Although Gordon Brown's latest Budget contained relatively few surprises, it did contain one fascinating admission. The Government announced that it wanted to discuss the options with business to ensure that the UK tax regime remained “robust to legal challenge” under European law.
This public acknowledgement of the vulnerability of domestic tax law shows the Inland Revenue putting a brave face on what is a major policy dilemma. It might seem surprising that European law has anything to say about tax at all. A casual reader of the EU Treaty might assume that it could safely be ignored when considering the interpretation of domestic tax rules. That assumption would be very much mistaken.
In a series of landmark decisions, the European Court of Justice (ECJ) has held that all member states are required to exercise their revenue raising powers in a manner that is consistent with the fundamental principles laid down in the treaty. The ECJ's decisions have required domestic tax rules to be rewritten when they have been found to discriminate against nationals of different member states, or found to limit the fundamental freedoms laid down in the EU Treaty.
Taxpayers across Europe are now taking steps in the courts to recover taxes that, in their view, have been unlawfully levied. The amounts at stake are potentially enormous. German and other foreign corporates have already successfully claimed back large amounts of money from the UK Treasury, when the German company Hoechst persuaded the ECJ that its UK subsidiary had suffered unfair discrimination because it was taxed more onerously than a UK subsidiary of a UK parent.
Marks & Spencer is the latest high-profile litigant in this area: it is now en route to the ECJ arguing that the UK's group relief rules are out of line with EU law because those rules prevent it from setting off losses suffered in its French and Belgian operations against its UK profits. Marks & Spencer alone stands to win £30m if it succeeds in its action.
The problem for the UK tax authorities – and their EU counterparts – is that domestic tax rules are littered with discriminatory provisions. The sheer breadth of the current attack on the UK tax system must be enough to cause sleepless nights at the Treasury. Central planks of the UK corporate tax code – transfer pricing, thin capitalisation, the taxation of dividends and controlled foreign companies rules – are now under threat from taxpayers arguing that they discriminate between UK nationals and foreigners in a way that makes them invalid and, therefore, unenforcable by the UK tax authorities.
So what can governments do? The only safe haven would be to remove direct taxation altogether from the EU Treaty, but this would require the unanimous approval of all member states, which appears impossible to achieve. It looks as though governments will be forced into radical reform of their tax laws, but this is easier said than done. Reforming a domestic tax code, which has built up over decades in a piecemeal fashion, so that it does not contain anything that is 'Euro offensive' is quite a challenge. How, for example, can the UK reform its transfer pricing rules? These are the rules that require companies to sell goods and services to their overseas affiliates at normal market prices. So far, these rules have only applied to cross-border situations, but that needs to change. If the Government abandons its transfer pricing code for transactions within Europe, it risks being exposed to massive loss of revenue as multinationals shift profit away from the UK to low tax centres such as Ireland. If, on the other hand, the UK makes its transfer pricing rules Euro-compliant by applying them within the UK as well as in cross-border situations, it will impose a highly unpopular extra compliance burden on domestic taxpayers.
So far, the decisions of the ECJ have been seen as a one-way bet for taxpayers, because successful litigation results in tax repaid and unsuccessful litigation merely preserves the status quo. The true price of the ECJ's decisions may only just be becoming apparent. If domestic tax rules have to be tightened in order for governments to preserve the potency of their taxing rights, business may start agitating for change of an altogether more fundamental nature and demand a common basis of European taxation after all. This is, no doubt, exactly what the ECJ has been hoping for all along.