Non-UK group finance companies under attack
March 2018 | SPOTLIGHT | CORPORATE TAX
Financier Worldwide Magazine
March 2018 Issue
Toward the end of 2017, the EU Commission announced its decision to open a state aid investigation into the group finance exemption (GFE) from the UK’s rules on the taxation of controlled foreign companies, stating that the GFE gives “some companies a better tax treatment than others”. This investigation is very significant for UK headed groups with non-UK finance subsidiaries, as the application of the UK’s CFC regime to these subsidiaries is an essential consideration.
What is the GFE?
The UK’s CFC regime aims to prevent UK companies from diverting income to subsidiaries in lower tax jurisdictions. But the current shape of the CFC regime has been driven by the EU.
The UK’s previous CFC regime was successfully challenged as being in breach of the EU right to freedom of establishment in two cases involving finance subsidiaries, Cadbury Schweppes and Vodafone 2. In both of those cases, the application of the CFC rules was held to breach EU law because the finance company was in an EU member state where it was carrying on “genuine economic activities”.
When the regime was reformed in 2013, the UK struggled to design EU-compliant CFC rules in relation to finance company activities. The UK was not prepared to exempt the entire profits of group finance companies, even if they were carrying out genuine economic activities. This was in part because what constitutes “genuine economic activities” for a treasury company may in fact not amount to all that much. The GFE – which either imposes UK tax at an effective 4.75 percent rate or (if certain other conditions are met) allows complete exemption for interest on loans made to non-UK affiliates – was a compromise, albeit one which was always vulnerable to a taxpayer challenge on Cadbury Schweppes principles.
Is the GFE state aid?
From being told that the CFC rules were too strict, the Commission now appears to be telling the UK that the rules are not strict enough. Its initial view is that the GFE is a selective derogation from the UK’s CFC regime, which is not justified and, therefore, amounts to unlawful state aid.
Is the GFE a derogation or exemption from the CFC regime? The UK argues that, despite its name, it is really a filter designed to exclude from the regime profits with a low risk of being artificially diverted from the UK – it is a limitation that defines the scope of the regime, rather than a derogation or exemption from it. The Commission’s view, however, is that the GFE must be a derogation because it exempts profits only from financing non-UK group companies, but not, for example, profits from third-party lending or lending to the UK.
Is it selective? Although available to all taxpayers, the GFE will still be ‘selective’ if it could lead to undertakings in comparable legal and factual situations getting different tax treatment. Following the CJEU decision in World Duty Free, a broad view is likely to be taken as to when situations are comparable. That case held that a Spanish tax exemption for investment in non-Spanish subsidiaries was state aid, even though it was generally available – it was selective because in practice it was available only to businesses investing overseas, rather than in Spain. Applying the approach in World Duty Free, it seems difficult to argue that the GFE is not also selective.
Is it justifiable? The UK justifies the GFE because it moderates the excessive effects of the CFC regime. The UK argues that artificial diversion of profits is a significant risk only where the CFC is excessively capitalised. This is the basis for the conditions underlying the complete exemption. In relation to the partial exemption, the UK argues that subjecting only 25 percent of the profits to tax is consistent with a typical funding profile of an operating company, which might be 1:3 debt to equity. The Commission can see no argument, however, to justify the fact that the GFE applies only to interest paid by non-UK group companies.
It is interesting that the Commission’s decision makes no reference to Cadbury Schweppes or Vodafone, given that the difficulties raised by these cases lies behind the GFE. Where an EEA-resident finance company is carrying out genuine economic activities, a UK group might be able to argue that the CFC rules should not apply anyway, so that (if they have been applying the partial rather than the full exemption) they have in fact been overpaying UK tax.
It may be some time before the final Commission decision is issued. In the meantime, groups which have relied on the GFE in respect of their EEA finance companies should evaluate the strength of any alternative defences from the CFC charge. Does the finance company have sufficient economic substance? Can any steps be taken now to improve the position, at least going forward? And should a back-up Cadbury Schweppes claim be filed?
And, of course, there is the far wider question of what the UK tax regime will look like if, post Brexit, it is not being shaped by EU requirements.
Sara Luder is a partner and Sarah Osprey is an associate at Slaughter and May. Ms Luder can be contacted on +44 (0)20 7090 5051 or by email: firstname.lastname@example.org. Ms Osprey can be contacted on +44 (0)20 7090 3709 or by email: email@example.com.
© Financier Worldwide
Sara Luder and Sarah Osprey
Slaughter and May