Judgments - Pirelli Cable Holding NV and others (Respondents) v. Her Majesty's Commissioners of Inland Revenue (Appellants)

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    52.  The third factor contributing to the problem which your Lordships must resolve is that the double taxation agreement (the 'DTA') between the UK and the Netherlands, and that between the UK and Italy, provided, under Article 10(3)(c), that a Netherlands/Italian company that had received a dividend from a UK subsidiary should (subject to certain qualifications which are irrelevant for present purposes) -

    "… be entitled to a tax credit equal to one half of the tax credit to which an individual resident in the United Kingdom would have been entitled had he received those dividends, and to the payment of any excess of that tax credit over its liability to tax in the United Kingdom" (see Netherlands: Convention of 7 November 1980: SI 1980/1961 and Italy: Convention of 21 October 1988: SI 1990/2590)

For the sake of completeness I should add that Article 10(3)(b) of each DTA provided for tax credits to be given to individual shareholders resident in the Netherlands or Italy.

    53.  The final event which has created the problem is the judgment given on 8 March 2001 by the European Court of Justice in two cases, heard together, Metallgesellschaft Ltd v Inland Revenue and Hoechst AG v Inland Revenue [2001] Ch. 620. The European Court of Justice was responding to requests for rulings on the question whether the denial by section 247(1) of the 1988 Act to companies of other member states and their UK subsidiaries of the right to make a group income election, and thereby to enable the subsidiaries to avoid payment of ACT in respect of dividends paid to their parents, while affording that right to UK companies and their UK subsidiaries, was consistent with Community law (see the formulation of the issue in paragraph 35 of the Court's judgment).

    54.  The Court noted (in paragraph 44) that the ACT/group income election statutory provisions gave the subsidiary of a UK parent

    "… a cashflow advantage inasmuch as it retains the sums which it would otherwise have had to pay by way of advance corporation tax until such time as mainstream corporation tax becomes payable … " (see also para.54).

The Court concluded that it was contrary to Article 52 of the Treaty (now Article 43) for this tax advantage to be made available where the parent company was resident in the UK but to be denied where the parent company was resident in some other member state.

    55.  Having reached the conclusion to which I have referred, the Court then had to consider what remedy the companies which had been denied the right to make group income elections should be entitled to. The Court's conclusion on this question is set out in paragraph 96 of the judgment and, having regard to some of the submissions addressed to your Lordships, I think it important to set out in terms what the Court said:

    "… where a subsidiary resident in one member state has been obliged to pay advance corporation tax in respect of dividends paid to its parent company having its seat in another member state even though, in similar circumstances, the subsidiaries of parent companies resident in the first member state were entitled to opt for a taxation regime that allowed them to avoid that obligation, article 52 of the Treaty requires 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 have sustained and from which the authorities of the member state concerned have benefited as a result of the advance payment of tax by the subsidiaries."

It is to be noticed that the European Court referred to the financial loss sustained by and the legal remedy that had to be afforded to "resident subsidiaries and their non-resident parent companies."

The issues in this appeal

    56.  Following the European Court's judgment there were, not surprisingly, claims for compensation by a number of foreign companies and their UK subsidiaries. Having regard to the number of cases and to the many common issues that were raised by these cases a Group Litigation Order was made. The GLO identified a number of common issues, one of which was the effect, if any, that the receipt by a foreign parent company of a tax credit should have on the compensation to which its UK subsidiary was entitled. That is the core issue which your Lordships must now resolve. There are, however, sub-issues.

    57.  Some of the facts that give rise to the issues are actual. Some must be assumed. The actual facts are as follows -

    (i)  Two of the respondents, Pirelli Cable Holding NV ('Pirelli Cable') and Pirelli Tyre Holding NV ('Pirelli Tyre') were resident in the Netherlands and one of the respondents, Pirelli SpA, was resident in Italy.

    (ii)  The respondents Pirelli UK plc ('the UK Holding Company') and Pirelli General plc ('the UK Subsidiary') were resident in the UK;

    (iii)  the UK Holding Company owned all the shares in the UK Subsidiary and Pirelli Tyre, Pirelli Cable and Pirelli SpA each owned 33? per cent of the issued ordinary shares of the UK Holding Company.

