The Court of Justice of the European Union (“CJEU”) today delivered its second judgment in the Franked Investment Income (“FII”) Group Litigation, finding for the taxpayer on all three key issues.
Commenting on the judgment, Chris Morgan, Head of Tax Policy at KPMG, said, “This case deals with a simple premise: that companies which have been over charged tax (on dividends or in the form of advance corporation tax) in breach of EU rules now want to be repaid.”
Chris continued “As regards advance corporation tax (‘ACT’), the claimants have effectively been making an interest free loan to the Exchequer. The Court has confirmed this must be repaid. As regards dividend taxation, the Court has agreed that the UK was entitled to top any foreign tax paid to the UK rate but had to give full credit for foreign tax at the foreign rate.“
The CJEU findings in the long running FII case
Three main issues were before the court.
The first issue related to the old UK tax rules on the taxation of dividends received from foreign companies as compared to the dividends received from UK resident companies. In December 2006, the CJEU held that in principle the UK rules were not in breach of European Union (“EU”) law provided that the foreign profits were not subject to a higher tax rate than domestic dividends. It was for the domestic court to decide whether the tax rates were indeed the same or whether a difference existed more frequently than in exceptional situations.
The CJEU has now clarified its earlier judgment, holding that as the effective rate of tax on UK dividends was generally lower than the rate of tax on foreign dividends and this was a breach of EU law.
The second issue related to the rules on Advance Corporation Tax (ACT) and Franked Investment Income (FII). In its first judgment, the CJEU had held that the FII rules were unlawful. Where are UK company received a foreign dividend which was paid out of tax profits, it should have received a credit for the foreign tax to offset the ACT due on its own dividends. Any ACT which had been unlawfully charged therefore had to be repaid. The Court has now confirmed this is also the case even where there is a more complicated group structure. It therefore does not matter that the foreign tax was paid by a lower tier subsidiary or the ACT was paid by a parent company of the one receiving the foreign dividend.
The third main issue before the CJEU concerned dividends received from a country outside the EU (ie a third country). The question asked of the CJEU was whether a UK resident company can rely on the principle of the free movement of capital (Article 63 of the Treaty of Functioning of the European Union (“TFEU”)), in respect of dividends received from a subsidiary over which it exercises decisive influence HMRC claimed that such a situation fell only within the scope of the freedom of establishment (Article 49 TFEU)), which was confined to establishments in EU Member States. THE CJEU held that if the rule, like the UK rules at issue, does not apply exclusively to situations in which the parent company exercises definite influence over the company paying the dividends, the EU freedom at stake will be free movement capital. Therefore, the EU rules also apply to the tax treatment of the dividends paid by the company established in a third country irrespective of the size of its shareholding, i.e. even if the dividends paid do not relate to a portfolio investment.
Michael Anderson, Head of Direct Tax Litigation at KPMG in the UK, said “This is a balanced and well reasoned judgement and makes the position under EU law clear. The question about whether taxpayers can claim back to 1973 still remains open though. There has been a separate referral to the European Court on this matter earlier in the year. The answer to that question will obviously have a significant impact on the value of many of the claims.”
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Notes to editors.
This long running litigation concerns the compatibility with EU law of certain aspects of the UK tax regime for company distributions. The key areas of dispute surround the taxation of non-UK dividends received by UK resident companies and mitigation of corporate economic double taxation.
The key issue is the UK tax treatment of dividends in the UK: while dividends received by a resident company from another resident company are exempt from corporation tax, dividends received from a comparable foreign company were (prior to the introduction of the exemption of foreign profits regime in 2009) subject to corporation tax, although entitled to a credit for the underlying foreign tax paid by the company making the distribution in the Member State in which it was resident.
Although the CJEU in 2006 already concluded that such difference in the treatment of domestic and overseas dividends was not in breach of EU law, the Court also stated that it would only be the case provided the tax of rate applicable to the overseas dividends is not higher than the tax rate applicable to the domestic dividends and that the tax credit is at least equal to the amount paid in the Member State of the company making the distribution, up to the limit of the amount of tax charged in the Member State of the company receiving the distribution. The CJEU added that it would be 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.
In this reference, the CJEU was requested to clarify its ruling in relation to these conditions, i.e. if the reference to “tax rates” and “different levels of taxation” refer solely to statutory or nominal rates of tax (the position held by the UK Government) or if these would also refer to the effective rates of tax paid (the position held by the claimants).
The FII and ACT rules
Under the legislation which was in force until 6 April 1999, a UK company making a dividend distribution was required to pay ACT at a specified percentage on the amount of the dividend. This ACT could then be offset against its final corporation tax liability, or surrendered to other UK group companies. At the same time, a tax credit was granted (equal to the ACT paid) to UK corporate shareholders, who received a dividend subject to ACT (FII). These rules meant that a resident company which had received foreign-sourced dividends and paid dividends of the same amount to its own shareholders had to pay ACT in full. By contrast, a resident company which received UK-sourced dividends and paid dividends to its own shareholders of the same amount typically benefited from a tax credit and incurred no ACT liability. In the case of a UK company receiving dividends from another UK company, the system ensured that, when the company receiving the dividends in turn distributed profits to its own shareholders, ACT was paid only once.
The CJEU previously found that the UK ACT rules operated in breach of EU law, such that UK parent companies should be entitled to recover surplus ACT. A question arose however as to whether this illegality was restricted to situations where: (i) the foreign company paying the dividends had itself paid tax; and (ii) the UK company receiving the dividend paid ACT on the onward payment of the dividends. The claimants argued that there was also an illegality where foreign tax had been paid lower down the chain or the UK receiving company did not itself pay ACT as it paid a dividend under a group income election ('corporate tree' issues). On the basis that such situations had not been specifically covered by the original CJEU decision, a further reference was made.
Third country dividends
In the first FII GLO judgement, the CJEU dealt with dividends received from a third country on the basis of a holding that did not give the recipient entity a definitive influence over the decisions of the company making the distribution. In this latest reference, the question was whether the freedom at stake will be free movement of capital (which extends to third countries) regardless of the particular facts of the case, i.e. irrespective of the size of the participation of the recipient company in a specific situation. This situation would entitle the UK companies receiving dividends from third countries to claim the refund of the extra tax incurred, even if the dividends where paid in a situation which does not qualify as a portfolio investment
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