UK finance company CFC exemption contrary to EU state aid rules

Update: The AG has now suggested that the EU Commission was wrong to view the CFC rules alone as the correct reference framework against which any selective advantage should have been judged. See our article on the AG opinion here.

The General Court of the CJEU has upheld the EU Commission’s decision that the group financing exemption within the UK CFC rules was, in part, illegal State Aid: UK and others v EU Commission (Cases T-363/19 and T-456/19). In a judgment which adds to the general body of law on the difficult question of the application of EU state aid rules to tax advantages, the Court accepted the Commission’s analysis that the UK rules gave rise to a selective advantage when judged against the broader operation of the CFC regime.

The decision is largely of historical interest since the UK rules were changed in 2019, though significant amounts are subject to reassessment as a result of the ruling. The decision may not be the end of the road, however, as an appeal does lie in principle from the General Court to the Court of Justice.

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 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. “Such a measure confers an economic advantage on its recipient if it mitigates the burdens normally included in the budget of an undertaking”.

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”.

Secondly, the UK argued that the group financing exemption did not give rise to a selective advantage, because, in essence, the rules must be viewed as a whole defining the scope of the taxation of the CFC profits. The exemption should not be viewed in isolation from the broader coherent body of rules.

Again, the Court has rejected this argument. The Court noted that “the exemptions at issue cannot be regarded as a variation in the taxation of CFCs profits. In so far as those exemptions disregard the very nature of the rules applicable to CFCs, namely the taxation of artificially diverted profits from the United Kingdom, they cannot be regarded as being a variation in the application of those rules”.

In addition, the UK argued that the group financing exemption was not a priori selective. This was on the basis that the Commission’s decision failed to take sufficient account of the fact that the rules applicable to CFCs sought to impose tax liability only in cases where there was a high risk of abuse or artificial diversion of profits from the UK. By contrast, the group financing exemption applied only in cases where there was a low risk of erosion of the UK corporation tax base.

Following an extensive review of the operation of the rules in practice, the General Court has concluded that the rules were selective. The Court considered that the Commission did not commit any errors of assessment when it concluded that there was an advantage in the present case and that it was a priori selective, since the exemptions derogated from the UK rules applicable to CFCs, in that they introduced a difference in treatment between taxable companies in a comparable situation, in the light of the objective of those rules.

Finally, the Court rejected the UK’s arguments that the rules were justified based either on the needs of administrative practicability or on the basis of the need to comply with the freedom of establishment (based, broadly, on the argument that a member state could not tax the parent entity for profits made at a subsidiary jurisdiction if it was located in another EU member state).

Recovery

EU state aid rules require that illegal state aid is recovered in order to remove the distortion of competition created by the aid. When State aid takes the form of tax measures or other levies, the amount to be recovered needs to be calculated based on a comparison between the amount of tax actually paid and the amount which should have been paid if the illegal exemption had not applied. Accordingly, the UK is required to reassess the tax liability of the UK companies that have illegally benefitted from the finance company exemption as it was applied to profits derived from UK activities.

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.

However, many international groups may be affected by the Commission’s ruling and will now be required to account for any illegal benefit they received under the rules in place from 2013 to 2018. It is reported that over 20 companies are facing a combined tax bill of £640m and that HMRC has already raised assessments in many cases.

However, a route of appeal does lie from the General Court to the Court of Justice, and it will be interesting to see if the UK or the other parties to the appeal (including ITV and the London Stock Exchange), choose to take up that option.