UNITED KINGDOM: CORPORATE TAXATION FOR RESIDENT MULTINATIONALS

If a multinational corporation (meaning, a company with subsidiaries or affiliates in more than just one or two countries) needs to be based in a high-tax country, for instance because it must have a listing on a major stock exchange, then the UK is often a good choice. As a member state of the EU, the UK is within the EU parent-subsidiary directive, and in addition the UK has a very broad network of double tax treaties, so that it is well-placed to receive dividend income with the lowest possible amount of foreign tax deduction.

However, this advantage has been somewhat compromised by measures in successive Finance Acts to limit international tax planning by multinationals.

Firstly, the UK's Controlled Foreign Company rules have been tightened to the point at which only marginal benefits can be obtained by locating a subsidiary in a low-tax jurisdiction. In addition, enabling legislation in the 2002 Finance Act allowed the British government to alter the tax treatment of controlled foreign companies in jurisdictions which were considered to allow 'harmful tax practices'.

Secondly, the use of tax 'mixing' intermediate companies in such jurisdictions as Holland and Denmark was severely pruned back by the Finance Act 2000. Whereas it used to be possible to use, say, a Dutch holding company to mix dividends from foreign subsidiaries taxed at say 10% and 50% to achieve a blended rate of 30%, thus ensuring that only a very small amount of UK corporation tax would be payable, the rules were changed.

One improvement that should be noted, however, was the abolition of the ACT (Advance Corporation Tax) withholding tax in 1998: although corporation tax is now payable earlier than before, the problem of excess ACT has disappeared.

Dividends to both resident and non-resident shareholders are paid without deduction of withholding tax.

Another improvement, contained in the 2001 budget, was the abolition of withholding tax on interest and royalty payments to companies subject to UK corporation tax.

Gordon Brown announced the extension of the abolition of withholding tax on international bonds and intra-UK payments of interest and royalties, to include non-bank entities, such as venture capital companies.

While this announcement was welcomed by British industry, there was disappointment that the change was not more far-reaching. The Chartered Institute of Taxation made the following suggestion for further reform:

'We are disappointed that this will only apply where the recipient company is within the charge to UK corporation tax. Gross rental income may be received by non-resident landlords who have undertaken to comply with UK tax obligations, and we would suggest that consideration be given to the introduction of such a scheme for the receipt of interest and royalty payments by those outside the charge to UK corporation tax.'

Some further improvements to the withholding tax regime were included in the 2002 Finance Act

As a result of the accumulation of negative measures imposed by the Treasury, it was reported in December, 2004, that leading tax advisers and accountancy firms such as PricewaterhouseCoopers and KPMG were advising their international clients to avoid establishing operations in the United Kingdom.

One favourable development for existing UK-based multinationals was (and is) the gung-ho attitude of the European Court of Justice, which is rapidly tearing down national fiscal barriers inside the EU. In 2002 it ruled against fiscal exit penalties on corporate relocation.

In a preliminary hearing of the Conseil d'Etat v de Lasteyrie du Saillant case, the ECJ's Advocate General decided that the French government had violated the freedom of establishment provisions contained within EU law by levying a punitive residential exit tax on an individual who wanted to transfer his tax residence out of France.

Several of the EU's member countries impose company emigration exit charges. They include the UK, France, Germany, Italy and Spain. The huge tax penalties act as a deterrent on companies wanting to relocate to other member states where running costs are less.

Tax charges vary from country to country, but most countries, including the UK, levy a penalty of about 30% of the value of a company's capital assets. Individuals must often pay up to 40%.

The ECJ has ruled against national governments in a number of cases involving freedom of establishment, and in August 2003 the English High Court followed ECJ precedents in a test case brought by Deutsche Morgan Grenfell, concerning EU 'freedom of establishment' and anti-discrimination laws.

Mr Justice Park's decision in the High Court was the conclusion of a case first initiated when 50 companies submitted a group claim in the English courts as the result of an European Court of Justice precedent which ruled that the British government had illegally imposed advance corporation tax.

