Plans by the Government to toughen Revenue powers have been dealt a blow in a ruling at the European Court of Justice yesterday, writes Dominic Coyle

The court, in a case concerning the British lender Halifax, said that tax authorities could only seek repayment of tax forgone in the event of arrangements that were clearly abusive.

In a move that will undermine the Government's efforts in the Finance Bill to impose 10 per cent penalties on companies whose tax avoidance scheme are subsequently ruled to be illegal, the court also ruled that "a finding of abusive practice must not lead to a penalty... but rather to an obligation to repay" any tax owing.

The ruling by the court, which sits in Luxembourg, relates to VAT. But Irish tax experts said last night it would affect any area of tax that was "governed by EU principles".

"While clearly establishing the right of taxpayers to legally organise their affairs in a tax-efficient manner, the court has indicated that taxpayers must not abuse that right," said Niall Campbell, a VAT partner at accountants KPMG.

However, he said that efforts by the Revenue and other EU tax authorities to apply as broad a definition as possible of abuse will be "severely limited by the high threshold which the court has set for what it considers to be abusive".

In confirming the initial opinion of the court's advocate general last year, the full court said: "The prohibition of abuse is not relevant where the economic activity carried out may have some explanation other than the mere attainment of tax advantages."

It also reiterated that taxpayers, when presented with alternative approaches, were not obliged to choose the one that involved paying the highest amount of VAT.

"On the contrary, as the advocate general observed ... taxpayers may choose to structure their business so as to limit their tax liability."

Greg Lockhart, head of VAT consultancy at Matheson Ormsby Prentice, said the ruling meant that where there was any commercial rationale to the taxpayer's decision leading to reduced liability to VAT, the tax authorities could not claim the procedure was an abuse.

"This is a huge limitation on what the Revenue is trying to get in the current Finance Bill," Mr Lockhart said.

KPMG's Mr Campbell said the court's ruling against the imposition of penalties even where a scheme is subsequently found to be abuse "means that the recently proposed changes to Irish anti-avoidance legislation in the Finance Bill 2006, where Revenue are seeking the right to a 10 per cent penalty, are contrary to European law."

Fellow KPMG VAT partner Terry O'Neill said the ruling would lay some ground rules for taxpayers and the Revenue in determining what was an attempt to abuse the tax code and what was simply prudent tax planning.

"This is where the debate has raged in recent years," said Mr O'Neill.

"The Revenue has been trying to argue that there is no difference between tax avoidance, or efficient tax planing, and tax evasion, which is illegal."