Home / ... / February 2006 / Genuine Tax Planning - OK in Europe?

Two tax cases came before the ECJ on 13th December, 2005. The cases were linked in that the taxpayer in each case claimed that UK legislation, as applied in each case, was in breach of fundamental freedoms contained in the EC Treaty, and specifically the freedom of establishment.

In the first case, that of Marks & Spencer, the ECJ delivered its judgment, and then went straight into the oral hearing of arguments by various Counsel in respect of Cadbury-Schweppes. It is not the purpose of this article to comment in detail on Marks and Spencer. Indeed, we may expect some complexities to arise from the decision. In an initial comment on the judgment, Brian Keegan, Director of Taxation at the Institute of Chartered Accountants in Ireland (ICAI) said:

“While this judgment is in the applicant's favour, its conditions are such that it is unlikely to become a matter of routine that Irish companies will be able to offset losses from their foreign subsidiaries for tax purposes.”

So that case is not clear-cut.

It is also recognised that the arguments of Counsel are not of special relevance to tax practitioners who naturally are more interested in the final decision of the Court. That said, because the two cases were so linked, it might be useful to do some crystal ball gazing as to the outcome of the Cadbury-Schweppes hearing, since the shadow of the Marks & Spencer decision can be expected to have some impact on the latter case. Marks & Spencer The ICAI’s initial comment made the point that the ECJ effectively recognised the right of the Member States to limit tax relief claims across national boundaries as long as these restrictions are compatible with the Treaty of Rome and further public interest. Undoubtedly the group relief provisions of the United Kingdom can constitute a restriction of freedom and establishment because of the difference of treatment of losses between residents and non-resident subsidiaries. The Irish group relief provisions are similar to the UK rules. The UK Government contended for three justifications for discriminating against freedom of establishment. The first of these, the need to protect a balanced allocation of the power to impose taxes between Member States, was at least partially cut down by the ECJ in its observation that loss of tax revenue is not a justification for overriding a fundamental freedom. The ECJ did accept a second contention by the UK that it would be appropriate to adopt measures against multiple claims for relief against the same losses. Thirdly it recognised a right to counter tax avoidance for example where low value tax losses might be transferred to profits in high tax jurisdictions. What is interesting in the context of the later hearing of Cadbury-Schweppes was the opinion of the ECJ that Member States were free to adopt or to maintain in force rules having the specific purpose of excluding wholly artificial arrangements from enjoying tax benefits. This point was immediately picked up by Counsel for the UK Government in the following case of Cadbury-Schweppes. A second and very important comment by the ECJ was that, insofar as it may be possible to identify other less restrictive measures [to deal with the Marks & Spencer type problem], “such measures in any event require harmonisation rules adopted by the community legislature”. The word harmonisation is of course bad news in the context of the Irish government’s policy in relation to direct tax in the EU. But given that the ECJ had or should have had specific measures in mind when it framed the comment, it should have spelled them out. One suspects that they may have been echoing the party line of the Commission. Cadbury-Schweppes The UK legislation under discussion here deals with controlled foreign companies (CFCs). Cadbury-Schweppes is incorporated and resident in the UK and has two subsidiaries, resident and established in Ireland whose business was to raise and provide finance for the group. These subsidiaries benefited from the IFSC regime for group treasury companies and at the time in question were entitled to the 10% corporation tax. The companies were not taxed in the UK except insofar as the CFC legislation of that country was brought to bear on the profits of those two subsidiaries. There are a number of exclusions to the operation of this legislation including where the controlled subsidiary satisfies a motive test: 4The parents must show the reduction of tax of the subsidiary was not the main purpose or one of the main purposes of the transactions and, 4The taxpayer must show that it was not the main reason or one of the main reasons for the CFC’s existence to achieve the reduction in UK tax by diversion of profits from the UK.

Presentations were made by a number of Member States and insofar as the company and Counsel for Ireland were the only ones arguing specifically in support of Ireland’s position it seemed to be rather a case of Ireland versus the rest of Europe.

The Commission and Ireland both had interesting comments on the motive test, referred to later in this article. The arguments from the rest of Europe mainly proceeded on the basis of justifying the anti-avoidance legislation in the UK. While it was generally accepted that the legislation did discriminate against freedom of establishment, Counsel for the UK had an interesting view of what was meant by freedom of establishment.

Freedom of establishment He argued that freedom of establishment essentially means the freedom to integrate into the national economy of the overseas country and to participate in a real sense in the development of that economy. Without indicating specifically why the two subsidiaries were not established in that sense, Counsel for the UK maintained that there were no such establishments and therefore that the CFC legislation was justified in this case. He argued that in the light of earlier ECJ decisions, tax avoidance legislation of this kind was justified taking into account the following considerations: 4The level of physical presence in the country concerned. 4The real substance of the transactions in question. 4The commercial economic value added to the group.

This analysis was incidentally supported by the lawyer for the European Commission who, interestingly enough, was the same lawyer who represented the Commission in the Hearing of the Marks & Spencer case.