Under the rules which applied until the 2001 and 2002 reforms of corporation tax, UK subsidiaries of European firms were wrongly made to pay tax on dividends repatriated to their continental parent companies.

Although tax law in this area has since changed (as mentioned above), the UK investment banking arm of the German bank was attempting to establish how far claims of wrongly paid tax can be backdated.

The Inland Revenue (now HMRC) argued that the claims are restricted to a six year period by the 1980 Limitation Act. However, Justice Parks ruled otherwise, announcing that such claims were not time-barred by the 1980 Act.

However, he added that: "This is not a result which I reach with much enthusiasm."

A further blow for national treasuries came in September 2004 when the ECJ ruled that the Netherlands' domestic tax law on 'exempt participations' was discriminatory and as a consequence, unlawful.

The ruling related to a case involving Bosal Holdings, a Dutch manufacturer of car exhausts which acquired a number of European firms during the 1990s, and was prevented from claiming tax relief for interest paid on borrowings financing subsidiaries which did not generate income taxable in Holland.

The ECJ found that this breached Bosal's fundamental 'freedom of establishment' rights, laid down in the founding Treaty of Rome, and therefore upheld its claim against the Dutch government.

The ECJ decision was expected to benefit many firms elsewhere in the union which had similar claims pending against national governments.

One such company was UK retail firm Marks and Spencer. M&S argued that under Article 43 of the European Union Treaty, it should be allowed to offset losses of around 160 million euros made by its French, Belgian, and German subsidiaries between 1997 and 2001 against UK profits, claiming a tax refund of GBP30 million.

In March 2005 came the initial result of the much-followed Marks and Spencer case, in which Advocate General Mr Poiares Maduro agreed with the company. European Union finance ministers however vowed to find a "defence mechanism" to counter the likelihood of tax revenue shortfalls should the British retailer ultimately be successful in its legal bid to offset losses made by foreign subsidiaries against tax.

The issue formed one of the main talking points during an Ecofin meeting of EU finance ministers. "There is great concern about this," remarked Jeannot Krecke, Economy Minister of Luxembourg, which was holder of the rotating EU presidency at that time.

The Advocate General's opinion was supported later that year by the full ECJ.

With regard to CFCs, further changes were brought forward in the 2005 budget. The 2005 Controlled Foreign Companies (Excluded Countries) (Amendment) Regulations aimed to prevent CFCs from manipulating their profit location in order to evade taxes, to stop them from secreting income in non-corporate entities, and to exclude them from receiving the benefits of the CFC regime if they are not liable for tax in another country. The measures came into full force on March 31st.

A spokesman for the Inland Revenue (as HM Revenue & Customs was known at the time) explained that: "All of the changes made are a reaction to schemes including some that were identified via the disclosure rules. The government could not have allowed significant amounts of tax to remain at risk."

In February 2006 HM Revenue and Customs won an important legal battle when the House of Lords ruled that companies which claimed a tax credit on a dividend paid to a foreign parent cannot claim a refund of advanced corporation tax.

The group litigation was brought by more than 60 companies and led by Pirelli, the Italian tyre manufacturer, which claimed that the obligation to pay advance corporation tax (ACT) in the UK on dividends it paid to its Dutch parent was in breach of European Union law concerning taxes levied on dividends.

Although the Dutch parent had received a repayment of 50% of the tax credit attached to the dividend under the tax treaty between the UK and the Netherlands, it claimed that the parent's right to receive the credit was legally separate from any obligation of the subsidiary to pay ACT.

However, in overturning judgments by the High Court and the Court of Appeal, Lord Nicholls, one of the five judges on the panel, said that Pirelli was looking to obtain "the best of both worlds."

In February, 2006, the ECJ seemed set to confirm the House of Lords ruling, when Advocate General Leendert Geelhoed stated that whilst the UK tax authorities were required to treat non-UK firms fairly, there was no pre-requisite for equal treatment.

