RSS feedsA preliminary European court ruling in a tax case concerning Cadbury Schweppes has been hailed as a victory for corporates in their ongoing battle against tax restrictions on their behaviour.
The case concerned the UK’s controlled foreign company (CFC) provisions, the anti-avoidance rules that prevent groups setting up subsidiaries in low tax jurisdictions simply to take advantage of low tax rates. The rules mean that any profits earned in the foreign subsidiary are treated as UK profits and taxed accordingly.
In the opinion, handed down on 2 May, advocate general Léger said that such rules could be disregarded by companies if the foreign venture had some economic purpose. Or, to put it another way, the rules only apply where companies have put in “wholly artificial arrangements intended to circumvent national law”.
Cadbury had set up a subsidiary in Ireland to engage in financing transactions taxed at the 10% Irish tax rate. It challenged the UK’s insistence that its Irish subsidiary was a CFC.
Challenging EU ideas
The case is significant not merely in terms of its own facts, but in its position alongside other challenges. It is the first challenge to controlled foreign companies legislation brought by an EU company alleging that such rules, which are also used by Germany, France and Spain among others, are contrary to EU single market ideas.
In the opinion, Léger made a number of important points about CFC rules. On the one hand, he says that he did not believe that “the fact that a parent company establishes a subsidiary in another member state for the avowed purpose of enjoying the more favourable tax regime in that state constitutes, in itself, an abuse of freedom of establishment.”
Case law, he adds, suggested that as long as there was genuine economic activity being undertaken, that would be sufficient to entitle companies to rights established under EU law.
Tax would be a good enough reason to locate elsewhere. “It may be regrettable that competition operates between the member states in this field without restriction. That is, however, a political matter,” he says.
Léger went on to say that the rules clearly created a hindrance to freedom of establishment, a central EU concept. A group with a UK subsidiary, or with a subsidiary in an EU state with similar or higher tax rates, would not be affected by the rules and they were thus discriminatory. Allowing a member state to dictate where groups could set up subsidiaries would run completely contrary to the notion of a single market.
Finally, Léger considered whether or not the restrictions that clearly did exist could be justified as an anti-avoidance measure, which has in various cases been an allowable reason for restricting freedoms.
In an important passage, Léger suggests that the Marks & Spencer case on group relief, in which a companies’ ability to swap losses around different tax regimes was heavily circumscribed, did not apply here.
“The provision of services by a subsidiary to its parent company is an economic activity which takes the form of transactions between distinct legal persons. The fact that those companies are linked does not prevent the pricing of those transactions from being determined under normal competitive conditions. The risk of tax avoidance in connection with such transactions is not, therefore, comparable to that which would be created by the transfer of losses of foreign subsidiaries to a resident parent company, at issue in the M&S case, since such a transfer of losses would be done by means of merely adjusting the accounts,” the opinion says.
Artificial avoidance
CFC arrangements could only be regarded as avoidance, and thus be restricted, if they were wholly artificial arrangements.
Léger proposed a three stage test for assessing whether or not arrangements were artificial. What matters, he says, is:
• the degree of physical presence of the subsidiary in the host state;
• the genuine nature of the activity provided by the subsidiary; and
• the economic value of that activity to the parent company and the entire
group.
Of those, the last seems the most complicated. Léger had this to say: “[This criterion] might make it possible to take account of an objective situation in which the services provided by the subsidiary have no economic substance in the light of the parent company’s activity. If that were the case, I think it can be accepted that there is a wholly artificial arrangement because there appears, in effect, to be no consideration for the payment by the parent company for the services in question.”
There are several consequences arising from the case. The court itself will have to give its verdict, and, assuming it follows Léger, Cadbury and the government are likely to return to the UK courts to dispute whether or not Cadbury’s arrangements constituted artificial arrangements, on which there is by no means agreement.
A separate case relating to Vodafone, and a possible £1.7bn tax charge arising from the Mannesman transaction, is also thought to be awaiting the Cadbury verdict, as is a group litigation order.
Anton Hume, an international tax expert at Grant Thornton, says: “The opinion reflected that member states are justified in protecting their tax base. However, such rules cannot be too general or too broad.”
Chris Morgan, head of the EU tax group at KPMG, says the reference in the opinion to the M&S case was particularly positive. Some tax advisers had been downbeat after the M&S decision, which appeared to have turned the tide in favour of the governments in the general sweep of ECJ decisions. The explicit setting aside of M&S as relevant only in respect of its facts is significant, Morgan argued.
