The Treasury is potentially facing a £5 billion black hole after suffering a High Court defeat at the hands of British American Tobacco yesterday.

The ruling comes days after Alistair Darling, the Chancellor, admitted that Britain’s public finances had deteriorated sharply since his March Budget and unveiled plans to borrow billions of pounds.

BAT, the world’s second-largest cigarette maker, had challenged HM Revenue & Customs over its policy of taxing dividend payments from foreign subsidiaries. The verdict paves the way for a £1.2 billion tax refund for BAT and exposes HMRC to a far bigger payout. That is because BAT was fighting a test case on behalf of some 20 multinational companies which, if successful, will spark similar cases.

The companies claim that HMRC’s policy is illegal under European law because the UK does not tax similar payments from domestic companies.

Significantly, BAT was chosen by the 20 to fight the test case because the circumstances of its situation are more complex than those of the others. The 20 have been assuming that, if BAT succeeds, they too will.

Although BAT said that it expected to recover about £1.2 billion, HMRC declined to say how much it might lose from the decision. However, finding for BAT, Mr Justice Henderson said that the final sum claimed from HMRC could be as much as £5 billion.

In a 150-page ruling, the judge stated: “Almost without exception, these issues are both difficult and important, and huge amounts of money are potentially at stake. I was told that the maximum amount of the \ claims is of the order of £5 billion.”

The verdict applies to any UK company that paid tax on dividends from foreign subsidiaries from 1973 onwards, and is not limited to the 20 companies that backed BAT’s test case.

Jonathan Bridges, associate partner in KPMG, said: “This judgment makes absolutely clear that the UK dividend taxation rules breach EU law, opening the door for massive tax rebates.”

Abandoning tax on foreign dividends was a major policy shift announced in Mr Darling’s Pre-Budget Report this week, although the details have yet to be finalised and the move could still be watered down. Mark Persoff, a tax partner in Clifford Chance, said: “The judge has made clear that UK taxation of EU dividends is illegal and so the ruling is a further and very significant spur towards scrapping it.”

Parties in a legal dispute typically receive a copy of the judgment about two weeks before it is made public, and so it is likely that Mr Darling and his advisers knew the High Court’s view on their foreign dividend policy while preparing the Pre-Budget Report.

Last night experts gave warning that HMRC would be almost certain to appeal against the ruling, while BAT admitted that it could be four years before the issue was finally resolved. HMRC does not have to pay any refunds while the legal process is continuing. A spokesman for HM Treasury said: “We will need to consider the specific points in this judgment before responding further.”

Yesterday’s decision is the latest in a series of tax rulings to have gone against the Government in the past two years. In several of these, judges have ruled that the Government failed to take sufficient notice of European law when devising UK tax laws.

In the most recent of these Rank, the owner of Mecca Bingo, won a £36.3 million refund from HMRC after appealing against taxes levied on slot machines played by punters during intervals between bingo games.

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