The second judgment of the European Court of Justice (ECJ) in the FII GLO was handed down today. The decision is mostly in favour of the taxpayers.
The Court’s judgment mainly deals with two historic aspects of the UK’s corporation tax regime, namely Advance Corporation Tax (ACT) and the charge to tax on foreign dividend income under Section 18 Schedule D Case V of ICTA 1988. The Court also answered the perennial question of whether free movement of capital can be relied upon in a third country context where, while the focus of the legislation was not establishment, the facts of the case involved an establishment circumstance.
The UK dividend taxation system exempted domestic dividends from tax while taxing foreign source dividend income and giving credit for the underlying tax paid on the profits (up to the UK rate). The Court had held in its first ruling that such a system would not be precluded where the tax rate was the same save in exceptional circumstances. This led to considerable debate in the UK courts. Did this mean that the effective or nominal rates of tax on domestic and foreign source income should be the same?
The clarification given by the Court in this second ruling supports the taxpayers’ interpretation of its first ruling. Inequality will arise where the national system provides for reliefs which will commonly reduce the effective tax rate so that domestic source income, if exempted in the hands of the dividend recipient, would usually be taxed at a lower rate than foreign source income which would always be taxed at least to the nominal rate. The court has added that such a system would be justified and proportionate if, unlike the UK rules, the credit provided against foreign corporation tax was set at the foreign nominal rate of tax (rather than the tax actually paid). In so doing the Court has followed the proposed answer of the Commission which the Advocate General had rejected in his opinion.
Also following the first ruling, HMRC had argued that ACT would only be contrary to EU law in very limited circumstances. The Court has further clarified its ruling to confirm that, if ACT was charged anywhere in the corporate group in excess of the nominal rate of foreign tax incurred on the underlying profits elsewhere in the EU, it will amount to an unlawful levy of tax. The Court has however rejected the submission that a form of relief should have been available to enable the recovery of lawful surplus ACT against the undistributed profits of EU subsidiaries.
Finally the Court has now directly answered a long standing debate concerning non EU (i.e. third country) investments. Third country investments are covered by the free movement of capital (art. 63 TFEU) but not the freedom of establishment (art. 49). In previous rulings (e.g. C-524/04 Thin Cap) the Court had held that if the focus of the national legislation was establishment (e.g. a group context) then only the freedom of establishment was engaged effectively excluding third country investments from protection. But what about legislation, like dividend tax and ACT, that equally affected both establishment and the movement of capital but in circumstances where there was in fact a controlling interest in the dividend paying company which would amount to an establishment situation? Was the claimant still able to exercise the free movement of capital to engage the protection of EU law in a third country context?
The answer of the Court is unequivocally “yes” in circumstances where the investment is from the EU into a non EU State. The Court noted that the contrary interpretation advocated by the Member States was inconsistent with the reference to establishment in the standstill provision in article 64(1).