Sixteen international companies and their subsidiaries argued that the so-called thin capitalization rule, which applied only to foreign companies until 2004, unfairly limited tax deductions on debt financing. The UK policy capped how much interest the companies could deduct when financing subsidiaries in Britain. Today’s decision by the European Court of Justice in Luxembourg will apply throughout the 27-nation EU, where US companies alone raised $174 billion in financing last year, Bloomberg data show.

The ruling clarifies the rules on taxing interest payments and may lead to government refunds, said a lawyer for the companies. „This is good news for EU-parented companies,” said Simon Whitehead, a partner at Dorsey & Whitney LLP acting for the companies. „It’s a very encouraging step toward the further resolution of their claims.” The companies that brought the case, including Caterpillar Inc., the world’s largest maker of earthmoving equipment, PepsiCo, the world’s second-largest soft-drink maker, Lafarge SA and Volvo AB, are seeking refunds for the tax disadvantages they suffered under the old system. The UK government estimated the cost of a negative ruling at about €300 million ($395 million), according to court documents.

 
The case is being watched by many European countries that have their own version of thin capitalization rules, said Waseem Khokhar, a tax specialist at law firm DLA Piper LLP in London. „In order to be justified, those rules must allow the companies concerned to produce evidence as to the commercial reasons for entering into the transaction in question,” the court ruled. The UK will have to repay any charges levied that breached that principle, the court said. The government welcomes the decision, which confirms that „the former UK thin cap rules were broadly compatible with EU law,” the Treasury said in an e-mailed statement. The repayments that the UK will face after today’s decision will be smaller than initially expected, Jonathan Bridges, a senior manager at accounting firm KPMG said in a telephone interview. „There will be a limited number of claims that will be successful following today’s ruling, but I do not expect that to be a substantial cost,” he said. „The court today passed the difficult questions to the national court.”

The EU court laid out the tests for the national court to decide whether the UK’s breach was „sufficiently serious” to warrant refunds. Successful refunds will depend on the national court’s consideration of „the clarity and precision of the rule infringed, whether the infringement and the damage caused were intentional or involuntary, whether any error of law was excusable or inexcusable” and whether unclear EU rules at the time may have led the UK to adopt illegal measures, according to the ruling. Britain’s High Court referred the case to the EU tribunal in 2004 to resolve when thin-capitalization rules are justified and whether they breach companies’ freedom of establishment.

The court today said that by treating domestic and overseas companies differently, the UK system „constitutes a restriction on freedom of establishment.” Still, such a restriction may be justified „to combat abusive practices” as long as it „specifically targets wholly artificial arrangements,” it said. Such a policy is only legal if companies are given the opportunity to prove that their transactions are commercially justified and aren’t „subject to undue administrative constraints,” the court said. The EU court in a previous case struck down Germany’s thin capitalization rule, following which several countries including Spain and the UK changed their system. The companies in today’s case filed their claims for compensation after that decision.

Today’s case is C-524/04 Test Claimants in the Thin Cap Group Litigation v Commissioners of Inland Revenue. (Bloomberg)