The European Commission has published a summary of its findings in its state aid investigation into the U.K.’s controlled foreign company (CFC) finance company exemption. Although the Commission did not find the entirety of the finance company exemption to constitute unlawful state aid, it did find certain aspects of this regime to be unlawful.
Under EU law the U.K. is required to take steps to recover this from recipients. We await publication of the full text of the Commission’s decision, and an announcement from the U.K.’s tax authority, HM Revenue & Customs (HMRC), as to what form recovery action will take and whether it intends to appeal the decision.
With effect from January 1, 2019 the finance company exemption has been amended, and as a result the Commission’s decision is only of relevance to groups which relied on certain aspects of the finance company exemption prior to that date.
What is State Aid?
The Commission describes state aid as arising when “a company which receives government support gains an advantage over its competitors.” State aid is any economic advantage granted by an EU member state (or through state resources) which favors certain companies or market sectors, and therefore distorts competition on the market.
Under EU law, the grant of state aid is, in principle, unlawful unless an exemption is available. The Commission enforces EU state aid rules, and can require EU member states to recover any unlawful aid from relevant recipients with interest. Examples of state aid include selective public subsidies, capital injections, loans, and guarantees on preferential terms.
Since 2013, the Commission’s Directorate-General for Competition has been carrying out a number of extensive state aid investigations into tax practices of various EU member states. Over the last five years, the Commission has scrutinized over 1,000 tax rulings and numerous tax measures, and has ordered the recovery of approximately 15 billion euros ($16.8 billion) of undue tax benefits.
In the context of corporate taxes, some high profile state aid cases have held that various governments were in effect providing benefits to large multinational groups that smaller groups would not have had the resources to access.
CFC Finance Company Exemption
The U.K.’s CFC rules, contained in Part 9A of the Taxation (International and Other Provisions) Act 2010 (TIOPA), were substantially reformed with effect from January 1, 2013 with the aim of targeting only foreign profits artificially diverted from the U.K.
One of the major changes was to introduce an exemption from the CFC charge for the profits of non-U.K. group finance companies, which may be located in low-tax or no-tax jurisdictions (the Exemption) which would otherwise give rise to a charge under the CFC rules.
Broadly, the Exemption applies to exempt either 75 percent (partial exemption) or 100 percent (full exemption) of the profits of such group finance companies from the CFC charge. This enables U.K. companies to finance foreign group companies via offshore subsidiaries acting as group finance companies, paying little or no U.K. tax on the resulting profits of financing transactions. The level of exemption available depends on a number of factors, including the source of funding for the group finance company.
This approach was justified in HMRC’s guidance on the basis that it addressed “…the difficult issues which arise as a result of the fungibility of money within a multinational group. The rules represent to a large extent a proxy for establishing the exact source and history of a group’s financing arrangements and the extent these are borne by the UK.”
From the introduction of the reformed CFC rules in 2013 until December 31, 2018, the Exemption was available in respect of the profits of group finance companies which would otherwise have been subject to the CFC charge because they derived from significant people functions undertaken in the U.K. or activities financed by funds sourced in the U.K.
However, the availability of the Exemption in circumstances where finance profits derived from U.K. significant person functions was incompatible with the requirements of the EU Anti-tax Avoidance Directive (ATAD) (Council Directive (EU) 2016/1164). To ensure the compatibility of the CFC rules with ATAD, with effect from January 1, 2019 the Exemption is now is only available in respect of profits not derived from U.K. significant people functions.
EU State Aid Investigation into U.K. CFC Rules
In October 2017 the European Commission initiated a formal investigation into the Exemption and its compatibility with EU state aid rules. Observing that “the general purpose of the [CFC] rules is to prevent UK companies from using a subsidiary, based in a low or no tax jurisdiction, to avoid taxation in the UK,” the Commission said that it had doubts that the Exemption was “consistent with the overall objective of the UK CFC rules.”
The Commission questioned the U.K.’s position that inter-company financing arrangements carried a lower risk of artificial diversion of profits than third party financing and so justified more lenient CFC treatment (in the form of the Exemption).
The Commission considered the Exemption to constitute a derogation from the general scheme of the U.K.’s CFC rules. In assessing whether the Exemption was justified, the main concerns raised by the Commission can be summarized as follows.
- The Commission questioned whether the use of a fixed 25 percent inclusion/75 percent exclusion of finance profits where groups qualified for the partial exemption was a justifiable proxy to counter excessive U.K. capitalization of group finance companies, leading to artificial diversion of profits.
- The Commission questioned whether it was justifiable to conclude that profits were not artificially diverted from the U.K. and so fully exempt from the CFC charge if the activities generating the profits were funded from “qualifying resources” (which could include the proceeds of an issue of shares by a U.K. company applied in capitalizing a group finance company). The Commission suggested this was contrary to the general scheme of the U.K. CFC rules, which in all other areas looked to the existence of U.K. significant people functions when identifying whether profits were artificially diverted from the U.K.
