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Thin Cap GLO: the EU and national direct taxation

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It’s a fair bet that if the founding fathers of the European Union had been asked whether the EU would have any involvement in national direct taxation, the response would have been a shrugged ‘Mais non’ or a rather more definitive ‘Nein nein nein’.

However, life didn’t turn out like that. A combination of European lawyers and European Court Judges developed the theory that national tax measures needed to treat EU activities and investments in a non-discriminatory manner.

Freedom of establishment and free movement of capital became the battle grounds between a European Commission keen to boost the Single Market, a range of taxpayers seeking windfall benefits and initially sceptical but increasingly beleaguered national tax authorities.

Faced with the prospect of losing significant revenue, EU Member States discussed in secret whether anything could be done to withdraw taxation from the unrealistic grasp of the Luxembourg Judges. It’s thought that Germany and the UK were at the forefront of this debate – which makes sense, given that there have been more German cases before the ECJ than from any other country and that the UK faced potentially enormous claims.

The Member States’ saviour came in the form of Advocate-General Geelhoed and the rotation of judges. AG Geelhoed explained that national taxation finances at least 95% of national spending – and so needs to be protected. Two vital doctrines were developed: proportionate justification and the notion that taxpayers should not be able to choose where profits should be taxed.

The problem

The problem we face, though, comes from the unhelpful way in which ECJ matters are litigated. The Court has manifestly changed its approach over the years, but operates under the fiction that nothing has changed. Earlier decisions are not overruled, or given a context. The Court isn’t helped by not knowing anything at all about taxation in the Member State whose laws are being challenged.

The way in which limited questions are put to the Court, combined with the lack of oral argument, and then the handing down of judgments in what at best could be called unusual language makes the job of the national court extremely hard.

The Court of Appeal judgment in the Thin Cap GLO

Last month the Court of Appeal handed down its judgment in the Thin Cap GLO (Test Claimants in the Thin Cap GLO v HMRC [2011] EWCA Civ 127). AG Geelhoed had explained that there had been no need for Member States to introduce domestic transfer pricing to defend international transfer pricing. Treating international transactions differently is legitimate, as it prevents tax avoidance and avoids taxpayers choosing where they’d like profits taxed. However, he said there needed to be the potential for a company to show that its transactions were motivated by commercial – and not tax – reasons. This would only be capable of being shown in exceptional cases he said – like Langhorst Hohorst which had triggered the whole issue.

Mr Justice Henderson heard the case when it returned to the UK. We must express huge sympathy for him as he listens to interminable arguments in EU cases and then writes a small book instead of a judgment. However, his judgment in Thin Cap is not his finest. He decided that HMRC bore the burden of proof to show that loans were not commercial, which they had failed to discharge. Accordingly, he decided that all claimants which had lent on non-arm’s-length terms succeeded. He also decided that there was a sufficiently serious breach of EU law that damages were due for the period from the Langhorst judgment to the change of UK transfer pricing law. 

The Court of Appeal wasn’t impressed. The whole Court decided that the burden of proof clearly rested with the taxpayer (who knew the facts), rather than with HMRC. Second, there wasn’t a sufficiently serious breach of EU law to justify damages. The government had acted as fast as reasonably possible to change the law. We then moved to the area where the judges split, with Lady Justice Arden in the minority. The majority thought that the ECJ’s judgment in Thin Cap should be interpreted in accordance with their later decisions in OY AA and SGI – and reached the conclusion that when the ECJ had referred to a taxpayer being allowed to show that a loan was made for commercial reasons simply meant that it was made on arm’s-length terms. As the UK allowed a deduction for arm’s-length loans, there could be no further remedy for amounts lent in excess.

The right answer after all?

Some will think the conclusion contradicts the Thin Cap judgment. However, it may well turn out to be the right answer in the end. AG Geelhoed was clear that there would only be rare exceptions where a loan was made for commercial reasons on non-arm’s-length terms. The claimants in the case are all significant multinationals: Lafarge, Volvo, IBM, Standard Bank of South Africa and Siemens. We haven’t seen their evidence, but many would be surprised to discover that their UK subsidiaries were in such dire straits that their only means of financing was a group loan on non-arm’s-length terms.

Surely where Mr Justice Henderson fell into error was in suggesting that just because the money was used for a commercial purpose – which is almost inevitable in a business context – excessive amounts would be deductible.

No doubt there will be an application to the Supreme Court for leave to appeal. However, I can’t help but wonder whether justice – albeit rough justice – would be done if that court declines to take the case.

Bill Dodwell, Head of Tax Policy, Deloitte