The UK’s tax rules in relation to controlled foreign companies (CFCs) have suffered a set-back following the European Commission’s recent preliminary decision that certain parts of the rules amount to unlawful state aid.
The UK’s CFC rules
CFC rules are a mandatory provision under the EU’s Anti-Tax Avoidance Directive (EU 2016/1164) and are found in many EU national tax systems. The CFC rules were introduced in the UK in the 1980s, to prevent UK multinational companies from diverting profits to subsidiaries based in low-tax jurisdictions and consequently diminishing the UK corporate tax base.
The UK CFC rules were rewritten in 2013 after they were found to be inconsistent with the EU principles of freedom of establishment. The change was intended to make sure that only “artificially diverted” profits i.e. those that could not be ascribed to a genuine economic activity, would fall within the scope of the rules.
Under the reformed rules, there is a tax exemption or reduction (known as the Group Financing Exemption (GFE)) for certain financing income received by non-UK subsidiaries from other non-UK affiliated group companies. This has resulted in companies with an overseas finance company being able to claim exemptions of up to 100% of tax charges relating to certain intra-group finance income.
The UK argued that the regime was in line with its general policy on taxation in relation to the profits of subsidiary companies. However, the Commission has held that operators carrying out finance transactions involving foreign debtors are treated more advantageously under the UK tax rules than transactions involving UK or third-party debtors.
The EU rules on state aid are in place to prevent certain companies from obtaining preferential tax treatment by deviating from domestic tax regimes. The Commission has the power to investigate any Member State’s tax systems where it suspects those systems of granting selective advantages to certain undertakings and where none of the exemptions to the rules apply. The exemptions are based on objective reasons that are consistent with the overall purpose of the rules.
Where advantages are found and no exemptions apply, the recipient companies may be required to repay the value of the advantage received (plus interest).
The Commission’s investigation into the UK’s rules is the latest in a long line of investigations against other Member States. In recent years, the Commission has investigated countries such as Luxembourg, the Netherlands, Ireland and Belgium, deciding they were granting selective tax advantages to various multi-national companies, including Apple, Fiat and Starbucks.
The Law Society of England and Wales’ Tax Law Committee presented the Commission with a written submission setting out its interpretation of the CFC rules and explaining why it believes that the UK’s CFC rules do not amount to the granting of unlawful state aid.
The Commission’s preliminary decision opened an in-depth Commission investigation into whether the UK CFC rules breach EU state aid rules. Were the Commission to issue a final decision finding a breach of state aid rules, the UK government may need to determine the amount of tax breaks granted to recipient companies and recover this, relying on UK court proceedings if necessary. It should be noted that a Commission decision on state aid can be appealed before the CJEU.
Despite the fact that the UK will leave the EU in March 2019, the Commission would be able to try the case during the Brexit transition period. Furthermore, the draft UK-EU Withdrawal Agreement published in March 2018 contains a provision granting the CJEU jurisdiction over any case still pending at the end of the transition period. If the UK and the EU agree to these terms, it is likely that any UK appeal against a Commission decision would still be heard by the CJEU, even if proceedings are delayed beyond the end of the planned transition period.