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ECJ: UK CFC rules in breach of freedom of establishment unless application limited to wholly artificial arrangements – details — Orbitax Tax News & Alerts

On 12 September 2006, the European Court of Justice (ECJ) gave its decision in the case of Cadbury Schweppes plc and Cadbury Schweppes Overseas Ltd v. Commissioners of Inland Revenue (C-196/04) regarding the compatibility of the UK controlled foreign company (CFC) rules with the EC fundamental freedoms.

Applicable freedom

The ECJ first decided that the legislation in question must be examined in the light of the freedom of establishment (Arts. 43 and 48 of the EC Treaty), as the UK CFC rules apply to resident companies that have a controlling holding in their subsidiary established outside the United Kingdom, which gives them definite influence on the subsidiary's decisions and allowing them to determine its activities (Baars (C-251/98)).

No abuse of the freedom of establishment

First, the ECJ answered the Special Commissioners' question as to whether or not the fact that a company establishes and capitalizes companies in another EU Member State solely because of the more favourable tax regime applicable in that EU Member State constitutes an abuse of freedom of establishment. In this regard, the ECJ referred to its previous judgments in Barbier (C-364/01), Centros (C-212/97) and Inspire Art (C-167/01), in which it held that the fact that a company was established in an EU Member State for the purpose of benefiting from more favourable legislation does not in itself suffice to constitute abuse of that freedom. Consequently, the fact that in the case in question the UK parent company decided to establish its subsidiaries in the Irish International Financial Services Centre (IFSC) for the avowed purpose of benefiting from the favourable tax regime which that establishment enjoys does not in itself constitute abuse and does not preclude the reliance of that parent company on Art. 43 of the EC Treaty.

Restriction on the freedom of establishment

The ECJ initially recalled that the freedom of establishment provisions of the EC Treaty also prohibit exit restrictions imposed by the EU Member State of origin hindering the establishment in another EU Member State of one of its nationals.

The ECJ then observed that the legislation on CFCs involves a difference in the treatment of resident companies on the basis of the level of taxation to that which their subsidiaries are subject. Such a difference in treatment means that a resident company that has incorporated a CFC in an EU Member State in which it is subject to a lower level of taxation is taxed, by the application of the CFC rules, on the profits made by the CFC, whereas, if the controlled company had been incorporated and taxed in the United Kingdom or in an EU Member State in which it is not subject to a lower level of taxation, the resident company would not have been taxed on the profits of the controlled company. This conclusion is not altered, according to the ECJ, by the fact that such a resident company does not pay on the profits of a CFC more tax than that which would have been payable on those profits if they had been made by a subsidiary established in the United Kingdom.

Consequently, the CFC rules, which entail a disadvantageous treatment of resident companies having a subsidiary subject to a lower level of taxation in another EU Member State, constitute a restriction on the freedom of establishment.

Tax avoidance justification

A restriction on the fundamental freedoms is permissible only if (i) it is justified by overriding reasons of public interest, (ii) it is appropriate to ensuring the attainment of the objective pursued and (iii) it does not go beyond what is necessary to attain the object (proportionality).

With regard to the first element of this test, the UK government relied on the prevention of tax avoidance, as the CFC rules are intended to counter the artificial trafficking of profits from a high tax jurisdiction to a low tax one. In this regard, the ECJ pointed out that the mere fact that a resident company establishes a subsidiary in another EU Member State could not set up a general presumption of tax evasion. A national measure restricting the freedom of establishment with the purpose of preventing tax avoidance may only be justified if it specifically relates to wholly artificial arrangements. In order to assess whether or not the taxpayer's conduct in a particular case amounts to a wholly artificial arrangement, regard has to be had to the objective pursued by the freedom of establishment, i.e. the actual pursuit of an economic activity in the host EU Member State by a national of another EU Member State (Reyners (Case 2/74), Gebhard (C-55/94) and Factortame (C-221/89)). It follows that, for a restriction on the freedom of establishment to be justified on the ground of prevention of tax avoidance, the specific objective of such a restriction must be to prevent conduct involving the creation of wholly artificial arrangements that do not reflect economic reality, with a view to escaping the tax normally due on the profits generated by activities carried out on national territory.

With regard to the second part of this test, the ECJ held that the CFC legislation is suitable to achieve the objective for which it was adopted insofar it makes possible to thwart practices that have no purpose other than to escape the tax normally due on the profits generated by activities carried on in national territory.

With regard to the proportionality of the measure, the ECJ emphasized that the CFC legislation must ensure that the CFC rules are not applied if the incorporation of a CFC reflects economic reality. In determining whether or not such an economic reality exists, objective circumstances must also be taken into account in addition to the subjective element consisting in the intention to obtain a tax advantage (Halifax (C-255/02) and Emsland-Stärke (C-110/99)). These objective factors, which should be ascertainable by third parties, are, in particular, the extent to which the CFC physically exists in terms of premises, staff and equipment. In conclusion, the CFC rules are proportionate if they allow the resident company to produce evidence that the CFC is actually established and that its activities are genuine in the assessment in respect of which the objective factors referred to previously must be taken into account.

Finally, the ECJ stated that it is for the national court to determine whether or not the UK CFC rules at issue, in particular, the motive test, can be interpreted in a way that ensures that the application of the CFC rules is restricted to wholly artificial arrangements within the meaning previously described.