    (iv)  Over the period 14 July 1995 to about 20 April 1999 Pirelli Tyre, Pirelli Cable and Pirelli SpA could, if they had been UK resident companies, have made a group income election in respect of all dividends declared by the UK Holding Company.

    (v)  The UK Holding Company therefore became liable to pay ACT on each occasion in the relevant period that it paid dividends to its three parent companies and it paid ACT accordingly. On two occasions ACT was paid by the UK Subsidiary in respect of dividends it paid to the UK Holding Company. The UK Holding Company subsequently paid dividends of the same amount to its three parent companies but in doing so incurred no additional ACT liability because the dividends it paid were "franked" payments equal to the "franked investment income" it had received from the UK Subsidiary (see s.241(1) of the 1988 Act). Nothing turns on this and it is simpler, for present purposes, to treat all ACT as if paid by the UK Holding Company. And

    (vi)  In respect of all these dividends the three parent companies received from the Revenue tax credits pursuant to the DTAs between the UK and Netherlands or the UK and Italy, the net amount of which was 6.875 per cent of the value of the dividends.

    The assumed facts are that over the whole of the relevant period a group income election would have been made by each of the three parent companies if it had been open to them to do so. This is an issue of fact yet to be resolved if it becomes necessary to resolve it.

    58.  The two main issues are, therefore, these -

    (i)  If the UK Holding Company had paid the dividends to its three parent companies while a group income election was in place, and thereby avoided liability to pay ACT in respect of those dividends, would the three parent companies nonetheless have been entitled to the tax credits that they received pursuant to the relevant DTA?

    (ii)  If the parent companies would not have been entitled to tax credits had the dividends been paid by the UK Holding Company without incurring any liability to ACT, should the tax credits in fact received by the parents be brought into account in calculating the compensation payable for the breach of Article 52 that, the European Court held, had been committed?

    59.  There is another issue, namely, whether ACT constituted a withholding tax within the meaning of Article 5.1 of Council Directive 90/435/EEC of 23 July 1990 ("the Parent/Subsidiary Directive") and, if so, whether it fell within the exception set out in Article 7.1 of that Directive, and whether that question should be referred to the European Court for a ruling. I will leave any further explanation of this issue until later.

    The first main issue

    60.  Both Park J and the Court of Appeal concluded, for substantially the same reasons, that even on the hypothesis that the Pirelli respondents had been entitled to make and had jointly made a group income election under section 247(1), so that the UK Holding Company in paying their dividends would have incurred no liability to pay and would not have paid ACT, nonetheless the parent companies would still have been entitled to tax credits pursuant to Article 10(3)(c) of the respective DTAs. The essential reasoning behind this conclusion, strongly supported by Mr Aaronson QC in his written and oral submissions to your Lordships, was that each DTA was the product of negotiation between the UK and the Netherlands or Italy (as the case may be), represented a give-and-take bargain between the negotiating states and should be applied according to its own internal provisions without regard to what might be thought to be the policy underlying the tax regime regarding ACT and tax credits.

    61.  Thus, Park J said that "… the question ultimately turns on the construction of the relevant provisions of art.10 in the two DTAs …" (para.35), that "Article 10, read with s.788(3) …. lays down the conditions which have to be fulfilled …" for entitlement to tax credits and, in paragraph 38, that the Pirelli parent companies

    "… complied with every specific condition [for entitlement to tax credits], and would have done whether the Pirelli UK dividends were paid to it as group income or not."

    62.  And the Court of Appeal judgment, in paragraph 45, said that

    "The impression that the provisions of the DTAs are intended to be exhaustive for prescribing the circumstances in which the right to a tax credit under s.231 in respect of qualifying distributions made by a UK-resident company is conferred on a non-resident is strongly confirmed by consideration of the Italy and Netherlands DTAs themselves. They are extremely detailed, and although they are substantially similar they are not identical … The DTAs contain their own formulas for calculating the amount of tax credit that is allowed, different from the amount of the tax credit available to a UK-resident shareholder, albeit expressed by reference to what a UK-resident shareholder would have received by way of tax credit. They contain their own conditions governing entitlement to the tax credit in particular amounts."

    63.  My Lords, I am in respectful agreement with Park J and the Court of Appeal that the issue depends upon the construction of article 10(3)(c) of the DTAs but I do not agree that that provision, or the DTA provisions as a whole, are "exhaustive", if the use of that adjective is intended to mean that the correct meaning and effect of the DTA provisions can be ascertained simply by reading the provisions themselves.

