Tax terms such as "thin capitalisation" and "group relief" rarely hit the headlines, but two recent decisions on the scope of EU rules on non-discrimination have brought them to the fore. In the long term they may lead to far reaching changes to the UK tax system and to how many international groups are structured and, in the short term, they may allow companies to claim a repayment of tax from the Inland Revenue.

Article 43 of the EC Treaty prohibits restrictions on the freedom of establishment of branches, agencies or subsidiaries in any EU member state. A tax disincentive has long been held to be a form of restriction; previous examples have included a situation where tax was payable by a UK company when paying a dividend to an EU parent company based outside the UK, but was not payable when the dividend was paid to a UK parent (Hoechst and Another v CIR and HM A-G, C-410/98, 8th March, 2001; www.practicallaw.com/A17507).

In Lankhorst-Hohorst GmbH v Finanzamt Steinfurt (Case C-324/00), a German taxpayer claimed that the same principle should apply to the German thin capitalisation rules. These rules are generally designed to prevent a subsidiary obtaining tax relief for interest on a loan where the loan is made by a parent or another group company and the interest would not have been paid in the absence of the group relationship. Among other things, they prevent a parent in a low-tax jurisdiction from charging excessive interest to a subsidiary in a high-tax jurisdiction, thereby reducing the overall group tax burden. If the interest is paid to a lender in the same jurisdiction, there would be no incentive in charging an excessive rate of interest or overburdening the subsidiary with debt, as the lender would usually be subject to the tax on the interest at the same rate and at the same time as the borrower. The rules did not apply if interest was paid to a German parent but could operate if the interest was paid to a parent resident in another member state. The European Court of Justice (ECJ) upheld the taxpayer's claim that this was discriminatory; the rules operated unfairly against parent company lenders that were not based in Germany.

Not all discrimination of this type is unlawful; it can be justified if it is necessary for the coherence of the relevant tax system and to prevent tax evasion. In Lankhorst-Hohorst, this defence (known as the Bachmann defence after the only case in which the ECJ upheld it (Bachmann v Belgian State, Case 204/90)) was unsuccessful because there was no "direct link" between the disadvantage (as a result of the restriction on the tax relief) suffered by the subsidiary and any compensating advantage enjoyed by the lending company. As a result, the German rules were held to breach Article 43 and so were unlawful.

This decision can be relied on by taxpayers throughout the EU and is likely to have ramifications on the way in which EU groups fund their groups. In the UK, section 209(2)(da) of the Income and Corporation Taxes Act 1988 (ICTA) operates to deny relief for interest on shareholder loans if the borrower is thinly capitalised. It only applies if the loan is from a related lender that is not itself subject to UK corporation tax. This can also be said to be discriminatory, in that in a similar way to the German rules, the subsidiary would be in a worse position if it had borrowed from a non-UK parent than if it had borrowed from a UK parent. If UK tax relief has been denied in the past because of this provision, and as a result more tax has been paid, a claim for repayment and interest could be made. Such a claim should be made sooner rather than later, and if refused, thought should be given to starting High Court proceedings to recover the overpaid tax so as to avoid being time-barred. The Revenue is claiming in the Hoescht case that if overpaid tax is to be recovered, court proceedings have to be started within six years of the additional tax being paid.

Tax managers and finance directors should not assume that all restrictions based on a person's nationality are unlawful and that any claim is bound to succeed. This has been illustrated by the recent Special Commissioners' decision in Marks and Spencer plc v Halsey (SpC 003520). Marks and Spencer PLC (M&S) had suffered losses in its French, German and Belgian subsidiaries, and sought to set those losses (by way of group relief) against the profits that had been made by the UK group. M&S claimed that any restriction on this was discriminatory as, if a UK group company had suffered the losses, it would have been entitled to surrender the loss to the profitable companies. The Commissioners rejected this argument, and held that it would not be correct to compare the ability of a UK company to surrender losses to another UK company with that of a French company. The UK subsidiary pays UK tax on its worldwide profits, while the French subsidiary only pays UK tax on profits from any UK activities. If the French activities had been profitable, these would not have been subject to UK tax. Even if the treatment were discriminatory, it would be justified. While the French companies were arguably penalised in not being able to surrender the losses, they enjoyed a compensating advantage in that any profits would not be subject to UK tax. Any discrimination could therefore be justified on the basis of Bachmann.

This is likely to be only the start of the litigation in this case; M&S is expected to appeal, and the issue could be referred to the ECJ. Even if the odds on a UK taxpayer succeeding on a challenge to the group relief rules are less favourable than one to the UK thin capitalisation rules, it is still possible that M&S will succeed. In the meantime, companies with loss-making group companies located in another EU jurisdiction should consider making protective claims to group relief, and, if necessary, commencing legal proceedings to ensure that any delay does not lead to a claim being time-barred. Companies should consider whether they have been adversely affected by any other UK tax rules that leave a non-UK EU company or subsidiary in a worse position. This could include the UK's controlled foreign company rules, which are designed to counter tax advantages from the establishment of subsidiaries in low-tax jurisdictions (sections 747-756, ICTA). Similar provisions in France have been held to be in breach of Article 43. The same principle could also apply to the UK transfer-pricing rules, which do not normally apply to a supply of services or goods between two UK companies but do apply where the supply is between UK companies and group companies in other jurisdictions (Schedule 28AA, ICTA).

It is not yet known how the government will react to these challenges to the UK tax system. It is likely that, in the short term, they will continue to argue that any discrimination is justified in order to prevent tax evasion and is therefore not unlawful, reinforced by the success of this argument in Marks and Spencer. In the long run, it is possible that the UK may be forced to continue to modify its tax system, so as to comply with Article 43. The government will be concerned that any relaxation in the UK rules could lead to a loss of revenue. One possibility might be to restrict those situations where UK taxpayers do have an advantage. For instance, the UK thin capitalisation rules could be extended to apply to interest paid to all related lenders, even if the lender is based in the UK. The same could apply in relation to the UK transfer-pricing regime, which could be applied to purely domestic UK supplies of goods and services, as well as cross-border supplies. While this may not lead to additional tax payable by domestic UK groups, their compliance burden would be significantly increased.