Cadbury Schweppes: how sweet it is to be loved by the EU
On 12 September 2006, the European Court of Justice (ECJ) decided that the UK's controlled foreign companies (CFC) rules (see box "CFC rules") are a restriction on the freedom of establishment under Articles 43 and 48 of the EC Treaty which can be justified only in relation to wholly artificial arrangements.
The decision is a partial victory for Cadbury Schweppes plc (Cadbury), which brought the case in relation to two group treasury companies that benefited from the 10% tax rate in the Republic of Ireland (Ireland) (see "Corporation Tax: Controlled foreign companies (www.practicallaw.com/6-204-6003)", Bulletin, Taxation, this issue).
The ECJ has left it for the Special Commissioners to determine whether in practice the CFC rules operate only in relation to wholly artificial arrangements and whether Cadbury's subsidiaries were carrying on genuine economic activities in Ireland.
"The ECJ has, however, dropped some pretty heavy hints as to how they think the first question should be decided," notes Guy Brannan, global head of tax at Linklaters. The ECJ thought that the CFC rules ought not to apply where, despite the existence of tax motives, the subsidiary is an actual establishment intended to carry on genuine economic activities in the EU member state in question.
Whether the CFC is an actual establishment should be determined not solely by reference to subjective factors, but by reference to objective factors such as the existence of premises, staff and equipment. For this reason, a key question will be whether the "motive test" (an exception to the CFC rules which broadly provides that the CFC rules will not apply where tax avoidance is not the motive for the incorporation or activities of the subsidiary) is an objective test.
"It will be difficult for the Special Commissioners to decide that the CFC rules motive test is an objective test compatible with the ECJ ruling," says Chris Bates, a partner at Norton Rose. They have already held that the first limb of the test, which looks at the purpose for which the CFC entered into the transaction, is subjective (Association of British Travel Agents , Case SPC 359).
The ECJ decision follows the earlier opinion of the Advocate General in the case, and has not come as a surprise to practitioners or HM Revenue & Customs (HMRC) (www.practicallaw.com/9-202-4622). Indeed, it has been reported that HMRC has been secretly consulting on potential legislative changes in anticipation of the decision (Financial Times, 11 September 2006).
Changing the rules
An HMRC announcement on changes to the CFC rules is expected imminently.
In the short term, the most likely legislative change is a tweak to the CFC rules so that they no longer apply to subsidiaries in the European Economic Area (EEA) except where the arrangements are wholly artificial. This would mirror the change made to equivalent rules in France following a similar challenge in the French courts.
However, as Miles Walton, a partner at Allen & Overy, notes, there is another case currently waiting to be decided by the ECJ which challenges the application of the CFC rules to non-EEA subsidiaries as a restriction on the free movement of capital contrary to Article 56 of the EC Treaty (CFC and Dividend Group Litigation Order, Case C-201/05). That case is not straightforward, but it is at least possible that the law will have to change at some point for non-EEA subsidiaries too.
Of more immediate concern for companies is the possibility that HMRC will undertake a radical review of the rules that allow companies to claim tax deductions for borrowing costs. "There has been some speculation about changes to the interest deduction rules but any change in this area would be seen by business as a harsh and draconian step that would raise serious questions about the UK's competitiveness as a tax jurisdiction," says Brannan.
Walton agrees, and notes that other options open to HMRC include a detailed review of the double taxation rules and perhaps even an extension of the CFC rules to include UK-resident subsidiaries (so removing the element of discrimination inherent in the current rules).
Repayment and compensation
"In practice, the decision is good news in the short term for companies with EEA subsidiaries that pay a low rate of tax and for jurisdictions such as Ireland that use low tax rates to attract inward investment," says Bates.
Some companies may need to consider making repayment claims, if they have not already done so, in relation to any tax paid under the CFC rules in respect of EEA subsidiaries. "Companies with repayment claims are likely to be the exception because, historically, very little revenue has been collected in this way," says Bates.
This is because groups typically arrange their operations so that no charge under the CFC rules arises (for example, there is no charge where the low-taxed subsidiary distributes most of its profits to the UK, where the foreign dividend is taxed instead).
Companies that have operated on the basis of an "acceptable distribution policy" along these lines may want to consider making compensation claims in respect of any loss suffered as a result.
Brannan notes that such companies may soon be faced with an embarrassment of potential claims because the taxation of foreign dividends is itself the subject of a separate ECJ challenge (dividends between UK companies are not taxed) and, if that challenge succeeds, companies that have paid tax on dividends from EEA subsidiaries may be able to claim a full repayment of any tax paid instead (www.practicallaw.com/5-202-2899).
Most groups will want to sit tight until after the Special Commissioners have made their decision and any legislative changes to the CFC rules have been made. Ultimately, however, groups with existing CFCs will want to review their current arrangements and may want to change their policies on, among other things, paying dividends.
Whether they have existing CFCs or not, groups will also want to assess the potential advantages of restructuring to include group treasury or intellectual property holding companies in low-tax jurisdictions in the EEA. "It is obvious from the ECJ decision that any subsidiaries performing these functions would need to be more than mere ‘letterbox' companies," notes Walton. How much more substantial they will have to be is not so clear.
Victory before the ECJ in a tax case is usually bittersweet, and this case is no exception.
Claimant companies may collect financial winnings before the Special Commissioners but, ultimately, HMRC will seek to recover the lost revenue, and in doing so it may argue that cases such as Cadbury Schweppes have forced it to take steps that are damaging to the UK's overall attractiveness as a tax jurisdiction.
In terms of the ECJ's own jurisprudence, the case does not represent a significant departure and broadly follows the approach in the recent Marks & Spencer case, with the ultimate decision being left to the national court, albeit in this case with a firm steer in the right direction (see News brief, “Marks and Spencer: these are not just losses", www.practicallaw.com/3-202-3079). The Special Commissioners' decision, though vital, is unlikely to be particularly interesting.
What will be interesting to see is whether the ECJ's approach will, over time, have a more general impact on other anti-avoidance cases before the English courts.
The ECJ said in Cadbury Schweppes that, while nationals of a member state cannot use the cover of their EC Treaty rights to circumvent national legislation, they are entitled to arrange their affairs so that they can benefit from tax advantages available in other member states. This is not a new principle, even for the ECJ, but it is a very clear statement of an old one that was once central to the concept of tax planning in the UK, but has fallen out of fashion of late (Inland Revenue Commissioners v Duke of Westminster  AC 1).
Sara Catley, PLC.
Cadbury Schweppes plc v CIR (and related appeal), Case C-196/04.
The controlled foreign companies (CFC) rules are intended to stop UK companies reducing their UK tax bill by diverting income to subsidiaries in tax havens.
They work by requiring the UK resident parent company to pay tax on the profits of low-tax paying subsidiaries as if they were part of the parent company's own profits (sections 747-756 and Schedules 24-26, Income and Corporation Taxes Act 1988).
Where the CFC rules do not apply, profits of subsidiaries are taxed only when distributed.
There are a number of exceptions from the CFC rules including where the CFC distributes most of its profits, where the CFC is a trading company and where the purpose of the CFC's incorporation and activities is not avoiding UK tax.