iIn a recent case involving Next Brand Ltd, the First-Tier Tribunal ruled in favor of HM Revenue & Customs (HMRC), finding that double tax relief was not available for dividends that in effect represented loan repayments.
Background
Prior to the introduction of the dividend exemption, when a UK parent company received foreign source dividends, it was possible to benefit from a credit for any foreign tax that the subsidiary had already paid—i.e., tax paid by a subsidiary was treated as tax paid by the parent. This arrangement was intended to prevent double taxation.
“Rate-booster” strategies were designed to use this principle to limit or completely avoid corporation tax in the United Kingdom on dividends by boosting the underlying double tax relief.
Next Brand’s Strategy
Next Brand’s strategy involved a complicated arrangement of loans, dividends, preference share issuances and share transfers. In broad summary, Next Brand’s Hong Kong subsidiary, Next Sourcing Ltd (NSL), subscribed for irredeemable preference shares in Next Near East Ltd (NNEL), one of Next Brand’s UK subsidiaries. After the board had satisfied itself that NNEL had sufficient distributable profits at the time, NNEL paid a dividend to NSL on the preference shares. Subsequently, NSL paid a dividend to the parent company, Next Brand.
Next Brand claimed double taxation relief equivalent to an amount that would eliminate all, or almost all, of the UK tax otherwise payable on the dividend. In calculating this relief, Next Brand took into account UK corporation tax that was payable by NNEL.
The underlying issues of the case were whether the NNEL dividends were “dividends” for the purposes of the relevant relief provisions, and whether any tax paid by NNEL could be taken into account in Next Brand’s claim for double taxation relief.
HMRC’s Position
HMRC rejected Next Brand’s claim for double taxation relief, arguing that the group’s arrangements constituted a series of artificial steps by which Next Brand sought to inflate the value of the relief to which it was properly entitled.
In particular, HMRC found that, despite the fact that the NNEL dividends had the legal form of dividends, they were in substance repayments of a loan. HMRC therefore reasoned that the dividends were not derived from taxed profits, but rather constituted cash circulated within the group.
The First-Tier Tribunal’s Ruling
Rejecting Next Brand’s appeal against HMRC’s decision, the First-Tier Tribunal stated that it was not enough for the paying company to declare a dividend; instead, it must be shown that the dividend is derived from profits. In the tribunal’s view, the key point was not whether the payment took the form of a dividend, or whether it had the character of income or capital, but whether the payment was of profits that had borne tax.
The tribunal agreed with HMRC’s reasoning that NNEL’s dividends were in fact loan repayments. The tribunal pointed out that the subsidiaries had themselves accounted for the issue of the preference shares as debt, and for the dividend as the repayment of debt.
Comment
Several rate-booster strategies are due to be heard in the UK courts in due course. Those taxpayers with facts similar to Next Brand might consider settling on the basis of the tribunal’s decision in this case, although it is likely that Next Brand will appeal in view of the amounts at stake (about £22 million).
This case indicates that rate-booster strategies are unlikely to work from a technical perspective, especially in light of the courts’ general hostility towards tax avoidance strategies in the current climate.
