On 12 September the European Court of Justice (ECJ) released its landmark decision in Cadbury Schweppes. The case concerned whether the UK’s controlled foreign companies (CFC) legislation, under which profits earned by a subsidiary company resident in a ‘lower-tax’ jurisdiction can be attributed to the parent company resident in the UK and thereby taxed in the UK, is lawful. The ECJ held that the legislation is contrary to European Commission law, where ‘wholly artificial arrangements’ (WAA) that do not reflect economic reality and which are aimed at circumventing the application of the legislation have been created. However, this was with one caveat – that it need not be amended if the UK can prove that it gives rise to a charge to UK tax in one circumstance only.
It will be impossible for the UK to prove this. The language used in the description of the WAA justification reproduces the wording of the ‘abuse’ doctrine. Establishment of a subsidiary in a low-tax jurisdiction for the purpose of enjoying that more favourable tax regime cannot, by itself, be an abuse; the reason why a company chooses to incorporate in a member state is irrelevant with regard to freedom of establishment.
In assessing whether there is abuse, the starting point is whether the objective pursued by the Commission law provision relied upon is fulfilled. Establishment within the meaning of Article 43 involves the actual pursuit of an economic activity in the state. Thus, if the subsidiary carries on a genuine economic activity, the purpose of Article 43 is met and it cannot be abusive. Whether that occurs is to be determined on an objective basis.
The objective/subjective distinction is crucial. The UK’s CFC rules require the taxpayer to rebut certain assumptions with regard to their subjective intent by showing that relevant transactions with the foreign-resident subsidiaries (as well as the subsidiaries’ existence) were not driven by a tax avoidance motive. Yet, as a matter of Commission law, if a company is genuinely established in a member state, the subjective intentions, even if wholly tax-driven, of the companies in the group are irrelevant. Thus, I have no doubt that the UK’s CFC rules cannot be saved by reference to WAA. The financial consequence of this decision in the UK alone will be measured in the hundreds of millions of pounds – even leaving aside the pending challenge against other aspects of the UK’s CFC regime, Vodafone 2.
The impact across the EU also will be significant, and not just in financial terms. While many other member states have CFC regimes that are similar to the UK’s and which, likewise, will need to be amended, other member states have low rates of tax, which will make them attractive jurisdictions for CFCs. Thus, there will be further pressure within the EU to consider the establishment of a common tax base.
This decision also confirms that the focus of the ECJ is on ensuring the effective operation of the single market. Provided that entities do not seek to obtain a benefit without incurring the appropriate economic cost, then they are entitled to rely on the fundamental freedoms. Many commentators took the view that Marks & Spencer marked the start of a less ‘taxpayer-friendly’ approach by the ECJ. But I believe that the correct interpretation of Marks & Spencer is that the UK’s group relief system is contrary to European law. Furthermore, in any event the case was exceptional: for the first time the ECJ had to consider a situation where, in reliance on a freedom, it may have been possible to obtain a ‘double benefit’ (ie use of the losses against more than one set of profits), which is analogous to WAA.
Cadbury Schweppes confirms that all the jeremiads post-Marks & Spencer were unnecessary. The ECJ will still keep the taxman away.
Hartley Foster, partner, DLA Piper