Surprising system may have implications for to Ireland’s system of taxing foreign dividend income

The European Court of Justice (ECJ) has today released a surprising judgement in the Franked Investment Income (FII) Group Litigation Order (GLO). The ECJ has in essence decided that the UK corporation tax rules which tax foreign dividends but exempt domestic dividends are in principle acceptable.  However, the ECJ has left to the national courts to review particular situations to see if such a system is unfair in practice. 

Declan Butler, tax partner at Deloitte, comments:
“I am surprised at the decision.  Like most commentators, I thought the tax payer would win hands down. 

I do believe however, applying the principles in the judgement to Ireland’s system of taxing foreign dividend income at a rate of 25% (whilst allowing a credit for foreign tax paid) is contrary to the judgement.  It would seem to me, that as dividends are tax free between Irish companies and those Irish companies normally pay tax at 12.5%, then 12.5% is the maximum rate Ireland should tax foreign (EU) dividend income. With the availability of a foreign tax credit, it would be most unlikely for incremental tax to arise.

Furthermore, the requirement in Ireland that the taxpayer must have a 5% plus shareholding to avail of a foreign tax credit is also discriminatory based on this judgement.”

Notes to the Editor

About the case:

This case is a Group Litigation Order, the UK name for a class action.  It is called the Franked Investment Income Group Litigation Order.  It concerns the tax treatment of dividends received by UK-resident companies from companies resident in other EU Member States (and as regards one question raised by the English High Court, from companies resident in third countries, i.e. countries which are not EU Member States).  The companies with shares in EU companies claimed compensation for paying more UK corporation tax on dividends from their EU shares than they would have paid on similar dividends from UK shares.  They also claimed compensation for having to pay more advance corporation tax than they would have had to pay had they received dividends from shares in UK companies than share in other EU companies. 

The first claim concerns the UK corporation tax as it has been for many years, and still is.  In summary a UK company which receives a dividend from another UK company normally is exempt from corporation tax on the dividend.  A dividend from a non-UK, in particular an EU, company is not exempt, but is subject to corporation tax subject in most cases to relief for certain foreign taxes paid.

In effect the companies were arguing that this tax system for dividends is contrary to EU law.

The other claims largely concern the UK corporation tax system as it was from 1973 until 1999.  UK legislation then required companies paying dividends to shareholders to pay advance corporation tax (ACT), which was in effect an early payment of corporation tax, to the Inland Revenue.  The ACT was set off against the amount of corporation tax payable, which was typically due 9 or more months later. 

If the company paying the dividend had received a dividend on which ACT had been paid then it could in effect reduce its payment of ACT by the ACT which had already been paid on the dividend received.  However no ACT was paid on foreign dividends received so no such reduction was due for foreign dividends.

In 2001 the European Court of Justice held, in a case involving a UK subsidiary of the German Hoechst group, that UK legislation contravened aspects of the EC Treaty, as it discriminated against companies which had an EU (but non-UK) parent, as compared to those with a UK parent.  The discrimination was that UK subsidiaries of EU parents paid corporation tax earlier than a UK subsidiary of a UK parent would have.  The European Court of Justice decided that compensation should be paid to those who had suffered this discrimination. 

The Hoechst case caused a number of groups to consider if other aspects of the UK’s corporation tax system, in particular relating to ACT, also contravened the EC Treaty. These groups have been gathered together into a number of Group Litigation Orders.  Group Litigation Orders are broadly the English equivalent of US class actions.  The ACT (Hoechst) Group Litigation Order is in turn divided into ‘classes’.  This case is generally called the Franked Investment Income GLO.

In October 2004, the High Court referred various questions to the European Court of Justice (ECJ) in respect of this Group Litigation Order.  A hearing was held in the European Court in November 2005.  The Advocate General (AG) gave his Opinion in April 2006. 

In its oral (but not written) submissions, the UK government stated that the potential value of the claims at issue could amount to £7 billion.  The government therefore requested that, should the ECJ find in favour of the taxpayer, the Court should consider limiting the effects of its judgment in time.  The test claimants rather believed that the figure at stake would be in the region of £100 million to £2 billion, depending on the question of time limitation since decided in favour of the claimants in the Deutsche Morgan Grenfell case, but now also depending on the new measures that the government has just announced in terms of the time limits for making a claim under mistake of law.

The Advocate General’s Opinion was in favour of the claimants in respect of all of the above arguments, though not on the ‘third country’ issue, where he has in effect held that UK’s system for taxing dividends from third countries will normally not breach any of the claimants’ EC Treaty freedoms.

The Advocate General’s Opinion was that it was for the UK national court to decide on the remedies that the claimants should receive, bearing in mind that the claimants must have an effective legal remedy in order to be reimbursed for the loss that they have suffered as a result of the breach of Community law.

In respect of the temporal limitation sought by the UK government, the Advocate General rejected the government’s submissions on the basis that the government had not sufficiently substantiated its arguments.  The ECJ has always held that it will only consider temporal limitation in exceptional circumstances.  Even ignoring the fact that the UK government had not substantiated its claim, the European Commission had never condoned the specific discriminatory features of the UK’s ACT system and hence the Advocate General did not believe that the ‘exceptional circumstances’ requirement needed for temporal limitation had been met.

A number of tax cases, in particular some Group Litigation Orders (the UK equivalent of US class actions) have been formed to make claims that other aspects of UK tax law are also contrary to the EC Treaty and have sought damages or restitution before the High Court.  Some of these Group Litigation Orders include classes dealing with non-discrimination under Double Tax Conventions, as well as discrimination under the EC Treaty.  There are currently six GLOs relating to direct taxation matters:

• Cross border loss relief;
• Thin capitalisation;
• Controlled foreign companies and foreign sourced dividends;
• Franked investment income (this Group Litigation Order);
• ACT, group income elections and treaty tax credits;
• Foreign income dividends.

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