Consequently the UK was entitled to enter into different tax treaties with different countries and did not need to offer the same benefits to everyone. In his opinion, Mr Geelhoed noted that this was an area where "predictability and legal certainty are crucially important, so that Member States can plan their budgets and design their corporate tax systems on the basis of relatively reliable revenue predictions.”

Following up on the M & S case, the United Kingdom government announced in February, 2006, that it would introduce legislation in the Finance Bill 2006 to amend the UK loss relief rules.

According to the UK government, the ECJ considered that the country's group loss relief rules are in principle compatible with European law, meaning that the system of group relief can be kept broadly as it is now, although the Court also held that, in some very limited circumstances, relief should be available in the UK for the otherwise unrelievable losses of some group companies resident in other States.

However, the government fears that groups with loss-making companies resident in another state could "engineer" their circumstances so as to preclude the possibility of a loss making company obtaining relief in its state of residence by, for example, liquidating that company whilst transferring its business to another company.

In response, the government introduced legislation to deny loss relief where there are arrangements which either: result in losses becoming unrelievable outside the UK that were otherwise relievable, or; give rise to unrelievable losses which would not have arisen but for the availability of relief in the UK, if the main purpose or one of the main purposes of those arrangements is to obtain UK relief.

The legislation was to be effective from Monday, February 20 of that year.

Then in April, 2006, the European Court of Justice Advocate General, Leendert Adrie Geelhoed, gave an opinion in favour of four UK companies who had claimed that corporation tax charged on dividends received from EU subsidiaries was illegal under EU free movement of capital rules.Between 1973 and 1999, when the UK scrapped its Advanced Corporation Tax system, which allowed UK companies to pay up dividends domestically at a favourable rate, dividends from non-UK EU subsidiaries of UK companies were charged at higher rates.

Although the four companies in the case, British American Tobacco, British Petroleum, Aegis Group and Imperial Chemical Industries, were claiming refunds of 'only' some hundreds of millions of pounds, the UK government warned during court proceedings that the total cost of an adverse ruling might be as high GBP7 billion if many companies applied for refunds, and that the ECJ should therefore reject the companies' case on the grounds that the UK's financial stability could be affected.

Mr. Geelhoed denied this reasoning.

In December 2006, the European Court of Justice followed his opinion, and ruled that ACT operated illegally between 1973, when the UK acceded to the EU, and 1999, giving rise to the prospect of substantial rebates to companies which have paid this tax in the past.

The Treasury warned that such a ruling could leave it open to repay claims totalling GBP9 billion, although draft blocking legislation which would limit a company's claims to six years would reduce this to about GBP2 billion, the government has estimated.

“In principle, today’s decision is good news for companies hoping for an ACT rebate. However, they are unlikely to receive anything until the UK and European courts reach a decision as to the legal status of the blocking legislation – a process that is likely to take some time," observed Jonathan Bridges of KPMG’s EU law group at the time.

The Court referred the matter back to the UK courts to determine whether the UK rules operate to achieve this parity.

“It is disappointing that the ECJ has stopped short of ruling that the UK should apply the same rules to both UK and foreign sourced dividends," Bridges noted.

He continued: “Achieving equality of treatment via a credit system may, on the face of it, sound reasonable but it is not straightforward."

"The ECJ’s ruling today fails to fully appreciate the fact that not all profits in the UK are taxed at the corporate tax rate of 30%. For example those deriving from share sales are completely exempt."

Bridges concluded:

"What today’s ruling does is potentially introduce yet another layer of complexity into the UK’s already overly cumbersome corporate tax system.”

In 2007, the UK Finance Bill implemented changes to the Controlled Foreign Company regime made in response to the previous year's high-profile Cadbury-Schweppes decision by the European Court of Justice.

