Advocate General's Opinion on UK Thin Capitalization Rules - International Law Office

Introduction
Justification
What is Thin Capitalization?
UK Thin Capitalization Rules
Outstanding Issues
Comment

Introduction

The United Kingdom is free to restrict to an arm's-length amount the deduction for interest paid by a UK company to another member of a group with a parent company in the European Economic Area (EEA), provided that certain safeguards are met. This is the view expressed by the advocate general to the European Court of Justice (ECJ) in the case of Test Claimants in the Thin Capitalization Group Litigation v Commissioners of Inland Revenue in his non-binding opinion issued at the end of June. The advocate general considered that, in principle, the UK rules were in breach of the freedom of establishment, but could be justified by the need to prevent abuse of national tax rules. An important aspect of the opinion - if it is upheld by the ECJ - is that the extension by the United Kingdom (in 2004) and other EU member states, including Germany, of thin capitalization and transfer pricing rules to wholly domestic situations was "quite pointless", "counterproductive for economic efficiency" and "anathema to the internal market".

For many companies the main interest of the opinion will lie in the basis on which - and extent to which - thin capitalization restrictions imposed by UK tax law on the relevant EU freedom can be 'justified' in the EU law sense. A national tax rule which is justified cannot be challenged on EU law grounds, even if it restricts an EU freedom. In the case in question, the relevant EU freedom is, in the advocate general's opinion, establishment. This may have implications for identifying which companies may rely on EU law to challenge the United Kingdom's thin capitalization rules.

The EU Treaty provides for:

• the free movement of goods (Article 23);

• the freedom of establishment (Article 43);

• the free movement of workers (Article 39);

• the freedom to provide services (Article 49); and

• the free movement of capital and payments (Article 56).

The sphere of operation of these freedoms is limited to the European Union and the EEA, with the exception of the free movement of capital and payments, which applies worldwide, subject to standstill for measures existing on December 31 1993.

Justification

The concept of justification has a particular meaning in EU law. In order for a discriminatory measure to be justified, a member state must show that:

• the aim of the measure is compatible with the EU Treaty and is justified by the public interest;

• the measure is apt to achieve the aim; and

• the measure is proportionate (ie, it does not go beyond what is necessary to achieve the stated aim).

Anti-abuse as a justified aim
The ECJ has accepted on a number of occasions that member states may justify measures which would otherwise restrict EU freedoms by the need to prevent tax avoidance. Helpfully, the advocate general has expressly acknowledged that it is perfectly valid for taxpayers to seek to arrange their tax affairs in the way which is most advantageous to them. However, this is the case only if the arrangement is "genuine - that is, it is not a wholly artificial construct aimed at abusing and circumventing national tax legislation".

This approach permits member states to put in place targeted anti-avoidance legislation even if this restricts EU freedoms. It is consistent with the approach taken by the ECJ in the Marks & Spencer Case in 2005 on cross-border loss relief, as well as the advocate general's recent opinion in the Cadbury Schweppes Case concerning the compatibility of the United Kingdom's controlled foreign companies rules with EU law (for further details please see "CFC Rules Compatible with EU Law, Says Advocate General"). However, it is in strong contrast to the narrow approach taken towards justification in the Lankhorst-Hohorst Case in 2002, which held that German thin capitalization rules amounted to an unjustified breach of EU law. Many years ago the United Kingdom started to introduce anti-avoidance provisions aimed at transactions for borrowing and lending money which are perceived to be abusive (eg, Section 786 of the Taxes Act 1988 and Schedule 9, Paragraph 13 of the Finance Act 1996). These provisions are not referred to by the advocate general and his opinion does not explain why further restrictions - aimed at thin capitalization only - can be justified. It is to be hoped that the ECJ's judgment will give clear guidance on this issue to states such as the United Kingdom whose domestic law contains such anti-avoidance provisions.

