Facts and legislative background
This case considers two key issues regarding the treatment of foreign-sourced dividend income: 1) whether the UK ACT rules, in operation up to 1999, were in breach of EU law; and 2) whether the UK rules that tax foreign-sourced dividend income (with double tax relief for foreign tax paid) but exempt from corporation tax UK-sourced dividend income were contrary to EU law. From 1 July 2009, dividends received from UK and non-UK sources are generally exempt from tax.
The claimants under the FII GLO are UK companies which:
- Paid ACT, but were not able to offset this ACT against mainstream UK corporation tax, because all or most of their profits came from foreign sources which had been taxed overseas rather than in the UK. These companies claimed that ACT in effect became an unlawful secondary or double tax which penalised companies who invested abroad.
- Suffered additional UK tax on their foreign-sourced dividends. If these dividends had been UK-sourced, they would have been received tax free.
Taxation of foreign dividends
Under UK law dividends received from other UK resident companies were exempt from UK corporation tax. In contrast, overseas dividends received were fully taxable (subject to credit relief for foreign tax paid).
In respect of taxation of foreign dividends, the ECJ held that provided the UK tax rate imposed on foreign-sourced dividends is not higher than that applied to UK-sourced dividends, the UK rules are not contrary to EU law. The Court found that the UK is not under an obligation to apply an exemption method to foreign dividends in the same way as it does with UK dividends, and that the existing credit method is consistent with EU law to the extent that it does not result in a higher tax on foreign dividends. However, the ECJ left it to the UK Courts to decide if, in practice, the system imposes a higher tax rate in respect of foreign dividends.
High Court decision
On whether the possibility of having a dual system provided that the UK tax rate imposed on foreign-sourced dividends is "no higher” than that applied to UK-sourced dividends, the Court accepted that the majority of UK companies' profits are taxed at an effective rate lower than the applicable statutory rate (for example, due to group relief, losses brought forward, capital allowances, etc) and therefore the UK legislation does not meet the "no higher” tax condition imposed by the ECJ. On this basis, the Judge concluded that the UK rules breach EU law.
With regard to non-EU non-portfolio dividends, the Court accepted that the rules did not breach EU law based on the application of Article 57 EC Treaty (standstill provisions) which permits the continued application of discriminatory rules as these rules were already in existence on 31 December 1993.
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 ECJ found that the UK ACT rules operated in breach of EU law, such that UK parent companies should be entitled to recover surplus ACT. In examining the FID regime which was introduced to alleviate the surplus ACT problem faced by UK parent companies and allowed UK companies to elect to get the ACT repaid where dividends were matched with foreign profits, the ECJ found that the UK rules operated in breach of EU law. Where a FID election was made, the shareholder receiving the dividend was not entitled to a tax credit. The Court concluded that the FID regime was contrary to EU law since a UK company investing overseas remained in a less favourable situation than that of a company receiving UK sourced dividends in that it suffered a cash disadvantage. Furthermore, the FID recipients were denied a tax credit which would have been available had the dividends been sourced from UK profits.
High Court decision
On the point regarding repayment of surplus ACT, the Court found that ACT should be repaid 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. However, the Judge took the view that another reference to the ECJ was necessary in order to determine the answer where foreign tax has 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). This being on the basis that such situations had not been specifically covered by the original ECJ decision. The High Court decision was subject to cross-appeals by HMRC and the claimants.
Court of Appeal decision
On 23 February 2010 the Court of Appeal published their decision on the FII GLO case. A range of specific issues were considered. The Judges' views were in line with the High Court on some issues, disagreed on others and referred certain issues back to the ECJ for the second time. The key points to note are as follows:
- In respect of whether the Schedule D Case V rules infringe Article 43 EC Treaty (freedom of establishment1 ), the opinion of the Judges was split. The Revenue's appeal against the High Court decision was successful and therefore the current position is that non-portfolio dividends are taxable. However, partly due to the substantial sums at stake in this case (up to £5bn), it was decided that a referral to the ECJ was required in order to seek clarification of the 2006 decision2. We continue to hold the view that the rules are not compliant with EU law.
