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On the 12th of September 2006 the European Court of Justice delivered its decision in the case of Cadbury Schweppes Plc V Commissioners of the Inland Revenue.

The Court held, that the UK Controlled Foreign Company (“CFC”) legislation which subjects UK companies to tax on the profits of their overseas subsidiaries where those subsidiaries are subject to a lower rate of tax was contrary to the freedom of establishment protected by the EC treaty.

However, it felt that this restriction was potentially justifiable on condition that it caught only wholly artificial arrangements. In situations where the overseas subsidiary was genuinely established in another Member State based on objective criteria as to staff, premises, equipment etc such a restriction could not be justified.

It left it to the UK Courts to determine whether the ‘motive test’ in the UK CFC rules could be interpreted in such a way as to only catch such artificial arrangements. If the test could not be interpreted in such a way as a matter of UK law, then the UK CFC rules would be contrary to Community law in their entirety in so far as they related to intra Community investment.

The impact of this decision may be three fold for the Irish economy.

Regardless of whether it is based on a new interpretation by the UK Courts of the existing rules, or new legislation by the UK Government, the UK CFC rules should no longer provide as strict a barrier to investment in Ireland by UK companies.

The downside for Irish Revenue is that Irish rules which similarly impede Irish individuals from investing in other Member States now need to be reviewed in the light of this judgment.

And finally, the judgment serves as a reminder that in all matters where Irish tax law impedes one of the fundamental freedoms protected by the EC treaty, the Irish tax authorities and courts should accept the primacy of Community law and interpret domestic legislation accordingly.

CADBURY-SCHEWPPES - THE DECISION

The Court's decision is clearer than the opinion of the Advocate General and this is to be welcomed. The Court started with an analysis of whether legislation such as that at issue, which subjected a UK company to tax on the profits of a non resident entity, restricted the fundamental freedoms. The Court gave a thorough analysis of its previous jurisprudence which was very helpful.

- Community law will not protect the improper circumvention of national legislation - The fact that the tax payer sought to avail of a tax advantage legally provided for by another Member State does not deprive him of his right to the protection of Community law - The fact that a company was established to take advantage of less restrictive legislation in another Member State does not justify depriving it of the protection of Community law

The Court held that the UK rules at issue restrict the freedom of establishment.

It then went on to consider whether such a restriction could be justified. The Court went through its previous jurisprudence on that matter in detail.

- It is settled case-law that because a subsidiary company gains a tax advantage by being established in another Member State, the Member State of the parent entity is not justified in offsetting that advantage by less favourable tax treatment of the parent company - The need to prevent the reduction of tax revenue is not a reason of overriding general interest - In circumstances where a national exercises their right to establish in another State the home state is not justified in having a general presumption of ‘tax evasion’. Whether the Court’s definition of tax evasion could also encompass aggressive tax avoidance is yet to be tested. However, as they used the phrase in relation to the Cadbury situation which involved avoidance rather than evasion this would seem to be the case - The objective of freedom of establishment is to allow a Community national (including a company) to participate on a stable and continuing basis, in the economic life of another Member State

As such, the Court felt that the restriction may be justifiable, but only if it was proportionate to the end it sought to achieve and only applied to ‘wholly artificial arrangements’. To this end the UK Revenue had suggested that the ‘motive test’ could be interpreted to refer to purely objective criteria including premises, staff and equipment.

However, the Court left it for the UK courts to determine whether they could interpret the subjectively worded ‘motive test’ in such an objective manner.

HOW DOES IT IMPACT IRELAND?

This decision impacts Ireland in three key ways.

1. A potential barrier to UK inbound investment is being addressed 2. The Court has reiterated the need for domestic Courts to give effect to Community law 3. While Ireland does not have controlled foreign company provisions, it does have similar provisions in relation to individuals which will need to be addressed

bARRIER TO INBOUOND INVESTMENT

As a result of the decision of the Court of Justice, the UK Courts need to determine whether they can interpret the UK ‘motive test’ in a manner proportionate to the ends to be achieved.

