UK High Court confirms corporation tax treatment of overseas dividends to be discriminatory--
 

The Test Claimants in the FII group litigation v HMRC [2008] EWHC 2893
On 27 November last, Henderson J handed down an important UK High Court decision concerning the compatibility of the UK's dividend taxation rules with the EC Treaty. The decision fundamentally represented a success for the taxpayers although there will inevitably be an appeal given the reportedly £5 billion at stake.

Background
In December 2006 the European Court of Justice (ECJ) concluded in an earlier round of the above case that the European law does not preclude the co-existence of a system whereby a Member State does not impose corporation tax on domestic dividends but subjects foreign source dividends to an imputation system. This was subject to the important proviso that the foreign source dividends must not be subject to a higher rate of tax the rate applicable to domestic dividends.

The ECJ did not follow precisely the opinion of former Advocate General Geelhoed who had concluded that the UK provisions were contrary to both free movement of establishment and free movement of capital rules. It was clear to him that the application of a credit system for relieving double taxation on foreign-source dividends could be less favourable than an exemption system.

As Henderson J noted, the decision of the ECJ is interpreted as requiring that a comparison be made between the imposition of a rate of tax on foreign dividends and the rate applicable to taxable income from domestic sources, such as trading profits, out of which domestic dividends are paid. A typical UK subsidiary might have paid corporation tax at a rate of 30% on its trading profits. Exempting the dividend is akin to recognizing that the UK parent is receiving a dividend sourced from profits that have already been taxed at 30%. The ECJ logic is because the rates are similar, different levels of taxation didn't arise.

The fundamental problem with the ECJ decision is that for some incomprehensible reason it did not address the impact of lower effective rates of corporation tax. It noted that the UK authorities had indicated that "the application to the company making the distribution and to the company receiving it of different levels of taxation occur only in highly exceptional circumstances which do not arise in the main proceedings" before concluding that , "in that respect, it is for the national court to determine whether the tax rates are indeed the same and whether different levels of taxation occur only in certain cases by reason of a change to the tax base as a result of certain exceptional reliefs." In a nutshell, whereas the Advocate General had concluded that a credit system was less advantageous than an exemption system the ECJ put the onus back on the UK courts to ascertain if differential tax rates existed that were not derived from exceptional reliefs.

UK High Court decision
The High Court, having quoted with approval the Advocate General, noted that there were difficulties in interpreting the ECJ decision as it applied to effective tax rates. The argument had been made by the UK taxpayers that in a domestic context, the company paying the dividend may have paid corporation tax at a lower rate than the nominal rate or may have paid no tax at all. Finding support from the French text of the decision, Henderson J noted this was in substance the argument of the Advocate General. However, the ECJ appears to have placed so much weight on a UK submission that different levels of taxation arose only in exceptional circumstances 'which do not arise in the main proceedings' that it failed to address the Advocate General's observations. Henderson J observed that "I cannot escape the impression that at this critical point the ECJ must have misunderstood the argument being advanced for the UK government". In arguing that the sole aim of the UK legislation was to eliminate economic double taxation, the UK submissions to the ECJ pointed out that in a domestic context the effect of the exemption was to prevent the same amount of profits being taxed twice at the same rate. A reference was contained in these papers to the small companies rate imposing a lower nominal rate of corporation tax and Henderson J felt that this reference explained the ECJ position. The UK's arguments were not directed at differences between nominal and effective rates yet there is "obviously nothing exceptional about the proposition that companies often pay corporation tax at an effective rate lower than the nominal rate, because the existence and availability of reliefs which reduce the tax base (such as group relief, or the carry forward of trading losses) are commonplaces of UK corporate taxation. The UK government could not rationally have argued that such cases were exceptional."

