The Treasury faces having to pay out up to £7 billion after the High Court ruled today in a landmark case that UK firms' dividends on foreign earnings should not have been taxed.

British American Tobacco chief executive Paul Adams was celebrating a possible £1.2 billion windfall today following the decision by Mr Justice Henderson.

BAT launched the test case on behalf of more than 20 firms, known as the FII Group - which includes advertsing giant Aegis - who argue that dividends from their foreign earnings should be treated as franked investment income. FII is corporate profits on which the tax has already been paid.

BAT's victory means that it and other firms did not need to pay corporation tax in advance on dividends from their foreign companies paid between 1993 and 1999. In the case of their earnings in the European Union, the rebate could extend as far back as 1973 when Britain joined the Common Market.

Today's judgment is described as being highly complex and runs to more than 150 pages.

Roopa Aitken, an international tax partner at accountants Grant Thornton, said that the court decision was not unexpected as it is another example of British courts having to fall into line with EU law. "This High Court judgment follows in the wake of an earlier European Court of Justice decision in 2006 that looked at whether UK rules for taxing dividends were compatible with EU laws," she said.

"Lots of companies are going to be able to get substantial compensation from HMRC," she added.

A spokesman for BAT said: "We are expecting Her Majesty's Revenue & Customs to appeal this very strongly. They could go to the Court of Appeal and then the European Court of Justice. We are expecting a total appeals process that could last three to fouryears."

Experts cautioned that the Treasury may also be keen to appeal because of the state of the nation's finances.

One source said: "Given what we heard in the Pre-Budget Report this week, it is not unreasonable to think HMRC doesn't have the money around to pay out BAT and other firms at the moment."

Even if HMRC is forced to accept the ruling in favour of BAT, it is likely that lawyers for the two sides will battle fiercely over the size of a payout. BAT cautioned that the estimated £1.2 billion compensation is "tentative" and is "the subject of a subsequent hearing".

HMRC said: "This is a process that is likely to take a number of years to conclude. We will need to consider the specific points in this judgment in some detail before responding further."

Sources close to HMRC insist it faces paying out no more than £ 5 billion.