UK: Thin Capitalisation - the Thin End of the Wedge?

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, whilst dividends and other distributions in respect of equity participations 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, and, often, a rate arbitrage. This may lead to the shareholder debt representing a higher proportion of the investee company’s total capital than would be normal if the debt finance were provided by an independent bank, with a corresponding reduction in the equity injected by the shareholder, hence the term "thin capitalisation".

Where the shareholder and the investee company are subject to tax in the same jurisdiction, there will usually be little tax advantage stemming from thin capitalisation, as the interest will be tax deductible for the investee company but taxable in the hands of the investor, at the same rate. It is where the shareholder/creditor is located in another jurisdiction (or is otherwise not subject to tax on the interest), that the tax advantage can be gained, at the expense, of course, of the fisc of the investee company’s jurisdiction. It has therefore been common for revenue authorities to adopt anti-thin capitalisation rules in an attempt to eliminate such mismatches and potential loss.

The UK’s thin capitalisation code has, in effect, two "layers". The first consists of rules which attained their current content in 1995 and are contained in section 209(2)(da) Taxes Act 1988 and ancillary provisions ("the Section 209(2)(da) rules"). The other layer is formed by the "transfer pricing" rules in Schedule 28AA Taxes Act 1988, which attained their current content in 1998. The rules in both layers are complex, but in essence:

• Under the Section 209(2)(da) rules, interest payable by a UK company to a non UK resident member of the same 75% group is treated as a dividend, and therefore not tax deductible, to the extent the interest exceeds what would have been paid had the parties been unconnected, and not otherwise parties to a "special relationship".
• The transfer pricing rules also apply (at least in the Inland Revenue’s view) where the shareholder debt content of the investee’s total capital is greater than it would have been as between parties at arm’s length, but only where the investor has the majority voting power in the investee (or vice versa) or both companies are under common voting control. (There is an extension of the scope of the provisions to "deadlock", or near deadlock, joint ventures).
• There are special provisions to extend the Section 209(2)(da) rules to cases where the "shareholder loan" is, in law, provided by a third party but it is the shareholder who bears "the exposure", by means of guarantees and back-to back loans. (There are no corresponding provisions for transfer pricing but the Inland Revenue claim, somewhat unconvincingly, that the transfer pricing rules implicitly cover such arrangements).

In this case, a Netherlands parent company ("LT BV") made a loan to a 100% indirect German subsidiary, Lankhorst-Hohorst GmbH ("Lankhorst-Hohorst"), which was in financial difficulties. The loan, which was for DEM 3,000,000 with variable interest repayable over 10 years, enabled Lankhorst-Hohorst to repay some DEM 2.8m of bank debt and to achieve a substantial reduction of its interest cost. LT BV undertook to waive its right to repayment of the loan if third party creditors made claims against Lankhorst-Hohorst.

The German tax authorities sought to deny a deduction for part of the interest payable by Lankhorst-Hohorst to LT BV on thin capitalisation grounds. German tax law then contained a provision which treated interest on shareholder debt as a "disguised distribution of profits", taxable at the appropriate German rate, rather than a deductible interest payment but only where the recipient of the interest was not itself a German taxpayer. (Like the UK rules summarised above, the German anti-thin capitalisation rules did not apply to the extent that the amount of the shareholder debt did not exceed the amount which would have been lent by an unconnected third party. The German rules also provided a "safe harbour" for companies whose debt-equity ratio was up to 3:1).

The German tax court concluded that a third party would not have lent as much as LT BV did, on the terms on which LT BV lent, and on the facts neither the 3:1 safe harbour nor any other exception in German tax law was available to Lankhorst-Hohorst. The case was, however, referred to the European Court of Justice, which held that, on the facts of the case, EU law invalidated the relevant German law. This was because the German law constituted a discriminatory obstacle to the freedom of establishment, by treating German subsidiaries of non-German EU parent companies less favourably than subsidiaries of a German parent company. Further, the ECJ held, the obstacle could not be justified in terms of EU law.

