|Judgments - Pirelli Cable Holding NV and others (Respondents) v. Her Majesty's Commissioners of Inland Revenue (Appellants)
23. Assessment of the compensation now in issue is not exclusively a matter for the domestic law of the United Kingdom. Assessment of the compensation has a Community law dimension because the compensation is payable for breach of an EC Treaty obligation. But this feature does not disturb the conclusion expressed above. I can see nothing in the above analysis which offends the Community law principles of equivalence and effectiveness.
24. Pirelli, however, raised a different point of Community law. The European Court of Justice has held that in certain circumstances the need to ensure cohesion of a member state's tax system may justify rules liable to restrict fundamental freedoms. This principle has been applied where a direct link existed, in the case of one and the same taxpayer, between the grant of a tax advantage and the offsetting of that advantage by a fiscal levy, both of which related to the same tax: Bachmann v Belgium  ECR I-249 and Commission v Belgium  ECR I-305. The precise limits of this principle remain to be explored. But the European Court has declined to apply the principle where the link between the taxes in question comprised the grant of a tax exemption to shareholders resident in the Netherlands in respect of dividends received by them and taxation of the profits of companies in another member state. They were 'two separate taxes levied on different taxpayers': Staatssecretaris van Financiën v BGM Verkooijen  ECR I-4071, 4132, paras 56-58.
25. Pirelli sought to apply this limitation on the scope of the 'tax cohesion' principle by analogy in the present case. They sought, further, a reference to Luxembourg if their submission on this point did not find favour. I am unable to accept either submission. Pirelli's argument breaks down at the very outset. The suggested analogy is misconceived. The grounds on which a restriction on a fundamental freedom may be justified say nothing about the principles applicable in assessing compensation for breach of a Treaty freedom. Assessment of compensation is primarily a matter for the domestic legal system of each member state, provided always that the principles of equivalence and effectiveness are duly observed.
26. Accordingly, I would hold in answer to the second question that the amount of the convention tax credits received by the Dutch and Italian parent companies is to be taken into account in calculating the compensation payable for the breach of article 43 of the EC Treaty. Essentially what is to be taken into account is the value of the benefits thus obtained. Depending on the circumstances a notional rate of interest on the amounts paid may properly be regarded as an element of the value obtained. But this is a matter to be evaluated in the context of the facts of the particular claims.
The third question
27. The third question is of a different character. It arises out of the terms of Council Directive 90/435 EEC of 23 July 1990, known as the 'Parent/Subsidiary Directive'. On this I have nothing to add to the observations of Lord Scott of Foscote. The terms of articles 5.1 and 7.1 of the directive, coupled with the decision of the European Court of Justice in Océ van der Grinten NV v Inland Revenue Commissioners  STC 1248, make plain that ACT is not prohibited by the directive. This is acte clair. I would not refer a question to the European Court of Justice as sought by Pirelli.
28. For these reasons, and those set out in the speeches of my noble and learned friends Lord Hope of Craighead, Lord Scott of Foscote and Lord Walker of Gestingthorpe, I would allow this appeal and remit the proceedings to Park J to decide the unresolved factual question whether, had group income election been available to the Pirelli group, the group would have elected to have the United Kingdom subsidiaries pay the dividends in question free of ACT or, instead, would have chosen that the United Kingdom subsidiaries should pay the dividends outside group income elections, thus enabling the overseas parents to receive convention tax credits.
LORD HOPE OF CRAIGHEAD
29. I have had the advantage of reading in draft the speeches of my noble and learned friends Lord Nicholls of Birkenhead, Lord Scott of Foscote and Lord Walker of Gestingthorpe. I agree with them, and for substantially the same reasons as they have given I too would allow the appeal and make the order which has been proposed by Lord Nicholls. But we are differing from judges in the courts below whose opinions in revenue matters have always commanded the greatest respect. So I should like to add these brief remarks to explain why I have reached the same conclusion as my noble and learned friends have done.
