Yesterday the EU General Court delivered its judgement in the Controlled Foreign Company (CFC) state aid case. Both the UK government and affected businesses will be disappointed: the court has upheld the EU Commission’s decision that the CFC rules conferred state aid, rejecting all of the counter-arguments put forward by the UK and affected taxpayers.
What are the rules in issue?
The CFC rules are aimed at protecting the UK’s corporate tax base. They work by taxing UK parent companies on the profits of their low-taxed foreign subsidiaries (i.e. CFCs) that have been diverted from the UK.
The Commission’s 2019 decision concerned an aspect of the rules in place between 2013 and 2018 that dealt with profits earned by CFCs from lending activity, known as Non-trading Finance Profits (NTFPs). The rules tax a CFC’s NTFPs where either the CFC is funded with UK-sourced capital or where the key decision-making functions (Significant People Functions, or SPFs) relating to the loans are made in the UK.
The rules draw a distinction between:
- NTFPs arising from loans to third parties or to UK connected parties, 100% of which are apportioned to and taxed on the parent; and
- NTFPs from lending to connected parties outside the UK (known as Qualifying Loan Relationships, or QLRs), only 25% of which are apportioned.
This distinction is intended to reflect the relative risk of diversion in each case.
Equity-funded CFC loans to third parties (or back to the UK) are seen by the rules as uncommercial arrangements, where all of the NTFPs have been diverted from the UK.
In contrast, QLRs are seen as having the legitimate purpose of funding foreign operations. The rules object only to that funding being provided solely as an equity contribution to a CFC – which does not give rise to taxable returns in the UK – which then passes the capital on as debt, earning taxable interest. They instead seek to treat the UK parent as if it funded the CFC with a mixture of debt and equity in a 1:3 ratio. That is equivalent to imputing 25% of the CFC’s NTFPs to the UK parent.
What did the Commission decide?
Following an investigation, in 2019 the Commission concluded that the rule requiring only 25% of the NFTPs arising from QLRs to be apportioned was a state aid.
They argued that:
- the CFC rules were a coherent framework for taxing UK companies in respect of their subsidiaries’ profits;
- the QLR rule was a derogation from that reference system; and
- that stood to distort intra-EU trade by selectively benefiting multinational businesses that were parented in the UK.
The Commission rejected the UK’s view that the different treatment of QLRs reflected differing levels of profit diversion. They accepted that the 25% apportionment could be partly justified in relation to loans funded with UK capital, on the grounds that tracing the source of capital is administratively difficult and the apportionment was an appropriate simplification. However, they did not agree that justification extended to loans with UK SPFs.
The General Court decision
The UK government and a number of affected businesses applied to the EU General Court to annul the Commission’s decision.
The annulment applications raised the core point about selectivity described above, arguing that the Commission had misunderstood the way that the CFC rules worked as a whole to identify diverted profits. They also raised several other arguments including that:
- the Commission had erred in identifying the CFC rules, rather than the wider UK corporation tax system, as the appropriate reference system;
- the rules around QLRs did not affect cross-border trade;
- the administrative simplification justification should extend to all NTFPs; and
- the Commission had given insufficient weight to the challenges the UK faced in designing a CFC regime that complied with EU law on freedom of establishment.
In the context of the Commission having recently lost several other high-profile tax state aid cases businesses and the government were cautiously optimistic. However, the General Court ruled comprehensively in favour of the Commission.
The grounds of appeal concerning reference system identification and the effect on cross-border trade were always likely to be difficult to sustain, however it is perhaps surprising that the court dismissed the EU law argument so readily. When the current CFC rules were designed in 2012 it was far from certain that they would be safe from challenge on freedom of establishment grounds – arguably the Commission and the court are assessing the rules with the benefit of hindsight.
The UK government will be reflecting on the decision and pondering its next move. It is likely to disagree fundamentally with the General Court’s reasoning and characterisation of the CFC rules and will be considering appealing yesterday's judgment to the Court of Justice of the European Union (CJEU) – a move which would no doubt be favoured by affected businesses.
Pending resolution of the annulment application HMRC was required to recover the alleged aid from affected companies and has done so. However, there is still considerable uncertainty about how UK SPFs should be identified and the aid quantified in individual cases. Most businesses that received recovery notices from HMRC therefore made protective appeals in order to preserve their ability to challenge the quantification in the domestic courts, while hoping that a positive result in the annulment process would mean that was unnecessary. If the Commission’s decision is ultimately upheld groups with material amounts at stake are likely to want to pursue those appeals.
The issue of quantification is not purely a legacy matter. From 1 January 2019 the CFC rules were amended to require 100% apportionment rule in relation to loans with UK SPFs. Any clarification from the UK courts about how those SPFs should be identified will therefore affect how HMRC applies the rules in the future, and may provoke groups to consider restructuring or changing their arrangements.
Despite the decision there is therefore still considerable uncertainty about how businesses will ultimately be impacted – perhaps the only certainty is that a final resolution will not come quickly.