Effect of historic MOD tax regime on pension funds breached EU law

The Tribunal concluded that the “detriment to the Trustee must be remedied in order that the UK legislation can conform to EU law”. The Trustee is entitled to be repaid UK MOD withholding taxes that had been applied.

"The Upper Tribunal comprehensively found in favour of the Trustee in a robust decision" said Jake Landman, a tax disputes expert at Pinsent Masons, the law firm behind Out-Law.com. Pinsent Masons acted for the Trustee in this case.

The Trustee had claimed the repayment of MOD withholding taxes in connection with stock lending of overseas shares in its portfolio. A number of other UK pension funds, life insurance companies, investment funds and charities have made similar claims, which depend upon the result of this case.

Stock lending involves the lending of shares to a borrower. Stock lending transactions typically require the borrower of the shares to pay a fee and make a payment equivalent to any dividends received on the shares during the period of the stock lending, a manufactured dividend (MD) when paid in respect of UK shares, or a MOD when paid in relation to overseas shares.

Under UK law at the relevant time the payment of a MD on a stock loan of UK shares was not subject to tax, but a payment of a MD on overseas shares (a MOD) was subject to UK withholding tax. In 2014 the law was changed so that there is no longer a requirement to withhold tax from MODs.

The Trustee argued that the UK rules applying MOD withholding tax were contrary to the EU principle of free movement of capital as they were liable to discourage investment in overseas shares. In 2016 the First-tier Tribunal dismissed the Trustee's claim, but it appealed to the Upper Tribunal.

The Upper Tribunal agreed with the Trustee. It said that in contrast to the position applied by the UK to manufactured dividends relating to UK shares, the UK applied domestic taxation to MODs in such a manner that precluded the recovery by the Trustee of that tax, which amounted therefore to a cost, in terms of UK tax, to the Trustee of undertaking stock lending using overseas shares.

It said that the difference in treatment was sufficient to amount to a dissuasive effect so far as the acquisition of overseas shares, and the continued retention of such shares, as opposed to UK shares, was concerned.

The Upper Tribunal disagreed with the First-tier Tribunal's previous decision, which was that because the Trustee would be in no better or worse position than if it had held onto the shares and received foreign dividends, the MOD regime could not have a dissuasive effect. In the Upper Tribunal's judgment, the correct comparison was “between the UK tax treatment of MDs and the UK tax treatment of MODs”.

The Tribunal also concluded that the tax position of the borrower can have no bearing on whether the Trustee was subjected to less favourable tax treatment.

Under EU law, even if a measure breaches one of the EU freedoms, it is not unlawful if it is justified on certain grounds, which include ensuring the balanced allocation of taxing powers between EU member states,  preventing  tax avoidance and ensuring the 'fiscal cohesion' of the UK tax system.

The Tribunal said that in the case of MODs, the breach of free movement of capital could not be justified. It said there was no  imbalance in taxing powers between Member States as the rate of the MOD withholding tax was entirely a matter of UK domestic law, even though it was calculated by reference to a hypothetical charge to foreign withholding tax on an assumed dividend received by a UK resident.

The Trustee’s stock lending transactions were undertaken for wholly commercial reasons, and there were no artificial arrangements for the avoidance of tax so the Tribunal said the MODs legislation could be justified on the basis of the prevention of tax avoidance.

It also said that HM Revenue & Customs could not rely upon 'fiscal cohesion' to justify the MODs withholding tax breaching EU law as it said the “withholding tax is not a real withholding tax on a real foreign dividend, but a statutory construct involving UK tax alone”.

"The Upper Tribunal had complete confidence in applying the EU case law to the facts and did not consider it was necessary to make a reference to the Court of Justice of the European Union (CJEU) in order to reach its decision" said Landman.

In May 2017 the Upper Tribunal decided that service by the UK of notice to leave the EU did not justify expediting a reference to the CJEU in this case.