This case was an appeal in proceedings brought as part of group litigation on the compatibility of the UK ‘thin capitalisation’ or ‘thin cap’ legislation with EU Community law. The appeal was brought to the UK Court of Appeal by both the claimants – a multinational group, acting as test claimants and the UK Revenue. Both parties appeal the judgement of the High Court given in November 2009 (2010 STC 3010). This judgement was reported in the January 2010 issue of tax.point.

History of Judgements

The case was brought to Europe in 2006; the Advocate General delivered his decision in 2006 and the ECJ gave its judgement in March 2007. The UK High Court delivered its judgement in November 2009 and found that the UK thin cap legislation was devoid of commercial justification and that the legislation should be disapplied in relation to the test claimants. In October 2010 HMRC appealed the decision of the High Court and the claimants cross appealed to the UK High Court of Appeal. The decision of that court was delivered last month and is summarised here.

Background

As in the case of The Test Claimants in the FII Group Litigation v Revenue [2010] EWCA Civ 103, the claimants in this case claimed that the provisions of UK corporate tax legislation (thin cap) were incompatible with the fundamental freedoms conferred by the EC Treaty.

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 Art 43 EC (freedom of establishment). This established for the first time that national ‘thin cap’ rules could in principle breach Art 43 EC 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 cap’.

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”. The second argument based on ‘prevention of tax avoidance’ depended on whether the rules allowed taxpayers, where a transaction did not satisfy the arm's length test set out in ICTA 1988, s. 209(2)(da), to produce evidence of the commercial justification for that transaction.

UK High Court Decision

The Court (Henderson J) 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 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 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.

Appeal

HMRC contended that the thin cap legislation was permissible under Community law if it affected transactions between related companies that were other than on arm's length terms even if those transactions were commercially justified. The claimants issued a contingent cross appeal, contending that, when applying the arm's length text to a subsidiary within a group of companies, it was necessary, in order to comply with EU law, for the Revenue and the court to take into account the fact that the subsidiary was within that group. The claimants also claimed an award of damages for breach of their treaty right.

Issue

The issue for the High Court of Appeal (Arden, Rimer and Stanley Burnton L JJ) was whether the proportionality teaching of the ECJ prescribes an arm's length test straight up or an arm's length test with a right on the part of the taxpayer to prove commercial justification for the transaction.

Decision

The judgment of the ECJ in Societe de Gestion Industrielle SA (SGI) v Belgium (Case 311/08) on the compatibility of Belgian thin cap legislation with Art 43 provided welcomed clarity on EU law in the context of the current case. It was now clear to the court that the inclusion in a members state's thin cap legislation of an arm's length test will be compliant with the requirements of proportionality and, therefore with Art 43.

Application of the arm's length test did not unlawfully interfere with Art 43 provided that the taxpayer was given an adequate opportunity to present their case to the tax authority before the national court. The UK legislation applied an arm's length test and it did not disallow any interest that would have been payable under a transaction on arm's length terms.

The commercial justification that the claimants could have put forward for their transactions was that their terms were those which would have been agreed between unconnected parties. Since this was the test applied by the UK legislation, the fact that the taxpayer could not put forward some other commercial justification did not render the UK legislation incompatible with their or their parent companies’ freedom of establishment. The taxpayers’ transactions in issue did not satisfy the arm's length test, and the UK thin cap legislation was appropriately and lawfully applied to them.

The Court found that there was no question of a conforming interpretation of the UK legislation, or of its modification by a process of disapplication, arising. The facts that would lead to the conclusion that there was some commercial justification for a non-arm's length transaction would be entirely within the knowledge of the taxpayer, and it would be able to prove any such justification.

Arden LJ (dissenting) held it was clear that the ECJ had, through the evolution of its case law, sought to provide a roadmap for determining what is or is not an abusive transaction. Such a transaction is to be found by the tax authorities first asking, by reference to objective and verifiable elements, whether the transaction is on arm's length terms, or as it is from time to time put, on fully competitive terms. It follows that the Revenue does not have to go further at this stage than consider whether the loans were on a fully competitive basis. If it was not on such terms, the taxpayer should be given an opportunity to show that the terms were nonetheless commercial, as in Lankhorst-Hohorst, and for that reason not abusive. It was for the national court to determine whether the ground that the taxpayer asserted was sufficient commercial justification for this purpose.

The appeal was allowed and the cross-appeal was dismissed (Arden LJ dissenting).

The full text of the case can be accessed at http://www.bailii.org/cgi-bin/markup.cgi?doc=/ew/cases/EWCA/Civ/2011/127.html&query=Test+and+claimants+and+in+and+thin&method=boolean