The European Court of Justice (Grand Chamber) ruled that art. 43 and 48 EC precluded the inclusion in the tax base of a resident company established in a member state of profits made by a controlled foreign company (‘CFC’) in another member state, where those profits were subject in that state to a lower level of taxation than that applicable in the first state, unless such inclusion related only to wholly artificial arrangements intended to escape the national tax normally payable. Accordingly such a tax measure was not applicable where it was proven, on the basis of objective factors which were ascertainable by third parties, that despite the existence of tax motives the controlled company was actually established in the host member state and carried on genuine economic activities there.

Facts

Under the controlled foreign companies legislation, a company resident in the UK might be taxed on the profits of a subsidiary resident in another state if those profits had borne a lower rate of tax than they would have done in the UK. It was accepted that, subject only to compatibility with Community law, the controlled foreign companies legislation applied to the appellants in this case.

The taxpayer (‘PLC’) was incorporated and resident in the UK. It was the parent company of a group comprising subsidiaries established in the UK, in other EU member states and in many other countries of the world. As concerned the controlled foreign companies legislation, the group included two indirect 100 per cent subsidiaries incorporated with unlimited liability in Ireland and agreed (for the purposes of this appeal only) to be resident in Ireland, ‘CSTS’ and ‘CSTI’. Those subsidiaries were subject to a tax rate of ten per cent in Ireland. The business of CSTS and CSTI was to raise finance and to provide that finance to subsidiaries in the PLC worldwide group.

CSTS was established by PLC to replace a previous structure that involved a Jersey company: to remedy a Canadian tax problem for Canadian resident preference shareholders of PLC; to avoid the need to obtain consents of the UK Treasury for overseas lending; and to reduce the withholding tax on dividends paid within the group structure by benefiting from the Parent Subsidiary Directive (Council Directive 90/435). Those three purposes would equally well have been achieved if CSTS had been incorporated and tax resident in the UK rather than tax resident in Ireland.

CSTI was incorporated as a subsidiary of CSTS with shares denominated in US dollars. It accounted in US dollars and acquired the benefit of loans in US dollars made by CSTS to a US and an Argentinian subsidiary of PLC. The reason for incorporating CSTI was to avoid the application to CSTS of certain foreign exchange provisions under UK tax law in the event that the controlled foreign companies legislation in issue in the appeal was applied to CSTS. PLC established CSTS and CSTI as tax resident indirect subsidiaries in Ireland solely in order that the profits arising from their intra-group lending treasury activities could benefit from the International Financial Services Centre regime for group treasury companies in Ireland and would not be taxed in the UK.

In 2000 the Inland Revenue directed that the controlled foreign companies legislation applied. The taxpayers appealed to the special commissioners contending that the application of the UK controlled foreign companies legislation in the circumstances constituted a breach of the freedom of establishment contained in art. 43 of the EC Treaty, of the freedom to provide services under art. 49 and of the freedom of movement of capital and payments under art. 56. The special commissioners referred to the European Court of Justice (‘ECJ’) for a preliminary ruling on the compatibility of the CFC legislation with Community law ((2004) Sp C 415).

Issue

Whether art. 43, 49 and 56 EC precluded national tax legislation which provided under certain conditions for the imposition of a charge upon the parent company on the profits made by a CFC.

Decision

The European Court of Justice (Grand Chamber) ruling accordingly) said that the fact that a Community national, whether a natural or a legal person, sought to profit from tax advantages in force in a member state other than his state of residence could not in itself deprive him of the right to rely on the EC Treaty. Further, the fact that the company was established in a member state for the purpose of benefiting from more favourable legislation did not in itself suffice to constitute abuse of that freedom. Accordingly the question was whether art. 43 EC (and art. 48 EC which conferred on companies the rights of natural persons) precluded the application of legislation such as that on CFCs.

In this case, it was common ground that the legislation on CFCs involved a difference in the treatment of resident companies on the basis of the level of taxation imposed on the company in which they had a controlling holding. The separate tax treatment under the CFC legislation and the resulting disadvantage for resident companies which had a subsidiary subject, in another member state, to a lower level of taxation were such as to hinder the exercise of freedom of establishment by such companies, dissuading them from establishing, acquiring or maintaining a subsidiary in a member state in which the latter was subject to such a level of taxation. They therefore constituted a restriction on freedom of establishment within art. 43 and 48 EC. Such a restriction was permissible only if it was justified by overriding reasons of public interest. Its application should also be appropriate to ensure the attainment of the objective pursued and not go beyond what was necessary to attain it.

Any advantage resulting from the low taxation to which a subsidiary established in a different member state to its parent was subject, could not be justifiably offset by less favourable tax treatment of the parent company. Furthermore, the mere fact that a resident company established a secondary establishment, such as a subsidiary in another member state, could not set up a general presumption of tax evasion and justify a measure which compromised the exercise of a fundamental freedom guaranteed by the Treaty. In order for a restriction on the freedom of establishment to be justified on the ground of prevention of abusive practices, the specific objective of such a restriction had to be to prevent conduct involving the creation of wholly artificial arrangements which did not reflect economic reality, in order to escape tax normally due on the profits generated by activities carried out on national territory.

The CFC legislation contained a number of exceptions where taxation of the resident company on the profits of CFCs did not apply, some of which exempted the resident company in situations in which the existence of a wholly artificial arrangement solely for tax purposes appeared to be excluded. The fact that none of the exceptions provided for by the CFC legislation applied and that the intention to obtain tax relief prompted the incorporation of the CFC and the conclusion of the transactions between the latter and the resident company did not suffice to conclude that there was a wholly artificial arrangement intended solely to escape that tax. However, if the CFC was a fictitious establishment not carrying out any genuine economic activity in the territory of the host member state, the creation of that CFC had to be regarded as being a wholly artificial arrangement. On the other hand, the fact that the activities which corresponded to the profits of the CFC could just as well have been carried out by a company established in the territory of the member state in which the resident company was established did not mean that there was a wholly artificial arrangement. The resident company, best placed for the purpose, should have an opportunity to produce evidence that the CFC was actually established with genuine activities.

In this case, it was for the national court to determine whether the motive test, as defined by the CFC legislation, enabled the tax provided for by that legislation to be restricted to wholly artificial arrangements, or whether the criteria on which that test was based meant that, where none of the exceptions applied and the intention to obtain a reduction in UK tax was central to the CFC being incorporated, the resident parent company came within that legislation, despite the absence of objective evidence to indicate the existence of an arrangement of that nature.

European Court of Justice (Grand Chamber). Judgment delivered
12 September 2006.