A 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
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.
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
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.