The Inward Investment and International Taxation Review: European Union

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1 The Inward Investment and International Taxation Review: European Union 1 Briefing note March 2012 The Inward Investment and International Taxation Review: European Union Introduction and overview This chapter considers the interaction of European Union ( EU ) law with the corporate income tax systems of EU Member States. 1. What is the EU? For those unfamiliar with the EU and its institutions, a word on this may be helpful background. This article was first published in The Inward Investment and International Taxation Review, (published in January 2012 editor Tim Sanders). The EU is not a federation like the United States. Nor is it simply an organisation for cooperation between governments, like the United Nations. The countries that make up the EU ( the Member States ) remain independent sovereign nations but have pooled their sovereignty in a number of agreed but strictly limited areas. One area of persistent tension between Member States (and in certain cases within Member States) is the battle between those seeking a more federal union with greater harmonisation of laws (including tax laws) and those seeking a looser federation who see even the existing harmonisation as too great a drag on national self-determination. The precursors to the EU started in the 1950s with relatively loose cooperation between six European states and has gradually added new members and increased the level of cooperation. There are now 27 EU Member States: Austria, Belgium, Bulgaria, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden and the United Kingdom. The key (current) EU treaties are the Treaty on European Union (the TEU) and the Treaty on the Functioning of the European Union ( the TFEU ). The European Economic Area ( the EEA ) consists of the EU Member States together with Iceland, Liechtenstein and Norway. The key EEA treaty is the Agreement on the European Economic Area ( the EEA Agreement ). EEA members benefit from and are subject to the same fundamental freedoms as EU Member States (see infra) but EU law does not apply in full to EEA members that are not EU Member States. 2. EU institutions The key EU institutions are, so far as tax is concerned, the following: The Council of the EU The Council is the EU s main decision-making body. It represents the Member States, and its meetings are attended by one minister from each of the EU s national governments. The Council is also the legislative body that adopts EU measures. The European Commission The Commission is the EU s executive arm. It is responsible for implementing the decisions of Parliament and the Council. That means managing the day-to-day business of the European Union: implementing its policies, running its programmes and spending its funds. The Commission is the body responsible for initiating EU legislation. The European Parliament The Parliament must be consulted on many legislative measures, including in the area of direct taxation. The Parliament

2 2 The Inward Investment and International Taxation Review: European Union may also ask the Commission to put forward legislative proposals. The European Court of Justice The European Court of Justice ( the ECJ ) is effectively the judicial arm of the EU. Its role is to make sure that EU legislation is interpreted and applied in the same way in all EU countries. The ECJ is composed of one judge per Member State. The ECJ usually sits as a Grand Chamber of 13 judges or in chambers of five or three judges. Cases (including tax cases) can reach the ECJ in one of two ways: (a) national courts and tribunals can refer points of EU law to the ECJ for determination (b) the Commission can bring infringement proceedings against Member States before the ECJ. 3. Interaction of direct tax rules of Member States and EU law Strictly speaking, direct tax remains within the competence of Member States. Direct tax is not generally a matter which is subject to harmonisation at EU level. One might have therefore thought that there would be no conflict between EU law and the direct tax systems of Member States. However, such an approach would overlook two critical points. The first is that Member States must exercise their taxing rights in accordance with the principles set out in the EU treaties, in particular the TFEU. The second is that there is legislation at EU level that harmonises the direct tax rules of Member States in a number of limited areas. 4. Supremacy of EU law and direct effect/direct application; remedies The following rules of EU law are critical to understanding the interaction of national tax laws and EU law: First, EU law has supremacy over national law. Therefore, national tax laws must be effectively set aside (or disapplied ) to the extent that those rules are contrary to EU law. Second, national law must, to the greatest extent possible, be interpreted so that it is consistent with EU law. If such an interpretation is not possible, the national law rule must be set aside. Third, EU law contained in the EU treaties (and also, generally, in EU secondary legislation such as Directives) has direct effect or direct application. This means that taxpayers are able to rely on EU law in national proceedings (such as before competent courts or tribunals dealing with tax disputes) and, in addition, that organs of state (including national tax authorities) are bound to act in accordance with EU law. Fourth, national courts are also obliged to give effect to EU law, including ensuring the adequacy of remedies for breaches of EU law. There are two key principles here. The first is the doctrine of equivalence ; that is, the remedies for breach of EU law must be no more limited than the remedies available for breach of national laws. The second is the doctrine of effectiveness ; that is, the remedies for breach of EU law must be such so as to ensure that the exercise of EU law rights is not rendered impossible or excessively difficult. 