UK: European Court Supports UK Thin Capitalisation Rules

Last Updated: 15 March 2007
Article by Michael Boutell and Mark Nichols

The European Court of Justice (ECJ) has handed down its judgment in Test Claimants in the Thin Cap Litigation (C-524/04). The case is concerned with whether the thin capitalisation rules (restricting the extent to which interest on lending from non-UK associated companies is deductible) that were in place in the UK prior to the Finance Act 2004 changes were compatible with EU law. The ECJ has largely followed the opinion of Advocate General Geelhoed, holding that the UK rules were essentially EU law compliant. This suggests that the Finance Act 2004 provisions designed to extend the thin capitalisation and transfer pricing rules to UK residents (so as to put residents and non residents on a level playing field) may have been unnecessary.

The Group Litigation involves several well known groups of companies that have lending arrangements in place under which a UK resident company is provided with loan finance either from a company resident in another EU member state or a company resident in a third state and in either case where there is either an ultimate parent resident in an EU member state or in a third state.

The High Court referred the case to the ECJ and in June 2006 Advocate General Geelhoed delivered his opinion, which has been largely followed by the ECJ. The ECJ held that the effect of the UK rules was to treat interest paid by a UK resident company to its parent as a distribution in circumstances where it would be treated as interest if the parent were UK resident and that this amounted to less favourable treatment. Where the loan finance was provided directly or indirectly by a company resident in another member state then in principle this was a breach of the freedom of establishment since it makes it less attractive for companies established in other member states to establish a subsidiary in the UK. Once again the ECJ held that where the national legislation in issue was concerned with groups of companies (as was the case in Marks & Spencer (group relief) and Cadbury Schweppes (controlled foreign companies) the case should be decided purely on the basis of freedom of establishment (and not for example, free movement of capital).

However, following the approach adopted in recent direct tax decisions of the ECJ, the ECJ held that a restriction on the freedom of establishment could be justified if the effect of the legislation was to counter "abusive practices". The Court ruled that a national measure restricting freedom of establishment might be justified where it specifically targets wholly artificial arrangements designed to circumvent the legislation of the member state concerned. Interestingly, the Court referred to this principle as based on "established case law" although it might be said that in reality this represents a new and developing approach by the Court (seen in Marks & Spencer and Cadbury Schweppes).

Referring to the decision in Marks & Spencer, the reference to "abusive practices" is concerned with conduct that undermines the right of a member state to exercise its tax jurisdiction in relation to the activities carried out in its territory and which therefore jeopardises a "balanced allocation between member states of the power to impose taxes". The UK thin capitalisation legislation prevented arrangements whose sole purpose was to avoid the tax that would normally be payable on profits generated by activities undertaken in the UK and that therefore, it was an appropriate means of attaining that objective.

However, in order for the legislation to be EU compliant it was necessary that it did not go beyond what was necessary to attain that objective (i.e. it was proportionate). Here, the ECJ referred specifically to the opinion of the Advocate General and his comments on the need for there to be a consideration of objective criteria to determine whether a transaction represents a purely artificial arrangement, entered into for tax reasons alone, and whether the legislation in issue goes beyond what is necessary to prevent such "abusive practices". The ECJ held that national legislation that re-characterises interest as a distribution may be justified where it does so only if, and in so far as, it exceeds what would have been agreed upon on an arm's-length basis. As long as the taxpayer is given an opportunity, without being subject to undue administrative constraints, to provide evidence of any commercial justification that there may have been for that arrangement the legislation can be justified.

Once again the ECJ has delivered a decision that will please the fiscs of the member states. The ECJ appears to be taking more notice of international tax practice and (in the absence of direct tax harmonisation) equating "abusive practices" with practices that seek to transfer in one form or another profits from one member state to another in such a way that jeopardises "a balanced allocation between member states of the power to impose taxes". Although the ECJ has left it to the UK courts to determine whether the UK legislation is proportionate when applied to the specific facts of the arrangements in the Group Litigation Order there can be no doubt that this is a significant win for the UK Government. It will also be interesting to see whether the Government may also take the opportunity of relaxing the Finance Act 2004 legislation in so far as it relates to UK residents.

While the decision makes it clear that the UK is entitled to counter uncommercial loan financing arrangements it also indicates that where it can be shown that the arrangements are consistent with the type of arrangements that could have been entered into in the open market the Revenue should accept them. To some extent this may vindicate the increasingly common practice of cross-border operators that obtain comparables and other third party support for the level of interest rates and debt/equity ratios that are used.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to

Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.

The original publication date for this article was 14/03/2007.

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