Revenue and Customs v Coal Staff Superannuation Scheme Trustees Ltd [2022] UKSC 10 (27 April 2022)

It is not known, and the borrower was not obliged to inform the Trustee or JPM, by whom the underlying shares were owned when the dividend was paid, where the then owner was based, or how much (if any) withholding tax was actually levied on the dividend by the Italian tax authorities. Nor is it known for which of the three main purposes (short selling, settlement of short positions or dividend arbitrage) the loan of these shares was requested by the AUKI. Nor is the amount of the lending fee recorded in the findings of fact. Ignoring the lending fee, in this and all the other sample cases the Trustee received exactly the same amount of net MOD as it would have received by way of net real dividend if the shares had not been lent.

The evidence does not show whether all or any of the MOD WHT for which the AUKI was liable to account in respect of the MOD in each case was actually paid to the Revenue. This would have depended upon the availability to the AUKI borrower of tax credits allowable by way of set-off. It is stated in the Written Case of the Revenue (with a persuasive explanatory note about the reasons) that, generally speaking, AUKIs as active stock traders usually had more than sufficient available and otherwise unusable withholding tax credits to soak up the whole of their MOD WHT accounting liability. Although not admitted, this was not effectively challenged by the Trustee. The effect of this is that the Revenue did not in practice receive any sums by way of payment of tax in relation to the foreign dividends in fact paid or in respect of the fictional MODs payable to the lender. The fact that liability for payment to the Revenue of tax in relation to the MODs depended on the tax affairs of the AUKIs also indicates that such payment was, within the UK tax regime, payment of a tax on the AUKI, not payment of a tax on the lender.

The Law: (i) the MOD Tax Arrangements

The most relevant provisions dealing with the taxation of MODs during the relevant period were originally to be found in Schedule 23A to ICTA. With effect from the 2007/08 tax year those provisions were caught up and replaced in the “re-write” of much of ICTA and re-enacted in Chapter 9 part 15 of the Income Taxes Act 2007, but it is common ground that this brought about no relevant change in their meaning and effect. Accordingly the examination of the issues in this litigation has been based on Schedule 23A ICTA rather than on its successor, a convention to which this judgment will gladly adhere.

Schedule 23A also deals, at paragraph 2, with the taxation of MDs. For the lender the MD is treated as if it were a real dividend from the UK company the shares of which had been lent. For the borrower the MD is treated as if it were a dividend paid by the borrower itself. Nothing turns on the language by which that tax treatment is achieved.

Paragraph 4 of Schedule 23A is headed “Manufactured overseas dividends” and provides, so far as is relevant, as follows:

“(1) This paragraph applies in any case where, under a contract or other arrangements for the transfer of overseas securities, one of the parties (the ‘overseas dividend manufacturer’) is required to pay to the other (‘the recipient’) an amount representative of an overseas dividend on the overseas securities; and in this Schedule the ‘manufactured overseas dividend’ means any payment which the overseas dividend manufacturer makes in discharge of that requirement.

(2) Subject to sub-paragraph (3) below, where this paragraph applies the gross amount of the manufactured overseas dividend shall be treated for all purposes of the Tax Acts as an annual payment, within section 349, but -

(a) the amount which is to be deducted from that gross amount on account of income tax shall be an amount equal to the relevant withholding tax on that gross amount; and

(b) in the application of sections 338B(4)(a) and 350(4) in relation to manufactured overseas dividends the references to Schedule 16 shall be taken as references to dividend manufacturing regulations;

…

(4) Where a manufactured overseas dividend is paid after deduction of the amount required by sub-paragraph (2) above, … then for all purposes of the Tax Acts as they apply in relation to persons resident in the United Kingdom … -

(a) the manufactured overseas dividend shall be treated in relation to the recipient, and all persons claiming title through or under him, as if it were an overseas dividend of an amount equal to the gross amount of the manufactured overseas dividend, but paid after the withholding therefrom, on account of overseas tax, of the amount deducted under sub-paragraph (2) above; and

(b) the amount so deducted shall accordingly be treated in relation to the recipient, and all persons claiming title through or under him, as an amount so withheld instead of as an amount on account of income tax.”

