The High Court held that the UK legislation on controlled foreign companies (CFCs), which depended on ICTA 1988, s. 747 and 748 for its effectiveness, had to be disapplied so that, pending amending legislation or executive action, no charge to tax could be imposed on a company such as the taxpayer under the CFC legislation. It followed that the Revenue's enquiry into the taxpayer's tax return for the relevant accounting period had no legitimate purpose and should be closed.

Facts

The taxpayer company appealed against a decision of the special commissioners taken in the context of proceedings brought by the taxpayer seeking an order directing Revenue and Customs to issue an immediate closure notice under para. 33 of Sch. 18 to the Finance Act 1998 in respect of their enquiry into the taxpayer's tax return for the accounting period ending 31 March 2001. The purpose of that enquiry was to establish whether or not the taxpayer should be held liable to a sum of tax as if it were an amount of UK corporation tax (ICTA 1988, s. 754(1)) on the profits of its wholly-owned Luxembourg subsidiary (VIL) under the CFC legislation contained in ICTA 1988, s. 747–756 and Sch. 24–26 as it stood and was applicable to the taxpayer's return for the relevant accounting period.

At an earlier stage of the proceedings the special commissioners had made a reference to the ECJ ((2005) Sp C 512). The ECJ subsequently gave judgment in the reference in Cadbury Schweppes plc & Anor v R & C Commrs (Case C-196/04) [2008] BTC 52; [2006] ECR I-7995, which, like the present application, concerned the compatibility of the CFC legislation (ICTA 1988, s. 747–756 and Sch. 24–26) with Community law. After that, the Registrar of the European Court asked the special commissioners whether, in the light of the judgment in Cadbury Schweppes, they wished to maintain the reference in the present application.

The taxpayer argued that the ECJ's judgment in Cadbury Schweppes gave clear guidance to the effect that the CFC legislation was not compatible with Community law and that therefore the commissioners should dispose of the application by directing the Revenue to issue a closure notice. In those circumstances they should withdraw the reference. The special commissioners decided (by the chairman's casting vote in accordance with reg. 18(2) of the Special Commissioners (Jurisdiction and Procedure) Regulations 1994 (SI 1994/1811)) that they should withdraw the reference to the ECJ but concluded that the CFC legislation was compatible with art. 43 EC and 48 EC, on the basis that the motive test as defined in the CFC legislation lent itself to the conforming interpretation of national statutes in relation to international obligations ((2007) Sp C 622). The taxpayer appealed contending that the CFC legislation was unenforceable by reason of its consequent non-compliance with art. 43, to the protection of which the taxpayer was entitled, with the result that the Revenue's enquiry into its tax return for the accounting period had no legitimate purpose and should be closed.

Issue

Whether the special commissioners erred in deciding that relevant UK legislation was capable of being construed in conformity with Community law.

Decision

Evans-Lombe J (allowing the appeal) said that the effect of s. 748(3) was to make available to the Revenue the power to apportion the profits of a CFC to the tax base of its parent company, where the relevant transactions achieved a tax advantage in the relevant accounting period, which was more than minimal, and it was one of the main purposes of the parent that, in entering into the transactions, it would do so, and that one of the main purposes of the parent, in incorporating the CFC to take part in the transaction, was to achieve such tax advantage. The subsection construed on normal English law principles therefore resulted in an entirely subjective test (save as to whether the resulting tax saving was minimal or not) of the state of mind of the parent in setting up the arrangement with the CFC which produced a tax advantage, namely, a main intention to achieve such advantage.

Applying the normal UK principles of construction, it was impossible to give s. 748(3) a construction which made it compliant with art. 43 as that article was applied to the taxation of CFCs by the judgment of the ECJ in the Cadbury Schweppes case. The effect of s. 2 of the European Communities Act 1972 Act gave rise to a special principle of construction known as the Marleasing principle (Case C-106/89 [1990] ECR I-4135). According to that principle, where legislation could reasonably be construed so as to conform with the UK's Community obligations, the English courts had to do so, even if that involved a departure from the strict and literal application of the words in the legislation. Applying the Marleasing principle in an appropriate case, could extend as far as implying words or provisions into UK legislation even where the relevant provisions of that legislation were unambiguous. However, the duty of UK courts to interpret UK legislation in conformity with EC law ‘where possible’ did not permit those courts, in the process, to amend UK legislation. The UK courts should not imply words into UK legislation under the principle of conforming construction where to do so involved the court in taking policy decisions which a court was unfitted to take.

It was impossible to construe s. 748(3) so as to make it conform with the right of freedom of establishment under art. 43. It was not in issue that the taxpayer enjoyed the directly enforceable right under art. 43 freely to establish a CFC (VIL) in a member state (Luxembourg) and that the Cadbury Schweppes case showed that the apportionment of the profits of VIL to the taxpayer, there to be taxed, constituted, prima facie, an unlawful interference with that freedom under Community law (Pirelli Cable Holding NV v IR Commrs [2006] BTC 181, at para. 77).

The provisions of s. 748(3) were unambiguous and its purpose was plain, namely, to defeat tax avoidance by parent companies resident for tax purposes in the UK, by channelling profits to CFCs resident in foreign countries where those profits were taxed at a significantly lower level and where one of the main reasons of a UK parent company for doing so was to achieve such tax advantage. The Cadbury Schweppes case demonstrated that the establishment of a CFC in a member state with such an objective was protected by art. 43. There were no words in s. 748(3) which, using conventional rules of construction, were capable of being construed as limiting the operation of the subsection so as to comply with art. 43 as explained in the Cadbury Schweppes case.

All UK taxpayers, including the appellant, were entitled to be told by legislation in plain language what the tax consequences for them would be if they decided to incorporate a CFC in a member state. As it stood, unamended, s. 748(3), although its meaning, on the basis of conventional methods of construction, was plain, when viewed against the background of art. 43, was wholly misleading as to its actual effect brought about by the operation of s. 2 of the European Communities Act 1972. The CFC legislation and the motive test were of potentially wide application throughout the UK business world. The nature of the defect in s. 748(3) was such that a single solution was required that could reasonably be applied to all taxpayers. That could only be done by Parliament, or possibly by appropriate executive steps as was suggested by the House of Lords in Fleming (tla Bodycraft) v C & E Commrs [2008] BTC 5,096.

Chancery Division.
Decision released 4 July 2008.