Heath's legacy

When in 1973 Edward Heath signed Britain up to the European Economic
Community, the chances are that the implications his decision would have for the
UK’s tax-making powers were very far from his mind.

By entering the Common Market Heath paved the way for previously unimaginable
levels of external influence over our country’s tax regime. What is perhaps more
surprising is where that influence came from and how central a role tax lawyers
would play in the process.

Because Chancellor Gordon Brown is adamant that the UK won’t bow down to
legal challenges to the public purse, Britain is experiencing something of a
Mexican stand-off between the authorities and the tax advisers and their
clients. The latter are unwavering in their belief that they are owed money
because the UK’s tax legislation falls foul of European law.

Billions of pounds of shareholders money is at stake, so companies are well
within their rights – nay, it is their duty – to pursue refunds for what they
see as wrongly paid tax.

As Chris Morgan, head of EU tax at KPMG says, an individual would have no
hesitation in putting in a claim for overpaid tax, so why should a company?

Back-door tax harmonisation

But because the government refuses to accept that the UK tax regime falls
short of EU law we have found ourselves in a situation experts describe as tax
harmonisation by the back door.

“I have a lot of sympathy with the comments,” says Peter Cussons,
international corporate tax partner at PricewaterhouseCoopers. “The backdrop of
course is the continuing requirements for unanimity for fiscal measures in the
European Council of Finance Ministers which, with 25 finance members, must be
very difficult to achieve.

“The greater part of the action on the EU tax stage has been courtesy of the
European Court of Justice whose output on direct tax cases is steadily
increasing and, moreover, they are not anorak-type cases. They are all big
picture issues.”

Cussons lists a host of cases currently at various stages at the ECJ (see
below) with Marks & Spencer the one most commonly referred to. UK tax
legislation covering cross border loss relief, controlled foreign companies,
thin capitalisation rules, advance corporation tax and franked investment income
are all being challenged in one form or another.

“I have a lot of sympathy with the dictum that the ECJ is setting the pace
and the output of the ECJ is at some level, slowly but steadily, bringing about
harmonisation by the back door,” says Cussons

France and Germany Join forces 

Sensing this, France and Germany have decided to take the bull by the horns.
Together the two countries have sponsored a plan for harmonisation of European
company taxation.

The EU’s tax commissioner, Laszlo Kovacs, is working on the details to create
a uniform system across Europe for calculating a company’s tax base. “At the
moment there are 25 different ways to calculate the corporate tax base,” Kovacs
told the Financial Times in May. “If we manage to have only one EU-wide
set of rules that will increase competitiveness.”

The EU is at pains to point out that the establishment of a uniform system to
calculate corporate taxation will not mean that individual member states will
lose their tax sovereignty. They will, Kovacs stresses, be free to set their own
tax rates, something which the UK is extremely sceptical of.

“They are afraid that it is a Trojan horse to implement the harmonisation of
tax rates at a later stage,” Kovacs continues. “We have no ambition and I have
no personal ambition to do that.”

The French and the Germans do, however. They see it as the perfect foil to an
avoidance industry that can take advantage of countries with low corporate tax
rates.

While this is a battle that Gordon Brown is well attuned with, he is loathe
to lose any control he has over the country’s tax system and hence fiscal policy
which is not an unreasonable position.

But this leaves the UK caught between two unstoppable forces: the European
Union mantra of a single market and the powers of the ECJ backed by fired-up tax
barristers.

One recent case involving Vodafone highlights how powerful a force the ECJ
has become. Asked by HM Revenue & Customs to produce information in relation
to a particular controlled foreign company (CFC) issue that the tax body felt
needed further investigation, the company refused.

Vodafone argued in front of the Special Commissioners that it would not offer
the documents in question because HMRC was asking for information in relation to
a provision which could be contrary to the EC Treaty. The commissioners sided
with Vodafone and referred HMRC’s request for information straight to the ECJ –
bypassing the whole of the UK judiciary – saying that until there is clarity on
whether or not the CFC regime is legal, it is up to the ECJ whether Vodafone is
required to provide that information.

“The Vodafone point is of very broad application because Vodafone has said
that HMRC cannot force it to provide information in relation to a provision
which is suspected of being contrary to the EC Treaty,” says Cussons.
“Commissioners have sympathised with that approach and that principle can be
applied to any area of tax law where the taxpayer has reasonable grounds to
assert that a particular facet of taxes are potentially contrary to the EC
Treaty.”

