Judgment summary
This is a reference for a preliminary ruling made by the Special Commissioners of Income Tax, London, under Article 234 EC, concerning the interpretation of Articles 43 EC, 49 EC and 56 EC (paras 1-2).
The dispute arose between Cadbury Schweppes plc (CS) and Cadbury Schweppes Overseas Ltd (CSO) and the Commissioners of Inland Revenue, concerning taxation of CSO in respect of profits made in 1996 by Cadbury Schweppes Treasury International (CSTI), a subsidiary established in the International Financial Services Centre (IFSC) in Dublin, Ireland (para 2).
The Court held that Articles 43 EC and 48 EC preclude the inclusion in the tax base of a resident company of profits made by a controlled foreign company (CFC) in another Member State, where those profits are subject to a lower level of taxation, unless the inclusion relates only to wholly artificial arrangements intended to escape national tax normally payable (para 75, operative part). The tax measure must not apply where it is proven, on the basis of objective factors ascertainable by third parties, that the CFC is actually established in the host Member State and carries on genuine economic activities there, despite the existence of tax motives (para 75).
Background
Under UK tax legislation, a company resident in the United Kingdom is subject to corporation tax on its worldwide profits, including profits of branches or agencies carrying on activities abroad, but is not generally taxed on the profits of its subsidiaries as they arise (paras 3-4).
The UK legislation on controlled foreign companies (CFCs), contained in sections 747 to 756 and Schedules 24 to 26 of the Income and Corporation Taxes Act 1988, provides an exception to this rule. Where a resident company owns more than 50% of a foreign company subject to a 'lower level of taxation' (less than three quarters of the UK tax that would have been paid), the CFC's profits are attributed to the resident company and taxed in its hands, subject to a tax credit for tax paid abroad (paras 5-7).
Exceptions to CFC taxation exist, including an 'acceptable distribution policy', 'exempt activities', a 'public quotation condition', a de minimis exception of UK £50,000, and a 'motive test' with two cumulative conditions relating to the purpose of transactions and the reason for the CFC's existence (paras 8-11).
CS, a resident company, is the parent of the Cadbury Schweppes group, which includes two Irish subsidiaries, Cadbury Schweppes Treasury Services (CSTS) and CSTI, held indirectly through CSO. CSTS and CSTI, established in the IFSC, were subject to a 10% tax rate at the material time and their business was to raise finance for group subsidiaries (paras 13-15).
It was common ground that CSTS and CSTI were established in Dublin solely so that profits from internal group financing activities could benefit from the IFSC tax regime (para 18). The UK tax authorities found that none of the exemptions under the CFC legislation applied for the 1996 financial year and, by decision of 18 August 2000, claimed corporation tax from CSO of UK £8,638,633.54 on CSTI's profits for the financial year ending 28 December 1996, CSTS having made a loss that year (paras 19-20).
CS and CSO appealed to the Special Commissioners of Income Tax, London, on 21 August 2000, arguing that the CFC legislation was contrary to Articles 43 EC, 49 EC and 56 EC (para 21).
Core dispute
The Special Commissioners of Income Tax referred a question asking whether Articles 43 EC, 49 EC and 56 EC preclude national tax legislation which, in specified circumstances, imposes a charge on a company resident in one Member State in respect of the profits of a subsidiary resident in another Member State and subject to a lower level of taxation (para 28).
The national court raised a series of related uncertainties: whether establishing and capitalising companies abroad solely to obtain a more favourable tax regime amounted to an abuse of Treaty freedoms; whether the CFC legislation should be viewed as a restriction or as discrimination; whether the fact that CS might pay no more tax than if CSTS and CSTI had been UK-resident meant there was no restriction; and whether the legislation could be justified as a measure to prevent tax avoidance and, if so, whether it was proportionate given the exemptions available under the motive test (paras 23-27).
Court findings
The Court held that the CFC legislation concerns holdings giving definite influence over a company's decisions and therefore falls to be examined under the Treaty provisions on freedom of establishment, Articles 43 EC and 48 EC, rather than under Articles 49 EC or 56 EC (paras 31-33).
