England and Wales Court of Appeal (Civil Division) Decisions

IN THE HIGH COURT OF JUSTICE
COURT OF APPEAL (CIVIL DIVISION)
ON APPEAL FROM THE HIGH COURT OF JUSTICE
CHANCERY DIVISION
MR JUSTICE HENDERSON
[2009] EWHC 2908 (Ch)

		Royal Courts of Justice Strand, London, WC2A 2LL
		18/02/2011

Lord Justice Stanley Burnton :

Introduction

1. On 17 November 2009, Henderson J gave judgment on preliminary issues in claims made by the Test Claimants in the Thin Cap Litigation against the Commissioners for Her Majesty's Revenue and Customs (to whom I shall refer as "the Revenue"). His judgment is reported on BAILII and at [2010] STC 301. Both the Claimants and the Revenue have appealed against those of his decisions that were adverse to their respective cases.
2. As in the case of The Test Claimants in the Franked Investment Income Group Litigation v The Revenue [2010] EWCA Civ 103, the Claimants in the present case contend that provisions of UK corporate tax legislation (in the present case, those in force until 2004) were incompatible with a fundamental freedom conferred by the EC Treaty. In that case too the judge at first instance was Henderson J. As in that case, his judgment in the present case is careful, clear and detailed. I express my admiration and gratitude for it, and I have been able to incorporate much of it in my judgment.

What is "thin cap" legislation?

3. "Thin cap" is an abbreviation of "thin capitalisation". Like transfer pricing legislation, thin cap legislation seeks to address what the Revenue considers to be transfers of profits, and therefore transfers of tax bases, from this jurisdiction to another. The subject was explained by Advocate General Geelhoed in the reference for a preliminary ruling in the present case to the Court of Justice of the European Communities ("the ECJ"):

3. There are two principal means of corporate finance: debt and equity finance. Many Member States draw a distinction in the direct tax treatment of these two forms of finance. In the case of debt finance, companies are generally permitted to deduct interest payments on loans for the purpose of calculating their taxable profits (i.e., pre-tax), on the basis that this constitutes current expenditure incurred for the pursuit of the business activities. In the case of equity finance, however, companies are not permitted to deduct distributions paid to shareholders from their pre-tax profits; rather, dividends are paid from taxed earnings.

4. This difference in tax treatment means that, in the context of a corporate group, it may be advantageous for a parent company to finance one of the group members by means of loans rather than equity. The tax incentive to do so is particularly evident if the subsidiary is located in a relatively "high-tax" jurisdiction, while the parent company (or indeed an intermediate group company which provides the loan) is located in a lower-tax jurisdiction. In such circumstances, what is in substance equity investment may be presented in the form of debt in order to obtain a more favourable tax treatment. This phenomenon is termed "thin capitalisation". By thus manipulating the manner in which capital is provided, a parent company can effectively choose where it wishes profits to be taxed.

5. Many States, viewing thin capitalisation as abusive, have implemented measures aimed at countering this abuse. These measures typically provide for loans which fulfil certain criteria to be regarded for tax purposes as disguised equity capital. This means that interest payments are recharacterised as profit distributions, so the subsidiary cannot deduct all or part of the interest payment from its taxable income, and the payment is subject to any applicable rules on dividend taxation.

4. For present purposes, two forms of tax avoidance may be regarded as paradigms. The first is appropriately referred to as thin cap, and is that referred to in the extract from the Advocate General's opinion cited above. The second paradigm involves a loan by the parent company (or another non-UK subsidiary) of an appropriate amount, but setting a rate of interest in excess of that which would be agreed between unconnected parties. By setting and paying an excessive interest rate, the profits of the subsidiary are excessively reduced. The aim of thin cap legislation would be to treat the interest as if it were payable at a reasonable rate, and to disallow the excess as a deduction from the gross profits of the subsidiary.
5. Abuses of the kind referred to above have long been recognised, and not surprisingly thin cap legislation is common internationally. However, abuse in the sense of deliberate evasion of tax is not the only possible object of thin cap legislation. Another is the regulation and preservation of the national tax base. In this connection, it is useful to refer to Article 9 of the OECD Model Convention with respect to Taxes on Income and Capital:

ASSOCIATED ENTERPRISES

1. Where

a) an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or

b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State,

and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.

6. It can be seen that Article 9 is not confined to deliberately abusive transactions. It applies a simple arm's length test to transactions between related companies. This test, commonly found in national legislation, was clearly regarded as appropriate by the 33 Member States of the OECD.
7. The difficulty in framing thin cap legislation within the EU is that the problem it seems to address is generally confined to international groups of companies. Generally, for a UK parent to set an excessive interest rate on its lending to its UK subsidiary will be tax neutral. In principle, the excessive interest received by the parent will be taxed in its hands at the same rate as it would have been had it not been payable by the subsidiary and had therefore not been taken into account in assessing its taxable profits. (For present purposes, I leave out of account the possibility that the parent has allowances or accumulated losses that it can set against its profits.) If, however, the excessive interest is payable to a foreign company, without appropriate thin cap legislation the consequence is that the UK tax base is reduced by the amount of that excess. It is therefore generally pointless to extend thin cap legislation domestically, and to do so imposes unnecessary administrative burdens on domestic companies and on the Revenue. However, if the legislation is confined to international transfers, it is necessarily discriminatory, and there is a risk of it being held unlawfully to interfere with a basic freedom conferred by the EC Treaty, and specifically Articles 43, 49 and 56. The cases in which the ECJ has considered thin cap legislation highlight the tension, if not the inconsistency, between national jurisdiction over direct taxation and EC Treaty freedoms, at least once those freedoms are interpreted as prohibiting unjustified differential tax treatment of national and foreign EU companies.

The UK tax rules

8. The UK tax rules were helpfully summarised by Henderson J in his judgment.

The rules applicable until 1995

18. Prior to their amendment by the Finance Act 1995, the main relevant domestic provisions were contained in s.209(2) of the Income and Corporation Taxes Act 1988 (ICTA).

19. Section 209(2)(d) provided that any interest paid by a company on a loan which represented more than a reasonable commercial return on the loan was to be regarded as a distribution of profits to the extent that it exceeded such return. The provision was in the following terms:

"(2) In the Corporation Tax Acts 'distribution', in relation to any company, means –

…

(d) any interest or other distribution out of assets of the company in respect of securities of the company, where they are securities under which the consideration given by the company for the use of the principal thereby secured represents more than a reasonable commercial return for the use of that principal, except so much, if any, of any such distribution as represents that principal and so much as represents a reasonable commercial return for the use of that principal."

"Security" was defined in s.254(1) as including securities not creating or evidencing a charge on assets, and it was also provided that interest paid by a company on money advanced without the issue of a security for the advance, or other consideration given by a company for the use of money so advanced, should be treated in the same way as if a security had been issued. So the scope of the paragraph extended to simple unsecured loans.

20. The effect of this provision was that the excess amount was not deductible as interest in computing the company's taxable profits, but was treated as a distribution (or in other words a dividend) paid out of post-tax profits. The fact that the excess interest was treated as a distribution also meant that the company was liable to pay advance corporation tax (ACT) under s.14 of ICTA on making the payment.

21. Section 209(2)(d) applied without distinction to payments made to both resident and non-resident lenders. However, s.209(2)(e)(iv) and (v) laid down a further rule which in effect treated as a distribution any interest (other than interest already treated as a distribution under para. (d) ) paid to any lender not resident in the United Kingdom which was a member of the same group of companies, as defined in the legislation. Accordingly, under the domestic provisions applicable until the legislation was amended in 1995, interest payments made by a UK-resident company to another group member (as defined) outside the United Kingdom were always treated as a distribution, even where the interest represented a reasonable commercial return on the loan.

22. However, the position under the domestic provisions had to be read subject to the arrangements in certain DTCs [Double Taxation Conventions] which prevented the application of these rules and thus ensured that the interest was allowed as a deduction from profits for tax purposes in certain circumstances. By virtue of s.788(3) ICTA such arrangements had effect, notwithstanding any provisions to the contrary in domestic UK legislation, in so far as they provided for relief from corporation tax in respect of income or chargeable gains, or for determining the income or chargeable gains to be attributed to persons not resident in the United Kingdom (and their agencies, branches or establishments in the United Kingdom), or to persons resident in the United Kingdom who had special relationships with persons not so resident. In other words, where and in so far as provisions contained in a DTC were given effect in UK domestic law by s.788(3), they prevailed over any provisions in domestic tax legislation which were inconsistent with them.

23. The wording of the relevant provisions in the United Kingdom's DTCs varies, but broadly they fall into two categories.

24. The first category of provisions, which are based on the original draft of the OECD (the Organisation for Economic Co-operation and Development), focus on whether the interest rate is commercial having regard to the amount of the debt. They do not enquire whether the amount of the debt itself is commercial. Such provisions are to be found, for example, in the treaties concluded with Luxembourg, Japan, Germany, Spain and Austria. Article 11(7) of the treaty with Luxembourg may be taken as typical:

"Where, owing to a special relationship between the payer and the recipient or between both of them and some other person, the amount of the interest paid, having regard to the debt-claim for which it is paid, exceeds the amount which would have been agreed upon by the payer and the recipient in the absence of such relationship, the provisions of this article shall apply only to the last-mentioned amount. In that case, the excess part of the payments shall remain taxable according to the law of each Contracting State, due regard being had to the other provisions of this Convention."

25. The second category of provisions involve a more general enquiry into whether the amount of the interest exceeds for any reason what would be paid on an arm's length basis. This includes the question whether the amount of the loan itself exceeds the amount which would have been lent on an arm's length basis. Such provisions are to be found, for example, in the treaties concluded with the United States, the Republic of Ireland, Switzerland, the Netherlands, France and Italy. Article 11(5) of the treaty with the United States may be taken as typical:

"Where, owing to a special relationship between the payer and the person deriving the interest or between both of them and some other person, the amount of the interest exceeds for whatever reason the amount which would have been paid in the absence of such relationship, the provisions of this article shall apply only to the last-mentioned amount. In that case, the excess part of the payments shall remain taxable according to the law of each contracting state, due regard being had to the other provisions of this convention."

26. The critical difference lies in the contrast between the words "for whatever reason" in the second category of treaty provisions, and the words "having regard to the debt-claim for which it is paid" in the first category. The broader scope of the second category of treaty provisions was confirmed by s.808A of ICTA , which was inserted by s.52 of the Finance (No.2) Act 1992. Section 808A(2) said that the special relationship provision, in treaties of this type, should be construed as requiring account to be taken of all factors, including:

"(a) the question whether the loan would have been made at all in the absence of the relationship,

(b) the amount which the loan would have been in the absence of the relationship, and

(c) the rate of interest and other terms which would have been agreed in the absence of the relationship."

Subsection (3) then provided that the special relationship provision should be construed as requiring the taxpayer to show that there was no special relationship, or (as the case might be) to show the amount of interest which would have been paid in the absence of the special relationship. These provisions apply to interest paid after May 14, 1992.

27. Section 808A was not itself overridden by s.788(3), because it is contained in the same part of ICTA ( Pt XVIII ) as s.788 , and s.788(3) is itself made "[s]ubject to the provisions of this Part". Accordingly s.808A had the effect of modifying the interpretation of the terms of DTCs in the manner which it provided.

The 1995 amendments

28. The domestic thin cap provisions were amended by the Finance Act 1995 with effect, generally, for interest paid after November 28, 1994. Section 209(2)(d) of ICTA remained unaltered. Section 209(2)(e)(iv) and (v) were, however, repealed and replaced by s.209(2)(da) . Under this provision, interest paid between group members (as defined) which exceeded an amount that would have been paid on an arm's length basis was to be treated as a distribution. However, under s.212(1) and (3) , as amended, s.209(2)(da) did not apply if the payer and the recipient of the interest were both within the charge to UK corporation tax.

29. Section 209(2)(da) provided:

"(2) In the Corporation Tax Acts 'distribution', in relation to any company, means –

…

(da) any interest or other distribution out of assets of the company ('the issuing company') in respect of securities issued by that company which are held by another company where –

(i) the issuing company is a 75 per cent subsidiary of the other company or both are 75 per cent subsidiaries of a third company, and

(ii) the whole or any part of the distribution represents an amount which would not have fallen to be paid to the other company if the companies had been companies between whom there was (apart from in respect of the securities in question) no relationship, arrangements or other connection (whether formal or informal),

except so much, if any, of any such distribution as does not represent such an amount or as is a distribution by virtue of paragraph (d) above or an amount representing the principal secured by the securities;"

30. Section 209(2)(da) was amplified by subs.209(8A) to (8F) , which were enacted at the same time. Section 209(8B) specified the criteria to be used in determining whether interest payments were to be treated as distributions. Section 209(8A), in conjunction with subs.(8B) to (8F), determined how far companies could be grouped together for the purposes of assessing the levels of their borrowing on a consolidated basis. In essence, the rules did not allow the consolidation of separate UK sub-groups which were part of a wider foreign group. The borrowing capacity of each UK sub-group had to be considered independently. Thus, for example, by virtue of s.209(8D)(c) , where the borrowing company ("the issuing company") is an effective 51 per cent subsidiary of a UK-resident holding company, the issuing company is to be taken to be a member of a UK grouping of which the only members are the UK holding company and the effective 51 per cent subsidiaries of the UK holding company.

The transfer pricing rules introduced in 1998

31. Finally, Sch. 28AA to ICTA, introduced by the Finance Act 1998, introduced a detailed code of rules on transfer pricing which also applied to interest payments. The transfer pricing rules applied where there was "provision by means of a transaction", or a series of transactions, between two companies under common control and the terms of the provision were different from what they would have been if the companies had not been under common control. For this purpose, control includes direct or indirect participation in the management, control or capital of any company concerned. The rules applied where the provision gave one of the affected persons an advantage in relation to UK tax. However, until the rules were amended by the Finance Act 2004 this was deemed not to be the case where the other party to the transaction was within the charge to UK tax and certain other conditions were fulfilled. The rules were then amended by the Finance Act 2004 so that they applied where both parties to the transaction were within the charge to UK tax. It was the making of these amendments which finally eliminated the possibility of any legislative discrimination between borrowers depending on whether or not they were resident in the UK.

The principal issue on this appeal

9. It is helpful to identify immediately the principal issue on this appeal. The Revenue contend that thin cap legislation is permissible under EU law if it affects transactions between related companies that are other than on arm's length terms. There is a subsidiary issue as to what is meant by arm's length terms, to which I refer in paragraph 58 below. The Claimants accept that the question whether a transaction is on arm's length terms is a permissible starting point for determining whether it should be subject to thin cap legislation, but contend that it is not the end point. They contend that thin cap legislation contravenes Article 43 of the EC Treaty, i.e. it unlawfully infringes their freedom of establishment, if it affects genuine commercial transactions. Only if a transaction has no genuine commercial justification may it lawfully be the subject of thin cap legislation. Thus, on the Claimants' case, the question whether the transaction is within the scope of permissible thin cap legislation depends on two questions: (a) are the terms arm's length? (b) if not are they commercially justified? It is only if both questions are answered in the negative that thin cap legislation may modify the tax treatment of the transaction so as to submit the taxpayer to the liability for tax that it would have incurred if the transaction had been on arm's length terms.
10. It is common ground that until 2004 UK thin cap rules applied to all international transactions between related companies if they were not on arm's length terms, irrespective of their commercial justification, but did not apply to domestic transactions. It follows that, if the Claimants' case as to the effect of Article 43 is well founded, the UK corporate tax rules in question infringed their rights under Article 43, and questions arise as to their remedies. For present purposes, one of the issues that would arise is whether the UK's breach of Article 43 is sufficiently serious as to entitle the Claimants to damages, quite apart from their restitutionary rights. If, however, the Revenue are right, and for the purposes of Article 43 thin cap legislation that affects non-arm's length transactions is permissible even if there is a commercial justification, then provided the UK legislation was a proportionate response to the problem it sought to address, no question of remedies arises.
11. The Test Claimants are companies in well known and respected international groups: Volvo, Lafarge, IBM, Siemens and Standard Bank. In paragraphs 104 to 179 of his judgment, Henderson J made clear and full findings of fact on the transactions that are the subject of the Test Claimants' claims. The judge found that their transactions to which the UK thin cap legislation had been applied were genuine commercial transactions. The Revenue has not sought to appeal against those findings of fact. In these circumstances, it is unnecessary to set out the facts of those transactions in this judgment, since I would simply be repeating what is to be found in Henderson J's judgment.
12. If, therefore, as the judge held, that legislation was incompatible with Article 43, because it extended to such transactions, the Test Claimants' consequential rights will fall to be considered.
13. Neither party suggested that a further reference to the ECJ was appropriate.

The history of this litigation

14. Again, I can take much of this from Henderson J's judgment.

3. The potential vulnerability of the UK legislation to such a challenge first became apparent to taxpayers and their advisers when the ECJ delivered judgment on December 12, 2002 in Lankhorst-Hohorst GmbH v Finanzamt Steinfurt (C-324/00) [2002] ECR I-11779; [2003] 2 CMLR 22 In that case, … the ECJ held that the German thin cap rules breached art.43 EC (freedom of establishment). The German rules considered in that case were in many respects very different from the UK rules, but the judgment made it clear that art.43 EC was likely to be engaged in cases where a Member State's thin cap rules did not apply to similar lending by a resident parent company, and that the grounds upon which a national measure which in principle breached art.43 EC could be justified were likely to be fairly narrow. In particular, [37] of the judgment suggested that any justification based on the risk of tax avoidance would have no hope of success unless the relevant national rules were specifically targeted and went no further than was necessary to achieve that purpose:

"37. As regards more specifically the justification based on the risk of tax evasion, it is important to note that the legislation at issue here does not have the specific purpose of preventing wholly artificial arrangements, designed to circumvent German tax legislation, from attracting a tax benefit, but applies generally to any situation in which the parent company has its seat, for whatever reason, outside the Federal Republic of Germany. Such a situation does not, of itself, entail a risk of tax evasion, since such a company will in any event be subject to the tax legislation of the state in which it is established …."

