EU State Aid Challenge to UK CFC Rules London | November 2017 CONTACT US | FEEDBACK | FORWARD | WEBSITE Client Alert 17 November 2017 If you would like further information, please contact: Patrick O'Gara Tax Partner London +44 20 7919 1633 Patrick.O'Gara@bakermckenzie.com Kate Alexander Tax Partner - London +44 20 7919 1908 Kate.Alexander@bakermckenzie.com Alistair Craig Tax Partner - London +44 20 7919 1679 Alistair.J.Craig@bakermckenzie.com Ross Denton EU Competition & Trade Partner London +44 20 7919 1978 Ross.Denton@bakermckenzie.com Alexandros Stratakis Sr. Associate London EU Competition & Trade +44 20 7919 1626 Alex.Stratakis@bakermckenzie.com Nina Niejahr Competition Counsel Brussels +32 2639 3746 Nina.Niejahr@bakermckenzie.com Bill Batchelor Partner EU Competition & Trade Partner Brussels +32 2639 3632 Bill.Batchelor@bakermckenzie.com The European Commission publishes its opening decision to launch investigation into the UK's CFC finance company exemption, reaching the preliminary view that the exemption constitutes unlawful State aid Summary The European Commission yesterday published its detailed decision to open an in-depth investigation into the UK's controlled foreign company ("CFC") rules introduced in 2013, focused on the finance company exemption in Chapter 9 of the legislation at Part 9A of the Taxation (International and Other Provisions) Act 2010. The Commission's decision reveals that it has been looking into the UK's CFC rules since 2013 and has been in correspondence with the UK Government since then. Notwithstanding the UK Government's representations to date, the Commission has expressed the preliminary view that the finance company exemption is an unjustified derogation from the broader UK CFC rules and constitutes unlawful State aid, contrary to Article 107(1) of the Treaty on the Functioning of the European Union ("TFEU"). The elective exemption can operate to exempt 75% of a CFC's finance profits earned from lending funds to overseas affiliates from a UK CFC charge, resulting in an effective UK tax rate of 4.75% in the current financial year, as compared to the regular rate of 19% on CFC profits. The exemption effectively assumes as a default that CFCs carrying on intra-group financing activities are funded with a debt/equity ratio of 1:3 for the purposes of imputing a CFC charge on profits arising from such activities. Where and to the extent that the CFC's overseas lending is ultimately sourced from "qualifying resources", effectively funds drawn from the jurisdiction in which the borrower is resident or from new overseas capital, or where the aggregate finance profits of the CFC and its overseas affiliates exceeds the net interest expense of the multinational group in the UK as a whole, the exemption can operate to exempt up to 100% of the CFC's finance profits from a UK CFC charge. The UK CFC regime was the outcome of extensive work and consultation with business by both the Labour and Coalition Governments between 2007 and 2012. The finance company exemption in particular was a carefully crafted compromise intended to balance the financial risk to the Exchequer with the need to create a simple, workable and competitive solution for UK multinationals that avoided the need for complex legislation and systems to trace a group's cross-border transactions and financial flows. If the European Commission finally decides that the finance company exemption does indeed constitute illegal State aid, all UK resident companies that have benefited from the exemption since it was introduced in 2013 could potentially be exposed to recovery proceedings to recoup the financial benefit they have derived from it from the outset, together with compound interest. The finance company exemption is a crucial feature of the UK CFC rules. The Commission's challenge, its potential impact on past periods and its influence on the future nature of the UK's CFC regime, will create significant uncertainty for UK-based multinationals. It will cast doubt on the continuing attractiveness of the UK as a headquarters location for outbound investment and M&A. It may prompt a new flight of redomiciliations overseas for multinationals that require a greater degree of certainty on their future tax position. In considering alternative options, however, the Commission's approach strongly suggests that other EU Member States will have limited freedom of action in respect of the future direction of their own CFC regimes. It will also no doubt influence the implementation of new CFC regimes in line with the requirements of the EU Anti-Tax Avoidance Directive. Coming at a time when there are already significant uncertainties on the future direction of UK policy in light of its impending exit from the EU, this development adds to the raft of broader concerns that many UK multinationals are currently grappling with. We will be running a breakfast briefing in the near future to discuss this development in further detail. Please click here to register your interest in this event. What is exactly is the Commission challenging? The European Commission has expressed no issue with the UK CFC rules in general. However, the Commission came to the preliminary view that the finance company exemption constitutes State aid within the meaning of Article 107(1) TFEU, which applies to any aid granted by a Member State, or through State resources in any form whatsoever, which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods, in so far as it affects trade between Member States. In particular, the Commission considers that the exemption is a derogation from the UK CFC rules. The Commission has rejected the UK Government's arguments that the exemption is an integral part of the CFC rules which establishes the proper boundaries of the regime. The Commission further considers that the exemption provides a selective advantage in that it leads to a difference in treatment between undertakings that are in a comparable legal and factual situation in view of the objective of the UK CFC rules as a whole. The objective of the UK CFC rules is to ensure that profits which have been artificially diverted from the UK are subject to UK tax. Under Chapter 5 of the CFC legislation, finance profits are broadly subject to a UK CFC charge if and to the extent that significant people functions in the UK have contributed to the generation of those profits, or those profits directly or indirectly derive from UK capital. For the purposes of qualifying for the finance company exemption on intra-group lending however, a group need only ensure that the CFC has business premises in the jurisdiction in which it is resident which are used with a reasonable degree of permanence for the purposes of its activities there. The contribution of decision makers in the UK to the CFC's lending business is irrelevant, provided the CFC maintains its non-UK residence status. Equally, the source of the CFC's capital is largely irrelevant, provided that an existing creditor relationship has not been contributed from the UK to the CFC with a main purpose of securing a reduction in taxable UK interest income. The finance company exemption is of course available on an elective basis to any UK company that satisfies its conditions. However, the Commission considers that the finance company exemption creates a selective advantage because it applies only to finance profits arising from intra-group