UK finance company CFC exemption and EU state aid

The CJEU has allowed the UK's appeal against the decision of the General Court upholding the Commission's state aid objections to the Group Finance Exemption under the UK's CFC rules: UK v European Commission (Case C-555/22). The Court has accepted the UK's argument that the Commission and General Court were wrong to view the CFC rules alone as the correct reference framework against which any selective advantage should have been judged. Seen correctly, the CFC rules were an integral part of the UK's broader corporation tax rules and its approach to territoriality. Since the Commission and Court had identified the wrong reference framework, the decision on selectivity could not stand.

The decision is the latest in the line of cases stemming from the Commission's concerted attack on what it sees as illegal State aid in relation to taxation. As in the recent Fiat case (Case C-885/19), the Cout has indicated that it is, in principle, up to Member States to exercise their fiscal autonomy and the characteristics of the tax system and the Commission must accept those characteristics and principles explicit in those domestic provisions. In this context, the determination of the reference framework is particularly important. The Commission and the General Court in this case had been wrong to view the CFC rules as a separate system of taxation and had failed to take into account how the rules, essentially, protected the mainstream CT system in the UK. Seen properly they were not separate but a part of that general system, designed to protect it from profit diversion and abuse.

Background

In 2013, the UK introduced a new and modernised CFC regime following extensive consultation. One aspect of this new regime was the inclusion of a "finance company exemption". This exemption enabled a UK headquartered group to use an foreign financing company (FFC) with the benefit of a 75% exemption from the CFC rules on intra-group financing activities outside the UK, notwithstanding that the income of that FFC might otherwise fall within the CFC rules. This might be the case because, for example, the funds used by the FFC for its financing activities derived from the UK or because activities related to the lending by the FFC took place in the UK.

The finance company exemption was an important part of the CFC rules and regarded as an attempt to provide a pragmatic solution. In particular, there was a desire to ensure that the rules did not include complex provisions on the tracing of funds back to the UK. The 75% exemption - and resulting 5% rate of tax at the time - was, therefore, very much a compromise.

The rules required that a FFC should be locally managed in its territory of residence, including an expectation that the management of monetary assets would include decision making relating to initiating and refinancing of intra-group loans. However, it was recognised that an FFC would not necessarily require significant substance in the form of employees located in the company's territory, depending on the level of activities being undertaken by the CFC.

Decision of the Commission

In 2019, the European Commission decided that the group financing exemption within the UK CFC rules was, in part, illegal State Aid. The Commission's press release explained the Commission's view that, to the extent that the exemption applied whilst there was UK activities in relation to the group funding activities, then that gave rise to a selective advantage to certain multinational companies. The full version of the Commission decision was published on 02 April 2019.

The decision of the Commission recognised that the financing company exemption could, in part, be justified by the UK. In particular, the Commission found that the restriction on the operation of the CFC rules in the context of determining the source of funds was justified. This was 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 Commission therefore acknowledged that, in line with UK arguments, the Group Financing Exemption in these cases provided a clear proxy that was justified to ensure the proper functioning and effectiveness of the CFC rules".

However, the Commission did not accept that there was any need to extend the exemption to cases where there was significant UK involvement in the management of lending activities. The press release stated that "when financing income from a foreign group company, channelled through an offshore subsidiary, derives from UK activities, the Group Financing Exemption is not justified and constitutes State aid under EU rules".

In these cases, the Commission rejected the argument that the exercise required to assess to what extent financing income derived from UK activities would be particularly complex or burdensome. Therefore, the use of a proxy rule in such cases was not justified and, according to the Commission, constituted illegal state aid.

Decision of the General Court

The UK appealed the Commission's decision that the Group Financing Exemption involved illegal state aid, but that appeal was dismissed by the General Court.

The Court noted that in the context of taxation, determining the existence of a selective advantage requires, at the outset, determining the normal taxation rules forming the relevant reference framework for that examination. In the case of tax measures, the very existence of an advantage may be established only when compared with 'normal' taxation. The EU Commission had based its analysis of the selective advantage against the base reference point of the CFC rules generally. Viewed against those rules, the group financing exemption provided a selective advantage for certain companies by relieving the burden of taxation. However, the UK argued that the correct reference point was not the CFC rules, but the general corporation tax rules.

Determining the correct reference framework required the Court to decide whether the CFC rules represented a separate and coherent code or an exception to the general corporation tax rules. "The selectivity of a tax measure cannot be assessed on the basis of a reference framework consisting of some provisions of the domestic law of the Member State concerned that have been artificially taken from a broader legislative framework. Where the tax measure in question is inseparable from the general tax system of the Member State concerned, reference must be made to that system. On the other hand, where it appears that such a measure is clearly severable from that general system, it cannot be ruled out that the reference framework to be taken into account may be more limited than that general system, or even that it may equate to the measure itself, where the latter appears as a rule having its own legal logic and it is not possible to identify a consistent body of rules external to that measure."

On this point, the General Court agreed with the Commission that the CFC rules representative a severable set of rules, distinct from the general corporation tax rules. In particular, Court noted that "the rules applicable to CFCs are based on a logic distinct from that of the general tax system in the United Kingdom". The Court went on to determine that viewed against the background of the CFC rules, the operation of the Group Finance Exemption represented a selective advantage.

