UK Corporate Taxation for Resident Multinationals:

If a multinational corporation (meaning, a company with subsidiaries or affiliates in more than just one or two countries) needs to be based in a high-tax country, for instance because it must have a listing on a major stock exchange, then the UK is often a good choice. As a member state of the EU, the UK is within the EU parent-subsidiary directive, and in addition the UK has 110 double tax treaties, more than any other EU country, so that the UK is well-placed to receive dividend income with the lowest possible amount of foreign tax deduction.

However, this advantage has been somewhat compromised by measures in successive Finance Acts to limit international tax planning by multinationals. Firstly, the UK's Controlled Foreign Company rules have been tightened to the point at which only marginal benefits can be obtained by locating a subsidiary in a low-tax jurisdiction - most types of income and capital gain in 40% offshore subsidiaries are now caught for UK corporation tax whether remitted to the UK or not. An offshore company owned by several unrelated UK entities would still escape the rules, but that does not accommodate many business situations.

In addition, enabling legislation in the 2002 Finance Act allows the British government to alter the tax treatment of controlled foreign companies in jurisdictions which are considered to allow 'harmful tax practices'.Further changes were brought forward in the 2005 budget. The 2005 Controlled Foreign Companies (Excluded Countries) (Amendment) Regulations aim to prevent CFCs from manipulating their profit location in order to evade taxes, to stop them from secreting income in non-corporate entities, and to exclude them from receiving the benefits of the CFC regime if they are not liable for tax in another country. The measures came into full force on March 31st. A spokesman for the Inland Revenue explained that: "All of the changes made are a reaction to schemes including some that were identified via the disclosure rules.

The government could not have allowed significant amounts of tax to remain at risk."Secondly, the use of tax 'mixing' intermediate companies in such jurisdictions as Holland and Denmark was severely pruned back by the Finance Act 2000. Whereas it used to be possible to use, say, a Dutch holding company to mix dividends from foreign subsidiaries taxed at say 10% and 50% to achieve a blended rate of 30%, thus ensuring that only a very small amount of UK corporation tax would be payable, the rules have now changed. Mixing has been brought onshore by limiting the availability of tax credits to directly-held subsidiaries only, and the maximum 'mixable' rate of tax is limited to 45%.

Evidently this has a substantial impact on the usefulness for UK companies of Danish and Dutch intermediary holding companies. One improvement that should be noted, however, was the abolition of the ACT (Advance Corporation Tax) withholding tax in 1998: although corporation tax is now payable earlier than before, the problem of excess ACT has disappeared. Dividends to both resident and non-resident shareholders are paid without deduction of withholding tax.Another improvement, contained in the 2001 budget, was the abolition of withholding tax on interest and royalty payments to companies subject to UK corporation tax. Gordon Brown announced the extension of the abolition of withholding tax on international bonds and intra-UK payments of interest and royalties, to include non-bank entities, such as venture capital companies.

While this announcement was welcomed by British industry, there was disappointment that the change was not more far-reaching. The Chartered Institute of Taxation made the following suggestion for further reform: 'We are disappointed that this will only apply where the recipient company is within the charge to UK corporation tax. Gross rental income may be received by non-resident landlords who have undertaken to comply with UK tax obligations, and we would suggest that consideration be given to the introduction of such a scheme for the receipt of interest and royalty payments by those outside the charge to UK corporation tax.' Some further improvements to the withholding tax regime were included in the 2002 Finance Act.

As a result of the accumulation of negative measures imposed by the Treasury, it was reported in December, 2004, that leading tax advisers and accountancy firms such as PricewaterhouseCoopers and KPMG are advising their international clients to avoid establishing operations in the United Kingdom. PwC's UK head of tax, Richard Collier-Keywood said: "When we advise US companies, we advise very few to base their headquarters here." Loughlin Hickey, head of UK tax at KPMG, reportedly suggested meanwhile that several other EU member states, such as Spain and Denmark, may end up pipping the UK to the post of Europe's leading inward investor.

One favourable development for existing UK-based multinationals is the gung-ho attitude of the European Court of Justice, which is rapidly tearing down national fiscal barriers inside the EU. In 2002 it ruled against fiscal exit penalties on corporate relocation. In a preliminary hearing of the Conseil d'Etat v de Lasteyrie du Saillant case, the ECJ's Advocate General decided that the French government had violated the freedom of establishment provisions contained within EU law by levying a punitive residential exit tax on an individual who wanted to transfer his tax residence out of France.

Twelve of the EU's 15 member countries impose company emigration exit charges. They include the UK, France, Germany, Italy and Spain. The huge tax penalties act as a deterrent on companies wanting to relocate to other member states where running costs are less. Tax charges vary from country to country, but most countries, including the UK, levy a penalty of about 30% of the value of a company's capital assets. Individuals must often pay up to 40%.The ECJ has ruled against national governments in a number of cases involving freedom of establishment, and in August 2003 the English High Court followed ECJ precedents in test case brought by Deutsche Morgan Grenfell, concerning EU 'freedom of establishment' and anti-discrimination laws.

