UK Thin Capitalisation rules may be in breach of EC Law

The European Court of Justice ("ECJ") has handed down its decision in Lankhorst-Hohorst GmbH v Finanzamt Steinfurt, which was concerned with whether Germany's thin capitalisation rules were in contravention of Article 43 EC Treaty. The ECJ has ruled that the German legislation was in conflict with Article 43. This has important implications for the legality of the UK's thin capitalisation legislation reflected in the fact that the UK (along with Germany and Denmark) submitted its views to the ECJ.

The case itself concerned the re-characterisation of payments of interest by a German subsidiary of a Dutch company to its ultimate Dutch parent, as distributions. German domestic law required interest paid by a German company to its parent to be characterised as a distribution where the subsidiary was "thinly capitalised" unless:

• the subsidiary could have obtained the loan from an unconnected third party; or
• the parent was entitled to a tax credit on dividends received from the subsidiary.

The German domestic court had ruled that the loan could not have been obtained from an unconnected third party.

Article 43 EC Treaty prohibits a member state from placing restrictions on the freedom of establishment (the right for nationals of other member states to be treated in the same way as nationals of the first member state). It was argued that there was no discrimination on the grounds of nationality because the test for whether interest was re-characterised as a dividend was not nationality but whether or not the parent was entitled to a tax credit. In rejecting this argument the ECJ noted that non-resident shareholders were not entitled to the tax credit and that apart from this it was really only German resident entities exempt from tax that were not entitled to the tax credit. A German resident parent established with a view to making profits would be entitled to the tax credit whereas a Dutch resident parent established with a view to making profits would not be so entitled.

The ECJ ruled that the correct question to be considered was whether a German subsidiary whose parent was resident in another member state was treated less favourably under German law than a German subsidiary of a German parent. The ECJ had no hesitation in finding that there was discrimination.

The ECJ then considered a number of arguments that were put forward in justification of the discrimination. It was argued that the thin capitalisation legislation (a form of which could be found in many other countries) was intended to combat tax "evasion" by inhibiting the transfer of profits from the subsidiary to the parent. The ECJ summarily rejected this making it clear that a reduction in tax revenue could not constitute an overriding reason in the public interest that could justify a measure that on the face of it was in breach of a fundamental freedom.

It was further argued that the legislation could be justified so as to ensure the fiscal cohesion of the German tax system. In particular, the German legislation reflected the internationally recognised arm's length principle requiring an adjustment of profits where loan capital provided by one party to a related party would not have been provided by an unrelated third party. In line with more recent cases, the ECJ emphasized the limitation of this justification and held that in order for the fiscal cohesion defence to apply it must be shown that the German subsidiary had obtained a tax advantage (not available to a German subsidiary with a non-German resident parent) in addition to suffering the tax disadvantage. This was not the case here. The ECJ simply viewed the German thin capitalisation rules as a means of avoiding tax leakage from Germany.

Comment:

• Whilst direct tax (unlike VAT) is not within the competence of the EC, the ECJ has made it clear that member states must comply with EC law when enacting domestic legislation (this is something that the EC Commission is keen to take advantage of in its quest to influence the development of direct tax within the EU). Therefore, whenever the tax law of a member state could be said to operate so as to discriminate against a taxpayer on the grounds of nationality (which for corporate tax purposes is broadly equivalent to residence) the ECJ will be sympathetic to arguments that it contravenes EC law.
• So far as the UK is concerned section 209(2)(da) Taxes Act 1988 re-characterises interest paid to a related party as a distribution where it exceeds the amount of interest that would have been payable had the parties not been related. However, section 212 Taxes Act 1988 operates so that the re-characterisation is not required where the recipient of the interest is within the charge to corporation tax. A company resident in another member state and not trading in the UK through a permanent establishment will not obtain the benefit of section 212. On the basis of the Lankhorst-Hohorst decision there seems little doubt that the ECJ would rule that section 209(2)(da) is in contravention of Article 43 EC Treaty.
• The Inland Revenue is also able to disallow for tax purposes interest paid by a UK resident company to the extent that it exceeds the amount that would have been payable on an arm's length basis (see Schedule 28AA Taxes Act 1988). This legislation will not generally apply where no UK tax advantage ensues from the transaction so that once again it would seem that this UK legislation is open to challenge on the basis of Lankhorst-Hohorst as Schedule 28AA will not apply to loans made by a UK parent to its UK subsidiary but potentially would apply to loans made by a non-UK EU parent to its UK subsidiary.
• It seems inevitable that UK thin capitalisation legislation will need to be amended. However, it should not be assumed that this would be done in such a way as to apply the current regime equally to non-UK EC resident companies. One possibility is for the current regime to be extended so that section 209(2)(da) would require interest to be re-characterised as a distribution whether or not the parent is UK resident and for Schedule 28AA to operate even where parent and subsidiary are both UK resident; in substance the introduction of a general rule requiring arms length funding. The alternative would be to, in effect, abolish the thin capitalisation rules, at least for related companies based in the EU. However, if this option were to be taken the UK might feel obliged to treat EU and non -EU companies in the same way (as was the route taken on the introduction of the changes to group relief necessitated by the decision of the ECJ in ICI v Colmer).
• In the meantime, companies that have been adversely affected by thin capitalisation restrictions, whether in the UK or elsewhere in the EU (including non-EU companies with EU holding companies or treasury operations), should consider the possibility of seeking redress from the UK or other relevant member states. We in our London Tax Group and our CMS colleagues across Europe are available to assist you in that process. One interesting point that will need to be considered is whether those who have been forced by thin capitalisation "safe haven" rules, such as the 3:1 ratio in Germany, to restrict the level of loan financing will themselves have grounds for complaint (rather than just those that have suffered directly through the denial of relief for interest paid).