Tax

Banking and finance – European Union - Corporation tax – EC law

Test claimants in the Thin Cap Group litigation v Revenue & Customs Commissioners: CA (Civ Div) (Lady Justice Arden, Lords Justices Rimer, Stanley Burnton): 18 February 2011

The appellant commissioners appealed against a decision ([2009] EWHC 2908 (Ch), (2010) STC 301) that the failure of UK thin capitalisation tax legislation to allow a commercial justification of transactions which were not conducted at arm's length infringed the respondent test claimant companies' (T) rights under article 43 of the EC Treaty (Nice).

T cross-appealed against the finding that the UK provisions were consistent with the arm's length test envisaged by the European Court of Justice in Test Claimants in the Thin Cap Group Litigation v Inland Revenue Commissioners (C-524/04) (2007) STC 906 ECJ (Grand Chamber). The UK had introduced legislation, the ‘thin capitalisation’ provisions, to counter tax avoidance by groups of companies through the parent company financing a subsidiary by means of loans rather than equity, as interest payments on loans were deductible for the purpose of calculating taxable profits. The effect of the ‘thin cap’ legislation, under section 209(2) of the Income and Corporation Taxes Act 1988, was to treat any interest paid on a loan which exceeded what would be paid on an arm's length transaction as a distribution of profits.

T had brought claims challenging the compatibility of those provisions with their right to freedom of establishment under article 43. The judge held that the thin cap legislation was incompatible with article 43 as the provisions were not proportionate to achieving the purpose of preventing abusive tax avoidance, as they did not allow for a separate defence of commercial justification. The commissioners contended that the thin cap legislation was permissible under EU law if it affected transactions between related companies that were other than on arm's length terms even if there was a commercial justification. T argued that when applying the arm's length test to a subsidiary within a group of companies, the UK legislation did not permit the fact that the subsidiary was within that group to be taken into account.

Held: (1) (Arden LJ dissenting in part) The ECJ judgments in Proceedings Brought by Oy AA (C-231/05) (2007) All ER (EC) 1079 ECJ (Grand Chamber) and Societe de Gestion Industrielle SA (SGI) v Belgium (C-311/08) (2010) 2 CMLR 38 ECJ (3rd Chamber) had given welcome clarity to European law. It was clear that the objectives of ensuring the balanced allocation between Member States of the power to tax, with the prevention of tax avoidance, could justify legislation that would otherwise be an unlawful interference with the freedom of establishment guaranteed by article 43. Further, the application of an arm's length test was appropriate and sufficient for that purpose. It was a proportionate measure to achieve those objectives, Oy AA and Societe de Gestion applied. It followed that the contention that thin cap legislation could only be justified if it was confined to abusive or sham transactions had to be rejected. Legislation that involved the application of the arm's length test did not unlawfully interfere with article 43 provided that the taxpayer was given an adequate opportunity to present their case to the tax authority that the transaction in question was on arm's length terms and to challenge the decision before the national court. Also, the effect of the legislation was limited to those aspects of the advantage conferred by the taxpayer company that did not satisfy that test. There was no doubt that the UK legislation satisfied those requirements. It applied the arm's length test; it did not disallow any interest payable under a transaction on arm's length terms; the taxpayer was given an adequate opportunity to present its case and had recourse to the courts if dissatisfied with the Revenue's decision (see paragraphs 55-57 of ­judgment).

(2) There was nothing in the ECJ's judgment in Thin Cap to suggest that the UK legislation might be incompatible because of its failure to take into account a subsidiary's membership of a non-UK group of companies. The commercial justification that the taxpayer companies could have put forward for their transactions was that their terms were those which would have been agreed between unconnected parties. As that was the test applied by the UK legislation, the fact that the taxpayer could not put forward some other commercial justification did not render the UK legislation incompatible with their or their parent companies' freedom of establishment. The taxpayers' transactions in issue did not satisfy the arm's length test and the UK thin cap legislation was appropriately and lawfully applied to them (paragraphs 60-61).

Appeal allowed, cross-appeal ­dismissed.

David Ewart QC, Rupert Baldry QC, Sarah Ford (instructed by in-house solicitor) for the appellant; Graham Aaronson QC, David Cavender QC, Laura Poots (instructed by Dorsey & Whitney (Europe)) for the respondent.