Mr Justice Park's decision in the High Court was the conclusion of a case first initiated when 50 companies submitted a group claim in the English courts as the result of an European Court of Justice precedent which ruled that the British government had illegally imposed advance corporation tax. Under the rules which applied until the 2001 and 2002 reforms of corporation tax, UK subsidiaries of European firms were wrongly made to pay tax on dividends repatriated to their continental parent companies. Although tax law in this area has since changed, the UK investment banking arm of the German bank was attempting to establish how far claims of wrongly paid tax can be backdated.

The Inland Revenue argued that the claims are restricted to a six year period by the 1980 Limitation Act. However, Justice Parks ruled otherwise, announcing that such claims were not time-barred by the 1980 Act. However, he added that: "This is not a result which I reach with much enthusiasm." A further blow for national treasuries came in September 2004 when the ECJ ruled that the Netherlands' domestic tax law on 'exempt participations' was discriminatory and as a consequence, unlawful.

The ruling relates to a case involving Bosal Holdings, a Dutch manufacturer of car exhausts which acquired a number of European firms during the 1990s, and was prevented from claiming tax relief for interest paid on borrowings financing subsidiaries which did not generate income taxable in Holland. The ECJ found that this breached Bosal's fundamental 'freedom of establishment' rights, laid down in the founding Treaty of Rome, and therefore upheld its claim against the Dutch government. Peter Cussons of PricewaterhouseCoopers observed that the ruling dealt "yet another heavy blow to the tax systems of the EU member states, and since direct tax issues being referred to the ECJ are becoming more fundamental and frequent it would appear it's a trend that looks set to continue".The ECJ decision is expected to benefit many firms elsewhere in the union which have similar claims pending against national governments. One such company is UK retail firm Marks and Spencer.

M&S has argued that under Article 43 of the European Union Treaty, it should be allowed to offset losses of around 160 million euros made by its French, Belgian, and German subsidiaries between 1997 and 2001 against UK profits, claiming a tax refund of GBP30 million.In March, 2005, came the initial result of the much-followed Marks and Spencer case, in which Advocate General Mr Poiares Maduro agreed with the company.European Union finance ministers however vowed to find a "defence mechanism" to counter the likelihood of tax revenue shortfalls should the British retailer ultimately be successful in its legal bid to offset losses made by foreign subsidiaries against tax. The issue formed one of the main talking points during an Ecofin meeting of EU finance ministers.

"There is great concern about this," remarked Jeannot Krecke, Economy Minister of Luxembourg, which is holder of the rotating EU presidency. He went on to add that EU ministers "will try to find a defence mechanism" against such claims.The AG stated that the risk of significant falls in tax revenues, as Germany had been arguing, was not a justifiable defence of the current system.

But he also argued that firms should not be able to offset tax loses against profits in the country where the parent company is based if they can also offset losses in the country where their subsidiary is based - which may offer an escape route to governments.Addressing the European Commission Conference on company taxation in Rome in January, 2004, Internal Market and Taxation Commissioner Frits Bolkestein defended the increasing role that the European Court of Justice is taking in defining corporate tax law across member states, a development that the business community in the UK in particular has warned threatens to undermine national governments' ability to influence tax policy.

“EU company tax matters and Court rulings in the field of direct taxation are making headlines these days, receiving a degree of public attention that was unheard of before,” he said, continuing: “Many people may regret the increasing number and significance of Court decisions in the tax field. I do not." He added: “I think it is fair to say that the Court is simply doing its work and applying the EU Treaty in the tax field.” Bolkestein rejected the arguments of those who propose that the EU Treaty should be amended to prevent the ECJ influencing tax law. “Such an action would be a fundamental step backwards and would endanger the whole concept of the Internal Market,” he observed. The Commissioner argued that the primary objective of the EU's company tax policy should be reducing the compliance burden and increasing competitiveness in relation to the United States. “And tackling these issues is a far cry from engaging in harmonisation of Member States' tax systems. Let me be blunt about this.

The notion that Brussels has a long-term agenda of wholesale tax harmonisation is just utter nonsense,” he remarked, adding: “Closer co-operation is the right response. And I say co-operation, not harmonisation.” The Commissioner then went on to warn that: “Member States can choose either to welcome these developments and contribute to the design of the future system or to oppose change and find themselves inevitably on the losing side as more and more issues are brought before the Courts.” Not all cases went the harmonisers' way, however. In September, 2003, the ECJ ruled in favour of the UK Inland Revenue in its dispute with Dutch copier firm Oce NV concerning withholding tax levied on its UK subsidiary.

The Dutch firm claimed that the 5% withholding tax it was required to pay on the earnings of its UK subsidiary was unlawful because it did not extend to British companies and was therefore discriminatory under European law which stipulates such dividend income cannot be taxed twice. However, the ECJ ruled that as the Dutch government allowed Oce to deduct its tax payments made to the Inland Revenue, the withholding tax did not constitute double taxation and as a result was not discriminatory against other firms within the EU.And in February 2006 HM Revenue and Customs won an important legal battle when the House of Lords ruled that companies which claimed a tax credit on a dividend paid to a foreign parent cannot claim a refund of advanced corporation tax.

