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The long and sustained period of growth that the Irish economy has undergone in the past 15 years gave rise to the birth and growth of the Celtic Tiger. Various factors have driven this growth, such as membership of the EU, a flexible regulatory regime (particularly in the past 10 years) and starting from a low-labour cost base. However, as the growth has continued and the country's competitiveness in areas such as labour costs has been eroded, the most crucial factor that has driven inward investment is the relatively low rate of corporation tax (12.5 per cent on trading income) and the many other tax benefits of operating in Ireland.
The recent decision of the European Court of Justice (ECJ) in the case of Cadbury Schweppes Overseas Ltd v Commissioners of Inland Revenue is a very significant decision for the Celtic Tiger, but also should be seen as good news for businesses in the UK and other EU jurisdictions with a high rate of corporation tax.
Background to the case
The case before the special commissioners arose from a tax assessment issued by the HM Revenue & Customs (HMRC) to Cadbury Schweppes in respect of two subsidiaries it had established in the Irish Financial Services Centre (IFSC) in Dublin. Companies established and carrying out specified activities in the IFSC were subject to only a 10 per cent rate of corporation tax (this 10 per cent rate has since been abolished and companies established in the IFSC are now taxed at 12.5 per cent). HMRC had sought to assess the UK parent company through the profits of one of the two Irish subsidiaries, relying on the Controlled Foreign Companies' (CFC) anti-avoidance provisions in the UK tax legislation. (As one of the subsidiaries had made a loss, no assessment was raised in respect of this subsidiary. However the losses of this company were not available for use in the UK.)
The UK legislation provides that a UK resident parent company is liable for tax on the profits of a CFC (being a company established outside the UK, but controlled by a UK resident company) subject to a credit for the foreign tax paid by the CFC. The CFC legis-lation applies only where the CFC is subject to a lower level of taxation, as was the case with the IFSC companies.
The special commissioners sought a preliminary ruling from the ECJ on a number of aspects of EU law and the application of EU law in the circumstances. Specifically, the special commissioners asked for guidance as to whether the CFC legislation was a restriction of a taxpayer's right to freedom of establishment as provided for under the EU treaty.
The ECJ held that the UK legislation restricted the exercise of the freedom of establishment. The court stated that such a restriction is permissible only if it is justified by overriding reasons of public interest and, in such case, any legislation must be appropriate and proportionate. In particular, the court held that the establishment of a subsidiary in another member state for the purposes of benefiting from more favourable tax legislation does not in itself constitute the abuse of the freedom of establishment.
However, the ECJ stopped short of declaring CFC rules illegal, affording the UK Government a partial victory, as it held that CFC rules may be justified where they have the specific objective of preventing the creation of 'wholly artificial arrangements', which do not reflect economic reality with a view to avoiding the tax normally due. The court did not rule on what 'wholly artificial arrangements were, but noted that the special commissioners, in deciding on this issue, must have regard not just to the intention of Cadbury Schweppes to obtain a tax advantage, but also to what is the objective position as to whether or not the taxpayer has a business establishment in Ireland.
Where to next?
UK taxpayers and their advisers will watch with interest to see how the special commissioners decide the case and whether they conclude that Cadbury Schweppes had sufficient presence in Ireland to benefit from the rights under the EU treaty. Also, tax authorities throughout Europe in those countries with laws similar to the UK CFC rules, such as Germany, Denmark, Finland, France, Portugal, Sweden and Italy, will have to reassess such laws to determine whether they comply with EU law.
If their legislation is designed to apply only to wholly artificial arrangements and such legislation enables the national courts to assess the position on a case-by-case basis as to whether taxpayers are using artificial arrangements to avoid tax, such legislation should not need amending.
However, if this is not the case, then such legislation is most likely in breach of the EU treaty. Furthermore, businesses in those jurisdictions will need to assess whether or not they have any potential claims against their authorities for a repayment of tax and will want to consider whether they can reduce their group's effective tax rate by using a CFC in a group structure.
An Irish perspective
The Irish government strongly supported Cadbury Schweppes' arguments in its submissions to the ECJ. This support was consistent with the approach of Irish governments for decades to use the corporate tax regime to attract companies to establish in Ireland. This approach resulted in the Irish government announcing in 1998, after years of discussions with the European Commission, that Ireland would have only one low rate of corporate tax on all trading income. This low rate has been gradually introduced since 1998, continued #+ continued and other specifically aimed reliefs, such as for companies operating in the IFSC, have been gradually withdrawn.
The decision has, unsurprisingly, been strongly welcomed in Ireland. It is to be hoped that EU companies that previously had considered, and then discounted, setting up Irish operations because of CFC-type legislation will reconsider their position. Ireland would now seem an obvious place for UK -parented groups to establish their group financial services operations as, provided such operations have the necessary personnel and infrastructure to make and implement the relevant policies and decisions, they should avoid falling foul of the 'wholly artificial' exemption.
However, as well as the low corporate tax rate on trading income, there are many other tax benefits in having an Irish resident company in a group structure, such as the fact that Ireland has no CFC, thin capitalisation or transfer pricing legislation and has an extensive tax treaty network, a substantial shareholdings exemption and a comprehensive unilateral tax credit system, allowing Irish dividend 'mixer' companies.
The Irish government will also have no difficulty with the reasoning of the ECJ that CFC legislation should not apply to companies with a sufficient presence and substance in a low tax jurisdiction. The approach of Irish governments has been to use corporate tax benefits to attract high value, blue-chip investment into the country and not to offer the many tax benefits available to Irish resident companies to 'brass plate' operations. Indeed, the fact companies will need to have substance in a low tax jurisdiction, if they are to avoid any CFC legislation in their own country and benefit from the EU treaty provisions on the freedom of establishment, sits comfortably with the aims of the Celtic Tiger. n
Gavin McGuire is a tax partner at O'Donnell Sweeney, part of Eversheds International