The European Commission ("EC") has now released its full decision supporting its conclusion that the UK's Group Financing Exemption in Chapter 9 Part 9A TIOPA 2010 for certain finance profits of Controlled Foreign Companies ("CFCs") partially constitutes illegal State aid. However, the decision has not yet been published in the Official Journal of the European Union which will start the clock running for appeals by taxpayers to the General Court.
The UK is obliged to fully implement the decision and recover the illegal State aid within four months of the UK government being notified of the decision. In addition, by early June 2019 the UK must submit a range of information to the EC, including documents demonstrating that beneficiaries have been ordered to repay the State aid. Whilst we think that this timeline will not practically be possible to achieve, taxpayers will need to act quickly to review their facts and be ready to engage with HMRC regarding their Group Financing Exemption claims in short order.
With this in mind, taxpayers should now be reviewing all CFC non-trading finance profits for which the Group Financing Exemption has been claimed and considering their nexus with UK activities, as well as considering whether to file a protective appeal against the decision to maximise flexibility.
The EC has drafted a very detailed (47 page) decision that describes the UK CFC regime, addresses comments made by the UK government and third parties to the EC, and sets out its reasoning regarding why the Group Financing Exemption constitutes illegal State aid in certain circumstances.
The UK government provided extensive comments and participated in lengthy discussions with the EC. Eight other interested parties submitted comments on the opening decision. Both the UK and the interested parties argued that the Group Financing Exemption is not State aid, focussing on:
- the choice of reference system, including the (absence of) implications on freedom of establishment, i.e. compliance with Cadbury Schweppes; and
- whether the Group Financing Exemption is a derogation and, even, if that is the case, whether such derogation is justified on the basis of needing administrable rules.
The EC is quick to find that the Group Financing Exemption is a scheme imputable to the UK, is financed through State resources, provides an advantage that affects trade between Member States, and at least threatens to distort competition
The most interesting discussion focusses on whether advantages provided under the Group Financing Exemption are also selective. Applying its established methodology on assessing selectivity of a tax measure, the EC identifies the UK CFC regime as the appropriate reference system on the basis that, whilst the regime derives from - and forms a logical extension to - the general UK corporate tax regime, the CFC regime is sufficiently distinct from the general corporate tax regime.
The EC also rejects the argument that Chapters 5 and 9 Part 9A TIOPA 2010 should be read together rather than viewing the Group Financing Exemption in Chapter 9 as an exemption from the CFC regime. Following a detailed analysis, the EC concludes that the Group Financing Exemption is a derogation from the CFC regime, exempting some companies in comparable situations from the CFC charge that would otherwise be due. Furthermore, the EC rejects arguments put forward that the Group Financing Exemption is consistent with Cadbury Schweppes or that it is justified under the freedom of establishment principle.
Having concluded that the Group Financing Exemption provides a prima facie selective advantage, the EC examines whether it can be justified by the nature or the overall structure of the tax system. Despite bearing the burden of proof, the UK government's argument that the Group Financing Exemption is needed to ensure that the CFC regime is manageable and administrable for both HMRC and taxpayers only partially persuades the EC, and it accepts that the Group Financing Exemption is justified only to the extent that it applies to profits generated from capital investment from the UK (under s 371EC TIOPA 2010) in order to avoid a burdensome tracing exercise. However, the EC does not accept that tracing finance profits of CFCs to UK SPFs (under s 371EB) is overly burdensome to taxpayers, and therefore it cannot be justified on this basis.
Accordingly, and as no obvious grounds on the potential compatibility apply in this case, the EC concludes that Group Financing Exemption constitutes state aid in so far as it applies to finance profits which fall within s 371EB (UK SPFs) but it does not constitute state aid when applied to finance profits falling within s 371EC (capital investment from the UK).
The EC repeats its view - already crystallised in section 4.4.1 of its draft recovery notice currently under consultation – that the illegal State aid should be calculated by reference to the applicable CFC charge as if the Group Financing Exemption had not been claimed. Moreover, this should be calculated without regard to "hypothetical alternative situations based on different operational and legal circumstances" that a beneficiary might have chosen if they had not been allowed to claim the Group Financing Exemption. This means, for example, that taxpayers may not be able to argue that they would have instead financed the relevant CFC in a different manner that would have resulted in a lower or nil CFC charge, or even that they would not have provided finance to the CFC in the first place.