    64.  Let me stay with article 10(3)(c), under which a Netherlands, or Italian, resident company can claim "one half of the tax credit to which an individual resident in the United Kingdom would have been entitled had he received those dividends." There are two points to be made about this language. First, there is no definition anywhere in these DTAs of the expression "tax credit". But article 3(2) of each DTA says that -

    "As regards the application of the Convention by one of the States any term not defined therein shall, unless the context otherwise requires, have the meaning which it has under the law of that State concerning the taxes to which the Convention applies."

    65.  The expression "tax credit" is defined in section 832(1) of the 1988 Act as "a tax credit under section 231" and the same wording is to be found in section 788(3)(d). So that is the meaning to be attributed to the expression "tax credit" in article 10(3)(c). Re-writing article 10(3)(c), the Netherlands or Italian company is to be entitled to "one half of the tax credit under section 231 of the 1988 Act to which an individual resident in the United Kingdom would have been entitled if he had received those dividends."

    66.  Section 231(1) says that

    "Subject to section … 247 … where a company resident in the United Kingdom makes a qualifying distribution and the person receiving the distribution is another such company or a person resident in the United Kingdom, not being a company, the recipient of the distribution shall be entitled to a tax credit …"

And section 247(2) says that where a group income election under subsection (1) is in force -

    "… the election dividends shall be excluded from sections 14(1) and 231 and accordingly are not included in references to franked payments made by the paying company or the franked investment income of the receiving company but are in the Corporation Tax Acts referred to as 'group income' of the receiving company."

    67.  It follows, in my opinion, from section 231(1) and section 247(2) that where a group income election is in force and dividends are paid by a UK company a section 231 tax credit cannot be claimed by the recipient of the dividends. The language of section 231(1) and section 247(2) bars such a claim. The language of article 10(3)(c) involves, therefore, a contradiction. The entitlement to a section 231 tax credit of a Pirelli parent company that received dividends that had been paid under a group income election is said by article 10(3)(c) to depend upon the entitlement to a section 231 tax credit of a UK-resident individual "had he received those dividends" (emphasis added). But "those dividends" would be dividends paid under a group income election and, therefore, in respect of which no ACT was payable or paid and no entitlement to a section 231 tax credit could arise. But an individual could not have received any such dividends. Only a company could receive dividends paid under a group income election. In order, therefore, to apply the hypothesis prescribed by article 10(3)(c), either the individual must be taken to have received dividends of a character different from those received by the Pirelli parent company, i.e. the individual must be supposed to have received dividends not paid under a group income election and in respect of which ACT had been paid, or, alternatively, the individual must be attributed for the purpose of the article 10(3)(c) hypothesis with the ability to receive dividends paid under a section 247 group income election.

    68.  Each of these solutions is somewhat unsatisfactory because each involves an element of unreality. But some degree of unreality in trying to apply the article 10(3)(c) condition is, perhaps, inevitable if one bears in mind that those who negotiated the terms of the DTAs and those, if different, who drafted article 10(3)(c) could not have had in mind that the provision would subsequently need to be applied to a hypothetical situation in which it has to be supposed that group income elections have been made by UK subsidiaries and their other member state parent companies, that dividends have been paid by the subsidiaries to the parent companies without incurring any ACT liability and that the parent companies that have received these dividends have then claimed section 231 tax credits. For my part I prefer the second of the two possible solutions which seems to me to do less violence than the other to the language of article 10(3)(c). There is no doubt about the character of the dividends assumed to have been received by the Pirelli parent companies and in respect of which it is to be assumed that they claimed tax credits. They are dividends assumed to have been paid under a group income election jointly made by the subsidiaries and the parents. The reference in article 10(3)(c) to "those dividends" that the hypothetical individual is to be taken to have received should be, it seems to me, dividends of the same assumed character. So the individual must be attributed with the ability to receive dividends of that character. If that is the right approach to the article 10(3)(c) hypothesis, the individual who had received dividends of that character would not have been entitled to a section 231 tax credit and, consequently, nor would the Pirelli parent companies. The alternative appears to me to involve overlooking the statutory definition of "tax credit" as a "tax credit under section 231" and attributing to the individual, and thence to the Pirelli companies, the right to a tax credit that an application of section 231 would reject.

