Background to the Judgment (issued Nov 2012)
This Judgment is but the latest iteration in a long running case. The group litigation was brought before the UK courts in 2003.
The crux of the matter is that the claimants believed the then UK taxation of cross border dividends was contrary to Art 49 Freedom of Establishment) and Art 63 (Free Movement of Capital) of the Treaty on the Functioning of the EU (TFEU).
The taxation rules in point were:
-Advance Corporation Tax (ACT) – this is not especially relevant in our context; and,
-The system for taxing foreign dividends v domestic dividends – this is relevant and is elaborated on below.
In 2004 the case was referred to the ECJ by the UK High Court.
In 2006 the ECJ handed down its opinion seemingly in favour of the claimant.
However, the High Court felt that the ECJ’s decision was not clear, made its ruling and the Case went on appeal to the UK Court of Appeal.
In 2010 the Court of Appeal referred the Case back to the ECJ to clarify its original judgment issued in 2006.
This judgment handed down in Nov 2012 is the clarification so requested. The Case will now go back to the UK Courts for interpretation and implementation.
How this Case works out before the UK Courts will be closely watched but we think the more important issue is the judgment and clarification handed down by the ECJ and how it will apply across Europe.
The Taxation Rules in Point
As mentioned above, ACT is not especially relevant in the current context therefore I have omitted it from further discussion.
The introduction of the company concept as a trading vehicle and the taxation of corporate entities in their own name (i.e. corporation tax) poses the problem of economic double taxation.
That is, in the absence of a tax relief, the use of a company to run a business would lead to one economic source of income (i.e. the business) being taxed twice; once at the company level (corporation tax) and again at the shareholder level on receipt of a dividend (income tax or corporation tax depending on who is the shareholder).
This is not desirable as it makes companies unattractive vehicles through which to trade and it should be recalled that companies were originally brought about to encourage trade by limiting liability of entrepreneurs.
As such, different tax reliefs have developed to prevent this double economic taxation (or in the modern world to make it less apparent that double economic taxation is occurring).
The two primary methods are as follows:
-The exemption method; and,
-The imputation or credit method.
The exemption method is exactly that; the shareholder is exempt from tax on the receipt.
The credit method however, charges the dividend to tax and then provides a credit for the corporation tax paid by the company.
To illustrate the difference effects consider the following example:
-Company A owns Companies B & C.
-Company A is exempt from tax on dividends from B but has to use the credit method on dividends received from Company C.
-Companies A, B and C all pay tax at 30%.
-Company B has an effective rate of tax of 16%. The effective rate of tax is basically the tax it pays divided by the profit. This is less than 30% due to certain tax deductible expenses (capital allowances, losses etc).
-Company C has an effective rate of 16% as well.
-Company A receives two dividends of £100 each from Companies B & C.
-On the dividend from Company B it will pay no more tax as the dividend is exempt.
-However, on the dividend from Company C it will pay 14% i.e. the dividend will be taxed at 30% with credit given for the 16% paid.
Herein lies the problem: dividends from Company C are taxed at a higher rate than dividends from Company B.
In the UK and Ireland, the exemption method was/is applied to domestic dividends while the credit method was/is applied to foreign dividends and clearly it can be seen that this tax system discriminates against the overseas dividends.
This in turn makes it less attractive to establish companies outside your home jurisdiction and as a result it is contrary to the TFEU (but see next section).
The ECJ Judgment – A Little More Detail
The original 2006 ECJ judgment made it clear that it did not see anything prima facie “bad” about using exemption for domestic dividends and the credit method for foreign dividends. That is, a country can theoretically use the dual approach without falling foul of the EU Treaty. The key however is the practical implementation; the two systems must in practice be equivalent or almost equivalent.
The ECJ went on to note that the two systems would lead to unequal results when the effective rate of taxation was considered as in the example above.
Basically, where the effective rate of taxation abroad (the 16% in our example) is less than the headline rate of tax (30% in our example), the foreign dividend is subject to a top up tax charge (the 14% in our example for Company C’s dividend) which the dividend from a domestic dividend is not.
So in practice, the system in our example above does not yield equivalent or almost equivalent results.
As a result, the practical outcome of how two differing systems for domestic and foreign dividends are implemented must be regarded as an unlawful restriction on the freedom of establishment and the free movement of capital.
The ECJ also went on to consider the implications for dividends received from “Third Countries” i.e. non EU countries.
The discussion is technical and largely irrelevant to our considerations. It suffices to say that the ECJ held that the above conclusion that such a dual system is discriminatory applies equally to dividends received from Third Countries i.e. dividends from countries outside the EU.
Current estimates put the loss to the UK Exchequer at £5bn.