Test Claimants In the Thin Cap Group Litigation v HM Revenue and Customs

By a majority, the Court held that cross-border thin-capitalisation legislation does not unlawfully restrict Article 43 of the EC Treaty merely because it applies an arm’s-length test to related-party financing. The test may be sufficient to protect the balanced allocation of taxing powers and prevent tax avoidance. The legislation must use objective and verifiable criteria, allow the taxpayer a proper opportunity to make representations and challenge the decision before a court, and limit any recharacterisation to the non-arm’s-length excess. A separate defence based on wider commercial justification is not required where the legislation applies the arm’s-length test. The majority therefore allowed the Revenue’s appeal. Arden LJ dissented on the central issue.

The Test Claimants, companies in international groups, challenged UK thin-capitalisation rules applied before 2004 to interest paid to non-UK group companies. Henderson J held that the rules were incompatible with Article 43 because they did not permit a separate defence based on commercial justification, and ordered their disapplication in relation to the test transactions. His decision is reported at [2009] EWHC 2908 (Ch).

Both sides appealed on liability issues. The principal question was whether proportionality required only an arm’s-length inquiry, or also an opportunity to establish that a non-arm’s-length transaction nevertheless had genuine commercial justification. Issues concerning damages for a sufficiently serious breach were also argued.

1. Disposition. By a majority, the Revenue’s appeal was allowed and the Test Claimants’ contingent cross-appeal was dismissed. Stanley Burnton LJ and Rimer LJ formed the majority. Arden LJ dissented on the principal issue.
2. Article 43 and proportionality. The majority held that the relevant freedom was freedom of establishment under Article 43 of the EC Treaty. The later decisions in Proceedings brought by Oy AA [2008] STC 991 and Société de Gestion Industrielle v Etat Belge (SGI) [2010] ECR I-0000 clarified that protecting the balanced allocation of taxing powers, together with preventing tax avoidance, could justify an otherwise discriminatory thin-capitalisation regime.
3. Arm’s-length test. The arm’s-length test was an objective and verifiable means of identifying financing arrangements that transferred profits in a manner inconsistent with independent dealing. The majority rejected the contention that the legislation also had to permit a separate defence based on commercial justification where the transaction failed that test. The UK legislation lawfully limited the deduction to interest that would have been payable between unconnected parties.
4. Procedural safeguards. Proportionality required an adequate opportunity to present evidence to the tax authority and to challenge its decision before a court. The evidence showed that those safeguards existed. The majority also rejected the argument that the UK rules were incompatible because the arm’s-length assessment considered each UK sub-group independently rather than taking account of the reputation or financial strength of the wider foreign group.
5. Damages. Since the legislation was compatible with Article 43, no damages issue arose. Alternatively, the majority held that the development of the law, particularly after Lankhorst-Hohorst GmbH v Finanzamt Steinfurt [2002] ECR I-11779, did not establish a sufficiently serious breach immediately after that decision. The Government was entitled to a reasonable period to assess the ruling, consult and legislate. A failure to be open about its view of the legislation could not, by itself, constitute such a breach.
6. Dissent. Arden LJ considered that Lankhorst-Hohorst remained good law and that an arm’s-length test did not exhaust the proportionality inquiry. In her view, a taxpayer had to be able to show that a non-arm’s-length transaction nevertheless had genuine commercial justification. She would have upheld the judge’s primary conclusion, but agreed that the damages finding and burden of proof were unsustainable.

• Court of Appeal (Civil Division): By majority, allowed the Revenue’s appeal, dismissed the contingent cross-appeal and reversed the conclusion that the UK thin-capitalisation rules required a separate commercial-justification defence.
• High Court, Chancery Division: Henderson J decided preliminary issues in [2009] EWHC 2908 (Ch), holding that the rules were disproportionate because they did not permit such a defence and ordering disapplication in relation to the test transactions.