On the question of abuse, the Court held that the fact that a company is established in a Member State for the purpose of benefiting from more favourable legislation does not in itself constitute abuse of freedom of establishment, and does not preclude reliance on Articles 43 EC and 48 EC (paras 36-38).
The Court found that the CFC legislation creates a difference in treatment amounting to a tax disadvantage for resident companies with CFCs subject to a lower level of taxation, since such companies are taxed on the profits of another legal person, unlike resident companies with UK subsidiaries or subsidiaries not subject to a lower level of taxation. This constitutes a restriction on freedom of establishment within the meaning of Articles 43 EC and 48 EC (paras 43-46).
Such a restriction is permissible only if justified by overriding reasons of public interest and if proportionate. The need to prevent reduction of tax revenue is not such a ground. The mere fact of establishing a subsidiary abroad cannot found a general presumption of tax evasion (paras 47-50).
However, a restriction may be justified where it specifically targets wholly artificial arrangements aimed at circumventing national legislation, which do not reflect economic reality and are designed to escape tax normally due on profits generated by activities in national territory (paras 51, 55).
The Court found the CFC legislation suitable to achieve the aim of thwarting wholly artificial arrangements (para 59), but held that the mere fact that none of the statutory exceptions applies and that tax relief motivated incorporation of the CFC does not, by itself, establish a wholly artificial arrangement. A finding of such an arrangement requires, in addition to a subjective intention to obtain a tax advantage, objective circumstances showing that the objective of freedom of establishment has not been achieved (paras 63-64).
The CFC legislation must therefore exclude taxation where, despite tax motives, the incorporation of the CFC reflects economic reality, corresponding to actual establishment carrying on genuine economic activities in the host State, based on objective factors ascertainable by third parties such as the extent of premises, staff and equipment (paras 65-67). If the CFC is a fictitious establishment, such as a 'letterbox' or 'front' subsidiary, this may be treated as a wholly artificial arrangement (para 68). The resident company must be given the opportunity to produce evidence of genuine establishment and activity (para 70).
Outcome
The Court ruled that Articles 43 EC and 48 EC preclude the inclusion in the tax base of a resident company established in a Member State of profits made by a CFC in another Member State, where those profits are subject to a lower level of taxation than in the first State, unless such inclusion relates only to wholly artificial arrangements intended to escape the national tax normally payable.
Such a tax measure must not be applied where it is proven, on the basis of objective factors ascertainable by third parties, that despite the existence of tax motives the CFC is actually established in the host Member State and carries on genuine economic activities there (para 75, operative part).
The Court left it for the national court to determine whether the UK motive test, as defined by the CFC legislation, could be interpreted so as to restrict taxation to wholly artificial arrangements. If so, the legislation would be compatible with Articles 43 EC and 48 EC; if not, it would be contrary to those provisions (paras 72-74).
As the decision on costs is a matter for the national court, no order for costs was made by the Court beyond stating that costs incurred submitting observations are not recoverable (para 76).
Major issues / areas of contention
- Whether establishing and capitalising subsidiaries in another Member State solely to benefit from a more favourable tax regime constitutes an abuse of freedom of establishment under the EC Treaty (paras 23, 34-38).
- Whether the UK legislation on controlled foreign companies (CFCs), which attributes a CFC's profits to the resident parent company where the CFC is subject to a lower level of taxation, amounts to a restriction on freedom of establishment under Articles 43 EC and 48 EC (paras 24, 43-46).
- Whether the fact that the resident company pays no more tax than if the CFC had been UK-resident negates the existence of a restriction (paras 25, 45).
- Whether such a restriction can be justified on grounds of preventing tax avoidance, and specifically whether it is confined to wholly artificial arrangements that do not reflect economic reality (paras 27, 47-56).
- Whether the 'motive test' under the CFC legislation, requiring the resident company to show that tax reduction was not a main purpose of transactions or of the CFC's incorporation, is capable of restricting the legislation's application to wholly artificial arrangements, or whether it catches cases lacking objective evidence of artificiality (paras 27, 62, 72-74).
- What objective factors are relevant in assessing whether a CFC reflects genuine economic activity as opposed to being a wholly artificial, 'letterbox' or 'front' arrangement (paras 66-68).