ECJ Advisor Hands Companies Qualified Victory In UK Thin Cap Case

by Ulrika Lomas, Tax-News.com, Brussels

03 July 2006

The Advocate General's report on a case involving the United Kingdom's thin capitalisation rules has been hailed by accountants as a victory for common sense which takes into account the commercial perspective whilst providing measures to counter abuse.

The disputes in question centre on UK anti-avoidance rules which seek to limit the extent to which a UK member of a group of companies can be debt-financed by a fellow group company.

The term 'thin capitalisation' is used to indicate that a company has excess debt as opposed to equity funding; multinationals often load up their subsidiaries with debt in order to offset the interest costs against their tax bills.

The rules, which were changed by the UK government in 2004, are being challenged by a number of multinationals including Caterpillar, Pepsi and Volvo in a group litigation order ('GLO'). They argue that the pre-2004 rules discriminated against UK companies with subsidiaryies in other member states.

In an opinion published last week, Advocate General Leendert Geelhoed agreed that the UK thin capitalisation rules were discriminatory until 2004, when they were only applied to borrowing from overseas companies. However, the opinion stated that on the other hand, the rules could, in certain circumstances, be justified on anti-abuse grounds.

“Overall this is a practical opinion," noted Chris Morgan, Head of the EU Law Group at KPMG.

"It recognises that Her Majesty’s Revenue and Customs can prevent UK subsidiaries being stuffed with debt but requires HMRC to accept genuinely arm’s length or commercially driven transactions," he added.

Mr Morgan went on to explain that while the UK thin cap rules employ an arm’s length test, in practice, HMRC often applies and sticks rigidly to ‘rule of thumb’ tests of a 1:1 debt:equity ratio and 3:1 interest cover.

"If the ECJ follows the AG’s opinion, it will strengthen the taxpayer’s hand. This will be particularly welcomed by industries such as private equity where high gearing is normal," he observed.

The Court of Justice follows the opinions of Advocates General in about 80% of cases.

The companies involved in the litigation are hoping to recoup some EUR300 million (GBP200 million) from the UK government in tax refunds, but Geelhoed predicted that his opinion will mean they will recover "considerably less" than this amount.

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