UK’s exemption in CFC rules is illegal state aid, says EU
The European Commission has decided that the UK’s group financing exemption in its controlled foreign company (CFC) rules gave an unfair tax advantage to certain multinational companies, constituting illegal state aid.
The UK will have to recover tax benefits given to multinational groups active in the UK that used the CFC rules to gain a tax exemption on payments received from loans between 2013 and 2018 (case number SA.44896).
Although the provision is no longer in effect since the EU Anti-Tax Avoidance Directive (ATAD) entered into force on January 1 2019, the Commission has said that in the five years that the incentive was available, it was used to avoid UK tax.
“The UK gave certain multinationals a selective advantage by granting them an unjustified exemption from UK anti-tax avoidance rules. This is illegal under EU state aid rules,” EC Competition Commissioner Margrethe Vestager said. “The UK must now recover the undue tax benefits.”
The UK Treasury told TP Week that is will “carefully consider” the Commission’s decision.
“We are clear that all multinationals operating in the UK must pay their fair share of tax. Our controlled foreign company rules are part of a robust package of anti-avoidance measures that prevents UK profits from being artificially diverted overseas,” a spokesperson said.
Initial reaction suggests the matter is complex and will not end with the recovery of aid.
“The decision appears pragmatic and reasoned in finding only part of the relevant UK tax rule give rise to an illegal tax advantage and the timing is not overtly political, falling as it does after the planned date of exit from the EU. That is not to say that the UK government and interested taxpayers will not seek to appeal this decision when the full text [of the decision] and therefore the Commission’s detailed reasoning becomes available,” said Ben Jones, a tax partner at Eversheds Sutherland.
For companies, Jones said the beneficiary of the relevant state aid can consider an appeal. "In other state aid tax investigations, the relevant member states have appealed and interested taxpayers - and other member states - have joined these appeals. Therefore, impacted multinationals should consider whether it is appropriate to appeal this finding," Jones said.
“In our view the UK CFC rules are themselves contrary to EU law – the Cadbury/Schweppes case only permits a CFC charge when a structure is ‘wholly artificial’, and treasury companies are not ‘wholly artificial’. So doubtful any aid will in fact be recovered,” tweeted Dan Neidle, tax partner at Clifford Chance in London.
However, Jones countered that this "radical" view ignores the wider context of the EU ATAD and the introduction of CFC rules across Europe that are essentially based on the UK CFC rules.
"It seems unlikely that a successful ECJ challenge to the current UK CFC rules could be brought on the grounds of Cadbury/Schweppes in this context," Jones said.
The UK CFC rules are intended to prevent UK companies from using a subsidiary, based in a low- or no-tax jurisdiction, avoiding tax in the UK. The UK tax authority, HMRC, can reallocate all profits artificially diverted to an offshore subsidiary back to the UK parent company to be taxed accordingly.
Through the Finance Act 2012, the group financing exemption was introduced, offering a 75% or full tax exemption for income received by an offshore subsidiary from another foreign group company, even if this income derived from UK activities or the capital being used was “UK connected”. Therefore, according to the European Commission, a UK multinational using this exemption was able to provide financing to a foreign group company via an offshore subsidiary and pay little or no tax on the profits from these transactions.
“To avoid the inevitable challenges, the Treasury came up with a kind of compromise, and reduced the charge on CFC companies by 75%,” Neidle explained via Twitter. “What's happened now is that the Commission has forgotten this history. Instead of appreciating that taxing treasury companies at all is contrary to EU law, the Commission thinks the 75% discount is state aid.”
“This is not going to end well,” he added.
Martin Hearson, an international relations fellow at the London School of Economics, argued that the UK government had no choice but to introduce the exemption to maintain its competitiveness to attract investment. Following a freedom of information request, he learned that there “were a lot of threats” from companies warning they would move abroad if the UK’s CFC regime was not made more generous in response to the consultation on the CFC changes following the Commission’s request.
Partial state aid
Although the European Commission has determined that the UK’s exemption offered an unfair tax advantage, it has stressed that it “does not call into question the UK's right to introduce CFC rules or to determine the appropriate level of taxation”. Instead, its position is to prevent selective companies being exempt from anti-avoidance measures.
As such, the Commission’s investigation, which was launched in October 2017, found that only a small part of the tests used by HMRC to reallocate diverted profits to the UK for taxation fall foul of EU law.
The UK rules include two tests to determine how much of the financing profits from loans granted by an offshore subsidiary should be reallocated to the UK parent company for taxation. Firstly, the ‘UK activities test’ determines which lending activities, which are most relevant to managing the financing activities and thus generating the financing income, are located in the UK. The second test examines which loans are financed with funds or assets that are derived from capital contributions from the UK, known as the ‘UK connected capital test’.
The Commission found that when using the ‘UK connected capital’ test and there being no UK activities involved in generating the finance profits, the group financing exemption is justified and does not constitute state aid under EU rules.
“This is because such an exemption avoids complex and disproportionately burdensome intra-group tracing exercises that would be required to assess the exact percentage of profits funded with UK assets,” the European Commission said in a press statement announcing its decision. “In line with UK arguments, the group financing exemption in these cases provides for a clear proxy that is justified to ensure the proper functioning and effectiveness of the CFC rules.”
However, when the same activity is done, but is derived from UK activities, the exemption is not justified and constitutes state aid under EU rules.
“This is because the exercise required to assess to what extent the financing income of a company derives from UK activities is not particularly burdensome or complex. Thus, the use of a proxy rule in these cases is not justified,” the European Commission said.
“Moreover, the group financing exemption does not seek to address any possible complexity related to the allocation of financing income to UK activities nor has the UK claimed it does,” the EC added.
However, Totis Kotsonis, partner and head of Eversheds Sutherland’s state aid practice said: “At this stage it is unclear whether the EC’s decision can or will be fully implemented, including recovery of any aid granted to deemed beneficiaries, if the UK were to leave the EU without a withdrawal agreement.”
Although the UK will soon leave the EU, EU state aid rules apply while it remains a member. As such, HMRC has to reassess the tax liability of the UK companies that have benefitted from the group financing exemption. The amount recovered will be calculated based on a comparison between the amount of tax actually paid and the amount which should have been paid if the generally applicable rule had been applied.