Supreme Court: no compound interest on repayment of tax levied in breach of EU law

However, the Court ruled in favour of Prudential on two other issues regarding the method of calculating the tax repayment.

In its decision on compound interest, the Supreme Court departed from the reasoning in a House of Lords case from 2007 involving Sempra Metals.

"The fact that the Supreme Court has decided to depart from the House of Lords judgment in Sempra Metals is a significant development for the purpose of claims for refund of overpaid tax," said Jake Landman, a tax disputes expert at Pinsent Masons, the law firm behind Out-Law.com.

The Prudential decision was a test case relating to repayments of tax made as a result of a ruling from the Court of Justice of the European Union (CJEU) that the UK's past tax treatment of overseas dividends received by UK taxpayers was contrary to EU law. Under the system that applied from 1999 to 2009, dividends from overseas companies received by UK resident companies which held less than 10% of the voting power in the overseas company ('portfolio dividends') were treated less favourably than dividends received from UK companies.

The decision on compound interest should save the Treasury having to pay around £4-5 billion of interest taking into account other pending cases, according to HM Revenue & Customs (HMRC) estimates. 

Prudential argued that HMRC should pay it compound interest on the ground that otherwise HMRC would be 'unjustly enriched'. It argued that the interest should be compounded by reference to the rates of interest applicable to borrowings by the government in the market during the relevant period. This approach had been favoured by a majority of the judges in the House of Lords in the Sempra Metals case.

Last year the Supreme Court decided that compound interest was not payable in relation to repayments of overpaid VAT in a case involving catalogue company Littlewoods.

Giving the judgment of the Supreme Court in the Prudential case, Lords Mance, Reed and Hodge departed from the reasoning in the Sempra Metals case. They said "the law of unjust enrichment has developed since Sempra Metals in ways which cannot easily be reconciled with the reasoning of the majority in that case."

The judges said that when money is paid by mistake, an obligation arises under the law of unjust enrichment to reverse the enrichment by repaying the money. However, the majority of the judges in Sempra Metals considered that there was also an additional and simultaneous transfer of value, comprising the opportunity to use the money, which also gave rise to a cause of action based on unjust enrichment, which had to be reversed by the payment of compound interest.

The Supreme Court said the recipient’s possession of money mistakenly paid to him, and his consequent opportunity to use it, was not a distinct and additional transfer of value.

"There is no right to interest on the basis of unjust enrichment: failure to pay a sum which is legally due is not a transfer of value, and does not give rise to an additional cause of action based on unjust enrichment," the judgment said.

The Court found in favour of Prudential on two points concerning how Prudential's tax repayment should be calculated.

HMRC said that Prudential was entitled to a tax credit equal to the overseas tax actually paid, whereas Prudential argued that the tax credit should be calculated by reference to the foreign nominal rate (FNR). FNR is the rate of tax charged by the overseas jurisdiction and so this method does not take into account the availability of losses or other reliefs which could reduce the tax actually paid below the FNR.

"Limiting the credit to the tax actually paid would have been a major hurdle as in most instances it would be practically very difficult to get the historic records to establish this," Landman said.

"CJEU case law had already established that the credit must be at the FNR and therefore the only argument for HMRC to pursue was extremely difficult and involved trying to persuade the Supreme Court that the existing CJEU case law did not apply to portfolio dividends," he said.

"The Supreme Court unsurprisingly rejected HMRC’s unlikely argument and ruled there was nothing in the CJEU case law to merit distinction of portfolio dividends. The tax credit to which Prudential was entitled was therefore at the FNR," Landman said.

The other issue on which Prudential was successful related to instances where it had a pool consisting of both lawful and unlawful advance corporation tax (ACT). The Supreme Court needed to determine which should be treated as having been utilised and on what basis. It decided that unlawful ACT should be treated as set first against unlawful corporation tax. It said that the unlawful ACT was recoverable unless it had been set against a lawful corporation tax charge.