5. Direct tax rules and fundamental freedoms; the single market One key aspect of the EU is that it establishes a single market (often referred to as an internal market ), whereby effectively all of the Member States operate as a single market rather than as a number of different markets with their own national borders. In order to give effect to the single market concept, the EU treaties place Member States under various obligations; in particular, Member States are prohibited from imposing restrictions on the freedom of establishment, 1 the free movement of services, 2 and the free movement of capital and payments, 3 which are together (with other freedoms, such as the free movement of persons) known as the fundamental freedoms. Also, the free movement of capital and payments can, at least in certain circumstances, apply not just to such movements between Member States, but also to such movements between Member States and non-eu countries. All of the other fundamental freedoms apply (in all circumstances) only between Member States; they have no extra-territorial application Article 49 of seq of the TFEU. Article 56 of seq of the TFEU. Article 63 of seq of the TFEU.

3 The Inward Investment and International Taxation Review: European Union 3 The ECJ s mantra is that, while direct taxation falls within the competence of Member States, the Member States must exercise that competence consistently with EU law (particularly the fundamental freedoms enshrined in the TFEU). The ECJ s case law indicates that there are two conceptual situations in which Member States must be prohibited from undermining the fundamental freedoms: (a) host state situations: Member States must not introduce measures (including tax) that discriminate against undertakings, employees or capital from (generally) other Member States (b) home state (or origin state ) situations: Member States must not introduce measures (including tax) that constitute a barrier to the exercise of the fundamental freedoms, or that make the exercise of those freedoms less attractive, by their own nationals in (generally) other Member States. Early cases such as Bachmann (decided in 1992) suggested that taxpayers could expect little from the ECJ in the field of direct tax. However, from the early 2000s when seminal cases such as Metallgesellschaft were heard, there has been a rapidly growing body of case law, with the ECJ increasingly willing (depending on your perspective) either to intervene to protect the fundamental freedoms or to interfere in national tax law. Inevitably, the ECJ is more federally minded than some of the Member States (or some political parties within them) and certain Member States have been slow to realise the full significance of the fundamental freedoms. Often, cases have involved taxpayers presenting imaginative arguments that challenge long-standing and fundamental national tax rules; these cases can establish principles that apply to many taxpayers. In some instances, national tax authorities have been obliged to compensate large numbers of taxpayers for tax levied contrary to EU law as well as changing direct tax rules prospectively, so that the ECJ s cases have involved very significant amounts of tax. The huge sums involved have made Member States reluctant to admit infringements of the fundamental freedoms have taken place. As a result, the ECJ has now had the opportunity to consider the potential conflicts between national tax laws and the protection of the fundamental freedoms enshrined in EU law in cases now numbering into the hundreds. More recently, it has become clear that the pendulum has swung back somewhat with the ECJ taking a more nuanced approach on these issues. The basic approach taken by the ECJ is as follows: (a) Is there a prima facie restriction on the operation of a fundamental freedom? (b) Are there one or more valid justifications for the restriction? (c) If the justifications are valid, does the restriction go no further than is necessary; or put another way: is the restriction proportionate? The ECJ s recent jurisprudence on tax shows that the ECJ is very willing to rule that there has been a prima facie restriction on the operation of a fundamental freedom, but that it is much more difficult to predict when the ECJ will accept that there is a valid justification and when such justification will be regarded as proportionate. The ECJ has in a number of recent cases ducked that issue. It has set out the parameters of what would be a valid (and proportionate) justification and what would not be, and then said that it is a matter for the national court to determine whether the national tax rules in question fall within those parameters. In principle, though, the case law indicates that (at least in certain circumstances) the following justifications may (by themselves or in combination) be acceptable in principle: (a) the prevention of double reliefs and allowances (b) the balanced allocation of taxing rights between Member States (c) the prevention of tax evasion and avoidance. 5. Direct tax rules secondary EU legislation Legislation at EU level harmonises (to a limited extent) the direct tax rules of Member States in the following areas. The Parent-Subsidiary Directive 4 This Directive eliminates tax obstacles in the area of profit distributions between groups of companies in the EU by abolishing withholding taxes on payments of dividends between associated companies of different Member States and preventing double taxation of parent companies on the profits of their subsidiaries. The directive does not currently apply to 4 Council Directive 90/435/EEC.