Since paragraph 4(4) provided that the recipient of a MOD was deemed to have suffered overseas tax on the MOD, in the ordinary course that would give rise to the possibility of double taxation relief, pursuant to any double taxation treaty arrangement or relief against foreign tax granted by the UK unilaterally as a matter of its own tax policy. However, section 796 of ICTA provides that relief in respect of tax paid in overseas territories, including tax deemed to have been so paid by Schedule 23A, is available only to the extent that the taxpayer has a UK income tax liability for the year of assessment. As explained above, UK pension funds do not have such liability and are therefore unable to claim double taxation relief.

Paragraph 4(5) of Schedule 23A defined the relevant withholding tax in relation to a MOD as an amount representative of the amount that would have been deducted by way of overseas tax from an overseas dividend of the same gross amount as the MOD, and the amount of any overseas tax credit in respect of such an overseas dividend. The dividend manufacturing regulations referred to in paragraph 4(2)(b) are the Income Tax (Manufactured Overseas Dividends) Regulations 1993 (SI 1993/2004), which provided for different rates of relevant withholding tax to apply in relation to shares located in different overseas territories. By regulation 3 they set the rate of the relevant withholding tax which is to be deducted under paragraph 4(2) of Schedule 23A (ie the MOD WHT) at the withholding tax rate which would, under the law of the relevant overseas country, have applied to the real overseas dividend of which the MOD is representative, if it had been paid to a UK taxpayer. Thus, in the example given in para 19 above, the withholding tax rate then imposed by Italy on dividend payments to a UK taxpayer was 15%. Therefore 15% was the rate of the MOD WHT which the AUKI had to deduct from the grossed-up MOD before payment to the Trustee.

Section 349 of ICTA, to which reference is made in paragraph 4(2) of Schedule 23A, provides as follows:

“(1) Where -

(a) any annuity or other annual payment to which this paragraph applies; or

(b) any royalty or other sum paid in respect of the user of a patent; or

is not payable or not wholly payable out of profits or gains brought into charge to income tax, the person by or through whom any payment thereof is made shall, on making the payment, deduct out of it a sum representing the amount of income tax thereon.”

Thus the effect of the deeming or “treating” of a MOD as if it were an annual payment under section 349 is to provide well-recognised machinery for the deducting of MOD WHT at source by the AUKI as borrower under a stock lending agreement, before payment of the MOD to the borrower. Mr Gammie QC for the Trustee explained that the section 349 mechanism for deduction of tax at source in respect of periodic payments as a feature of the UK tax regime was first introduced in 1803.

A major issue between the parties on this appeal was whether this way of providing for the deduction and payment of MOD WHT had the effect that it was tax levied by way of deduction at source, on the Trustee’s income as lender, or merely a tax liability of the AUKI as borrower. The submission of the Trustee that it was the former was the cornerstone of its case that, since the MOD WHT was unlawful, the Trustee’s proper remedy was a claim for repayment, rather than damages. This was the only real issue about the meaning and effect of the MOD tax regime. We return to this point in the section on remedy below.

The Law: (ii) article 63 TFEU

Article 63 of the TFEU provides as follows:

“1. Within the framework of the provisions set out in this Chapter, all restrictions on the movement of capital between member states and between member states and third countries shall be prohibited.”

This short provision, which enshrines one of the fundamental freedoms guaranteed by the TFEU, has been interpreted and applied by the CJEU in a way that has cut a deep swathe through UK tax law (as it had previously been understood). It has led to claims for the repayment of many billions of pounds of tax alleged to have been unlawfully demanded in breach of article 63, to numerous large cases before this court and its predecessor, and to numerous references to the CJEU. It has also led to a fundamental and contentious reappraisal of UK law about unjust enrichment and the limitation of actions. The position can be summarised as follows.