4. Following Lankhorst-Hohorst, numerous claims were brought in the High Court by UK-resident subsidiaries of multinational groups, and on July 30, 2003 a Group Litigation Order (GLO) was made by Chief Master Winegarten for the orderly management and disposal of the claims. The proceedings are known as the Thin Cap Group Litigation, and the order of July 30, 2003 as the Thin Cap GLO. Within the group litigation appropriate test claimants have been identified. Two corporate groups, Lafarge and Volvo, with their headquarters in France and Sweden respectively, have been test claimants from an early stage, and agreed statements of facts relating to them were included in the order for reference to the ECJ which was made by Park J. on December 21, 2004. The other three test groups of companies whose claims are now before me have been added since the date of the reference. They are IBM, Siemens and Standard Bank, which have their respective headquarters in the United States, Germany and the Republic of South Africa.

5. The questions posed in the order for reference were, in summary, as follows. Question 1 asked (in effect) whether the United Kingdom's thin cap rules were contrary to arts 43, 49 or 56 EC, in circumstances where the loan finance to the UK-resident borrowing company was granted by a parent company resident in another Member State. Question 2 asked what difference (if any) it would make to the answer to Question 1 in various factual situations where the states of residence of the lending and/or the direct or indirect parent company were not Member States ("third countries"). Question 3 asked whether it would make any difference to the answers to Questions 1 and 2 if it could be shown that the borrowing constituted an abuse of rights or was part of an artificial arrangement designed to circumvent the tax law of the Member State of the borrowing company, and (if so) what guidance the ECJ thought it appropriate to provide as to what constituted such an abuse or artificial arrangement. Question 4 may for present purposes be ignored, because it proceeded on the footing that there was a restriction on the movement of capital between Member States within art.56 EC, and the ECJ has now held that the only article engaged in the present context is art.43 EC. Questions 5 to 10 then asked a number of detailed questions relating to remedies, very similar to the questions asked in the FII group litigation with which I have already dealt at considerable length in my judgment in Test Claimants in the FII Group Litigation v Revenue and Customs Commissioners [2008] EWHC 2893 (Ch); [2009] STC 254 ("FII Chancery" ).

6. The Advocate General delivered his opinion on June 29, 2006, and the ECJ gave judgment on March 13, 2007: Test Claimants in the Thin Cap Group Litigation v Inland Revenue Commissioners (C-524/04) [2007] STC 906; [2007] 2 CMLR 31. The case was heard by the Grand Chamber of the Court, and both the Advocate General (Geelhoed) and the Judge Rapporteur (Lenaerts) were the same as in the FII case, in which judgment had been given four months earlier on December 12, 2006: Test Claimants in the FII Group Litigation v Inland Revenue Commissioners (C-446/04) [2007] STC 326; [2007] 1 CMLR 35 ("FII ").

15. The judge summarised the principal decisions of the ECJ on the reference as follows.

8. First, …, on the issues of liability (Questions 1 to 3 in the order for reference) the court held that the only freedom of movement which applied was the freedom of establishment in art.43 EC. The basic reason for this was that the relevant UK legislation was "targeted only at relations within a group of companies": see [33] of the judgment and the cases there cited, Cadbury Schweppes Plc v Inland Revenue Commissioners (C-196/04) [2006] ECR I-7995; [2007] 1 CMLR 2 (Cadbury Schweppes) at [32] and FII at [118].

9. Secondly, the court held that the United Kingdom's thin cap rules at all material times involved a difference in treatment between resident and non-resident borrowing companies which constituted a restriction on freedom of establishment; that the restriction could not be justified by the need to ensure cohesion of the United Kingdom's tax system; but that the restriction would be justified on the ground of prevention of abusive practices so long as it did not go beyond what was necessary to attain that objective: see [36] to [78] of the judgment.

10. Thirdly, the court held that the question whether the latter test was satisfied depended on the answers to two further questions which it was for the national court to determine ([79] to [87] of the judgment).

11. Fourthly, on the assumption that liability was established in the paradigm situation envisaged in Question 1 in the order for reference (i.e. where the loan was granted by a parent company resident in another Member State), the court held that the same result would follow where the lending company and the parent company were resident in different Member States, but that art.43 EC was not engaged where the lending company (wherever it was resident) did not control the UK borrowing company, and where the ultimate parent company of both the lending and the borrowing companies was resident in a third country ([93] to [102] of the judgment).

12. Fifthly, on the questions relating to remedies, the court gave guidance very similar to that which it had given a few months earlier in FII. In relation to the issue of "sufficiently serious breach" (in the context of a Factortame damages claim), it expressly directed the national court to take into account the fact that the consequences in the field of direct taxation arising from the freedoms of movement guaranteed by the EC Treaty had only gradually been made clear, and said that until delivery of the judgment in Lankhorst-Hohorst "the problem raised by the current reference for a preliminary ruling had not, as such, been addressed in the Court's case-law" : see [121] of the judgment (the section on remedies runs from [106] to [128]).

13. In the light of this mixed success for both sides, … Directions were given for the trial of the following issues:

(a) whether any of the claims should be stayed applying the principles set out by the House of Lords in Autologic Holdings Plc v Inland Revenue Commissioners [2005] UKHL 54; [2005] 3 CMLR 2 ("Autologic");

(b) whether the UK thin cap provisions and, if relevant, the corresponding transfer pricing provisions were incompatible with art.43 EC ;

(c) if so, how compensation or relief should be assessed;

(d) whether there has been a breach of any provision of a relevant double taxation convention (DTC) between the United Kingdom and another state; and

(e) if so, how compensation or relief should be assessed.

14. In general terms, the intention was that all issues of principle relating to liability and remedies should be determined, but that questions of causation and quantum should be deferred for decision (if necessary) at a later date. …

16. Henderson J gave judgment on 17 November 2009. In summary, he held:

(i) Article 43 EC was not engaged where the company providing finance was neither itself EU resident nor controlled by an EU resident. The freedom of establishment which was infringed was not that of any EU parent which happened to have a UK subsidiary, but only that of an EU parent which itself lent to the UK subsidiary or which controlled the financing company, wherever the financing company was resident. Conversely, there was no breach of Article 43 EC where the financing company was under third country control, even if the financing company was itself EU resident.

(ii) The UK thin cap provisions in issue were not proportionate to achieve the purpose of preventing abusive tax avoidance, because they did not allow for a separate defence of commercial justification. It followed that these provisions breached Article 43.

(iii) It was not possible to construe the UK legislation compatibly with Article 43.

(iv) However, the principle of disapplication required the UK legislation to be restricted so as not to apply to international non-arm's length transactions between related companies that were commercially justified.

(v) The burden of proof was on the Revenue for it to establish that transactions to which it sought to apply thin cap legislation were devoid of commercial justification.

(vi) None of the Claimants' transactions in question was devoid of commercial justification. It followed that the UK thin cap legislation should be disapplied in relation to all of them.

(vii) The Claimants were entitled to restitutionary remedies.

(viii) The UK's breach of Article 43 became sufficiently serious immediately after the decision of the ECJ in Lankhorst-Hohorst, which was given on December 12, 2002. It followed that the Claimants were entitled to damages for their losses suffered as a result of the UK's breaches after that date.

17. On 23 February 2010 this Court gave judgment in Test Claimants in the Franked Investment Group Litigation v Commissioners of the Inland Revenue [2010] EWCA Civ 103. The Court allowed the Revenue's appeals against decisions of Henderson J on legal issues relating to restitutionary remedies and limitations of action. The Supreme Court has given permission to appeal in respect of the decisions of the Court of Appeal as to the scope of the Woolwich remedy (Woolwich Equitable Building Society v IRC [1993] AC 70) and whether it constitutes a sufficient remedy for the purposes of the San Giorgio principle, and it may give permission to appeal in relation to other decisions on restitution once the ECJ has given judgment in further references. In these circumstances, it would have been wasteful for this Court to hear argument on issues as to remedies, in which it would have been bound to follow its previous decision in FII, until the Supreme Court has given judgment on those issues or declined to grant permission to appeal in respect of them. Accordingly, the appeals on those issues were adjourned, and argument before us confined to the issues of liability, including the issue whether, if the UK legislation was incompatible with Article 43, the UK's breach was sufficiently serious to entitle the Claimants to damages.
18. On 21 January 2010 there was a further development in the jurisprudence of the ECJ, when judgment was given in Case C-311/08 Société de Gestion Industrielle SA (SGI) v État Belge [2010] ECR 1-0000, on the compatibility of Belgian thin cap legislation with Article 43. In my view, the judgment of the Court clarified the law on this subject, and I shall refer to it in some detail below.
19. In summary, therefore, there have been two important decisions since Henderson J gave judgment in this case which would have affected his judgment (and would have been bound to affect his decisions on restitutionary remedies) had they been available before he gave judgment. In addition, we have considered the judgment of the Grand Chamber of the ECJ in Case C-231/05 Proceedings brought by Oy AA [2008] STC 991 [2009] 3 CMLR 1, which was not cited to Henderson J, and not surprisingly was in consequence not referred to by him in his judgment. It too, in my view, is of importance in this area of developing European jurisprudence.

The principal issue: did the failure of UK legislation to permit a commercial justification of transactions that were not on arm's length terms infringe the Test Claimants' rights under Article 43?

20. While discussing this question, it is also useful to consider the development of the jurisprudence of the ECJ in this area of the law, since that is relevant to the issue whether, if UK law was in breach, its breach was sufficiently serious to entitle the Test Claimants to damages.
21. The starting point must be the judgment of the ECJ in Lankhorst-Hohorst, which was given on 12 December 2002. It was in some respects an extreme case. Lankhorst-Hohorst GmbH ("Lankhorst-Hohorst") was a company incorporated and carrying on business in Germany. It was in financial difficulties. In particular, it had a large bank loan on which it was of course liable to pay interest. It was a wholly owned subsidiary of Lankhorst-Hohorst BV, a company registered in the Netherlands, which in turn was a wholly owned subsidiary of another Netherlands company, Lankhorst Teselaar BV, referred to as LT BV. LT BV lent Lankhorst-Hohorst 3 million deutschmarks. The loan was intended as a substitution for capital, and was accompanied by a letter of support under which LT BV waived repayment if third party creditors made claims against Lankhorst-Hohorst. The loan enabled Lankhorst-Hohorst to reduce its bank borrowings very substantially, and thus to reduce its interest charges.
22. The German tax law (referred to as the KStG) provided, at paragraph 8a:

"Repayments in respect of loan capital which a company limited by shares subject to unlimited taxation has obtained from a shareholder not entitled to corporation tax credit which had a substantial holding in its share or nominal capital at any point in the financial year shall be regarded as a covert distribution of profits,

...

2. where repayment calculated as a fraction of the capital is agreed and the loan capital is more than three times the shareholder's proportional equity capital at any point in the financial year, save where the company limited by shares could have obtained the loan capital from a third party under otherwise similar circumstances or the loan capital constitutes borrowing to finance normal banking transactions. ..."

Non-resident shareholders had no entitlement to corporation tax credit. As a result, there was a difference between the taxation of subsidiaries of German holding companies and those of foreign holding companies.

23. The German tax authority decided that the payments of interest made by Lankhorst-Hohorst to LT BV were equivalent to a covert distribution of profits within the meaning of the German tax law and taxed Lankhorst-Hohorst on them as such at the rate of 30 per cent. The German finance court held that the company could not rely on the exception italicised above because no such loan could have been obtained from a third party, because of the poor financial situation of Lankhorst-Hohorst and its inability to provide security. Thus this was not a case of an excessive interest charge, above what could have been obtained from an independent third party: to the contrary, it was the provision of financial support for a company that had no alternative means of finance, and at a rate of interest lower than that payable to the bank. Nonetheless, the German thin cap legislation applied. Furthermore, it did not treat as a distribution only the amount of any excessive interest: the entirety of a payment affected by the legislation was treated as a distribution. The company's argument is summarised by the ECJ as follows:

14. In support of its action before the national court, Lankhorst-Hohorst stated that the grant of the loan by LT BV constituted a rescue attempt and that the interest repayments could not be classified as a covert distribution of profits. It also submitted that Paragraph 8a of the KStG was discriminatory in the light of the treatment accorded to German shareholders, who are entitled to the tax credit, unlike companies such as LH BV and LT BV which have their registered offices in the Netherlands. Consequently, Paragraph 8a infringed Community law and Article 43 EC in particular.

15. Lankhorst-Hohorst added that regard should be had to the purpose of Paragraph 8a of the [tax law], which is to prevent tax evasion by companies limited by shares. In the present case, however, the loan was granted with the sole objective of minimising the expenses of Lankhorst-Hohorst and achieving significant savings in regard to bank interest charges. Lankhorst-Hohorst claimed in that regard that, prior to reduction of the bank loan, interest charges had been twice the amount subsequently paid to LT BV. This is accordingly not a case of a shareholder with no right to a tax credit seeking to avoid tax chargeable on true distributions of profits by arranging for the payment of interest to itself.

24. The ECJ, in a judgment that broadly followed the opinion of Advocate General Mischo, held that the difference between the tax treatment of German and foreign holding companies interfered with the freedom of establishment conferred by Article 43:

32. Such a difference in treatment between resident subsidiary companies according to the seat of their parent company constitutes an obstacle to the freedom of establishment which is, in principle, prohibited by Article 43 EC. The tax measure in question in the main proceedings makes it less attractive for companies established in other Member States to exercise freedom of establishment and they may, in consequence, refrain from acquiring, creating or maintaining a subsidiary in the State which adopts that measure.

25. The Court then considered whether the interference with the freedom of establishment could be justified:

33. It must still be established whether a national measure such as that in Paragraph 8a (1), Head 2, of the KStG pursues a legitimate aim which is compatible with the Treaty and is justified by pressing reasons of public interest. In that event, it must also be such as to ensure achievement of the aim in question and not go beyond what is necessary for that purpose (see, in particular, Case C-250/95 Futura Participations and Singer [1997] ECR I-2471, paragraph 26, and Case C-35/98 Verkooijen [2000] ECR I-4071, paragraph 43).

34. First, the German, Danish and United Kingdom Governments and the Commission submit that the national measure at issue in the main proceedings is intended to combat tax evasion in the form of the use of 'thin capitalisation' or 'hidden equity capitalisation'. All things being equal, it is more advantageous in terms of taxation to finance a subsidiary company through a loan than through capital contributions. In such a case, the profits of the subsidiary are transferred to the parent company in the form of interest, which is deductible in calculating the subsidiary's taxable profits, and not in the form of a non-deductible dividend. Where the subsidiary and the parent company have their seats in different countries, the tax debt is therefore likely to be transferred from one country to the other.

35. The Commission adds that Paragraph 8a(1), Head 2, of the KStG does indeed provided for an exception in the case of a company which proves that it could have obtained the loan capital from a third party on the same conditions, and fixes the permissible amount of loan capital in comparison with equity capital. However, the Commission points to the existence, in the present case, of a risk of double taxation since the German subsidiary is subject to German taxation on interest paid, whereas the non-resident parent company must still declare the interest received as income in the Netherlands. The principle of proportionality requires that the two Member States in question reach an agreement in order to avoid double taxation.

36. It is settled law that reduction in tax revenue does not constitute an overriding reason in the public interest which may justify a measure which is in principle contrary to a fundamental freedom (see Case C-264/96 ICI [1998] ECR I-4695, paragraph 28; Verkooijen, cited above, paragraph 59; Metallgesellschaft and Others, cited above, paragraph 59, and Case C-307/97 Saint-Gobain ZN [1999] ECR I-6161, paragraph 51).

37. As regards more specifically the justification based on the risk of tax evasion, it is important to note that the legislation at issue here does not have the specific purpose of preventing wholly artificial arrangements, designed to circumvent German tax legislation, from attracting a tax benefit, but applies generally to any situation in which the parent company has its seat, for whatever reason, outside the Federal Republic of Germany. Such a situation does not, of itself, entail a risk of tax evasion, since such a company will in any event be subject to the tax legislation of the State in which it is established (see, to that effect, ICI, cited above, paragraph 26).

38. Moreover, according to the findings of the national court itself, no abuse has been proved in the present case, the loan having been made in order to assist Lankhorst-Hohorst by reducing the interest burden resulting from its bank loan. Furthermore it is clear from the case-file that Lankhorst-Hohorst made a loss in the 1996, 1997 and 1998 financial years and its loss largely exceeded the interest paid to LT BV.

39. Second, the German and United Kingdom Governments submit that Paragraph 8a(1), Head 2, of the KStG is also justified by the need to ensure the coherence of the applicable tax systems. More specifically, that provision is in accordance with the arm's length principle, which is internationally recognised and pursuant to which the conditions upon which loan capital is made available to a company must be compared with the conditions which the company could have obtained for such a loan from a third party. Article 9 of the Model Convention of the Organisation for Economic Cooperation and Development (OECD) reflects that concern in providing for inclusion in profits for tax purposes where transactions are concluded between linked companies on conditions which do not correspond to market conditions.

40. In Case C-204/90 Bachmann [1992] I-249 and in Case C-300/90 Commission v Belgium [1992] ECR I-305 the Court held that the need to ensure the coherence of the tax system may justify rules which restrict the free movement of persons.

41. However, that is not the case with the rules at issue here.

42. Although in Bachmann and Commission v Belgium, since the taxpayer was one and the same person, there was a direct link between deductibility of pension and life assurance contributions and taxation of the sums received under those insurance contracts and preservation of that link was necessary to safeguard the coherence of the relevant tax system, there is no such direct link where, as in the present case, the subsidiary of a non-resident parent company suffers less favourable tax treatment and the German Government has not pointed to any tax advantage to offset such treatment (see, to that effect, Wielockx, paragraph 24; Case C-484/93 Svensson and Gustavsson [1995] ECR I- 3955, paragraph 18; Eurowings Luftverkehr, paragraph 42; Verkooijen, paragraphs 56 to 58, and Baars, paragraph 40).

