The Supreme Court held that a UK company receiving overseas portfolio dividends must be given a tax credit by reference to the foreign nominal rate of tax, not only the tax actually paid overseas, so as to match the exemption given to domestic dividends. It rejected a general claim to compound interest in unjust enrichment for the Revenue’s use of unlawfully levied tax, and held that lawfully charged advance corporation tax cannot be recovered in restitution merely because it was set against an unlawful mainstream corporation tax charge.
Why the tax treatment was unlawful
Prudential Assurance Company Ltd (PAC) was a UK-resident company receiving dividends on overseas “portfolio” holdings, usually much less than 10% of the overseas company’s share capital. From 1990 to 1 July 2009, a dividend paid by one UK-resident company to another was exempt in the recipient’s hands under section 208 of the Income and Corporation Taxes Act 1988. Corporation tax was charged once, on the company that earned the profit. A dividend from an overseas company was in principle taxable. Relief for foreign tax on the underlying profits was available, by treaty or under section 790, only where the UK company controlled a significant share of the voting power, typically 10%. Portfolio holdings received no such relief. Until 6 April 1999, advance corporation tax (ACT) was also charged when a UK company paid a dividend, and could later be set against its mainstream corporation tax (MCT).
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Following decisions of the Court of Justice, it was common ground that this treatment breached article 63 of the FEU Treaty on free movement of capital. Henderson J had held that the remedy was an appropriate tax credit, not a complete exemption from UK tax. HMRC accepted that corporation tax charged because of the incompatibility had to be repaid. The dispute was how large the credit should be, and what else could be recovered.
The foreign tax credit
HMRC said the credit should reflect only tax actually paid overseas. PAC said it should be calculated by reference to the foreign nominal rate: the headline statutory rate in the source state.
Earlier Court of Justice rulings had accepted a mixed system — exemption for domestic dividends, and a credit for tax actually paid on foreign dividends — where UK effective and nominal rates did not significantly diverge. Later UK proceedings showed that the effective rate was commonly below the nominal rate, for example because of group relief or losses carried forward. Exempting a domestic dividend therefore gave relief as if tax had been paid at the full nominal rate, even when it had not. Crediting only tax actually paid overseas left the foreign dividend worse off.
In a later judgment in the franked investment income litigation, the Court of Justice treated a credit by reference to the nominal rate as an acceptable alignment of the two. Lord Mance, Lord Reed and Lord Hodge, with whom Lord Sumption and Lord Carnwath agreed, held that this applied to portfolio holdings as well as to larger holdings. There was no principled distinction, for this purpose, between a holding that confers control and a smaller one.
The Court noted a reservation. A UK recipient may itself be taxed at an effective rate below the nominal rate, so a nominal-rate credit can sometimes remove UK tax that a comparison of effective rates would still leave in charge, and can favour the overseas dividend. The Court of Justice had accepted that the solution would not remove every inequality, and had rejected a full comparison of the two tax systems as impractical. A further reference was not justified.
Two further questions were not open: whether one looks only at the overseas company that paid the dividend or also at the companies that earned the underlying profits, and whether a difference between UK effective and nominal rates had been shown. The Court of Appeal had refused permission to argue either point. Because the credit is given by reference to the foreign nominal rate, PAC’s fallback argument — disapplying the UK charge, or using nominal or consolidated rates as a proxy if tax actually paid could not be proved — did not arise.
Compound interest
PAC claimed compound interest in unjust enrichment on unlawfully levied tax and on the time value of ACT. HMRC had already accepted compound interest, following the House of Lords in Sempra Metals, for unlawfully levied ACT later set off against lawful MCT, for the period until set-off. The dispute concerned other unlawfully levied tax, and the time value after set-off. Across related cases, HMRC estimated the difference between simple and compound interest at of the order of £4–5 billion.
The Court departed from the unjust-enrichment reasoning in Sempra Metals. A mistaken payment transfers one item of value: the money. The recipient’s opportunity to use it is a consequence of that payment, or of failing to repay the resulting debt, not a separate transfer from the payer. Repayment of the sum restores the opportunity to use it. If repayment is delayed, section 35A of the Senior Courts Act 1981 can award simple interest as compensation for being kept out of money that was legally due. Failure to pay a debt is not itself an unjust enrichment. EU law requires an adequate indemnity, but, as this Court had held in Littlewoods, simple interest can meet that requirement.
The claims to compound interest were therefore rejected, apart from the category HMRC had already conceded. Read literally, section 35A does not apply where the sum was set off before proceedings began. The Court recorded that EU law still requires interest in that situation, but did not decide how it should be awarded.
Lawful ACT set against unlawful MCT
The Court gave HMRC permission to argue whether restitution lies to recover “lawful” ACT set against “unlawful” MCT. Lawful ACT is ACT still due after the domestic exemption and the foreign nominal-rate credit. Unlawful MCT is the part of the MCT charge caused by the failure to give that credit.
The Court held that no such restitutionary claim lies. An unlawful MCT charge is a nullity. Lawful ACT cannot be set against a nullity. It remains available to be carried back, carried forward, surrendered, or set against lawful MCT. It was lawfully due when paid, so its payment was not a defective transfer of value. PAC’s loss came from the unlawful MCT and from both sides’ misunderstanding of the law, which meant the ACT was not used as it could have been. That may matter to a damages claim if the conditions for damages are met. It does not support restitution. The Court was told that PAC’s returns for 1994 to 1998 were still open, so carry-forward might still be possible, but it did not decide that question of fact.
Allocating mixed ACT and franked income
The Court also gave PAC permission to argue two connected questions. Where a pool contained both lawful and unlawful ACT, and was treated as set against an MCT liability that was partly unlawful, the unlawful ACT is treated as used first against the unlawful MCT, not split pro rata. Both unlawful charges are nullities, so the unlawful ACT is recoverable unless it has been set against lawful MCT. Any left over is treated as used against lawful MCT, and the company then has a claim for interest on that sum.
Where domestic franked investment income received in a later quarter was carried back to an earlier quarter, it is treated as having relieved only lawful ACT. Any excess remained available to be carried forward. A pro rata split would use lawful UK franked income to cancel part of the foreign tax credit required by EU law. If £100 of ACT was paid in a quarter in which a £25 credit ought to have reduced the lawful ACT to £75, and £75 of domestic franked income was later carried back, attributing a quarter of that £75 to the unlawful ACT would cancel £18.75 of the credit.
The parties disagreed on facts that might affect how these rulings are applied. The Court left those matters for further submissions.
Verdict: HMRC succeeded on compound interest, subject to its concession, and on the claimed recovery of lawful advance corporation tax set against unlawful mainstream tax. Prudential succeeded on the nominal foreign tax rate and on treating unlawful advance tax as used first against unlawful mainstream tax. Its fallback cross-appeal did not arise. Carried-back franked income relieved lawful advance tax. Questions about applying those rulings to the facts remained.
