Case 270/83 Commission v France. Until delivery of the judgment in Lankhorst-Hohorst, the problem raised by the current reference for a preliminary ruling had not, as such, been addressed in the Court’s case-law.”
“108. I would add that, in the FII case, which concerned the UK’s tax treatment of incoming dividends, I expressed serious doubts whether the Brasserie du Pêcheur conditions – and in particular the requirement of a sufficiently serious breach – was fulfilled for the aspects of the UK’s system which breached Community law. I have even stronger doubts on this point in the present case. The application of Article 43 EC to national thin cap legislation was confirmed by the Court only in 2002 with its Lankhorst-Hohorst judgment, and even following this judgment the scope of such application has not been totally clear. Moreover, the UK altered its legislation on numerous occasions, making the application of its rules more transparent and seemingly, in the case of the 2004 changes, keeping compatibility with Community law in mind. This does not seem to me sufficient to constitute a manifest and grave disregard of the limits on its discretion within the meaning of the Court’s case-law.”
“5. It is also relevant to look at the state of mind of the infringer, and in particular whether the infringer was acting intentionally or involuntarily. A deliberate intention to infringe would obviously weigh heavily in the scales of seriousness. An inadvertent breach might be relatively less serious on that account. Liability may still be established without any intentional infringement. More broadly, the purpose of the infringer should be considered. If the purpose was to advance the interests of the Community a breach committed with that end in view might be seen as less serious than one committed with the purpose of serving merely national interests. 6. The behaviour of the infringer after it has become evident that an infringement has occurred may also be of importance. At the one extreme the immediate taking of steps to undo what has been done and correct any error which has been committed may operate to mitigate the seriousness of the breach. At the other extreme a persistence in the breach, the retention of measures or practices which are contrary to Community law, especially where they are known so to be, will add to the seriousness of what has been done …”
“I believe Sue Walton has mentioned to you separately the need to bear in mind the EC dimension. If we are going to work up a scheme along the lines outlined in the papers we shall need to make sure that we do not run a significant risk of covert discrimination. The real problem case is the one to which I have referred to above … In particular, I feel uneasy about imposing UK standards when the facts strongly indicate (or for that matter prove) that a disproportionate amount of the group’s total indebtedness is not being dumped in the UK. This too needs a good deal more thought.”
“7. Returning to the comments in your second paragraph I was concerned at the implication that any thin cap rule we might develop should operate only in the case of international tax avoidance – so that we might for instance be obliged to have some sort of avoidance motive test. In many instances thin cap does indeed represent a device to mitigate tax but I would accept that it does not always – there may indeed be business reasons why debt finance has been raised rather than equity in any particular case, or there may be a mixture of motives … But the point remains that such a business choice erodes the UK tax base.”
“7. So far as the EC dimension is concerned what can be said with certainty is that if the [ECJ] is in the mood it will have no qualms about trampling all over and rejecting OECD principles. For evidence of that you need look no further than Commission v France and Commerzbank … I suppose it must be the case that thin capitalisation legislation will always be vulnerable to challenge … But it is slightly unfortunate that our debt/equity ratios are out of line with our European partners and enshrining those ratios in legislation would set up a high-profile target. The counter argument I assume would be that the UK company tax regime must be considered as a whole, is built around UK ratios, the arm’s length principle [is] internationally recognised and preserves the “cohesion” of the system both domestically and at the international interface. Whether that argument would succeed for the Court I do not know.”
“the rules regarding equality of treatment forbid not only overt discrimination by reason of nationality or, in the case of a company, its seat, but all covert forms of discrimination which, by the application of other criteria of differentiation, lead in fact to the same result”
“The problem with this however is that looked at in isolation section 209(2)(e)(iv) is a “blunderbuss” provision and might therefore fail the proportionality test. At that point I suspect things start to get a bit tricky and less clear cut.”