43. Third, the United Kingdom Government, referring to paragraph 31 of the judgment in Futura Participations and Singer, submits that the national measure at issue here could be justified by the concern to ensure the effectiveness of fiscal supervision.

44. It is enough to find in that regard that no argument has been put to the Court to show how the classification rules contained in Paragraph 8a (1), Head 2, of the KStG are of such a nature as to enable the German tax authorities to supervise the amount of taxable income.

45. Having regard to all the foregoing considerations, the answer to be given to the national court must be that Article 43 EC is to be interpreted as precluding a measure such as that contained in Paragraph 8a(1), Head 2, of the KStG.

26. A number of points need to be made on this important judgment.

(i) Only Article 43 was considered to be engaged by the thin cap legislation.

(ii) It followed from the judgment that any thin cap legislation would infringe Article 43 unless it could be justified: paragraph 33 of the judgment. The criteria for the validity of any justification, as set out there, are well established.

(iii) The permissible scope of the justification of the need to maintain the coherence of the tax system was held to be very narrow indeed, so narrow as to approach vanishing point.

(iv) The argument that the German tax law aided fiscal supervision was manifestly unfounded.

(v) The fact that the German law prevented a reduction in German tax revenues was not a sufficient justification: paragraph 36.

(vi) The only other justification put forward was the combat of tax evasion. The insurmountable problem for the Governments seeking to uphold the legislation on this basis was that it was not confined to evasion: paragraphs 37 and 38.

27. It is, I think, important to note that the reference in paragraph 37 of the judgment to "wholly artificial arrangements, designed to circumvent German tax legislation" was in the context of the discussion of the question whether the legislation was justified by the avoidance of tax evasion, that is, of legislation intended to address such arrangements.
28. Incidentally, in his opinion in Lankhorst-Hohorst Advocate General Mischo suggested that Germany's thin cap legislation should be extended to purely domestic transactions:

99. It falls to the German authorities to determine whether the provision in issue should be replaced by, for example, a provision extending to subsidiaries with a resident parent company the rules on the reclassification of interest as dividends. In the meantime, however, the provision at issue cannot be applied.

As we shall see, the contrary view was emphatically expressed by Advocate General Geelhoed in paragraph 68 of his opinion in the reference in the present case.

29. In Case C-446/03 Marks & Spencer v Halsey (HM Inspector of Taxes) [2005] ECR I-10837 [2006] STC 237, in which judgment was given on 13 December 2005, the ECJ considered whether UK legislation which permitted group relief, allowing companies in a group to offset their profits and losses among themselves, which was restricted to group companies resident in the UK, infringed Articles 43 and 48. Marks & Spencer contended that the UK rules did infringe its Treaty rights, in that it had been unable to offset the losses of its German, Belgian and French subsidiaries against its UK profits. The Court directly addressed the tension between the provisions of the Treaty, which had been interpreted so as to apply the freedoms under consideration to discriminatory legislation, and the fact that direct taxation is within the competence of the individual Member States. The Court held that the exclusion of the advantage conferred by the availability of group relief "constitutes a restriction on freedom of establishment within the meaning of Articles 43 EC and 48 EC, in that it applies different treatment for tax purposes to losses incurred by a resident subsidiary and losses incurred by a non-resident subsidiary" (paragraph 34 of the judgment), and

35. Such a restriction is permissible only if it pursues a legitimate objective compatible with the Treaty and is justified by imperative reasons in the public interest. It is further necessary, in such a case, that its application be appropriate to ensuring the attainment of the objective thus pursued and not go beyond what is necessary to attain it …

30. The UK and other Member States had contended that the restriction was permissible by reason of the territoriality of their tax regimes, and three factors:

43. First, in tax matters profits and losses are two sides of the same coin and must be treated symmetrically in the same tax system in order to protect a balanced allocation of the power to impose taxes between the different Member States concerned. Second, if the losses were taken into consideration in the parent company's Member State they might well be taken into account twice. Third, and last, if the losses were not taken into account in the Member State in which the subsidiary is established there would be a risk of tax avoidance.

31. The Court recognised that these factors gave rise to legitimate objectives:

 44. As regards the first justification, it must be borne in mind that the reduction in tax revenue cannot be regarded as an overriding reason in the public interest which may be relied on to justify a measure which is in principle contrary to a fundamental freedom (see, in particular, Case C-319/02 Manninen [2004] ECR I-7477, paragraph 49 and the case-law cited).

45 None the less, as the United Kingdom rightly observes, the preservation of the allocation of the power to impose taxes between Member States might make it necessary to apply to the economic activities of companies established in one of those States only the tax rules of that State in respect of both profits and losses.

46 In effect, to give companies the option to have their losses taken into account in the Member State in which they are established or in another Member State would significantly jeopardise a balanced allocation of the power to impose taxes between Member States, as the taxable basis would be increased in the first State and reduced in the second to the extent of the losses transferred.

47 As regards the second justification, relating to the danger that losses would be used twice, it must be accepted that Member States must be able to prevent that from occurring.

48 Such a danger does in fact exist if group relief is extended to the losses of non-resident subsidiaries. It is avoided by a rule which precludes relief in respect of those losses.

49 As regards, last, the third justification, relating to the risk of tax avoidance, it must be accepted that the possibility of transferring the losses incurred by a non-resident company to a resident company entails the risk that within a group of companies losses will be transferred to companies established in the Member States which apply the highest rates of taxation and in which the tax value of the losses is therefore the highest.

50 To exclude group relief for losses incurred by non-resident subsidiaries prevents such practices, which may be inspired by the realisation that the rates of taxation applied in the various Member States vary significantly.

51 In the light of those three justifications, taken together, it must be observed that restrictive provisions such as those at issue in the main proceedings pursue legitimate objectives which are compatible with the Treaty and constitute overriding reasons in the public interest and that they are apt to ensure the attainment of those objectives.

32. Nonetheless, the ECJ went on to state:

55 … the Court considers that the restrictive measure at issue in the main proceedings goes beyond what is necessary to attain the essential part of the objectives pursued where:

– the non-resident subsidiary has exhausted the possibilities available in its State of residence of having the losses taken into account for the accounting period concerned by the claim for relief and also for previous accounting periods, if necessary by transferring those losses to a third party or by offsetting the losses against the profits made by the subsidiary in previous periods, and

– there is no possibility for the foreign subsidiary's losses to be taken into account in its State of residence for future periods either by the subsidiary itself or by a third party, in particular where the subsidiary has been sold to that third party.

56 Where, in one Member State, the resident parent company demonstrates to the tax authorities that those conditions are fulfilled, it is contrary to Articles 43 EC and 48 EC to preclude the possibility for the parent company to deduct from its taxable profits in that Member State the losses incurred by its non-resident subsidiary.

57 It is also important, in that context, to make clear that Member States are free to adopt or to maintain in force rules having the specific purpose of precluding from a tax benefit wholly artificial arrangements whose purpose is to circumvent or escape national tax law (see, to that effect, ICI, paragraph 26, and De Lasteyrie du Saillant, paragraph 50).

58 Furthermore, in so far as it may be possible to identify other, less restrictive measures, such measures in any event require harmonisation rules adopted by the Community legislature.

59 Accordingly, the answer to the first question must be that, as Community law now stands, Articles 43 EC and 48 EC do not preclude provisions of a Member State which generally prevent a resident parent company from deducting from its taxable profits losses incurred in another Member State by a subsidiary established in that Member State although they allow it to deduct losses incurred by a resident subsidiary. However, it is contrary to Articles 43 EC and 48 EC to prevent the resident parent company from doing so where the non-resident subsidiary has exhausted the possibilities available in its State of residence of having the losses taken into account for the accounting period concerned by the claim for relief and also for previous accounting periods and where there are no possibilities for those losses to be taken into account in its State of residence for future periods either by the subsidiary itself or by a third party, in particular where the subsidiary has been sold to that third party.

33. Marks & Spencer was not concerned with thin cap legislation. Nonetheless, the judgment of the Grand Chamber of the ECJ is important as being the first decision which accepted the legitimate concerns of the Member States referred to in paragraph 43, and in particular of the legitimacy of the object of the preservation of the allocation of the power to impose taxes between Member States. Paragraph 57 of the judgment would seem to support the present Test Claimants' case. However, paragraphs 44 to 51 point to the lawfulness of wider thin cap provisions.
34. Advocate General Geelhoed gave his opinion in the reference in the present proceedings on 29 June 2006. He said:

2. The case raises once again the issue of the compatibility with the free movement provisions of national 'anti-abuse' direct tax legislation, as raised in particular in the Lankhorst-Hohorst judgment of 2002 (concerning the German thin capitalisation rules) and in the pending Cadbury Schweppes case (concerning the UK's controlled foreign corporation rules). Following the Lankhorst-Hohorst judgment, however, the limits of permissible thin cap restrictions have not been wholly clear, leading certain Member States – including the UK and Germany – to extend their thin cap legislation to domestic intra-group payments, despite the fact that no possible risk of 'abuse' can arise in purely domestic situations. For this reason, and as the UK rules at issue differ in significant respects from the German legislation impugned in Lankhorst-Hohorst, this case requires a fresh look at the issue.

35. Following Lankhorst-Hohorst and Marks & Spencer, the Advocate General considered that the UK thin cap rules, which subjected transactions between UK companies within a group to different rules to those applicable to transactions between UK and non-UK group companies, prima facie was in breach of Article 43, and had to be justified. He turned to the justification relied upon by the UK. He said:

62. The Court has on numerous occasions recognised that, in principle, Member States may be justified in taking otherwise-discriminatory direct tax measures in order to prevent abuse of law (although to date, it has never in fact found a national measure to be so justified). This is most recently evident in the Marks & Spencer judgment, where the Court held that in principle a national rule restricting deduction of cross-border losses could be justified by the risk of tax avoidance, and in particular the risk that within a group of companies losses would be transferred to companies established in the Member States which apply the highest rates of taxation and in which the tax value of the losses was therefore the highest. Such recognition is also evident in the Court's judgments in Lankhorst-Hohorst, X & Y, and ICI, as well as in Leur-Bloem (on the Merger Directive), Halifax (on indirect tax), and numerous judgments in non-taxation fields.

63. The rationale underlying acceptance of such a justification is as follows. In principle, it is quite valid, and indeed fundamental to the idea of an internal market, for taxpayers to seek to arrange their (cross-border) tax affairs in a manner most advantageous to them. However, this is only permissible insofar as the arrangement is genuine; that is to say, not a wholly artificial construct aimed at abusing and circumventing national tax legislation. …

36. The Advocate General considered that the UK legislation was apt to achieve the aim of avoiding the effect of abusive transactions, and therefore proceeded to consider whether it was proportionate to this aim. He said:

66. On this point, it is my view that, depending on its formulation and application, legislation aimed at avoiding thin capitalisation may in principle be a proportionate anti-abuse measure. It is true that the idea that companies have the right to structure their affairs as they wish means that, in principle, they should be allowed to finance their subsidiaries by equity or debt means. However, this possibility reaches its limit when the company's choice amounts to abuse of law. It seems to me that the arm's length principle, accepted by international tax law as the appropriate means of avoiding artificial manipulations of cross-border transactions, is in principle a valid starting point for assessing whether a transaction is abusive or not. To use the reasoning of the Court developed in the indirect tax sphere and other non-tax spheres, the arm's length test represents in this context an objective factor by which it can be assessed whether the essential aim of the transaction concerned is to obtain a tax advantage. Moreover, it is in my view valid, and indeed to be encouraged, for Member States to set out certain reasonable criteria against which they will assess compliance of a transaction with the arm's length principle, and in case of non-compliance with these criteria for them to presume that the transaction is abusive, subject to proof to the contrary. The setting out of such criteria is, to my eyes, in the interests of legal certainty for taxpayers, as well as workability for tax authorities. This approach is to be contrasted, for example, with the use of a single fixed criterion to be applied in all cases – such as a fixed debt-equity ratio – which does not allow other circumstances to be taken into account.

67. However, the formulation and application in practice of such a test must also satisfy the requirements of proportionality. This means in my view that:

– It must be possible for a taxpayer to show that, although the terms of its transaction were not arm's length, there were nonetheless genuine commercial reasons for the transaction other than obtaining a tax advantage. In other words, as the Court noted in its Halifax judgment, 'the prohibition of abuse is not relevant where the economic activity carried out may have some explanation other than the mere attainment of tax advantages'. An example that comes to mind is the situation on the facts in Lankhorst-Hohorst, where the purpose of the loan, as accepted by the Court, was a rescue attempt of the subsidiary via minimising the subsidiary's expenses and achieving savings on bank interest charges. One could imagine, however, that similar situations (i.e., where a transaction was not concluded on arm's length terms, but was nonetheless made non-abusively and not purely to obtain a tax advantage) would be relatively exceptional;

– If such commercial reasons are put forward by the taxpayer, their validity should be assessed on a case-by-case basis to see if the transactions should be seen as wholly artificial designed purely to gain a tax advantage;

– The information required to be provided by the taxpayer in order to rebut the presumption should not be disproportionate or mean that it is excessively difficult or impossible to do so;

– In cases where the payments are found to be abusive (disguised distributions) in the above sense, only the excess part of the payments over what would have been agreed on arm's length terms should be re-characterised as a distribution and taxed in the subsidiary's state of residence accordingly; and

– The result of such examination must be subject to judicial review.

68. Nor am I of the view that, in order to conform with Article 43 EC, Member States should necessarily be obliged to extend thin cap legislation to purely domestic situations where no possible risk of abuse exists. I find it extremely regrettable that the lack of clarity as to the scope of the Article 43 EC justification on abuse grounds has led to a situation where Member States, unclear of the extent to which they may enact prima facie 'discriminatory' anti-abuse laws, have felt obliged to 'play safe' by extending the scope of their rules to purely domestic situations where no possible risk of abuse exists. Such an extension of legislation to situations falling wholly outwith its rationale, for purely formalistic ends and causing considerable extra administrative burden for domestic companies and tax authorities, is quite pointless and indeed counterproductive for economic efficiency. As such, it is anathema to the internal market.

69. I would add that I agree with the Commission that, in order for the application of thin cap rules to be proportionate to their aim, the Member State applying these rules must ensure via DTC that the requalification of the transaction within its tax jurisdiction is mirrored by a counterpart requalification (i.e., from receipt of interest payments to receipt of dividend distributions) in the parent company's Member State. Failure to do so would in my view go beyond what is necessary to achieve the aim of the thin cap rules, and would impose a disproportionate burden (double taxation) on the group as a whole. I have already observed elsewhere that the effect of DTCs on a taxpayer's situation should be taken into account in assessing the compatibility of a Member State's legislation with Article 43 EC. This is subject to the caveat that it is no defence to an action for breach of Article 43 EC to argue that the other Contracting State to the DTC was in breach of its DTC obligations by failing to treat the payments received by the parent company consistently with their re-qualification by the UK.

37. The Advocate General turned to consider the UK's reliance on the principle of fiscal cohesion. He concluded that it added nothing to his conclusions on the issue of anti-abuse:

91. In the present case, the result of applying reasoning based on fiscal cohesion is in my opinion precisely the same as that explained above as regards anti-abuse justification. Thus, while it is in principle justified for the UK to seek to enforce and to prevent abuse of the tax rules applicable within its own tax jurisdiction (i.e., the distinction in tax treatment of interest and profit distributions) based on the accepted arm's length principle of apportionment, it may only do so in a proportionate manner.

38. It can be seen that paragraph 67 of Advocate General Geelhoed's opinion explicitly supports the present Test Claimants' case. So did his proposed answers to the referred questions.
39. The judgment of the Grand Chamber of the Court was given on 13 March 2007. In many respects, it followed the opinion of the Advocate General. The UK rules, since they discriminated between UK companies and non-UK companies within the EC, were held to interfere with the freedom of establishment conferred by Article 43. They therefore required justification if they were to be upheld. The Court dismissed the UK's contention that its rules were justified by virtue of the need for fiscal cohesion, and proceeded to consider whether they were justified as combating abusive practices. This part of the judgment is not as clear as it might have been. It stated:

71 As regards … the issues relating to the fight against tax avoidance, the United Kingdom Government states that, unlike the German legislation at issue in Lankhorst-Hohorst, the national provisions relating to thin capitalisation are targeted at a particular form of tax avoidance, which consists in the adoption of artificial arrangements designed to circumvent the tax legislation in the State in which the borrowing company is resident. The provisions in force in the United Kingdom go no further than is necessary in order to attain that objective, inasmuch as they are based on the internationally-recognised arm's-length principle, they treat as a distribution only that proportion of the interest which exceeds what would have been paid under a transaction entered into on an arm's-length basis and they are applied with flexibility, particularly as they provide for an advance clearance procedure.

72 It must be pointed out that, according to established case-law, a national measure restricting freedom of establishment may be justified where it specifically targets wholly artificial arrangements designed to circumvent the legislation of the Member State concerned (see, to that effect, Case C-264/96 ICI [1998] ECR I-4695, paragraph 26; Lankhorst-Hohorst, paragraph 37; Marks & Spencer, paragraph 57; and Cadbury Schweppes and Cadbury Schweppes Overseas, paragraph 51).

73 …

74 In order for a restriction on the freedom of establishment to be justified on the ground of prevention of abusive practices, the specific objective of such a restriction must be to prevent conduct involving the creation of wholly artificial arrangements which do not reflect economic reality, with a view to escaping the tax normally due on the profits generated by activities carried out on national territory (Cadbury Schweppes and Cadbury Schweppes Overseas, paragraph 55).

75 Like the practices referred to in paragraph 49 of the judgment in Marks & Spencer, which involved arranging transfers of losses incurred within a group of companies to companies established in the Member States which applied the highest rates of taxation and in which the tax value of those losses was therefore the greatest, the type of conduct described in the preceding paragraph is such as to undermine the right of the Member States to exercise their tax jurisdiction in relation to the activities carried out in their territory and thus to jeopardise a balanced allocation between Member States of the power to impose taxes (Cadbury Schweppes and Cadbury Schweppes Overseas, paragraph 56).