4 4 The Inward Investment and International Taxation Review: European Union portfolio investors. In January 2011, the Commission issued a public consultation paper inviting stakeholder responses on, inter alia, its proposal to abolish withholding taxes on cross-border dividend payments to portfolio investors. The Interest & Royalties Directive 5 This Directive eliminates withholding tax obstacles in the area of cross-border interest and royalty payments within a group of companies by abolishing withholding taxes on interest and royalty payments arising in a Member State (and otherwise exempting those payments from taxes in that Member State) where (broadly) the beneficial owner of the payment is an associated person and is a company or permanent establishment in another Member State. Again, the Directive does not apply to payments made to portfolio investors; nor does it apply to payments made to third parties. The Merger Directive 6 This Directive removes fiscal obstacles to cross-border reorganisations (mergers and divisions, exchanges of shares) by effectively providing for deferral of taxes that would otherwise have been charged in a broad range of circumstances. Secondary tax legislation also operates in the area of indirect taxation, such as VAT and capital duties. Specific issues 1. Withholding taxes Withholding taxes on dividends The ECJ has, in a number of cases, considered whether the imposition of withholding tax on outbound dividend payments is contrary to the free movement of capital. (Note that the Parent-Subsidiary Directive 7 will in many circumstances prohibit Member States from imposing withholding tax on outbound dividend payments to associated companies as opposed to portfolio investors ). The current state of ECJ jurisprudence (see, e.g., Commission v. Italy, judgment published in November 2009) is broadly as follows: While resident shareholders and non-resident shareholders in receipt of dividends are not necessarily in a comparable situation, as soon as a Member State imposes a charge to tax on the income of non-resident (as well as resident) shareholders from dividends which they receive from a resident company, the situation of those non-resident shareholders becomes comparable to that of resident shareholders. The exercise by that Member State of its taxing powers, irrespective of any taxation in another Member State, creates a risk that a series of charges to tax or economic double taxation may arise. In such circumstances, the Member State is obliged under the free movement of capital provisions to ensure that non-resident shareholders are subject to the same treatment as resident shareholders. Therefore, differential treatment of outbound dividends as compared to domestic dividends (in cases where domestic dividend payments are in effect exempt from domestic tax (see, e.g., Commission v. Germany, judgment published in October 2011) or the source state subjects outbound dividends to a higher rate of tax than domestic dividends) constitutes a prima facie restriction on the free movement of capital. The source state may in principle ensure compliance with its EU law obligations by concluding a double tax treaty with another Member State. However, this can be achieved only if the treaty in question achieves full compensation for the difference in treatment imposed by the source state (i.e., if the withholding tax imposed by the source state is actually set off in full against the tax due in the residence state). Where the choice as to whether to tax the source state income in the residence state, or the level at which it is to be taxed, depends not on the source state but on the tax rules laid down by the residence state, the infringement of EU law is not Council Directive 2003/49/EC. Council Directive 2009/133/EC. Council Directive 90/435/EEC.

