The European Court of Justice held that the national provisions relating to thin capitalisation gave rise to a difference in treatment between resident borrowing companies according to whether or not the related lending company was established in the UK. Such legislation would be considered a restriction on freedom of establishment if it was capable of restricting the exercise of that freedom in one member state by companies established in another member state, and it was not necessary to establish that the legislation in question had actually had the effect of leading some of those companies to refrain from acquiring, creating or maintaining a subsidiary in the first member state. It followed that the difference in treatment constituted a restriction on freedom of establishment which was permissible only if it was justified by overriding reasons of public interest and did not go beyond what was necessary to attain it.

Facts

This reference for a preliminary ruling concerned the interpretation of art. 43 EC. The reference was made in proceedings between groups of companies (‘the taxpayers’) and the Revenue (now HMRC) concerning the tax treatment of interest paid by UK-resident companies in respect of loans granted by a company belonging to the same group which was not resident in that member state. The main proceedings were part of a group litigation concerning the rules on thin capitalisation (‘Thin Cap Group Litigation’), consisting of a number of claims for restitution and/or compensation brought by groups of companies against the Revenue following the judgment in Lankhorst-Hohorst GmbH v Finanzamt Steinfurt (Case C-324/00) [2003] BTC 254; [2002] ECR I 11779.

Each of the cases selected by the national court as test cases involved a UK-resident company which was at least 75 per cent owned, directly or indirectly, by a non-resident parent company and had been granted a loan either by that parent company or by another nonresident company which was at least 75 per cent owned, directly or indirectly, by that parent company. Some of the taxpayer companies converted part of those loans to equity in order to prevent the interest payments under the loans being re-characterised as a distribution under the UK legislation. Some of the taxpayers had concluded an agreement with the UK tax authorities as to how that legislation should be applied, laying down the terms upon which the tax authorities would assess loans to be granted within the group of companies in future years. Following the judgment in Lankhorst-Hohorst, the taxpayers brought claims for restitution and/or compensation for the consequential tax disadvantages which they claimed to have suffered as a result of the application of the UK legislation, including, in particular, the additional corporation tax paid following the decision of the UK tax authorities to disallow interest paid as a deduction against their taxable profits and/or to limit such deductions, and the additional tax arising as a result of those companies having converted loans to equity. The national court stayed the proceedings and made a reference to the European Court of Justice (‘ECJ’) for a preliminary ruling on the proper interpretation of art. 43 EC.

Issues

Whether art. 43 EC precluded legislation of a member state which restricted the ability of a resident company to deduct, for tax purposes, interest paid on loan finance granted by a direct or indirect parent company which was resident in another member state, where that resident company would not have been subject to such a restriction if the interest had been paid on loan finance granted by a parent company which was resident in the first member state; and whether the answer would differ if it could be shown that the borrowing constituted an abuse of rights or was part of an artificial arrangement designed to circumvent the tax law of the member state in which the borrowing company was resident.

Decision

The ECJ (Grand Chamber) (ruling accordingly) said that, in accordance with settled case-law, national provisions which applied to holdings by nationals of the member state concerned in the capital of a company established in another member state, giving them definite influence on the company's decisions and allowing them to determine its activities, came within the substantive scope of the provisions of the EC Treaty on freedom of establishment. Legislation such as the present, which was targeted at relations within a group of companies, primarily affected freedom of establishment and should, accordingly, be considered in the light of art. 43 EC. The documents before the court showed that the fact that interest paid to a related company was treated as a distribution was capable of increasing the liability of the borrowing company to tax, not only because taxable profits could not be reduced by the amount of the interest paid, but also because, by treating that interest as a distribution, that company might be liable to advance corporation tax when that transaction took place.

Article 43 EC precluded legislation of a member state which restricted the ability of a resident company to deduct, for tax purposes, interest on loan finance granted by a direct or indirect parent company which was resident in another member state or by a company which was resident in another member state and was controlled by such a parent company, without imposing that restriction on a resident company which had been granted loan finance by a company which was also resident, unless, first, that legislation provided for a consideration of objective and verifiable elements which made it possible to identify the existence of a purely artificial arrangement, entered into for tax reasons alone, to be established and allowed taxpayers to produce, if appropriate and without being subject to undue administrative constraints, evidence as to the commercial justification for the transaction in question and, secondly, where it was established that such an arrangement existed, such legislation treated that interest as a distribution only in so far as it exceeded what would have been agreed upon at arm's length.

Article 43 EC had no bearing on legislation of a member state which applied to a situation in which a resident company was granted a loan by a company which was resident in another member state or in a non-member country and which did not itself control the borrowing company and where each of those companies was controlled, directly or indirectly, by a common parent company which was resident in a non member country.

In the absence of Community legislation, it was for the domestic legal system of each member state to designate the courts and tribunals having jurisdiction and to lay down the detailed procedural rules governing actions for safeguarding rights which individuals derived from Community law, including the classification of claims brought by injured parties before national courts and tribunals. Those courts and tribunals were, however, obliged to ensure that individuals had an effective legal remedy enabling them to obtain reimbursement of the tax unlawfully levied on them and the amounts paid to that member state or withheld by it directly against that tax. As regards other loss or damage which a person might have sustained by reason of a breach of Community law for which a member state was liable, the latter was under a duty to make reparation for the loss or damage caused to individuals under the conditions set out in para. 51 of the judgment in Brasserie du Peâàcheur SA v Germany; R v Secretary of State for Transport, ex parte Factortame Ltd (No. 4) (Joined Cases C-46/93 and C-48/93) [1996] ECR I-1029 1996] QB 404, but that did not preclude the state from being liable under less restrictive conditions, where national law so provided.

Where it was established that the legislation of a member state constituted an obstacle to freedom of establishment prohibited by art. 43 EC, the national court might, in order to establish the recoverable losses, determine whether the injured parties had shown reasonable diligence in order to avoid those losses or to limit their extent and whether, in particular, they availed themselves in time of all legal remedies available to them. However, in order to prevent the exercise of the rights which art. 43 EC conferred on individuals from being rendered impossible or excessively difficult, the national court might determine whether the application of that legislation, coupled, where appropriate, with the relevant provisions of double taxation conventions, would, in any event, have led to the failure of the claims brought by the claimants in the main proceedings before the tax authorities of the member state concerned.

European Court of Justice (Grand Chamber).
Judgment delivered 13 March 2007.