The Court agreed with the ECJ and High Court decisions in stating that in the case of dividends received from third country (non-EU) subsidiaries (non-portfolio holdings), the Schedule D Case V rules did not infringe EU law. Whilst Article 56 EC Treaty (free movement of capital) may be breached by the UK rules, the 'standstill' provisions of Article 57 EC Treaty apply such that the rules are permitted.
It was not disputed that the surplus ACT provisions are unlawful. As proposed in the High Court decision, the Judges agreed that the 'corporate tree' questions regarding the compatibility of various ACT provisions with EU law should be referred back to the ECJ for further consideration.
In line with the ECJ and High Court ruling, it was held that the FID regime infringed Article 56 EC Treaty and that the 'standstill' provisions of Article 57 EC Treaty do not apply.
With regard to claim time limits, the Court determined that restitution claims are restricted to tax paid in the last six years and that the extended time limits granted in 'mistake of law' cases under the 1980 Limitation Act are not available. The Judges reached this conclusion by stating that sufficient remedy, for EU law purposes, is provided under Woolwich claims (restitution for payments unlawfully levied) and the UK does not have an obligation to provide an extended limitation period. Despite the fact that the 'blocking' legislation (s320 FA 2004 and s107 FA 2007) which is aimed at limiting tax claims under the 1980 Limitation Act is likely to be incompatible with EU law due to the lack of transitional provisions, this was not relevant as the six year period was deemed to be sufficient. We would expect that this issue will be appealed.
The Court decided that, where the UK rules are in breach of EC law, the breach is not sufficiently serious so as to entitle the claimants to damages.
It is frustrating that certain key issues have been referred back to the ECJ as it is likely to be a number of years before this, already lengthy, process will reach an ultimate conclusion. However, this is not wholly surprising given the substantial sums at stake. The opinion of the Judges was split with regard to the compatibility of the Schedule D Case V rules and they felt the need to seek clarification on the ECJ's original decision from 2006. The claimants may seek permission to appeal to the Supreme Court against the ECJ referral. If permission was granted, the Supreme Court would then decide whether to uphold the referral or make a judgment on the case.
As all claims pursued through the FII GLO relate to parent-subsidiary relationships, the Court of Appeal did not specifically comment on portfolio shareholdings. However, we have considered the decision in the context of portfolio dividends in the appendix to this note.
In respect of the 'corporate tree' ACT issues, the High Court felt that another reference to the ECJ was needed and the Court of Appeal respected this approach.
With regard to the ruling on dividends paid from third countries, it should be noted that this decision relates to non-portfolio (10% or more) holdings where credit relief was available for underlying tax suffered. In respect of portfolio holdings, where such relief is not granted, there are separate cases ongoing.
The ruling regarding remedies and time limits will be viewed by some as the most interesting element of the decision. HMRC have long sought to limit the claim periods relating to EU law and they will view this decision favourably. The principles set out will apply to many EU claims and could significantly reduce the repayments available. We fully expect that this decision will be appealed and, ultimately, may be debated in the Supreme Court.
On the positive side for claimants, the previous decisions stating that the surplus ACT and FID regimes are in breach of EU law were upheld. Whilst there remain certain questions to be answered by the ECJ, the ruling remains in favour of the claimants on these issues.
Non-portfolio shareholdings (holdings of 10% or more)
- No action required regarding dividend exemption claims already filed, given the referral to the ECJ.
- Claimants that have filed surplus ACT claims when ACT was paid by the UK water's edge company should consider speaking with HMRC to try to get their claims agreed. However, given the referral to the ECJ on the 'corporate tree' issues, HMRC may resist.
- Dividend exemption claims should continue to be filed. Considering the change in time limits that will take effect from 1 April 2010, action must be taken as soon as possible:
- Where a UK company has suffered tax on EU/EEA dividends received in respect of open periods, or if it has not been possible to quantify the credit relief, the tax return can be filed/re-filed on the basis that the dividends should be exempt;
- Where a UK company has suffered tax on EU/EEA dividends received in the last six years in respect of periods which are no longer open, a mistake claim can be filed with HMRC to exempt dividends;
- Where a UK company has suffered tax on EU/EEA dividends in a period outside of the six year time limit, it may be possible to file a mistake of law claim with the High Court on the basis that the dividends should be exempt and this should be done before 1 April 2010. Claims filed using this route may ultimately be defeated if the Court of Appeal judgment regarding remedies is upheld. We expect that this judgment will be appealed.