    69.  I disagree, therefore, with the conclusion reached by Park J and the Court of Appeal on the first issue, the so-called "election" issue. The error which I think was made can be identified in paragraphs 37 and 38 of Park J's judgment. In paragraph 37 he sets out in sub-paragraphs (i) to (v) the article 10(3)(c) conditions that, in his view, the Pirelli parent companies had to satisfy in order to claim tax credits. I respectfully agree that these conditions must all be satisfied and were satisfied. The judge then moves to his conclusion which he sets out in sub-paragraph (vi)

    "(vi)  If the foregoing conditions were satisfied, as they were, Pirelli SpA was entitled to tax credits equal to half the tax credits to which a United Kingdom resident individual would have been entitled."

In my opinion, however, the judge omitted an additional condition that had to be satisfied, namely, that a UK-resident individual who had received the dividends received by Pirelli SpA (i.e. "those dividends") would have been entitled to section 231 tax credits. This, in my opinion, is the critical condition.

    70.  In paragraph 38, second sentence, Park J said that:

    "Pirelli SpA complied with every specific condition, and would have done so whether the Pirelli UK dividends were paid to it as group income or not." (emphasis added)

Not so, in my respectful opinion. The judge's conclusion overlooks the article 10(3)(c) requirement that the hypothetical UK resident individual must be taken to have received "those dividends", that is to say, the dividends paid to Pirelli SpA under a group income election. In that hypothetical event the omitted condition would not be satisfied. The UK-resident individual would not have been entitled to a section 231 tax credit; nor, therefore, would Pirelli SpA.

    71.  The Court of Appeal apparently did not accept that references to "tax credit" in article 10 of the two double taxation agreements meant "tax credit under section 231" (see paragraphs 46 to 48). But the section 832(1) definition is essential in order to give a meaning to "tax credit" in article 10, for the term is nowhere else defined and article 3(2) expressly imports domestic law definitions for terms not defined in the DTAs themselves. The Court of Appeal say, in paragraph 48, that "the reference [in s.788(3)(d)] to s.231 was necessary in order to cause the tax credit to be aggregated with the distribution in respect of which the tax credit is conferred and so to be rendered chargeable to tax under para.2 of Sch.F". That is no doubt true but does not, in my opinion, justify writing the definition out of the DTAs. Article 10 in express terms hinged a Netherlands/Italian parent company's right to a tax credit to the entitlement that a UK resident individual would have had to a tax credit if he had received the dividends that the foreign parent company had received. That being so I do not, for my part, find it at all surprising that specific provisions in domestic legislation restricting in specified circumstances the right to a tax credit should govern the availability of a tax credit under article 10. Be that as it may, the only tax credit available, at least in this area of tax law, is a tax credit under section 231. There is no such thing as an article 10(3)(c) tax credit that is not a "tax credit under section 231".

    72.  In my opinion, therefore, and in agreement with my noble and learned friend Lord Walker of Gestingthorpe, on the true construction of article 10(3)(c) the Pirelli parent companies would not have been entitled to tax credits in respect of dividends paid to them by the UK Holding Company as group income under a section 247(1) group income election and, therefore, without incurring any liability to pay ACT.

The second issue

    73.  So what are the consequences of that conclusion for the compensation claims made by the Pirelli respondents? Both Park J and the Court of Appeal treated this second issue as one which depended upon whether the separate corporate identity of the UK Holding Company, which had paid the ACT, could be ignored. There were references to Salomon v Salomon & Co [1897] AC 22 and to the remarks about a single economic unit or lifting the corporate veil in such cases as DHN Food Distributors Ltd v Tower Hamlets London BC [1976] 1 WLR 852, Adams v Cape Industries [1990] Ch.433 and Ord v Belhaven Pubs Ltd [1998] 2 BCLC 447. Park J held, and the Court of Appeal agreed, that compensation payable to the Pirelli subsidiaries was not to be reduced by reference to the value of the tax credits received by the Pirelli parent companies.

    74.  It must, for the purposes of this second issue, be accepted that if section 247 group income elections had been able to be made and had been made by the Pirelli companies and if dividends had been paid to the Pirelli parent companies by the UK Holding Company while the elections were in force, the UK Holding Company would not have paid ACT and the Pirelli parent companies would not have been entitled to tax credits.