Are the rules apt to achieve the purpose?
The advocate general noted that the UK thin capitalization rules are apt to achieve the aim of preventing international groups from artificially styling what are in reality distributions of profit as deductible interest payments.

When will thin capitalization rules be proportionate?
The advocate general stated that thin capitalization rules which are based on the arm's-length principle can be a proportionate response to the need to prevent tax avoidance, provided that certain criteria are fulfilled. He considered that member states' legislation containing a rebuttable presumption that a non-arm's-length transaction is abusive, along with reasonable criteria for the assessment of compliance with the arm's-length principle, complies with EU law. The advocate general stated that the arm's-length approach is preferable to that of using a single fixed criterion such as a debt-to-equity ratio. In order to comply with EU law, a test based on the arm's-length principle must also satisfy the following requirements:

• Only the amount in excess of the amount which would have been agreed between parties on arm's-length terms should be recharacterized as a distribution. The UK rules have always met this criterion (although until 1995 this was achieved only in combination with the relevant double tax treaty), but it appears that the German rules considered by the ECJ in Lankhorst-Hohorst did not, according to the advocate general. This was one factor on which he relied in order to depart from the ECJ’s decision in Lankhorst-Hohorst.

• The rules must allow the taxpayer to show that, although the transaction was not at arm's length, there were nonetheless genuine commercial reasons for the transaction other than obtaining a tax advantage. The advocate general referred to the taxpayer's assertion in Lankhorst-Hohorst that the disputed loan was part of an attempt to rescue a subsidiary, but considered that such a situation would be "relatively exceptional".

• Where the taxpayer puts forward commercial reasons to justify a non-arm's-length transaction, such reasons must be assessed on a case-by-case basis. The evidential burden on the taxpayer must not be excessively difficult to satisfy or disproportionate in terms of the information required.

• The taxpayer must have a right of appeal to the courts against the tax authority's conclusion.

• The member state must ensure that the lender is entitled to a compensating adjustment under the relevant double tax convention; to the extent that interest paid is recharacterized by the source state (normally the state where the borrower is resident), the lender's state of residence must follow that recharacterization.

What is Thin Capitalization?

It is often more tax efficient to finance a cross-border corporate investment with shareholder debt than with equity because interest on debt is generally deductible for tax purposes, whereas dividends and other distributions in respect of equity participations are not. 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 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 capitalization'.

Where the shareholder and the investee company are subject to tax in the same jurisdiction, there will usually be little overall tax advantage stemming from thin capitalization, as the interest will be tax deductible for the investee company, but taxable in the hands of the investor, usually at the same rate. However, where the shareholder or creditor is located in another jurisdiction (or is otherwise exempt from tax on the interest), a tax advantage can be gained at the expense of the exchequer of the investee company's jurisdiction. Therefore, it has been common for tax authorities to adopt anti-thin capitalization rules to restrict such potential loss.

For example, company A, established in EEA member state 1, sets up a subsidiary, company B, in member state 2. The subsidiary needs a capital of 1,000 and the market interest rate is 6% a year. The tax rate in state 1 is 33%, compared with 38% in state 2. Company B generates pre-interest, pre-tax profits of 150 annually. If the required capital is injected solely as share capital, the tax on company B's profits will be 57. However, if three-quarters of the required capital is injected by company A as a loan at 6% a year and the interest on the loan is tax deductible, the tax on company B will be reduced to 40, company A will be subject to tax of 15 on the loan interest and the group will save tax of 2 annually. It can be seen that the negative effect of the loan (as distinct from equity) on state 2's exchequer is a multiple of the overall advantage gained by the group.

UK Thin Capitalization Rules

The thin capitalization rules in the United Kingdom went through various formulations during the period covered by the thin capitalization group litigation order. However, the rules have at all times used a version of the arm's-length standard (in combination with the relevant double tax convention until 1995, when the domestic law was revised) as the key criterion for governing the deductibility of interest on related-party loans, rather than, for example, a 'safe harbour' formulation. In April 2004 the transfer pricing rules, which by then also governed thin capitalization, were extended to apply to UK domestic related-party transactions, including loans.