The motive test as it stands is couched in the negative. A company can satisfy the motive test in relation to a CFC unless: - The existence of that controlled foreign company achieves a reduction in UK tax, and - It is reasonable to assume that had the foreign company not existed, the whole or a substantial part of the receipts of that foreign company would have been received in the UK.

It would appear to be quite difficult for the UK Courts to interpret this test as being objective and looking to criteria such as premises, staff etc when Parliament included no such guidelines. In all likelihood this question will ultimately have to be addressed by the UK’s highest court, the House of Lords.

If the motive test can not be interpreted in such a manner then the UK courts will be obliged to set aside the UK CFC legislation, as it currently stands, in its entirety in so far as it relates to EC based companies.

Many UK commentators are already suggesting that this is the only possible outcome, and that the UK will legislate to introduce statutory tests in line with the suggested criteria to ensure that going forward the UK CFC rules are consistent with Community Law.

However, regardless of whether the UK courts can apply an objective version of the motive test, or whether the UK Government legislates to amend the test, a barrier to investment in Ireland going forward has been removed by the judgement.

Where, in the past UK companies may have been loath to put intra group activities into Ireland to avail of the 12.5% rate on account of the UK CFC rules, it would seem now that where the activities have sufficient substance in Ireland to warrant a trading ruling from Irish Revenue, they should also have sufficient substance to be able to avail of the protection of the freedom of establishment article of the EC treaty.

DIRECT EFFECTIVENESS OF COMMUNITY LAW

The Court of Justice in its judgement yet again provided a reminder to national courts that they are obliged to interpret domestic legislation in a manner consistent with Community law. The treaty is directly effective and supreme over domestic law. The Court issued guidance as to the appropriate tests, but ultimately left it to the UK courts to determine whether the UK CFC rules are consistent with Community law.

As a result, where Irish legislation is inconsistent with community law, Community law prevails and Revenue and the Irish Courts should seek to apply an interpretation consistent with Community law.

If the Irish Courts are not prepared to do so, then alternative remedies protecting Community law rights should be provided by the Irish Courts which are no less effective than those covering comparable domestic laws, and which do not render practically impossible or excessively difficult, the exercise of rights under Community law.

IRISH TAX LEGLISLATION

Finally, Irish legislation may have become more vulnerable to challenge as a result of the Cadbury Schweppes judgement. Although the Irish corporate tax code does not have controlled foreign company (“CFC”) legislation, it would be a mistake to conclude that the Cadbury Schweppes decision is only of relevance insofar as it impacts Ireland’s ability to encourage inward investment.

Ireland has a number of provisions which seek to attribute to Irish individuals the income or gains of offshore (including EU) entities. Therefore, the Court’s decision in Cadbury Schweppes that such legislation may be a justifiable restriction on intra-EU free movement only insofar as it applies to wholly-artificial arrangements intended to circumvent national law raises a number of questions about Irelands transfer of assets abroad legislation (section 806 – 807A TCA 1997) and section 590 TCA 1997 which seeks to attribute the gains of non-resident close companies to Irish participators.

1. Transfer of Assets Abroad

The Transfer of Assets Abroad legislation in TCA ’97 s806, s807 and s807A is very similar to the UK Controlled Foreign Company legislation at issue in the Cadbury Schweppes case insofar as it relates to Irish resident or ordinarily resident individuals.

It provides that, where Irish residents transfer income generating assets abroad, or where they benefit from income generating assets being transferred abroad, they are subject to Irish tax on that income regardless of whether the income is paid to them.

There is an exemption from this rule where the individual can prove to the satisfaction of Irish Revenue that either: - The purpose of avoiding tax was not the purpose or one of the purposes of the transfer, or - The transfer was for bona fide commercial reasons and not for the purpose of avoiding liability to tax

After the Cadbury Schweppes judgement it would seem that such provisions are contrary to the freedom of establishment articles of the EC treaty on the basis that no similar provisions apply to transfers of assets within Ireland.

