UK manufactured overseas dividend scheme not contrary to EU law

The First Tier Tax Tribunal (FTT) has held that the UK’s manufactured overseas dividend (MOD) regime, as it operated until 2014, was not contrary to the free movement of capital: Coal Staff Superannuation Scheme Trustees Ltd v HMRC [2016] UKFTT 450. The Tribunal considered that the operation of the regime did not restrict the freedom of capital movement and, even if the Tribunal was wrong in that conclusion, any restriction was justified and proportionate.

In essence, the Tribunal accepted that the scheme replicated the effect that foreign withholding tax would have on the holding of overseas shares and considered that in those circumstances the rules did not make the acquisition of overseas shares less attractive than UK shares (on which no withholding tax was levied). The decision raises a number of novel points, however, and it appears far from certain that another court would not take a different view on these issues.

Background

The Appellant Trustees were responsible for managing the British Coal Staff pension scheme. The reclaimed repayment of withholding taxes in connection with stock lending transactions entered into in tax years 2002/3 to 2007/8. The stock lending transactions typically required the borrower of the shares to make a payment equivalent to any dividends received on the shares during the period of the stock lending (a manufactured dividend).

Under UK law a payment of a manufactured dividend on a stock loan of UK shares was not subject to tax, but a payment of a manufactured dividend on overseas shares (an MOD) was subject to UK withholding tax where an actual payment of a dividend on the overseas shares would have been subject to withholding tax in the country of origin. This withholding tax could be recovered by a UK taxpayer, however the pension fund was exempt from UK tax and, as such, was unable to claim credit for the MOD withholding tax.

The Trustees contended that the UK rules applying MOD withholding tax were contrary to the free movement of capital and claimed a repayment on the basis that the UK withholding tax was illegal.

Free movement of capital

The Tribunal accepted that the investment by a fund in overseas shares was an exercise of the free movement of capital. The Trustees argued that the UK scheme of taxation dealing with MOD rendered the exercise of this freedom less attractive than investing in UK shares, which were not subjected to withholding tax when subject to a stock lending transaction. Clearly one of the rights associated with share ownership was the right to lend the shares and as such the MOD scheme impinged adversely on ownership rights of overseas shares in a way that it did not in relation to UK shares.

The Tribunal, however, rejected this argument. The Tribunal pointed out that it could not be said that a pension fund would be dissuaded from investing in overseas shares as compared with UK shares due to the MOD scheme. This was because income from overseas shares suffers a withholding tax for which the UK does not give credit to a pension fund, whether or not that income arises in respect of actual dividends or manufactured overseas dividends. UK credit in respect of actual foreign withholding tax on dividends would not be available to a tax exempt pension scheme and such treatment is not contrary to EU law (it is simply caused by the other jurisdiction’s decision to impose withholding tax).

The MOD regime was directed towards ensuring that the recipient was taxed in the same way as if it had received the underlying dividend. In effect, therefore, the Trustees’ claim was for tax treatment more advantageous on its MOD income than on an actual dividend had it not lent the shares. To focus the argument on the MOD and ignore the underlying tax treatment of the dividends themselves, as the Trustees did, was incorrect. The only factor which might persuade a pension scheme from acquiring overseas shares was the existence of a foreign withholding tax for which it could not claim credit because its investment as a whole was exempt from UK tax. To look at the MOD scheme in isolation was not the correct approach.

Justifications

In case it was wrong on its main conclusion that the imposition of UK withholding tax on MOD was a restriction on the free movement of capital, the Tribunal went on to consider if the restriction could be justified. On this issue, the Tribunal considered that HMRC would also succeed.

Firstly, the Tribunal considered that the imposition of withholding tax was justified by the need to preserve the balanced application of taxing rights between Member States together with the need to prevent avoidance. The UK had agreed to relieve juridical double taxation in the form of withholding taxes by giving credit, but not to exempt pension funds. The MOD regime was designed to maintain that position and prevent tax avoidance by using lending arrangements to side-step such treatment. This was not tax avoidance in the “wholly artificial” sense, but the Tribunal accepted that in the context of the need to maintain the balanced allocation of tax rights, tax avoidance of the straightforward type involved in this case was sufficient to engage the justification.

Secondly, the Tribunal also accepted that the UK could rely on the defence of fiscal cohesion first expounded in Bachmann. The Tribunal was satisfied that there is a direct link between the right of the UK counterparty to obtain credit for foreign withholding tax and its obligation to withhold UK under the UK MOD scheme. As such, the MOD scheme matched the tax advantage and tax liability exactly.

Comment

This is a case that raised a number of novel issues concerning the application of the fundamental freedoms to direct taxes. As such, perhaps it is not surprising that the decision of the FTT in this case appears to contain a number of elements which may give the claimants cause for optimism on any appeal.

The decision to equate the UK withholding tax with the foreign withholding tax which would have been suffered if the shares had not been lent is perhaps controversial. The MOD was, after all, not an item of income which was itself taxed by the overseas jurisdiction and, as such, the decision of the UK to apply a withholding tax to an overseas dividend but not a UK manufactured dividend would, on its face, clearly appear to involve a restriction. As such, perhaps the real issue should have been whether the restriction could be justified.

On that point, the decision to accept the Bachmann justification is also something of a surprise. The Bachmann defence has been raised on numerous occasions but very rarely succeeded in subsequent case law. In particular, the decision to accept the defence in this case would appear to fail the test that the tax and the countervailing benefit should apply in relation to the same taxpayer (as the benefit here arguably applies to the intermediary, rather than the tax exempt fund).

Equally, the decision of the Tribunal on the balanced application of taxing rights may be open to criticism. After all, the withholding tax on MODs was a quite separate UK tax levy, distinct from any foreign withholding tax.

This may be a case in which the Tribunal has gone out of its way to reach what felt like the “right” conclusion. However, the long history of UK tax cases engaging the fundamental freedoms indicates that what feels “right” is often not a good indicator of the correct approach under EU law.