A claim that there has been a breach of article 63 requires it to be shown that the relevant provisions of national law constitute a restriction, directly or indirectly, on the free movement of capital. That will be the case if they are liable to have a dissuasive effect in relation to cross-border investment. As the CJEU put it in Bouanich v Directeur des services fiscaux de la Drôme (Case C-375/12) ECLI:EU:C:2014:138, para 43 (“Bouanich”):

“According to settled case law, the measures prohibited by article 63(1) TFEU, as restrictions on the movement of capital, include those which are such as to discourage non-residents from making investments in a member state or to discourage that member state’s residents from doing so in other States (Joined Cases C-338/11 to C-347/11 Santander Asset Management SGIIC and others [2012] ECR, para 15 and the case law cited).”

A restriction for the purposes of article 63 may arise from the application of different tax rules to objectively similar situations or the application of the same tax rules to situations which are objectively different (see Bouanich, para 45). There will therefore generally be a dissuasive effect if an international transaction constituting a movement of capital is treated less favourably, whether directly or indirectly, for tax purposes than one which is otherwise substantially similar but purely domestic in character (see Test Claimants in the FII Group Litigation v Inland Revenue Comrs (Case C-446/04) [2012] 2 AC 436, para 145 (“FII Test Claimants (No 1)”)). The tax treatment of income is capable of giving rise to a dissuasive effect because of the impact this may have on the attractiveness of the capital investments from which the income is derived, including, in the case of income from or related to dividends, the acquisition, retention and transfer of shares (see Staatssecretaris van Financiën v Verkooijen (Case C-35/98) [2002] STC 654, para 35). A dissuasive effect may therefore be created by treating, for tax purposes, income derived from shares in a foreign company less favourably than income derived from shares in a company resident in the same member state as the taxpayer. Thus, in Bouanich (para 56), the CJEU held that:

“… legislation such as that at issue in the main proceedings, because of the difference in treatment it imposes between resident taxpayers depending on whether they receive dividends from a company established in the national territory or from a company established in another member state, constitutes a restriction on the free movement of capital prohibited, in principle, by article 63 TFEU.”

Similarly, in Proceedings brought by Manninen (Case C-319/02) [2005] Ch 236 (“Manninen”), Advocate General Kokott said, at point 32 of her opinion, that: “The worse tax treatment of an investment in the shares of companies established abroad makes such investment less attractive for the investor than the acquisition of the shares of domestic companies and thus impedes the movement of capital.”

Demonstration that the provisions of national law have the relevant dissuasive effect is not generally a matter of proof, by evidence, that relevant persons have actually been, or will actually be, dissuaded. Rather it is a matter of logical analysis: see Advocate General Kokott in Manninen, point 28. Nor need it be shown that the dissuasive effect is universal, or even particularly serious: see, by analogy with freedom of establishment, De Lasteyrie du Saillant v Ministère de l’Économie, des Finances et de l’Industrie (Case C-9/02), para 43, applied to article 63 TFEU in the Opinion of Advocate General Kokott in Haribo, point 23, footnote 15.

Applying those principles, any assessment of the potential dissuasive effect of the relevant provisions of national law will therefore entail the court asking what impact they would be likely to have on the behaviour of (it is to be assumed rational) economic actors doing business in the relevant market in relation to the transaction constituting the movement of capital. In other words, as indicated at para 13 above, the analysis is ultimately an economic one based upon the mechanics of the relevant type of transaction and its actual or potential real-world consequences for the different parties involved. Here, the relevant types of transaction are, first, the “lending” of shares by means of stock lending agreements and secondly, the acquisition of shares as investments, with a view to benefiting from them by stock lending thereafter.

For a case such as the present where, as already noted, juridical double taxation is already a dissuasive factor affecting the acquisition of overseas shares, by comparison with UK shares, the economic analysis needs carefully to distinguish between that (unfortunate but lawful) aspect of dissuasive effect and that alleged to be attributable to the purely domestic tax legislation contrary to article 63, here the tax treatment of MODs compared with MDs. This is not a problem with which the existing EU jurisprudence has yet had to grapple.

However, it is established in EU law that a member state commits no violation of article 63 where its tax regime does not seek to correct for the fact of juridical double taxation (Kerckhaert v Belgium (Case C-513/04) [2007] 1 WLR 1685, paras 17-20), nor as regards a decision taken as a matter of its own tax policy when it grants a tax credit in respect of foreign withholding tax levied in another state to limit or avoid such double taxation (Bouanich, paras 39 and 41). In our view, therefore, the EU jurisprudence accepts that analysis of dissuasive effect for the purposes of article 63 should proceed against the background of juridical double taxation as a fact of life.

