In this article we look in detail at the Cadbury Schweppes case. After considering the facts of the case and relevant European and U.K. law we comment on the pending ECJ decision.
Cadbury Schweppes Plc is incorporated and resident in the United Kingdom. It is the parent company of a group of companies including two indirect 100 percent subsidiaries incorporated with unlimited liability in Ireland and agreed (for the purposes of this appeal only) to be resident in Ireland, Cadbury Schweppes Treasury Services (CSTS) and Cadbury Schweppes Treasury International (CSTI). CSTS and CSTI were subject to a tax rate of 10 percent within the International Financial Services Centre in Dublin. CSTS and CSTI raised finance and provided that finance to subsidiaries in the PLC worldwide group.
On August 18, 2000 the Inland Revenue assessed Cadbury Schweppes Overseas Limited (the first United Kingdom resident company in the chain of companies) to an amount equal to corporation tax of £8,638,633.54 (being tax at 33 percent on the profits of £34,684,038 equals £11,445,732.54 less credit for Irish tax of £2,807,099) in respect of the profits of CSTI for the period ended December 28, 1996 (CSTS made a loss in the same period that was surrendered for Irish tax purposes partly to CSTI and partly to another Irish company). The taxpayer appealed to the Special Commissioners on August 21, 2000.
The Special Commissioners determined that the reason for incorporating CSTI was to avoid the application to CSTS of certain foreign exchange provisions under United Kingdom tax law in the event that the controlled foreign companies' legislation in issue in this appeal was applied to CSTS. The Special Commissioners ultimately concluded that PLC established CSTS and CSTI as tax resident indirect subsidiaries in Ireland solely for the purpose of ensuring 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 United Kingdom. In view of this, it referred the following question to the European Court of Justice (ECJ) in a decision dated June 6, 2004.
Do Articles 43, 49 and 56 of the EC Treaty preclude national tax legislation which provides, in specified circumstances, for the imposition of a charge upon a company resident in that Member State in respect of the profits of a subsidiary company resident in another Member State and subject to a lower level of taxation?
The treaty establishing the European Community recognises that existing obstacles need to be removed to guarantee steady expansion, balanced trade and fair competition within the European Union and expresses the desire to progressively abolish restrictions on international trade. This is partly realised through the community policies on the so-called fundamental freedoms, including the freedom of establishment, the freedom to provide services and the free movement of capital. Article 43 of the treaty prohibits restrictions on the freedom of establishment of nationals of a member state in the territory of another member state. Article 48 also extends this right to companies and firms within the European Union. Article 49 prohibits restrictions on the freedom to provide services within the Community in respect of nationals of member states who are established in another member state and Article 55 of the extends this right to companies and firms. Finally, Article 56 prohibits all restrictions on the movement of capital between member states and between member states and third countries. However, Article 56 does not prejudice the right of member states to apply the relevant provisions of their tax law which distinguish between taxpayers who are not in the same situation with regard to their place of residence or with regard to the place where their capital is invested, nor to take requisite measures to prevent infringements of national law and regulations, in particular in the field of taxation, or to take measures which are justified on grounds of public policy or public security, provided that such measures do not constitute a means of arbitrary discrimination.
Like a number of other E.U. countries, the United Kingdom has implemented CFC legislation. Under the classic definition of CFC legislation, a country taxes the undistributed (and sometimes unrealised) income and gains of a foreign subsidiary at the level of the parent company upfront. If the parent company is resident in a country providing tax credits for the underlying taxation on (deemed) dividend distributions (such as the United Kingdom), it is often undertaken done in order to prevent a deferral of parent company taxation on the subsidiary's income.
Logically, there is little opportunity for deferral if the subsidiary is subject to a tax which is as high or higher than the tax it would have paid, had it been resident in the Parent company jurisdiction (U.K. tax rate = 30 percent). Therefore the United Kingdom, like many other CFC jurisdictions exempt subsidiaries subject to tax equal to at least 75 percent of the tax such companies would have paid in the United Kingdom. Other similar exemptions apply for cases in which it can be assumed that the subsidiary is not primarily resident outside the parent company jurisdiction for tax deferral (subsidiary distributes 90 percent of its taxable profits, subsidiary is engaged in an active trade or business, subsidiary is listed and actively traded on a recognised stock exchange, etc.).