76 As the United Kingdom Government observes, national legislation such as the legislation at issue in the main proceedings is targeted at the practice of thin capitalisation, under which a group of companies will seek to reduce the taxation of profits made by one of its subsidiaries by electing to fund that subsidiary by way of loan capital, rather than equity capital, thereby allowing that subsidiary to transfer profits to a parent company in the form of interest which is deductible in the calculation of its taxable profits, and not in the form of non-deductible dividends. Where the parent company is resident in a State in which the rate of tax is lower than that which applies in the State in which its subsidiary is resident, the tax liability may thus be transferred to a State which has a lower tax rate.

77 By providing that that interest is to be treated as a distribution, such legislation is able to prevent practices the sole purpose of which is to avoid the tax that would normally be payable on profits generated by activities undertaken in the national territory. It follows that such legislation is an appropriate means of attaining the objective underlying its adoption.

78 It remains necessary to determine whether or not that legislation goes beyond what is necessary to attain that objective.

79 As the Court held in paragraph 37 of its judgment in Lankhorst-Hohorst, that requirement is not met by national legislation which does not have the specific purpose of preventing wholly artificial arrangements designed to circumvent that legislation, but applies generally to any situation in which the parent company has its seat, for whatever reason, in another Member State.

80 By contrast, legislation of a Member State may be justified by the need to combat abusive practices where it provides that interest paid by a resident subsidiary to a non-resident parent company is to be treated as a distribution only if, and in so far as, it exceeds what those companies would have agreed upon on an arm's-length basis, that is to say, the commercial terms which those parties would have accepted if they had not formed part of the same group of companies.

81 The fact that a resident company has been granted a loan by a non-resident company on terms which do not correspond to those which would have been agreed upon at arm's length constitutes, for the Member State in which the borrowing company is resident, an objective element which can be independently verified in order to determine whether the transaction in question represents, in whole or in part, a purely artificial arrangement, the essential purpose of which is to circumvent the tax legislation of that Member State. In that regard, the question is whether, had there been an arm's-length relationship between the companies concerned, the loan would not have been granted or would have been granted for a different amount or at a different rate of interest.

82 As the Advocate General stated at point 67 of his Opinion, national legislation which provides for a consideration of objective and verifiable elements in order to determine whether a transaction represents a purely artificial arrangement, entered into for tax reasons alone, is to be considered as not going beyond what is necessary to prevent abusive practices where, in the first place, on each occasion on which the existence of such an arrangement cannot be ruled out, the taxpayer is given an opportunity, without being subject to undue administrative constraints, to provide evidence of any commercial justification that there may have been for that arrangement.

83 In order for such legislation to remain compatible with the principle of proportionality, it is necessary, in the second place, that, where the consideration of those elements leads to the conclusion that the transaction in question represents a purely artificial arrangement without any underlying commercial justification, the re-characterisation of interest paid as a distribution is limited to the proportion of that interest which exceeds what would have been agreed had the relationship between the parties or between those parties and a third party been one at arm's length.

84 In the present case, the documents before the Court show that, prior to the amendments made in 1995, the legislation in force in the United Kingdom provided that interest paid by a resident subsidiary in respect of a loan granted by a non-resident parent company was treated, in its entirety, as a distribution, with no assessment of whether the loan satisfied a relevant criterion, such as that of being granted at arm's length, and without that subsidiary being given any opportunity to provide evidence as to any valid commercial justifications there may have been for the loan.

85 However, those documents also show that that legislation did not apply in cases involving a DTC which prevented the application of those rules and thus ensured that the interest in question was allowed as a deduction for tax purposes, provided that the rate of interest did not exceed what would have been agreed upon on an arm's-length basis. Under such a DTC, only that proportion of the interest which exceeded what would have been paid on an arm's-length basis was treated as a distribution.

86 Whilst a tax regime such as the regime which arises, in cases to which they apply, under the DTCs concluded by the United Kingdom appears initially to be based on a consideration of objective and verifiable elements which make it possible to determine whether a purely artificial arrangement, entered into for tax reasons alone, is involved, it is for the national court to determine, should it be established that the claimants in the main proceedings benefited from such a regime, whether that regime gave them an opportunity, if their transactions did not satisfy the conditions laid down under the DTC in order to assess their compatibility with the arm's-length criterion, to provide evidence as to any commercial justification there may have been for the transactions, without being subject to any undue administrative constraints.

87 The same applies to the national provisions in force after the legislative amendments introduced in 1995 and 1998. It is a matter of agreement that, under those provisions, it is only interest which exceeds what would be paid on an arm's-length basis that falls to be re-characterised as a distribution. Whilst, at first sight, the criteria laid down by those provisions appear to require a consideration of objective and verifiable elements in order to determine whether a purely artificial arrangement, entered into for tax reasons alone, is involved, it is for the national court to determine whether those provisions allow taxpayers, where the transaction does not satisfy the arm's-length criterion, to produce evidence of the commercial justifications for that transaction, under the conditions referred to in the preceding paragraph.

88 Contrary to what the Commission submits, where a Member State treats all or part of the interest paid by a resident company to a non-resident company belonging to the same group of companies as a distribution, after having determined that a purely artificial arrangement, designed to circumvent its tax legislation, is involved, that Member State cannot be obliged to ensure in such a case that the State in which the latter company is resident does everything necessary to avoid the payment which is treated as a dividend being taxed, as such, at group level both in the Member State in which the former company is resident and in the Member State in which the latter company is resident.

89 In so far as, in such a case, the Member State in which the former company is resident may lawfully treat interest paid by that company as a distribution of profits, it is not, in principle, for that State to ensure that profits distributed to a non-resident shareholder company are not subject to a series of charges to tax (see, to that effect, Test Claimants in Class IV of the ACT Group Litigation, paragraphs 59 and 60).

…

92 The answer to Questions 1 and 3 must therefore be that Article 43 EC precludes legislation of a Member State which restricts the ability of a resident company to deduct, for tax purposes, interest on loan finance granted by a direct or indirect parent company which is resident in another Member State or by a company which is resident in another Member State and is controlled by such a parent company, without imposing that restriction on a resident company which has been granted loan finance by a company which is also resident, unless, first, that legislation provides for a consideration of objective and verifiable elements which make it possible to identify the existence of a purely artificial arrangement, entered into for tax reasons alone, and allows taxpayers to produce, if appropriate and without being subject to undue administrative constraints, evidence as to the commercial justification for the transaction in question and, secondly, where it is established that such an arrangement exists, such legislation treats that interest as a distribution only in so far as it exceeds what would have been agreed upon at arm's length.

40. Some questions were resolved by this judgment. It is clear that the provisions of double taxation conventions are to be taken into account in determining whether national legislation contravenes a Treaty freedom. The Court accepted the need for "objective and verifiable elements" to be the basis for determining whether a transaction should be affected by thin cap legislation. The arm's length test was accepted as appropriate, at least in the first place, as a test as to whether a transaction should be affected by the legislation. Other matters were less clearly resolved. The Court referred to "artificial arrangements designed to circumvent the legislation of the Member State concerned", to "wholly artificial arrangements which do not reflect economic reality, [created] with a view to escaping the tax normally due on the profits", and in paragraph 92 and its answer to Questions 1 and 3 to "a purely artificial arrangement, entered into for tax reasons alone". One could be forgiven for thinking that these are references to sham transactions. But if the Court was referring to sham transactions, to tax evasion rather than avoidance or minimisation, why should the legislation be required to permit the amount of interest that would have been payable on an arm's length basis to be deducted from taxable profits? Indeed, how could it do so, if there was no genuine underlying transaction?
41. Paragraph 81 of the judgment suggests that the only question to be considered in order to determine whether a transaction is "in whole or in part, a purely artificial arrangement, the essential purpose of which is to circumvent the tax legislation of that Member State" "is whether, had there been an arm's-length relationship between the companies concerned, the loan would not have been granted or would have been granted for a different amount or at a different rate of interest". If, as paragraph 82 suggests, and the dispositif in paragraph 92 states, a taxpayer must be able to provide evidence of any commercial justification there may have been for the transaction, what is meant by a commercial justification? Is it, as the language of the Court suggests, something other than evidence demonstrating that the transaction and its terms do satisfy the arm's length test? In my judgment, the answer to this crucial question was unclear.
42. Moreover, sham transactions are relatively rare. A more obvious and common transaction that attracts thin cap concerns is a loan at an excessive rate of interest (by which I mean a rate greater than would be required by an independent lender). The loan is normally genuinely required by the recipient of the loan for its business. The loan is a genuine transaction. It would not normally be described as "a purely artificial arrangement, entered into for tax reasons alone". Yet surely such a loan should be a legitimate and lawful target of thin cap legislation? Similar comments may be made in respect of a literally thin cap transaction. A UK subsidiary is established by a non-UK EU parent. It requires working capital. On purely commercial grounds, ignoring the differential tax rates in the UK and in the state of the parent company, that capital should and would be provided in the form of subscriptions for shares. Instead, because the corporation tax rate applicable to the profits of the parent is significantly lower than the rate applicable to the UK subsidiary's profits, the subsidiary is established with nominal share capital and substantial loan capital provided by the parent company. The loan is not "a purely artificial arrangement", yet surely it is a legitimate, and should be a permissible, object of thin cap legislation? If not, the parent company is permitted to reduce the UK tax base and to arrange where it is to pay tax on its subsidiary's profits. It is clear that the ECJ had such transactions in mind, yet its language was, on one view, inapposite to describe them.
43. The judgments in Marks & Spencer and Thin Cap were considered by the Grand Chamber in Oy AA, in which judgment was given on 18 July 2007. Oy AA was a Finnish company, a subsidiary of a UK Company, AA. AA had made losses and was expected to continue to do so. Oy AA, on the other hand, was profitable. It therefore proposed to make an intra-group financial transfer to AA. Under Finnish tax law, such transfers could be deducted from the taxable income of a company provided certain requirements were met, one of which was that "the corresponding expense and income are entered in the accounts of the transferor and transferee concerned". This requirement could not be met where transferor and transferee were not both established in Finland. Oy AA sought to establish that it was entitled to deduct the transfer it proposed to make to AA, on the basis that this requirement contravened Articles 43 and 56 EC. At first instance, Oy AA failed. The Finnish appeal court referred the following question to the ECJ:

Do Articles 43 EC and 56 EC, having regard to Article 58 EC and Directive 90/435/EEC ... preclude the system established by the Finnish Law on Intra-Group Financial Transfers, which makes the deductibility of intra-group financial transfers subject to the condition that the transferor and the transferee be national companies?

44. Following Marks & Spencer, the Court held that the restriction on deductibility to Finnish companies was a restriction on the freedom of establishment, and it therefore required justification if it were to be upheld. Having summarised the rival contentions, the Court stated:

51. As is apparent from para 51 of the judgment in the Marks & Spencer case, the need to safeguard the balanced allocation of the power to impose taxes between the member states was accepted by the court in conjunction with two other grounds of justification, based on the risks of the double use of losses and of tax avoidance (see also Rewe Zentralfinanz eG v Finanzamt Koln-Mitte (Case C-347/04) [2007] ECR I-2647, [2007] 2 CMLR 1111, para 41).

52. It should also be remembered that, in the absence of any unifying or harmonising Community measures, member states retain the power to define, by treaty or unilaterally, the criteria for allocating their powers of taxation (see Gilly v Directeur des Services Fiscaux du Bas-Rhin (Case C-336/96) [1998] STC 1014, [1998] ECR I-2793, 1 ITLR 29, paras 24, 30, N v Inspecteur van de Belastingdienst Oos/kantoor Almelo (Case C-470/04) [2006] ECR I-7409, [2006] 3 CMLR 49, para 44, Kerckhaert v Belgium (Case C-513/04) [2007] STC 1349, [2007] 1 WLR 1685, paras 22, 23 and the Test Claimants in the Thin Cap Group Litigation case (para 49)).

53. Concerning, first, the need to safeguard a balanced allocation of the power to tax between member states, it should be pointed out that that need cannot justify a member state systematically refusing to grant a tax advantage to a resident subsidiary, on the ground that the income of the parent company, having its establishment in another member state, is not capable of being taxed in the first member state (see, to that effect, the Rewe Zentralfinanz case (para 43)).

54. That element of justification may be allowed, however, where the system in question is designed to prevent conduct capable of jeopardising the right of the member states to exercise their taxing powers in relation to activities carried on in their territory (see the Rewe Zentralfinanz case (para 42)).

55. The court has thus held that to give companies the right to elect to have their losses taken into account in the member state in which they are established or in another member state would seriously undermine a balanced allocation of the power to impose taxes between the member states (see the Marks & Spencer case (para 46) and the Rewe Zentralfinanz case (para 42)).

56. Similarly, to accept that an intra-group cross-border transfer, such as that at issue in the main proceedings, may be deducted from the taxable income of the transferor would result in allowing groups of companies to choose freely the member state in which the profits of the subsidiary are to be taxed, by removing them from the basis of assessment of the latter and, where that transfer is regarded as taxable income in the member state of the parent company transferee, incorporating them in the basis of assessment of the parent company. That would undermine the system of the allocation of the power to tax between member states because, according to the choice made by the group of companies, the member state of the subsidiary would be forced to renounce its right, in its capacity as the state of residence of that subsidiary, to tax the profits of that subsidiary in favour, possibly, of the member state in which the parent company has its establishment (see also the Test Claimants in Class IV of the ACT Group Litigation case (para 59)).

57. Concerning, secondly, the risk that losses might be used twice, it is sufficient to point out that the Finnish system of intra-group financial transfers does not concern the deductibility of losses.

58. Concerning, finally, the prevention of tax avoidance, it must be acknowledged that the possibility of transferring the taxable income of a subsidiary to a parent company with its establishment in another member state carries the risk that, by means of purely artificial arrangements, income transfers may be organised within a group of companies towards companies established in member states applying the lowest rates of taxation or in member states in which such income is not taxed. That possibility is reinforced by the fact that the Finnish system of intra-group financial transfers does not require the transferee to have suffered losses.

59. By granting a subsidiary the right to deduct an intra-group financial transfer in favour of its parent company from its taxable income only in cases where the latter has its principal establishment in the same member state, the Finnish system of intra-group financial transfers is able to prevent such practices, likely to be encouraged by the finding of significant disparities between the bases of assessment or rates of tax applied in the various member states and designed only to avoid the tax normally due in the member state of the subsidiary on its profits.

60. Having regard to the combination of those two factors, concerning the need to safeguard the balanced allocation of the power to tax between the member states and the need to prevent tax avoidance, this court therefore finds that a system, such as that at issue in the main proceedings, which grants a subsidiary the right to deduct a financial transfer in favour of its parent from its taxable income only where the parent and the subsidiary both have their principal establishment in the same member state, pursues legitimate objectives compatible with the Treaty and justified by overriding reasons in the public interest, and is appropriate to ensuring the attainment of those objectives.

61. It must, however, be examined whether or not such a system goes beyond what is necessary to attain all of the objectives pursued.

62. It should be noted at the outset that the objectives of safeguarding the balanced allocation of the power to impose taxes between member states and the prevention of tax avoidance are linked. Conduct involving the creation of wholly artificial arrangements which do not reflect economic reality, with a view to escaping the tax normally due on the profits generated by activities carried out on national territory is such as to undermine the right of the member states to exercise their tax jurisdiction in relation to those activities and jeopardise a balanced allocation between member states of the power to impose taxes (see the Cadbury Schweppes case (paras 55, 56) and the Test Claimants in the Thin Cap Group Litigation case (paras 74, 75)).

63. Even if the legislation at issue in the main proceedings is not specifically designed to exclude from the tax advantage it confers purely artificial arrangements, devoid of economic reality, created with the aim of escaping the tax normally due on the profits generated by activities carried out on national territory, such legislation may nevertheless be regarded as proportionate to the objectives pursued, taken as a whole.

64. In a situation in which the advantage in question consists in the possibility of making a transfer of income, thereby excluding such income from the taxable income of the transferor and including it in the taxable income of the transferee, any extension of that advantage to cross-border situations would, as indicated in para 56 of this judgment, have the effect of allowing groups of companies to choose freely the member state in which their profits will be taxed, to the detriment of the right of the member state of the subsidiary to tax profits generated by activities carried out on its territory.

65. That detriment cannot be prevented by imposing conditions concerning the treatment of the income arising from the intra-group financial transfer in the member state of the transferee, or concerning the existence of losses made by the transferee. To allow deduction of the intra-group financial transfer where it constitutes taxable income of the transferee company, or where the opportunities for the transferee company to transfer its losses to another company are limited, or to allow deduction of an intra-group financial transfer in favour of a company whose establishment is in a member state applying a lower rate of tax than that applied by the member state of the transferor only where that intra-group financial transfer is specifically justified by the economic situation of the transferee, as Oy AA has proposed, would nevertheless mean that, in the final analysis, the choice of the member state of taxation would be a matter for the group of companies, which would have a wide discretion in that regard.

66. In the light of the above considerations, there is no need to examine the other justifications raised by the Finnish, German, Netherlands, Swedish and United Kingdom governments and by the Commission.

67. The answer to the question referred must therefore be that art 43 EC does not preclude a system instituted by legislation of a member state, such as that at issue in the main proceedings, whereby a subsidiary resident in that member state may not deduct an intra-group financial transfer which it makes in favour of its parent company from its taxable income unless that parent company has its establishment in that same member state.

