The ECJ Decision In Cadbury Schweppes In Relation To The Controlled Foreign Company Rules

Originally published in The International Tax Review

Cadbury Schweppes was a UK resident company. It was the parent company of a group of companies, which included two subsidiaries that were resident in the Republic of Ireland, established in the International Financial Services Centre in Dublin and subject to a rate of tax of 10%. HMRC issued an assessment on the parent company on the basis that the CFC legislation applied. Cadbury appealed arguing that the CFC legislation in the UK was contrary to EU law. The case was referred to the ECJ for a preliminary ruling.

2. Decision

There were two key issues to be considered by the ECJ:

1. whether, in establishing a company in a Member State solely to take advantage of a more favourable tax regime than in the UK, Cadbury's abused freedoms included in the EC Treaty, and
2. whether the UK CFC rules constituted a restriction on the exercise of the EC freedoms, or discrimination and if they did, could they be justified.

The ECJ decided that a company which sought to profit from tax advantages in force in a Member State other than the state of residence should not be deprived of the right to rely on the provisions of the Treaty and establishing a company in another Member State for the purposes of benefiting from more favourable legislation did not, of itself, constitute an abuse of the freedom of establishment.

As the CFC rules applied where a UK resident company established a subsidiary in a country which had a lower level of taxation within the meaning of the legislation and not where an equivalently controlled company was incorporated and taxed in the United Kingdom or in a State which was not subject to a lower level of taxation, the rules created a disadvantage for a resident company to which the legislation on CFCs was applicable which was such as to hinder the exercise of freedom of establishment by dissuading them from establishing, acquiring or maintaining a subsidiary in a Member State with a "low level of taxation". Accordingly, the CFC rules constituted a restriction on freedom of establishment within the meaning of articles 43 and 48 of the EC Treaty.

Such a restriction could be justified, and accordingly would be acceptable under EC law, if the legislation is aimed at preventing wholly artificial arrangements and if proportionate in relation to that objective.

The ECJ reviewed the UK CFC legislation and noted that in certain instances the rules offered an exclusion for the UK resident company in situations in which there should be no tax motivated wholly artificial arrangement. The ECJ also commented on an exception within the rules which is often referred to as the "motive test", which will apply, broadly, if the UK resident parent company can show that (i) the reduction in UK tax resulting from the transactions carried out by the CFC was not the main purpose or one of the main purposes of the transactions, or was minimal, and (ii) that the achievement of a reduction of tax by diverting profits from the United Kingdom was not the main reason, or one of the main reasons, for incorporating the CFC.

The ECJ considered that in order for there to be a "wholly artificial arrangement" intended solely to avoid tax there must be objective circumstances showing that, despite formal observance of the conditions laid down by Community law, the objective pursued by freedom of establishment has not been achieved. Also, in order for the legislation on CFCs to comply with Community law, there should be an exclusion where, despite the existence of tax motives, the incorporation of a CFC reflects "economic reality".

• The ECJ has stated that it is for the UK courts to decide if the effect of the "motive test" is that the UK CFC rules are compliant with EC law - as this exemption is drafted on the basis of "subjective" factors – the purpose of the transaction and the reasons for the existence of the CFC, it seems unlikely that a UK court would consider it to meet the requirements of objectivity set out by the ECJ decision.

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