“In particular I wonder whether it could not be said that Section 209(2)(e)(iv) offends the freedom of establishment provisions of Chapter 2 – on the basis that a non-resident company will find it more expensive to establish a subsidiary in the UK, financed with debt, the interest on which does not attract relief for the subsidiary in arriving at its UK tax bill, than a UK competitor company establishing an equivalent UK subsidiary, complete with its UK tax relief for interest charges. 4. Section 209(2)(e)(iv) is the basis for the UK’s thin capitalisation defences. If it is susceptible to challenge then we would have to move quickly to put something else in its place. I would like to be able to establish what the likely risk of a successful challenge is generally …”
“22. To end on a slightly more optimistic note, Halliburton was concerned with a transaction which was internal to the Netherlands … There was, therefore, no Bachmann cohesion of the tax system argument available to the Dutch. It seems to me that where the transaction is a cross-border transaction it may still be possible to argue that the different treatment is justified by the need to ensure the cohesion of the UK tax system.”
“Mr Durrans’ view is that we are vulnerable to challenge and that our chances of resisting the challenge are considerably less than slim. Very briefly, it is likely that the provisions are contrary to European law on grounds that they are discriminatory and because, viewed as a piece of anti-avoidance legislation, they are out of proportion to the abuse which they seek to counter.”
“Loss of section 209(2)(e)(iv) to combat thin capitalisation even if only for EC transactions would be extremely costly. The UK would quickly become a dumping ground for increasing amounts of intra-group debt, routed via the EC where necessary. There would be a considerable drain on the UK tax take. I have no doubt whatsoever that, on the basis of Mr Durrans’ advice, we have no alternative but to seek a legislative solution.”
“That in itself might not be without difficulties but could be accomplished in the time available and a lack of consultation would be more defensible – and could be explained. However, it would be far from an ideal solution. We acknowledge that, present EC pressures apart, the legislation is by no means perfect so that tinkering at the edges would represent an impoverished course of action, in particular coming so close after the Interest Review. It would be no more than a patch-up job.”
“9. We are not entirely without arguments on which to place a defence of the application of Section 209(2)(e)(iv) and there are some possible bargaining counters we could use in order to negotiate agreements with those companies raising the matter, so one option is to resist any challenge to the application of section 209 by deploying these arguments/counters pending the introduction of legislation in 1996. If we could do so, that would be a satisfactory approach from our viewpoint. But Mr Durrans has made it clear that he believes such arguments would ultimately fail and that they could not be pressed to litigation. … 10. It could instead be accepted that, following Halliburton, Section 209(2)(e)(iv) is in breach of European law and that it cannot be applied, beyond the time of the Halliburton decision, to affected transactions. Effectively that would largely close down the thin capitalisation shop until remedial legislation began to bite. Even if this were only for one year – and it could be for much longer … - the damage would be serious. For 1993/94 the yield … was£204 million from adjustments to profits of£650 million and a fair proportion of this related to the combating of thin capitalisation cases. That would represent a mere fraction of the potential tax loss should we openly acknowledge that we had lost Section 209(2)(e)(iv), leaving the field clear for the tax planners. In such case, announcement by the Chancellor to signal the intention to legislate for thin capitalisation in 1996 might help to put a brake on the process but it could be a pretty ineffectual brake.”
