Bill Dodwell, tax partner at Deloitte, comments:
“Mr Justice Henderson has decided that the UK’s double tax relief system infringes European law, where dividends have been paid to the UK from EU-based companies, in which the UK shareholder owned more than 10%.  He has carefully examined the full background to the European Court of Justice’s (ECJ) decision which, on this aspect, was confusing and poorly expressed. This means that the UK is not entitled to charge tax on dividends from EU-based companies and groups which have suffered such tax liabilities may now able to seek refunds.  However, he has concluded that these rights do not extend to dividends from countries outside the EU.

“The cost to the Exchequer of this aspect of the judgement is likely to be relatively modest though; it is thought that actual UK tax paid on all overseas dividends is no more than £100 million pa and the majority of dividends on which tax has been paid are likely to have come from outside the EU.  Interest will of course be due on repayments.

“The judge also held that attempts to limit direct tax claims to the last 6 years contravened European law. This opens up extra possibilities for companies to make EU-based direct tax claims. The judge followed the well-known decision of the House of Lords in Condé Nast – that if the Government seeks to curtail existing rights, a transitional period to allow those affected to make claims must be allowed.  As a result, it is likely that the Treasury will need to grant a new transitional period for all EU direct tax claims, as it has done for VAT claims. Given the clear judgement on this aspect, it would be sensible for the Treasury to accept the point and act immediately, rather than prolong the period by taking it to the House of Lords.

“Other aspects of the judgement related to the now abolished ACT system and are thus of more limited interest – although significant amounts of money are at stake.  Here, the judge accepted some claims, refused others and suggested that further references to the ECJ would be necessary.

“Inevitably, the judgement will be appealed.”

Notes to Editors

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.  The European Court of Justice gave its judgement in December 2006, nearly two years ago.  As discussed in more detail below certain points were referred back to the UK’s High Court, which heard the case during most of July. The High Court decision has now been given today.

In its oral (but not written) submissions to the ECJ, 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 ECJ’s decision was complex and difficult to follow.  It clearly disliked the UK’s old ACT system and broadly gave companies the reliefs they sought.  However, on the key issue of whether a system of double tax relief is acceptable, confusion reigned.

The ECJ considered that the UK needs to change its system for portfolio dividends (those from less than 10% shareholdings) – but it may keep its system from 10% or greater shareholdings.

On the key question whether the UK’s system of double tax relief is acceptable, the ECJ in essence decided that:

• for dividends from companies where the UK corporate recipient has more than 10%, the UK corporation tax rules which tax foreign dividend receipts, but allow credit for tax paid by the overseas company are in principle acceptable. However, the ECJ left it to the national courts to review particular situations to see if such a system is unfair in practice.  The ECJ indicated that the UK Courts should look to see whether the tax rates on UK profits and overseas profits are the same and whether different levels of tax occur in some cases due to exceptional reliefs.
• For dividends from companies where the UK corporate recipient has less than 10%, the UK corporation tax rules which tax foreign dividend receipts, without allowing credit for tax paid by the overseas company are not acceptable.

These decisions cover dividends from EU companies and do not normally extend to non-EU dividends.

The second part of the judgement covered issues arising from the advance corporation tax (ACT) system, now abolished.  Here, the ECJ’s decisions were broadly in favour of the taxpayers:

• The system which required UK companies to pay ACT when it paid dividends to its shareholders out of foreign profits, whilst not requiring ACT to be paid on dividends from UK companies breached the EC Treaty;
• The system which prevented UK companies from surrendering ACT to overseas companies was contrary to the freedom of establishment and to the free movement of capital, under the EC Treaty.
• However, the restriction on the offset of ACT against UK tax (as reduced by double tax relief) was legitimate.
• The Foreign Income Dividend (FID) regime, whereby companies which paid FIDs could recover ACT paid on the dividends, but the shareholders could not recover a tax credit contravened the EC Treaty.
• The ECJ held that whilst the UK provisions generally breached the free movement of capital rules (and thus could in principle apply to dividends from capital investments made outside the EU), most of the UK’s restrictions were in force in 1993 and so grandfathered under the EC Treaty.  The FID regime was introduced in 1994 and the ECJ left it to the UK Courts to decide if it represents a new restriction, or simply the continuation of a grandfathered restriction, in another form.  With this last exception, the judgment in practice applies only to EU dividends.
• The ECJ also left questions of what might be called consequential loss to the UK courts, whilst dropping a hint that claims under this head were unlikely to succeed.  Companies had claimed that they had increased FID dividends to reflect the fact that the tax credit could not be reclaimed; the ECJ effectively suggested that this was unlikely to allow them to claim damages.
• The ECJ dismissed the request made by the UK Government to impose a time limit on the judgement. Therefore, companies may now be able to claim back tax paid or damages relating to EU dividend receipts.  Companies’ claims may be limited by changes to UK limitation law made in 2004 and 2007.  However these changes are themselves either subject to, or expected to be subject to, litigation

It is that decision the High Court has taken forward, and delivered its judgement today.

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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