By Eric Tomsett

In an order dated 23 April 2008, in the case of Test Claimants in the CFC and Dividend Group Litigation v. CIR (C-201/05), the European Court of Justice (ECJ) reviewed the compatibility of the U.K. taxation of companies on foreign dividends and of controlled foreign companies (CFCs) with EC law. The Court confirmed its previous rulings in the leading cases of FII Group Litigation and Cadbury Schweppes, whilst additionally determining that compliance requirements relating to the CFC provisions may be compatible with the EC law, but earlier legislation relating to the taxation of foreign dividends received by insurance companies is not.

Foreign Dividends

The ECJ reviewed the U.K. system of taxing companies on domestic and foreign dividends. Dividends received from other U.K. resident companies are generally exempt from corporation tax. Foreign dividends received by a U.K. company, however, are taxable, with a credit granted for the foreign taxes on the profits out of which the dividends were paid. Credit is granted for both underlying tax and withholding tax paid on the dividends where the U.K. recipient company holds 10% or more of the payor, but, where the shareholding is less than 10%, credit is granted only for the foreign withholding tax.

The ECJ followed its previous approach in Test Claimants in the FII Group Litigation, holding that the provisions governing the taxation of foreign dividends where the participation is 10% or more is compatible with EC law, provided (1) the tax rate on foreign-source dividends is not higher than that applied to domestic-source dividends; and (2) the foreign tax credit is at least equal to the tax paid in the country of the company making the distribution up to the amount of the U.K. corporation tax.

The ECJ confirmed, however, that the system of taxing foreign dividends received by companies on less-than-10% shareholdings (while exempting dividends from corresponding domestic shareholdings) is potentially contrary to EC law.

CFC Rules

The ECJ next reviewed the U.K. CFC legislation under which the income of a CFC in which a U.K. resident company has an appropriate interest is apportioned to and taxed in the hands of the U.K. company if the CFC is subject to foreign taxation of less than 75% of what the U.K. tax would be on equivalent profits. There are various exemptions from the CFC provisions.

The Court followed its previous decision in the Cadbury Schweppes case by indicating that the U.K. CFC legislation did represent a restriction on freedom of establishment, contrary to EC law, but the restriction may be justified where the legislation specifically targets wholly artificial arrangements that are designed to circumvent U.K. tax legislation and that do not reflect economic reality.

Application to Non-EU Countries

The ECJ also considered the application of the above principles as they relate to the taxation of foreign dividends on companies and CFCs, where the foreign company concerned is established outside the EU. The ECJ indicated that its ruling on CFCs applies only to EU subsidiaries. With respect to foreign dividends, the principles may extend to non-EU companies, depending on whether the foreign tax credit provisions were measures in existence before 1993 (i.e. under the “standstill” provision of the EC Treaty, Member States may continue to apply rules that were in existence on 31 December 1993 with respect to third countries, even if the rules are discriminatory or restrict the free movement of capital). However, the ECJ did not have sufficient information to determine whether changes to the foreign tax credit rules after 1993 amounted to new restrictions or repeated the 1993 position.

The ECJ also decided that it is permissible for the foreign tax credit system for dividends on less than 10% shareholdings to allow effective discrimination against dividends from non-EU countries by imposing compliance requirements that the non-EU country does not meet.

CFC Compliance Requirements

The ECJ held, however, that the imposition of compliance requirements in respect of the CFC provisions (i.e. requirements to provide extensive information about the CFC’s income and activities) are acceptable under EC law, provided their purpose is to verify that the CFC is actually established and that its economic activities are genuine without imposing an undue administrative burden.

Foreign Dividends Received by Insurance Companies

The ECJ considered the position in relation to the pre-1997 legislation concerning the taxation of dividends received by insurance companies. Under these rules, an insurance company was allowed to elect for certain dividends received from U.K. resident companies not to be chargeable to corporation tax (although if such an election was made, the company was unable to claim any tax credits with respect to the dividends to which it otherwise would have been entitled). The election was not available in respect of foreign dividends. The ECJ concluded that these provisions were contrary to EC law as a restriction on the free movement of capital, insofar as they resulted in less favorable treatment of foreign dividends.

Claims

With respect to taxpayer claims relating to taxation that may have been imposed contrary to EC law in the areas considered in this case, the ECJ indicated that it was for the U.K. legal system to establish detailed procedural rules for such claims. An aggrieved taxpayer must have an effective legal remedy to obtain reimbursement for tax unlawfully levied and there must be provisions to make reparation for other loss or damages caused, provided specified conditions are satisfied.

Effectiveness of GLO Procedure

The Test Claimants case has not resolved any of the broad areas of uncertainty remaining as a result of the previous cases (e.g. FII Group Litigation and Cadbury Schweppes), such as whether foreign tax credit relief is actually equivalent to exemption, whether the U.K. tax treatment of dividends from non-EU countries is compatible with EC law and what the terms “wholly artificial arrangement” and “genuine economic activities” mean in relation to the CFC legislation. Individual cases, therefore, will need to be initiated (primarily in the U.K. courts) to resolve these issues, so that the group litigation order procedure is not effective in helping to resolve such issues in EC law situations.

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