5 The Inward Investment and International Taxation Review: European Union 5 excused. In Commission v. Italy, the ECJ also considered the position with respect to outbound dividends paid to a Liechtenstein shareholder (being a person resident in an EEA country, but not resident in an EU Member State). In those circumstances, the ECJ held that the restriction on the free movement of capital was justified by the desire to combat tax avoidance or evasion, noting in particular that no exchange of information provisions existed in double tax treaties (if any) between Italy (the source state) and any of the non-eu Member State EEA countries (Iceland, Liechtenstein and Norway). A similar analysis applies in relation to countries that are neither Member States nor members of the EEA and which do not have a double tax treaty with the source state in question (see the ECJ s order in the CFC and Dividend Group Litigation, published in April 2008). Withholding taxes on interest In December 2008, the ECJ published its judgment in Truck Center. In this case, the ECJ considered whether the imposition by Belgium of withholding tax on outbound interest payments to an overseas affiliate was contrary to the freedom of establishment, in circumstances where no such withholding would have been imposed on interest paid to a recipient company resident in Belgium. This was the first time that the ECJ had considered whether the imposition of withholding tax on interest payments was contrary to EU law. The ECJ concluded that there was no discrimination on the basis that the application of different taxation arrangements to companies established in Belgium and to those established in another Member State, relates to situations that were not objectively comparable. This was because, when both the borrower and the lender were resident in Belgium, Belgium was exercising taxing rights as the state of residence. In contrast, where the lender (and recipient of the interest) was a non-resident company, Belgium was exercising taxing rights as the state of source. Moreover, even if Belgium did not impose withholding tax on payments made to a Belgian lender, it would nonetheless remain subject to Belgian corporate income tax in the hands of the lender and on the same basis as the lender s other income. Furthermore, a Belgian lender would be directly subject to the supervision of the Belgian tax authorities, which could ensure compulsory recovery of taxes. This would not be the case with non-resident lenders, since in that case recovery of the tax would require the assistance of the tax authorities of the other Member State. The ECJ also held that any difference in treatment did not in any event necessarily procure an advantage for resident lenders. This was because, firstly, Belgian lenders were obliged to make advance payments of corporation tax and, secondly, the amount of withholding tax deducted from the interest paid to a non-resident lender was significantly lower than the corporation tax charged on the income of resident companies which received interest. Consequently, the ECJ held that the imposition of withholding tax on outbound interest payments was not contrary to the freedom of establishment. Note, however, that the Interest & Royalties Directive 8 will in many circumstances prohibit Member States from imposing withholding tax on outbound interest payments to associated persons, irrespective of the ECJ s analysis of the position under the fundamental freedoms. 2. Thin capitalisation and transfer pricing ECJ case law general position There has been a gradual evolution in the ECJ s case law in this area. Lankhorst In December 2002, the ECJ published its judgment in Lankhorst. In this case, the ECJ considered whether Germany s thin capitalisation rules were contrary to EU law (and in particular the freedom of establishment). This was the first time that the ECJ had the opportunity to consider the compatibility of a Member State s thin capitalisation rules with EU law. The ECJ noted the argument raised by some Member States that the German rules were intended to give effect to the arm s length 8 Council Directive 2003/49/EC.