It leads Cussons to offer a straightforward appraisal of where the power of
tax policy lies. “My views are that the reins of tax policy in Europe are
largely held by the ECJ,” he says. Simon Whitehead, a partner at law firm Dorsey
& Whitney who acts as lead solicitor to the vast majority of the group
litigation orders currently underway, says that Vodafone’s decision not to
comply is a first.

“I would have to say that it is a farreaching position, it’s not a position
our clients have taken before,” he says. “It’s simply saying we are not going to
comply. It shows a very aggressive attitude among some taxpayers.”

From its 2005 annual report, it soon becomes clear why Vodafone is taking
such an aggressive stance. “The company has taken provisions, which at 31 March
2005 amounted to £1,757 million, for the potential UK corporation tax liability
and related interest expense that may arise if the Company is not successful in
its challenge of the CFC regime,” it states.

Whitehead goes on to explain that it is the ECJ’s role to protect the
European single market which the 25 member states signed up to with the EC
Treaty. Because tariffs and taxes are how countries have traditionally protected
their fiscal borders, it is also up to the ECJ to address these.

“If you are going to have a single market then tax and tariff barriers are a
logical area for conflict,” says Whitehead. “It’s the court’s job to maintain a
single market so it’s the court’s job to do something about differential tax
effects.”

M&S judgment critical

The hundreds of companies involved in tax litigation are well within their
rights to use the courts, and every time a company joins a litigation, the power
of the ECJ grows and the power of the government diminishes.

As Roger Taylor, chief financial officer of Carphone Warehouse says: “You
have an opportunity, so you either put down your claim or you lose your
opportunity to do so.”

It will become clearer how powerful the ECJ has become in the next few weeks
as the M&S judgment is finally delivered. Should the court side with M&
S and rule that the UK should be offering relief on losses that the retailer
incurred in Europe, vast swathes of tax legislation would have to be rewritten.
HMRC has even threatened to abolish group relief within the UK in order to avoid
the massive refunds. It is a move that would cost UK plc a staggering £11bn and
highlights the desperate position the government is now in.

TAX AND THE EURO
EU member states seem certain to lose even more control over their tax laws as a
result of adopting the euro.

Derek Scott, economic consultant to KPMG and a former economic adviser to
Tony Blair, says that tax “will be part of that agenda” although he conceded
that it may not initially be the main focus.

Writing in the Financial Times in August, Jean Pisani-Ferry,
director of the Brussels think tank Bruegel, argued that growth in a weak and
underperforming eurozone “can only be expected from structural reforms” of which
tax is sure to be one.

GLOS: THE ORDER OF THE DAY
Tax payers have succeeded at the European Court of Justice on several
occasions, which has encouraged tax lawyers and accountants to work together to
establish six group litigation orders (GLOs) on behalf of their clients.

The GLOs challenge a wide variety of corporate tax legislation, all of which
they believe is in contravention of the EC Treaty and the directives emanating
from Brussels. It is one of the treaty’s four key fundamental freedoms – the
freedom of establishment – that is most often seen as being breached by the
British tax regime.
From a British perspective the most oft-cited challenge at the ECJ is Marks
& Spencer’s £30m loss-relief claim. A ruling from the ECJ
is expected any day now, and would set the scene for a substantial GLO sitting
in its slipstream.

The loss-relief GLO – whose test claimants include Autologic, BT and Heinz –
is still in the UK courts after HMRC tried to block the claim on a technicality.
Should M&S win, the GLO will almost certainly be referred to Europe.

Perhaps the biggest GLO, however, is based on the potential illegality of the
UK’s advance corporation tax regime.

There are four separate classes in the overall GLO, with Class 1 having
already been won by the taxpayer Deutsche Morgan Grenfell. Class 4 has been
referred to the ECJ while Classes 2 and 3 are at various stages in the UK
courts.

The UK’s thin capitalisation rules have also been challenged
by Volvo, IBM and Pepsi.

The GLO was referred to the ECJ in November 2004 and a trial is likely to be
heard mid-2006.

A fourth GLO challenging the UK’s controlled foreign company
legislation was also referred to Europe in January this year, with Cadbury
Schweppes at the helm. Although more questions will be heard this month the
trial is expected next July.

Two further GLOs have been established.

A franked investment income challenge from companies
including British American Tobacco and Aegis is with the ECJ and should be heard
early next year.

Finally, a foreign income dividend GLO spearheaded by the BT
Pension Scheme was given permission by the High Court in July 2004 – a case
management conference has been scheduled at the High Court for 4 October.

Any decision from the ECJ in favour of the taxpayer would lead to the
Treasury having to rewrite sections of its tax legislation.