30. The issues which we have been asked to decide are (1) whether, if a group income election had been made under section 247(1) of the Income and Corporation Taxes Act 1988 ("ICTA 1988"), the three EU parent companies would have been entitled to a tax credit under the relevant Double Taxation Agreement ("DTA") ("the election issue") on the dividends paid to them as group income by their UK subsidiaries; (2) whether, if that question is answered in the negative, the tax credits which were received by the EU parent companies under the relevant DTA should be brought into account in assessing the compensation payable to the UK subsidiaries for the breach of article 52 of the EC Treaty (now article 43 EC) because the tax advantage of a group income election was not made available where the parent company was not resident in the UK ("the assessment issue"); and (3) whether ACT is a withholding tax within the meaning of article 5.1 of Council Directive 90/435/EEC ("the Parent/Subsidiary Directive"). I would give the answers "no" to the first question, "yes" to the second question and "no" to the third question, holding the answer to the third question to be acte clair.
The election issue
31. The answer to the question raised by the election issue is to be found in arrangements for double taxation relief that were created for companies not resident in the United Kingdom by sections 788(3)(d), 231(1) and 247(2) ICTA 1988. These arrangements have to be seen in the context of the system which Lord Scott has described for giving tax credits to a parent company resident in the UK in respect of distributions made to it on which its UK subsidiary had paid Advance Corporation Tax ("ACT") under section 14(1) ICTA 1988. I have listed the sections of the ICTA 1988 in that order because taking them in that order reveals most clearly the question of statutory construction on which the answer to the issue depends. In my opinion it is to the domestic legislation, and not only to the relevant DTA, that one must look for the answer. For the reasons that I shall give, and in agreement with Lord Scott, I think that the legislation provides the answer which is contended for by the revenue.
32. Section 788(3)(d) ICTA 1988 gave domestic effect to the arrangements specified in a DTA for conferring on non-resident companies such as the EU parent companies "the right to a tax credit under section 231 in respect of qualifying distributions made to them" by companies which were resident in the United Kingdom. The expression "tax credit" is defined in section 832(1) as meaning a tax credit under section 231. So it is to the provisions of that section that one must go in the first instance to see what the right was that was being referred to in section 788(3)(d).
33. Section 231(1) provided that, where a company resident in the United Kingdom made a qualifying distribution and the person receiving the distribution was another such company, the recipient of the distribution was to be entitled to a tax credit equal to such proportion of the amount or value of that distribution as corresponded to the rate of ACT in force for the financial year in which the distribution was made. But the opening words of that subsection stated that it was subject to sections 95(1)(b) and 247. Section 95(1)(b), which applied where a company purchased its own shares from a dealer, is not in point in this case. But section 247 is very much in point. It is that section, and in particular section 247(2), that creates the difficulty for the Pirelli companies.
34. Section 247(1) ICTA enabled an election ("a group income election") to be made not to account for ACT in two situations that might arise within a group of companies all of whose members were resident in the United Kingdom. The first is the one that would have applied to this case, had all the companies within the Pirelli group had been so resident. It was where the paying company was a 51 per cent subsidiary of the receiving company or of another UK resident company of which the receiving company was a 51 per cent subsidiary. In that situation the receiving company and the paying company could jointly elect that ACT was not to be payable on the dividends which the parent received from the paying company.
35. The consequences of such an election, so long as it was in force, were two-fold. First, ACT was not payable under section 14(1) ICTA 1988 on the election dividends. Secondly, the income represented by the amount of the election dividends was not franked investment income (that is to say, franked as having borne ACT) in the hands of the recipient company, but was to be treated in the ordinary way as group income of the receiving company. This meant that income of this description did not qualify for a tax credit under section 231. As section 247(2) puts it, the election dividends "shall be excluded from sections 14(1) and 231". The payment of ACT was not enacted as a condition that had to be fulfilled before a shareholder could become entitled to a tax credit, as Park J was right to point out:  STC 250, para 36. But the link between these two provisions - imposing the liability to ACT and giving the right to the tax credit - could not have been more clearly expressed.
