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Recovery of Unlawful State Aid - Multinational Companies and the CFC Rules in the UK

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Following an investigation opened in October 2017, the European Commission ("EC") has concluded that the UK's policy (from 2013-2018) of allowing total or partial exemption for non-trading finance profits from the UK Controlled Foreign Company ("CFC") rules in part constituted unlawful State aid. As a result, the UK must now recover that "aid" from UK corporates with offshore group finance subsidiaries which benefited from the relevant exemption.

This decision follows a general EC review of Member State tax rulings over the past few years. Tax avoidance is one of the EC's top regulatory priorities given its potential to threaten fair competition. The EC has left it to the UK to determine the amount and the companies involved on a case-by-case basis. However, there are reports that the total amount at stake exceeds £1 billion.

In a post-Brexit world, it remains to be seen whether the UK's Competition and Markets Authority (the "CMA") will adopt a similar approach to the treatment of UK tax exemptions. This will depend on the terms of exit, although the CMA has indicated a commitment to replicating EU State aid rules under national law. It could therefore apply the same considerations in determining whether particular exemptions create a situation of selective disadvantage between multinational and domestic companies where both generate profits from UK activities.

Background to the CFC rules and the application of the Group Financing Exemption

The UK CFC rules are an anti-avoidance measure. They are designed to prevent UK companies from artificially shifting profits into foreign subsidiaries that are located in low or no tax jurisdictions, avoiding the payment of UK tax.

Under the rules as they applied until 1 January 2019, the non-trading profits of a CFC which were derived from intra-group lending could be subjected to UK tax in the hands of a UK parent company where (in particular) those offshore profits: (i) were attributable to UK activities ("UK activities"); or (ii) were attributable to loans financed with funds or assets deriving from capital contributions from the UK ("UK connected capital").

However, those CFC rules included a total or partial (75%) exemption from the UK CFC charge for certain non-trading finance income of a CFC which was derived from loan relationships with non-UK group members (the "Group Financing Exemption"). This exemption applied by election, and covered qualifying income of an offshore group company that would otherwise have been caught by the CFC rules - so even where it involved UK activities or UK connected capital.

Distinguishing between lawful and unlawful State aid

In its decision, the EC distinguished between the application of the Group Finance Exemption to circumstances involving profits from UK activities and profits from UK connected capital. That is, they concluded that the Group Financing Exemption for finance income of an offshore subsidiary:

  • did not constitute unlawful State aid where the income was derived solely from UK connected capital with no UK activities involved. In its view, the Group Finance Exemption could be justified in those circumstances due to the "disproportionately burdensome" tracing exercise this would impose; but
  • did constitute unlawful State aid where the income was derived from UK activities on the basis that it should be straightforward to determine the proportion of income deriving from UK activities.

The application of the Group Financing Exemption in this way created a selective advantage. The "aid" amounted to the benefit received by certain multinational companies in the form of an exemption not available to UK-based companies in the same or similar position (e.g., generating and using profits from UK activities).

The Group Finance Exemption was amended with effect from 1 January 2019 to comply with the Anti-Tax Avoidance Directive. That amendment removed the Group Finance Exemption for non-trading finance profits derived from UK activities and the EC has confirmed that the UK CFC rules will not raise further EU State aid concerns as a result.

Practical implications

This decision has serious ramifications for UK corporation taxpayers that had group companies falling within the CFC rules between 2013 and 2018. All the non-trading finance profits of such CFCs generated by UK activities (and which previously fell within the Group Finance Exemption) are now, in effect, retrospectively subject to the CFC charge at the applicable historic rate plus compound interest. Over the affected period, corporation tax rates ranged from 19% to 23%.

Those taxpayers that may be affected will need to consider to what extent the relevant finance income was attributable to UK activities. In particular, this will mean considering whether and to what extent UK personnel have been involved in decisions relevant to the assumption and management of the relevant financing risks and assets, and their economic ownership.

Any affected taxpayer with a group financing subsidiary established within the European Economic Area would have a strong argument against any such charge on the basis it represents an unlawful restriction on freedom of establishment, in line with the ECJ's decision in Cadbury Schweppes. For group financing subsidiaries located elsewhere, there may be other grounds for appeal.

Any taxpayer wishing to consider an appeal to the General Court should be aware that the time limit for doing so is short, and expires two months from the date on which the EC's decision is published in the Official Journal. It is worth noting, however, that an individual taxpayer can only appeal the amount to be recovered (as set by the UK government) in a national court.

It is not yet clear whether the UK government itself will seek to appeal the EC's decision. But given that it does not appear to sit well with the ECJ's view of CFC rules as expressed in Cadbury Schweppes, this is possible. Under the principles expressed in that case, for instance, it is arguable that the profits of an offshore treasury company should not be subject to a CFC charge at all.

Even if the UK government decides to make such an appeal, the UK will likely still need to recover the alleged aid, pending the outcome of any legal proceedings: requests to suspend implementation of EC decisions in these cases are not typically granted by the General Court. Moreover, even if the UK were to leave the EU without a withdrawal agreement, the UK is unlikely to ignore its recovery obligation (despite the EC's enforcement powers in such a scenario being unclear).

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