Findings of the European Commission
The Commission has not yet published the full text of its decision. However, in its press release summarizing its conclusions the Commission has stated only certain aspects of the Exemption constitute unlawful state aid. This is in contrast to the Commission’s initial investigation in 2017 which indicated that the entire Exemption may be unlawful.
The Commission has stated that it considers the Exemption to be justified in circumstances where the profits of a group finance company are not derived from U.K. activities. Where profit-generating activities are carried out in the U.K. (for example, where investments were managed from the U.K. or other U.K. significant people functions are carried on), the Commission considers the Exemption to constitute unlawful state aid by giving “certain multinationals a selective advantage by granting them an unjustified exemption from UK anti-tax avoidance rules.”
To qualify as state aid, a state measure must be “selective”; it must favor “certain undertakings or the production of certain goods.” In the present case, the Exemption was available, at least on its face, to all companies meeting certain criteria, and was not formally reserved to companies active in a given sector or region.
In Heitkamp v Commission (Case T-287/11) the EU General Court found that a general tax measure may be selective if “the measure at issue differentiates between operators which are, in the light of the objective pursued by that regime, in a comparable factual and legal situation” (although this case has been criticized as obscure and inherently difficult to apply).
However, the rules on selectivity in such circumstances are unclear and there is no consensus on their application among the EU member states, the Commission, and the EU courts.
What Happens Next?
The Commission has ordered the U.K. to identify the companies that received allegedly unlawful state aid pursuant to the Exemption, and to recover the undue tax benefits arising from the Exemption together with interest.
The Commission is likely to specify a time limit for the execution of the recovery order, which in the majority of cases is two months (extendable by another two). However, we expect that the recovery process in the current case may be significantly longer because the U.K. has not adopted specific legislation to establish a process for recovering unlawful state aid.
The quantification of allegedly unlawful state aid in respect of each affected group is likely to require a complex and lengthy case-by-case assessment.
It is unclear what effect the U.K.’s potential departure from the EU will have in this area. Although the U.K. government’s current stated position is that the U.K. will continue to comply with EU state aid rules, it may be difficult, if not impossible, to compel the U.K. to implement the Commission’s recovery order following the U.K.’s potential departure from the EU (in particular, in a “hard Brexit” scenario).
The Commission’s decision is considered to be of primary relevance to groups which relied upon the Exemption between 2013 to 2018, but have been unable to do so since the January 1, 2019 change, or which have historically relied on the exemption in cases where finance profits are derived from U.K. significant people functions.
Affected groups should, in the first instance, consider the extent to which they are affected by the Commission’s decision. They have, in principle, three defense options.
First, they may directly appeal the Commission’s decision in the EU General Court in Luxembourg.
An appeal (“action for annulment”) in the EU General Court can be brought within two months and 24 days from the publication of the Commission’s decision in the Official Journal of the European Union (OJ).
For an appeal to be admissible, prospective appellants must show that they are directly and individually concerned by the contested decision, which in practice would require a detailed explanation of the reasons why they consider that they have to repay allegedly unlawful state aid as a result of the decision.
An appeal can result in the annulment of the Commission’s decision in whole or in part. Grounds of appeal include procedural irregularities in the Commission’s decision, legal errors or errors of assessment.
It is not uncommon for the EU General Court to annul the Commission’s state aid decisions. For example, in February 2019 the EU General Court annulled a Commission decision finding that a Belgian tax measure (the “excess profit scheme”) constituted unlawful state aid.
It did so on the basis that the Commission had wrongly identified the domestic statutory measure to be an aid scheme, because any such aid necessarily required further implementing measures (including the case-by-case consideration of the facts by the Belgian tax authority and the issuance of a ruling) (Case T-131/16, Belgium v Commission, and T-263/1, Magnetrol International v Commission).
Making an appeal does not suspend the effect of the Commission’s decision and so would not generally preclude HMRC from pursuing recovery of state aid. Appellants can request that the effect of the contested decision be suspended pending the outcome of the appeal, but this form of relief is rarely granted by the EU courts.
Second, affected companies may intervene in support of any appeal against the Commission’s decision by the U.K. government. An application to intervene must be made within six weeks from the publication of the notice of such an appeal in the OJ, and prospective interveners must show that they are affected by the contested decision.
Third, affected companies may seek to challenge the U.K. recovery proceedings in the English courts. This is considered to be an option of last resort, as the Court of Justice of the European Union has previously held that alleged recipients of unlawful state aid who could “without any doubt” have challenged a recovery order in the EU General Court can no longer challenge its validity in national proceedings (see, for example, Case C-188/92, TWD Textilwerke Deggendorf GmbH v Germany).
Potentially affected groups should not wait for HMRC to open inquiries or raise assessments further to the Commission’s decision and should independently confirm any state aid exposure as soon as possible. This will enable them to make an informed and timely decision as to whether and how to challenge the Commission’s decision.
Kate Habershon is a Partner and Neil McKnight and Leonidas Theodosiou are Associates with Morgan Lewis in London.