The case of Next Brand Ltd v HMRC involved a claim for double tax relief by a UK resident parent which had received a dividend from a Hong Kong resident subsidiary. That subsidiary had in turn received a dividend from another UK resident company at the bottom of the structure. It was held that the UK tax paid by the bottom company did not qualify for double tax relief in the hands of the parent, because the dividend paid by the bottom company did not represent any of the accounting profits of that company; and because no part of that dividend was reflected in the dividend paid by the intermediate company to the parent. The first of these grounds seems more persuasive than the second.
The recent decision of the
First-tier Tribunal in the case of Next Brand Ltd v HMRC [2015] UKFTT 175 (reported in Tax Journal, 22 May 2015) has been eagerly awaited by many in the tax world. This is despite the fact that, following the introduction of the dividend exemption in 2009, the calculation of underlying tax in respect of a foreign dividend is now of limited relevance.
The material facts of the case, heavily simplified, are as follows. A UK resident company (Next) held shares in a Hong Kong resident subsidiary (HKCo). HKCo had profits which had borne tax at a rate which was considerably below the UK corporation tax rate. Accordingly, in an attempt to boost the rate of underlying tax which could be credited against the UK corporation tax payable by Next on a dividend from HKCo, HKCo acquired preference shares in a UK resident member of the group (UKCo) and shortly afterwards received a significant dividend on those shares; the effect of this was to deprive the shares of any meaningful residual value.
In keeping with the economic substance of the transaction, UKCo treated the issue of the preference shares and the subsequent payment of the dividend in its accounts as, respectively, a borrowing and a repayment of the borrowing. HKCo accounted for the preference shares and the dividend in a similar fashion. It did not account for the dividend in its income statement, but simply wrote down the value of the preference shares in its balance sheet by the amount of the dividend received. In consequence, the dividend paid by UKCo on the preference shares had no impact on the accounting profits of HKCo. The dividend paid by UKCo did, however, reduce the distributable reserves of UKCo, because an amount equal to the dividend was transferred from its retained earnings to a non-distributable reserve.
HKCo then paid a dividend out of its profits to Next. Next argued that, in consequence of the above steps, it was entitled to take into account, as an underlying tax credit in respect of the dividend it received from HKCo both the foreign taxes paid by HKCo itself and the UK corporation tax paid by UKCo; thereby, in effect eliminating any UK corporation tax liability of Next in respect of the HKCo dividend.
Next based its claim on ICTA 1988 ss 799 and 801. In combination, those sections provided that in a case (such as this one) where underlying tax relief is available, the credit to be given was for as much of the foreign tax borne on the relevant accounting profits of the dividend payer as was ‘properly attributable to the proportion of the [relevant accounting] profits represented by the dividend’ and that, in the case of a dividend paying chain, where an overseas company received a dividend from a company beneath it in the chain, any foreign tax or UK corporation tax payable by the bottom company should be treated as tax paid by the overseas company to the extent that the overseas company would have been entitled to a credit if it had been UK resident and if the bottom company had been overseas resident. Thus, said Next, since HKCo had clearly received a dividend from UKCo, HKCo should be treated as having paid such a proportion of the UK corporation tax (paid by UKCo) as corresponded to the proportion which the dividend (paid by UKCo) bore to UKCo’s relevant accounting profits. Similarly, Next believed that such a proportion of those taxes as corresponded to the proportion which the dividend (paid by HKCo) bore to HKCo’s relevant accounting profits should attach to the HKCo dividend received by Next.
The tribunal rejected Next’s claim on two grounds.