The Analysis of the Courts Below

The FtT (Judge Jonathan Cannan and Mrs Helen Myerscough) [2016] SFTD 750 (TC) considered that there was no restriction which offended article 63. In their view the MOD tax regime could not sensibly be said to inhibit the lending of overseas shares (once acquired), but on their analysis the Trustee’s real case was that it inhibited their acquisition in the first place. Addressing that case directly, at paras 127 to 129, they said that the MOD regime needed to be appraised as to its effect not in a vacuum but against the context of the withholding tax regime affecting actual dividends on overseas shares, and the inability of a tax-exempt shareholder to make use of the consequential tax credit. In their view it was that withholding tax regime (ie the fact of juridical double taxation) which was the only real dissuasive factor in the decision of a tax exempt investor to acquire overseas shares, which the MOD regime merely replicated in the event of stock lending. The MOD regime therefore involved no infringement of article 63.

The UT (Morgan J and Judge Berner) [2018] STC 1095 took an altogether different approach, which in substance adopted the whole of the Trustee’s case. In their view the restriction was constituted by the imposition of the whole of the MOD WHT and the inability of a tax-exempt investor such as the Trustee to make any use of the corresponding tax credit. Since a tax-exempt investor would incur no tax on a MD (in the context of a lending of UK shares) there was a difference in treatment of MDs and MODs which arose from comparable transactions. This was a difference in treatment solely attributable to the UK tax regime and since it derived from the different treatment of overseas shares by contrast with UK shares, it necessarily amounted to an infringing restriction on the free movement of capital constituted by both the acquisition and lending of overseas shares. The UT rejected the Revenue’s defence of justification. Since, on the UT’s view, the MOD WHT was a deduction of tax at source from the Trustee’s income, it was entitled to claim repayment in full.

The Court of Appeal (Newey, Asplin and Rose LJJ) [2020] 1 WLR 777 reached the same end-point as the UT, but by a more nuanced route. In a joint judgment they rejected the Trustee’s case, and the UT’s conclusion, that the relevant restriction was constituted by the imposition of the whole of the MOD WHT. Their starting point was that juridical double taxation in the form of foreign withholding tax would adversely affect the income stream from dividends on lent overseas shares in any event. Even in the absence of the MOD tax regime, the Trustee could not have expected to receive as a MOD the whole of the gross dividend paid by the overseas company. For example, if the borrower had retained the shares it would have suffered foreign withholding tax on the dividend and the Trustee could not have expected to receive more than the net amount as its MOD. If the borrower had engaged in dividend arbitrage by selling the shares to a buyer which would incur less withholding tax (or none at all) the Trustee could not expect to receive the whole of the consequential benefit: “at best, it might have shared in the gain that could be realised” (para 39).

At para 41 the Court of Appeal expressed its conclusion in these terms:

“In the circumstances, we cannot accept Mr Baldry’s submission that the MOD regime did not give rise to any ‘adverse consequences’ for the Trustee. True it may be, as the FTT said, that the Trustee was left in the position that it would have been in had it not lent the shares, but that cannot be determinative. While, as we have said, the MOD regime will not have reduced the Fund’s MODs by the full amount of the tax deducted pursuant to it, it can be expected to have impaired them to some degree. More often than not, the borrower will not have retained the shares and the dividend of which the MOD was representative may not then have been subject to overseas withholding tax at the rate used for the MOD regime, if at all. That suggests that, but for the MOD regime, the Trustee could have hoped to lend overseas shares on better terms. It could rationally be supposed that borrowers might at least sometimes be willing to pay the Trustee more than the net amount of a dividend after deduction of ‘relevant withholding tax’ in accordance with paragraph 4 of Schedule 23A to ICTA. It follows, as we see it, that the MOD regime limited the returns available to investors such as the Fund from stock lending of overseas shares and, hence, was liable to discourage such investors from buying or retaining overseas shares. Investment in UK shares, of course, gave rise to no such issues.”