The group litigation was brought by more than 60 companies and led by Pirelli, the Italian tyre manufacturer, which claimed that the obligation to pay advance corporation tax (ACT) in the UK on dividends it paid to its Dutch parent was in breach of European Union law concerning taxes levied on dividends.Although the Dutch parent had received a repayment of 50% of the tax credit attached to the dividend under the tax treaty between the UK and the Netherlands, it claimed that the parent's right to receive the credit was legally separate from any obligation of the subsidiary to pay ACT.However, in overturning judgments by the High Court and the Court of Appeal, Lord Nicholls, one of the five judges on the panel, said that Pirelli was looking to obtain "the best of both worlds.

"The law lords' decision was welcomed by Chris Morgan, Head of KPMG's EU Tax Group, who noted that it was a victory for "common sense.""The decision will obviously be a relief to the Revenue. However, it is interesting because it shows how far EU law goes in modifying UK domestic legislation and treaty rights," Mr Morgan observed."The case demonstrates that where a claim is made under EU law it is necessary to understand all the implications. Raising an EU argument in one situation may have a knock-on effect as regards other decisions," he added.In February, 2006, the ECJ seemed set to confirm the House of Lords ruling, when Advocate General Leendert Geelhoed stated that whilst the UK tax authorities were required to treat non-UK firms fairly, there was no pre-requisite for equal treatment.

Consequently the UK was entitled to enter into different tax treaties with different countries and did not need to offer the same benefits to everyone.In his opinion, Mr Geelhoed noted that this was an area where "predictability and legal certainty are crucially important, so that Member States can plan their budgets and design their corporate tax systems on the basis of relatively reliable revenue predictions.”Following up on the M & S case, the United Kingdom government announced in February, 2006, that it would introduce legislation in the Finance Bill 2006 to amend the UK loss relief rules.According to the UK government, the ECJ considered that the country's group loss relief rules are in principle compatible with European law, meaning that the system of group relief can be kept broadly as it is now, although the Court also held that, in some very limited circumstances, relief should be available in the UK for the otherwise unrelievable losses of some group companies resident in other States.

However, the government fears that groups with loss-making companies resident in another state could "engineer" their circumstances so as to preclude the possibility of a loss making company obtaining relief in its state of residence by, for example, liquidating that company whilst transferring its business to another company.In response, the government is introducing legislation to deny loss relief where there are arrangements which either: result in losses becoming unrelievable outside the UK that were otherwise relievable, or; give rise to unrelievable losses which would not have arisen but for the availability of relief in the UK, if the main purpose or one of the main purposes of those arrangements is to obtain UK relief.The proposed legislation will be effective from Monday, February 20.Then in April, 2006, the European Court of Justice Advocate General, Leendert Adrie Geelhoed, gave an opinion in favour of four UK companies who had claimed that corporation tax charged on dividends received from EU subsidiaries was illegal under EU free movement of capital rules.Between 1973 and 1999, when the UK scrapped its Advanced Corporation Tax system, which allowed UK companies to pay up dividends domestically at a favourable rate, dividends from non-UK EU subsidiaries of UK companies were charged at higher rates.

Although the four companies in the present case, British American Tobacco, British Petroleum, Aegis Group and Imperial Chemical Industries, are claiming refunds of 'only' some hundreds of millions of pounds, the UK government warned during court proceedings that the total cost of an adverse ruling might be as high GBP7 billion if many companies applied for refunds, and that the ECJ should therefore reject the companies' case on the grounds that the UK's financial stability could be affected. Mr. Geelhoed denied this reasoning.At first sight, UK plc should be having a party based on the Advocate-General's ruling (which is very likely to be confirmed by the full Court), but companies worry that the Government might react in ways which could cost them more than they will save through the ruling.At issue is the highly complex system of 'onshore pooling' in which foreign dividends are mixed with domestic ones according to an intricate set of rules before final taxation rates are determined. An ECJ determination that dividends from the EU had to be taxed on all fours with dividends from UK subsidiaries might cause the government to increase the effective taxation of UK dividends. Alternatively, it could adopt a thorough participation exemption, something that is operated by many EU states; but the Treasury has been very reluctant to do this, fearing a long-term loss of revenue, and would probably feel forced into additionally reducing the deductability of debt interest, as well as tightening thin capitalization rules.Whatever the Treasury does, it is likely to cause problems for business, which hates change almost as much as it hates paying tax. So both the CBI and the Treasury are probably hoping that the ECJ, just for once, ignores the advice of its Advocate-General.

This is unlikely; the ECJ has issued a stream of tax judgements in favour of corporations over the past year. Meanwhile, the governments themselves have been busy formulating ways in which to protect their tax income, and last June, former German Finance Minister Hans Eichel proposed the setting up of a high level committee of European tax experts to examine how EU governments can defend themselves against attacks to their revenue bases by multinational corporations in the ECJ.

Version date: 07.05.06