Thin capitalization group litigation order
The case in question is part of the group litigation order launched in the United Kingdom following the ECJ's decision in 2002 in Lankhorst-Hohorst with a view to the claimants recovering tax previously paid as a result of the UK thin capitalization rules. In Lankhorst-Hohorst the ECJ found that where a group established in an EU member state (the Netherlands) capitalized a subsidiary in another member state (Germany), partly by way of shares and partly by way of a subordinated loan, the German thin capitalization rules could not restrict the deduction for German tax purposes of interest on the subordinated loan. An important part of the decision in Lankhorst-Hohorst was that the German rules as they then stood could not be justified in terms of EU law. It is perhaps in this respect that the advocate general's recent opinion breaks most clearly with precedent.

As a result of Lankhorst-Hohorst a number of member states, including the United Kingdom and Germany, extended their thin capitalization rules to cover purely domestic related-party borrowing in order to avoid the concern that thin capitalization rules which apply only to cross-border related-party borrowing were in breach of EU law. In the advocate general's view, this approach showed a misunderstanding of the effect of the Lankhorst-Hohorst decision.

Advocate general's opinion
The advocate general had little trouble in concluding that the UK thin capitalization rules (as they applied up to April 2004) created differential tax treatment for UK companies with overseas parents compared with UK companies with a UK parent because the rules applied only to UK companies paying interest to an overseas group lender. He did not accept that the rules served merely to allocate taxing jurisdiction between the United Kingdom and its double taxation treaty partners (which would not be discriminatory). Instead, he considered that the rules resulted from unilateral action by the United Kingdom.

In principle, therefore, the UK thin capitalization rules amounted to a breach of the freedom of establishment. However, the advocate general went on to conclude that this breach could be justified by the need to prevent tax avoidance.

Consequences
The advocate general concluded that, as the UK thin capitalization rules are based on the arm's-length standard, they comply in principle with EU law. This is subject to two provisos.

First, it is for the UK courts to determine whether the UK rules and the way in which the double tax conventions are applied permit the taxpayer to demonstrate that non-arm's-length transactions are nonetheless commercially justified and should not therefore give rise to a disallowance. It seems unlikely that the UK rules did permit this, although the advocate general considered that non-arm's-length terms will be commercially justified only in certain rare circumstances.

Second, the advocate general also left it to the UK courts to determine whether the lender is in all cases entitled to have the 'excess' interest treated in the same way as a distribution of profit under the relevant double tax convention, which will not necessarily be so in all cases. Under Article 9(2) of the Organization for Economic Cooperation and Development's Model Tax Convention, where a transfer pricing adjustment leads to an increase in the taxable profits of an enterprise located in one contracting state, the other state must make an "appropriate adjustment" to the taxable profits of the other enterprise. The tax authorities of the two states must consult if necessary, but this will not automatically lead to symmetrical treatment in all cases.

Outstanding Issues

Does the advocate general's opinion accord with previous ECJ case law?
The advocate general gave a number of explanations of why the ECJ had concluded that the German thin capitalization rules at issue in Lankhorst-Hohorst were not justified and could thus be distinguished from the UK rules. He concluded that the German rules failed the proportionality test because:

• they applied a fixed debt-to-equity ratio which was rebuttable only if the company could have borrowed on similar terms from a third party;

• it appeared that the effect of the German provision was to disallow all the interest on the relevant debt (and not merely the excess above an arm's-length amount); and

• there does not appear to have been a mechanism under the tax convention between Germany and the Netherlands for granting a compensating adjustment to the lender.

On investigation, this reasoning is perhaps a little weak. In particular, it appears that the effect of the German thin capitalization rules as they then stood was not generally to disallow related-party interest in its entirety but to disallow only the excess interest above an arm's-length amount. However, the interpretation of the Lankhorst-Hohorst judgment is slightly clouded by confusion as to whether the disallowance of the interest arose only because of a letter of support (Patronatserklärung) from the Dutch parent, waiving repayment of the loan by the German subsidiary if third-party creditors made claims against the borrower, or because of the general provisions of the German thin capitalization rules.