45. In my view, it is difficult to reconcile this judgment with that of the ECJ in Thin Cap. The Finnish legislation did not target, and was not restricted in its application to "purely artificial arrangement(s), the essential purpose of which is to circumvent the tax legislation of that Member State"; yet it was upheld. The Court placed far greater weight on, and gave greater consideration to, the right of Member States "to define, by treaty or unilaterally, the criteria for allocating their powers of taxation". It took into consideration the Member States' objectives of "safeguarding the balanced allocation of the power to impose taxes between member states" and "the prevention of tax avoidance", which justified the restriction of the Finnish legislation to national companies. I have difficulty in seeing any principled distinction between legislation applicable to an intra-group financial transfer of the kind considered in Oy AA and that applicable to an intra-group loan. It is, I think, significant that the Advocate General and the Court in Thin Cap considered the lawfulness of the UK legislation primarily in relation to the objective of addressing tax avoidance, and not the need to safeguard the balanced allocation of the power to tax. Both Thin Cap and Oy AA were judgments of the Grand Chamber, and the latter cannot therefore be sidelined or treated as of less significance than the former. As mentioned above, the judgment of the ECJ in Oy AA was not cited to Henderson J and is not referred to in his judgment.
46. The next, and final, judgment in this sequence is that of the ECJ in SGI, delivered on 10 September 2009. Given its importance in the present context, I shall set out substantial extracts from the opinion of Advocate General Kokott and the judgment of the Court (Third Chamber), which largely followed her opinion.
47. The facts of the case, it must be accepted, were extreme. SGI was a holding company incorporated under Belgian law. It had a 65 per cent holding in the capital of Recydem SA ("Recydem"), a company incorporated under French law. It was also one of the directors of that company. Cobelpin SA ("Cobelpin"), a company incorporated under Luxembourg law, had a 34 per cent shareholding in SGI. Cobelpin was also managing director of SGI. A Mr Leone was a managing director of SGI and a director of Cobelpin and Recydem. On December 31, 2000, SGI granted an interest-free loan of BEF 37,836,113 (€ 937,933) to Recydem. From July 1, 2000, SGI paid director's remuneration of LUF 350,000 (€ 8,676) per month to Cobelpin.
48. Belgian tax law included, in article 26 of the Code des impôts sur les revenus 1992, a thin cap provision applicable to "unusual or gratuitous advantages" granted by a Belgian company to a non-resident company. According to Belgian case law, an advantage was regarded as unusual if it was contrary to the normal course of events or established business rules and practice, in the light of the prevailing circumstances. A gratuitous advantage was one which was conferred in the absence of any corresponding obligation or consideration.
49. The Belgian tax authorities refused to allow the remuneration paid to Cobelpin as deductible business expenses. The sums paid were considered to be clearly disproportionate and unrelated to the economic benefit of the services in question. Cobelpin's representative on the SGI board of directors was also on the board in his own name. In addition, the tax authorities added to SGI's declared profits a sum in respect of the gratuitous loan, corresponding to a notional interest rate of 5 per cent per annum.
50. There was an Arbitration Convention between the Member States, described by the Advocate General in his opinion as follows:

6 The Member States of the European Community took art.9 of the OECD Model Convention as the model for the Convention on the elimination of double taxation in connection with the adjustment of profits of associated enterprises (90/436/EEC) of 23 July 1990 ("the Arbitration Convention"). All of the Member States concluded that convention, based on art.220 EEC (subsequently art.220 EC, now art.293 EC), or have acceded thereto.

7 Article 4(1) of the Arbitration Convention corresponds on a word-for-word basis with art.9(1) of the OECD Model Convention. If an adjustment of profits effected in accordance with art.4 of the Arbitration Convention results in double taxation, on application by the relevant enterprise, a procedure aimed at reaching mutual agreement and, where necessary, an arbitration procedure must be implemented between the tax authorities of the Member States concerned (arts 6 and 7 of the Arbitration Convention ).

51. SGI brought an action before the tribunal de première instance de Mons (the Court of First Instance, Mons) challenging the decisions of the Belgian tax authorities. The court considered that there was no economic justification for the loan: whereas, during the period in question, the subsidiary was in a secure financial position and generated profits, SGI was subject to a severe financial burden as a result of granting loans. The court also considered that the director's remuneration paid by SGI to Cobelpin was not deductible as business expenses and that it should be added to SGI's own profits. However, the court had doubts as to whether the Belgian thin cap tax provision was compatible with the principle of freedom of establishment within the meaning of Article 43 EC and the principle of the free movement of capital enshrined in Article 56 EC: the profits of a resident company were increased by the amount of the unusual or gratuitous advantages granted by it if the recipient company with which it had a relationship of interdependence was established in another Member State, but not where such advantages had been granted to another resident. The court made a reference to the ECJ for a preliminary ruling on two questions. The first was:

1. Does art.43 EC, in conjunction with art.48 EC and, if appropriate, art.12 EC, preclude legislation of a Member State which, like that at issue, gives rise to the taxation of a company resident in Belgium in respect of an unusual or gratuitous advantage which it has granted to a company established in another Member State with which the Belgian company has, directly or indirectly, a relationship of interdependence, whereas, in identical circumstances, the company resident in Belgium cannot be taxed in respect of an unusual or gratuitous advantage where that advantage is granted to another company established in Belgium with which the Belgian company has, directly or indirectly, a relationship of interdependence?

The second question was in almost identical terms, but referred to Article 56 rather than Article 43.

52. Advocate General Kokott applied earlier jurisprudence and concluded that Article 43 was engaged, rather than Article 56, and that the Belgian legislation restricted the exercise of the right to freedom of establishment guaranteed in Article 43, and therefore would be lawful only if justified. The Belgian and other Governments submitting observations contended that the legislation was justified by the need "to ensure a balanced allocation of the power to tax between Member States and the need to combat tax avoidance through the prevention of abusive practices". The Advocate General summarised the contentions of the Governments and under the heading "Examination of the justification" stated:

64 First, it is necessary to determine whether art.26 of the CIR 92 is appropriate for the purpose of attaining the objectives pursued.

65 In order to differentiate artificial arrangements undermining the allocation of the power to tax from normal business transactions, art.26 of the CIR 92 establishes as distinguishing criteria, first, a relationship of interdependence between the companies concerned and, secondly, the unusual or gratuitous nature of the advantage conferred. If those requirements are satisfied, the advantage is added back to the tax base of the company which granted the advantage.

66 …

67 The national provision is based on art.9 of the OECD Model Convention and art.4 of the Arbitration Convention, which provide for corresponding adjustments to profits when transactions between associated companies fail to satisfy the at-arms-length test.

68 In Test Claimants in the Thin Cap Group Litigation, the Court recognised, in principle, that the arm's-length principle constitutes an appropriate test by which to distinguish artificial arrangements from genuine economic transactions.

The Advocate General set out paragraph 81 of the judgment in Thin Cap and continued:

69 Admittedly, art.26 of the CIR 92 deviates, in detail, from art.9 of the OECD Model Convention, which provides Member States with useful guidance on the allocation of the power to tax. Thus, under art.26 of the CIR 92, participation in management, control or capital is not regarded as substantive proof of a relationship of interdependence between companies. Further, it does not expressly require a comparison to be made with the conditions under which a corresponding transaction would have been effected between independent companies. However, the interpretation applied by the domestic courts to the concept of an unusual advantage demonstrates that that was indeed the intention.

70 The concept of a direct or indirect relationship of interdependence limits the category of companies having a potential interest in agreeing atypical terms and conditions of business for the purposes of tax avoidance. Admittedly, that concept is extremely broad. While the Court has held that, under Community law, a taxpayer must be aware of the obligations imposed on him, in particular in the case of rules entailing financial consequences, the national provision does not infringe the principle of legal certainty. Legislation aimed at counteracting abusive practices must inevitably have recourse to imprecise legal concepts in order to cover the greatest number of conceivable arrangements created for the purposes of tax avoidance. Moreover, a relationship of interdependence is not the only determining factor. Of greater and indeed primary significance is whether, between companies in a relationship of interdependence, unusual or gratuitous advantages were granted.

71 Notwithstanding those differences in relation to art.9 of the OECD Model Convention and art.4 of the Arbitration Convention, art.26 of the CIR 92 is appropriate for the purpose of attaining the objective of counteracting artificial arrangements adopted for the purposes of tax avoidance.

72 By excluding the possibility for undertakings in a relationship of interdependence with each other to grant unusual or gratuitous advantages and thus transfer profits from the tax base of a resident company to that of a non-resident company, art.26 of the CIR 92 also safeguards the balanced allocation of the power to tax.

73 Such advantages are, in fact, disguised profit transfers between undertakings in a relationship of interdependence with each other. In Oy AA, the Court held that payments between associated companies undermine the allocation of the power to tax. If such transfers were to be recognised for tax purposes, companies within a group could choose freely the Member State in which profits are to be taxed, regardless of where they were generated.

74 However, it remains to be determined whether the legislation in question goes beyond what is necessary to attain those objectives.

75 On that point, first, it follows from Test Claimants in the Thin Cap Group Litigation that legislation designed to prevent artificial arrangements, in reliance on the arm's length principle, may refuse to recognise such arrangements for tax purposes only if, and in so far as, those arrangements differ from what independent companies would have agreed on an arm's-length basis. Therefore, the fact that the price for the provision of services between associated companies is abnormally low or excessively high may not, for example, result in a refusal to recognise the entire transaction as legitimate for tax purposes. Instead, such prices must be raised or, where appropriate, reduced to the normal level for tax purposes.

76 Admittedly, the wording of art.26 of the CIR 92 does not indicate unequivocally whether, in all cases, the adjustment of profits entails applying normal conditions to unusual advantages. However, the provision was clearly interpreted and applied by the tax authorities and courts in such a manner. The amount of interest added to SGI's income was determined by reference to the usual market interest rates. Subject to any definitive finding of the referring court, it must be presumed, therefore, that the provision, as applied in practice, complies with the principle of proportionality.

77 Secondly, legislation intended to combat abuse must give the taxpayer, on each occasion on which an artificial arrangement is suspected, the opportunity to provide evidence of any commercial justification that there may have been for that arrangement.

78 Article 26 of the CIR 92 requires an unusual or gratuitous advantage to have been conferred. That provision does not exclude the possibility for the taxpayer to contest any such assessment made by the tax authorities. For those purposes, it must prove that the contested transaction is in fact economically justified, and that independent companies acting at arm's length would have concluded the transaction on the same terms.

79 In the present case, it is evident from the order for reference that the grant by SGI to Recydem of an interest-free loan was not justified in economic terms, as SGI itself was highly indebted whereas the financial position of Recydem was secure. Nor, in the view of the referring court, could SGI establish that the payments to Cobelpin constituted appropriate remuneration for its services as director.

80 Finally, it must be observed that the negative effects of any adjustment of profits in accordance with art.26 of the CIR 92 are largely neutralised by the fact that the beneficiary undertaking may require, on the basis of the Arbitration Convention, account to be taken of such an adjustment in connection with its own tax assessment. The additional burdens associated with such a procedure must be accepted, since no less onerous measure is available to safeguard the balanced allocation of the power to tax.

81 It follows that a rule such as that laid down by art.26 of the CIR 92 does not go beyond what is necessary to maintain a balanced allocation of the power to tax between the Member States and to prevent tax avoidance.

82 Thus, a rule such as that laid down in art.26 of the CIR 92 results in a restriction on the freedom of establishment guaranteed by art.43 EC, in conjunction with art.48 EC. However, such a rule is justified on grounds of the need to safeguard the balanced allocation of the power to tax between the Member States and to prevent tax avoidance.

53. Paragraph 78 of the Advocate General's opinion is explicit in restricting the taxpayer to showing that an impugned transaction is in fact on arm's length terms.
54. In its judgment, the ECJ confirmed that, since by reason of their shareholdings SGI had the power to exercise "definite influence" over the decisions and activities of Recydem, and Cobelpin had similar power over the decisions and activities of SGI, it was necessary to answer the questions referred by reference to Articles 43 and 48 EC only: i.e., freedom of establishment was engaged, rather than freedom of movement of capital. Like the Advocate General, the Court concluded that the Belgian legislation constituted a restriction on freedom of establishment within the meaning of Article 43, and therefore required to be justified. The Court continued:

Whether the legislation at issue in the main proceedings can be justified

56 According to established case law, a measure which is liable to hinder the freedom of establishment enshrined in art.43 EC is permissible only if it pursues a legitimate objective compatible with the Treaty and is justified by overriding reasons in the public interest. It is also necessary, in such a case, that its application be appropriate to ensuring the attainment of the objective thus pursued and not go beyond what is necessary to attain it …..

57 The Swedish Government and the Commission take the view that the legislation at issue in the main proceedings is justified by the need to ensure a balanced allocation of the power to tax between Member States, the fear of tax avoidance and the need to combat abusive practices, taken together. However, the Commission points out that it is necessary to comply with the principle of proportionality. The Belgian and German Governments rely, in the alternative, on the same grounds of justification.

58 The Belgian Government states that the legislation at issue in the main proceedings seeks to combat tax avoidance by making it possible to adjust, for taxation purposes, situations in which the companies concerned apply conditions to their relationships which go beyond what would have been agreed under fully competitive conditions. At the hearing, the Belgian Government stated that the system in question was based on art.9 of the model tax convention on income and on capital drawn up by the Organisation for Economic Cooperation and Development (OECD) and art.4 of the Arbitration Convention , which provide for similar adjustments to profits when transactions between associated companies are inconsistent with the arm' s length principle.

59 According to the Belgian Government, the concept of "advantage" within the meaning of the legislation at issue in the main proceedings is based on the premise that the recipient is enriched and the person granting the advantage receives no real consideration equivalent to that advantage. The requirement that the advantage must be "unusual" is designed to cover situations which are contrary to the normal course of events, rules or established practice or contrary to what is customary, in similar cases. The requirement that the advantage must be "gratuitous" presupposes that it is granted on the basis that it does not represent the fulfilment an obligation or that no consideration is provided in that connection.

60 First, as regards the balanced allocation between Member States of the power to tax, it should be recalled that such a justification may be accepted, in particular, where the system in question is designed to prevent conduct capable of jeopardising the right of a Member State to exercise its tax jurisdiction in relation to activities carried out in its territory. …

61 The Court has recognised that the preservation of the allocation of the power to impose taxes between Member States may make it necessary to apply to the economic activities of companies established in one of those States only the tax rules of that State in respect of both profits and losses (see inter alia, Oy AA at [54], …

62 To give companies the right to elect to have their losses or profits taken into account in the Member State in which they are established or in another Member State could seriously undermine a balanced allocation of the power to impose taxes between the Member States, since the tax base would be increased in one of the States in question, and reduced in the other, by the amount of the losses or profits transferred (see, to that effect, Marks & Spencer at [46]; Oy AA at [55]; …

63 In the present case, it must be held that to permit resident companies to transfer their profits in the form of unusual or gratuitous advantages to companies with which they have a relationship of interdependence that are established in other Member States may well undermine the balanced allocation of the power to impose taxes between the Member States. It would be liable to undermine the very system of the allocation of the power to impose taxes between Member States because, according to the choice made by companies having relationships of interdependence, the Member State of the company granting unusual or gratuitous advantages would be forced to renounce its right, in its capacity as the State of residence of that company, to tax its income in favour, possibly, of the Member State in which the recipient company has its establishment (see, to that effect, Oy AA at [56]).

64 By providing that the resident company is to be taxed in respect of an unusual or gratuitous advantage which it has granted to a company established in another Member State, the legislation at issue in the main proceedings permits the Belgian State to exercise its tax jurisdiction in relation to activities carried out in its territory.

65 Second, as regards the prevention of tax avoidance, it should be recalled that a national measure restricting freedom of establishment may be justified where it specifically targets wholly artificial arrangements designed to circumvent the legislation of the Member State concerned (see, to that effect, ICI [1998] 3 CMLR 293 at [26]; Marks & Spencer at [57]; Cadbury [2007] 1 CMLR 2 at [51]; and Test Claimants in the Thin Cap Group Litigation at [72]).

66 In that context, national legislation which is not specifically designed to exclude from the tax advantage it confers such purely artificial arrangements— devoid of economic reality, created with the aim of escaping the tax normally due on the profits generated by activities carried out on national territory— may nevertheless be regarded as justified by the objective of preventing tax avoidance, taken together with that of preserving the balanced allocation of the power to impose taxes between the Member States (see, to that effect, Oy AA at [63]).

67 As regards the relevance of that ground of justification in the light of circumstances such as those of the main proceedings, to permit resident companies to grant unusual or gratuitous advantages to companies with which they have a relationship of interdependence that are established in other Member States, without making provision for any corrective tax measures, carries the risk that, by means of artificial arrangements, income transfers may be organised within companies having a relationship of interdependence towards those established in Member States applying the lowest rates of taxation or in Member States in which such income is not taxed (see, to that effect, Oy AA at [58]).

68 By providing that the resident company is to be taxed in respect of an unusual or gratuitous advantage which it has granted to a company established in another Member State, the legislation at issue in the main proceedings is able to prevent such practices, liable to be encouraged by the finding of significant disparities between the bases of assessment or rates of tax applied in the various Member States and designed only to avoid the tax normally due in the Member State in which the company granting the advantage has its seat (see, to that effect, Oy AA at [59]).

69 In the light of those two considerations, concerning the need to maintain the balanced allocation of the power to tax between the Member States and to prevent tax avoidance, taken together, it must be held that legislation such as that at issue in the main proceedings pursues legitimate objectives which are compatible with the Treaty and constitute overriding reasons in the public interest and that it is appropriate for ensuring the attainment of those objectives.

70 That being so, it remains necessary to examine whether legislation such as that at issue in the main proceedings goes beyond what is necessary to attain the objectives pursued, taken together.

71 National legislation which provides for a consideration of objective and verifiable elements in order to determine whether a transaction represents an artificial arrangement, entered into for tax reasons, is to be regarded as not going beyond what is necessary to attain the objectives relating to the need to maintain the balanced allocation of the power to tax between the Member States and to prevent tax avoidance where, first, on each occasion on which there is a suspicion that a transaction goes beyond what the companies concerned would have agreed under fully competitive conditions, the taxpayer is given an opportunity, without being subject to undue administrative constraints, to provide evidence of any commercial justification that there may have been for that transaction (see, to that effect, Test Claimants in the Thin Cap Group Litigation at [82], and order in Test Claimants in the CFC and Dividend Group Litigation v Inland Revenue Commissioners (C-201/05) [2008] ECR I-2875; [2008] 2 C.M.L.R. 53 at [84]).

