Advocate General strikes down UK CFC legislation
In his opinion of May 2, 2006 on the Cadbury Schweppes case (C-196/04), Advocate General Léger advised against the compatibility of British Controlled Foreign Company (CFC) legislation with the right of establishment of Article 43 EC Treaty.
CFC legislation applies when the profits made by a foreign group company controlled by a resident company are subject to substantially lower taxation than the tax rate in effect in the home State. Unless specified exceptions can be relied upon, CFC legislation will include the profits of such foreign controlled companies, as they arise, in the tax base of the parent company. CFC rules therefore are an exception to the general rule that only profits distributed in the form of dividends can be added to the tax base of the parent company.
The “lower level of taxation” triggering the application of UK CFC legislation at the time of the facts of the case, was set at three-quarters of the amount of tax which would have been due if the profits of the subsidiary had been taxed in the United Kingdom. A tax credit for the (lower) host State taxation and subsequent dividend taxation, if any, is granted to the UK resident company. CFC legislation also provides for a set of five exceptions, including a so-called “motive test” in which the taxpayer is allowed to show that a reduction in the UK tax base was not the main purpose, or one of the main purposes, of setting up the foreign company and of conducting business therewith.
Two Irish subsidiaries of Cadbury Schweppes enjoyed a tax rate of 10% under the (now abolished) IFSC regime and, hence, were hit by the UK CFC legislation. The non-tax motives submitted by Cadbury Schweppes did not satisfy the UK tax authorities, nor did they convince the referring judge, as the main purpose for establishing the Irish subsidiaries. Advocate General (AG) Léger, therefore, implicitly assumes that the main purpose for establishing the Irish subsidiaries was of a fiscal nature. Nevertheless, AG Léger finds that the level of taxation is a factor which a company may legitimately take into account in exercising its right of establishment of Article 43 EC and that the UK CFC legislation constitutes a restriction of that right. The AG goes on to examine whether the counteraction of tax avoidance may be a justification for such a restriction.
The UK tax authorities argued that its CFC legislation was adopted to counter the artificial diversion of profits from a resident company to a foreign subsidiary established in a low-tax country and carrying out intra-group transactions. However, referring to the ICI, X and Y, Lankhorst-Hohorst, and De Lasteyrie du Saillant cases, the AG reminds of the fact that only legislation aimed at countering wholly artificial arrangements can justify a hindrance to a freedom guaranteed by the Treaty. The quintessential criterion, according to the AG, is whether the foreign subsidiaries are engaged in the actual pursuit of economic activity in the host State. As long as the foreign subsidiary performs genuine services from the host State to the parent company, such a situation cannot be considered as tax avoidance, even if the establishment of the foreign subsidiary had the reduction of the tax burden as its main purpose.
It is not clear to the AG whether the “motive test”, which provides for an exception to the CFC legislation, enables the taxpayer to redeem himself by providing proof of the substance of the foreign establishment in the host State and of the reality of the services rendered thereby. Only under such circumstances would the CFC legislation apply to wholly artificial situations and, therefore, be justified and proportionate. Based on the ambiguity of the “motive test”, the AG has recommended the remittal of the case to the referring national Court in order to determine whether the UK CFC rules only apply to wholly artificial situations within the abovementioned meaning.
If the ECJ’s grand chamber follows AG Léger’s opinion, it appears that the UK CFC legislation will be found to operate disproportionately restrictive whenever foreign subsidiaries with economic substance are targeted. It is to be expected that UK legislation and similar legislation in other Member States will have to be amended. A final ruling by the ECJ in support of Cadbury Schweppes will encourage investments in those Member States with low general rates of taxation or with favourable tax regimes such as the Belgian notional interest deduction.
