Are the proposed CFC changes EU law compliant?

CMS Cameron McKenna was delighted to host the spring meeting of the CMS pan European tax group recently in London. The meeting focused on transfer pricing disputes, the topic for this year’s CMS tax conference, which will be held in Paris in November.

At that meeting Professor Melchior Wathelet (Honorary Judge at the ECJ and Of Counsel, CMS Bureau Francis Lefebre (Paris)) analysed the case law of the ECJ and highlighted the extent to which the national law of a member state, which in principal constituted an obstacle or restriction to one of the fundamental freedoms (free movement of persons, services, capital and the freedom of establishment), could be justified so as to prevent the risk of tax avoidance. Professor Wathelet’s analysis is relevant to an assessment of whether the UK’s proposed legislative response (in Schedule 15 Finance Bill 2007) to the decision of the ECJ in Cadbury Schweppes is EU law compliant.

The latest issue of Tax Connect contains an article (see page 42) looking at HM Revenue & Customs’ (HMRC) response to Cadbury Schweppes. Professor Wathelet’s analysis lends support to the contention that, if the legislation is enacted in its current form, it will be incompatible with EU law.

‘Tax Avoidance’ per the ECJ

In his talk Professor Wathelet traced the history of the case law in this area noting that the ECJ accepted in principal that the prevention of the risk of tax avoidance could be a justification (see ICI v Colmer) but only when the national legislation has ‘the specific purpose of preventing wholly artificial arrangements, set up to circumvent [national] tax legislation’ and is proportionate (that is to say, legislation goes no further than is required to counter the risk of tax avoidance).

It is also clear that ‘…a general presumption of tax avoidance or fraud is not sufficient to justify a fiscal measure which compromises the objectives of the treaty…’ (see EC Commission v France). Therefore, in a number of cases the ECJ has rejected the idea that certain actions of the taxpayer may give rise to a presumption of tax avoidance. For example, the ECJ held that tax avoidance could not be presumed simply through the establishment of a subsidiary abroad (ICI v Colmer) or the transfer of a natural person’s tax residence outside the territory of a member state (see Hughes de Lasteyrie du Saillant).

The following general principles can be distilled from the case law of the ECJ:

1. It is a legitimate objective for a taxpayer to establish himself in the most advantageous tax system within the EU.
2. Article 43 EC Treaty protects any establishment provided that the operations have a true economic substance (in other words, there is a genuine establishment that carries on genuine economic activities as opposed to a ‘letterbox’ operation).
3. There is no irrebutable presumption of an abuse of law by the taxpayer.
4. The finding that the taxpayer has entered into ‘artificial arrangements’ ‘which do not reflect economic reality’ can only be established on the basis of objective criteria and not the intention of the taxpayer (i.e. by looking at personnel, premises, equipment, etc).
5. The taxpayer must be afforded the opportunity of providing evidence of commercial justification.

The proposed amendments to the CFC legislation are designed to operate not simply to disapply the CFC rules where the subsidiary is carrying on genuine activities but also to introduce a mechanism for attributing the level of profits to those activities. The proposed amendments to the CFC legislation operate by assuming that only profits arising from the work of individuals engaged in the business of the CFC in the member state where it is established may constitute ‘genuine economic activities’. HMRC guidance specifically states that profits from capital will rarely constitute profits from ‘genuine economic activities’. It is difficult to see how this assumption can be EU law compliant.

If there is artificial profit shifting from the parent (or another group company) into the low tax subsidiary, the transfer pricing rules should be available to counter this. If the transfer pricing rules cannot apportion the profits to the UK parent in the way that HMRC would wish this is surely an indication that a proper attribution of profit is not so much the concern of HMRC as the diversion of profits away from the charge to UK tax. However, the Cadbury Schweppes judgment permits diversion of profits away from the UK provided that genuine activities are being conducted in the low tax member state; in other words, the taxpayer is free to carry on activities in another member state rather than the UK even though the sole reason for doing so is to reduce tax.

Purposive interpretation – the European approach

Professor Wathelet also made some interesting general remarks about the effect of ECJ case law on the interpretation of national legislation. In particular whether national legislation should be construed in a way that is consistent with the effect of a decision of the ECJ even where the language used in the national legislation cannot be interpreted consistently with the decision of the ECJ by using the normal statutory rules of interpretation of the member state. Indeed one of the arguments that was advanced in the Court of Appeal in the Marks and Spencer case on group relief was that, as the UK legislation explicitly provided that losses cannot be surrendered by a non resident subsidiary to its UK resident parent, the group relief provisions limiting the surrender of losses to UK resident companies should be disapplied so that the legislation simply operates to permit the surrender of losses by a subsidiary (wherever, it is resident in the EU) to its parent.

Professor Wathelet was of the view that it was incumbent on the referring court to construe its national legislation consistently with the decision of the ECJ and that the ECJ would increasingly rely on national courts to do so. The concept of ‘purposive’ interpretation is well established in UK case law where UK courts have tried to reflect the intention of Parliament. However, the ECJ’s approach may now require UK courts to take this a step further and read legislation consistently with European law, even where it was clearly not Parliament’s intention. The Court of Appeal in Marks and Spencer seems to have accepted this view while recognising that the House of Lords will soon get an opportunity to consider this issue in Fleming v HMRC and Conde Nast Publications v HMRC, both of which are VAT cases. The Court of Appeal indicated that where there was “no real possibility” that the losses could be used in the member state of the loss making subsidiary (within the appropriate time period) the UK legislation had to be interpreted as if there was no requirement that the subsidiary must be resident in the UK so that the losses could be surrendered. However, where the losses could be used in the member state of the subsidiary the UK legislation denying the right of a non-UK resident subsidiary to surrender losses was compliant with EU law.

The result of the purposive approach is that legislation cannot be said to be discriminatory or non-discriminatory until the legislation is actually applied to a taxpayer’s particular circumstances. There will rarely be absolutes. In relation to Cadbury Schweppes it cannot be said that the legislation is in breach of EU law unless the UK CFC legislation is applied to a subsidiary carrying on genuine activities. However, if the subsidiary is not undertaking “genuine economic activities” then the UK CFC rules would be EU compliant; in other words whether the UK legislation is in breach of EU law can only be determined by reference to the facts of the particular case.