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The FII Group Litigation Order – Where are we now on portfolio investments?

This article considers what scope is left for institutional portfolio investors such as investment funds and life insurance companies to reclaim UK corporation tax on overseas dividends paid to them before 1 July 2009 following February’s Court of Appeal decision in the case of Test Claimants in the FII Group Litigation v Revenue and Customs Commissioners. The case was brought about by UK parents of international groups, but the various stages of the case also impact on portfolio dividends.

The case and the judgements

Corporation tax on overseas portfolio dividends before 1 July 2009 – was it legal?

Since 1 July 2009 the taxation of overseas and UK dividends on UK corporates has been aligned so that overseas dividends, like UK dividends, are now generally outside the scope of the charge to UK corporation tax.

The ECJ judgement

Prior to this alignment however, in December 2006, in the case of Test Claimants in the FII GLO v Inland Revenue Commissioners, the European Court of Justice found against the UK, inter alia, that Article 56 of the EC Treaty on the freedom of movement of capital precluded the following aspects of UK tax legislation:

  1. The exemption from corporation tax of dividends from a UK resident company while a dividend from a non-UK resident company was taxed without a tax credit for the tax it actually paid in its country of residence (‘underlying tax’) if the UK recipient owned less than 10% of the voting rights. This was reinforced by the ECJ in a reasoned order delivered in Test Claimants in the CFC and dividends GLO v Inland Revenue Commissioners.
  2. Before the Foreign Income Dividend (“FID”) regime was introduced in 1994, the ability of a UK company to offset dividends received as FII from a UK company against dividends paid by it for the purpose of calculating ACT (now abolished), without a similar mechanism for passing on foreign company dividends received without ACT.
  3. Before the 1997 abolition of ACT and, in consequence the phasing out of tax credits, the availability of a repayable tax credit on UK company FII for exempt investors e.g. pension funds and charities, but not on FIDs.

A number of issues were left to be decided by the English Court, including a factual question relevant to the legality of taxing dividends of overseas companies in the hands of UK companies holding more than 10% of the voting rights and the crucial question of what the taxpayers were entitled to reclaim.

The High Court decision

Initially the High Court held in favour of the taxpayer:-

  1. That the taxation of EU subsidiary dividends, despite the underlying tax credit, was in breach of Article 43 (freedom of establishment) and Article 56 of EU law.
  2. That the claim for recovery of the unlawful tax suffered could be made as a claim for repayment under a mistake of law. It could therefore benefit from s.32(1)(c) of the Limitation Act 1980, without restriction by s.320 FA 2004 and s.107 FA 2007, which are in breach of Community Law having been introduced without transitional rules.

The Court of Appeal decision

  1. The Court of Appeal reversed the ruling on the legality of the taxation of the dividends by a majority of 2 out of 3 judges but, in view of the amounts involved, the case was referred back to the ECJ.
  2. It was held that since the Woolwich restitution remedy was acceptable under the San Giorgio principle to effectively obtain redress for Community Law infringements it was not necessary for the mistake of law remedy to be in accordance with that principle, and therefore the protection of the s.32(1)(c) of the Limitation Act was not available. A claim could therefore only be lodged under Paragraph 51 of Sch 18 FA 1998, and within the time limits set out therein.
  3. The Court however ruled that the discretion regarding what is “just and reasonable” contained in Paragraph 51 should not be applied in a manner incompatible with Community Law.

In general, the case is likely to take many years to reach a conclusion, taking together the reference to the ECJ and any UK appeal or other issues.

What happens now for portfolio investors?

We are working on the basis that the ambiguous Court of Appeal ruling discussed above does not prevent corporate portfolio investors from making a claim for the tax treatment of overseas dividends received for the following reasons:-

  1. The Court of Appeal case was not about portfolio dividends but about whether the dividends of overseas subsidiaries should be exempt. The ECJ decision regarding portfolio dividends therefore remains our authority on the matter.
  2. It is therefore our view that even if EU law does not hold that overseas dividends should always have been exempt, underlying tax at least should have been accountable as a credit on portfolio dividends in the same way as dividends on a larger holding.
  3. On the basis that the calculation of underlying tax would be much more complex for portfolio investors as they would generally have little information, this complexity in itself would be in breach of Article 56 as it could discourage investment in overseas equity, and the answer should in fact be total exemption. In this respect the outcome of two cases referred to the ECJ by the Austrian Courts, the Salinen and Haribo cases, are awaited with interest.
  4. Portfolio investment is not affected by the standstill provisions in respect of dividends paid by companies outside the EU. It is therefore possible to make reclaims in respect of non-EU portfolio dividends, although this is still to be tested in the CFC and dividend GLO High Court judgement to be delivered this month.

Practical implications

Portfolio investors who have made protective claims should therefore attempt to close the matter with HMRC on that basis. Portfolio investors who have not yet lodged protective claims should consider the value of such a claim to them in terms of tax actually suffered on a case by case basis, and there are detailed considerations. A few starting points: -

  • Life insurance companies (in respect of their BLAGAB) and investment funds are normally able to offset management expenses against their taxable investment returns.
  • For investment funds investing predominately in overseas equity, this tends to cancel out the UK tax charge because of the level of overseas tax withheld at source. This however may raise some considerations of its own, with reference to claims under the Fokus or Aberdeen principles. Portfolio investors should be reviewing their European portfolios to consider the merits of lodging such claims.
  • Funds which could benefit the most are balanced funds which have sufficient non-dividend income to generate a tax charge and those that offer some or all of their investors discounts at source on their management expenses thus leaving some UK tax expense. Life insurance companies may also have more capacity to reclaim because of the diversity of their investments.

With reference to timing, investment fund managers and life insurance companies should bear in mind the scope for lodging an error or mistake claim, or alternatively a late Double Tax Relief claim, bearing in mind the new 4 year time limit. For instance, the deadline for a claim for a fund with a 30 April 2006 year end is 30 April 2010. With reference to wider remedies for earlier years the issue is not settled and still to be appealed.

If you would like further details on how to make a claim in respect of any of the UK or overseas taxes described in this article please contact Carine Beidas on 0207 063 4311.

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The FII Group Litigation Order

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