“1. As we have mentioned to Ministers in the past, the European Court has held in recent years that provisions of direct tax systems at national level (which continue to remain unharmonised) are subject to the non-discrimination rules of the Rome Treaty. So far, we and other Member States have survived largely (albeit not completely) unscathed. To that extent the present position whilst sub-optimal is just about tolerable. But there is no guarantee that things will stay this way and the evidence now rapidly accumulating strongly suggests that they will not. There is a growing risk of a major setback in Exchequer and political terms. 2. In so far as there is any comprehensive solution to this problem the only option worth serious consideration is a Treaty revision with the objective of securing tax carve-outs in the relevant Articles. At this distance, the prognosis for achieving that is highly uncertain … In practice, much may turn on future developments including the judgment in what will become a leading case, Schumackers (involving Germany), expected in early 1995. However, even at this stage our concerns are shared by senior officials in France and Germany and we have agreed to meet early next year to go over the issues. … 3. Short of amending the Treaty there are very real limits to what can be done at national level to reduce the potential for damage. But there are some practical steps that can be taken which would involve building on the strategy we have developed over the last few years. This has consisted of – (i) making full use of our right to make observations to the Court in individual cases (and encouraging others to do likewise); (ii) ensuring that we do not put new provisions on the statute book with obvious vulnerabilities; and (iii) where practicable and consistent with Parliamentary sensitivities, using legislative opportunities as and when they arise to revisit existing legislation.” (i) making full use of our right to make observations to the Court in individual cases (and encouraging others to do likewise); (ii) ensuring that we do not put new provisions on the statute book with obvious vulnerabilities; and (iii) where practicable and consistent with Parliamentary sensitivities, using legislative opportunities as and when they arise to revisit existing legislation.”
“The vulnerabilities of ourselves and indeed other Member States run to the length of a ball of string. Our external customers have not given notice of where they intend to concentrate their attention next. For internal purposes we have drawn up a list of UK vulnerabilities. We shall let you have a copy as soon as it is in a more user-friendly form.”
“The difficulty with the notion of adding to these amendments a provision excluding intra-group payments between UK residents is, of course, that the additional provision reintroduces discrimination. Using the device in s.212 ICTA 1988 of disapplying s.209(2)(e)(iv) where the lender is within the charge to corporation tax, whether in relation to the loan income or any income, would avoid direct discrimination contrary to Article 52 but not, I think, indirect discrimination. This is because although on its face the exclusion would apply without distinction to all companies wherever resident it would essentially favour UK resident companies.”
“The residual risk that our Euro-proofing might still get knocked flat by ECJ is something we will have to live with … The risk of our losing in ECJ is pretty marginal – clear enough from Bill Durrans’ note, and confirmed to me on the telephone. If the ECJ do hit us, it will be on the basis that the only way of conforming to EU law will be for UK to impose on domestic taxpayers a nonsensical tax charge, with significant compliance burdens. If the threat comes, the Germans and others will have to join in with us in representations to ECJ to protect their own position. (Because our new formula is, in effect, modelled on what Germany already has to keep its domestic taxpayers out of the frame.) If ECJ were nevertheless perverse enough to find against us, it would be such a preposterous result that it would add momentum to the campaign to get an ECJ change in the Treaty of Rome …”
“9. … It is now clear that our vulnerability is real, and acute. It arises because our thin capitalisation legislation expressly applies only to payments made to non-residents … Our legal advice, in the light of Halliburton, is that our legislation would be held to be discriminatory and contrary to Community law, if we were taken to Court. 10. The final nail in the coffin of our defences arises from an element of over-kill in the thin capitalisation rules. Where they apply, they knock out all of the interest, not just the amount that exceeds what would be involved in an arm’s length financing arrangement. So the legislation can apply even when companies’ financing decisions are not driven primarily by tax considerations. On this count the provisions would be held to have an effect disproportionate to the abuse they counter, on top of being “discriminatory”. 11. The over-kill effect is usually limited through our double taxation treaties with other Member States. But the ECJ has specifically held that alleviating provisions in double taxation treaties will not be taken into account in considering the basic legislation. In any event, some of our other double taxation treaties (eg with Ireland and Italy) have no such alleviation.”
“It needs some rather subtle drafting to produce an end-product which both guards against ECJ challenges and still leaves intra-UK loans unaffected. The solution we have got, modelled on the German solution, should do the trick. But it leaves a residual risk of an ECJ challenge. This clearly has to be accepted. But we thought you should be aware of it.”