lending, and not finance profits arising in other circumstances. So, a CFC's finance profits from lending to another CFC are eligible for the exemption, whereas a CFC lending funds to a UK affiliate or to third parties in the UK or overseas are not. The Commission has no doubt been emboldened by the decision of the European Court in the case of World Duty Free Group [Link] in December 2016. According to the Court of Justice in that case, the Commission does not need to identify a particular category of undertakings that exclusively benefit from a tax measure. What does this mean for UK multinationals? How much could they potentially have to pay? If the European Commission finds that the finance company exemption amounts to illegal State aid, the UK government is obliged under EU law to recover from the beneficiaries the benefit they have received from the exemption, plus compound interest. The limitation period for recovery goes back 10 years from when the investigation started. The finance company exemption was first introduced in 2013, so any group that has benefitted from the exemption since then could potentially be liable to pay the difference between the full rate of UK corporation tax on its CFC finance profits (at rates of between 23% in 2013 to 19% today), and the reduced rate of tax claimed under the exemption of between 5% and 0%, subject to the availability of other defences. It may be possible for a group to demonstrate that, absent the exemption, a company would have been subject to either no or a lower CFC charge in any event and so it has received no benefit. For example this may be because the CFC was funded wholly or partly with foreign capital, and no or limited significant people functions were performed in the UK in respect of the CFC's lending activities. In these circumstances, it is arguable that no illegal State aid has been received by the group in any event, notwithstanding the reliance on the exemption. Equally, it may be possible to argue that, in respect of CFCs that are resident in other EU Member States, no illegal State aid has been received because the imposition of a UK CFC charge in the absence of the exemption would be contrary to the freedom of establishment guaranteed under EU law, relying on the decision of the European Court of Justice in Cadbury Schweppes. It was this very judgment in 2006 which pulled the rug from under the UK's former CFC rules introduced in 1984, finding that a UK CFC charge on the profits of a subsidiary established in an EU Member State was illegal and unenforceable except where it related to wholly artificial arrangements intended to avoid UK tax. Where it can be shown that a CFC is established in an EU Member State and carries on genuine economic activities there, by reference to objective factors such as premises, staff and equipment, a UK CFC charge could be contrary to EU law in any event. The nature and degree of local substance in this context, and the unresolved challenges and uncertainties in this area that were such hot topics ten years ago come sharply back into focus. Many groups have not been electing into the finance company exemption to date because the overseas finance profits of their CFCs are derived from overseas capital and there has been little or no contribution from significant people functions in the UK to its overseas lending activities. For these, the exemption has been an attractive and comforting fall-back defence, providing a limited down-side risk in the event that HMRC were to successfully challenge their primary position. In this context, the European Commission's decision will cause concerns as to whether this fall-back defence can indeed be relied on in respect of past periods, and whether it will continue to be available in the future. Therefore, although CFCs in these circumstances are not directly in the cross-hairs of the European Commission's investigation, there is a risk that they will be indirectly affected, given HMRC's predilection to force reliance on the finance company exemption. What's next? The UK Government will be working on its initial response to the Commission's decision, which it will have to make later this month, unless an extension is obtained. We would expect publication of the Commission's decision in the Official Journal to follow in the next few weeks. This will kick-off the one-month comment period for all interested third parties to submit their observations. Third parties can do so without having their identity revealed to the UK Government or the public. The UK Government will receive copies of observations submitted and will be able to react. Our expectation is that the Commission intends to move quickly and it is reasonable to expect its final decision within the next 12 months. We do not anticipate that the Commission's investigation will be particularly prolonged. The Commission could potentially adopt its final decision before its August break, if it was eager to do so. If the European Commission decides that the finance company exemption constitutes illegal state aid, in theory the UK Government will have in practice four months to make an effective recovery. In theory the UK has to recover within 4 months but given the complexity of calculating the amount to be recovered in the present case, we would expect that full recovery may in practice take longer, perhaps a year or more. If the Commission deems that the UK is not moving at a reasonable pace and/or does not keep the Commission up-to-date, it may consider referring the UK to the European Court of Justice. Recovery proceedings will not be postponed pending the resolution of an appeal by the UK Government or an alleged aid beneficiary to the General Court or the Court of Justice of the EU. It is not clear whether enforcement could start before the scheduled date for the UK to leave the EU at the end of March 2019. However there is a reasonable prospect that EU State aid rules will become part of domestic UK law following Brexit in line with current UK Government policy and the provisions of the EU (Withdrawal) Bill currently before Parliament. The EU's expectation is that any trade deal with the UK, and no doubt any transitional period agreed before then, must ensure a level playing field both in terms of competition and State aid going forward. The enforcement role of the European Commission and the influence of the European Court of Justice in the application of those rules during these uncertain times will remain in doubt. Will the Commission be publishing a list of names of affected companies? No, not necessarily. This is not a case against one individual company; although companies will obviously know if they are affected and will be able to claim that their identity should not be publicly disclosed. Companies were able to successfully argue this in the State aid proceedings brought by the European Commission against the Belgian Excess Profit regime and decided in 2016. How can I find out more? The Commission's initial press release [link] and its decision can be found here [link]. We will be hosting a breakfast briefing in the near future with our tax and State aid experts from London and Brussels. Click here to register your interest in the event. Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference to a "partner" means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an "office" means an office of any such law firm.