It cannot be doubted that this has the potential of being a very important case. However, the first question to raise is whether the ECJ will decide on this case at all or whether this case will follow the Walter Schmid case (C-516/99) in which the ECJ determined that it had no jurisdiction to answer the questions referred to it, since those questions were not referred by a court or tribunal as meant under Article 234 of the EC Treaty.
The ECJ determined that such a court or tribunal must be a body established by law, that it must be permanent, its jurisdiction must be compulsory, its procedure must be inter partes, it must apply rules of law and finally, it must be independent. In the case of Walter Schmid, it was determined that the institution referring the questions to the ECJ was not a court or tribunal, since it lacked independence. It lacked independence since it was not an authority acting as a third party in relation to the authority which adopted the contested decision because it had an organisational and a functional link with the latter authority. Since I am not a U.K. tax professional, I will not try to answer the question whether the Special Commissioners qualify as a court or tribunal under Article 234.
If I were an EC Judge, I would argue that these rules make it more attractive - from a U.K. tax point of view - to set up a group finance subsidiary in a jurisdiction where the tax paid by the foreign subsidiary is (just) more than three-quarters of the amount of U.K. tax, than to set it up in a jurisdiction where it is (just) less than that, and that the CFC rules therefore do constitute a restriction on both the freedom to establish subsidiaries in the lower tax jurisdictions and the freedom to provide services from the lower tax jurisdictions. As an aside, please note that the large member states have still not managed to force a consensus that low tax rates are abusive or constitute harmful tax competition.
Once it has been determined that CFC rules do constitute a restriction on the fundamental freedoms, it is necessary to see if such a restriction is justifiable under the EC treaty. This is the case if a measure pursues a legitimate objective compatible with the EC Treaty and is justified by imperative reasons in the public interest (Hughes de Lasteyrie du Saillant, Case C-9/02).
Let's start with those arguments which are not accepted as justifications by the ECJ. In this case it would be a loss of revenue, which has never been accepted as justification by the ECJ see for instance Bosal (Case C-168/01). The generally acceptable justifications in tax cases are: the cohesion of the tax system (Bachman, Case C-204/90), territoriality (Futura Participations SA and Singer, Case C-250/95) and tax evasion. In this case, it cannot be cohesion, since cohesion requires one taxpayer and one tax; this concerns more taxpayers and more taxes. Since territoriality also requires one taxpayer, it cannot be that either.
That leaves tax evasion, which I will split into two separate parts. The first is whether the use of lower tax rates in another jurisdiction could be qualified as tax evasion. I think not, see the comment on low tax rates here above; see also the ECJ arguments in the Anneliese Lenz case discussed hereafter. The second part is whether the use deferral can be qualified as evasion. Since this too depends in part on the existence of a lower tax rate, I doubt if it could form a justification for a restriction on the fundamental freedoms, especially not if it applies equally to all periods of deferral, albeit for one year, 10 years, or indefinitely.
Finally, even if there were to be a justification, such a justification would need to ensure the attainment of the objective pursued and must not go beyond what is necessary to attain it (Futura Participations SA and Singer, Case C-250/95).
I always have difficulty in understanding the mechanics of this freedom when it comes to taxes. Yet, this is arguably the most important freedom, since this is the only freedom which cannot be restricted with regard to third countries outside the European Union. Furthermore, unlike the freedom of establishment, I believe that this freedom also does not require control in the case of a foreign subsidiary (i.e., whereas it may be uncertain whether the freedom of establishment can apply with regard to a minority interest in a subsidiary, the free movement of capital potentially applies to any interest in a foreign company).
Is it sufficient to say that CFC rules have the effect of making it easier, from a U.K. tax point of view, to move group capital through a higher tax jurisdiction than a lower tax jurisdiction or to borrow from a higher tax jurisdiction than a lower tax jurisdiction and that the CFC rules therefore constitute a restriction. Does previous or pending case law provide any answers? We look at a number of cases below.
I therefore conclude from the above that previous ECJ decisions do show that the U.K. CFC rules can constitute an unjustifiable restriction on the free movement of capital.