72 Secondly, where the consideration of such elements leads to the conclusion that the transaction in question goes beyond what the companies concerned would have agreed under fully competitive conditions, the corrective tax measure must be confined to the part which exceeds what would have been agreed if the companies did not have a relationship of interdependence.

73 According to the Belgian Government, the burden of proof as to the existence of an "unusual" or "gratuitous" advantage within the meaning of the legislation at issue in the main proceeding rests with the national tax authorities. It states that when those authorities apply that legislation, the taxpayer is given an opportunity to provide evidence of any commercial justification that there may have been for the transaction in question. The taxpayer has a month, a period which may be extended, within which to establish that no unusual or gratuitous advantage is involved, having regard to the circumstances in which the transaction was effected. If, however, those authorities persist in their intention of issuing a revised assessment and do not accept the taxpayer's arguments, the latter can challenge the assessment to tax before the national courts.

74 The Belgian Government adds that, where the legislation at issue in the main proceedings is applied, only the unusual or gratuitous part of the advantage in question is added back to the profits of the company which granted it.

75 In those circumstances, subject to verification to be carried out by the referring court as regards the last two points, which concern the interpretation and application of Belgian law, it must be concluded that, in the light of the foregoing, national legislation such as that at issue in the main proceedings is proportionate to the set of objectives pursued by it.

76 Accordingly, the answer to the questions referred is that art.43 EC, read in conjunction with art.48 EC, must be interpreted as not precluding, in principle, legislation of a Member State, such as that at issue in the main proceedings, under which a resident company is taxed in respect of an unusual or gratuitous advantage where the advantage has been granted to a company established in another Member State with which it has, directly or indirectly, a relationship of interdependence, whereas a resident company cannot be taxed on such an advantage where the advantage has been granted to another resident company with which it has such a relationship. However, it is for the national court to verify whether the legislation at issue in the main proceedings goes beyond what is necessary to attain the objectives pursued by the legislation, taken together.

55. The judgments of the ECJ in Oy AA and SGI have given welcome clarity to European law in the present context. It is now clear that the objectives of ensuring the balanced allocation between Member States of the power to tax, together with the prevention of tax avoidance, may justify legislation that would otherwise be an unlawful interference with the freedom of establishment guaranteed by Article 43. Secondly, the application of an arm's length test is appropriate and sufficient for this purpose. It is a proportionate measure to achieve those objectives. The Belgian legislation was upheld (subject to the verification referred to in paragraph 75 of the judgment) although it was not limited to "purely artificial arrangement(s), the essential purpose of which is to circumvent the tax legislation of that Member State", but extended to any transaction within a group that was "unusual". In paragraphs 71 and 72 of its judgment, the Court explained (and on one view placed a gloss on) what had been said in Thin Cap as to "the commercial justification for the transaction" that the taxpayer must be allowed to put forward. In paragraph 72 of the judgment in SGI, what must be established is whether "the transaction in question goes beyond what the companies concerned would have agreed under fully competitive conditions": in other words, the application of the arm's length test.
56. It is also important to identify what the provisos were to the Court's upholding of the Belgian legislation. They were whether, as the Belgian Government asserted, the taxpayer had an opportunity to put forward to the tax authority its case as to the commercial justification for the transaction, and if dissatisfied with the decision of the tax authority could challenge the decision before the national courts; and whether, when the legislation was applied, it was only the gratuitous or unusual part of the advantage in question that was added back to the profits of the company which granted it.
57. It follows, in my judgment, that it is now clear that the contention of the Claimants in the present proceedings that thin cap legislation can be justified only if it is confined to abusive or sham transactions must be rejected. Legislation that involves the application of the arm's length test, as embodied in Article 9 of the OECD Model Convention, does not unlawfully interfere with Article 43 EC, provided the taxpayer is given an adequate opportunity to present his case to the tax authority that the transaction in question was on arm's length terms, and may challenge the decision of the tax authority before the national court, and, secondly, that the effect of the legislation is limited to those aspects of the advantage conferred by the taxpayer company that do not satisfy that test. There is no doubt that the UK legislation satisfied all of these requirements. It applied the arm's length test; it did not disallow any interest that would have been payable under a transaction on arm's length terms; the taxpayer was given an adequate opportunity to present its case, and it had recourse to the courts if dissatisfied with the decision of the Revenue. As to the latter two provisos, I refer to paragraph 101 of Henderson J's judgment:

101. … if the Revenue are right in their interpretation of the guidance given by the ECJ, and the only test that needs to be applied is the arm's length test, the evidence clearly establishes that the claimants had every opportunity to adduce evidence of any commercial justification upon which they wished to rely in the context of the arm's length test. Furthermore, if agreement had not been reached they would have been free to test the issue by bringing an appeal against an assessment or closure notice to the General or Special Commissioners in the usual way. There is no suggestion anywhere in the evidence that there was any systematic inhibition or constraint in the way in which the thin cap provisions were in practice operated by the Revenue, such as to amount to an "undue administrative constraint" of the type contemplated by the ECJ in paragraphs 82, 86 and 92 of the judgment. Nor, for their part, have the claimants ever contended that there was.

The Test Claimants' contingent cross appeal

58. Mr Aaronson QC sought to raise a point on the requirements of the arm's length test envisaged by the jurisprudence of the ECJ. This issue was raised late in this appeal in the Test Claimants' skeleton argument in response to the Revenue's skeleton argument. Mr Aaronson submitted that when applying the arm's length test to a subsidiary within a group of companies, it was necessary, in order to comply with the requirements of EU law, for the Revenue, and the court, to take into account the fact that the subsidiary was within that group. The reason for this submission is evident. He would argue, by way of example, that an independent third party, in considering whether to lend to such a subsidiary (for example) would take into account the fact that its parent company was a reputable and credit-worthy company that was unlikely to allow its subsidiary to fail to meet its liabilities. It would follow that such a subsidiary would require less share capital than a stand-alone company in other respects in the same financial and commercial situation, since third party lenders would be willing to provide loan capital to what would otherwise be an under-capitalised company. The Test Claimants contended that UK law, and specifically section 209(8A) to (8F) of ICTA in force from 1995, did not permit the group to be taken into account. This submission involved a challenge to the finding of Henderson J that the UK provisions were consistent with the arm's length test envisaged by the ECJ: in see paragraph 73 and 75 of his judgment.
59. Mr Ewart QC, for the Revenue, contended, not surprisingly, that if accepted this submission might render the arm's length test ineffective for its purpose. More fundamentally, he submitted that Henderson J had correctly held it was not open to the Test Claimants to raise this issue. In paragraph 74 of his judgment, the judge said:

74. One aspect of this, to which Mr Aaronson attached considerable importance both in his oral submissions and in his cross-examination of the Revenue's witnesses, is that the statutory arm's length test in s 209(2)(da) of ICTA requires the borrowing capacity of each UK sub-group to be considered independently. It follows that the wider financial circumstances of the group, including for example the strength of a covenant provided by the ultimate holding company of a group such as IBM or Volvo, cannot be taken into account in applying the arm's length test. In their written submissions, the claimants argued that this and certain other features of the UK legislation, as applied by the Revenue, meant that it did not provide an appropriate objective test based on the arm's length principle. However, this argument was not pursued by Mr Aaronson in his oral submissions, and I do not think that it is open to the claimants in the light of the ECJ's judgment. In my view the judgment must be taken to have endorsed the use of an arm's length test for this purpose, …

60. I agree. The ECJ was clearly aware of the effect of the UK legislation. Both the Judge-Rapporteur's report and Advocate General Geelhoed's opinion (in paragraph 14) stated in terms: "The borrowing capacity of each UK sub-group is considered independently." The Test Claimants had argued the point. Mr Aaronson pressed it in his oral submissions to the ECJ. He said:

… the OECD arm's length test is not applied by the UK. They omit one critical point. Under the UK rules, regard could not be had for the other group members beyond the UK sub-group.

If someone is lending to any Volvo company, they will know that Volvo's reputation is at stake. Although Volvo simply cannot allow a subsidiary to default on its loan. If it did so, no one would ever lend money to Volvo again. This is why the OECD test takes into account the borrowing capacity of the group. But this simply cannot be taken into account in the UK context. …

There is nothing in the Thin Cap judgment to suggest that UK legislation might be incompatible because of its failure to take into account a subsidiary's membership of a non-UK group of companies. The only matters left open in paragraphs 86 and 87 of the judgment (as clarified by the judgments in Oy AA and SGI) are whether UK law gave an adequate opportunity to the taxpayer to present his case, and whether it had access to the courts if dissatisfied with the Revenue's ruling.

61. I add that I do not accept Mr Aaronson's submission that the UK arm's length test is more stringent than the OECD test. His submission is inconsistent with the "functionally separate entity" approach of the OECD.
62. In my judgment, the decision of Henderson J summarised in paragraph 16(ii) of my judgment and reflected in paragraph 1 of his order is inconsistent with the judgments of the ECJ in Oy AA and SGI, and indeed with the judgment in Thin Cap itself as explained and applied in those judgments. The commercial justification that the taxpayer companies could have put forward for their transactions was that their terms were those which would have been agreed between unconnected parties. Since this was the test applied by the UK legislation, the fact that the taxpayer could not put forward some other commercial justification did not render the UK legislation incompatible with their or their parent companies' freedom of establishment. The taxpayers' transactions in issue did not satisfy the arm's length test, and the UK thin cap legislation was appropriately and lawfully applied to them.

The burden of proof

63. It also follows that no question of a conforming interpretation of the UK legislation, or of its modification by a process of disapplication, arises. If I had concluded that Henderson J's conclusion that it was necessary to disapply the legislation by permitting the taxpayer company to contend that there was a commercial justification for its transaction, notwithstanding that its terms were not those that would have been agreed between unconnected parties, I should have reversed his decision that it was for the Revenue to establish that the transaction was devoid of commercial justification. The facts that would lead to the conclusion that there was some commercial justification for a non-arm's length transaction would be entirely within the knowledge of the taxpayer, and it would be able to prove any such justification. To require the Revenue to establish a negative in such circumstances would be unfair and would impose an impractical burden on it. My view is consistent with what was said by the ECJ at paragraph 82 of its judgment in Thin Cap, for the necessity for the taxpayer to be given an opportunity… to provide evidence of any commercial justification that there may have been for that arrangement, following in this respect the opinion of the Advocate General at paragraph 67 of his opinion. I do not think this is inconsistent with the judgment in SGI, since in that case the Belgian Government contended that its own legislation placed the burden of proof that a transaction was gratuitous or unusual on the tax authority.

Sufficiently serious breach

64. On the basis of my conclusion as to the compatibility of the UK thin cap legislation with Article 43 EC, no question of an award of damages for breach of the Claimant's treaty rights arises. I shall therefore comment on this aspect of the case only briefly.
65. The development of the jurisprudence of the ECJ in this area of the law would have led me in any event to have allowed the Revenue's appeal against paragraph 8 of the order made by Henderson J, reflecting his conclusion summarised at paragraph 16(viii) of my judgment. The all important justification for thin cap legislation that it protects the Member States' rights to maintain the balanced allocation of the power to tax, in other words to protect their territorial tax base, is a latecomer in the jurisprudence of the ECJ. One sees the development of the jurisprudence in the judgments to which I have referred. It is not surprising to find that there were those in the Revenue who took what turned out to be an unduly pessimistic view of the prospects of the UK legislation being upheld. Initially, even the relevance of double taxation conventions was unclear: see, in this connection, paragraph 278 of Henderson J's judgment. Given the uncertainty of the law (until Oy AA and SGI), I think that the judge should have followed the guidance given by Advocate General Geelhoed in his opinion in the reference:

108. I would add that, in the FII case, which concerned the UK's tax treatment of incoming dividends, I expressed serious doubts whether the Brasserie du Pêcheur conditions – and in particular the requirement of a sufficiently serious breach – was fulfilled for the aspects of the UK's system which breached Community law. I have even stronger doubts on this point in the present case. The application of Article 43 EC to national thin cap legislation was confirmed by the Court only in 2002 with its Lankhorst-Hohorst judgment, and even following this judgment the scope of such application has not been totally clear. Moreover, the UK altered its legislation on numerous occasions, making the application of its rules more transparent and seemingly, in the case of the 2004 changes, keeping compatibility with Community law in mind. This does not seem to me sufficient to constitute a manifest and grave disregard of the limits on its discretion within the meaning of the Court's case-law.

66. It is impossible to reconcile the Advocate General's view with Mr Aaronson's submission that the UK Government should have announced, within 24 hours of the publication on 12 December 2002 of the judgment in Lankhorst-Hohorst, that the thin cap rules would not be enforced. On any basis, it seems to me that the judge's finding on the timing of a sufficiently serious breach cannot be supported. The Claimants accept that until that judgment the compatibility of the UK legislation with the EC Treaty was uncertain. Even if the position had been made clear by that judgment, it would be unreasonable not to allow the Government time to consider it and the terms of remedial legislation, and if thought appropriate to consult with outside bodies, and time to bring the legislation before Parliament, before it could fairly be held to be in sufficiently serious breach for the purposes of the Brasserie du Pêcheur conditions.
67. In his submissions on the question of sufficiently serious breach, Mr Aaronson contended that what he had contended was the failure of the UK Government to be open and honest to taxpayers as to its opinion as to the legality of its legislation and its plans for its amendment was an aspect of its abuse of its legislative competence. In this connection, he relied on Henderson J's findings in paragraphs 297 and 300 of his judgment. In common with what I understand to have been Henderson J's view, expressed in paragraph 322 of his judgment, I do not consider that such conduct on the part of a government can, of itself, constitute a sufficiently serious breach, an abuse of its legislative competence. That conduct may give rise to national remedies; it may be relied upon as evidence that the government knowingly acted in breach of Treaty rights; but it cannot of itself constitute a breach giving rise to damages for breach of a Treaty right.

Conclusion

68. It follows that I would allow the Revenue's appeal and I would reject the Test Claimants' contingent cross-appeal.

Lord Justice Rimer:
 


