The ECJ has ruled that companies are entitled to operate in countries such as Ireland which have a favourable tax regime without attack from the tax authorities of the country of the group parent.

In an important judgment issued on Tuesday 12 September (Case C196-04), the ECJ found that the controlled foreign company (CFC) rules in operation in the UK can be contrary to the treaty of Rome. The case involved two subsidiaries of the Cadbury Schweppes group, located in the IFSC in Dublin. HMRC had sought to raise tax of some £8m on profits arising to the subsidiaries under the CFC rules. These were triggered by a number of criteria including the nature of the shareholding relationships with the UK parent company, but principally that the subsidiaries were paying less than 75% of the tax which would have been payable had the profits arisen and been taxed within the UK.

The case went to appeal, and was referred to the ECJ by the Special Commissioners who raised a number of points for the Court to consider. Perhaps the key issue was whether Cadbury Schweppes, by establishing companies in Ireland solely to take advantage of a more favourable tax regime, was abusing the freedom of establishment rules in the EC treaty.

The ECJ commented (at paragraphs 53 and 54 of its judgment) that freedom of establishment “is intended to allow a Community national to participate, on a stable and continuing basis, in the economic life of a Member State other than his State of origin and to profit therefrom Consequently, it presupposes actual establishment of the company concerned in the host Member State and the pursuit of genuine economic activity there.” Provided the condition of genuine economic activity is met, taxation measures such as the CFC regime must be excluded from Community law.

The fact that the economic activity could be carried out in another Member State with less favourable tax consequences does not imply that there is an artificial arrangement. The key issue is that there are genuine economic activities underway in the State where the subsidiary is located.

The Court specifically adverted to arrangements involving what it termed “letterbox” subsidiaries, indicating that the CFC legislation could legitimately apply to such arrangements.

A full report of the case is published below.