Henderson J today gave judgment in the FII Group Litigation following a three-week hearing of the case in July. We summarize below the main findings and consequences of the Judgment, which runs to nearly 250 pages.
Dividend taxation unlawful (EU/EEA distributions)
Tax on dividends received by UK companies from holdings of 10% or more in EU/EEA companies is discriminatory and unlawful.
This is because the rate of corporation tax incurred on domestic distributed profits is commonly lower (taking into account reliefs and allowances) than the rate applied to distributed profits from the EU/EEA. Reductions in the tax base of the domestic subsidiary are passed up to its parent whereas any such reduction by the non-resident subsidiary was equalised up to the UK nominal rate .
This finding by the High Court supplements the finding, already made by the ECJ, that the taxation of portfolio dividends is discriminatory.
Dividend taxation lawful (non EU/EEA distributions)
By contrast tax on dividends from direct investments such as subsidiaries outside the EU is lawful. Taxpayers can in principle invoke EU capital movement rights in relation to third countries for both portfolio dividends and dividends from direct investments. However, the tax pre-dates 1994 and in the case of direct investment is therefore protected by the grandfathering provision in the EC Treaty (article 57(1)). The EUFT system represented a substantial change in the rules in 2001 but it did not alter the underlying tax liability and therefore did not disrupt the protection under the grandfathering provision.
EU/EEA sourced income to be treated as Franked Investment Income (FII)
For the purposes of calculating the ACT repayable as a result of the unlawful FII rules in the period to 5 April 1999, dividends from the EU/EEA are to be treated as franked investment income. They should have carried a credit as if they were dividends from a UK company on which ACT had been made. There is no need to undertake a reconstruction exercise tracing the source of foreign income distributed by the UK parent.
The Judge concludes tentatively on the basis of the ECJ’s reasoning that it makes no difference which company in the UK group paid the ACT and whether corporation tax on the profits was paid by the (water’s edge) EU subsidiary which paid the dividend or by a subsidiary lower down the chain. However, the Judge notes that this question, referred to in the Judgment as “the corporate tree point”, was not explicitly answered by the ECJ and will at some stage in the proceedings need to be referred back to the ECJ for clarification.
Whether relief equivalent to the surrender of ACT to a UK subsidiary should have been given for EU subsidiaries is also an open question which must be referred back to the ECJ.
Foreign Income Dividends (FIDs): unlawful even for non EU income
The FID regime was unlawful in relation to dividends received from the EU. In relation to ACT claims under FIDs the corporate tree point arises in the same way as above.
The FID regime was also unlawful in relation to third countries, and the UK could not rely on the grandfathering clause under Article 57(1). On the facts FIDs were enhanced to compensate tax exempt shareholders for the absence of the credit.
What claims can be made?
In general terms claims can be made without restriction for repayment of tax actually paid and for time value/loss of use, whereas more sophisticated claims for set-off of reliefs or enhancement of dividends fail.
Repayment v Damages
The distinction at Community law between a repayment (“San Giorgio”) claim and a damages claim can be important as the former is recoverable as of right but the latter requires a finding that the UK’s breach of Community law was “sufficiently serious”.
Claims for the repayment of tax actually paid (surplus ACT/loss of use of utilised ACT/dividend tax) are repayment claims at Community law.
Claims arising from the enhancement of FIDs to compensate exempt shareholders for a lack of a credit and the incidence of lawful CT caused by waiving reliefs to enable unlawful ACT to be utilised more quickly are damages claims.
Claims arising from the utilisation of reliefs to shelter unlawful tax liabilities have not been defined as damages claims by the ECJ. But they are not restitution (DMG) claims under English law. DMG claims are limited to repayment of tax paid by mistake and the reversal of any directly associated benefits retained as a result of the mistaken payment. Here the link was not sufficiently direct.
English law defences inapplicable to Community law repayment claims
HMRC’s defence that they have “changed position” by spending the tax receipts on public purposes is a valid defence. However it cannot apply to the “San Giorgio” repayment claims (above). If the English law DMG claims had gone beyond San Giorgio claims (which they do not) then there would in principle be a change of position defence to exclude or limit compensation. HMRC’s defence that it would be unconscionable and inequitable to require them to compensate the claimants is in reality a request for a temporal restriction which must be sought from the ECJ. Such a restriction was sought twice and refused. It is not a defence under national law.
Retrospective Reduction in Limitation Period Unlawful
Repayment claims, together with claims for interest, can be made in the High Court back to 1973. The reductions in limitation periods introduced without notice and/or retrospectively (s320 FA 04 and s107 FA 07) are unlawful and fall to be disapplied in so far as the DMG claims give effect to San Giorgio claims.
No Sufficiently Serious Breach
The claims in damages fail because the breach was not sufficiently serious, at least for the period before 2000.
HMRC can be justly criticised for “their apparently total failure to give any serious consideration to the potential Community law issues” (para 399). Their general approach was one of “insular insouciance”. But had they taken advice they could reasonably have left the legislation unchanged. Thus, the damages claims (in particular for the cost of enhancing FIDs to compensate shareholders) fail.
High Court Jurisdiction over Mistake Claims
The statutory provisions for error and mistake claims (s33 TMA) do not exclude restitution claims which rely on Community law.
Conclusions, Compliance and the PBR
The Judgment is an extremely thoughtful and thorough piece of work. Inevitably given the sums and issues involved it will be subject to appeal; moreover, the Judge has indicated that further guidance from the ECJ is required on certain issues.
As things stand, tax on EU/EEA dividends is unlawful. For the current year (and open years) clients can claim by filing on that basis. In the Pre- Budget Report the Government announced the introduction of an exemption for dividends from subsidiaries. A separate note on the implications of this will follow once more detail has been announced.
The disapplication of s 320 FA 2004 and s 107 FA 2007 means that claims can be made in the High Court for closed years back as far as 1973. This applies to both dividend taxation and ACT repayment claims.
Although as things stand more sophisticated claims (ACT or other reliefs set off against dividend tax liabilities or capital allowances disclaimed) fail, consideration should still be given to protecting the position by including such claims in any claim now made given the likelihood of appeal and the partial success in arguing that the ECJ had not defined the general use of reliefs as damages claims.
As matters stand claims for tax on dividends from direct investment such as subsidiaries are limited to dividends from the EU. Again however, consideration should be given to protecting the position in respect of claims for tax on third country dividends from direct investment.
It should be noted that claims remain possible for tax on portfolio dividends from third countries following the rulings in C-101/05 A and C- 201/05 CFC and Dividend GLO. In that GLO claims for the recovery of tax on dividends from portfolio investments are likely to go to trial in late 2009.
More generally, the Judgment adds further elements to be considered in preserving the position under the CFC rules pending the outcome of the Cadbury Schweppes, Vodafone 2 and the CFC GLO litigation.