“Não há duas sem três” (if you have two, you’ll have three)

“Não há duas sem três” is a popular Portuguese proverb which basically means that if you have two, you’ll have three. Since I covered in the last posts, two UK cases (UBS and NEC), I feel obliged to attempt to cover the third. Pirelli case ([2006] UKHL 4) is another case in the mounting assault by foreign companies operating in the UK on the famous advance corporation tax (ACT) provisions. In this case, the House of Lords concluded, contrary to the Court of Appeals ([2003] EWCA Civ 1849) that UK subsidiaries that claim compensation for ACT paid on dividends to their EU parent companies will have their claims reduced by the parent company's tax credits set out in tax treaties.

As mentioned above, this litigation concerns compensation for ACT paid on dividends paid to their EU parent companies. In broad terms the UK imputation system provided that when a UK company resident paid a dividend to its shareholders it became liable to pay ACT in respect of the dividend. ACT was then set against the company's liability to MCT (mainstream' corporation tax). A recipient of the dividend, if resident in the United Kingdom, became entitled to a tax credit. The amount of the tax credit corresponded to the current rate of ACT. In the case of an individual a tax credit was utilised primarily as a credit against his income tax. Any excess was paid to the individual. Where the recipient of the dividend was a company the amount of the dividend plus the amount of the tax credit constituted franked investment income. This could be used to frank dividends paid by the company so the company would not be liable to ACT on its dividends.

Within a group of companies, and provided group election was made, no ACT was payable upon distribution to the parent company. Group election allowed a deferral of corporation tax until the subsidiary was liable to MCT, or until the parent company distributed the profits to a recipient outside the group and accounted for ACT itself. In summary, dividends paid by a subsidiary to its parent while the election was in force did not trigger liability to pay ACT. Nor did their receipt trigger entitlement to a tax credit. Shortly after ACT was abolished, the ACT group election scheme, whereby deferral of ACT was only available if the parent company was resident in the UK, was held contrary to the freedom of establishment by the ECJ (Joined Cases C-397/98 and C-410/98 - Hoechst Case). It should be noted that the ECJ also decided the U.K. subsidiary was entitled to compensation from the UK tax authorities for the cost of having to pay ACT until it could be offset against their corporation tax liabilities.

The ECJ ruling lead to widespread consequences in the UK system, with several groups of companies seeking, by way of group litigations, to exploit the apparent debilities of the imputation system. The Pirelli case was a test case, in one category of claims within the ACT group litigation order, namely involving UK subsidiaries with parent companies in the Netherlands and Italy, whose treaties included entitlement to tax credit refunds on dividends (this was relevant since the ECJ case covered the UK-Germany tax treaty, where no UK imputation tax credit was available).

Under the Pirelli case, since group income election was not available, ACT was paid on dividends paid by a UK subsidiary to parent companies resident in Italy or the Netherlands. Nevertheless, the respective tax treaties entitled the parent companies to tax credits of a reduced amount.

Three issues were raised in this case: (i) whether, if a group income election had been made the EU parent companies would have been entitled to a treaty tax credit (ii) if that was not the case, whether the tax credits received by the EU parent companies should be brought into account in assessing the compensation payable to the UK subsidiaries for the breach of freedom of establishment under Hoechst case and (iii) whether ACT is a withholding tax within the meaning of article 5(1) of the Parent/Subsidiary Directive.

As mentioned above the first issue in debate was, assuming UK law had permitted EU parent companies to make a group election (as held by the ECJ), would the EU parent companies, at the same time, remain entitled to a tax credit under the tax treaty?

According to the House of Lords, whether EU parent companies would still be entitled to treaty tax credits depends upon the proper interpretation of the tax treaties. For example, under Article 10(3)(c) of the treaty with the Netherlands, a Dutch resident company which received dividends from a UK company was entitled to a tax credit calculated and payable as follows:

a tax credit equal to one half of the tax credit to which an individual resident in the United Kingdom would have been entitled had he received those dividends, and to the payment of any excess of that tax credit over its liability to tax in the United Kingdom.