Artificial transactions in general Counsel for the UK government and other States supporting CFC style legislation focussed on the quotation from the Marks & Spencer case concerning the right of Member States to counter tax avoidance and, in particular, artificial transactions. Given the views expressed by the ECJ in the Marks and Spencer case, one can surmise that legislation which is aimed only at artificial structures should have no difficulty in gaining ECJ approval. But does the UK legislation do that? As Counsel for the company pointed out, a CFC subsidiary is at a disadvantage as compared with the resident subsidiary and not least because the legislation ignores the possibility that the CFC could make losses. Significantly, one of the subsidiaries in the 1996 financial year did in fact make such a loss. However, this was only referred to in the stated case material and was not highlighted by any of the lawyers in making oral presentations. So the UK legislation does seem out of balance. One would suppose that in a situation where an artificial transaction was taking place that neither of the subsidiaries in question would actually make a loss. The fact that one of them did so would tend to support the idea that they weren’t that artificial after all. The company further argued that the legislation did not work on a case-by-case basis but was simply a scatter gun approach. For example, a CFC would be outside the scope of the legislation if it pursued an acceptable distribution policy (the 90% rule). This exclusion, however, ignored the possibility that it might not be possible or legally appropriate for a company to pay dividends up to 90% if at all. Furthermore, while the UK legislation does indeed exempt certain trading activities, none of the exemptions apply to the kind of activities which were carried on by the two Cadbury-Schweppes subsidiaries. Given the assertion by the company, that these were genuine companies, it was wrong for the UK government to assert that genuine companies would not be affected. They most certainly could be and the legislation was not in itself aimed solely at artificial tax avoidance schemes.

Artificiality of Cadbury-Schweppes Given the inherent problems in the UK legislation, Counsel for the UK was inevitably obliged to show that the creation of the two subsidiaries was a sham or artificial transaction of itself. There were some difficulties with this line of approach. The company argued that the UK government were quite wrong to allege or suggest that there were sham activities involved. Such issues had never been raised before the Special Commissioners which was the Tribunal in the UK which determined the facts. In effect, since such facts had not been introduced at a primary level in the hearing of this case, they could not be brought forward at this stage by means of simple assertion by the UK Revenue. But, as to the particular points made by the Revenue, the company pointed out that there was nothing unusual in a group company employing all the employees in a group and in allocating their services to group companies insofar as they were needed. The absence of direct employees in the case of these two subsidiaries was, he suggested, no evidence at all of artificiality. This is where the arguments became interesting from an Irish viewpoint because James Nesbitt SC representing the Irish government commenced by stating that there was no reference anywhere in the documentation that these specific CFC operations were a sham. He pointed out that there had been a Jersey operation before the Irish subsidiaries had been formed and that there had been no case whatsoever of UK profits being moved from UK to Ireland. The transactions in question had in fact come to Ireland from Jersey. In support of his argument against the artificiality, he also highlighted the fact that the activities of the Cadbury-Schweppes’ subsidiaries had been certified by the Irish authorities as trading activities. Certainly, in the latter stages of the certification of companies in the context of IFSC approval, it was an essential feature that companies should show that their activities were not artificial and that there was real substance there. Unfortunately, this point was not also made by Counsel for the company and it remains to be seen as to what view is taken by the ECJ if any as to the nature of the transactions of the two subsidiaries.

The motive test However, and continuing with the arguments on behalf of the Irish government, it was even more interesting when Counsel said that ordering one’s tax affairs in a certain manner is not an abuse and, more interestingly still, it was argued that the motive test which lay at the heart of the UK legislation was an unreasonable test because any businessman must have regard to the below line profit! Remember that this argument came as the view of the Irish government and presumably also that of the Irish Revenue!

Position of the European Commission Mr Lyall, appearing for the European Commission, pointed out that the ECJ has supported tax avoidance legislation in the past but has maintained that such legislation cannot block real activities. He noted that the UK rules on CFCs are broad-based but for him the question was whether the exclusions in the UK legislation are sufficient to limit the CFC rules to wholly artificial transactions. Implicitly, he seemed to be suggesting they were not. He then went on to ask the Court specifically if it could assist by defining what is artificial. He also rejected the validity of the motive test, but did argue that Group Treasury can and do pass such a test. He did not specifically link it to the case in front of the Court. Lyall further suggested that the whole business of showing that profits were being moved from one country to another could and should be dealt with through transfer pricing mechanisms. Whether this is entirely practical in the case of profits from services he did not elucidate. However, one was left with the distinct impression that a potential decision by the Court might well be on the lines of justifying the UK legislation only in a situation where the case in question involved wholly artificial transactions. In that event, one would expect the question as to whether Cadbury-Schweppes’ activities were artificial to be left to the UK to sort out and presumably for the matter to be referred back to the Special Commissioners for their view. And, if the ECJ does come up with some definitions of artificiality which might be imported into legislation then, as with the Marks & Spencer case, we might have a win-win situation for Revenue and taxpayer. So where stands co-operative compliance?

Gerald Murphy is Taxation Executive with the Institute of Chartered Accountants in Ireland.

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