At long last, the European Commission has announced the final decision in its state aid investigation into the UK’s controlled foreign company (CFC) rules – in particular the finance company exemption / partial exemption within the CFC regime. The decision is a nuanced one, and clearly reflects a rather better understanding of the proper function of the exemption within the wider CFC regime.
Nevertheless the decision may still leave some affected taxpayers with material liabilities, and will certainly spell continued uncertainty for many. In broad terms, the decision (as it stands) will require taxpayers to demonstrate adequate substance in their CFCs’ foreign lending operations. This is anyway necessary for 2019 onwards, but was not previously a requirement in the domestic rules.
Prohibited state aid, but only in some cases
The CFC regime introduced in 2012 operates by reference to ‘gateways’, through which CFC income must ‘pass’ if it is potentially to be subject to CFC tax. For non-trading lending activity in low-taxed CFCs, income can pass through a relevant ‘sub-gateway’ either if the capital being deployed has been sourced from the UK part of the group, or if the ‘significant people functions’ (SPFs) in respect of the lending activity are located in the UK. Formerly, the exemption challenged by the Commission could prevent income on certain loans (broadly, loans to other non-UK members of the relevant group) from passing through either sub-gateway. From 1 January 2019, the exemption only protects against the ‘UK capital’ sub-gateway, and not the ‘UK SPFs’ one.
In its opening decision (available here), the Commission focused on the ‘UK capital’ aspect. As many (including the UK government) have argued, this betrayed a fundamental misconception about the underlying purpose of the CFC regime, and the way its different components interact to achieve that purpose. Taken together, the ‘UK capital’ sub-gateway and the finance company exemption / partial exemption can be seen to target artificial erosion of the UK tax base in a coherent (and administratively workable) way. Hence so-called ‘foreign to foreign’ lending by a CFC is treated favourably, but UK base-erosive upstream lending is not.
In its final decision, the Commission seemingly has accepted those arguments. However, it has nevertheless concluded that the exemption constitutes unlawful state aid, but only to the extent that it protects against the ‘UK SPFs’ sub-gateway. In effect, therefore, the Commission’s view is that the rules should always have been as they now stand. That is certainly rather less politically explosive than the opening decision’s provisional conclusion that the exemption was flawed in its entirety: indeed, taxpayers might on this basis hope to take some comfort from the fact that HMRC did not expect the 1 January 2019 changes to have a significant impact. (It also elegantly dodges an elephant in the room, in the form of the CJEU decision in Cadbury Schweppes (Case C-196/04). There is – to put it at its lowest – a very good argument that applying the ‘UK capital’ sub-gateway without the exemption, as the opening decision would have required, could actually breach taxpayers’ fundamental EU Treaty right to freedom of establishment.)
It will be interesting to read the Commission’s reasoning when the decision itself is published (which will take at least a few weeks). The conceptual underpinning for the ‘UK SPFs’ side of the rules is certainly less obvious: if, for a CFC’s loan asset, artificial diversion of UK profits can be tested by looking at where the CFC’s capital came from and what it does with it, then why should it matter at all where the SPFs (which might be quite limited for such intra-group activity in any event) are located? But a mere lack of coherence in the tax code cannot suffice to show state aid (or the Commission would truly have its work cut out!). And in particular, here, it is not immediately obvious how the exemption (in its original form) is said to have given particular taxpayers a potentially unlawful ‘selective advantage’. Over whom were they advantaged, exactly, and how?
Next steps
The Commission has (as we would expect) ordered the UK to recover the unlawful state aid. Ordinarily, this would be required within four months; but since quantifying the aid will require a case-by-case testing of the extent to which the income in question would (absent the exemption) have passed through the ‘UK SPFs’ sub-gateway, it is hard to see that that is realistic. (Interestingly, the press release does not mention the four month deadline.) Nevertheless taxpayers will need urgently to prepare themselves for that case-by-case testing of the SPFs position.
We do not yet know how the UK government will react to the decision. In particular, will the UK seek to annul the decision through litigation (initially before the General Court, then the CJEU)? It has 2 months and 10 days to decide. Or might the UK be tempted to accept the more limited scope of the final decision? Affected taxpayers could still litigate themselves, even if the UK government does not. (Time is short, but for taxpayers the ‘2 months and 10 days’ clock will only begin to run when the decision is published in the Official Journal.)
Perhaps even more importantly, how will HMRC approach the process of recovery? This will have to proceed, regardless of any EU litigation. The key question, plainly, will be how HMRC apply the ‘UK SPFs’ sub-gateway to intra-group lending activities. But there will be plenty of other points of detail to deal with too, both procedural (will HMRC re-open self-assessments, and if so on what basis?) and substantive (will affected taxpayers be able to bring other tax attributes to bear to reduce any recovery amount?).
Last but not least, how might Brexit affect things? The Commission’s press release pointedly notes that the state aid rules continue to apply to the UK ‘until it is no longer a member of the EU’. The terms of the Withdrawal Agreement would certainly require the UK to implement this decision as if it had not left the EU. But if there is a ‘no deal’ departure, then all bets are off.
The Commission’s press release announcing the decision is available here.