Clearly, countries which have a credit system and CFC rules similar to the United Kingdom, will also be affected by a decision in which it is determined that CFC rules constitute an unjustifiable restriction on the fundamental freedoms. However, there are also other systems to consider. The parent company may be resident in a country providing an exemption for (deemed) dividend distributions. Since such distributions do not lead to taxation in the parent company jurisdiction, CFC rules under an exemption system not only change the timing of taxation of the income in the parent company jurisdiction, but also change the nature of the income from tax-exempt income to taxable income. There can be little doubt that these regimes too would have to be revised, following an ECJ decision in favour of Cadbury Schweppes. However, there is a third category.
Most tax practitioners and authors seem to be in agreement that an exemption regime where the exemption is denied to certain foreign participations, but not moved forward in time, does not qualify as a CFC regime. I disagree, since a) such regimes still deal with Controlled Foreign Companies and b) such legislation in effect is often far worse than the classic forms of CFC legislation, for while it may allow the deferral of income, it generally does not provide for any type of indirect tax credit relief.
So, will a positive decision for Cadbury Schweppes mean that the Dutch participation exemption will require amendment? That would depend on the wording of the ECJ decision and the arguments upon which the decision is based. However, it is difficult to imagine a wording of decision in which CFC legislation is qualified as an unjustifiable restriction on the fundamental freedoms that will not apply to the participation exemption as well. I also refer to the Anneliese Lenz decision described above, and in particular to the ECJ's determination that the prevention of double taxation on a national level, but not within the European Union cannot be an acceptable justification. Therefore, where member countries choose to apply the participation exemption as a form of prevention of double taxation on a national level, regardless of the activities of the resident subsidiary, a decision in favour of Cadbury Schweppes would be another reason for member states to apply their participation exemptions at least to subsidiaries in other member states and possibly - under the free movement of capital - to subsidiaries outside the European Union.
In the case of Lankhorst Hohorst (Case C-324/00) most E.U. member states affected by the decision reacted by introducing thin capitalisation rules not only in cross border situations, but also in pure national situations. Denmark even responded with legislation guaranteeing double taxation in many cases of related party financing, thereby forcing investments out of the country to, among others, neighbouring Sweden. Only Spain reacted by abolishing its thin cap legislation. The question is whether a similar solution would work for CFC legislation and the, rather obvious, answer seems to be "no". First, we will not be able call it Controlled Foreign Company legislation, but then, what's in a name. More important is that it will make no sense, because there can hardly be deferral in case of a local subsidiary, whereby the current minimum taxation exemption will always apply. Therefore, such legislation will continue to affect only foreign subsidiaries and remain unjustifiable restrictions, just like conditions regarding language skills or nationality tend to constitute indirect restrictions on the fundamental freedoms.
Whether other solutions are available will depend on the arguments of the ECJ. If CFC rules constitute an unjustifiable restriction on the fundamental freedoms, it is difficult to imagine other available solutions. However, if the ECJ holds that there could be justifiable restrictions, provided they are effective and do not go beyond the goals they set out to attain, then there is hope for those member states wishing to hold on to their CFC regimes. Following cases like the recent Hughes de Lasteyrie du Saillaint (Case C-09/02) or the more distant Leur Bloem (Case C-28/95), this would most likely entail applying CFC rules much more on a case by case basis (no CFC rules, unless there is abuse) and most possibly entail moving the burden of proof from the taxpayer to the tax authorities (E.U. citizens should not have to prove their right to the fundamental freedoms). Furthermore, member states would have to extend their CFC regimes (or narrow down the goals they wish to achieve) such that the regimes cannot be said to be ineffective because it allows taxpayers to achieve the same results through other structures.
The one other big case we are now waiting for is the one arguing that any measure under national law (thin cap rules, other restrictions on interest deductions, transfer pricing) wilfully leading to double taxation constitutes an unjustifiable restriction on the fundamental freedoms, which hinders the steady expansion, balanced trade and fair competition within the European Union. Will such a case be the ultimate proof that the ECJ is "out of control"? I think not: we are talking about trying to abolish double taxation through European law. I do not think that it is the ECJ that is "out of control".