    75.  The answer to this issue does not, in my opinion, depend upon whether the corporate veil can be lifted or whether the Pirelli companies should for compensation purposes be treated as a single economic unit. The answer requires as a start that the nature of the wrong for which compensation is payable be identified.

    76.  The European Court of Justice held that the ACT/group income election tax regime imposed an unwarranted restriction on the freedom of establishment guaranteed by article 52 of the Treaty and hence was a breach of that article. The rights conferred by article 52 are described in paragraph 41 of the judgment:

    "Article 52 of the Treaty constitutes one of the fundamental provisions of Community law and has been directly applicable in the member states since the end of the transitional period. Under that provision, freedom of establishment for nationals of one member state within the territory of another member state includes the right to take up and pursue activities as self-employed persons and to set up and manage undertakings under the conditions laid down for its own nationals by the law of the country where such establishment is effected. The abolition of restrictions on freedom of establishment also applies to restrictions on the setting up of agencies, branches or subsidiaries by nationals of any member state established in the territory of another member state."

And in paragraph 42

    "Freedom of establishment thus defined includes, pursuant to article 58 of the Treaty, the right of companies or firms formed in accordance with the law of a member state … to pursue their activities in the member state concerned through a branch or agency … With regard to companies, it should be noted in this context that it is their corporate seat … that serves as the connecting factor with the legal system of a particular state, like nationality in the case of natural persons …. Acceptance of the proposition that the member state in which a company seeks to establish itself may freely apply to it a different treatment solely by reason of the fact that its seat is situated in another member state would thus deprive article 52 of all meaning. … "

    77.  It is important, in my opinion, to notice two things from these passages. First, the right to freedom of establishment conferred by article 52 is the right of a company (or an individual) with its seat in one member state to establish itself in another member state. Unwarranted restrictions imposed by the latter member state on the branch or agency or subsidiary company by means of which the parent company is seeking to establish itself in that member state is plainly a breach of the article 52 right to freedom of establishment of that parent company. It is more difficult to describe an infringement of article 52 rights brought about by unwarranted restrictions being placed by a member state on the subsidiary of a parent company that has its seat in another member state as a breach of article 52 rights of the subsidiary. It is, surely, strictly speaking, the parent company's right to freedom of establishment that is interfered with.

    78.  Secondly, the language of these passages shows that a company in one member state and its branch, or its agency, or its subsidiary, in another member state are regarded as a group. The subsidiary, unlike the branch or an agency, will have separate legal identity from that of the parent company but there is no suggestion that this makes any difference.

    79.  It is entirely consistent and natural, therefore, that when the European Court discusses the remedies to be made available for an infringement of article 52 rights it treats the parent companies, whose rights have been infringed, and the subsidiaries, on whom the unwarranted restrictions have been placed, as a group.

    Thus

    (i)  paragraph 77 refers to the situation where -

    "… a subsidiary resident in the member state concerned and its parent company having its seat in another member state have been wrongfully deprived of the benefit of a taxation regime which would have enabled the subsidiary to pay dividends to its parent company without having to pay advance corporation tax …"

    (ii)  paragraph 96 concludes that

    "… article 52 of the Treaty requires 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 have sustained and from which the authorities of the member state concerned have benefited as a result of the advance payment of tax by the subsidiaries."

    (iii)  paragraphs 98 and 107 refer to a claim for compensation

    "… brought … by a resident subsidiary and its non-resident parent company for reimbursement or reparation of the financial loss which they have suffered as a consequence of the advance payment of corporation tax by the subsidiary …"

    (iv)  in paragraph 2 of the court's ruling (p 668), the Court says that

    "… article 52 of the Treaty requires 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 have sustained …"

and  (v)  in paragraph 3 of the ruling there is a similar reference.

It is true that in the passages to which I have referred the European Court was responding to questions which had been referred to it by the national court and that the formulation of the responses may have owed something to the nature of the questions. But the questions, set out in paragraph 13 of the Opinion of the Advocate General, do not require the explicit responses that the Court's responses appear to me to constitute in making clear that the compensation claims could be put forward by the subsidiaries and parent companies as a group to recover the loss that they, the group, had suffered in consequence of the article 52 infringements.

 
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