6 6 The Inward Investment and International Taxation Review: European Union principle, as recognised in Article 9 of the OECD Model Tax Convention. This did not persuade the ECJ, which simply ruled that the German rules were contrary to the freedom of establishment. Thin Cap GLO Moving forward to March 2007, the ECJ was asked to consider the validity of the UK s thin capitalisation rules (as they existed prior to April 2004) under EU law in Test Claimants in the Thin Cap Group Litigation v. Commissioners of Inland Revenue. On this occasion, the ECJ appeared to adopt, and certainly articulated, a much more nuanced stance than it had in Lankhorst. The ECJ accepted that Member States were entitled under EU law to take steps to prevent activities that amounted to wholly artificial arrangements designed to undermine the right of Member States to exercise their tax jurisdiction in relation to the activities carried out in their territory and thus to jeopardise a balanced allocation between Member States of the power to impose taxes. It followed therefore that, in principle, Member States should be allowed to adopt thin capitalisation rules designed to prevent taxpayers from avoiding the payment of tax (through obtaining tax deductions for interest payments) that would normally be payable on profits generated by activities undertaken in the national territory. However, this was subject to the application of a proportionality test, which meant that the thin capitalisation rules in question needed to satisfy a number of conditions. First, thin capitalisation rules needed to be based on the arm s-length principle; that is, tax deductions could only be denied if and to the extent that the interest paid by a resident subsidiary to a non-resident parent company exceeded what those companies would have agreed in an arm s-length situation. Secondly, the Member State also needed to show (even if the arrangement was not one that would satisfy the arm s-length test) that such arrangement was a purely artificial arrangement without any underlying commercial justification and that, even where it was established that such an arrangement existed, such legislation treated that interest as a non-deductible distribution only insofar as it exceeded what would have been agreed upon at arm s length. SGI In January 2010, the ECJ published its judgment in SGI. This case was concerned with the compatibility of Belgium s transfer pricing rules with EU law. In essence, the ECJ followed the same approach that it had taken in the Thin Cap case. The ECJ accepted that Member States were entitled to apply transfer pricing legislation in order to maintain the balanced allocation of the power to tax between Member States and prevent tax avoidance. However, the ECJ confirmed that, for such legislation to comply with the principle of proportionality, it was necessary (in circumstances where a transaction went beyond what the companies concerned would have agreed under fully competitive conditions) to satisfy two conditions. First, that the taxpayer was given an opportunity, without being subject to undue administrative constraints, to provide evidence of any commercial justification that there may have been for the transaction. Second, that even where the transaction in question went beyond what the companies concerned would have agreed under fully competitive conditions, the corrective tax measure must be confined to the part that exceeded what would have been agreed if the companies did not have a relationship of interdependence. ECJ case law territorial scope of EU law in context of thin cap rules In the Thin Cap case, the ECJ also considered a number of different factual scenarios in relation to the territorial scope of EU law in the context of thin capitalisation rules: (a) Borrower is subsidiary and resident in Member State A, and Lender is parent and resident in Member State B: freedom of establishment applies (b) Borrower is resident in Member State A, and Lender is another company belonging to the same group of companies resident in Member State B and parent (of the group) is resident in Member State B (or Member State C): freedom of establishment applies (c) Borrower is resident in Member State A, and Lender is another company belonging to the same group of companies which is resident in Member State B, where the common parent companies of the Borrower and the Lender are resident outside the EU: freedom of establishment does not apply (d) Borrower is resident in Member State A, and Lender is another company belonging to the same group of companies resident in Member State B but provides the loan through a branch situated outside the EU, where the common parent companies of the Borrower and the Lender are resident outside the EU: freedom of establishment does not apply