When can EU law apply to thin capitalization rules?
The group litigation order deals with a number of different fact patterns, some involving non-EEA parent companies and/or group lenders. This means that the ability to rely on EU law in order to challenge thin capitalization rules may depend on which EU freedom is at issue.

The EEA comprises the EU member states plus Iceland, Liechtenstein and Norway. The freedoms which are granted by the EU Treaty within the European Union also apply within the EEA. Thin capitalization rules potentially bring into play the freedom of establishment, the free movement of capital and the freedom to provide services. A company which establishes a subsidiary in another member state is exercising its freedom of establishment. The very rationale for thin capitalization rules is that a company may use its control over another company in order to agree lending on non-arm's-length terms. Thin capitalization rules thus amount to a direct restriction on the freedom of establishment in the opinion of the advocate general. A restriction on the free movement of capital flows and on freedom to provide services would, the advocate general suggests, merely be an indirect result of the application of the thin capitalization rules. This view led the advocate general to conclude that no challenge to the UK thin capitalization rules based on EU law can apply where the parent company and lending company (if different) are established in a third state which is not in the EEA. Cases of the present kind, where national legislation appears to infringe more than one of the EU freedoms, have spawned difficult and conflicting case law in the ECJ. The case law appears overdue for careful and reasoned consideration by the ECJ and clear guidance to member states is urgently required.

The opinion of the advocate general in Baars (1999) suggests that the problem should be resolved by a 'direct infringement' test. This involves establishing which of the freedoms the national provision directly infringes, infringements of other freedoms then being disregarded as indirect effects of the infringement of the former freedom. The advocate general recommends this test to the ECJ in the present case, but it is not specifically supported by ECJ case law. The decision in Konle (1999), which involved a prima facie infringement of freedom of establishment and free movement of capital, but was decided by reference to free movement of capital, undermines it, as does the decision in Svensson (1995). The direct infringement test also introduces an undesirable and arguably unnecessary degree of uncertainty. A further difficulty with this approach is that it seems not to take full account of the extension (under the Maastricht Treaty) of free movement of capital to movements between the EEA and third states. Since enterprises of third states have no right of freedom of establishment, it is difficult to see why loans from them to EEA subsidiary undertakings (or vice versa) should be denied the benefit of free movement of capital by reference to a right of free establishment which third-state enterprises do not possess.

If the advocate general's reasoning is adopted by the ECJ, it would lead to the results set out in the table above for a UK subsidiary, based on the fact patterns considered by the advocate general in the present case. There are clearly gaps in this table; the advocate general's opinion does not consider all possible scenarios and, as the advocate general's reasoning is less than clear in this area, it is difficult to draw out the principles on which it is based and apply them to other cases.

At first sight the opinion that free movement of capital does not apply appears to be a significant blow for the claimants under the group litigation order which are owned by non-EEA companies, given that they cannot rely on freedom of establishment. However, their position has always been weaker than those which are able to rely on this freedom. This is because the free movement of capital does not apply in relation to non-EEA countries where the restriction in question already existed on December 31 1993. The United Kingdom had thin capitalization rules at that time; although they have been modified a number of times since then, there is a good argument that the rules existed on December 31 1993. If so, this would prevent UK companies with non-EEA parents from relying on free movement of capital.

Comment

If the ECJ follows the advocate general's opinion, its decision will mark a major shift in its jurisprudence since the Lankhorst-Hohorst decision in 2002. It is possible to draw a number of other conclusions from the advocate general's opinion:

• The advocate general's explanation in the recent opinion of why the German rules were held to be unjustified in Lankhorst-Hohorst is somewhat difficult to follow. A more likely message which the advocate general was seeking to convey is that the ECJ is becoming (or should become) increasingly reluctant to disturb member states' anti-avoidance legislation, provided that it is correctly targeted. Although this is also reflected in the Marks & Spencer decision, it is not clear how existing UK anti-avoidance legislation relating to interest fits in.

