08 Nov 2019

Coal Staff Superannuation Scheme Trustees Ltd v Revenue and Customs Commissioners

Having found itself in an intriguing space between UK and Italian tax regimes, the pension fund at British Coal inadvertently found itself testing principles by which UK tax law impinged upon the freedom of movement of capital set out in the Treaty on the functioning of the European Union (EU). 

What are the practical implications of this case?

The Manufactured Overseas Dividends (MOD) regime, which the court has found amounted to an unjustified restriction on the freedom of movement of capital under EU rules, ceased to apply in 2014.

However, there was around £900m at issue for the historical impact of the regime on UK-registered pension scheme trustees (and any other entities which are not liable to income tax on investment income) who engaged in stock lending subject to the regime.

Practically, therefore, any UK-registered pension scheme trustees should confirm with their investment advisers whether they entered into stock-lending arrangements before 2014 and were negatively affected by the MOD regime. If so, they may be due a payment from HMRC in respect of those amounts.

It is similar in many ways to the position following the case of C-628/15 (Trustees of the BT Pension Scheme v Revenue and Customs Commissioners [2018]) where the EU Courts found that foreign investment dividends had to be treated in the same way as UK dividends.

What was the background?

One of the requirements for a working stock market is that there are shares available to meet trading requirements, particularly around such transactions as settling trades, short selling and dividend arbitrage.

One way that many trustees make some additional revenue for their schemes is by lending elements of their stock portfolios to support these systems. Legal title to the stocks loaned by the trustees passes to the borrower who may well need to buy stock to return to the trustee when the loan expires.

The main benefit to trustees of engaging in these sorts of stock-lending arrangements is a fee for entering into the agreement (plus a functioning stock market system given the need for settling trades at least). Additionally, most agreements provide that where a dividend would have been paid on the lent stock in the relevant period, the entity borrowing the stock will pay the equivalent of that dividend to the trustees.

Depending on whether the dividend related to a company based in the UK or abroad, HMRC referred (at the material time) to them as Manufactured Dividends (MDs) and Manufactured Overseas Dividends (MODs) respectively.

Treatment under the tax rules at the time varied depending on whether the trustees received an MD or an MOD.

Trustees who received an MD would receive the value of the MD in full as it was treated by HMRC as an actual dividend, and UK dividends are not subject to withholding (section 736A and Schedule 23A of the Income and Corporation Taxes Act 1988 (ICTA 1988), as it then was). This fitted with the legal position of registered pension scheme trustees in respect of investment income—generally they will not be liable to tax as the UK pensions system is an EET system (exempt from tax on payments into the scheme (within limits), exempt from tax on investment returns, and taxed only when the member takes benefits as income or a lump sum (subject to the 25% tax-free lump sum) (section 592(2) of ICTA 1988 (as it then was) and section 186(1) of the Finance Act 2004)).

However, a trustee receiving a MOD was treated differently. Paragraph 4 of Schedule 23A to ICTA 1988, required that the borrower withheld an amount equivalent to the headline rate of withholding tax applicable in the relevant jurisdiction (in this case, Italy and 15% respectively) from the amount paid to the trustee. This was the case even when the actual rate of withholding tax in the jurisdiction was lower than the headline rate, which was entirely possible under Italian law.

This resulted in the trustee receiving a reduced sum in respect of the MOD despite registered pension schemes being exempt from the relevant tax under UK law on UK dividends and MDs (and not being directly liable for the withholding amount on the MOD).

Had tax rules treated the withheld amounts as an amount ‘withheld in respect of income tax’, the trustee would have been able to claim a tax rebate, thereby ending up with the full amount of the MOD despite withholding. However, tax rules stated that the amount was ‘withheld on account of overseas tax’ which only generated an income tax offset. For the trustee this was worthless as it had no tax liability to offset the credit against.

In summary, in respect of a payment in respect of a missed dividend of £100:

  • a trustee receiving an MD in respect of a UK company would receive £100
  • a trustee receiving an MOD in respect of an Italian company would receive £85, plus a (worthless) £15 tax offset. The borrower, as an ‘approved United Kingdom intermediary’ (AUKI), was able to claim a tax credit for the tax withheld

This difference in treatment was a potential breach of the freedom of capital movement rules set out in the EU Treaties through what was effectively double taxation.

If the tax measures were ‘liable to discourage’ UK trustees from investing in other EU countries (given they would end up with less money from these manufactured dividends from an EU company as opposed to a UK one), then it was a ‘restriction’ under the Treaties (Articles 63–66 of the Treaty on the Functioning of the EU (TFEU)).

Such a restriction could still be acceptable if it was a ‘juridical’ form of double taxation (taxation of income twice in the hands of the same taxpayer), which the EU Courts have accepted as being incapable of objection given that each state sets its own corporation tax rates outside the EU framework. However, it would not be acceptable if it were ‘economic’ double taxation, which is taxing the same income twice in the hands of different taxpayers, unless it could be objectively justified under the relevant principles of EU law.

Objective justification would require HMRC to show that the restriction:

  • pursued a legitimate objective compatible with TFEU
  • was justified by imperative reasons in the public interest, and
  • ensured the attainment of the objective thus pursued and did not go beyond what was necessary to attain it.

