Cadbury Schweppes plc v CIR (and related appeal), Case C-196-04 The UK’s Controlled Foreign Company rules have been one of HM Revenue and Customs' key weapons in combating the establishment by insurers of subsidiaries in low tax jurisdictions, such as Ireland. The recent decision of the European Court of Justice in the Cadbury Schweppes case has cast doubt on whether these rules, as currently drafted, are valid. Andrew Roycroft assesses the implications for UK insurers. A basic principle of UK tax law is that a shareholder only has to pay UK taxation on the profits of the company in which it holds shares when that company distributes those profits (by way of dividend, for example). Shareholders are not generally subject to UK taxation on the undistributed profits of the company in which they hold shares. The CFC rules
The UK’s Controlled Foreign Company (CFC) rules are an exception: they require UK resident companies to pay corporation tax on the undistributed profits of certain subsidiaries. (Sections 747-756 and Schedules 24-26, Income and Corporation Taxes Act 1988 (ICTA)). These rules are intended to discourage UK groups from establishing subsidiaries in low-tax jurisdictions in order to divert profits from – and retain them outside – the UK’s corporation tax system. Accordingly, the rules only require the UK parent to pay corporation tax on the undistributed profits of subsidiaries which are subject to a “lower level of taxation” in the territory in which they are resident. This will be the case if the tax paid in that territory is less than 75 per cent of the corporation tax which would have been payable in the UK.
The CFC rules contain a number of exceptions which permit the profits of certain subsidiaries in low-tax jurisdictions to be taxed in the UK on the usual basis – that is, when they are distributed rather than when they are earned. These excluded cases include the profits of subsidiaries which: pursue an acceptable distribution policy;
- satisfy the exempt activities test;
- satisfy the public quotation test; or
- have profits of less than a de minimis level (£50,000).
The motive test
The CFC rules also do not apply where a “motive” test is satisfied. This test requires the UK parent to establish that any reduction in UK tax was minimal, or was not the main purpose (or one of the main purposes) of the transactions which resulted in that reduction and that achieving a reduction in UK tax, by diverting profits from the UK, was not the main purpose (or one of the main purposes) of the subsidiary’s existence in the accounting period in question.
Cadbury Schweppes in Ireland
Cadbury Schweppes plc established subsidiaries in the Republic of Ireland to raise and provide finance for the rest of its group. These Irish subsidiaries benefited from a low tax rate of 10 per cent in Ireland. HM Revenue and Customs assessed the immediate UK-resident parent company of the Irish subsidiaries to UK tax in respect of the profits of one of the companies. Cadbury Schweppes appealed, arguing that the application of the CFC rules constituted a breach of EU law; in particular, it was an unlawful restriction on the freedoms of establishment, to provide services and of movement of capital (as set out in Articles 43, 49 and 56 of the EC Treaty).
Referral to European Court of Justice
The Special Commissioners referred a number of questions on the compatibility of the CFC rules with the EC Treaty to the European Court of Justice (ECJ). This involves a two-stage process. First, an opinion in the case is delivered by the Advocate General. Then, the ECJ delivers its judgment. Although the Advocate General’s opinion is not binding, it is often followed by the ECJ.
Advocate General’s opinion
The Advocate General’s opinion in this case suggested that tax legislation which treats the profits of a CFC as part of the profits of its parent is not necessarily contrary to the EC Treaty, provided that such rules only apply to wholly artificial arrangements intended to circumvent national law. As a result, the Advocate General was of the opinion that, to be compatible with the EC Treaty, CFC rules must exempt any taxpayers which provide proof that the controlled subsidiary is established for genuine commercial reasons in another Member State and that its transactions are actually carried out in that other Member State and are not devoid of economic purpose.
The ECJ ruled that the UK’s CFC legislation constitutes a restriction on the freedom of establishment within the meaning of Articles 43 and 48 of the Treaty, but that such a restriction may be justified where it is related to wholly artificial arrangements aimed at circumventing the application of the legislation of the Member State concerned. The freedom of establishment exists to allow a Community national to participate, on a stable and continuing basis, in the economic life of a Member State other than their state of origin and to profit from it. In view of this objective, the ECJ concluded that the UK’s CFC legislation must not apply to subsidiaries which are intended to carry on genuine economic activities in the host Member State. This must be determined by objective factors that third parties can ascertain – such as the premises, staff and equipment of the subsidiary. The ECJ ruled that it is for the UK courts to determine whether the motive test constitutes a suitable exclusion.
Although the ECJ has left the final say on whether the UK’s CFC rules are compliant with EU law to the UK courts, it seems unlikely that the motive test will be found to be sufficiently wide to satisfy the requirements laid down by the ECJ. Whilst we expect some extension of the exclusions from the CFC rules to follow, this may take some time while the case moves through the UK courts. The decision may give UK insurers an opportunity to look again at captives in low tax jurisdictions within the EU, such as Ireland – provided the Government does not take the opportunity to restrict, for instance, the availability of interest relief for the funding of that subsidiary (assuming that such a restriction would itself be compatible with EU law). Any such captives cannot be mere letter-box/front companies, as they must have the elements (premises, staff and equipment) to demonstrate that they constitute a genuine economic activity in that jurisdiction and are not an artificial arrangement.
Non-EU low tax jurisdictions
The ECJ’s judgment only concerns subsidiaries established in other Member States of the EU, it does not provide an opportunity to set up captives in low tax jurisdictions outside the EU, such as Bermuda. If the Government only applies any new exemption from the CFC rules to subsidiaries established in other Member States of the EU, insurers wishing to establish subsidiaries in other low tax jurisdictions or tax havens will have to bring those subsidiaries within the existing exemptions (such as the exempt activities test) in order to avoid the rigours of the UK’s CFC rules.