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Cadbury Schweppes case Back  
The European Court of Justice (ECJ) have given their decision on the legality of the UK’s Controlled Foreign Company (CFC) rules. Will the UK replace explicit tax charges with administrative harassment of firms setting up in Ireland? What are the implications for firms who set up in Ireland on the basis of outsourcing and agency arrangements? All is not yet clear.
The Judgement
The ECJ judgement has largely confirmed the opinion of the Advocate General in the Cadbury Schweppes case. The Advocate General opinion was discussed in the July issue of the KPMG Tax Monitor.
Brian Daly

Cadbury Schweppes had set up group treasury subsidiary in the IFSC, where it benefited from the 10p.c. rate of corporation tax. The UK courts had held that the principal motive in setting up the operation in Dublin rather than in the UK was to avail of a lower tax charge in Ireland. The UK sought to assess the Cadbury Schweppes holding company in the UK under UK CFC rules on the profits that accrued to the Irish treasury operation. Cadbury Schweppes challenged that assessment on the basis that the CFC rules interfered with its freedom of movement of capital, and its freedom of establishment, as provided by the EU treaties.

The practical effect of the judgement of the ECJ is to uphold Cadbury Schweppes’ objection and to rule that the UK’s CFC regime is contrary to freedom of movement of establishment within the community. However, in a formal sense the ECJ ducked the issue and left it to the UK courts to have the final word on the legality of the CFC rules. The ECJ laid down that if the CFC rules had application only where a UK company set up a foreign subsidiary that was wholly artificial and did not carry on real economic activities in another Member State, then the CFC rules were compatible with the EU treaties. But if the CFC rules could be applied where the foreign subsidiary carried on real economic activity abroad, then, notwithstanding the establishment of the subsidiary abroad was wholly tax-motivated, the CFC rules were contrary to the EU treaties and therefore illegal.

It remains to be seen if the UK courts will be able to hold that the CFC rules meet the criteria set out above in order to be legal. It would seem entirely extraordinary if they found themselves able to do so.

In one sense it doesn’t matter whether or not. If the UK courts decide that the CFC rules do not apply to any subsidiary which genuinely carries on economic activity in another EU Member State, regardless of it being set up there for tax reasons, then the CFC rules would be largely deprived of any effectiveness or relevance, in discouraging UK firms from taking advantage of Ireland’s lower tax regime. But were the UK courts to arrive at that conclusion, it could affect the right of UK firms which have been previously assessed to tax under the CFC rules, to recover the tax as having been unlawfully levied. Some companies therefore will have a continuing interest in following this saga to its final conclusion.

The Freedom to Establish
The ECJ held that the freedom of establishment set out in the EU treaties was there to ‘assist economic and social interpenetration within the community’ and to enable firms ‘to participate, on a stable and continual basis, in the economic life of a Member State other than his State of origin and to profit there from’. Accordingly, freedom of establishment involves the right to ‘the actual pursuit of economic activity through a fixed establishment in that (foreign) State for an indefinite period’. What freedom of establishment does not extend to is ‘the creation of wholly artificial arrangements which do not reflect economic reality, with a view to escaping tax’.

The Court made it quite clear that taxpayers are fully entitled to establish themselves within the community wherever they can get the best tax deal, and the fact that their moves are tax-motivated is entirely irrelevant, provided their firm establishment does involve ‘actual pursuit of an economic activity through a fixed establishment’ and does not involve ‘the creation of wholly artificial arrangements that do not reflect economic reality’.

How do you determine whether the taxpayer is involved in the actual pursuit of economic activity, as opposed to wholly artificial arrangements? The ECJ stated that this ‘must be based on objective factors which are ascertainable by third parities with regard, in particular, to the extent to which the CFC physically exists in terms of premises, staff and equipment.’ This part of the ECJ finding is, at first sight, rather disappointing. It could be interpreted as limiting the freedom of establishment to firms which take on substantial premises, staff, and equipment in a foreign country for the purpose of economic activity. As is well known, significant economic activity can be carried on without having substantial premises, staff or equipment. It is quite possible to carry on economic activity through the use of agents and subcontractors.

The ECJ judgment is open to a more reasonable interpretation, in that it does not lay down any specific criteria as regards the extent of premises, staff and equipment, that are to be taken as objective evidence of the carrying on of genuine economic activities. The existence of premises and staff are merely matters of evidence to be taken into account in arriving at a conclusion, rather than absolute tests in themselves. Arguably, if a company is carrying on genuine economic activity in Ireland and is succeeding in doing this without significant premises or staff, it would not be open to the courts of a foreign country to rely solely on the relative absence of premises and staff as grounds for justifying CFC legislation. The real test remains, whether or not the company is carrying on genuine economic activities in Ireland, in contrast to ‘the creation of wholly artificial arrangements which do not reflect economic reality’.

Nonetheless, it is unfortunate that the Court chose to make such specific reference to premises and staff (which it did at the invitation of the UK and of the EU Commission). It opens the risk that the UK Revenue will seek to determine the genuineness of the economic activities carried on Ireland solely by reference to these factors in a manner which would inhibit companies from adopting agency arrangements or outsourcing. A pessimist might expect that we will see a further case going to the ECJ turning on these issues.

Transfer pricing
Where genuine economic activity is not carried on in Ireland, it would be difficult, and indeed impossible, for significant profits to be attributable to an Irish operation on an arm’s length basis. If significant profits in an Irish operation can be justified on an arm’s length basis, it must follow almost certainly, that genuine economic activity is being carried on in Ireland. Transfer pricing rules, which exist in many EU Member States though not in Ireland in any detailed way, usually require that transactions between a locally resident firm and a connected overseas firm should be conducted on an arm’s length basis. It would seem to be the case that such transfer pricing legislation, which the UK possesses, is fully capable of doing all that is legitimately possible within the confines of EU rules, to ensure that the profits of UK firms are not artificially diverted abroad by means of ‘artificial arrangements which do not reflect economic reality’. Given the limits that the legislation set out in the ECJ judgement, it is difficult to see any legitimate role for CFC rules, over and above that provided by transfer pricing rules.

The Advocate General, in his opinion, made a radical statement where he suggested that it was legitimate for Member States to introduce transfer pricing rules solely on a cross-border basis. He said that this did not involve unlawful discrimination as between transactions between two firms resident within the UK as compared to a transaction between a firm resident in the UK and an overseas firm. This was on the grounds that tax avoidance by means of use of non-arm’s length prices was likely to occur only in a cross-border situation. The ECJ in its final judgement made no reference to this issue and did not seek to endorse the view of the Advocate General. This may have been because the point was not an issue in the Cadbury Schweppes case. On the other hand, it may have been that the Court were not completely happy with the Advocate General’s opinion on the matter. The Court’s failure to confirm the view of the Advocate General may have to be taken into account in Ireland should we resume consideration of the introduction of transfer pricing in Ireland, as was proposed some years ago.

Some commentators had feared that if the ECJ severely restricted the scope of CFC legislation within the community, the floodgates would be opened for the diversion of high value business to the lower tax States, and that the finances of the larger countries would be seriously undermined. Now that the dust has settled, these fears seem overstated. Transfer pricing rules should ensure that the movement of profits from high tax countries to low tax countries reflect real economic movements between the countries as opposed to ‘brass plate’ operations. That leaves the door open to genuine tax competition. At the end of the day, that is competition between Member States as to which governments can most cost effectively deliver the essential services that a modern State requires. The least efficient governments will face the risk of economic decline in their territory. The big question for the future may well be, ‘how efficient is your public service?’. That could be an uncomfortable question.

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