'Thin cap' rules breach free movement of capital

UK law preventing companies to claim tax deduction on interests paid by subsidiaries is contrary to the EU's free movement of capital principle, the High Court has ruled, opening claims for the repayment of millions of pounds of unduly paid tax.

The case, brought by multinationals including Volvo, Lafarge and IBM, challenged the grounds on which companies could deduct interest on loan repayments by subsidiaries based in other EU member states.

Parent companies choosing to fund subsidiaries through capitalisation would usually be taxed on dividends. An alternative is to fund subsidiaries through loans and claim tax-deduction on interest repayments, a mechanism known as 'thin capitalisation'.

The UK sought to prevent tax legislation to be circumvented by companies trying to take advantage of lower tax legislation in other member states, by applying a higher rate of tax to parts of the interest that it deemed could not be regarded as being an ordinary arm's length transaction.

In a two-part test, UK law required companies to show that the transaction was entered into on a commercial basis.

Ruling in Thin Cap Group Litigation, Test Claimants In v Revenue and Customs [2009] EWHC 2908 (Ch), Mr Justice Henderson said the UK's thin cap provisions infringed article 43 EC (freedom of establishment) 'because of their failure to provide a separate and independent defence of genuine commercial justification'.

As a result, Henderson J said, the UK thin cap provisions must be disapplied in relation to transactions which had a genuine commercial justification, and that it would be for the Revenue to establish the contrary in any given case.

The judge made clear that the onus was 'on the Revenue to do so by positive evidence, and not merely as an inference to be drawn from the fact that the arm's length test under the rules in force at the relevant time was not satisfied'.

'None of the transactions entered into by the test claimants were, either wholly or in any relevant part, purely artificial arrangements devoid of any commercial justification, nor have the Revenue sought to establish that they were,' he said.

The claimants were also entitled to recover interests and to seek compensation from the UK for having committed a 'sufficiently serious breach' of EU law under the Factortame principles.

The judgement follows a preliminary ruling by the European Court of Justice in case C-524/04 in February 2007 where the ECJ ruled that UK legislation constituted an obstacle to the free movement of capital.