Finance: European justice gives taxing time to the Revenue

LAST MONTH, Austria began its presidency of the European Union by pledging to push for greater harmonisation of direct taxes across Europe in advance of the single currency. The European Commission has set 2001 as the implementation date for its definitive pan-European VAT system, which requires increased harmonisation in the indirect tax field.

Yet many people are unaware of just how real the impact of EU law already is on the UK corporation tax system. It is not directives from Brussels that are the force for change - it is the 15 judges of the European Court of Justice (ECJ) in Luxembourg. Last month, in the space of three days the Court handed down two landmark judgements concerning the UK tax system. The "First National Bank of Chicago" case involved the VAT treatment of foreign exchange payments, while the "ICI" case concerned consortium relief. UK tax law was found wanting on both occasions, and companies will be able to reclaim many millions of pounds.

The UK government always realised that, in introducing VAT, it could expect the ECJ to pass judgement on its implementation of that law. But the ICI case concerned the UK corporation tax system and to see the ECJ rule that the UK violates EU law in that area must be more disturbing for the Government. Disturbing, yes, but not surprising. The first corporation tax case heard at the ECJ was in 1986, and the French government lost that case. Yet governments and revenue authorities around Europe have largely ignored the impact of EU law on corporate taxes. In 1993 the UK government lost its first direct tax case at the ECJ.

There have now been 15 cases at the ECJ which have examined whether direct tax laws are compatible with the EC Treaty. This is somewhat surprising as the Treaty itself says virtually nothing on corporation and income taxes. No member state prior to 1986, and certainly not the UK, viewed direct taxes as within the EC sphere of competence. However, no one counted on the ECJ pointing out that tax rules which restrict companies freedom to establish subsidiaries or branches, or render services within the EU could violate the EC Treaty.

What the ECJ has made clear in recent cases is that, if the Inland Revenue applies a less beneficial tax rule to the UK operations of a branch or a subsidiary of a group based in another member state, compared to the tax rule for similar operations of a UK company, then such a rule may be held to be discriminatory and, unless justified, will be contrary to the EC Treaty. In the ICI case, the ECJ has held that if a tax rule makes it more difficult for a UK company to do business in another member state, then that may also violate EU law.

The ICI case is another vivid reminder that tax rules of member states must not restrict the ability to provide services across the EU. Companies must look further than just UK tax legislation to determine what tax treatment should be accorded to the cross-border provision of services, and for cross-border investments within the EU.

For the Revenue, the position is difficult. In the ICI case, they saw their defence of a discriminatory tax rule laid bare. It will no longer do to say that the rule is necessary to raise revenue to balance the UK budget. The Revenue have a choice. They can either ensure that the UK legislation is reviewed to remove distortions in the tax system that deter investment in the EU compared to UK investment, or see the UK tax system taken apart by the ECJ.

However, it is not all bad news for the UK tax authorities. Other member states are equally affected by ECJ rulings - if, for example, the UK law preventing excessive interest deductions was found to be contrary to EU law, then such a ruling would prevent other EU states applying similar rules. The UK has significant inward investments and may expect to lose revenue as profits are paid out as tax deductible interest. But the UK is also an outward investor, and UK companies may equally like to fund their investment in other EU member states by way of interest, thus creating UK taxable profits.

With the ECJ due to give many more rulings on direct taxes, companies must look increasingly to Luxembourg, as well as Brussels, for the latest developments on tax harmonisation. Knowledge of the UK tax law is no longer sufficient.

The writer is an international tax director at KPMG