The Civil Division of the Court of Appeal handed down its judgment in the case of Test Claimants in the Thin Cap Group Litigation v Commissioners for Her Majesty’s Revenue and Customs [2011] UKCA Civ 127 on 18 February 2011, part of a group litigation challenging the compatibility of UK “Thin Cap” legislation with European Community law. The respondents in this case were UK resident subsidiaries of multinational groups of companies which had received loan finance from parent companies located elsewhere in the EC and contended that provisions of UK corporate tax legislation were incompatible with Article 43 of the EC Treaty, which provides that “restrictions on the freedom of establishment of nationals of a Member State in the territory of another Member State shall be prohibited. Such prohibition shall also apply to restrictions on the setting-up of agencies, branches or subsidiaries by nationals of any Member State established in the territory of any Member State”.

“Thin Cap” (an abbreviation of “thin capitalisation”) legislation sought to address what Her Majesty's Revenue and Customs (“HMRC”) considered to be transfers of profits, and therefore transfers of tax bases from the UK to another jurisdiction. The differing tax treatment of debt and equity finance offers an incentive for a parent company in a low tax jurisdiction to finance by means of debt a subsidiary in a high tax jurisdiction by providing what is in substance equity investment in the form of debt, or “thin capitalisation”, and effectively choose where it wished profits to be taxed. Viewing this as inherently abusive, many states implemented measures aimed at countering this abuse, notably in the form of criteria in order for certain loans to be regarded as disguised equity capital, so the payment would be subject to any applicable rules on dividend taxation. Another form of tax avoidance involved loans by the parent company which were then repaid at a rate higher than would be payable were the parties unconnected. Thin cap legislation would treat the interest as if it were payable at a reasonable rate, and disallow the excess as a deduction from the gross profits of the subsidiary.

Thin cap legislation attempted to avoid not only the deliberate evasion of tax but also to regulate and preserve the national tax base, and this was reflected in Article 9 of the OECD Model Convention on Taxes on Income and Capital which provided for an “arm's length test” to deal with abusive transactions. Under that test, which the UK followed in its legislation, interest payable by a UK resident group borrower to an non-resident group lender was treated as deductible in the computation of the borrower's taxable profits so long as it did not exceed what would have been payable under a loan transaction negotiated at arm's length. Interest in excess of what would have been so payable was treated as a non-deductible distribution.

The issue for the Court of Appeal was whether the failure of UK legislation to permit a commercial justification of transactions that were not arm's length terms infringed the claimants' rights under Article 43. At first instance, the judge had held that while the rules were consistent with an arm's length test it was not proportionate to achieve the purpose of preventing abusive tax avoidance because the provisions did not allow for a separate defence of commercial justification.

HMRC contended in its appeal that thin cap legislation was permissible under EC law if it affected transactions between related companies that were other than at arm's length, while the respondents contended that such legislation unlawfully infringed freedom of establishment under Article 43 where it affected genuine commercial transactions. The claimants submitted that when applying the arm's length test to a subsidiary within a group of companies it was necessary for HMRC and the court to take into account the fact that the subsidiary was within that group.

Stanley Burnton LJ, delivering the judgment of the court, held that legislation that involved the application of the arm's length test did not automatically breach Article 43, provided that both: the taxpayer was given an adequate opportunity to present his case to the tax authority that the transaction in question was on arm's length terms and could challenge the decision of the tax authority before the national court; and that the effect of the legislation was limited to those aspects of the advantage conferred by the taxpayer company that did not satisfy that test.

There was no doubt that the UK legislation satisfied all of those requirements in this case: it applied the arm's length test; it did not disallow any interest that would have been payable under a transaction on arm's length terms; the taxpayer was given an adequate opportunity to present its case; and it had recourse to the courts if dissatisfied with the decision of the Revenue. There was nothing in EU case law to suggest that UK legislation might be incompatible because of its failure to into account a subsidiary's membership of a non-UK group of companies.

The Court of Appeal thus overruled the High Court and allowed the appeal (Arden LJ dissenting).