To understand the basis for this remarkable decision, and to appreciate its full implications, it is necessary to explain briefly the principles of EU law involved.

The EU Treaty guarantees four fundamental freedoms, and these include:

• Freedom of "establishment" (Article 43) – the right for an individual or body corporate which 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; and
• Free movement of capital (Article 56) – the right for nationals of Member States to move capital freely to and from other Member States, and, since 1 January 1994, to and from non-Member States.

These freedoms are not unqualified and some of the qualifications relevant to tax disputes will be discussed below. The important point, though, is that it is now established that direct taxation provisions, which are still mainly within the legislative domain of Member States, will be set aside by the ECJ if they restrict these freedoms in a discriminatory manner and there is no adequate "justification".

In Lankhorst-Hohorst, freedom of establishment meant that the (Netherlands) parent company had the right to form and operate subsidiaries in Germany, as it had done, and that freedom would be denied if discriminatory and unjustified restrictions were placed in its way. The restriction imposed by the German anti-thin capitalisation rule clearly discriminated between those German companies which had German parent companies and those which did not. (German companies owned by restricted categories of German parent companies, were also subject to the thin capitalisation restrictions but the ECJ concluded that German companies in those categories were not in a comparable situation to Lankhorst-Hohorst’s parent).

A number of arguments were put to the ECJ to the effect that, even if the rule did constitute a discriminatory restriction on the freedom of establishment, it was nonetheless justified by the "public interest", which is specified in the Treaty to be a qualification to freedom of establishment and free movement of capital (see Articles 43 and 58). At the outset though it should be noted that the ECJ does not take at face value claims by Member States that provisions restrictive of one of the freedoms are justified. No restriction can be justified unless its aim is clearly identified, it is apt to secure that aim and it does not go further than is necessary for that purpose. Further, as the ECJ reiterated, the prevention of a reduction in German tax revenue is not a sufficient justification.

A number of suggested justifications were put to the ECJ both by the German Government, and the UK Government (which offered observations).

The German (and UK) Governments argued unsuccessfully that the thin capitalisation rule was necessary to protect the "coherence of the tax system". Some ECJ case law supports the need to ensure the coherence of Member State’s tax system as a justification. The Court’s approach is currently that coherence can only be a justification where there is a "direct link" between the tax restriction at issue and an associated tax benefit for the taxpayer affected by the restriction. The best-known example is Bachmann, where a German national individual lived and worked in Belgium but proposed to retire to Germany. He took out a pension contract with a German insurer, it being assumed that the pension (following the taxpayer’s retirement) would not to be taxable in Belgium. Belgium allowed a tax deduction for pension payments to Belgian insurers but not to German ones. The ECJ held that the resulting discriminatory restriction of freedom of establishment was justified, because in the case of a Belgian taxpayer there would be a link between tax deductibility of pension contributions and taxation of the pension.

In Lankhorst-Hohorst the German and UK Governments could demonstrate no such benefit linked to the discriminatory restriction. The German and UK Governments had prayed in aid the "arm’s length principle" enshrined in Article 9 of the OECD Model Convention, but to no avail.

The UK Government also argued that a rule of the type at issue in Lankhorst-Hohorst could be justified by the need to ensure the "effectiveness of fiscal supervision". This argument was based on the ECJ’s decision in the Futura Participations case in 1997. It was held by the ECJ in that case that a Member State (Luxembourg) was entitled to require that an overseas company seeking to carry forward tax losses in its Luxembourg branch justify the calculation and allocation of those losses under Luxembourg law. It is not clear how (if at all) anti-thin capitalisation provisions enhance "fiscal supervision" in this sense and the ECJ in Lankhorst-Hohorst did not accept this proffered justification.

