European influence: the EU fire fight

Chancellor Gordon Brown has never been very keen on Europe. Not only has he
resisted the charms of the euro, he has also fought off repeated attempts by the
European Union to create a unified European tax system.

But some things remain beyond Brown’s iron grip. The tax cases brought by
European companies over the last ten years have seen power over UK corporate tax
law ebb away from the Treasury. The legal challenges, upheld on the basis that
the UK tax regime breaks rules, guaranteed by European treaty, on the freedom of
establishment or freedom of the movement of capital, have forced the UK into
retreat.

But while the satisfaction of seeing Brown lose hundreds of millions in tax
Revenues may please some FDs, others will be nervously anticipating the
fall-out. After all, with some predicting that the Treasury coffers could lose
between £10bn and £20bn from these cases, the government has to make up the
likely shortfall somewhere. So at what stage are the group litigation orders
(GLOs), the six major cases causing the trouble, and what is likely to be the
consequence of the UK government losing the cases?

1 Loss relief

The loss relief GLO is the best known, relating to the ability of companies
to claim losses incurred elsewhere in Europe against their UK profits. The
action has been brought by around 70 companies, although Marks & Spencer is
trailblazing on the issue in a separate case. The European Court of Justice gave
its verdict on M&S in December last year, ruling that corporate losses
incurred in France or Germany, as in the case of M&S, could be offset
against UK profits. But the ECJ also ruled that such losses could only be used
if there was no possibility of them being used elsewhere.

That, in itself, is the subject of further action. M&S has since dropped
its French claim, since the losses could have been used by Galerie Lafayette,
but the retailer is pursuing its German and Belgian claims. Those claims are now
going through The UK courts, and at the last count, M&S had won in the Court
of Appeal, with the government refused leave to appeal. The court said losses
could be used where there was ‘no real possibility’ of them being used
elsewhere, narrowing down the claim requirements.

The actual GLO that awaits the claim will be heard when the M&S case has
been resolved, which may or may not be imminent. And the GLO itself has various
permutations that mean it will probably have to go to the ECJ.

The UK has responded to the action, accepting it will have to pay out some,
it thinks modest, claims. And it says that companies can claim relief only on
what they could have claimed abroad, or here, whichever is the smaller. That
interpretation too may be challenged.

2 Controlled foreign companies

The controlled foreign companies (CFCs) challenge is similar, in that one
company, Cadbury Schweppes, is pursuing the arguments. Cadbury had set up an
Irish treasury function that was taxed at the 10% Irish tax rate.

Controlled foreign companies rules dictate that any company set up in a
foreign jurisdiction just to obtain a lower tax rate is treated as forming part
of the UK’s group profits, and taxed as such. Cadbury and others are arguing
that the rules themselves contradict EU rules on freedom of establishment. The
courts ruled last September that CFC rules were fine in principle, as long as
they were only used to rule out ‘artificial arrangements’.

Cadbury and HM Revenue & Customs are now set to return to the special
commissioners in the UK so that they can argue over whether the company’s
arrangements were ‘artificial’.

The GLO case relating to Cadbury is still waiting for a hearing, but it
expected that, like M&S, it will return to the ECJ once it has been worked
through. There has also been a government response on the issue, the UK opting
to fight the issue of CFCs. It said in a consultation in last year’s Pre-Budget
Report that it wanted to draw a new distinction for offshore companies. Either
they make money from labour, which is fine, or they make money from capital,
which will be taxed at UK rates. As part of its attempt to take on the ECJ
challenge, and accept that dividend taxation will have to go, the UK wants to
stamp out CFC abuse, but it may not be as simple as that. Advisers are fighting
the new distinction tooth and nail.

3 Franked investment income

The franked investment income case came before the ECJ early in 2006, with
the court ruling earlier this year. Franked investment income rules apply an
effective tax credit when a subsidiary pays a dividend to a group, where the
credit is not available, or available to a lesser extent, to foreign parents.

The UK had said that a decision against it, brought by British American
Tobacco, among others, would cost £7bn,a figure disputed by claimants, who said
it would be between £200m and £2bn. But no-one really has any idea whether that
is likely, after the ECJ released one of its most complicated judgments.
Deloitte called it ‘poorly drafted’ and its corporate tax specialist Bill
Dodwell termed it ‘Delphic’.

The ruling attempted to force a difference between ‘equivalent’ treatment and
‘parity’, essentially looking for some way of saying UK law created parity if
not exactly equal treatment. The case returns to the High Court, but the ECJ
ruling has posed more questions than it has solved.

4 Thin capitalisation

The ECJ has ruled on the thin cap GLO, as it is known. Thin capitalisation is
all about debt levels, and loading subsidiaries with debt profit from interest
relief in low-tax jurisdictions. The UK applied broad rules of thumb to such
transactions, meaning many companies were caught unfairly. Challenges came from
Lafarge, Pepsi, Volvo and Caterpillar (as test claimants), and the ECJ decided
that the rules stood or fell on the issue of ‘commerciality’– in plain English,
whether or not the debt being shifted around was done for legitimate commercial
purposes. It too returns to the UK courts.

5 Advanced Corporation Tax

The advanced corporation tax challenge comes in four parts. In essence, the
case is about whether foreign parent companies receiving UK dividends should get
the same tax credits that UK parents get. The ECJ ruled a long time ago that
they should, leading to various disputes over which circumstances apply. The
Deutsche Morgan Grenfell case establishes how far back claims can go, ideally
(for taxpayers) all the way back to 1973, when the UK joined the EU.

The House of Lords ruled in Deutsche’s favour in October by a majority of
four to one, but don’t get your hopes up yet. ‘All is not lost for HMRC,’ Rupert
Shiers Of McGrigors says. ‘The multinationals will Now have to prove that they
were indeed operating under a mistake, rather than acknowledging that there was
doubt as to whether the tax was due but deciding nonetheless not to challenge
HMRC, when paying the overpaid tax in question.’

The Sempra Metals case determines whether or not claims should attract
compound interest or simple interest. The Class 2ACT case determines the
situation where other countries gave some tax credits. The Class 3 case is about
parent companies not resident in the EU, and the Class 4 case concerns whether
foreign parents can receive partial or whole credits according to what is
available to them in their and other jurisdictions.

The ACT case is in various respects paying out, with the only issues then
being how much and who can properly claim. The government has already admitted
it has paid out hundreds of millions of pounds here, and will be wondering how
much more it has to pay.

6 Foreign income dividends

The foreign income dividends GLO is currently waiting on the outcome of other
GLOs. Brought by pension funds, it essentially claims discrimination on the
basis of discriminatory provisions relating to the GLOs as a whole. It is still
at a largely administrative stage, discussing how claims ought to be made and
whether or not they will be time-barred.