House of Lords
|Session 2005 - 06|
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|Judgments - Pirelli Cable Holding NV and others (Respondents) v. Her Majesty's Commissioners of Inland Revenue (Appellants)
LORD NICHOLLS OF BIRKENHEAD
1. The primary issue on this appeal concerns the application of two double taxation conventions in circumstances not envisaged when they were made. The problem arises from the unforeseen impact of Community law on the partial 'imputation' system of corporation tax operated within the United Kingdom between 1973 and 1999. This system was introduced by the Finance Act 1972 as a means of avoiding the perceived double taxation of distributed profits, once in the hands of the company and again in the hands of its shareholders. The central principle of the new taxation scheme was that part of the corporation tax paid by a company was 'imputed' to its shareholders by giving them an appropriate tax credit. The means adopted for this purpose was that a company was required to pay a tax on its dividends known as advance corporation tax, or ACT in short, and its shareholders were given a corresponding tax credit. Nowhere did the legislation state that liability to pay ACT was a precondition of entitlement to a tax credit. But this unspoken linkage lay at the heart of the scheme, and the legislation was drawn in a form which achieved this result. This linkage is central to the first issue raised by this appeal.
2. In broad outline the legislation provided as follows. Where a company resident in the United Kingdom paid a dividend to its shareholders it became liable to pay ACT in respect of the dividend. ACT was set against the company's liability to 'mainstream' corporation tax. A recipient of the dividend, if resident in the United Kingdom, became entitled to a tax credit. The amount of the tax credit corresponded to the current rate of ACT. In the case of an individual a tax credit was utilised primarily as a credit against his income tax. Any excess was paid to the individual. Where the recipient of the dividend was a company the amount of the dividend plus the amount of the tax credit constituted franked investment income. This could be used to frank dividends paid by the company so the company would not be liable to ACT on its dividends: see sections 14, 231 and 238-241 of the Income and Corporation Taxes Act 1988, or ICTA 1988 in short.
3. This basic scheme was subject to an important exception. Special provision was made for dividends paid by one company to another company in the same group. These companies could jointly make a group income election under section 247 ICTA 1988. A group income election had a twofold effect, reflecting the linkage between payment of ACT and entitlement to a tax credit. Dividends paid by a subsidiary to its parent while the election was in force, conveniently described as 'election dividends', did not trigger liability to pay. Nor did their receipt trigger entitlement to a tax credit. So election dividends did not constitute franked investment income of the parent. They constituted, in the language of the legislation, 'group income' of the receiving company: hence the description 'group income election'.
4. On the face of the legislation the right to make a group income election was expressly confined to cases where both companies were resident in the United Kingdom. In March 2001 the Court of Justice of the European Communities ruled that affording groups of companies the right to make a group income election where they were resident in the United Kingdom but denying them that right where the parent companies were not resident in the United Kingdom was contrary to article 52 (now article 43) of the EC Treaty providing for freedom of establishment: Joined Cases C-397/98 and C-410/98 Metallgesellschaft Ltd and Hoechst AG v Commissioners of Inland Revenue  ECR I-1727. The court held that the claimant companies in these cases were entitled to compensation for loss of the use of the money paid as ACT between the date of payment and the date when the ACT was used by being set off against the subsidiary company's mainstream corporation tax liabilities.
5. This ruling had a widespread effect in practice. Shortly stated, the effect of this decision was that wherever group companies had been denied the opportunity to make a group income election, the United Kingdom government became liable to compensate them for the loss they suffered if the denial was an infringement of article 43 of the EC Treaty as interpreted by the court in the Hoechst decision.
6. Not surprisingly, many groups of companies sought to take advantage of this ruling. The present appeal concerns the assessment of compensation payable to one such group, the Pirelli group, chosen as a test case in one category of claims within a group litigation order. For the purposes of this appeal the detailed facts, summarised in the speech of my noble and learned friend Lord Scott of Foscote, are not material. The essential facts are that dividends were paid by a subsidiary company resident in the United Kingdom to parent companies resident in Italy or the Netherlands. Group income election was not available, because the parent companies were not resident in the United Kingdom. So ACT was paid by the subsidiary company in respect of the dividends. For the same reason the parent companies were not entitled to tax credits under section 231 ICTA 1988. But under double taxation conventions made by this country with Italy and the Netherlands the parent companies became entitled to tax credits of a reduced amount calculated as set out in those conventions. I shall call these 'convention tax credits'.