In order to understand the mechanics of the repelled imputation system and its interaction with tax treaties, it is helpful to attempt to articulate a numerical example. Assuming that ACT rate was 25% and the amount of the dividend was 750, a UK company paying the dividend to a UK individual would pay ACT of 250 generating a tax credit of the same amount for the individual. If the recipient was a Dutch individual, he would be entitled to claim a payment of the tax credit of 250, less the tax of 15% on the sum of the dividend (750) plus the full credit (250), i.e. 150. The individual could, under the treaty, submit a claim to the UK authorities for the payment of 100 (i.e. 250 – 150). According to Article 10 (3)(c) a qualifying Dutch company would also be entitled to a tax credit of half that amount, i.e. 125. Under the treaty the UK withholding tax is set as 5% of (750 +125) which would correspond to 43,75. Therefore, the half tax credit to be refunded in accordance with the treaty would then be 81,25 (125 - 43,75).

In the Pirelli case, the first important point the House of Lords noted was that entitlement to a tax credit under the treaty “marched hand-in-hand with liability to pay ACT”. Accordingly, for the House of Lords, the treaty assumes that the dividend whose receipt attracts a tax credit will also have attracted liability to ACT. As such, in the wake of ECJ decision, the House of Lords considers that when interpreting article 10(3)(c) the treaty tax credits should not apply to election dividends (i.e. dividends not subject to ACT). In this point the House of Lords diverged from the High Court and Court of appeals reasoning.

Nevertheless, Pirelli had more arguments as to why no account should be given to treaty tax credits received by EU parent companies, such as Pirelli. Under the second issue under discussion, it was argued that the UK subsidiary and its parent are separate legal entities and the breach of EU Law (in the ECJ case referred above) was suffered by the UK subsidiary while the tax credits were received by the parent companies.

The House of Lords did not receive in a better manner this second argument, even referring that Pirelli were seeking to have the best of both worlds! In the House of Lords view, assessment of the overall loss (i.e. money paid as ACT and tax credits received) represents the only fair way to assess the amount of loss suffered where a subsidiary and its parent have been denied the opportunity jointly to obtain a single package such as group election.

Pirelli raised an additional point of Community law by attempting to apply by analogy the tax cohesion principle (two separate taxes levied on different taxpayers). The House of Lords held that the grounds on which a restriction on a fundamental freedom may be justified say nothing about the principles applicable in assessing compensation for breach of a Treaty freedom and thereby denied a reference to the ECJ. The House of Lords stated that assessment of compensation is primarily a matter for the domestic legal system, provided that the principles of equivalence and effectiveness are duly observed.

Finally, the third issue raised before the Court was based on the Parent-Subsidiary Directive, namely that ACT was a withholding tax within the terms of the Directive. On this point the House of Lords considered Art. 5(1) and 7(1) of the Directive, coupled with the ECJ decision in the ECJ decision on Océ van der Grinten (C-58/01), on what represented a dividend withholding tax, sufficiently clear not to refer any question to the ECJ.

In the previous High Court and Court of Appeal decisions the first and second questions had been answered in favour of Pirelli and therefore there was no need to evaluate the third issue. Conversely, in the House of Lords decision, the third issue needed to be addressed since both of the two grounds were answered in favour of the revenue.

According to Art 5(1) of the Directive ”profits which a subsidiary distributes to its parent company shall … be exempt from withholding tax …". However, Art. 7(1) of the Directive states “The term 'withholding tax' as used in this Directive shall not cover an advance payment or prepayment (précompte) of corporation tax to the Member State of the subsidiary which is made in connection with a distribution of profits to its parent company …"

In that regard, Pirelli submitted that certain passages of ECJ cases make it arguable that ACT is indeed a withholding tax and that the point should be referred to the European Court for a definitive ruling. The House of Lords noting that ACT is not a tax charged on the shareholders considered that ACT does not qualify as a withholding tax under the description of a withholding tax given by the ECJ. The judges mentioned a passage of the Océ van der Grinten Case, where the ECJ referred to the Athinaiki case (and the Epson Europe case) as establishing that:

"(47) … any tax on income received in the State in which dividends are distributed is a withholding tax on distributed profits for the purposes of art.5(1) of the directive where the chargeable event for the tax is the payment of dividends or of any other income from shares, the taxable amount is the income from those shares and the taxable person is the holder of the shares …"

In conclusion and as a result of this decision by the House of Lords, it is expected that the compensation to be payable by the UK tax authorities for ACT compensation (in line with the ECJ Hoechst decision) will be significantly lower than initially thought.