7 The Inward Investment and International Taxation Review: European Union 7 (e) Borrower is resident in Member State A, and Lender is another company belonging to the same group of companies which is, together with the common parent companies of the Borrower and the Lender, resident outside the EU; freedom of establishment does not apply. UK case law following the ECJ s judgment in the Thin Cap case Following the ECJ s judgment in the Thin Cap case, the case was remitted back to the English courts for further consideration. The High Court held (in a judgment published in November 2009) that, although the UK thin capitalisation rules (as they existed prior to April 2004) were based on an arm s-length test, they did not give any opportunity for taxpayers to advance any commercial justification. Consequently, they failed the proportionality test, and were contrary to the freedom of establishment. Moreover, it was not possible to read in a commercial justification test, since it was clear from the UK rules that the arm s length test alone was to be decisive. Consequently, the rules had to be disapplied, but only in relation to transactions that had a genuine commercial justification (either in whole or in any relevant part). The High Court decision was appealed to the Court of Appeal and, in its judgment published in February 2011, the judges held (by a majority) that, while the UK s thin capitalisation rules (as they existed prior to April 2004) were contrary to the freedom of establishment, they were justified by the need to preserve the balanced allocation of taxing rights between Member States and prevent tax avoidance. In overturning the High Court decision, the Court of Appeal considered that allowing taxpayers the opportunity to advance commercial justification for a loan meant only that the taxpayer should be allowed the opportunity to prove that the terms of the loan were arm s length and that there was no need for a separate commercial justification test. In June 2011, the Supreme Court dismissed the taxpayer s application for leave to appeal. 3. Grouping or fiscal consolidation rules The compatibility of fiscal consolidation rules (of various shapes and sizes) with EU law has been the subject of a number of recent ECJ decisions, including the following: Marks & Spencer In December 2005, the ECJ gave its judgment in Marks & Spencer. In that case, the ECJ considered the compatibility of the UK group relief rules with EU law. The UK rules then in force permitted losses of one group member to be grouped with profits of another group member and thereby gave tax relief, but only (broadly) if both companies were UK resident or within the charge to UK corporation tax. The rules in question prevented the grouping of losses by a subsidiary located in another Member State to a UK parent company, whereas had that subsidiary been located in the UK, those losses could have been grouped. The ECJ accepted that there had been a prima facie restriction on the exercise of the freedom of establishment by the UK parent. However, the key issues were whether that restriction was justified and proportionate. The ECJ concluded that the restriction was justified, on the basis of three points: (1) the need to preserve symmetry between profits and losses in the same tax system in order to protect the allocation of taxing rights between Member States; (2) the risk of utilisation of losses in two different Member States; and (3) the risk of avoidance, in that losses might be transferred to the group company with the highest tax rate. The ECJ also held that the restriction was proportionate, except where the losses of the non-resident EU subsidiary were terminal ; namely, where (1) the non-resident subsidiary had exhausted the possibilities available in the state of its residence for having the losses taken into account for current and past periods, including by transferring losses to a third party and (2) there was no possibility of those losses being taken into account in that state for future periods either by the subsidiary itself or by a third party, in particular where the subsidiary had been sold to that third party. Oy AA In July 2007, the ECJ published its judgment in Oy AA. In this case, the ECJ considered the compatibility of the Finnish group contribution system with EU law. Under that system, members of a group may transfer profits to other members of the same group enabling the transferred profits to be taxed in the hands of the transferee (so that, in practice, they can be sheltered from tax by losses of the transferee). However, transfers of profits could only be made between Finnish-resident group members. The question was whether this was contrary to EU law. The ECJ agreed that there was a prima facie restriction on the freedom of establishment. The question was whether such restriction was justified and proportionate. The

8 8 The Inward Investment and International Taxation Review: European Union ECJ held that it was. The ECJ considered that the need to preserve symmetry between profits and losses in the same tax system in order to protect the allocation of taxing rights between Member States and to guard against the risk of avoidance here, by preventing income from being transferred to the jurisdiction applying the lowest rates of taxation were together sufficient to provide a justification that was proportionate. The ECJ did not consider it necessary to demonstrate that the rules were necessary to prevent losses from being used twice, noting that the Finnish rules did not per se concern the deductibility of losses. This point seems to overlook the fact that the Finnish rules were designed to achieve the same end result as the UK group relief rules that is, removing the disadvantage of profits and losses being generated in different corporate entities. The position of terminal losses was not mentioned or discussed, although this may be because it was not in point on the facts of the case. X Holding BV In February 2010, the ECJ published its judgment in X Holding BV. In that case, a Dutch parent company filed a request with the Dutch tax authorities to form a fiscal unity with its Belgian resident subsidiary. The Dutch tax authorities denied this request since the subsidiary was not tax resident in the Netherlands, as required under Dutch tax law. The ECJ ruled that the condition that the fiscal unity is only applicable to companies that are subject to Dutch