69. I have had the advantage of reading Stanley Burnton LJ's comprehensive judgment and I gratefully adopt his account of the background to this appeal. I respectfully agree with his conclusions on all issues. I too would allow the Revenue's appeal and dismiss the Test Claimants' contingent cross-appeal.
70. Argument on the primary issue before this court occupied most of the three and a half day hearing. It is, in principle, a short issue. There is no dispute that the UK thin cap legislation in force at the material time was only compatible with Article 43 (freedom of establishment) if it was proportionate in its method of preventing abusive tax avoidance. The proportionality test adopted by the legislation was the arm's length test. Under that test, interest payable by a UK resident group borrower to a non-resident group lender was treated as deductible in the computation of the borrower's taxable profits so long as it did not exceed what would have been payable under a loan transaction negotiated at arm's length. Interest in excess of what would have been so payable was treated as a non-deductible distribution. The Revenue's case was and is that such a test was proportionate and so compliant with the requirements of Community law. It was apparently common ground below that if the Revenue is right, the claims of the Test Claimants' could not succeed (paragraph [33] of Henderson J's judgment).
71. The Test Claimants' case was and is that the UK's legislation's adoption of an arm's length test did not go far enough, with the consequence that it did not satisfy the Community law proportionality requirements and so was materially wanting. Their case was that the teaching of the Court of Justice of the European Union ('the ECJ') requires a member state's thin cap legislation also to provide that, in a case in which a cross-border inter-group loan transaction does not satisfy the arm's length test, the taxpayer must have the opportunity of showing in the alternative that there was nevertheless a proper commercial justification for the transaction. If, say the Test Claimants, they cannot satisfy the arm's length test, but can satisfy that alternative test, any legislative provision purporting to re-characterise as a distribution any of the interest payable under their loans is incompatible with Community law. Henderson J agreed with that interpretation of the proportionality requirement; and also that the Test Claimants' loan transactions had a proper commercial justification although they did not satisfy the arm's length test. The first holding is challenged by the Revenue and it was the central issue argued before us.
72. That issue, therefore, is whether the proportionality teaching of the ECJ prescribes an arm's length test pure and simple; or an arm's length test with, in default of its satisfaction, a right on the part of the taxpayer to prove a commercial justification for the transaction. For practical purposes, if the latter alternative is right, it appears to me that it would be likely to confine the grasp of correctly proportionate thin cap legislation to cases in which the transaction was of a wholly artificial nature whose sole purpose was the circumvention of the tax legislation of the state in which the taxpayer borrower was resident.
73. The considerable length of the argument before us was largely attributable to the time necessarily devoted by counsel to teasing out of the decisions of the ECJ the principles by reference to which to assess the proportionality or otherwise of the UK legislation. The key judgments are rich with references to 'arm's length' terms and 'commercial justification' and provide ammunition for both sides. Mr Aaronson's submission for the Test Claimants was that these references are to two independent criteria. Mr Ewart's submission for the Revenue was that, properly understood, the commercial justification references are nothing other than references to the arm's length test.
74. I fully concur with the tribute paid by Stanley Burnton LJ to the high quality of Henderson J's judgment, although one has come to expect nothing less of him. Henderson J's decision on this issue focussed on the ECJ's judgment on the Chancery Division's reference in this very litigation, Test Claimants in the Thin Cap Group Litigation v. IRC Case C-524/04; [2007] ECR 1-2107; [2007] STC 906 ('Thin Cap'). His conclusion was not only that its correct interpretation supported the Test Claimants' case but that the Revenue's contrary arguments were 'threadbare' (paragraph [69]). There is indeed much in the language of the judgment in Thin Cap which, on its face, supports the judge's conclusion. The question, however, is whether his conclusion was right: in particular, whether in Thin Cap the ECJ actually meant what at times it appeared to be saying. Stanley Burnton LJ has cited the relevant paragraphs from the judgment and I will not repeat them.
75. Paragraph 80 introduced the arm's length test and defined it by reference to the 'commercial terms' that unrelated parties would have agreed. It is an important paragraph because it showed that the UK legislation could be justified upon the basis that it was targeted at interest in excess of 'arm's length' interest. Paragraph 81 identified the same test as the touchstone by reference to which the loan in question can be assessed as representing 'in whole or in part, a purely artificial arrangement, the essential purpose of which is to circumvent the tax legislation of that Member State …'. It explained in the last sentence that the loan will be such an arrangement 'in whole' where, on an arm's length negotiation, it would not have been granted at all; and 'in part' where, on an arm's length negotiation, it would have been for a different amount or at a different rate of interest. I interpret the court's use of the word 'artificial' as referring to that element of the transaction that falls short of satisfying the arm's length test.
76. The trouble starts with paragraph 82, which introduced the need for the taxpayer to have a fair and proper opportunity to prove 'any commercial justification that there may have been for the arrangement.' That was a point that the Advocate General had made. Mr Ewart advanced submissions to the effect that the references in this and subsequent paragraphs to 'commercial justification' conveyed no more than that the taxpayer was to have a proper opportunity to prove that the terms of the arrangement were, in whole or in part, equivalent to terms that would have been negotiated on an arm's length basis. Cogently though these arguments were advanced, the court's choice of language in this paragraph and, in particular, in paragraphs 86 and 87, pose apparent difficulties with such an interpretation. At least one difficulty that I have with it flows from the fact that in paragraph 82 the court was apparently agreeing with what the Advocate General had said in paragraph 67 of his Opinion; and a reading of that paragraph (quoted by Stanley Burnton LJ) appears to me to show that the Advocate General did have a separate test of 'commercial justification' in mind. If, in paragraph 82 and subsequently, the court was using the phrase 'commercial justification' as meaning something different from what the Advocate General had been referring to, one might expect it to have made it clear what it meant.
77. If this court had nothing more by way of assistance on the primary issue than the judgment of the ECJ in Thin Cap, I think it probable that I would have arrived at the same interpretation of Thin Cap as did Henderson J. Stanley Burnton LJ's conclusion in paragraph [41] of his judgment is that the ECJ's choice of language in Thin Cap left unclear whether the court's various references to 'commercial justification' were or were not to the 'arm's length' test. I respectfully agree that the court did leave it unclear.
78. I have not, however, considered it necessary to agonise further over the true meaning of the court's statements in Thin Cap. That is because I consider that Mr Ewart's interpretation of it has since been vindicated by the ECJ in its subsequent judgment in Société de Gestion Industrielle (SGI) v. Etat Belge Case C-311/08; [2010] ECR 1-0000 ('SGI'). Stanley Burnton LJ has explained the issues that were referred in that case to the ECJ and has cited the material passages from the Opinion of the Advocate General and the judgment of the court. The Advocate General appears to me to have interpreted Thin Cap as showing that the only test of proportionality that it was recognising was the arm's length test (paragraph 75 of her Opinion). In paragraph 77 she expressed her view that the legislation must 'give the taxpayer, on each occasion on which an artificial arrangement is suspected, the opportunity to provide any commercial justification that there may have been for the arrangement (my emphasis).' And in paragraph 78 she showed that what the taxpayer has to prove is that 'independent companies acting at arm's length would have concluded the transaction on the same terms.' As it seems to me, those three paragraphs show that she was interpreting paragraphs 82, 86 and 87 of the judgment in Thin Cap as meaning that the opportunity 'to provide any commercial justification' (paragraph 77) meant nothing other than an opportunity to prove that the arrangement satisfied, in whole or in part, the arm's length test. They provide no support for the view that she considered that an alternative 'commercial justification' test was available.
79. The judgment of the court dealt with proportionality in paragraphs 70 to 75. The authority for the principle it explained in paragraph 71 is Thin Cap and the court does not suggest that it was saying in SGI anything different from what it had earlier said in that case. Paragraph 71 shows that what Thin Cap was saying (or intended to say) was that if there is a suspicion that the terms of the transaction differ from what they would have been on an arm's length basis (the court here favouring the synonymous phrase 'fully competitive conditions'), the taxpayer must be given a proper opportunity 'to provide any commercial justification there may have been for that transaction.' It is in my view apparent that in that paragraph, the court, like the Advocate General, meant that the opportunity 'to provide any commercial justification' etc was an opportunity to prove that the terms were the equivalent of arm's length terms: that is, I consider, made clear in paragraph 72, which shows that proof of nothing less than such an equivalence will do.
80. In my judgment, therefore, any doubts there may have been as to the true sense of the ECJ's judgment in Thin Cap read in isolation have been removed by the decision in SGI. SGI has now tacitly explained, and applied, Thin Cap. The guidance that this court must apply is what, thanks to SGI, it can now see to have been the common guidance of both cases. It is to the effect that the inclusion in a member state's thin cap legislation of an arm's length test pure and simple will be compliant with the requirements of proportionality and, therefore, also with the Article 43 freedom of establishment. In holding, as he did, that the UK legislation was deficient in not also providing UK resident borrowers with the opportunity of proving in the alternative that a loan arrangement which failed the arm's length test was nevertheless commercially justified, I respectfully consider that Henderson J fell into error. With nothing better than the judgment in Thin Cap to guide him, his error was, if I may say so, understandable. If, like us, he had also had the benefit of the decision in SGI, I regard it as probable that he would have decided the case differently.
81. For the reasons that Stanley Burnton LJ has set out in paragraph [57] of his judgment, I therefore respectfully agree with him that the UK legislation with which this appeal is concerned did not unlawfully interfere with the Article 43 freedom. I also agree with what he has said in relation to the Test Claimants' contingent cross appeal, the burden of proof and 'sufficiently serious breach'. There is nothing I wish to add on those matters.

Lady Justice Arden:

82. I am extremely grateful to Lord Justice Stanley Burnton for delivering his comprehensive judgment, and in particular for setting out the relevant jurisprudence of the Court of Justice of the European Union ("the Court of Justice") in such detail. His judgment will considerably shorten my task. For the reasons given below, I respectfully disagree with his conclusion and that of Lord Justice Rimer that the application of an arm's length test is sufficient justification for discriminating against non-resident parent companies in the European Union (see paragraph 54 above). It follows that in my judgment the cross-appeal does not arise. In other respects, I agree with the judgment of Lord Justice Stanley Burnton and that of Lord Justice Rimer. I also join in their tributes to the judge's judgment.
83. The parties are agreed that the paradigmatic factual situation which gives rise to this appeal is where a resident subsidiary borrows money from an overseas parent company for the purposes of the subsidiary's business in an amount which is greater than the subsidiary would have been able to obtain from an unconnected third party. The subsidiary may agree to pay a market rate of interest, but, on the Revenue's interpretation of the decision of Court of Justice in Thin Cap, that does not preclude the application of the domestic rules on thin capitalisation because of the excessive amount of the loan. Under those rules, where the loan is not on arm's length terms, interest paid can be re-characterised as a distribution. The claimants, however, contend, and the judge held, that the effect of that decision is that they must have an opportunity to show that, even though the terms of the loan, including its amount, were not such as would have been agreed between parties dealing at arm's length, they were nonetheless commercial. Thus, on their case, the subsidiary/borrower could not lawfully be denied relief for the interest on such a loan against its taxable profits as, before 1 April 2004, the date when the relevant changes in the Finance Act 2004 took effect, such relief would have been available if the lender had been resident for tax purposes.
84. The judge made findings about a number of the situations involving the claimants in which the rules on thin capitalisation had been applied. It is sufficient for my purposes to point to the example of one of the loans within the Lafarge group, where the resident subsidiary borrowed a very substantial sum of money from a non-resident fellow subsidiary of the same parent company (which had raised the money by making a rights issue and lent it to the fellow subsidiary) in order to finance a major acquisition by the resident subsidiary. The amount of the loan, however, taken with other intra-group loans, was deemed to exceed the amount that would have been agreed between parties dealing at arm's length, and so the thin capitalisation rules were applied to the part of the loan that represented that excess.
85. The crucial paragraphs of the judgment of the Court of Justice in Thin Cap are the following:

"81      The fact that a resident company has been granted a loan by a non-resident company on terms which do not correspond to those which would have been agreed upon at arm's length constitutes, for the Member State in which the borrowing company is resident, an objective element which can be independently verified in order to determine whether the transaction in question represents, in whole or in part, a purely artificial arrangement, the essential purpose of which is to circumvent the tax legislation of that Member State. In that regard, the question is whether, had there been an arm's-length relationship between the companies concerned, the loan would not have been granted or would have been granted for a different amount or at a different rate of interest.

82      As the Advocate General stated at point 67 of his Opinion, national legislation which provides for a consideration of objective and verifiable elements in order to determine whether a transaction represents a purely artificial arrangement, entered into for tax reasons alone, is to be considered as not going beyond what is necessary to prevent abusive practices where, in the first place, on each occasion on which the existence of such an arrangement cannot be ruled out, the taxpayer is given an opportunity, without being subject to undue administrative constraints, to provide evidence of any commercial justification that there may have been for that arrangement.

83      In order for such legislation to remain compatible with the principle of proportionality, it is necessary, in the second place, that, where the consideration of those elements leads to the conclusion that the transaction in question represents a purely artificial arrangement without any underlying commercial justification, the re-characterisation of interest paid as a distribution is limited to the proportion of that interest which exceeds what would have been agreed had the relationship between the parties or between those parties and a third party been one at arm's length."

86. Paragraphs 86 and 87 of the judgment of the Court of Justice repeat the need under European Union law for the taxpayer to be given the opportunity to produce evidence of "commercial justification" in relation to the application of double tax conventions permitting the re-characterisation of loans made by non-resident companies other than on arm's length terms, and in relation to domestic law after the amendments made in 1995 and 1998:

"86.  Whilst a tax regime such as the regime which arises, in cases to which they apply, under the DTCs concluded by the United Kingdom appears initially to be based on a consideration of objective and verifiable elements which make it possible to determine whether a purely artificial arrangement, entered into for tax reasons alone, is involved, it is for the national court to determine, should it be established that the claimants in the main proceedings benefited from such a regime, whether that regime gave them an opportunity, if their transactions did not satisfy the conditions laid down under the DTC in order to assess their compatibility with the arm's-length criterion, to provide evidence as to any commercial justification there may have been for the transactions, without being subject to any undue administrative constraints.

87      The same applies to the national provisions in force after the legislative amendments introduced in 1995 and 1998. It is a matter of agreement that, under those provisions, it is only interest which exceeds what would be paid on an arm's-length basis that falls to be re-characterised as a distribution. Whilst, at first sight, the criteria laid down by those provisions appear to require a consideration of objective and verifiable elements in order to determine whether a purely artificial arrangement, entered into for tax reasons alone, is involved, it is for the national court to determine whether those provisions allow taxpayers, where the transaction does not satisfy the arm's-length criterion, to produce evidence of the commercial justifications for that transaction, under the conditions referred to in the preceding paragraph."

87. The key question is what the Court of Justice meant by "commercial justification" in paragraph 82 of its judgment (and it follows in paragraphs 86 and 87). Mr David Ewart QC, for HMRC, submits that the Court of Justice was using the words "arm's length basis" and "commercial terms" interchangeably. The real point was that the Court of Justice regarded arm's length terms as marking the line between a balanced allocation between member states of the right to tax and abusive practices: accordingly relief could be denied for any loan to the extent that it was not on arm's length terms. When the agreed terms were not on arm's length terms, the non-resident parent company would be taking more profit out of the country in which they are generated than was justified. The Court of Justice attached importance to the test being objective, and one that could be independently verified (see paragraph 81 of its judgment), and thus it is unlikely that it would have contemplated that a taxpayer should be able to bring forward commercial terms, since that would amount in effect to a subjective test. Paragraph 81 of the judgment contained the complete substantive answer of the Court of Justice. The reason why the taxpayer was required to be given the opportunity, "without being subject to undue administrative constraints, to provide evidence of any commercial justification that there may have been for [the loan]" was to ensure due process, that is, that the rules of natural justice were complied with, and in case the advance clearance system as described to it (over which there was some difference between the parties before the Court of Justice) was not enough.
88. Furthermore, on Mr Ewart's submission, the meaning of paragraph 83 had been elucidated in (Case C-311/08) Société de Gestion Industrielle v Etat Belge ("SGI"), particularly paragraph 72. Here the Court of Justice dealt with the corrective tax measure if the terms of the loan in question went beyond what the companies concerned would have agreed under fully competitive conditions, i.e. arm's length terms, and said nothing about commercial justification.
89. The fundamental difficulty that I have with the arguments of the Revenue and the conclusion of Lord Justice Stanley Burnton and Lord Justice Rimer is that they do not in my judgment provide an explanation for decision of the Court of Justice in (Case C-324/00) Lankhorst-Hohorst Gmbh v Finanzamt Steinfurt, decided by the Fifth Chamber of the Court of Justice on 12 December 2002. In this case, the Court of Justice held that a provision of German law for the disallowance of interest paid by a resident subsidiary to its non-resident parent could not be justified discrimination against the non-resident parent and was contrary to Article 43 of the EC Treaty even though it contained an exception for arm's length transactions. The presence of such an exception was not enough. It could not in fact be met by the taxpayer in Lankhorst-Hohorst because the loan in that case would not have been made between parties acting at arm's length: the borrower was in such a parlous condition that no unconnected party would have lent to it:

"Having regard to the over-indebtedness of Lankhorst-Hohorst and its inability to provide security, it could not in fact have obtained a similar loan from a third party…(judgment paragraph 12)"

90. In my judgment, the Court of Justice has not cast doubt on this decision in its later case law. If Lankhorst-Hohorst is still good law, it would appear to hold that a domestic rule which does not permit the deduction of interest paid by a resident subsidiary on a loan made by its non-resident parent other than on arm's length terms, in circumstances where interest on a similar loan by a resident parent company would be deductible, is contrary to European Union law if the loan can be shown to be capable of commercial justification.
91. The Court of Justice in Lankhorst-Hohorst observed that the national court had found that there was no abuse. It was argued before the Court of Justice that the national rule was justifiable because there was an exception for a transaction at arm's length (Judgment, paragraph 39). The Court of Justice rejected this argument because the subsidiary suffered a tax disadvantage (the disallowance of interest paid) and there was no tax advantage to offset that (presumably that would have been a tax advantage obtained by the parent company in the form of the receipt of interest if received in a lower tax jurisdiction). It further held that this legislation could not be justified on the grounds of the need to prevent tax avoidance. Tax was not avoided since tax would be paid in the state in which the lender is resident. The legislation was also not justified by the need to ensure the effectiveness of financial supervision by the state authorities.
92. Mr Ewart submits, correctly, that in Lankhorst-Hohorst the national legislation disallowed interest on a loan by a non-resident lender in the EU by reference to a fixed test (ratio of loan to share capital) and not by reference to some more flexible arm's length test or a test directed to the question whether the loan was artificial. According to the Written Observations made by the UK to the Court of Justice (paragraph 29(c)(i)), it is likely that, under the UK's arm's length test, some of the loan would have been regarded in substance as equity but that some of it would have been treated as a loan. The UK therefore accepted that it was appropriate for part at least of the loan to be treated as made at arm's length. However, the fact remains that in Germany the loan failed the arm's length test and there appears to have been no provision for the type of agreement that might have been made with the Revenue in the UK. In those circumstances, in my judgment, if the Court of Justice had had in Lankhorst-Hohorst to consider what test to impose on an European Union-wide basis, it might reasonably have concluded that it would not be satisfactory to have a rule based purely on an arm's length test. Such a test was open to different interpretations and practical application in different member states. It would moreover be contrary to principle for the matter simply to be left to the discretion of the taxing authority in the member state.
93. The problem in Lankhorst-Hohorst is not solved by the holding in Thin Cap that a loan could be allowed for tax purposes in part and that, even if the loan was wholly disallowable, this would only result in disallowance of terms to the extent that they exceeded arm's length terms. In Lankhorst-Hohorst, the Court of Justice accepted that the national court had held that the terms were not at arm's length. It might not therefore have accepted any of the practical solutions that the UK Revenue would have been prepared to accept. It might have held that the financial position and prospects of the subsidiary were so dire that no third party would have lent money to it. Moreover the Revenue's pragmatic solution on the facts of Lankhorst-Hohorst depend on the willingness of the parent company to subscribe for further share capital, a matter over which the subsidiary would have no control. If there was no such willingness, the position would remain that the subsidiary was not in a position to secure a loan in the open market and thus that it would be a possible conclusion in such a case that no part of the loan would be capable of being considered to be on arms' length terms, a result which would have caused concern to the Advocate General at least.
94. While it might be tempting to think that, if a transaction fails to meet a test of arm's length, it cannot be commercial, it is necessary to recall the jurisprudence of the Court prior to Thin Cap and the context in which the question of what is commercial arises. The Court of Justice was laying down the tests for assessing whether transactions that offended the thin cap rules were abusive as this was the only ground on which domestic rules which discriminated against non-residents could be justified. The facts of Lankhorst-Hohorst appear to demonstrate that there can be transactions that are not at arm's length that could not be described as abusive.
95. In its result Lankhorst-Hohorst demonstrated that the taxpayer had to be given an opportunity to show that, even though the terms were not such as would have been agreed between parties at arm's length, they were still commercial, and worthy of being allowed for tax purposes in the borrower's country of residence. The judgment does not, however, address the issue in those terms. That particular condition was not formulated in that way until the judgment of the Grand Chamber of the Court of Justice in these proceedings, delivered on 13 March 2007. The Court of Justice in these proceedings held that national legislation providing for the disallowance of interest paid on loan capital to a non-resident parent company was an appropriate means of preventing abusive practices provided it was proportionate (see paragraphs 74 to 79 of its judgment). As paragraphs 81 to 83, set out above, show, it would be proportionate if it either specifically targeted abusive practices or met the following conditions: (1) it provided for the taxing authority to determine whether the loan was on arm's length terms both as to interest and amount; (2) it gave the taxpayer the opportunity to show that, even though the terms are not at arm's length, there was commercial justification for them, and (3) only the excess of interest paid over the amount payable on an arm's length basis was disallowed.
96. The argument of the Revenue, which is accepted by Lord Justice Stanley Burnton and Lord Justice Rimer, is that the Court of Justice made it clear in SGI that only the hurdle of showing that a loan was not on arm's length terms needs to be successfully surmounted by the Revenue. This was a decision of the Third Chamber of the Court of Justice dated 21 January 2010. In this case, the Belgian legislation disallowed substantial remuneration paid to a director and re-characterised an interest-free loan as interest-bearing so as to increase the taxable profits of the taxpayer, SGI. The Belgian case law showed that the legislation only applied to transactions that were unusual or gratuitous. The Court of Justice repeated condition (1) and (2) laid down in Thin Cap, including the condition that, if the authorities suspected that the transaction was not at arm's length, the taxpayer should have an opportunity to show that it had a commercial justification:

"71. National legislation which provides for a consideration of objective and verifiable elements in order to determine whether a transaction represents an artificial arrangement, entered into for tax reasons, is to be regarded as not going beyond what is necessary to attain the objectives relating to the need to maintain the balanced allocation of the power to tax between the Member States and to prevent tax avoidance where, first, on each occasion on which there is a suspicion that a transaction goes beyond what the companies concerned would have agreed under fully competitive conditions, the taxpayer is given an opportunity, without being subject to undue administrative constraints, to provide evidence of any commercial justification that there may have been for that transaction (see, to that effect, Test Claimants in the Thin Cap Group Litigation, paragraph 82, and order in Case C-201/05 Test Claimants in the CFC and Dividend Group Litigation [2008] ECR I-2875, paragraph 84)."

