Thin Cap Group Litigation, Test Claimants In v Revenue and Customs

UK thin-capitalisation rules breached Article 43 EC where they applied an arm’s-length test but gave taxpayers no separate opportunity to establish genuine commercial justification. The arm’s-length test was an appropriate objective means of identifying artificial arrangements, but it was not sufficient by itself. The rules had to permit evidence of commercial justification and limit any recharacterisation to interest exceeding the arm’s-length amount.

The defective provisions could not be interpreted conformably with Community law. They were therefore disapplied only to commercially justified transactions, with the Revenue bearing the burden of proving the absence of such justification. Restitution was available for unlawfully paid tax and certain directly related reliefs. Damages were recoverable only for breaches occurring after 12 December 2002.

The proceedings were test claims in the Thin Cap Group Litigation by UK-resident subsidiaries of multinational groups against HMRC. The claims challenged the compatibility of successive UK thin-capitalisation rules with Article 43 EC and raised issues concerning disapplication, restitution, damages, limitation and the United States–United Kingdom double taxation convention.

The ECJ had held that Article 43 was engaged and had remitted questions concerning whether the UK rules were proportionate. The High Court had to determine whether the rules allowed taxpayers to establish commercial justification separate from the arm’s-length test, what consequences followed from any incompatibility, and whether the claims of the IBM companies under the US Treaty succeeded.

1. Liability. The UK thin-capitalisation provisions breached Article 43 EC. The ECJ’s judgment required two distinct safeguards: an objective and verifiable arm’s-length assessment, and a genuine opportunity for the taxpayer to prove commercial justification without undue administrative constraints. The UK rules supplied only the first safeguard.
2. The arm’s-length test remained an appropriate objective tool. It could identify wholly or partly artificial arrangements and measure the excess interest liable to recharacterisation. It was not, however, a complete proxy for abusive tax avoidance. Commercial justification had to be assessed on the full facts, rather than by reference to an artificially narrowed UK sub-group.
3. A conforming interpretation under section 2(4) of the European Communities Act 1972 was impossible. Adding a separate commercial-purpose defence would contradict the fundamental feature of the legislation that the arm’s-length test was the sole criterion. The provisions therefore had to be disapplied.
4. Disapplication was proportionate rather than wholesale. The provisions were not to be invoked against transactions which had genuine commercial justification, wholly or in the relevant part. The Revenue bore the burden of proving, by positive evidence, that a transaction lacked such justification. All transactions of the test claimants were commercially justified and none constituted abusive tax avoidance.
5. Article 43 was not engaged where the lender was neither resident in the EU nor controlled by an EU-resident parent. IBM’s separate claim under Article 24(5) of the US Treaty failed because the relevant hypothesis did not engage Article 43.
6. Restitution under the San Giorgio principle covered additional corporation tax or ACT actually paid, together with directly related interest or loss of use of money. Claims based on trading losses or capital allowances used to offset unlawful tax could in principle qualify. Claims based on substituted equity, reduced interest, group relief, compliance costs or foreign tax liabilities were compensatory or otherwise outside the San Giorgio category.
7. For Factortame damages, the breach was not sufficiently serious before 12 December 2002. Following Lankhorst-Hohorst, the breach became sufficiently serious, and damages were in principle recoverable from that date. Mistake-based limitation under section 32(1)(c) of the Limitation Act 1980 began to run on the same date.