“4. I am clear that we should take immediate remedial action to Euro-proof the anti-avoidance provisions, so that they remain effective despite the Halliburton ruling. The solution proposed broadly reproduces the status quo. In particular, it would still ensure that intra-UK loans in practice are kept out of the thin capitalisation net. There is a residual risk of an ECJ challenge in this. But it is much better to accept this small risk than engage in the policy nonsense of exposing intra-UK loans to unnecessary restrictions, and the compliance burdens that would go with them. The legislation would have two incidental effects. One is that the immunity currently enjoyed by Japanese and German parent companies because of the terms of the current tax treaties will disappear. This will remove an anomaly and should not be controversial. 5. Another effect of the revised rules will be to take out an element of over-kill in the present provisions. Under the current rules, the whole of the loan is caught if the thin capitalisation legislation applies. Our tax treaties override this to produce a more sensible result: only the excess of the loan (over and above an arm’s length standard) is caught. The new legislation will generalise the tax treaty treatment, even where no tax treaty is in force. This relaxation should be presentationally helpful.”
“This year’s thin capitalisation legislation means replacing a few lines of the tax code by 3 pages of complex legislation, with some fancy footwork to avoid the nonsensical result of bringing intra-UK loans into the thin capitalisation net. But this, I fear, is only a minor example of the problems we will face in dealing with the impact of the Halliburton decision, and other ECJ decisions in the future.”
“Following a recent European Court of Justice decision claims have been made that the rules relating to certain payments between connected companies is [sic] discriminatory. Although the Inland Revenue has not accepted that this is so, the Government wishes to amend the legislation in a way designed to avoid any such suggestion.”
“Following a recent European Court of Justice decision involving a Netherlands company (Halliburton Services BV) it has been suggested that these provisions may be discriminatory and would be struck down by the ECJ. Although the Inland Revenue has not accepted that this analysis is correct, it is hoped that the new provisions will put the matter beyond doubt.”
“A decision of the Court of Justice has cast doubt over some aspects of the distribution legislation as it applies to certain payments of interest and other similar sums between connected companies. This has created uncertainty for the Revenue and taxpayers alike. The proposed change is intended to clarify the position in a way which will result in no change of practice for the majority of companies etc.”
“A recent European Court of Justice decision has prompted speculation about the application of the existing rules relating to certain payments between connected companies. This has led to some uncertainty for taxpayers. The Government therefore wishes to amend the legislation in order to clarify the position.”
“There has been some speculation about the possible relevance for these provisions of a recent [ECJ] decision involving a Netherlands company (Halliburton Services BV). The Government intends the new provision to remove any possible doubt this may have caused. At the same time the opportunity has been taken to respond to representations about the harshness of the current rules in certain circumstances.”
“As agreed, this gives very low key treatment to the ECJ angle. We have buried this as well as we can in the thickets of technical explanation about the changes (in fact relatively minor) that are being made to the rules. The technical commentators will, of course, register the true significance of the ECJ point. But with a bit of luck (and some suitably low-key briefing) this should postpone the point at which the issue goes live politically.”
“1. At present payments of interest and similar sums to certain non-resident connected companies are, for the purposes of United Kingdom domestic law, treated in the same way as distributions. This means that the paying company is not entitled to deduct the payment in calculating its profits for tax purposes and is obliged to make a payment of [ACT] at, or around, the time of the payment. These rules have enabled the Inland Revenue to challenge “thin capitalisation”. “Thin capitalisation” is the process of financing subsidiaries with greater amounts of debt in comparison with equity than would be normal in an arm’s length funding arrangement. Such a funding structure may be intended to reduce or eliminate the company’s liability to corporation tax by loading it with “excessive” interest payments. 2. This domestic treatment is modified by the terms of agreements between the governments of the United Kingdom and certain overseas countries for the elimination of double taxation. The precise wording of such agreements varies but, for the majority of companies, the effect is to limit the amount of a payment to be treated as if it were a distribution to only the part which exceeds what would have been paid between unconnected companies. 3. The proposed measures will amend the rules for identifying the connected companies to which the legislation applies. They will deal with relevant payments between such companies on a consistent basis no matter where in the world the companies are resident and will follow the approach of most of the United Kingdom’s recent double taxation agreements by only treating the “excessive” part of such payments as if they were distributions. 4. The new provisions will leave most companies in the same position as at present – after taking account of the interaction of current domestic law and the relevant existing double taxation agreement. Where there is no such agreement or where it varies from the current norm, a minority will find their position altered. To assist companies (and their advisers) in establishing whether and how the new measures will affect them, a draft of the Finance Bill clause has been issued today. A copy is annexed to this Press Release. 5. The new measures respond to representations about the harshness of the current rules in a few cases. The Government has also taken the opportunity to remove any uncertainty for taxpayers which recent speculation about the application of the existing rules following a European Court of Justice decision may have caused. 6. The Chancellor intends the new provisions to apply generally to payments made on or after today. … 7. The Government intends to keep this legislation – and its effectiveness in achieving its purpose – under review.”