- Surplus ACT claims should continue to be made in the High Court before 1 April 2010.
Portfolio shareholdings (holdings less than 10%) - worldwide dividends
- Claims should be maintained. Even if the ECJ finds that the rules in Schedule D Case V do not infringe Article 43 EC Treaty, the UK dividend exemption claims for portfolio dividends, which argue a breach of Article 56 EC Treaty, remain strong as the taxpayer was not able to obtain full credit relief.
- Consider filing claims before 1 April 2010 to exempt both EU and non-EU dividends received before 1 July 2009.
Should you require further assistance in this matter, please contact:
Chris Morgan - 020 7694 1714
Caroline Austin - 020 7311 2537
Pilar Espejo - 020 7311 4982
Jon Simons - 020 7694 4032
Kit Dickson - 0161 246 4503
Appendix - Interpreting the Court of Appeal decision in the context of portfolio dividends
The comments below refer to dividends received by UK companies which have less than a 10% holding in the dividend paying company as portfolio dividends.
Until this week, portfolio dividends received by UK companies from non-UK companies had, since the 2008 High Court judgment, become exempt from corporation tax. There is still some uncertainty as to the effect on portfolio dividends of the UK Court of Appeal judgment, earlier this week. There are two possible alternative views:
- one view is that the UK legislation has to be interpreted in compliance with EU law so as to give underlying tax relief on portfolio dividends in the same way as for non portfolio dividends;
- the other view is that such a condition cannot be read into the UK domestic rules and so non UK dividends must be treated as exempt in the same way that UK dividends are.
Until further clarification is obtained, it is difficult to be more certain on the current state of UK law in relation to portfolio dividends.
UK law as it stood following the 2008 judgment
Under UK domestic legislation portfolio dividends received by a UK company from a non UK company before July 2009 were chargeable to corporation tax with no relief for underlying tax.
In 2006 the ECJ gave a ruling on the UK legislation on dividends, following the referral of the Franked Investment Group Litigation case to the ECJ. The ECJ ruling suggested that the UK legislation in relation to portfolio dividends was not consistent with the EC Treaty. The ECJ ruling held that the UK was not permitted to exempt, from the charge to corporation tax, portfolio dividends received from UK companies whilst taxing portfolio dividends received from non-UK companies and not allowing relief for underlying tax.
This implied two possible outcomes for UK tax law in relation to portfolio dividends. Either non-UK dividends were exempted from the charge to Corporation Tax or relief was given for the underlying tax suffered on non-UK dividends. The ruling of the ECJ was conditional on a question of comparing the UK tax rates that applied to UK dividends, to the UK tax rates that applied to non-UK dividends. The case was passed back to the UK High Court to give further comment on exactly how it should be applied.
The UK High Court answered the question posed by the ECJ in relation to the comparability of tax rates applying to UK and non-UK dividends by saying the rates were not sufficiently comparable. The High Court held, therefore, that it was not consistent with the EC Treaty for the UK to tax dividends received from non-UK companies whilst exempting those received from UK companies. Therefore portfolio dividends received by UK companies from non-UK companies became exempt from corporation tax.
Position following the Court of Appeal decision
The judgment in the Franked Investment Income Group Litigation case changed the UK law position described above. Under UK law as it currently stands following the Court of Appeal judgment, and prior to any further clarification from the ECJ or appeal to the UK Supreme Court, the UK domestic legislation relating to non portfolio dividends is compliant with EU law.
It is, however, clear that the taxation of portfolio dividends under UK domestic legislation is in breach of EU law. There is still some uncertainty as to the effect on portfolio dividends of the Court of Appeal judgment. One view is that the rules have to be interpreted in compliance with EU law so as to give underlying tax relief on portfolio dividends in the same way as for non portfolio dividends. However there is an argument that such a condition cannot be read into the UK domestic rules and so non UK dividends must be treated as exempt in the same way that UK dividends are.