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Vodafone 2 - death knell for UK CFC rules? Back  
On 4th July, the UK High Court ruled in the Vodafone 2 case that the UK controlled foreign company (“CFC”) rules were incompatible with EU Law in the light of the Cadbury Schweppes case. Liam Lynch discusses the implications of this ruling.
The final words of Justice Evans-Lombe sum up his ruling: “the CFC legislation …must be disapplied so that, pending… amending legislation or executive action, no charge can be imposed on a company such as Vodafone under the CFC legislation”.
This ruling is very significant for subsidiaries of UK companies based in EU jurisdictions, such as Ireland, as it effectively renders the UK CFC rules inapplicable (at least prior to the 2007 Finance Act amendments).

It leaves open the possibility for UK multinationals with EU resident subsidiaries, which have been caught by CFC rules, to make claims for repayments of tax levied under the rules in prior years. It also provides a monumental analysis of the obligation to interpret domestic legislation so as to comply with EU law.

UK rules attribute certain income of an overseas subsidiary which is subject to a tax rate less than 75% of the UK rate, to its UK parent, taxing those profits in the UK, with credit for foreign tax paid by the subsidiary. The rules are targeted at passive income and several let outs exist, including where the main purpose of the establishment of the subsidiary was not the avoidance of tax (the “motive test”).

Cadbury Schweppes case (“Cadbury”)
Cadbury concerned the application of the UK CFC provisions to Irish IFSC treasury companies. It determined that such rules constituted a clear restriction of the EC Treaty Freedom of Establishment doctrine.

However, this ruling accepted that this restriction might be justified in certain circumstances, such as where the ability to transfer profits and losses between jurisdictions in a discretionary manner undermined the power of Member States to tax economic activities carried out in their territory.

The conclusion was that CFC rules are compatible with European law to the extent that their application is restricted to “wholly artificial arrangements”, i.e. those which did not involve genuine economic activity in the host state. But they should not restrict the right of establishment in another EU State.

The ECJ left it up to the UK courts to decide:
- whether this limitation to “artificial arrangements” could be read into the wording of the UK motive test, (if yes, the determinant of whether a UK CFC tax liability arose was whether there was adequate substance or not in the host State), or
- whether the existing UK CFC rules could not be construed with this limitation in mind and therefore can never apply to EU subsidiaries.
Vodafone 2 has provided the answer.

Vodafone 2
Vodafone effectively contended that Cadbury rendered the UK CFC provisions redundant and inoperable because the limitation to “artificial arrangements” could not be read into the wording of the UK legislation.

The UK Special Commissioners disagreed but the High Court has accepted this argument. The pre-Finance Act 2007 UK CFC provisions have thus been effectively disapplied in respect of EU subsidiaries.

While HMRC is likely to appeal the case, an extensive and thorough analysis of case law is provided in this judgement.
UK Finance Act 2007 (“FA 2007”)

In an effort to deal with Cadbury, new legislation was introduced in the UK in 2007, effectively allowing for elimination of the CFC charge where certain conditions are met. It refers specifically to where the CFC has a business establishment in a Member State.

It remains to be seen whether Vodafone 2 continues to render the rules inoperable for periods beginning after this legislation became effective, but Justice Evans-Lombe’s comments (which have no binding effect) that he doubted the FA2007 sections were compliant with the freedom of establishment principle, should be borne in mind.

So, where do we stand?
In the absence of a reversal of the decision in the higher courts, it seems Irish and other EU subsidiaries should not be subject to pre-FA 2007 UK CFC rules (regardless of genuine substance considerations) as the rules were fundamentally incompatible with European law. Claims for tax repayments should be considered where relevant.

The post-FA 2007 position remains to be challenged, but if the Judge’s non binding comments are anything to go by, these may also be deemed inoperable.

The judgement’s complete disapplication of a domestic direct tax provision as a result of European law raises the possibility of re-assessing numerous other cases on the EU-compatibility of anti-avoidance provisions in a new light.

Overall, there is an environment of uncertainty. This has not been alleviated by the effective withdrawal of last year’s proposals for reform of the UK taxation of foreign profits regime (encompassing the CFC rules) following (although not necessarily linked to) this judgement. Further consultation is to take place. However, policy decisions and concrete action will need to be taken to provide a more certain environment for businesses.

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