A recent decision of the European Court of Justice in a case involving the German company Lankhorst-Hohorst may have important tax consequences for UK companies that are members of European wide groups.

THIN CAPITALISATION

Companies which are highly geared through intra-group debt are often referred to as "thinly capitalised". In the absence of specific rules, companies would be able to borrow large amounts intragroup claiming a deduction for the interest payments. This has the effect of reducing the taxable profits in countries with higher tax rates, so reducing the worldwide tax charge for the group. To counter this, tax authorities in many countries have introduced rules to prevent companies claiming "excessive" interest deductions in respect of interest payments to associated companies. The rules generally operate to treat interest incurred on the excessive debt as nondeductible for tax purposes. The UK legislation is primarily contained in section 209 of the Income Corporation Taxes Act ("ICTA") 1988.

DISCRIMINATION IN EUROPE

A Netherlands parent company had made a loan to its German subsidiary to enable the German company to reduce its bank borrowings and overall interest charges. The German tax authority denied the German company interest deductions and sought to re-characterise the payment as a dividend. The rules in the German Tax Code are similar in effect to the relevant UK provisions. It should be noted that there was no suggestion by the German tax authorities that the loan was for tax avoidance purposes and indeed it was accepted that it was for commercial and financial reasons. The taxpayer appealed from the tax authority’s decision. The German Court referred a question to the European Court of Justice ("ECJ") as to whether or not the provision of the German tax code which the tax authorities relied upon was in breach of the European Community Treaty ("the EC Treaty"), which contains a general prohibition against discrimination on the basis of nationality.

The argument is that a German company with a Netherlands parent should not be treated less favourably than one with a German parent (which was the effect of the German tax rules).

This non-discrimination principle is encapsulated in the "fundamental freedoms" contained in the Treaty. The fundamental freedoms which are most relevant to corporation tax are:

  • the freedom of establishment;
  • freedom to provide services and;
  • free movement of capital.

If a breach is identified then the onus is on the national government to justify the breach is in the public interest.

A number of Governments including the UK Government made submissions to the ECJ. The UK government argued that the "thin capitalisation rules" were needed to combat tax evasion and to ensure the coherence of the tax system.

The ECJ noted these arguments but rejected the submissions of all the member states and found in favour of the taxpayer. In its decision it stated "it is settled law that reduction in the tax revenue does not constitute an overriding reason in the public interest which may justify a measure which is in principle contrary to a fundamental freedom".

SAVINGS FOR UK COMPANIES

The full tax consequences of this decision are not yet clear. However, it appears that:

  • going forward, any UK company paying interest to an overseas parent that is based in the European Union ("EU") should be able to claim interest relief in respect of such payment without concerns regarding thin capitalisation; similarly any non-UK, but EU-based subsidiary should be able to claim interest relief in respect of any interest payment to its UK parent.
  • UK companies should consider claiming a deduction for the full amount of any interest paid to an overseas EU-based parent company where that deduction was restricted by the thin capitalisation rules, if the tax returns have not been agreed with the Inland Revenue.

However, the Inland Revenue have not issued any statement in respect of the decision yet. When they do, it is likely that they will point out that the ECJ emphasised the fact that the taxpayer companies were undertaking the transactions for commercial reasons and not for tax avoidance purposes. Also, the Inland Revenue may seek to deny an interest deduction for another reason, such as it was for an unallowable purpose. There are many reasons available to them in the UK tax rules.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.