Although CFCs were not mentioned in the Chancellor's March Budget speech, the Treasury released a detailed response to the ECJ's decision, which commentators said represented the minimum that the Government could have done to comply with Cadbury.

The new provisions restricted the application of CFC rules to profits arising from the activities of employees but not of capital, meaning that they will only become significant in respect of trading operations in a 'low-tax' EU or EEA territory. The ECJ did not make such a distinction. To the disappointment of many tax advisers, the Treasury did not provide for an advance clearance mechanism for the CFC regime. In addition, the Treasury stiffened the effective management test, making it more difficult for EEA-based companies to satisfy the Exempt Activities exemption.

Then in July 2008, it emerged that Vodafone had won a key legal battle against the UK tax authority in a judgment that cast major doubt on the compatibility of the UK's controlled foreign companies (CFC) regime with European Union law.

Mr Justice Edward Evans-Lombe ruled in the High Court on 4th July that Vodafone does not have to pay UK corporation tax on income attributed to its Luxembourg holding company Vodafone Investments Luxembourg Sarl (VIL). Consequently, he ordered HMRC to shut an ongoing tax inquiry into Vodafone's tax for the year to March 2001.

Vodafone estimated that the court victory has saved it more than GBP2bn (USD4bn) in tax and interest that it might have been ordered to pay had the judgment gone against the company.

However, the ruling also had ramifications that go much wider than Vodafone's corporate arrangements, and several UK-based multinationals with subsidiaries in favourable EU tax jurisdictions such as Ireland, Luxembourg and the Netherlands, who are said to be under a similar type of scrutiny from HMRC, are likely to be breathing a sigh of relief as a result.

The case dates back to 2002 after Vodafone set up VIL to dispose of its shares in the German telecommunications group Mannesman, which it acquired in 2000. VIL is also used to circulate cash and profits around the group and as a vehicle to fund other acquisitions.

HMRC argued that under the UK CFC rules, it had the right to tax the difference between rate a subsidiary pays in a low tax jurisdiction overseas and the rate it would have paid on that income in the UK - a principle that it attempted to apply in the Vodafone case.

However, Justice Evans-Lombe referred back to a precedent set in 2006 by the European Court of Justice (ECJ) in the case involving Cadbury-Scweppes, which said that the UK CFC rules were incompatible with EU law because they were too restrictive and should only be applied in cases where companies set up artificial arrangements aimed solely at avoiding tax.

While the UK Treasury moved to amend CFC regulations in the wake of the Cadbury-Schweppes ruling, Justice Evans-Lombe argued that these amendments had not gone far enough to address their incompatibility with EU law, and he urged the government to revisit the legislation.

"In my judgement, the CFC legislation must be disapplied so that, pending amending legislation or executive action, no charge can be imposed on a company such as Vodafone under the CFC legislation," he said, going on to add that:

"It seems to me that all UK taxpayers, including Vodafone, were and are entitled to be told by legislation, of which the meaning is plain, what the tax consequences for them will be if they decide to incorporate a controlled foreign company in a (EU) member state."

The UK government was in the process of reviewing its stance on the taxation of multinationals' international income at the time of the July ruling, but tax experts said that the latest judgment had thrown the situation into chaos, and may have left the UK with a completely unenforceable set of CFC legislation.

“The High Court has expressed ‘some doubt’ as to the efficacy of sticking plaster amendments introduced in 2006,” Mark Persoff of Clifford Chance, the legal firm was quoted as saying by the Financial Times. “This means, as matters now stand, the UK probably has no enforceable CFC legislation so far as EU/EEA subsidiaries are concerned.”

Peter Cussons, a tax partner at PriceWaterhouseCoopers, described the ruling as a "blockbuster judgement."

"This is big news because there are thousands of UK companies with foreign subsidiaries in the European Union," he told the Telegraph. "There will have been CFC tax paid over the years, hundreds of millions of pounds per annum, and potentially, upon claims being made, all that tax is up for grabs," he added.