It was observed that the ECJ had agreed with the general approach of its Advocate General. Why then was the argument concerning effective tax rates, which the Advocate General accepted, dealt with so briefly? If the argument was mistaken or irrelevant the ECJ would have said so. Henderson J felt the ECJ endorsed it but that it was unclear as to the factual question raised by the UK. The right questions to be determined by the High Court fell to be:

1. whether different nominal tax rates applied in the UK to domestic and foreign dividends; and
2. whether different levels of effective taxation occur in the UK only in certain exceptional cases.

HMRC's suggestion that the ECJ had disagreed with the Advocate General and that the only question referred back to the UK Court concerned the existence of the small companies rate (and thus different levels of nominal tax rates rather than effective rates) was rejected.

This lengthy High Court judgment also covered other aspects of UK taxation such as ACT and FIDs that are not relevant in Ireland. Of the remaining issues, the criticism of the UK Revenue to give serious consideration to the potential community law issues of foreign dividends is of most interest. Henderson J noted that the uncertainty in treatment existed at least until the earlier decision of the ECJ in Verkooijen.

In conclusion the UK High Court has affirmed that the UK dividend taxation rules, by imposing corporation tax on UK companies receiving dividends from EU/EEA-resident companies, have at all material times been incompatible with the freedom of establishment and are therefore invalid.

Application of the decision to Ireland

Under the Irish tax code distributions received from EU resident companies are liable to Irish corporation tax (at rates up to 25%) subject to any tax credit for underlying taxes paid by the non-resident companies available under unilateral credit relief rules or under a double taxation agreement. The 2008 Finance Act introduced a 12.5% rate of corporation on dividends received from EU and tax treaty partner resident companies, subject to certain conditions, one of which is that the profits out of which the dividend was sourced were trading profits. This measure was introduced retrospectively to dividends received on or after 1 January 2007 but does not address earlier dividends, a striking anomaly particularly in light of the observation above that that UK Revenue should have faced up to the emerging issue much sooner.

The fundamental problem prior to Finance Act 2008 was that dividends received from overseas subsidiaries were liable at rates up to 25% whereas a dividend from a domestic company was exempt. Irrespective of the ongoing UK litigation this treatment was clearly unsustainable. If an Irish parent company received a dividend from a Hungarian subsidiary that suffered Hungarian tax at an effective rate of 12.5% (say) it would have been subjected to an additional 12.5% tax charge. The same dividend from an Irish trading subsidiary that paid the exact same tax (say 12.5%) would not have been subjected to additional corporation tax at the level of the parent.

Following Finance Act 2008, the Irish rules are now similar to the UK rules that were examined by Henderson J and the ECJ. Thus Henderson J's analysis of the ECJ decision is directly relevant in Ireland. While the UK High Court decision is under appeal and is only of persuasive authority in Ireland, the logic of examining effective tax rates appears to be incontrovertible when the stated rationale for an exemption system is to merely eliminate double taxation. In effect what the exemption system does is to provide a unilateral credit for underlying corporation tax paid by domestic subsidiaries irrespective of whether or not those Irish companies have in fact paid any tax. In addition to the measures noted by the courts so far, e.g. losses and group relief, the Irish mix still includes the final years of manufacturing relief. To put it another way, why should a dividend from a loss making Hungarian company be liable to corporation tax at 12.5% while a similar dividend from a loss making Irish subsidiary is exempt?

One obvious solution to this problem is to exempt foreign dividends. This will be the UK solution.

What wasn't addressed by the UK High Court was the position of portfolio dividends. It didn't have to. The ECJ made it clear that the inability to access underlying tax credits on foreign dividends was discriminatory vis-a-vis a domestic exemption for portfolio dividends. The introduction of a 12.5% rate in the 2008 Finance Act impacted on the cost/ benefits analysis of pursuing a claim against the Irish authorities but didn't fix the fundamental problem.

Sooner or later the tax treatment of dividends will need to be addressed by the Irish authorities in light of the fact that many companies have being asserting EU claims in this area for some years. An Appeal Commissioner decision on the corporation tax treatment of foreign dividends is expected in 2009.