The first question
7. In the present case the first question arising on the assessment of compensation is this. If the United Kingdom legislation had permitted parent companies resident in other member states of the European Community to make a group election, and if an election had been made in respect of the dividends in question, would the parent companies have been entitled to payment of the convention tax credits they in fact received under the double taxation conventions? If they would have been so entitled then no deduction should be made in respect of these tax credits when calculating the compensation. If, however, the parent companies would not have been so entitled, then in principle - and subject to the other issues raised on this appeal - due allowance should be made in respect of these tax credits when calculating the compensation. Due allowance should be made because, in this event, the convention tax credits received by the parent companies comprise financial benefits they would not have received had the group been able to make a group income election and had the group duly done so.
8. Whether the parent companies would have been entitled to convention tax credits in this hypothetical circumstance depends upon the proper interpretation of the relevant double taxation conventions. The two conventions are the Netherlands Convention of 7 November 1980 (S I 1980/1961) and the Italian Convention of 21 October 1988 (S I 1990/2590). Both conventions have effect in United Kingdom law pursuant to Orders in Council made under section 788 ICTA 1988.
9. In all respects material on the present issue the two conventions are in similar form. For convenience I will refer only to the Netherlands convention. The relevant provision in the Netherlands convention is article 10(3). This was applicable as long as an individual resident in the United Kingdom was entitled to a tax credit in respect of dividends paid by a company resident in the United Kingdom. Article 10(3)(c) entitled a company resident in the Netherlands which received dividends from a company resident in the United Kingdom to a tax credit calculated and payable as follows:
'Tax credit' in this subparagraph has the same meaning as in ICTA 1988: see article 3(2) of the convention. Entitlement to a convention tax credit was subject to tax at a rate not exceeding 5% on the total amount of the dividend and the tax credit: article 10(3)(a)(ii). Nothing turns on this additional provision.
10. The first point to note is that, as would be expected, article 10(3)(c) accords with the scheme of the underlying legislation whereby entitlement to a tax credit marched hand-in-hand with liability to pay ACT. Article 10(3)(c) did not, in terms, exclude election dividends from its scope. But this was not necessary. On the face of the legislation a parent company resident in the Netherlands could not make a group income election. By definition, an election dividend was payable only to a company resident in the United Kingdom. So, on the face of the legislation, there could be no question of a Netherlands resident company ever being in a position to claim a convention tax credit on a dividend whose payment did not attract ACT.
11. This analysis of article 10(3)(c) accords with the intended purpose of the Netherlands convention as stated in section 788. The object of section 788 is to enable effect to be given to arrangements made with the governments of other countries 'with a view to affording relief from double taxation'. Section 788(3) provides that, notwithstanding anything in any enactment, arrangements such as the Netherlands convention shall have effect in relation to income tax and corporation tax:
In section 231(1) entitlement to a tax credit was expressed to be subject to section 247. The effect of section 247 was to exclude an election dividend from entitlement to a tax credit under section 231 and from attracting liability to ACT under section 14(1) as a qualifying distribution.
12. So much is clear. The question before the House, however, requires one to inhabit a new and different world, a world where an election dividend may be paid to a non-resident company. How is article 10 to be read and understood in this new world? If article 10 is to be read literally I would agree with Park J and the Court of Appeal that a Netherlands resident parent would be entitled to a convention tax credit on an election dividend. That is the effect of the literal interpretation of article 10. But is this the proper interpretation?
13. Article 10, like all documents, must be interpreted purposively. So, in answering these questions it is important to have in mind how they come to arise at all. They arise from the explosive effect of Community law on a prime feature of the legislation regarding groups of companies. On its face section 247 precluded non-resident parent companies from making a group income election. The Netherlands convention was drafted and agreed on this basis. But this residence limitation, in its application to companies resident in member states of the European Community, was negated by the Hoechst decision. Consequent upon this decision section 247 fell to be applied in a circumstance for which it was not designed. This had a knock-on effect on the application of article 10 of the Netherlands convention. The further effect was that article 10 fell to be applied in a circumstance for which it too was not designed, namely, that a Netherlands resident company could receive a dividend which had not attracted payment of ACT.