corporate income tax was not contrary to the freedom of establishment. The ECJ agreed that the Dutch rules constituted a prima facie restriction on the freedom of establishment. However, the ECJ reiterated that the rules were justified by the need to preserve symmetry between profits and losses in the same tax system in order to protect the allocation of taxing rights between Member States. Extending the fiscal unity to cover situations involving non-resident subsidiaries would mean that the parent company would effectively be free to choose the jurisdiction in which the losses of the subsidiary would be taken into account for tax purposes. The ECJ also thought that the restriction was proportionate. The taxpayer argued that the Dutch rules meant that subsidiaries were treated for tax purposes in the same way as branches. Since, under Dutch law, the losses of overseas branches could be temporarily offset against profits of the Dutch company with subsequent recapture provisions (in the event that the overseas branch subsequently made a profit), it was argued that a similar rule with respect to non-resident subsidiaries would be a more proportionate response than simply prohibiting the non-resident subsidiary from forming a fiscal unity with the Dutch parent. The ECJ rejected this argument, concluding that foreign branches and non-resident subsidiaries were not in a comparable position with regard to the allocation of taxing rights. Notwithstanding that traders should be free to choose the appropriate legal form in which to carry out activities in another Member State, the state of origin (in this case, the Netherlands) was nevertheless free to determine the conditions and levels of taxation for different types of establishments chosen by national companies operating abroad, so long as there was no discrimination as compared to national establishments. Consequently, the Netherlands was not obliged to apply the same tax regime to non-resident subsidiaries as that for foreign branches. As in Oy AA, the ECJ did not address the question of final or terminal losses; if a similar terminal loss situation were to arise under the Dutch fiscal unity rules, it is likely that (in those circumstances) the rules could be seen to be disproportionate and incompatible with the freedom of establishment. 4. Controlled foreign companies rules Cadbury Schweppes Typically, Member States controlled foreign companies ( CFC ) rules apply to tax resident shareholders on profits of non-resident companies where the non-resident is controlled by resident shareholders. In September 2006, the ECJ published its judgment in Cadbury Schweppes v. IRC concerning the question of whether the UK s CFC rules were contrary to EU law (and in particular the freedom of establishment). This was the first time that the ECJ had the opportunity to consider the compatibility of a Member State s CFC rules with EU law. The ECJ held that (1) the operation of CFC rules by the UK with respect to subsidiaries located in other Member States constituted a prima facie restriction on the exercise of the freedom of establishment and (2) such rules could only lawfully apply in respect of wholly artificial arrangements, which did not reflect economic reality, and which were intended to escape the national tax normally payable. In particular, the CFC rules could not be lawfully applied in respect of a non-resident company where it was proven, on the basis of objective factors, that the CFC was actually established in another Member State and carried on genuine economic activities there. Such a determination had to be made on the basis of objective factors which are ascertainable by third parties with regard, in particular, to the extent to which the CFC physically existed in terms of premises, staff and equipment.

9 The Inward Investment and International Taxation Review: European Union 9 The ECJ did not rule on whether the CFC rules were contrary to EU law and left it to the UK courts to determine whether the CFC rules (and in particular the motive test) could be interpreted so that their application was restricted to wholly artificial arrangements. Test Claimants in the CFC and Dividend Group Litigation The ECJ confirmed its judgment in Cadbury Schweppes in a subsequent order (published in April 2008) in Test Claimants in the CFC and Dividend Group Litigation v. Revenue and Customs Commissioners. The ECJ declined to examine the validity of the CFC rules under the provisions governing the free movement of capital and payments on the basis that the only fundamental freedom at stake was the freedom of establishment (since by their nature those rules were concerned only with circumstances where a UK company had a controlling holding over an overseas entity). Consequently, the question of whether the CFC rules were contrary to EU law required consideration only in the context of subsidiaries established in other EU (or EEA) Member States, but not with respect to subsidiaries established outside the EU or EEA. Vodafone 2 In Vodafone 2 v. Revenue and Customs Commissioners (No. 2), the English Court of Appeal ruled that it was possible to apply a conforming construction to the CFC rules as a whole, such that those rules could be read in a way such that they would give full effect to the ECJ s judgment in Cadbury Schweppes and thereby not unlawfully restrict the exercise of the freedom of establishment. The Court of Appeal appeared to endorse the approach that a conforming interpretation would be achieved simply by introducing an additional exception in respect of a CFC if it is, in that accounting period, actually