36. The reason for the exclusion, in the domestic context, of the right to a tax credit under section 231 was simple. A group income election dividend was a dividend on which no ACT was payable. The purpose of section 231 was to provide the receiving company with a tax credit equivalent in amount to the ACT payable on the dividend. The tax credit was designed to avoid tax having to be paid twice on the same dividend when tax was paid on its profits by the parent company. As no ACT was payable in the case of a group income election dividend, there was nothing against which credit needed to be given to the recipient company. There was no risk of tax being paid twice in respect of the amount distributed to the parent, so there was no need of a tax credit to avoid that result.
37. It has to be borne in mind, of course, that ACT was a tax payable by the paying company. It was not a tax on profits in the hands of the recipient. Receipt of distributions that had borne ACT could arise in circumstances where, due to such features as capital allowances, the paying company did not have sufficient profits at the end of its relevant accounting period to give rise to a liability to mainstream corporation tax. This was frequently the case, as Park J explains in his judgment in para 61. But the tax credit was always given, and given only, where the company making the qualifying distribution in respect of which it was given was liable under section 14(1) of ICTA 1988 to payment of ACT on an amount equal to the amount or value of the distribution. As Mr Glick QC for the revenue put it, it was the payment of the ACT that made the giving of the tax credit to the recipient necessary.
38. Park J said in paras 38-41 that the answer to the election issue was to be found in the DTA and that section 788(3)(d), which referred only to section 231 and made no mention of section 247(2), had to be read consonant to the Treaty. The Court of Appeal adopted the same approach:  STC 130, para 46. Mr Aaronson QC for the Pirelli companies urged your Lordships to take the same view. If this argument was right its effect would be that section 247(2) had the effect already mentioned in the domestic context but did not qualify the entitlement to relief from double taxation provided for by the DTA. But I do not think that this approach fits either with the clear language of section 231 itself, or with the system which the tax credit mentioned in that section was designed for.
39. It seems to me that there is no escape from the fact that it is section 231 that section 788(3)(d) uses to identify the relief that is to be given in accordance with the DTA by way of a relief under the domestic system to the non-resident companies. It was the domestic system, not the Treaty, that defined the extent of that relief. According to its own terms section 231 had to be read subject to section 247. And the giving of a tax credit for qualifying distributions only became necessary because qualifying distributions were distributions on the making of which the paying company was liable to ACT. Reading these two provisions together, it is clear that the prerequisite for the giving of a tax credit was the making of a qualifying distribution which was liable to ACT. A group income election extinguished that liability and with it the right to the tax credit that was the counterpart of the liability. It follows that, if the same system had been available to them and a group election had been made, no ACT would have been payable on the distributions to the EU parent companies. So there would have been no entitlement to a tax credit with respect to those distributions under section 788(3)(d). I would answer the question raised by this issue in favour of the revenue.
The assessment issue
40. The assessment issue raises an entirely different point. The argument for the Pirelli companies is that the harm of having to pay the ACT and of losing the cash flow advantage that a group income election would have given them was suffered by the UK subsidiary only, not by the parent which received the advantage of the tax credit paid to it under section 788(3)(d). So the amount of the compensation to be paid to the subsidiary should be assessed without bringing the tax credit received by the parent companies into account. To this the answer for the revenue is that section 247(1) gave the right to make a group income election to both the parent and to the subsidiary jointly. It was an election which was available to them which would only have been made where it was in their joint interests to make it, and in the event of a joint election the tax credit would not have been payable. So the group should be treated as a single unit for the purpose of assessing the amount of the compensation payable in order to give effect to the judgment of the European Court of Justice. Park J said in para 48 that this was a huge and unjustifiable step, as it ignored the separate corporate identities of the respective companies.
41. I do not think that the revenue's approach falls into the trap of ignoring the companies' separate identities. What it does is to look at them instead as members of the group. I agree with Lord Scott that the relevant harm was the harm that the group suffered by reason of the breach of the parent companies' right to freedom of establishment under article 52 of the Treaty. The breach deprived the group of the benefit of a joint election which, if there had been no breach, would have been available under section 247(1) ICTA 1988 for the benefit of the group as a whole. It would have been exercisable by the paying and the recipient members of the group jointly. It is the joint nature of the exercise that makes it appropriate to look at the group as whole when the compensation is being assessed rather than the effect of the breach on each company taken in isolation.
