Changes to CFC rules are not enough, says EC

The European Commission has formally requested the UK to amend its controlled foreign companies (CFC) legislation to ‘better take into account’ recent rulings of the European Court of Justice. As a ‘very public next step’ towards possible EU infringement proceedings, the EC’s request cannot be taken lightly by the UK, James MacLachlan, Partner at Baker & McKenzie, told Tax Journal.

HM Treasury emphasised that the EC’s ‘reasoned opinion’ relates to the current rules. ‘The government will also consider it alongside future proposals,’ a spokesperson told Tax Journal.

He added that the government is now aiming to release the next CFC consultation document in June. ‘This is a particularly important and complex area, therefore it is important that the necessary time is taken to ensure the policy proposals achieve their desired aims.’

The ‘full’ CFC reform consultation was originally earmarked for publication this month.

Genuine economic activities

Despite the ECJ’s ruling in 2006 in Cadbury Schweppes plc v HMRC C-196/04 [2007] Ch 30, the UK is ‘still not complying with EU law on freedom of establishment and free movement of capital’, the EC said last week. The UK’s response to a formal notice issued in March 2010 was ‘not considered satisfactory’.

‘In particular, the UK continues to tax in the UK profits of subsidiaries established in the EU or in Member States of the European Economic Area. Under EU law, profits of CFCs … should not be subject to additional taxation in the country of the parent company if the subsidiaries are engaged in genuine economic activities,’ it added.

In the absence of a satisfactory response within two months the EC may refer the UK to the ECJ. The EC considers that measures put in place by the UK are ‘not a sufficient response’ to the ECJ’s decisions in Cadbury Schweppes and in C-201/05 Test Claimants in the CFC and Dividend GLO.

The UK's legislative response to these rulings does not eliminate ‘the discriminatory restriction’ of the CFC regime, it said.

‘The new provisions allow a UK taxpayer to reduce the taxable basis of a UK-owned CFC under certain restrictive conditions. However, they fail to exclude from the CFC regime all subsidiaries established in EU/EEA Member States which are not purely artificial and are not involved in profit-shifting transactions.’

Finance Bill

The interim measures included in the current Finance Bill (clause 47 and Sch 12) are unlikely to make the UK regime compliant with the EC Treaty, the ICAEW Tax Faculty said, adding that the forthcoming consultation on ‘full’ CFC reform may offer a better indication as to how far the UK is intending to change the regime and ‘whether the proposed changes will “head off” the potential legal action from the Commission'.

One expert suggested that government’s new proposals may have to be revised before they become law. Gary Richards, Corporate Tax Partner at Berwin Leighton Paisner, said the challenge is ‘yet another move that will instil uncertainty in the UK's CFC rules, which have already caused several companies to move their headquarters out of the UK'.

Richards said the EC was implicitly criticising UK law for ‘focusing too narrowly on the value of work done overseas’.

‘On balance this challenge by the Commission is helpful for business if it means that the new rules will comply with European law. However, if HMRC choose to wait for the outcome of the challenge, rather than adjusting their current proposals, the continuing uncertainty over CFC rules will deter investors just at a time when the end seemed in sight,’ he added.

‘And UK taxpayers may face even more challenges from HMRC in other areas to “fill the gap” if new CFC rules raise less tax from companies choosing to establish overseas bases, in lower tax jurisdictions.’

‘Timing is surely awkward’

James MacLachlan, a Partner at Baker & McKenzie, told Tax Journal:

‘Whilst one might take a cynical view of why the European Commission issued its request now, and the timing is surely awkward for HM Treasury in that its consultation document on full CFC reform is due to be released shortly, the substance of the Commission's reasoned opinion surely cannot have come as a great surprise.

‘There has always been significant doubt whether the 2007 exclusion for profits of CFCs with an EEA business establishment conforms to EC Treaty freedoms as interpreted in the ECJ's decision in Cadbury Schweppes.

‘However, as a very public next step towards possible EU infringement proceedings, the Commission's opinion cannot be taken lightly by the UK. So, when commenting on the upcoming CFC consultation document, companies and their advisers should particularly focus on the circumstances where profits genuinely earned outside the UK from capital, intellectual property and intra-group activities ought to be excluded from a CFC charge.’