The first was that even if the dividend on the UKCo preference shares was a ‘dividend’ on the basis of the decision in First Nationwide [2012] EWCA 278, and could not simply be characterised as a repayment of debt in accordance with its accounting treatment, the accounting treatment was relevant in determining what proportion of UKCo’s relevant accounting profits were ‘represented by the dividend’ for the purposes of s 799. The dividend was not a distribution of UKCo’s profit even though, in its accounts, UKCo transferred an amount equal to the dividend from its retained earnings to a non-distributable reserve as a result of the dividend payment. In the words of the tribunal judge, the UKCo dividend was the ‘wrong kind of dividend’. As the dividend could not be said in any meaningful sense to be a distribution of profit, the proportion of UKCo’s relevant accounting profits represented by the dividend was nil. Therefore, the legislation did not apply in such a way as to deem HKCo to have borne any of the UK corporation tax (paid by UKCo).
The tribunal gave a second ground for rejecting the claim. It said that even if it was correct to conclude that the UK corporation tax (paid by UKCo) did attach to the UKCo dividend, no part of that dividend was reflected in the dividend paid by HKCo to Next. This is because, as mentioned above, the UKCo dividend had no effect on the relevant accounting profits of HKCo. It followed that none of the accounting profits of UKCo were represented in the dividend paid by HKCo; and therefore that none of the UK corporation tax deemed to be paid by HKCo as a result of its receipt of the UKCo dividend should attach to the dividend paid by HKCo to Next.
The first ground seems more persuasive than the second. It is true that since the House of Lords decision in Bowater Paper Corp v Murgatroyd (1969) 46 TC 37, the underlying tax relief attaching to a dividend has generally been calculated by applying a fraction (the numerator of which is the dividend and the denominator of which is the relevant accounting profits); however, this is predicated on the assumption that a dividend is a distribution of the relevant accounting profits. Is an automatic adherence to that fraction required, in circumstances where it can be shown that the dividend is not a distribution of those profits? On the other hand, does the fact that an amount equal to the dividend was required to be transferred to a non-distributable reserve (and therefore that the future distribution capacity of UKCo was impaired to that extent) mean that the dividend should have been regarded as a distribution out of UKCo’s relevant accounting profits?
The statutory provision requires the identification of the proportion of the relevant accounting profits represented by the dividend. What proportion is that where the accounts show the dividend as a repayment of debt, but the distributable reserves of the dividend paying company are reduced by an equivalent amount?
One thing is clear. The tribunal’s reasoning here is to be preferred to the approach adopted by the tribunal in the similar case of The Peninsular & Oriental Steam Navigation Company v HMRC [2013] UKFTT 322. In this case, the tribunal simply resorted to recharacterisation and held that no dividend had been paid by the bottom company.
Whilst the first ground was sufficient to get HMRC home, it is not easy to understand the second ground given by the tribunal for rejecting Next’s claim. If it is accepted that the UKCo dividend carried a tax credit in respect of the UK corporation taxes (paid by UKCo), then it is clear that the legislation works mechanistically at that point to deem those taxes to have been paid by HKCo in respect of its own relevant accounting profits. Therefore, such a proportion of those taxes as corresponded to the proportion which the dividend (paid by HKCo) bore to HKCo’s relevant accounting profits should logically have attached to the HKCo dividend in Next’s hands. There is no requirement in the legislation that any of the profits of UKCo needed to be included in the dividend paid by HKCo in order for the tax to attach to the HKCo dividend.
There are a number of similar transactions standing in line behind this case and it seems inevitable that the case will be subject to appeal. One point which the taxpayer might highlight on appeal is that, assuming that there had been no change in our dividend system to an exemption regime, this decision would result in a permanent loss of credit for the relevant proportion of taxes paid by the bottom company; and, hence, the potential for double taxation.
There is another category of booster disputes. These involve cases which rely on a credit for deemed (as opposed to actual) UK corporation tax. The arguments here are subtly different. The tribunal’s second ground referred to above would appear to be more relevant in these cases, because the relevant provisions in these cases expressly require consideration of the extent to which the dividend paid by the bottom company is represented in the dividend at the higher level.
We should expect further judicial examination of these issues in the near future. The appeal in the deemed UK corporation tax booster case of The Peninsular & Oriental Steam Navigation Co was heard by the Upper Tribunal in December.
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