The Court reminded us that it is settled case law that the fact that a taxpayer sought to benefit from a tax advantage provided by another Member State does not deprive them of the right to have their freedoms protected. Indeed, it is somewhat ironic that in two cases where the Court has stated this point, the country providing the tax advantage was Ireland.

The next question would be whether the Irish rules were justifiable and on the back of the Cadbury Schweppes judgement it would seem that this could only be the case if they were designed to catch only wholly artificial arrangements. This would mean that where the taxpayer had genuinely availed of their right to establish in another State they should not be caught by the Irish rules. In concluding on this matter the Irish Courts should have regard to objective criteria including employees, premises equipment etc overseas, but not to the motivation of the Irish taxpayer. As with the UK example in Cadbury Schweppes, if the Irish Courts can not read such objective criteria into the Irish legislation at issue, then the Irish legislation insofar as it relates to any intra community transfers is surely contrary to Community law.

2. Gains of Close Companies

TCA 1997 s590 provides that where a foreign company would be close if it was Irish resident i.e. under the control of its directors, or five or fewer participators, then where it disposes of an asset at a gain, an amount of the gain proportionate to the Irish resident investor’s interest in the company shall be assessed on him.

As with the transfer of assets abroad legislation above, there is an exemption from this charge. However, the exemption is even more restrictive than the bona fide commercial purpose exemption in the transfer of assets abroad legislation as it exempts only gains on the disposal of ‘trading assets’.

Where there is a genuine overseas establishment, such a tax charge would be contrary to Community law where an Irish taxpayer is subject to a tax charge based on the gains of a separate legal entity.

Again, after the Cadbury Schweppes case it would seem that unless the Irish Courts can interpret this exemption as including all cases where there is, objectively by reference to employees, premises etc, an establishment elsewhere in the EC, then this rule is invalid insofar as it brings within the Irish tax net gains derived by non resident companies in the hands of those companies’ shareholders.

3. Procedural Points

Irish Revenue should also take note of the Advocate General’s opinion in the Franked Investment Income Group Litigation Order (“FII GLO”) case. This case challenges the UK rules which exempt UK dividends in the hands of UK companies as franked investment income, yet tax EU dividends with credit. The UK government wanted to raise a ‘temporal restrictions’ argument. In the “IRAP” case the A-G allowed the setting of limitations as to which claims could proceed due to the potential impact on the Italian finances. (The Court of Justice has since ruled in favor of the Italian Government on the main point rendering the ‘Temporal Restrictions’ argument unnecessary).

In refusing the UK Government’s request for such a restriction in the FII GLO case the Advocat General, noted that one of the requirements for a temporal restriction was evidence of ‘objective, significant uncertainty’ on the part of both the national Government and taxpayer as to the scope of community law. The A-G further felt that since the Avoir Fiscale case (C-270/83) in 1986, the UK Government should have been aware that the difference in tax treatment under UK legislation between UK dividends and foreign dividends was contrary to Community law.

As a result, it would seem likely that from the date of the Cadbury Schweppes case, if not earlier, the Irish Government should be aware that that these provisions are contrary to Community law.

CONCLUSION

For taxpayers this result is to be welcomed, both in terms of encouraging further inbound investment from EC countries with CFC regimes, and for bringing into the question the wide scope of a number of Irish anti-avoidance rules in so far as they relate to genuine establishments in other member states.

Where Irish taxpayers believe that Irish tax rules are contrary to Community law they should consider making protective claims now. This is particularly true where either of these two sections noted above could apply to levy a tax charge on an Irish resident as a result of income or gains accruing to a resident of another Member State.

Declan Butler is a Partner and Aisling Donohue is a Manager in Deloitte’s Tax Department.

very intresting Declan