• If the ECJ adopts the advocate general's opinion, the circumstances in which UK companies will be able to claim compensation for the UK thin capitalization rules being in breach of EU law are likely to be extremely limited. The total liability of Her Majesty's Revenue and Customs is likely to be considerably less than its own estimate of €300 million. For this reason the advocate general rejected the UK government's argument that a decision that the UK rules were in breach of EU law should have effect only for a limited period.

• If the advocate general's opinion is adopted by the ECJ, it is to be hoped that the UK government will reverse the extension of the UK's transfer pricing rules to domestic related-party borrowings and other domestic related-party transactions, since such extension is now revealed to be unnecessary.

• The advocate general deduces from the ECJ's decision in Marks & Spencer a principle that EU law permits "balanced allocation of taxing powers" to be used by member state governments as a justification for measures restricting EU freedoms. However, over the past 10 years and in its judgment in Marks & Spencer the ECJ has emphasized that preservation of the tax revenues of member states is not a justification for restricting an EU freedom. Although one can understand the political pressures to which all EU institutions are subject, Professor Melchior Wathelet, a retired ECJ judge, has pointed out that neither the ECJ in Marks & Spencer nor the advocate general in his recent opinion satisfactorily explained how the line is to be drawn between the impermissible preservation of a member state's tax revenues on the one hand and the (apparently permissible) balanced allocation of taxing powers on the other.

• The ECJ held as long ago as 1995 (in its decision in Wielockx) that, where a double tax convention is in point, "fiscal cohesion", a long-established acceptable justification, is "shifted to another level, that of the reciprocity of the rules applicable in the states which are parties to the convention". This suggests that, if the ECJ accepts that the UK thin capitalization rules are justified, the present cases can be dealt with very simply - and without making new law - by reference to the conventions in place between the United Kingdom and the jurisdiction of each lending company.

• The effect of the advocate general's opinion is to produce considerable uncertainty in a number of respects, particularly the uncertain boundary between balanced allocation of taxing powers and preservation of tax revenues, and the justification of prevention of tax avoidance on which the advocate general largely based his conclusions on the UK thin capitalization rules. To explain the limits of this justification, the advocate general had recourse to notions of continental European origin, such as artificial construct and abuse of law. For EEA states whose legal systems are based on common law, such as the United Kingdom, the introduction of such concepts into direct tax law does not constitute such helpful guidance as it does for EEA states whose legal systems are based on Roman-inspired civil law. ECJ cases on value added tax (VAT) provide little foundation for the importation of these concepts into the direct tax law of the United Kingdom and other common law member states, since even member states with common law systems have to accept that VAT is a matter for EU law, by which they must abide. This is not the case with direct tax, as since Schumacker (1995) the ECJ has always recognized that each EEA state has, in principle, an individual right to levy direct tax. The effective denial of free movement of capital rights to parent companies located outside the EEA which directly involve themselves in the UK subsidiary's business appears questionable.

Were the advocate general's opinion to be followed by the ECJ, an undesirable degree of uncertainty would be likely to remain and would continue to inhibit effective tax collection as well as tax planning. Development by the ECJ of its jurisprudence in this area has been taking place for 20 years and thin capitalization has been a headache for tax authorities, taxpayers and tax advisers for even longer. It is surely time for the ECJ to face the relevant issues squarely and provide guidance which will lend a measure of certainty - on EU law at least - for taxpayers and taxation authorities.

For further information on this topic please contact Matthew Desborough-Hurst or Emma Nendick at Herbert Smith by telephone (+44 20 7374 8000) or by fax (+44 20 7374 0888) or by email (matthew.desborough-hurst@herbertsmith.com or emma.nendick@herbertsmith.com).