- On 2 April 2019, the European Commission ("Commission") announced the conclusion of its in-depth state aid investigation into the UK's group financing exemption (“GFE”) under the controlled foreign company tax rules ("CFC Rules"). The Commission found that the GFE was partially incompatible with the prohibition on illegal state aid as it provided a selective advantage to certain multinational companies by granting them ‘an unjustified exemption from UK anti-tax avoidance rules’.
- More specifically, the Commission found that the GFE – which provided an exemption for certain revenues generated by intercompany loans accruing to foreign subsidiaries of UK multinationals – amounted to an effective application of the CFC Rules in certain circumstances but illegal state aid in other circumstances. In adopting this partial finding of illegal state aid, the Commission’s decision rowed back on its opening decision in October 2017 where its preliminary case was that the GFE in its entirety constituted an illegal state aid scheme.
- The Commission’s decision requires the UK Government to recover the illegal aid by collecting the additional amounts of tax which would have otherwise been payable from the relevant UK multinationals. A large number of UK multinational companies have benefitted from the GFE, with over 47 having declared a potential exposure amounting to more than £1.2bn in aggregate in their published accounts. While the narrow nature of the Commission’s decision means that the UK Government will not have to recover all tax exempted under the GFE, it will now have to reassess the tax liability of UK multinationals that benefitted from the GFE to begin the recovery process.
- More broadly, the Commission’s decision is the first formal state aid tax decision on a so-called aid scheme since the General Court overturned the Commission’s finding of the existence of an incompatible aid scheme in the Belgian Excess Profits case indicating that the Commission has no intention of scaling back its focus on “unfair” tax competition. As such, it is the latest in a line of recent decisions where the Commission has compelled Member States to recover tax which it considers to be unlawful state aid. These have concerned individual tax rulings in favour of companies like Apple, Starbucks Fiat and Engie. Finally, the obligation for the UK Government to recover the aid will apply post-Brexit, given the unlawful aid was granted during the UK’s membership of the EU. There is, however, likely to be a significant question mark over enforceability of the Commission’s decision, should the UK Government fail to secure recovery, in the event of a “no deal” Brexit.
UK’s CFC Rules and the Group Finance Exemption
Controlled foreign company rules governing the circumstances in which tax is levied on profits of foreign subsidiaries of locally domiciled companies are a common means by which tax authorities ensure that multinational companies do not erode or diminish their corporate tax bases by shifting their profits to foreign subsidiaries based in low or no tax jurisdictions.
The UK’s reformed CFC Rules – of which the GFE is part – have been in force since 2013 and were described by the UK Chancellor at the time as necessary to create a "competitive" tax regime. The UK’s existing CFC Rules significantly reformed the earlier rules in force following the Court of Justice of the European Union (“CJEU”) decision in Cadbury Schweppes which found that the UK’s prior CFC rules infringed the EU freedom of establishment.
Within those rules, the GFE provides an exemption in certain circumstances for tax that would have otherwise been payable on revenues from qualifying intercompany loans made by foreign subsidiaries of UK multinationals to other group companies. The GFE provided both a partial exemption (75%) or fully exemption (100%) from the CFC tax that would have otherwise been payable on the revenues from qualifying loans to other group companies.
The EU’s state aid rules prohibit Member States from granting aid through State resources to favour certain undertakings or the production of certain goods. To assess whether a measure confers a selective advantage on an undertaking, it is first necessary to identify the "normal" regime applicable.
In this case, the Commission reached a complex conclusion finding that the GFE constituted illegal aid in some circumstances but was also a proportionate application of anti-tax avoidance rules in other circumstances. In brief:
- Where the GFE concerned tax otherwise payable on qualifying intercompany loans provided by a foreign subsidiary 'financed with UK connected capital and … [with] no UK activities involved in generating the finance profits' (the “UK connected capital test”), the Commission found that the GFE was an administratively efficient means of ensuring the proper functioning and effectiveness of the CFC Rules.
- Conversely, where the GFE concerned tax otherwise payable on revenues from qualifying intercompany loans provided by a foreign subsidiary managed from the UK (the “UK activities test”), the Commission found that the exemption was not appropriate as ‘the exercise to assess to what extent the financing income of a company derives from UK activities is not particularly complex’ and, accordingly, constituted illegal state aid.
In so doing, the Commission narrowed its findings from its opening decision in October 2017 where it preliminarily concluded that the GFE in its entirety was likely to constitute illegal state aid.
