Following its most recent reverse in the European Court of Justice (ECJ), the UK government has unveiled changes to the control foreign companies (CFC) regime with the stated aim of bringing it into compliance with EU law.
The changes followed the decision in the Cadbury Schweppes case, which held that the existence of the UK’s CFC rules constituted a restriction on the right to freedom of establishment, which could only be justified to counteract "wholly artificial" arrangements to avoid tax.
The UK’s CFC rules operate to apportion the income of a low-taxed foreign resident company to that of its UK-resident shareholders. Similar rules operate in a number of comparable jurisdictions.
As they stood before the recent amendments, the rules provided that where the local tax incurred by the CFC is less than three quarters of the tax they would pay in the United Kingdom were they so taxable, then all UK resident 25 per cent shareholders would be subject to tax on a proportionate amount of those profits. Exemptions exist for profits arising from certain trading activities carried on by a business establishment of the CFC; for CFCs with profits below £50,000; where 90 per cent of the CFC’s profits are distributed to the United Kingdom and thus taxed in the United Kingdom; for certain publicly quoted CFCs and for CFCs resident in certain "white-listed" jurisdictions.
Additionally, there is a "motive test" exemption for companies unable to bring themselves within any other exemption, which looks to the purposes behind both the existence of the CFC and the transactions it entered into, and, in broad terms, exempts such a structure from the CFC rules where the purpose was not the reduction of tax by means of the diversion of profits from the United Kingdom.
The ECJ left it to the United Kingdom courts to decide whether the existence of the "motive test" exemption was sufficient to render the CFC legislation treaty-compliant, but by legislating now the government has effectively decided to pre-empt that decision. This decision was in any event widely expected to go against the government, as the motive test, by its nature, looks to the purpose of the CFC and not (as the Cadbury Schweppes judgment requires) to its substance.
Amendments to the rules
The new rules (which were announced in the Pre-Budget Report on 6 December 2006 and take effect immediately) introduce a system whereby UK resident companies with CFCs resident in the European Economic Area can apply to Her Majesty’s Revenue & Customs (HMRC) for a reduction in the profits of the CFCs that are apportioned to the UK parent company.
A reduction can only be claimed in respect of a CFC that has individuals working for it and also has a business establishment. The amount of the apportionment will be equivalent to the "net economic value" that accrues to the group as a whole as a result of work done by the individuals employed by the CFC.
Whilst the concept of "net economic value" is somewhat vague, the philosophy behind the new legislation is clear: "profits from labour—good; profits from capital—bad". HMRC are trying to re-establish what they would claim has always been the guiding principle of the CFC legislation—that it is intended to prevent the diversion of profits out of the UK tax net and is not intended to render taxable in the United Kingdom any productive activities of a foreign subsidiary company.
Consequently, profits arising from simple intra-group loans will remain within the CFC rules if there has been no "value added" by the employees of the CFC, in the sense of their undertaking productive work which benefits the group as a whole.
By contrast, the profits of a treasury company may not in the future be the subject of an apportionment under the CFC rules provided there are clearly individuals working for the company who add value to the group as a whole by providing economies of scale and managing the group’s cash efficiently. In such circumstances, profits of the treasury company CFC will not be apportioned where the CFC receives a small interest "turn" commensurate with the scope of its activities of, say, 25 basis points.
Revenue guidance (which was issued with the new legislation and includes a number of case studies) also indicates a hostility to IP-holding and licensing CFCs, although in this respect they may be on slightly weaker ground. No account is taken in HMRC’s example case studies of the possibility that the disposal of IP by a UK company to a CFC would mean that it had already been taxed in the United Kingdom (thus making it inequitable to tax receipts in respect of such IP in the United Kingdom). If the IP is developed and maintained by the CFC, that would surely result in the creation of net economic value for the group. What HMRC may be targeting is CFCs which develop IP by subcontracting the work to contractors based elsewhere, but the guidance is somewhat vague and suggests that HMRC will seek to apply the CFC rules to any CFC whose principal activity involves the management of IP.
Underpinning this reform is HMRC’s belief that the existing CFC legislation does not contravene the principle of freedom of establishment, and that these legislative changes are merely intended to put the question beyond doubt.
HMRC seem to have reached this conclusion largely on the basis of comments in the Cadbury Schweppes judgment to the effect that, in determining whether a CFC reflects "economic reality", it is necessary to have reference to "objective factors….with regard, in particular, to the extent to which the CFC physically exists in terms of premises, staff and equipment". The judgment also refers to "letterbox" or "front" subsidiaries as potentially being "wholly artificial" arrangements in respect of which the CFC rules can legitimately apply. HMRC’s view is that a subsidiary without directly employed staff is essentially artificial, even if resident in its jurisdiction of incorporation and effectively managed in that jurisdiction by a properly constituted board of directors.
This is not a view shared by a large number of commentators, many of whom assumed that the CFC rules would require more radical surgery following Cadbury Schweppes. It is, however, consistent with the position that HMRC took in relation to the group relief rules following the decision of the ECJ in the Marks & Spencer case. What appeared on the face of the judgment to be a defeat for the government was, to HMRC, actually an affirmation of the validity of the status quo with only a few minor tweaks required to remove any ambiguity.
The net cost to the Exchequer of the reforms is estimated at £100 million for 2007/8, rising to £250 million in 2009/10. This is largely counteracted by the abolition of the quoted companies exemption (the government having apparently concluded that this was being exploited for the purposes of tax avoidance). Whilst this is a significant sum, it is far from constituting the degree of financial meltdown for the government that some had predicted when the judgment was issued.
This legislation is, however, unlikely to be the last word on the issue. In the first place, it is implicit in the legislation that the government believes that it can still apply a CFC apportionment to the specific case of Cadbury Schweppes (which concerned Irish financing subsidiaries with neither staff nor offices). This will be tested when the case returns to the Special Commissioners later this month for them to apply the ECJ’s ruling to the facts of the case. It must also still be arguable that, even following these amendments, the rules contravene the EU treaty right to the freedom of movement of capital between member states, which the judgment does not consider in detail. Either way, the government may be forced, either by the UK or European courts, to relax the CFC rules more significantly than it would wish.
Just as it did following the Marks & Spencer judgment, the government has sought to bring UK law into line with the ECJ’s dictum in as minimalist fashion at the least cost to the public finances. The reforms offer few immediate new planning opportunities, but further developments are likely and multinational groups are well-advised to follow these closely, as well as ensuring that they file repayment claims with HMRC to the extent that the relevant ECJ judgments enable them to do so.