On 2 April 2019, the European Commission adopted an interesting decision in regard to the UK's "Controlled Foreign Company" (CFC) rules. The Commission decided that the rules were partly compatible and partially incompatible with EU State aid law. The case is interesting because it demonstrates that the EU State aid rules continue to apply in the UK notwithstanding its "intention" to leave the bloc.
Essence of the Decision
The case concerned the UK's CFC rules and the Group Financing Exemption. The Commission decided that part of the scheme involved the provision of illegal State aid (by way of tax advantages to certain multinational companies). However, it was not all bad news for the UK because the Commission also decided that other parts of the scheme did not involve aid and were therefore compatible with EU State aid law.
Tax Regime at Issue
The Commission described the regime as follows:
"The UK's Group Financing Exemption was introduced with the reform of the UK CFC regime under the Finance Act 2012. In order to benefit from the tax exemption, companies do not need a tax ruling. The scheme was in force from 1 January 2013 until the end of 2018.
Following the adoption of the Anti-Tax Avoidance Directive (ATAD), all EU Member States had to introduce CFC rules in their legislation as of 1 January 2019. In line with ATAD, as of 1 January 2019, the Group Financing Exemption applies only where a CFC charge on financing income from foreign group companies would otherwise apply exclusively under the UK connected capital test (i.e. not also or exclusively under the UK activities test). The CFC rules as currently applied therefore no longer raise concerns under State aid rules."
Background to the Issue
This case is one of a series of Commission decisions on both:
(a) individual tax rulings; or
(b) rulings granted under tax schemes of Member States under EU State aid rules.
The Commission has been investigating the issue of tax rulings/schemes and EU State aid law since June 2013. It extended an information inquiry to all Member States in December 2014.
So far, the Commission has concluded the following decisions in this area:
Luxembourg recovered €23.1 million from Fiat
Netherlands recovered €25.7 million from Starbucks
"Excess profit" tax rulings but in 2019, the General Court of the European Union annulled the Commission decision so the European Commission is considering its position.
Ireland granted undue tax benefits to Apple which led to a recovery by Ireland of €14.3 billion.
Luxembourg granted undue tax benefits to Amazon, which led to a recovery by Luxembourg of €282.7 million.
Luxembourg granted undue tax benefits of c.€120 million. Recovery procedure is on-going.
The non-taxation of certain McDonald's profits in Luxembourg did not lead to illegal State aid, as it is in line with national tax laws and the Luxembourg-US Double Taxation Treaty.
Undue tax benefits of c.€100 million to several multinational through a corporate tax exemption scheme and tax rulings. Recovery procedure is on-going.
The Commission has two ongoing in-depth investigations concerning tax rulings issued by The Netherlands in favour of Inter IKEA and Nike and an investigation concerning tax rulings issued by Luxembourg in favour of Huhtamäki.
Tax Scheme at Issue in the Case
The present case concerned the so-called CFC rules. These rules prevent UK companies from using a subsidiary, based in a low or no tax jurisdiction, to avoid taxation in the UK.
The CFC rules allow the UK tax authorities to reallocate all profits artificially diverted to an offshore subsidiary back to the UK parent company, where they can be taxed.
The Commission appeared impressed by the general thrust and purpose of the regime:
"CFC rules in general are an effective and important feature of many tax systems to address tax avoidance. UK CFC rules establish two tests to determine how much of the financing profits from loans granted by an offshore subsidiary are to be reallocated to the UK parent company and, hence, taxed in the UK (“CFC charge”), namely:
[(a)] The extent to which lending activities, which are most relevant to managing the financing activities and thus generating the financing income, are located in the UK (“UK activities test”); or
[(b)] The extent to which loans are financed with funds or assets, which derive from capital contributions from the UK (“UK connected capital test”)."
However, like so many of the other Commission decisions on tax breaks, the Commission had no concern with the regime as such but rather how it was applied:
"Between 2013 and 2018, the UK's CFC rules included a special rule for certain financing income (i.e. interest payments received from loans) of multinational groups active in the UK – the Group Financing Exemption.
The Group Financing Exemption provided a derogation from the general CFC rules. It partially (75%) or fully exempted from taxation in the UK financing income received by an offshore subsidiary from another foreign group company, even if this income is derived from “UK activities” or the capital being used is “UK connected”. Therefore, a multinational active in the UK using this exemption was able to provide financing to a foreign group company via an offshore subsidiary paying little or no tax on the profits from these transactions.
The Commission's State aid investigation does not call into question the UK's right to introduce CFC rules or to determine the appropriate level of taxation. The role of EU State aid control is to ensure Member States do not give some companies a better tax treatment than others. The case law of the EU Courts makes clear that an exemption from an anti-avoidance provision can amount to such a selective advantage."
In October 2017, the Commission commenced an in-depth investigation. The investigation demonstrated, according to the Commission, that the Group Financing Exemption and, hence, the different treatment, was partially justified. At the same time, the exemption grants a selective advantage to certain multinational companies.
On the negative side, the Commission found that the scheme unduly exempted certain selected multinational groups from the UK rules targeting tax avoidance. This involved selectivity. As Competition Commissioner Margrethe Vestager said:
"anti–tax avoidance rules are important to ensure that all companies pay their fair share of tax. But they must apply equally to all taxpayers. 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. The UK must now recover the undue tax benefits."
The Commission observed:
"Managing the financing activities from the UK (“UK activities test”)
…the Commission found 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.
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. 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 Commission therefore concluded that multinationals claiming the Group Financing Exemption while meeting the “UK activities test” received an unjustified preferential tax treatment that is illegal under EU State aid [law]…."
Given that the aid was illegal, the UK must now recover the illegal State aid from the multinational companies which benefitted from it.
On the more positive side, the European Commission found that the scheme was partly justified and did not constitute State aid, insofar as it ensured the proper functioning and effectiveness of the relevant tax rules.
The Commission commented:
"Financing with UK connected capital (“UK connected capital test”).
In particular, the Commission found that when financing income from a foreign group company, channelled through an offshore subsidiary, is financed with UK connected capital and there are 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 Commission therefore acknowledges that, 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."
Despite its announced "intention" to leave the EU under Article 50 of the Treaty on the European Union, the UK is still a Member State of the EU. The Commission therefore commented that as long as the UK is a Member State, it has all the rights and obligations of the membership. In particular, EU competition law, including EU State aid rules, continue to apply in full to the UK and in the UK, until it is no longer a member of the EU. Therefore, the UK is, according to the Commission, obliged to recover the illegal State aid from the beneficiaries. The Commission made a useful observation on how the amount of the aid would be calculated:
"When State aid takes the form of tax measures or other levies, the amount to be recovered should 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.
In this case, the UK should reassess the tax liability of the UK companies that have illegally benefitted from the Group Financing Exemption as it was applied to profits derived from UK activities. The precise number of beneficiaries affected and the exact recovery amount can only be determined by the national authorities based on a case-by-case examination."
The published version of the Commission decision will be awaited eagerly because it will demonstrate what was lawful and what was not lawful. The case demonstrates that the EU State aid rules continue to apply to the UK for so long as it is an EU Member State. It also demonstrates how there is a need for an agreement between the EU and the UK on how State aid rules would apply to a post-Brexit UK because otherwise the UK could simply recover the aid and then return it to the companies after the UK leaves the EU but that would spark various trade disputes which would be in no one's interests.