42. In Metallgesellschaft Ltd v Inland Revenue Commissioners (Joined Cases C-397 and 410/98)  Ch 620, para 88 the European Court stressed that in an action for restitution the principal sum due was none other than the amount of interest which would have been generated by the sum use of which was lost as a result of the premature levy of the tax. In para 89 it said that article 52 of the Treaty entitled a subsidiary resident in the UK and/or its parent company having its seat in another member state to obtain interest on the ACT paid by the subsidiary during the period between the payment of the ACT and the date on which the mainstream corporation tax became payable. Elaborating on this point in para 96, the court said that article 52 of the Treaty required that resident subsidiaries and their non-resident parent companies should have an effective legal remedy in order to obtain reimbursement or reparation of the financial loss which they had sustained as a result of being deprived of the entitlement to a tax regime that allowed them to avoid the obligation on the subsidiary to pay ACT in respect of dividends paid to the parent company.
43. The language that the European Court uses in these and the other passages in the judgment referred to by Lord Scott shows that the loss for which an effective legal remedy is to be made available is the loss which was sustained by the subsidiaries and their parent companies as members of a group. This is because the taxation regime which was denied to them was a regime that was available to a group under the domestic system. The effect of the breach of article 52 which denied the opportunity to opt for that regime to the Pirelli companies cannot be assessed without looking at both sides of that regime - at the differences that it would have made to the receiving companies within the same group as well as to those companies that were paying the dividends. Decisions as to whether to opt for that regime, which had to be made by these companies jointly, were always made by reference to what was in the best interests of the group looked at as whole. It would be artificial, and therefore wrong, to look only to the effect on the subsidiaries that opting for that regime would have had without having regard to its effect on the parent companies within the same group also.
44. Mr Glick QC for the Revenue accepted that a common law claim against the parent companies for repayment of the tax credits would fail because they were not paid to the parent companies under a mistake. But he submitted that it was nevertheless open to the revenue to rely on the amount of the tax credits given to the parents to reduce or extinguish its liability to the subsidiaries in the same group. In my opinion reparation for the breach of article 52 of the Treaty for the loss that was sustained by the group in this case, as explained by the European Court's judgment, permits this approach. I would answer this question too in favour of the revenue.
The withholding tax issue
45. The third issue is whether ACT was contrary to EC law on the ground that it was a withholding tax within the meaning of the Parent/Subsidiary Directive. As Park J pointed out in para 61, it only needs to be addressed if both of the two previous questions are answered in favour of the revenue. Both of those questions were answered both by him and by the Court of Appeal against the revenue, so it was not necessary for them to deal with it. As we are in favour of the revenue on both points we must do so.
46. The wording of article 5.1 does not provide a clear answer to the problem. But it comes close to doing this, as it provides that profits which a subsidiary distributes to its parent shall be exempt from withholding tax. The wording of this paragraph suggests that the exemption applies where the taxable person from whom the tax is being withheld is the parent company to whom the profits are being distributed. That is how the concept of withholding tax was explained in Ministério Público and Fazenda Pública v Epson Europe BV (Case C375/98) 2000 ECR 1-4243, where the European Court said that a tax was a withholding tax where it was a tax on the parent company's dividend income, not a tax on the profits of the subsidiary: see paras 23 and 24. ACT did not fall within that description, as under section 239 of ICTA it was a tax payable by the subsidiary which was to be set against the subsidiary's liability to mainstream corporation tax. So it was a tax on the profits, if any, of the subsidiary, not those of the parent company. This is made clear by the fact that income of the parent by way of distributions made by its subsidiary under deduction of ACT entitled the parent to a tax credit under section 231 equal in amount to the tax payable by the subsidiary as ACT. Article 7.1 however seems to me to put the matter beyond doubt. It provides that the term "withholding tax" does not cover an advance payment of corporation tax to the Member State of the subsidiary which is made in connection with a distribution of profits to its parent company. ACT answers to this description.