14. So where does this leave article 10(3)(c)? In my view no one could suppose that in the new world ushered in by the Hoechst decision a group with a Netherlands resident parent could elect to avoid payment of ACT by making a group income election pursuant to the Hoechst ruling and, at the same time, remain entitled to a tax credit under the Netherlands double taxation convention. That would be to entitle a company resident overseas to a convention tax credit where a company resident in this country was not entitled to a tax credit. That would put a Netherlands resident parent in a better position than a United Kingdom resident parent. That would fly in the face of the stated purpose of article 10(3)(c), namely, to entitle a Netherlands resident parent to part ('one half') of the tax credit to which a United Kingdom resident would have been entitled had he received the dividend.
15. An interpretation of article 10 having this effect would comprise such a gross and obvious departure from the evident purpose of article 10(3)(c), and from a fundamental feature of the tax credit scheme on which article 10(3)(c) is superimposed, that in my view article 10(3)(c) cannot be so read. The Netherlands convention assumes that the dividend whose receipt attracts a convention tax credit will also have attracted liability to ACT. That is an assumption implicit in article 10(3)(c). When interpreting article 10(3)(c) in the post-Hoechst world effect should be given to this implicit assumption. Article 10(3)(c) is to be read as not applying to election dividends.
16. Accordingly, on the first issue raised on this appeal I would declare that if the U K- resident subsidiary of a parent resident in another member state of the European Union had paid a dividend to its parent while a group income election was in force the parent would not have been entitled to a tax credit in respect of the dividend under double taxation conventions in the form of the Netherlands and Italian conventions.
The second question
17. The Pirelli group have another string to their bow. Mr Aaronson QC submitted that, even so, when assessing the compensation payable to a U K-resident subsidiary for the wrongful denial of an opportunity to exclude payment of ACT by making a group income election, no account should be taken of the convention tax credits received by the overseas parent companies. Even though (on this footing) the parent companies were not entitled to these tax credits and the consequential payments, these should be left out of account because a subsidiary and its parent are separate legal entities. The harm suffered in consequence of the breach of Community law was suffered by the United Kingdom subsidiary, whereas the countervailing advantages were enjoyed by the parent companies.
18. I have to say I find this argument of Pirelli no more attractive than their submission on the first question. Here again, Pirelli are seeking to have the best of both worlds. The outcome for which they contend is so artificial that it cannot be right.
19. A group income election is a group election. A group income election cannot be made by a subsidiary alone. It is an election made jointly by the subsidiary paying the dividend and the parent receiving the dividend. By making such an election both companies seek the fiscal consequences of making the election. One consequence is that by making the election the subsidiary will obtain the advantage of not paying ACT in respect of the relevant dividend. Another consequence is that the subsidiary will obtain this advantage at the cost of depriving the parent of a tax credit in respect of the dividend. These two fiscal consequences are inextricably linked. You cannot have one without the other. That is why the election has to be made jointly. The advantage to the paying subsidiary comes at a price to the recipient parent.
20. Accordingly the loss sustained by the subsidiary cannot fairly be assessed in isolation. The commercial reality is that by not having the opportunity to make a group income election the group lost the opportunity to take advantage of a fiscal package: a package which affected the parent in one way and its subsidiary in a different way. In calculating the loss suffered by the group, that is, the parent and the subsidiary, regard must be had to both elements in the package. The effect on the parent must be considered as well as the effect on the subsidiary. The subsidiary lost the use of the money paid as ACT. In some instances, where the ACT was not set off against its mainstream corporation tax, the subsidiary lost the money altogether. But this cannot be treated as the amount of compensation payable by the Commissioners of Inland Revenue without also taking into account any adverse consequence a group income election would have had on the parent. By the same token, assessment of the compensation must take into account any countervailing fiscal benefit received by the parent which would not have been available had a group income election been made.
21. Pirelli sought to side-step this difficulty by presenting their claim as a claim by the subsidiary alone. But this difference in presentation cannot make any material difference in the outcome. A group income election cannot be made, or continued in force, by a subsidiary acting alone. Pirelli cannot, by presenting their claim in this way, alter the fundamental nature of the wrong for which compensation has become payable, namely, the loss of an opportunity for the parent and the subsidiary jointly to take advantage of a single fiscal package having different effects on the parent and the subsidiary.
22. It is for this reason that assessment of the group's overall loss, rather than the loss of the subsidiary alone, does not involve departure from the basic principle of company law that a parent company and its subsidiary are separate legal entities. Assessment of the overall loss represents the only fair way to assess the amount of loss suffered where a subsidiary and its parent have been denied the opportunity jointly to obtain a single package of this nature.