“5. As a further point, there has been some speculation about the possible relevance for the existing provisions of a recent European Court of Justice decision involving a Netherlands company (Halliburton Services BV). The Government intends the new provision to remove any possible doubt this may have caused.”
“Hopefully this will give you a rough idea of what we are doing and how we are handling questions. The general line we want to give is that this measure will not alter the position for most companies.”
“What are the reasons for the “uncertainty” to which the press release refers?”
“Some people have suggested that our existing approach is discriminatory under the Treaty of Rome. Although we do not agree, we have taken the chance in this legislation to remove some of the aspects of the existing provision (particularly the distinction between resident and non-resident holders of securities) which led people to think they might have a case.”
“22. No. Some taxpayers have contended that the present law is discriminatory and have referred to a European Court of Justice decision which dealt with a discrimination issue, but not one involving thin capitalisation. These contentions have been rejected by the Inland Revenue and have not been pursued in the Courts. As the Press Release accompanying announcement of the new clause explained, we simply decided to use the opportunity presented by the change in law to remove any uncertainty which may remain in the minds of taxpayers.”
“Although it has not been conceded that the recent ECJ decision causes any problems for the UK, legal advice received on the subject figured prominently in the decision to amend the present law. It was decided that this aspect should be played down and the measure portrayed as a boring technical one.”
“The amendments to Clause 75 were designed to exclude financial arrangements between charities and their trading subsidiaries from its scope. At most a few million pounds, which it had never been intended to catch, was being “given up” as a result of the amendment. The wider consequences of not announcing and introducing this amendment would, however, have been considerable and, potentially, financially costly. Following three scare stories in national newspapers, the Charities Lobby was beginning to build up a head of steam at the time when the announcement of the intention to amend the legislation was made … What can be said with greater certainty is that the continued focus on the inclusion of UK residents within the scope of the clause would, inevitably, have risked drawing attention to its “Euro-proofing” aspects in a way which Sir George had decided he wished to avoid. An undue focus on the European dimension might, in itself, have added to the difficulty of getting the clause past Standing Committee. It would also without doubt have alerted many taxpayers and their advisers to the possibility of contending that the legislation being replaced was discriminatory and therefore could not be applied. If such arguments had gained wide currency and been accepted by the Courts we estimated that approximately£25 million tax would be lost. If, in addition to alerting taxpayers and losing before the Courts the new clause had not passed through Parliament at all, we estimated that a figure well in excess of£150 million would be lost in a year – before taking account of the likely behavioural effects which would have led to further exploitation of the resultant weakness in our defences.”
“On a quick read the Court seems to me to be leaving the door open, albeit ever so slightly, for thin cap regimes to be capable of being objectively justifiable where they are closely targeted on abusive (wholly artificial?) arrangements. Whether a Member State could ever get such a closely targeted regime through the eye of the objective justification needle on the facts of a particular case is, of course, another matter.”
“There isn’t really any intrinsic merit in this (that is, apart from its enabling us to ECJ-proof the application of the thin capitalisation rules to foreign-owned companies), so we should have to minimise the additional compliance burden on domestically-owned companies while ensuring we did enough to satisfy the ECJ.”