In our previous alert discussing the EC's press release we considered the possibility of a "cliff edge" facing taxpayers who had CFC finance profits that derived from both capital investment from the UK and UK SPFs. In that case, the EC's press release suggested that, in determining the amount of illegal State aid, taxpayers had to assume that the Group Financing Exemption election was not made in respect of any of these profits (i.e. all of the CFC's finance profits should have been subject to a CFC charge with no apportionment to SPFs outside of the UK)
Whilst some of the recitals are slightly unclear on the correct approach (e.g. recitals 201 - 203 in relation to the quantum of the State aid), we think it is tolerably clear from Article 1 of the decision that the EC is not adopting this "cliff edge" approach. That is, in determining the amount of illegal State aid, taxpayers should apportion a CFC's finance profits to SPFs located both inside and outside of the UK, with only the former being subject to recovery.
What should multinationals be doing now?
1.Review UK SPFs for all CFC non-trading finance profits
Multinationals should start the fact-finding process of identifying non-trading finance profits for CFCs that may be affected by this decision as well as the more difficult process of identifying the SPFs that are relevant to the assets and risks generating those profits. Taxpayers will inevitably face two key challenges in this process.
Firstly, and most fundamentally, what constitutes an SPF in the context of profits derived under a loan? Whilst there is some guidance published by the OECD in relation to what constitutes SPFs in the context of loan financing (e.g. the BEPS discussion draft regarding financial transactions and guidance regarding the attribution of profits to permanent establishments), there remains no clearly established consensus on the methodology to be adopted. In addition, HMRC has some existing guidance regarding SPFs but again it does not clearly set out the way in which taxpayers should approach this question.
The EC quotes extensively from HMRC manuals considering SPFs, including sections of the guidance that suggest that the question is not answered simply by looking at the decision to enter into loans (e.g. at the CFC's board meetings). Instead, taxpayers will need to take a much broader view and look to the original planning and inception of the idea, as well as where the structure of the investment as a loan was considered.
The EC also seems to adopt HMRC's view in its international tax manual that UK headed groups will almost always have UK SPFs for significant structural loans, even in cases where it can be demonstrated that the group's treasury / group finance functions are located outside of the UK.
The second issue faced by taxpayers is - at what point during the life of the loan should they be testing for UK SPFs? There may have been a number of SPFs throughout the life of a loan, particularly in the case of longer term loans, from the planning and inception of the structure, considering the terms and entering into the loan, refinancing or new draw downs under the loan, as well as ongoing maintenance. There will necessarily need to be an exercise to weigh the UK and non-UK SPFs based on the significance of their activities and the time at which they were involved with the relevant loan in order to determine the finance profits attributable to them.
Clearly, these two questions will be very difficult for taxpayers to determine, particularly if they need to consider loans that have been in place for a number of years and documents or people are no longer available. In addition, the timing that taxpayers will theoretically have to undertake this exercise (discussed below) will only make this task more difficult.
2. Consider filing protective appeals
Affected taxpayers will have roughly three months from the publication of this decision in the EU's Official Journal by which to file an appeal the General Court. Whilst the timing of this publication is impossible to predict, it could be as soon as the end of May 2019, although we expect this will take longer.
Given that taxpayers will need to undertake a significant amount of work to determine who constituted the relevant SPFs and their location throughout the life of the loans, we recommend that taxpayers should consider making a protective appeal against the decision. This is particularly the case since it may take some time before HMRC's and the EC's views on the methodology that should be adopted by taxpayers to identify and allocate profits to SPFs becomes known.
A protective appeal has the benefit of preserving the taxpayer's flexibility whilst a consensus builds regarding what constitutes an SPF in the context of loan financing and taxpayers apply this to their own facts.
The UK is obliged to fully implement the EC's decision and recover the illegal State aid with compounded interest within four months of the UK government being notified of the decision (which we understand took place shortly after the EC's adoption of the decision and press release on 2 April 2019). Given the complexity in calculating the amounts to be recovered we expect that this will not be feasible within the 4 month window. However, the UK government will be under pressure to recover the illegal State aid as soon as practically possible.
In addition, within two months of notification (early June 2019), the UK must submit a range of information to the EC, including a list of the beneficiaries of the illegal State aid, their corporate tax returns setting out the tax charged and the CFC charge that would have arisen but for the Group Financing Exemption. Importantly, the UK must also submit to the EC by early June 2019 documents demonstrating that the beneficiaries have been ordered to repay the State aid (presumably in the form of amended tax assessments or similar). Whilst we think that this timeline will not practically be possible, it does suggest that taxpayers need to act quickly to review their facts and be ready to engage with HMRC regarding their Group Financing Exemption claims in short order.
Interestingly, the UK must also provide to the EC a list of taxpayers who made a Chapter 9 claim in relation to profits falling within s 371EC (capital investment from the UK) and not falling within s 371EB (UK SPFs), i.e. taxpayers who are not strictly beneficiaries of any illegal State aid. This suggests that the EC will be carefully monitoring the UK's recovery process and may take action if it is perceived to be too lenient to taxpayers.