47. In Athinaiki Zithopiia v Elleniko Dimosio (Case C-294/99)  STC 559 it was argued to the European Court that article 5 did not apply because the tax in question was a tax on the profits of the subsidiary to its parent company within the meaning of article 7.1. In para 29 of its judgment this argument was rejected on the ground that it related to income which was taxed only in the event of a distribution of dividends and up to the limit of the dividends paid. This description seems to me to indicate that the reason why the taxation was held not to fall within article 7.1 was that it was a tax on the parent's income as holder of the shares which entitled it to payment of the dividends, not on the income of the subsidiary. This interpretation of that decision is confirmed by what the European Court said in Océ van der Grinten NV v Inland Revenue Commissioners (Case C-58/01)  STC 1248, para 47 where, treating the matter as having been settled by its decisions in the Epson and Athinaiki cases, the court made it clear that a withholding tax is a tax on the income from the shares on which the dividend is paid and where the holder of the shares is the taxable person from whom the tax is withheld.
48. It is true, as Park J pointed out in para 61, that ACT could only be said to be an advance payment of tax payable by the subsidiary if its profits were sufficiently large at the end of the accounting period to attract mainstream corporation tax. If this was not the case - and it often was not the case - it could not be said to be an advance payment of tax that was ultimately to be borne by the subsidiary. But this not the criterion to which article 7.1 as interpreted by the European Court addresses itself. The essence of a withholding tax within the meaning of article 5.1 as explained by article 7.1 is that it is a tax on the income of the parent company. The court's own jurisprudence makes it clear that ACT was not a withholding tax for the purposes of the Parent/Subsidiary Directive.
LORD SCOTT OF FOSCOTE
49. The problem that your Lordships must resolve on this appeal is produced by a combination of four things. First, the Finance Act 1972 introduced advanced corporation tax (ACT) to our tax system. The charging provision, originally section 84(1) of the 1972 Act, became section 14(1) of the Income and Corporation Taxes Act, 1988. It required a company which made a "qualifying distribution" (typically the payment of a dividend) to its shareholders to pay ACT to the Revenue. The ACT (described in section 14(1) as "an amount of corporation tax) was made payable on an amount equal to the amount or value of the distribution and at the rate at which income tax at the basic rate was charged. The ACT was not deducted from the dividend paid to the shareholder (as had been the case with Schedule F income tax: see the explanation given by Peter Gibson LJ in paragraphs 5 and 6 of the judgment of the Court of Appeal) but instead the ACT attributable to each dividend was "imputed" to the shareholder to whom the dividend was payable and, if the shareholder was resident in the UK, the shareholder generally became entitled to receive from the Revenue a tax credit equal to the amount of the ACT (see s.231(1) of the 1998 Act). The shareholder was then taxable on the aggregate of the dividend and the tax credit. As for the company that had paid the ACT, that company was entitled to set the ACT against its liability to mainstream corporation tax.
50. The second contributory factor was the availability of group income elections. Provision for these elections was made by section 247(1) of the 1988 Act. Where both a subsidiary company and its parent company were resident in the UK they were permitted by section 247(1) to make a joint election that the sub-section should apply to the dividends paid by the subsidiary to the parent. Then, so long as the election remained in force, ACT would not be payable in respect of those dividends and the parent company would not receive a corresponding tax credit.
51. The right to receive tax credits pursuant to section 231(1) of the 1988 Act did not apply to recipients of dividends who were not resident in the UK. But the liability of companies to pay ACT when dividends were paid arose regardless of the place of residence of the shareholder. The position of non-resident shareholders was catered for, to the extent that it was catered for at all, under double-taxation agreements entered into between the UK and other states. Some of these double-taxation agreements contained provision for tax credits to be given by the Revenue to foreign shareholders in a UK resident company which had paid dividends and, accordingly, also paid ACT. The amount of the tax credits to which the foreign shareholders were to become entitled and the conditions on which entitlement to the tax credits depended were agreed by negotiation between the UK and the state in question and were spelt out in the double-taxation agreements. Not all double-taxation agreements contained provisions enabling the foreign shareholders to claim tax credits but, relevantly for present purposes, the double-taxation agreements between the UK and the Netherlands and the UK and Italy did. The agreements themselves did not ipso facto become enforceable in our domestic law but section 788 of the 1988 Act gave them that enforceability. Sub-section (1) of section 788 declared that
and sub-section (3) says that