The House of Lords allowed an appeal by the Revenue against the decision ([2004] BTC 50) that compensation or restitution for the loss of use of money paid as advance corporation tax (ACT) by UK subsidiaries of parents in other member states, which could not make group income elections, was not to be reduced or extinguished by tax credits received under double tax agreements (DTAs) with the relevant countries.

Facts

At the relevant time where a company resident in the UK paid a dividend to its shareholders it becam liable to pay ACT in respect of the dividend. ACT was set against the company's liability to ‘mainstream’ corporation tax. A recipient of the dividend, if resident in the UK, became entitled to a tax credit. The amount of the tax credit corresponded to the current rate of ACT. Companies in the same group could make a group income election under ICTA 1988, s. 247. A group income election had a twofold effect, reflecting the linkage between payment of ACT and entitlement to a tax credit: dividends paid by a subsidiary to its parent while the election was in force (‘election dividends’) did not trigger liability to pay ACT nor did their receipt trigger entitlement to a tax credit. So election dividends did not constitute franked investment income of the parent. The legislation restricted the right to make a group income election to cases where both companies were resident in the UK but the European Court of Justice (ECJ) in Metallgesellschaft Ltd v IR Commrs; Hoechst AG v IR Commrs (Joined Cases C-397/98 and C-410/98) [2001] BTC 99; [2000] ECR I-1727 ruled that denying groups of companies the right to make a group income election where the parent was non-resident in the UK but resident in another member state was contrary to art. 43 EC providing for freedom of establishment. The court held that the claimant companies in these cases were entitled to compensation for loss of the use of the money paid as ACT between the date of payment and the date when the ACT was used by being set off against the subsidiary company's mainstream corporation tax liabilities. The feature which differentiated the claims of the Pirelli companies from the claims in the Metallgesellschaft/Hoechst cases (where the parent company was German) was that the DTAs between the UK on the one hand and Italy and the Netherlands on the other contained provisions (art. 10) for the foreign parents to receive tax credits from the UK Revenue equal to 6.875 per cent of the dividends. The Revenue took the view that the DTA payments should be taken into account to reduce the compensation due to the Pirelli companies.

The Pirelli companies challenged that view on the wording on the UK legislation and the tax treaties and because the loss had been suffered by the subsidiaries and the DTA payments received by the parents. They further argued that ACT was contrary to EC law as a withholding tax within art. 5(1) of Directive 90/435 (the parent/subsidiary directive).

The High Court ([2003] BTC 218) and Court of Appeal ([2004] BTC 50) held that compensation was to be assessed on the basis that the taxpayers were entitled to the DTA payments even if they had been able to and had made a group income election. The Revenue appealed to the House of Lords.

Issues

1. Whether, if a group income election had been made under ICTA 1988, s. 247(1), the EU parent companies would have been entitled to a tax credit under the relevant DTA on the dividends paid to them as group income by their UK subsidiaries (‘the election issue’);
2. if not, whether the tax credits which were received by the EU parent companies under the relevant DTA should be brought into account in assessing the compensation payable to the UK subsidiaries (‘the assessment issue’); and
3. whether ACT was contrary to EC law on the ground that it was a withholding tax within the meaning of art. 5(1) of Directive 90/435.

Decision

The House of Lords allowed the appeal.

The election issue

If the UK-resident subsidiary of a parent resident in another member state of the EU had paid a dividend to its parent while a group income election was in force the parent would not have been entitled to a tax credit in respect of the dividend under double taxation conventions in the form of the Netherlands and Italian conventions.

Article 10 had to be interpreted purposively. On its face s. 247 precluded non-resident parent companies from making a group income election. The conventions were drafted and agreed on that basis. Following Metallgesellschaft/Hoechst s. 247 and art. 10 fell to be applied in a circumstance for which they were not designed, namely that a non-resident company could receive a dividend which had not attracted payment of ACT. No one could suppose that a group with a nonresident parent could elect to avoid payment of ACT by making a group income election pursuant to the Metallgesellschaft/Hoechst ruling and, at the same time, remain entitled to a tax credit under the relevant double taxation convention. That would fly in the face of the stated purpose of art. 10(3)(c), namely to entitle a nonresident parent to part of the tax credit to which a UK resident would have been entitled had he received the dividend. Article 10(3)(c) had to be read as not applying to election dividends. Reading s. 231 and s. 247 together, it was clear that the prerequisite for the giving of a tax credit was the making of a qualifying distribution which was liable to ACT. A group income election extinguished that liability and with it the right to the tax credit that was the counterpart of the liability. It followed that, if the same system had been available to them and a group election had been made, no ACT would have been payable on the distributions to the EU parent companies. So there would have been no entitlement to a tax credit with respect to those distributions under s. 788(3)(d) which gave effect to the DTAs so far as tax credits were concerned.

The assessment issue

The infringement of which the taxpayers complained was infringement of the parent companies’ right to freedom of establishment in the UK. The primary measure of the loss thus caused was the financial detriment to the UK subsidiary caused by its liability to pay ACT and the inability to make a group income election. But the benefit of the tax credits that the parent companies would not have received but for that infringement should be brought into account. The compensation should be compensation to the group for the detriment suffered by the group. Compensation that concentrated on the financial detriment of the subsidiary and ignored the financial benefit of the parent appeared to overlook the nature of the infringement. The identity of the recipient or recipients of the compensation payable for the loss suffered by the group could be left to be decided by the group, but could not affect the quantum of the compensation. Assessment of compensation was primarily a matter for the domestic legal system of each member state, provided that the principles of equivalence and effectiveness were duly observed. Accordingly, the amount of the DTA payments received by the parent companies was to be taken into account in calculating the compensation payable for the breach of art. 43 EC.

The withholding tax issue

The essence of a withholding tax within the meaning of art. 5(1) of Directive 90/435, as explained by art. 7(1), was that it was a tax on the income of the parent company. The ECJ's jurisprudence made it clear that ACT was not a withholding tax for the purposes of the directive (Athinaiki Zithopiia v Greece (Case C-294/99) [2001] BTC 451; [2001] ECR I-6797 and Océ van der Grinten NV v IR Commrs (Case C-58/01) [2003] BTC 535; [2003] ECR I-9809 applied). Accordingly, the appeal was allowed and the proceedings remitted to Park J to decide the unresolved factual question whether, had group income election been available to the taxpayer group, the group would have elected to have the UK subsidiaries pay the dividends in question free of ACT or, instead, would have chosen to have the UK subsidiaries pay the dividends outside group income election, thus enabling the overseas parents to receive convention tax credits.

House of Lords. Judgment delivered 8 February 2006.