EU law is being used to strike down member state tax laws that discriminate against nationals of other EU states. In the short term at least, this trend is set to benefit companies in the UK and the rest of the EU by enabling them to reduce the tax cost of intra-EU business.
Tax law – a national prerogative?
The power to make tax laws has generally remained with the individual member state – hardly surprising, given that the power to levy taxes is fundamental to the ability to govern. But it is now clear that the tax laws of member states must be consistent with the basic principles of EU law. This is borne out by a series of decisions from the European Court of Justice (ECJ), the most recent of which was released just before Christmas last year.
The 'freedoms' granted by EU law mean that member states must remove aspects of their tax systems that treat EU-based non-residents less favourably than residents, unless the 'discrimination' can be justified. Member states are also facing claims for compensation and tax rebates from businesses claiming to have suffered tax discrimination in the past. For example, group litigation is proceeding against the UK Inland Revenue on the rules relating to advance corporation tax, repealed in 1999, which the ECJ held to have discriminated against EU companies with UK subsidiaries. Claims in this area alone could top tens of millions of pounds.
Tax and freedom of establishment
The EU Treaty of Rome (1957) guarantees four fundamental freedoms. Most relevant to tax is the 'freedom of establishment' in Article 43. This is the right for an individual or a company that is a national of a member state to establish itself – either in the form of a branch or a subsidiary – in another member state of its choosing.
So, how does freedom of establishment operate in the tax context? There are many examples of aspects of the UK's tax system that are vulnerable to challenge.
Cross-border interest payments – 'thin capitalisation'
UK rules restricting the ability to claim a tax deduction for payments of interest to EU-based affiliated companies may be invalid.
It is often more tax-efficient to finance a cross-border corporate investment with shareholder debt than with equity. This is because interest on debt is generally deductible for tax purposes, while dividends on shares are not deductible. This enables the tax charge to be shifted from the jurisdiction where the investment is made to that of the investor, allowing more flexible tax planning. Traditionally, governments have tried to prevent this by introducing 'anti-thin capitalisation' rules.
The ECJ held in Lankhorst-Hohorst (2002) that the German anti-thin capitalisation rules breached EU law. The UK's anti-thin capitalisation rules are very similar to those outlawed in Lankhorst-Hohorst and the logical conclusion is that the UK's anti-thin capitalisation rules are also incompatible with EU law. There should now be greater scope for UK companies to claim a tax deduction for interest paid to EU-based parent companies.
Losses of overseas subsidiaries
A UK group with a loss-making overseas branch can often set the branch losses against its UK profits and so reduce its overall UK tax bill. However, under UK tax law, if the loss-making overseas activity is carried on in a separate overseas subsidiary, the losses cannot be offset in this way.
This rule has been challenged recently by Marks & Spencer. In the mid-1970s, Marks & Spencer commenced an ultimately ill-fated expansion onto the Continent. Marks & Spencer made a claim to set the losses of its European subsidiaries against the profits of its UK operations. This claim was refused, as under UK law only tax losses incurred by UK companies or UK branches of overseas companies can be 'surrendered' within a group.
Marks & Spencer claimed that the UK rules infringe the freedom of establishment by discriminating against companies that choose to carry on an activity in another member state through a subsidiary rather than a branch. In a controversial decision issued in December 2002, Marks & Spencer lost before the special commissioners, but has appealed to the High Court. A reference to the ECJ may be needed to resolve the question.
Cross-border sales and licences
The UK's 'transfer pricing' rules are also vulnerable to challenge under EU law. This code limits the tax deduction that a UK company can claim for payments made to overseas associates in return for services, such as the use of intellectual property rights and for sales of goods and raw materials. There is no corresponding restriction on payments to UK associates.
The logic of the ECJ decision on cross-border interest payments is that the UK's transfer pricing rules amount to an unjustified restriction on the freedom of an EU parent company to establish subsidiaries in more than one EU territory.
What will happen next?
In the short term, these developments are good news. Companies may be able to claim compensation and tax rebates for past periods and greater tax savings may be achievable on intra-EU transactions.
The longer-term impact is much harder to predict. There is a risk that, rather than removing only the elements of tax law that discriminate against other EU nationals, member states may instead opt to remove tax benefits that are confined to purely domestic transactions and companies. The Dutch government has stated that it may adopt this approach following an EU law challenge to the Dutch tax rules on debt financing.
In the UK, this option could have far-reaching consequences, such as disallowing tax deductions for all the costs of financing overseas shareholdings or dismantling the UK's system for surrendering tax losses within a group of companies. The overall tax cost to UK business of this type of response could dwarf the short-term tax benefits of the EU argument. n
Ross Fraser is a partner and Emma Nendick a professional support lawyer in Herbert Smith's tax department