For the decision of the General Court, see our earlier article. The UK then appealed that decision to the CJEU.

Decision of the CJEU

The CJEU has now confirmed the opinion of the AG that the Commission and General Court made an error of law in determining that the normal reference frame against which the particular provisions should be considered was the CFC rules rather than the general UK corporation tax rules.

The Court noted that the classification of a measure as State aid requires four conditions to be met: there must be an intervention by the State or through State resources; the intervention must be liable to affect trade between the Member States; it must confer a selective advantage on the beneficiary; and it must distort or threaten to distort competition.

As regards the condition relating to selectivity, which was the issue in this case, it requires a determination as to whether, under a particular legal regime, the national measure at issue is such as to favour 'certain undertakings or the production of certain goods' over other undertakings which, in the light of the objective pursued by that regime, are in a comparable factual and legal situation and which accordingly suffer different treatment that can, in essence, be classified as discriminatory.

In the context of taxation, in order to classify a national tax measure as 'selective', the Commission must begin by identifying the reference framework, that is the 'normal' tax system applicable in the Member State, and demonstrate that the tax measure at issue is a derogation from that reference framework, in so far as it differentiates between operators who, in the light of the objective pursued by that system, are in a comparable factual and legal situation. However, the Court noted that it does not catch measures where the Member State is able to demonstrate that that differentiation is justified, in the sense that it flows from the nature or general structure of the system of which those measures form part.

In this case, the UK (together with ITV and the London Stock Exchange) argued raised four grounds of appeal: the incorrect determination of the reference framework; the existence of a selective advantage; the justification for the contested scheme by the need to enable the administrative practicability of the CFC rules; and the justification of that scheme by the need to respect freedom of establishment.

The correct reference framework

The UK argued that the Commission had failed to place the CFC rules in their correct context of the broader CT rules. The CT system is largely territorial and provides for the taxation, in principle, of only the profits of UK established companies and non-residents with PEs in the UK. The CFC rules provide a corrective measure to the broader CT rules, inseparable to that system, which aims to protect the CT base from abuses involving the use of CFCs to divert profits from the UK CT net.

In essence, the CJEU has agreed with these arguments. The Commission and General Court were mistaken in treating the CFC rules as a separate and distinct regime from the general CT system. Indeed, the CJEU points out that the General Court accepted that the CFC rules were a "corollary" to (and "supplementary" or an "extension" to) the CT system and that something that is a "corollary" (or "supplementary" or an "extension ") cannot be clearly severable to the principal element from which it stems.

More generally, the Court considers the purpose of the CFC and CT systems generally and concludes that the CFC rules are part of the overall CT system. The CT system is "largely" territorial, but the CFC rules provide an element of extra-territoriality to protect the CT rules from abuse. The CFC rules operate as an exception to the CT general rules in capturing profits arising to foreign companies only where they have been artificially diverted or the arrangements are abusive.

The Court agreed with the UK that the General Court had failed to take into account how far the CFC rules draw upon and are part of the broader general CT legislation. Structurally Part 9A of TIOPA forms part of the UK CT legislation, not an autonomous reference framework. This conclusion was backed up by a close consideration of the provisions of the CFC rules themselves.

The Court also accepted that the provisions reflected the principles set out by the CJEU itself in the Cadbury Schweppes Overseas case (Case C-196/04). That decision precludes the taxation of the profits of overseas entities unless it relates to wholly artificial arrangements intended to escape the national tax normally due. The UK's interpretation of the rules in this case reflected the fact that the exemptions allowed taxpayers the possibility of making a charge where certain conditions  which eliminate or reduce the risk of abusive arrangements are satisfied.

As such, the Court accepted that the rules complained of "supplement the [normal CT system], and follow the same logic which is largely based on the principle of territoriality. The CFC charge is not applied, or is applied only at a reduced level, to CFCs' non-trading finance profits, such as those arising from qualifying loans, which do not have a sufficient territorial connection with the United Kingdom and which therefore do not constitute artificially diverted profits or an erosion of the tax base of United Kingdom corporation tax".

Accordingly, the Court has held that the CFC rules are not severable from the broader CT rules and that the General Court had made an error in the determination of the reference framework. This necessarily vitiated the whole analysis on whether there was any selective advantage provided. As a result, the Court has annulled the decision of General Court on the basis that the Commission had erred in finding there was a selective advantage. In the circumstances, it was not necessary to consider the other arguments put forward by the UK.

Comment

The UK has already amended the finance company exemption within the CFC rules to ensure that it is compliant with the EU Anti-Tax Avoidance Directive (ATAD) which came into force with effect from 01 January 2019. In particular, the changes addressed the situation where "significant people functions" (SPFs) take place in the UK. The finance company exemption allowed a 75% exemption to apply to the finance profits of CFCs even where they derived from UK SPFs. The changes removed the exemption to the extent that finance profits derived from UK SPFs from 01 January 2019.

Nevertheless, many international groups would have been affected by the Commission's ruling and would have been required to account for any illegal benefit they received under the rules in place from 2013 to 2018 if they had been found to be illegal. It has been reported that over 20 companies are facing a combined tax bill of £640m and that HMRC has already raised assessments in many cases. As such, the decision of the CJEU will come as a great relief to those affected taxpayers.