97. The Court of Justice in SGI then dealt with the consequences of a taxpayer failing to show what was required of it. The critical paragraph for present purposes is paragraph 72:

"72      Second, where the consideration of such elements leads to the conclusion that the transaction in question goes beyond what the companies concerned would have agreed under fully competitive conditions, the corrective tax measure must be confined to the part which exceeds what would have been agreed if the companies did not have a relationship of interdependence."

98. "Such elements" appears to be a reference to "the objective and verifiable elements" referred to at the start of paragraph 71, and thus there is no separate mention of terms which are not at arm's length but which are shown by the taxpayer to be commercially justified. This leads Lord Justice Rimer to hold that this paragraph makes it clear that nothing less than proof that the terms were the equivalent of arm's length terms will suffice. The difficulty with this is that, if this is correct, then Lankhorst-Hohorst would no longer be good law since the terms in that case were not arm's length terms. Mr Ewart submits that that case is distinguishable because German law would have disallowed the loan in its entirety and because the test of the fixed ratio of debt to equity used in the German legislation was not the same as an arm's length test. I have in part dealt with these points above. The passages cited below will further show that this is not how either the Advocate General or the Court of Justice in Thin Cap viewed Lankhorst-Hohorst.
99. Paragraph 82 of the judgment of the Court of Justice in Thin Cap expressly refers to paragraph 67 of the Opinion of the Advocate General and would thus appear to be placing the same meaning on commercial justification as the Advocate General did in the first indent to that paragraph. That meaning is that put forward by the claimants on this appeal, and not that put forward by the Revenue in this case:

"67.      However, the formulation and application in practice of such a test must also satisfy the requirements of proportionality. This means in my view that:

–        It must be possible for a taxpayer to show that, although the terms of its transaction were not arm's length, there were nonetheless genuine commercial reasons for the transaction other than obtaining a tax advantage. In other words, as the Court noted in its Halifax judgment, 'the prohibition of abuse is not relevant where the economic activity carried out may have some explanation other than the mere attainment of tax advantages'. An example that comes to mind is the situation on the facts in Lankhorst-Hohorst, where the purpose of the loan, as accepted by the Court, was a rescue attempt of the subsidiary via minimising the subsidiary's expenses and achieving savings on bank interest charges. One could imagine, however, that similar situations (i.e., where a transaction was not concluded on arm's length terms, but was nonetheless made non-abusively and not purely to obtain a tax advantage) would be relatively exceptional;

–        If such commercial reasons are put forward by the taxpayer, their validity should be assessed on a case-by-case basis to see if the transactions should be seen as wholly artificial designed purely to gain a tax advantage;

–        The information required to be provided by the taxpayer in order to rebut the presumption should not be disproportionate or mean that it is excessively difficult or impossible to do so;

–        In cases where the payments are found to be abusive (disguised distributions) in the above sense, only the excess part of the payments over what would have been agreed on arm's length terms should be re-characterised as a distribution and taxed in the subsidiary's state of residence accordingly; and

–        The result of such examination must be subject to judicial review. "

100. In these circumstances, it seems to me unlikely to be the correct interpretation of paragraph 72 of the judgment in SGI that it was intended to depart from the judgment of the Grand Chamber. Paragraph 72 of the judgment is only a partial replication of paragraph 83 of the judgment in Thin Cap. It can be seen from paragraph 79 of the Opinion of the Advocate General in SGI that the Court of Justice only had to deal with the corrective tax measure when a transaction was not at arm's length since it was not alleged that there was commercial justification in that case:

"In the present case, it is evident from the order for reference that the grant by SGI to Recydem of an interest-free loan was not justified in economic terms, as SGI itself was highly indebted whereas the financial position of Recydem was secure. Nor, in the view of the referring court, could SGI establish that the payments to Cobelpin constituted appropriate remuneration for its services as director."

101. Finally, so far as SGI is concerned, in paragraphs 73 and 74 of its judgment in SGI (set out in paragraph 53 above), the Court of Justice noted the submission of the Belgian government that under Belgian law the national legislation permitted a taxpayer to resist its application if he could establish that the transaction had a commercial justification, and that the national legislation only led to disallowance of interest exceeding the commercial amount. The Court of Justice accordingly appear to have attached significance to the taxpayer having the ability to provide commercial justification and did not repeat the view, apparently taken by Advocate General Kokott in paragraph 78 of her Opinion, that the taxpayer was required to show that the transaction was on arm's length terms. However the question whether Belgian law was in fact proportionate was left to the national courts to determine. In those circumstances, in respectful disagreement with Lord Justice Rimer, I have not derived assistance on the legal point at issue on this appeal from the terms of the Advocate General's Opinion.
102. I likewise derive no assistance for the purposes of this appeal from the other recent case of (Case C-231/05) Oy AA, in which the Grand Chamber of the Court of Justice gave judgment on 18 July 2007. This held that the denial of relief in respect of a transfer of income to a non-resident in a different member state in the EU from that of the transferor could be justified by the need to preserve a balanced allocation of the taxing power between the two states but it had to be proportionate. The legislation did not have to be specifically designed to exclude abusive transactions. It did not matter that there were no exceptions as no viable exceptions had been suggested that would not run the risk of the parties having the ability to choose in which state the income would be taxed. In respectful disagreement with the view expressed by Lord Justice Stanley Burnton at paragraph 44 above, I do not consider that this case is difficult to reconcile with Thin Cap as it is concerned with a transfer of income to a resident of another member state of the taxpayer's choice, not the deduction of interest in the member state exercising its right to tax.
103. I have set out above paragraphs 86 and 87 of the judgment of the Court of Justice in Thin Cap. These provide some small additional support for my reasons for rejecting the Revenue's argument apart from the fact that they also refer to the need for the taxpayer to have an opportunity to bring forward evidence of commercial justification for the transaction. Paragraph 87 of the judgment of the Court of Justice in Thin Cap is expressed in a manner which is inconsistent with the Revenue's case, and, given the succinctness of the judgment, it is difficult to dismiss this as a mere matter of language as Mr Ewart invited us to do. The point is one which Lord Justice Rimer made to Mr Ewart in the course of his reply. If the Revenue's argument is correct, the final sentence would have included the words which I have italicised in the quotation which follows, whereas the words actually used are inconsistent with its argument:

"... it is for the national court to determine whether those provisions allow taxpayers, where it appears that the transaction does not satisfy the arm's-length criterion, to produce evidence of the commercial justifications for that transaction, under the conditions referred to above."

104. In conclusion, in my judgment, it is clear that the Court of Justice has, through the evolution of its case law, sought to provide a roadmap for determining what is or is not an abusive transaction. Such a transaction is to be found by the tax authorities first asking, by reference to objective and verifiable elements, whether the transaction is on arm's length terms, or as it is from time to time put, on fully competitive terms. It follows that the Revenue does not have to go further at this stage than consider whether the loans were on a fully competitive basis. If it is not on such terms, the taxpayer must be given an opportunity to show that the terms were nonetheless commercial, as in Lankhorst-Hohorst, and for that reason not abusive. It is for the national court to determine whether the ground that the taxpayer asserts is sufficient commercial justification for this purpose.
105. Accordingly, in my judgment, the judge was correct to hold:

"[65] As will already be apparent, I am unable to accept the Revenue's submission that the ECJ regarded the question of commercial justification as no more than an aspect of the arm's length test. In my judgment it is abundantly clear that the ECJ regarded them as separate tests, each of which had to be satisfied if the thin cap rules of the UK or any other member state were to meet the criterion of proportionality. The proposition that the ECJ regarded the arm's length test alone as sufficient for this purpose, or as a complete 'proxy' for determining whether there was abusive tax avoidance, is in my opinion impossible to reconcile with the clear terms of the ECJ's judgment, in particular paras 82, 83, 86, 87 and 92.

106. The judge went on to hold that:

"The details of how that test is to be applied are, of course, a matter for the national court, subject to the requirement that there should be no 'undue administrative constraints'." (Judgment , paragraph 69)

107. The judge went on to make findings of fact with respect to the loans by the claimants. In the light of those findings, his order provides that:

"3. None of the transactions entered into by the claimants were, either wholly or in any relevant part, purely artificial arrangements devoid of any commercial justification and the Thin Cap provisions must be disapplied in relation to all of those transactions."

108. The judge's order quoted above is apparently based on paragraph 82 of the judgment of the Court. For the purposes of this appeal the Revenue have accepted that, in the case of the claimants' test claims, there was some commercial reason for the non-resident parent company providing the money to its resident subsidiary, and that, if the judge was right on the test, it was satisfied in all these cases. Accordingly we are not required to consider the limits of the exception for "commercial justification" and whether the judge was right in saying that the exception for commercial terms raised no question of European Union law. Furthermore, it has not been argued that, if only some commercial justification was shown, part of the loan could be treated as non-allowable for tax purposes on the basis that paragraph 83 of the judgment of the Court of Justice is dealing only with the extreme situation where the whole of a loan is found to be aimed at tax avoidance. These are issues therefore for another day.
109. Paragraph 67 (first indent) of the Opinion of the Advocate General in Thin Cap made the point that it would be relatively exceptional for there to be any case, like Lankhorst-Hohorst, where the loan was not on arm's length terms but yet was not abusive or entered into purely to obtain a tax advantage. The Court of Justice did not however express a view on that. It is apparent from the judge's findings in this case that such cases will not necessarily be rare.
110. I agree with the judge that the domestic legislation can only take effect subject to taxpayers' rights under European Union law. It is common ground on this appeal that that result can be achieved and that it does not matter whether it is achieved by disapplication or conforming interpretation, and no time in argument was spent on that distinction. I therefore do not intend to spend time in considering whether this is an appropriate case of disapplication or conforming interpretation. However, I agree with Lord Justice Stanley Burnton that the judge was wrong to impose the burden of proof on the Revenue for the reasons that he gives save that I would also refer to paragraphs 105 and 106 of the decision of this court in Test Claimants in the FII Group Litigation v Revenue and Customs Commissioners [2010] EWCA Civ 103; [2010] STC 1251.
111. On the conclusions that I have reached, the claimants' contingent cross-appeal does not arise.
112. The judge dealt with the claimants' claim for damages on the basis of sufficiently serious breach of European Union law at paragraphs 335 to 338 of his judgment, and found that there was a sufficiently serious breach as from the handing down by the Court of Justice of its judgment in Lankhorst-Hohorst:

"[335] The position following delivery of the judgment [in Lankhorst-Hohorst on 12 December 2002], however, is a different matter. The ECJ had now ruled on the German thin cap provisions which were used as a model for the 1995 amendments, and had held that they breached art 43 EC. Furthermore, defences of fiscal cohesion and the risk of tax avoidance had been considered and rejected. The writing was now clearly on the wall so far as the UK thin cap provisions were concerned, and although the fiscal cohesion and tax avoidance defences remained arguable, they offered only a slender prospect of success. Leading counsel advised the Revenue in March 2003 that the German provisions could not be relevantly distinguished from the UK regime, and apparently estimated the chances of successfully resisting a challenge to them in the ECJ at around 10%. In my judgment that was an accurate assessment.

[2010] STC 301 at 105

[336] The decision of the ECJ in Lankhorst-Hohorst largely followed the advice and reasoning of the Advocate General, who had delivered his opinion on 26 September 2002, so the judgment did not come as a bolt from the blue. On the contrary, it had been expected, and the mood within International Division was pessimistic. Against that background, it seems to me that the UK's breach of art 43 EC became, objectively, a serious one as soon as the ECJ had delivered its judgment, and that liability to the claimants in damages for maintaining the UK provisions in force should run from 12 December 2002.

[337] I have considered whether the commencement of the period of liability should be somewhat later, to allow time for the Revenue to have taken advice about the judgment and made a public announcement of its future policy. However, I do not consider an enquiry of that nature to be appropriate. The question is rather when the breach, viewed objectively, became sufficiently serious, taking account of 'all the factors which characterise the situation'. At least in the context of the present case, and the passive policy which the UK had adopted since 1995, it seems to me that the critical turning point was the ruling in Lankhorst-Hohorst, and that it would be potentially unfair to the claimants to prevent them from recovering damages from the moment when the law was clarified.

[338] For these reasons, I conclude that no sufficiently serious breach is established before 12 December 2002, but that damages are in principle recoverable by the claimants from that date."

113. In my judgment, although the Court of Justice rejected the fiscal cohesion defences, the basis of the judgment of the Court of Justice in Lankhorst-Hohorst was far from clear. It was not until Case C-446/03 Marks & Spencer plc v Halsey, a decision of the Grand Chamber of the Court of Justice handed down on 13 December 2005, which concerns discrimination with respect to loss relief and which holds that a member state could not discriminate against losses incurred by non-resident subsidiaries where they were not allowable in the country of residence, that the Court of Justice took account of the balanced allocation between the member states of the right to tax. This is one of the justifications on which the Court of Justice ultimately relied in coming to its decision in Thin Cap.
114. Furthermore, in his Opinion in Lankhorst-Hohorst, the Advocate General suggested that the German thin cap provision might be extended to loans by resident lenders (Opinion, paragraph 99). However, that was a drastic solution, and one which was later disavowed in trenchant terms by Advocate General Geelhoed in paragraph 68 of his Opinion in the Thin Cap case:

"68.      Nor am I of the view that, in order to conform with Article 43 EC, Member States should necessarily be obliged to extend thin cap legislation to purely domestic situations where no possible risk of abuse exists. I find it extremely regrettable that the lack of clarity as to the scope of the Article 43 EC justification on abuse grounds has led to a situation where Member States, unclear of the extent to which they may enact prima facie 'discriminatory' anti-abuse laws, have felt obliged to 'play safe' by extending the scope of their rules to purely domestic situations where no possible risk of abuse exists.  Such an extension of legislation to situations falling wholly outwith its rationale, for purely formalistic ends and causing considerable extra administrative burden for domestic companies and tax authorities, is quite pointless and indeed counterproductive for economic efficiency. As such, it is anathema to the internal market."

115. I do not consider that there could be a liability in damages for sufficiently serious breach by virtue only of the delivery of the judgment in Lankhorst-Hohorst, from which the three conditions in Thin Cap might with sufficient prescience have been foretold. Moreover, the government was in the particular circumstances of this case entitled to a reasonable time in which to conduct consultation with interested parties on the options for reforms available to it and to prepare legislative proposals and lay them before Parliament. Its delay will not have prejudiced the direct rights of taxpayers before legislation was enacted. The period of 15 months or thereabouts between December 2002 and April 2004 does not seem to me to be excessive in the circumstances.
116. In discussing this claim, the court is of course proceeding on the basis that the arm's length test is not, contrary to the judgments of Lord Justice Stanley Burnton and Lord Justice Rimer, the sole test for the deductibility of interest paid to non-resident parent companies. My conclusion that liability for serious breach on that hypothesis is not established is confirmed by the further factor, namely that the limits of the commercial terms exception, which is now in effect the only shortcoming in domestic law capable of giving rise to liability under this head, cannot, even on the hypothesis on which this discussion is proceeding, in the light of the judgment of Lord Justice Stanley Burnton and Lord Justice Rimer, be described as clear. That in my judgment puts it beyond doubt that liability in damages for sufficiently serious breach of European Union law in this case is not established.
117. For these reasons and those given by Lord Justice Stanley Burnton, I do not consider that the judge was correct in his holding that this claim succeeded with respect to the period between the publication of the judgment in Lankhorst-Hohorst and 1 April 2004. Nor (insofar as this point was in the end argued by Mr Aaronson on behalf of the claimants) do I consider that liability under this head can be established for any earlier period given the points made above and the judge's clear findings that the government acted in good faith, that it had sought to amend the law in 1995 so as to make it immune from challenges under EU law and that it was reasonable for it to do no more at least until a decision of the Court of Justice in the field of thin capitalisation was concerned (see in particular paragraphs 312, 319 and 334 of his judgment). The observations of the Advocate General (Opinion, paragraph 108) and the Court of Justice (Judgment, paragraph 121) in Thin Cap confirm my conclusions on this point.
118. For these reasons, I would allow the appeal in part only, namely with respect to the burden of proof and sufficiently serious breach points, and dismiss both the remainder of the appeal and the whole of the respondents' contingent cross-appeal.