“All that said, we clearly need to guard against complacency here. So we shall keep the position under active review. We are also urgently exploring the scope for reducing the Exchequer cost of any ECJ decisions that go against us.”
“Nor am I of the view that, in order to conform with Article 43 EC, Member States should necessarily be obliged to extend thin cap legislation to purely domestic situations where no possible risk of abuse exists. I find it extremely regrettable that the lack of clarity as to the scope of the Article 43 EC justification on abuse grounds has led to a situation where Member States, unclear of the extent to which they may enact prima facie “discriminatory” anti-abuse laws, have felt obliged to “play safe” by extending the scope of their rules to purely domestic situations where no possible risk of abuse exists. Such an extension of legislation to situations falling wholly outwith its rationale, for purely formalistic ends and causing considerable extra administrative burden for domestic companies and tax authorities, is quite pointless and indeed counterproductive for economic efficiency. As such, it is anathema to the internal market.”
“Before hearing about the Lankhorst-Hohorst case, I had no idea that the UK’s thin cap rules might be unlawful and certainly it did not cross my mind to advise the business that they could ignore those rules. I do not recall any conversations with any other IBM employee prior to December 2002 in which the legality of the thin cap rules was questioned.”
“I cannot remember exactly when I learnt of the possibility that the thin capitalisation rules might be unlawful under European law, but I am sure that it was not until late 2003.”
“In a situation such as that in the main proceedings, the State of residence cannot take account of the taxpayer’s personal and family circumstances because the tax payable there is insufficient to enable it to do so. Where that is the case, the Community principle of equal treatment requires that, in the State of employment, the personal and family circumstances of a foreign non-resident be taken into account in the same way as those of resident nationals and that the same tax benefits should be granted to him.”
“24. As the Advocate General observed in point 54 of his Opinion, the effect of double-taxation conventions which, like the one referred to above, follow the OECD model is that the State taxes all pensions received by residents in its territory, whatever the State in which the contributions were paid, but, conversely, waives the right to tax pensions received abroad even if they derive from contributions paid in its territory which it treated as deductible. Fiscal cohesion has not therefore been established in relation to one and the same person by a strict correlation between the deductibility of contributions and the taxation of pensions but is shifted to another level, that of the reciprocity of the rules applicable in the Contracting States. 25. Since fiscal cohesion is secured by a bilateral convention concluded with another Member State, that principle may not be invoked to justify the refusal of a deduction such as that in issue.”
“(5) Enterprises of a Contracting State, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned Contracting State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the first mentioned State are or may be subjected.”
“Enterprises of the UK, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the US, shall not be subjected in the UK to any taxation or any requirement therewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the UK are or may be subjected.”
“Interest derived and beneficially owned by a resident of the United States shall be exempt from tax by the United Kingdom.”
“Where, owing to a special relationship between the payer and the person deriving the interest or between both of them and some other person, the amount of the interest paid exceeds for whatever reason the amount which would have been paid in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount. In that case, the excess part of the payment shall remain taxable according to the law of each Contracting State, due regard being had to the other provisions of this Convention.”
“In my opinion [section 247] plainly does not [discriminate on the grounds that the capital of the subsidiary is controlled by a non-resident company]. For example, if a US parent were to interpose a UK-resident holding company between itself and its UK-resident subsidiary, the control would remain in the US but there would be no objection to an election by the UK subsidiary and its immediate, UK-resident parent. On the other hand, an individual US shareholder and the company he controls in the UK could not elect, but the reason is not because the company is subject to US control. An individual UK shareholder and his company could not elect either, for the same reason that a non-resident company cannot elect. It is because an individual is not liable to corporation tax. An election is a joint decision by two entities paying and receiving dividends that one rather than the other will be liable for ACT. This is not a concept which can meaningfully be applied when one of the entities is not liable for ACT at all.”