This case concerned the compatibility of the UK ‘thin capitalisation’ legislation with EU Community law. The challenge was brought by multinational groups, acting as test claimants, with investments in UK-resident subsidiaries by means of loan finance.

Background

The potential vulnerability of the UK ‘thin cap’ rules to challenge first became apparent when in the case Lankhorst-Horost GmbH v Finanzamt Steinfurt [2002] ECR I-11779 [2003] STC 606 (“Lankhorst-Horost”) the ECJ held that German ‘thin cap’ rules breached Article 43 EC (freedom of establishment). This established for the first time that national ‘thin cap’ rules would in principle breach Art 43 EC (freedom of establishment) if their effect was to treat resident subsidiaries of a non-resident parent in another Member State less favourably than if the parent were resident in the same State as the subsidiary. Following the judgment in the Lankhorst-Horost case, numerous claims where brought in the High Court by UK resident subsidiaries of multinational groups. The proceedings were part of group litigation concerning the UK rules on ‘thin capitalisation’.

ECJ Preliminary Ruling

Following a reference for a preliminary ruling, the ECJ held that the difference in treatment between UK resident subsidiaries depending on the place where their parent company had its seat constituted a restriction on freedom of establishment. Such a restriction was permissible “only if it is justified by overriding reasons of public interest”, and the application of the restriction was “appropriate to ensuring the attainment of the objective in question and not go beyond what is necessary to attain it”. The UK government argued that the UK ‘thin cap’ provisions were justified on two grounds; cohesion of the national tax system and the prevention of tax avoidance. The ECJ stated that for an argument based on cohesion to succeed “a direct link must be established between the tax advantage concerned and the offsetting of that tax advantage by a particular levy”. No such direct link had been demonstrated by the UK. The second argument based on ‘prevention of tax avoidance’ was rejected by the ECJ as the proceedings were not proportionate to achieve the purpose of preventing abusive tax avoidance; if a transaction did not satisfy the arm's length test set out in Income and Corporation Taxes Act 1988 (“ICTA”) 1988 s209(2)(da), a separate defense of commercial justification must be allowed.

UK High Court Decision

The Court considered the position at three separate periods: first, the rules applicable until 1995 which were contained in section 209(2) ICTA; secondly, the amendments which were made in 1995 and which remained in force until 1998; and thirdly, the transfer pricing rules which were introduced in Finance Act 1998 schedule 28AA to ICTA, and which remained in force, in a potentially discriminatory form, until 2004. Considering the three periods, the critical question for the Court was whether the UK ‘thin cap’ rules were compatible with Article 43 EC. In the light of the judgment of the ECJ, the answer to this question depended on whether the UK ‘thin cap’ rules were proportionate to achieve the purpose of preventing abusive tax avoidance.

The Court referred to the judgment in the Lankhorst-Horost case and the ECJ decision, and held that an arm's length test provided an objective and verifiable filter; however, it was essential that the taxpayer had the opportunity to show that the arrangement had a commercial justification. The Revenue's submission that the ECJ regarded the question of commercial justification as no more than an aspect of the arm's length test and that the ECJ regarded them as separate tests, each of which had to be satisfied, was rejected.

The ECJ analysis of the relevant principles of Community law established that the only defect in the UK provisions, both before and after 1995, was the failure to provide for a defense of commercial justification, and therefore to confine the scope of the provisions to cases of abusive tax avoidance. The Court declared that to preserve the Community right of the test claimants, the provisions could only be invoked against them in cases where the relevant transactions constituted (either wholly or in part) abusive tax avoidance.

The Court held that the UK national rules would be disapplied only in relation to transactions which satisfied the test of commercial justification, either in whole or in any relevant part. The UK rules should have at all material times have afforded the claimants an opportunity to demonstrate the existence of a commercial purpose, but did not do so. Therefore the onus was on the Revenue to show that the transactions in question lacked any commercial purpose. However, the Court held that to require the claimants to demonstrate a commercial justification after the event, and when the issue did not arise under the rules as they were then understood and applied, would infringe the Community principle of effectiveness.

The Court held that none of the relevant transactions entered into by the test claimants were, either wholly or in part, purely artificial arrangements devoid of any commercial justification. Therefore the UK ‘thin cap’ provisions had to be disapplied in relation to all of the transactions.

The full text of the case can be accessed at http://www.bailii.org/cgi-bin/markup.cgi?doc=/ew/cases/EWHC/Ch/2009/2908.html&query=Thin+and+Capitalisation&method=boolean