HMRC had won at the First-tier Tax Tribunal (which held that the MOD regime was not a restriction at all, but that if it was, it was justified under EU law) but had lost on appeal at the Upper Tribunal (which held that there was a restriction, and that it was not justified). This led to the current Court of Appeal case in which the court was asked:

  • did the MOD regime amount to a ‘restriction’ on the movement of capital
  • if so, was the restriction justified
  • if not, what remedy should be granted to the trustee.

What did the court decide?

The court found that:

  • the MOD regime did represent a restriction contrary to Articles 63-66 of TFEU
  • the restriction was not justified under EU law
  • as a remedy, ICTA 1988 should be read as if paragraph 4(4) of Schedule 23A (which created the UK tax liability which caused the breach of EU freedom of movement of capital rules) did not apply to the trustees of registered pension schemes or any entity which was not liable to tax on these sorts of transactions.

Was there a restriction?

HMRC had argued that there was no restriction on the movement of capital as the MOD regime did not affect the trustee's net return. Had the MOD regime not existed, the trustee would still only have received the MOD minus the appropriate foreign withholding (which, in this case, was a matter for Italy). Also, MDs and MODs were treated the same in that they were both exempt from income tax for trustees.

HMRC had also argued that rather than a tax-collecting exercise, the MOD regime was ‘a bespoke mechanism to pass the double tax credit to the right place’. It also pointed out that HMRC had not in fact collected £8m from the trustee's stock lending as the trustee claimed.

The court was not impressed with these arguments and pointed out the fatal flaw in HMRC's reasoning—that the MOD regime did not actually apply the level of withholding in the relevant jurisdiction, it applied a notional rate based on headline rates in that jurisdiction (even where that headline rate might not apply in a particular case). That made it a UK measure and one that had no real sense to it. It also meant that this was not a ‘juridical double taxation’ matter.

Was the restriction justified?

On justification, HMRC argued two points:

  • the need to ensure the balanced allocation of the taxing powers of Member States, and
  • the need to ensure fiscal cohesion.

HMRC's argument on the first point was that the MOD regime just implemented the double taxation regime agreed with Italy—Italy took its 15% and the UK could tax anything above that as long as it gave a tax credit for Italian withholding. If HMRC allowed a tax credit for the borrower and the trustees to claim the 15% back, there would be a double tax credit.

It also tried to argue tax avoidance issues and suggested a scenario where a pension fund could lend its shares to a taxable person just before the date when the dividend was declared, the taxable person claim a tax credit for the withholding tax in Italy, and then return the shares plus the MOD to the scheme and split the tax credit to the benefit of both and the detriment of the Exchequer.

The court dismissed these arguments, saying that HMRC's MOD regime did not actually address either issue. As the amount of the withholding and the amount deducted from the MOD were not necessarily the same, this was clearly a domestic tax issue. It also was difficult to argue that it was aimed at tax avoidance given that trustees do not pay income tax anyway. All it did was to prevent a tax-exempt person getting a refund of UK tax on a legitimate cross-border transaction.

It then pointed out that the EU Courts had held that such an anti-avoidance measure would need to be targeted at artificial arrangements and to provide for a method of making representations to explain how the measure was actually legitimate. The MOD regime did not do this.

Regarding HMRC's suggestion that fiscal cohesion required the MOD regime, the court found that this was a tough ask as under EU case law there needs to be a direct link between the tax advantage conferred and the corresponding tax levy which comprised the restriction. This was not true of the MOD regime.

What remedy applied?

Having lost down the line on restriction and justification, HMRC turned to the actions of the court and argued that in Schedule 23A of ICTA 1988 the provisions dealing with the tax treatment for the borrower (paragraph 4(2)) and those applicable to the trustee as lender (paragraph 4(4)) were so interlinked as to be impossible to remove one without removing the other—otherwise creating a windfall for the trustee.

As became a recurring theme in this case, the court disagreed stating that it would use its powers to make the provision conform to EU law to read out paragraph 4(4) for tax exempt entities like the trustee, leaving paragraph 4(2) in place. It based this on its reading of EU case law (which was uncontroversial). By removing paragraph 4(4), it simply removes the UK taxing provision on the trustee which contravenes the principle of EU freedom of capital movements. The trustee has a right to recover unlawfully levied tax.

The provisions of paragraph 4(2) did not offend against that principle and so could stay.

  • the MOD regime did represent a restriction contrary to Articles 63-66 of TFEU
  • the restriction was not justified under EU law
  • as a remedy, ICTA 1988 should be read as if paragraph 4(4) of Schedule 23A (which created the UK tax liability which caused the breach of EU freedom of movement of capital rules) did not apply to the trustees of registered pension schemes or any entity which was not liable to tax on these sorts of transactions.

First published in LexisNexis: Manufactured Overseas Dividends (MOD) regime amounted to unjustified restriction on freedom of capital under EU rules (Coal Staff Superannuation Scheme Trustees Ltd v Revenue and Customs Commissioners) [21 October 2019]