As reported previously, on 12 December 2006, the European Court of Justice (ECJ) gave its decision in the case of Test Claimants in Class IV of the ACT Group Litigation v. Commissioners of Inland Revenue (C-374/04) regarding the compatibility with the EC fundamental freedoms of the previous UK rules governing the entitlement to tax credits on dividends paid by UK resident companies to non-residents. The rules at issue in this case formed part of the UK's partial imputation and advance corporation tax (ACT) system, which were in force prior to 6 April 1999. Details of the judgment are summarized below.

Decision. The first question at issue was whether or not a rule, which grants a full tax credit on a payment of dividends by a UK resident company to an ultimate shareholder resident in the United Kingdom or in a State with which the United Kingdom has concluded a tax treaty providing for such credit, but does not grant a full or partial tax credit to companies receiving such dividends that are resident in certain other EU Member States, is compatible with the freedom of establishment (Art. 43 of the EC Treaty) and the freedom of movement of capital (Art. 56 of the EC Treaty).

The ECJ clarified that the principal issue in the case was the alleged restriction of the free movement rights of non-resident companies receiving UK-sourced dividends and not the differential treatment of the ultimate shareholders receiving dividends from resident companies, on the one hand, and from non-resident companies, on the other hand.

First, the ECJ held that the UK rules at issue must be examined in light of both the freedom of establishment and the free movement of capital. As the reasoning applied by the ECJ to the two freedoms did not differ, reference in the followings is only made to the freedom of establishment.

The ECJ, by reference to the established case law, recalled that the freedom of establishment is intended to guarantee the benefit of national treatment in the host EU Member State by prohibiting any discrimination based on the place in which companies have their seat. In order to determine whether or not a difference in tax treatment is discriminatory, it is necessary to consider whether or not, having regard to the national measure at issue, the companies concerned are in an objectively comparable situation.

In this regard, the UK government argued that, in respect of a national measure which grants a tax credit to shareholders receiving dividends from a resident company, the situation of resident shareholders and that of non-resident shareholders are not identical, in that a non-resident company is not liable to tax in the United Kingdom on those dividends. Conversely, the claimants argued that both resident and non-resident companies receiving UK-sourced dividends are in an identical situation to a resident company to which such dividends are paid is also exempt from corporation tax in the United Kingdom on those dividends.

Rather than ruling on the comparability of the situation of resident and non-resident companies receiving UK-sourced dividends, the ECJ distinguished between the requirements relating, on the one hand, to the tax legislation of the EU Member State in which the shareholders receiving the dividends are resident (the residence State) and, on the other hand, that of the EU Member State in which the company making the distribution is resident (the source State). As to the obligation of the residence State, the ECJ stated, referring to the Lenz (C-315/02) and Manninen cases (C-319/02), that, if the EU Member State has a system for preventing or mitigating a series of charges to tax or economic double taxation for dividends paid to residents by resident companies, it must treat dividends paid to residents by non-resident companies in the same way. The ECJ then clearly stated out that the source State is not in the same position, as regards the prevention or mitigation of a series of charges to tax and of economic double taxation, as the resident State. First, to require the source State to ensure that profits distributed to a non-resident shareholder are not liable to a series of charges to tax or to economic double taxation, would mean, in fact, that the State would have to abandon its right to tax a profit generated through an economic activity undertaken on its territory. Second, as regards a procedure for preventing or mitigating economic double taxation by the grant of a tax advantage to the ultimate shareholder, it is usually the EU Member State in which the latter is resident that is best placed to determine the shareholder's ability to pay tax.

The ECJ pointed out that the difference in treatment entailed by the UK rules lies in the fact that UK resident companies that receive dividends from another UK resident company are authorized, on the payment of dividends, to grant a tax credit to their ultimate shareholders that are resident in the United Kingdom, whilst non-resident companies are not so authorized.

The position of an EU Member State that acts as both the source State of the dividends and as the residence State of the ultimate shareholders is, however, not comparable to that of an EU Member State that only acts as a the source State of dividends, which are paid to non-resident companies and then redistributed to ultimate shareholders. The latter State does not have an obligation to subject dividends received by resident shareholders, on the one hand, and non-resident shareholders, on the other hand, to the same tax treatment.

Finally, the ECJ emphasized that, in contrast to that stated previously, when an EU Member State, unilaterally or by a convention, imposes a charge to income tax not only on resident shareholders but also on non-resident shareholders in respect of dividends that they receive from a resident company, the position of those non-resident shareholders becomes comparable to that of resident shareholders. In these circumstances, the source State must ensure that non-resident shareholder companies are subject to the same tax treatment as resident shareholder companies.

In summary the ECJ held, adopting the outcome and reasoning proposed by Advocate General Geelhoed in his Opinion, that the legislation of an EU Member State, which, on a payment of dividends by a resident company, grants a tax credit only to resident companies receiving the dividends and which extends the benefit of that tax credit exclusively to resident ultimate shareholders, does not constitute discrimination prohibited by Art. 43 of the EC Treaty.

The second issue concerned two related questions. First, whether or not Arts. 43 and 56 of the EC Treaty preclude an EU Member State from applying tax treaties concluded with other EU Member States in terms of which, on a payment of dividends by a resident company, companies receiving those dividends that reside in some EU Member States are not entitled to a tax credit, whilst companies receiving such dividends that reside in certain other EU Member States are granted a full or partial tax credit. Second, whether or not it is permissible for an EU Member State to apply a "limitation of benefits" (LOB) provision in its tax treaties. The LOB clauses contained in certain tax treaties concluded by the United Kingdom result in the denial of a tax credit to a company resident in the other contracting EU Member State if that company is controlled by a company resident in a third State with which the United Kingdom has concluded a tax treaty that makes no provision for a tax credit for a company, which is resident in the third State on its receipt of dividends.

With regard to the first question, the ECJ emphasized that the situations in which the United Kingdom grants a tax credit to companies resident in the other Contracting State receiving UK-sourced dividends are those in which the United Kingdom also retains the right to tax the companies on those dividends. There is also a direct link between the entitlement to tax credit and the rate of tax set out laid down in such tax treaties. Accordingly, the grant of a tax credit cannot be regarded as a benefit separable from the remainder of those tax treaties, but is, rather, an integral part of the tax treaties and contributes to their overall balance, as was stated in the "D" case (C-376/03). The ECJ held that the same applies to the LOB clauses in question. Consequently, a company resident in an EU Member State that has concluded a tax treaty with the United Kingdom that does not provide for a tax credit is not in the same situation as a company resident in an EU Member State that has concluded a tax treaty that provides for one.

Consequently, the application by the United Kingdom of the tax treaties in question in the reference for the preliminary ruling does not result in discrimination and is not precluded by either the freedom of establishment or the free movement of capital.