A tax-exempt pension fund trustee claimed repayment of over £8.8m in manufactured overseas dividend withholding tax credits, arguing the UK’s stock lending tax regime restricted free movement of capital contrary to article 63 TFEU. The Supreme Court held there was no breach of article 63 and, alternatively, the remedy claimed was disproportionate.
Background
The respondent, Coal Staff Superannuation Scheme Trustees Ltd (‘the Trustee’), was the corporate trustee of a large tax-exempt pension fund holding substantial portfolios of both UK and overseas shares. Between 2002 and 2008, it engaged in stock lending arrangements whereby it transferred shares to UK-based Authorised UK Intermediaries (‘AUKIs’) under standard Overseas Shares Lending Agreements (‘OSLAs’). Under these agreements, AUKIs paid manufactured overseas dividends (‘MODs’) to the Trustee, equivalent to the net dividend income the Trustee would have received had it retained the shares. The borrower was liable to account for manufactured overseas dividend withholding tax (‘MOD WHT’), calculated as if it had deducted tax from a gross payment. The Trustee’s contractual entitlement was to the net amount. The Trustee received corresponding tax credits but, as a tax-exempt entity, could not utilise them. The Trustee claimed repayment of over £8.8 million in respect of those credits, contending the MOD tax regime constituted a restriction on the free movement of capital contrary to article 63 TFEU.
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The Issue(s)
1. Restriction on Free Movement of Capital
Did the UK’s MOD tax regime, when compared with the treatment of manufactured dividends on UK shares (MDs), create an additional disincentive to investment in overseas shares, beyond the disincentive already created by juridical double taxation, so as to constitute a restriction on the free movement of capital contrary to article 63 TFEU?
2. Justification
If a restriction existed, could it be justified?
3. Remedy
If an unjustified restriction existed, was the Trustee entitled to repayment of the full amount of MOD WHT tax credits as claimed?
The Court’s Reasoning
No Restriction on Free Movement of Capital
The Supreme Court, in a judgment delivered by Lord Briggs and Lord Sales (with whom Lord Reed, Lord Hodge and Lord Hamblen agreed), held that the MOD tax regime did not constitute a restriction on the free movement of capital. The Court agreed with the First-tier Tribunal that the regime was designed to be, and was, tax-neutral with respect to the decision whether or not to lend shares. It found both the Upper Tribunal and the Court of Appeal had erred in their analyses.
The Court emphasised that juridical double taxation — the effect of foreign withholding tax on overseas dividends combined with a tax-exempt investor’s inability to use corresponding tax credits — was a lawful fact of life under EU law, not attributable to any breach by the UK. The critical question was whether the MOD regime created any additional disincentive beyond this.
The Court adopted a ‘but for’ test: would the Trustee have been better off from stock lending absent the MOD regime, such that the regime’s presence could be described as an additional disincentive to acquiring overseas shares?
The Court of Appeal had reasoned that, absent the MOD regime, lenders could have bargained for higher MODs reflecting a share of the borrower’s dividend arbitrage gains. The Supreme Court rejected this analysis as flawed:
The lender’s sharing of the additional benefits generated by the borrower’s use of the lent shares is to be found not in the MOD but in the lending fee, which is tax-free in the hands of an exempt investor like the Trustee, just as are fees for the lending of UK shares.
The Court explained that the standard OSLAs were specifically structured so that MODs precisely replicated the lender’s net dividend income, not to provide any share of borrower benefits. The lending fee was the mechanism through which lenders shared in borrowers’ profits, including from dividend arbitrage. The MOD tax regime imposed no constraint on what lenders could bargain for by way of fees.
There was no market evidence on whether MOD WHT reduced lending fees. HMRC’s unchallenged explanation was that borrowers typically had enough otherwise unusable credits to set off the liability, so the Revenue generally received no cash. That made it difficult to see how the regime could have affected borrowers’ willingness to share profits through the lending fee:
It is no more than pure speculation whether the MOD tax regime made any contribution by way of addition to the existing disincentive for tax-exempt investors to acquire overseas rather than UK shares, constituted by juridical double taxation. Pure speculation of that kind falls well short of the logical inferences which the court may be able to draw under the article 63 jurisprudence, typically in the absence of evidence about dissuasive effect.
Additionally, the Court observed that even on the Court of Appeal’s analysis, dividend arbitrage depended on differences in foreign withholding tax rates — a benefit unavailable in relation to UK shares (the comparator class):
It cannot be a legitimate element of an alleged dissuasive effect upon the free movement of capital that a particular tax regime impedes the generation of an additional benefit which would not be available in any event in relation to the comparator class.
Remedy
The Supreme Court held that even if, contrary to its primary conclusion, the Court of Appeal had been correct to identify a limited breach of article 63, the Trustee’s claim would still fail on remedy grounds. The Court analysed the extended San Giorgio principle as applied in Trustees of the BT Pension Scheme v Revenue and Customs Comrs (BTPS) and concluded that the remedy must be proportionate to the breach identified.
The Court held that MOD WHT was a tax on the AUKI borrower, not on the lender. The Trustee had no contractual entitlement to the gross MOD from which tax was then deducted; its entitlement was only to the net amount. The credit for foreign withholding tax had a substantive effect. The Court distinguished it from the deemed deduction on a gross payment to which the lender had no contractual entitlement. As the Court explained:
Paragraph 4(4) also sought to ensure that no one was misled by the use of the section 349 mechanism in this situation into thinking that the MOD WHT was withheld on account of UK tax payable by the lender.
The Court concluded that the MOD WHT neither impoverished the lender nor enriched the Revenue. Accordingly, there was no basis for full restitution. The only proportionate remedy would have been compensation for the limited economic value of the lost opportunity to share in dividend arbitrage gains — a loss the Trustee had never sought to quantify or prove:
The Trustee has never sought to claim for such a loss and has not presented any evidence to show that in fact it suffered any such loss.
Practical Significance
This decision is significant for several reasons. It clarifies the analytical approach to be taken when assessing whether a domestic tax regime restricts free movement of capital under article 63 TFEU in circumstances where juridical double taxation already operates as a disincentive. The Court endorsed the use of a ‘but for’ test to isolate any additional dissuasive effect attributable to the domestic regime, proceeding against the background of juridical double taxation as a lawful fact of life.
The judgment also limits the scope of the extended San Giorgio principle established in BTPS. While confirming that the principle extends beyond pure restitutionary claims to include situations where a member state fails to make payments (such as tax credits), the Court held that the remedy must be proportionate to the breach. A claimant cannot recover sums far exceeding the economic impact of the identified restriction. This ensures proper balance between EU law rights and the sovereign taxing powers of member states, and avoids undermining the ‘sufficiently serious breach’ threshold for damages claims under the Brasserie du Pêcheur and Factortame principles.
This was a test case. The potential cost to the Revenue if the claim succeeded was said to exceed £600 million. The Supreme Court’s decision resolved the matter in HMRC’s favour on both grounds advanced.
Verdict: The Supreme Court unanimously allowed HMRC’s appeal on two grounds: (i) the MOD tax regime did not constitute a restriction on the free movement of capital contrary to article 63 TFEU; and (ii) alternatively, even if there had been such a breach, the Trustee’s claim for full repayment of MOD WHT credits failed because the remedy sought was wholly disproportionate to any breach identified, and the Trustee had not presented any alternative case or evidence for relief in a lesser amount reflecting such breach.
Reported citations [2022] 1 WLR 2359; [2022] 3 All ER 335; [2022] STC 776; [2022] BTC 14; [2022] WLR 2359