The ECJ was prepared to accept in principle that, had abuse been proved on the facts, "tax evasion" ("tax avoidance" in UK terminology) might have been a justification. The ECJ noted, however, that the German anti-thin capitalisation rules applied even in the absence of "wholly artificial arrangements, designed to circumvent German tax legislation" (implying that the aim of the provisions was not clearly identified) and that LT BV would be subject to corporate tax on its profits in the Netherlands.

The implication seems to be that liability to tax, at whatever rate and calculated on whatever basis, in a Member State negates tax evasion/avoidance and rules out any justification on that ground. The possible corollary of this conclusion is that the freedom of establishment includes the right to select a structure and place its various elements in Member States with beneficial tax regimes. The Court further noted that a conclusion that the German anti-thin capitalisation provisions were justified opened up the risk of double taxation, if under Netherlands law the interest would have been taxable there (despite being recategorised as a distribution of profit in Germany). Such double taxation would have meant that the German anti-thin capitalisation rules were disproportionate to the aim sought to be achieved and therefore unjustifiable.

The structure of the UK’s thin capitalisation rules so far as relevant is very similar to the that of the German rules considered in the Lankhorst-Hohorst case, apart from the absence of the 3:1 safe harbour.

The configuration of the UK rules is very slightly different, in that in UK law the discriminatory feature is included through what purports to be a relieving provision, ICTA 1988 Section 212 in the case of the "first layer", Section 209(2)(da), and Schedule 28AA paragraph 5, in the case of the "second layer", transfer pricing. By contrast, the discriminatory feature in the German rules was to be found in the body of the provision itself. This minor difference would not, it is thought, carry the day with the ECJ, which has shown a determination in direct tax cases to look through convenient labels attached by Member States to direct tax provisions, to their substantive effect (as in the case of Epson where an impost on a dividend was held to be a withholding tax even though it was described as a gift tax by the source Member State).

It is worth noting at the outset that decisions of the ECJ are binding throughout the EU and are not appealable.

There appear to be two ways forward for the UK and other Member States wishing to keep anti-thin capitalisation restrictions in place. First, the scope of the restrictions could be restricted to "wholly artificial arrangements designed to circumvent" the tax laws of the relevant Member State, with appropriate agreements with other Member States to safeguard against potential double taxation (and consequent disproportionality). Secondly, the scope of the restrictions could be widened to embrace inter-company financing wholly internal to the Member State concerned (i.e where the subsidiary, the corporate shareholder and the affiliated lender are all resident in that Member State). It is understood that the Netherlands is considering such a step as a result of an EU law challenge on a separate issue regarding group financing.

As was pointed out above (see "The freedoms"), free movement of capital is a separate and distinct freedom from freedom of establishment. Free movement of capital applies not only to movements of capital between two or more Member States, but, with effect from 1 January 1994 (and with a saving for restrictions already in place on that date), to movements of capital between one or more Member States and a non member state.

When a company ("X") resident in a particular territory ("A") forms and capitalises a subsidiary ("Y") in another territory ("B"), X is not only (in terms of EU law) establishing itself in B, it is also moving capital from A to B. Where both A and B are EU States, it is more natural to analyse the issues in terms of freedom of establishment (as was the case in Lankhorst-Hohorst) and there is no need to consider free movement of capital. However, where A is a non-EU State and B is an EU State, anti-thin capitalisation rules under the law of B may be capable of constituting an unjustifiable obstacle to Y’s right to obtain its capital from the territory of its choosing. It should not, therefore, automatically be assumed that anti-thin capitalisation rules which apply only to companies whose parent is not in a Member State will be upheld.

In cases where thin capitalisation restrictions are relevant to an open enquiry, consideration of arguments based on the Lankhorst-Hohorst decision, will clearly be appropriate. (Indeed in view of the Court’s general approach to Member States’ direct international tax rules, some of the wider points of principle may be relevant to disputes in other areas, such as the controlled foreign companies rules). Consideration might also be given to review, to the extent permitted by applicable time limits, of CTSA returns which are not the subject of an enquiry.

© Herbert Smith 2003

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