Finally, the Commission noted that in line with the EU Anti-Tax Avoidance Directive, from 1 January 2019 the GFE applies only where a CFC charge on financing income from foreign group companies would otherwise apply exclusively under the UK connected capital test i.e. not exclusively under the UK activities test. The current CFC regime therefore no longer raises concerns under the State aid rules.
In terms of next steps, both the UK Government and beneficiaries of the incompatible GFE who were found to have received unlawful state aid have the option to appeal the Commission's decision to the EU’s General Court.
Over 47 multinational companies have declared their exposure (with the total declared amount already topping £1.2bn). However, given the Commission has declared that the GFE is partially compatible with Article 107, companies will now have to assess whether they are still negatively affected by the Commission's decision. Companies will not be affected if they applied the GFE in relation to (deemed) non-trading profits financed with UK connected capital and which were not generated by UK activities.
A General Court appeal is unlikely to suspend the implementation of the decision and the UK Government will thus likely be obliged to adopt measures to recover the alleged aid. While there is limited scope to request suspension of implementation of the decision pending outcome of the appeal, the General Court has typically rejected such requests (e.g. in the Belgian excess profit rulings case), indicating that there must be exceptional circumstances justifying the suspension of recovery and imposing strict conditions in this respect.
The mechanics of recovery are a matter of national law. The UK Government will have to identify which companies benefitted from the GFE as a result of the “UK activities test” and calculate the actual amounts of incompatible aid that have been granted to various companies through the application of the GFE. They will then need to take steps to ensure the companies pay the additional amounts of tax (plus interest at the EU rates) that are due. The amount of aid to be recovered may be reduced through the application of other tax provisions in certain cases and Companies may challenge recovery (before the national courts) on an individual basis. They may offer to put the amount in escrow, pending outcome of any EU appeal (similarly to the Apple state aid case) or seek suspension of recovery before the national courts. However, based on EU case law the latter is unlikely to be accepted by the Commission.
Implications of Brexit
Any appeal proceedings will likely take at least a few years and will likely go beyond the date that the UK is currently scheduled to leave the EU. It is not yet clear whether the UK and the EU will adopt a withdrawal treaty before this date. If a treaty is adopted, Brexit will not affect the appeal proceedings or enforcement. EU state aid law will continue to apply, and the UK will be required to recognize and enforce judgments given in legal proceedings instituted before the end of the transition period.
However, in case of a "no deal" Brexit, the CJEU will no longer have jurisdiction over the UK. Whilst technically the UK would still be liable for EU law compliance during its membership of the EU (and therefore is legally bound by state aid decisions prior to exit day) it is unclear whether EU enforcement mechanisms will be available to the Commission should the UK Government not comply with any recovery obligation - this may then become a matter of enforcement under international law. Affected companies should be wary of assuming that the UK will not comply with the Commission's decision in case of a no deal Brexit. The European Council's guidelines for negotiating the UK's withdrawal from, and future relationship with, the EU specified that any future trade agreement "must ensure a level playing field, notably in terms of competition and state aid". The UK has also made preparations to ensure that a domestic state aid regime will be in place in the event of a no deal Brexit, showing its commitment to achieving such a level playing field.
While the Commission has adopted a “narrow” finding of illegal state aid, the decision is nevertheless another boundary-pushing case on the applicability of the state aid rules to Member States’ tax regimes. More practically, the Commission’s decision will affect those multinational companies which have benefitted from the GFE exempting them a CFC charge on financing income, channelled through an offshore subsidiary, derived from UK activities.
The Commission’s decision must be considered in context of its wider policy in relation to harmful tax competition. The Commission has recently assessed individual tax rulings conferring benefits on multinational companies as in the Apple and Starbucks cases. The Belgian excess profit case is the only recent case where the Commission has examined an aid scheme. The recent General Court decision to annul the Commission's decision in this case shows however that the Commission is not immune from challenge.
Commissioner Vestager has emphasized that the Commission decisions regarding state aid and taxation are important “to make sure that companies pay their fair share of tax”. However, she highlights that in order to reach that goal, Member States also need “to bring their tax laws in line with EU rules” . By stating that the Commission applies “the same underlying principles regardless of whether illegal tax advantages are given as part of a scheme or not” , she indicates that the Commission is likely to continue pushing tax harmonisation via the state aid rules, not only by considering tax rulings but also by taking into account taxation schemes.