The European Commission has announced that it is pursuing a State Aid investigation in relation to a particular aspect of the UK’s controlled foreign company (CFC) regime – namely the so-called finance company partial exemption (FCPE). If the Commission’s 'doubts' over whether the FCPE complies with EU State Aid rules are confirmed in a final decision, then it is possible (subject to the outcome of any appeal) that the UK might be ordered to recover the benefit of the FCPE from affected taxpayers.
The CFC regime targets the artificial diversion of taxable income from the UK, and operates by subjecting a UK parent to tax on income earned in a CFC in certain scenarios identified by the rules as abusive. Passive finance income earned in a low-taxed CFC that is funded by equity sourced from the UK parent could be caught by the rules. However, the FCPE reduces the UK tax charge on such income by 75 per cent (to an effective rate of just under 5 per cent) in certain circumstances where, broadly, the CFC’s funds are used to finance other foreign subsidiaries of the UK parent. The FCPE is not available for upstream lending to the UK, which prevents it from being used to reduce the UK tax base.
The FCPE forms part of a CFC regime that was comprehensively overhauled in 2012. The previous regime had been the subject of a successful taxpayer challenge in the CJEU case of Cadbury Schweppes plc v R&CC C-196/04, on the grounds that (unless read with a restrictive EC Treaty-based overlay) it breached EC Treaty fundamental freedoms. Having reformed the old regime in light of that CJEU decision (as part of a wider shift to a more territorial tax system), the UK now finds itself accused by the Commission of creating a new regime that is (at least in one particular respect) too taxpayer-friendly. Extensive use has certainly been made of the FCPE by UK-headed groups; indeed HMRC’s published guidance on the CFC regime explains the structures that taxpayers commonly use to access it.
The State Aid challenge
In order to be successful with a State Aid challenge, the Commission would need to establish that the FCPE conferred a selective advantage on certain taxpayers (or on a particular category of taxpayers). (There are other conditions, but these are the critical ones.)
Identifying a selective advantage within a tax system is possible, but not straightforward: any tax code naturally differentiates between taxpayers, imposing a heavier or lighter burden according to whether generally-applicable conditions for liability or relief are met. But if a feature of the code can be characterised as a derogation from the ‘reference system’, then it may be vulnerable. (The Commission is already challenging a Belgian ‘excess profits’ regime on this basis. The Commission’s final decision in that case is currently under appeal.) It would appear from the press release that the Commission considers the FCPE to represent a derogation from the CFC regime ‘reference system’ of which it forms part.
Even so, a derogation may confer an advantage, yet not be selective: that depends on whether the effect of the derogation is to differentiate between taxpayers who are in a ‘comparable factual and legal situation’. The press release does not address this explicitly, but the suggestion is that the Commission would argue simply that the measure favours multinationals (who can access the FCPE) over purely domestic UK groups (who cannot) – albeit of course domestic groups have no need to access the FCPE, which might be thought firmly to place them in a different factual and legal situation. This is certainly a very broad (and questionable) concept of selectivity, but the Commission did last year have some success with similar arguments in the case of Commission v Banco Santander C-21/15 P. In that case, the CJEU upheld the Commission’s decision that Spanish rules permitting goodwill amortisation in relation to the acquisition of foreign shareholdings, but not domestic ones, constituted unlawful State Aid.
An ATAD side-swipe
The Commission’s press release refers in passing to the CFC provisions in the Anti-Tax Avoidance Directive (EU 2016/1164) (ATAD). It notes that the ‘minimum standard’ for CFC rules laid down in ATAD does not include anything corresponding to the FCPE. Member States are required to introduce ATAD-compliant CFC rules by 1 January 2019; the UK government has not to date indicated that it considers any changes to the UK rules would be required.
Next steps, and Brexit…
The press release announced an opening decision, following which there will be an in-depth investigation. Looming in the background, of course, is Brexit; and it is hard not to see a political angle to the press release. The Commission may look to fast-track its investigation to ensure that its final decision is published before the UK leaves the EU. The EU’s rules would permit the UK to appeal the decision (initially before the General Court of the EU, and then the CJEU). Absent clarity as to the terms on which the UK will leave the EU, or what the duration or form might be of any transitional period, taxpayers should still be paying attention to these proceedings. (And similarly, looking forward to the position from 1 January 2019, it may not be safe to assume that Brexit makes the ATAD angle irrelevant.)
The Commission’s press release is available here.