On 26 October 2017 the European Commission announced that it had opened a State aid investigation in relation to the UK's Controlled Foreign Company (CFC) rules and specifically, the group financing exemption under the rules. Should the Commission conclude that the group financing exemption represents incompatible State aid, it will order recovery from all companies that have benefitted. In light of current timing, the progression and ultimate determination of the Commission's investigation is unlikely to be impacted by Brexit.
The Commission will in due course publish its decision opening the investigation (opening decision), setting out its detailed reasoning as to why it considers that the group financing exemption may represent State aid. Interested parties, including those companies that could be affected, will have an opportunity to provide comments on the decision, and contest the Commission's case.
1. The UK CFC Rules and the Group Financing Exemption
The UK CFC rules were introduced to address the potential artificial diversion of profits to lower-tax jurisdictions by multinationals using group companies. When a group company is designated as a CFC, all the profits of that company for UK tax purposes are apportioned to its UK shareholders and are therefore subject to taxation in the UK (the CFC charge). Similar anti-avoidance rules are a common feature of many tax systems and under the EU's Anti-Tax Avoidance Directive, all EU Member States are required to implement CFC rules by 1 January 2019.
In January 2013, the UK CFC rules were revised and relaxed in a number of ways, including through the addition of the group financing exemption, which facilitated intra-group financing arrangements by multinationals. Under the group financing exemption, the profits of CFCs that are intra-group financing companies could be either partially or fully exempt from the CFC charge.
2. The Commission's Investigation
The Commission press release announcing the investigation explains that as a result of the group financing exemption, multinationals active in the UK can provide financing to a foreign group company via an offshore subsidiary and then pay little or even no tax on the profits from those transactions. This is because the offshore subsidiary pays little or no tax on the financing income in the country where it is based and the offshore subsidiary's financing income is also not (or only partially) reallocated to the UK for taxation due to the group financing exemption.
Based on the press release it would seem that the Commission's concern is that the group financing exemption provides a "selective advantage" for State aid purposes in favour of those multinationals engaging in intra-group financing activities as compared to those multinationals that do not. There is only limited information in the press release, however the Commission will in due course publish a non-confidential version of its opening decision, setting out the detailed reasoning underlying its concerns.
While Commission State aid investigations have no hard deadline, they do not generally extend beyond 18 months to two years and indeed many similar investigations have been completed in significantly shorter timeframes.
Should the Commission ultimately confirm the position in its opening decision and conclude that the group financing exemption represents incompatible State aid, it will require the UK to recover unpaid tax (including interest) from all beneficiaries.
The UK investigation is the latest in a line of recent high-profile enforcement activity by the Commission addressing the tax practices of EU Member States in relation to multinationals' tax planning arrangements. The majority of these cases have focused on specific tax rulings issued by EU Member States to individual multinationals, including Amazon, Apple and Starbucks, among others. However the Commission has also targeted broader tax schemes, notably the so-called "excess profit" tax scheme implemented by Belgium, in which at least 35 multinationals participated. Most of these decisions have been appealed by the Member States as well as the beneficiaries concerned and the cases remain pending in the EU courts.
The UK investigation however appears to differ from those cases. While the Commission's existing cases concerned whether the Member States' tax treatment deviated from the so-called "arm's length principle" (as interpreted by the Commission) or resulted in so-called "double non-taxation", the UK investigation involves simply an exemption from a generally applicable anti-avoidance rule that relates to specific activities, namely intra-group financing. One of the main questions in the UK investigation will likely be whether the exemption can be justified – this will be assessed in light of the overall objective and nature of the UK CFC rules.
The timing of the Commission's investigation may at first glance appear slightly curious given that the group financing exemption at issue was introduced by the UK nearly four years ago. Indeed, in the Commission's 2014 draft interpretative notice on the notion of State aid, the Commission had already stated that it considers derogations from anti-avoidance rules for specific undertakings or transactions may be selective (which was repeated in the Commission's final interpretative notice in 2016). The timing could be connected to the recent landmark judgment of the Court of Justice of the EU (CJEU) in the World Duty Free case handed down in December 2016 which arguably expanded somewhat the notion of "selective advantage". In the World Duty Free case the CJEU confirmed that measures providing for benefits conditioned on certain behaviours or activity would give rise to a selective advantage, notwithstanding that any company might have been able to undertake that activity. It is possible that the Commission may have been waiting for the outcome of this case before pursuing more cases that involve this so-called "behavioural selectivity".
The timing of the Commission's investigation is also significant in the broader context of Brexit and it indicates that the Commission is prepared to enforce fully the State aid rules against the UK for the time being. Indeed the press release pointedly states that so long as the UK is an EU Member State, it has all of the rights and obligations of EU membership, including the obligation to abide by the EU State aid rules.
The status of ongoing EU administrative actions, such as EU State aid investigations, forms part of the Brexit negotiations, the results of which remain uncertain. In these circumstances, there will likely be pressure for the Commission to complete its investigation before the UK exits the EU, which is currently envisaged to be on 30 March 2019. This should be quite achievable given the duration of State aid procedures as explained above. By way of recent example, the Commission's investigation in the Belgian excess profits tax scheme case, which like the UK investigation involved a tax scheme with multiple beneficiaries, took around 11 months.
4. Next Steps for Affected Companies
The Commission will publish its opening decision once a non-confidential version is agreed with the UK. Interested parties, including those companies that have benefitted from the group financing exemption, will have a month from the date of publication in the EU Official Journal to provide comments and to contest the Commission's case. The Commission will need to take into account all relevant comments in coming to its final decision.
The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.
© Herbert Smith Freehills 2020