established in another Member State of the EEA and carries on genuine economic activities there. The Court of Appeal said that the effect of such an amendment would be to remove from the CFC rules the hindrance or restriction with which the ECJ was concerned in Cadbury Schweppes. Response of UK government to ECJ case law; some observations Some comments on the UK government s response to Cadbury Schweppes may be instructive since the response gives an indication of how Member States typically respond to losing ECJ cases. Generally, it might be observed that such responses try to limit the scope of the judgment as much as possible and, in doing so, create additional potential areas for ECJ challenge. Given the potentially large amounts of tax at stake, this type of response is hardly surprising. Following Cadbury Schweppes, HM Revenue & Customs ( HMRC ) stated that the UK government did not consider the CFC rules to be in breach of EU law. However, in response to the judgment, and (in HMRC s words) to give certainty to circumstances at the margins where it may not have been entirely clear, Parliament introduced (in the Finance Act 2007) Sections 751A and 751B ICTA. These Sections mean that, if no other exemptions to the CFC rules are available under Section 748 ICTA, the profits apportioned to a UK company under the CFC rules may, on application by the UK company, be reduced (including down to nil) by an amount specified by the claimant UK company provided that certain conditions are met. That amount must not exceed an amount representing the net economic value created directly by work carried out by individuals working for the CFC throughout the relevant period in a business establishment in the EEA territory. The relevant UK company can only make an application under Section 751A if throughout the accounting period in question (1) the CFC has a business establishment in the EEA territory, and (2) there are individuals who work for the CFC in that territory. HMRC s guidance on these provisions suggests that, in HMRC s view, the ECJ in Cadbury Schweppes made a distinction between the genuine creation of profits in another Member State (being created by work done by individuals, and as a result of genuine economic activities undertaken, there) and the diversion of profits to another Member State from elsewhere (being profits created from holding assets and not profits created by genuine economic activities being undertaken there). HMRC states in its guidance that: the net economic value is the real economic profit to the group as a whole created directly by the work of individuals working for the CFC in an EEA state, after allowing for the full economic costs to the group of carrying

10 10 The Inward Investment and International Taxation Review: European Union out the work [ ] For example, work that has minimal content and nominally (or notionally) relates to capital or other assets placed artificially in the CFC may have some intrinsic value; however this value will be limited and very marginal when compared to the value of the profits that arise from holding the capital or other assets [ ] A useful guide is that the net economic value should equate to what the group would be prepared to pay a third party to undertake the work done by staff working for the CFC in the relevant state(s), over and above the full economic costs of undertaking the work. HMRC s view following the Court of Appeal decision in Vodafone 2 is that, by applying Sections 751A and 751B retrospectively as they intend to do (i.e., applying those Sections to profits arising before 6 December 2006, being the date on which this legislation was announced and originally had effect from), they would ensure compliance with EU law. However, HMRC have also acknowledged that Parliament s view of how compliance with EU law may be achieved (i.e., Sections 751A and 751B) is not the only possible interpretation and stated that: HMRC will be happy to consider alternative proposals for ensuring that apportionments do not include pre-6 December 2006 profits arising from genuine economic activities carried out with a view to profit through an actual establishment in another Member State. But companies should note that it is HMRC s view that any such proposals have to take into account as a minimum the requirements that: the CFC must be actually established in another Member State (incorporation is neither necessary nor, of itself, sufficient; there must be, for example, premises, staff and equipment) the CFC must carry on genuine economic activities that add real value to the group and that are carried out by staff of the appropriate number, ability and seniority (the company must not, in particular, be simply acting as a vehicle to divert profits from one part of the group to another). It is also understood that HMRC are seeking to argue that subsequent ECJ case law supports a transactional approach to the interaction of the CFC rules with EU law. In other words, HMRC consider that an entity -based approach is inappropriate; in their view, the question is not whether the entity itself is a wholly artificial arrangement. The Commission issued a reasoned opinion in May 2011 requesting that the UK amend its CFC rules and HMRC s stance will in all in all likelihood be tested as a result. Overall, it remains to be seen whether HMRC s responses to Cadbury Schweppes are appropriate. However, it would appear that there must be some doubt as to whether (1) HMRC s attempts to draw a distinction between profits derived from labour and profits derived from capital and (2) HMRC s transactional approach, are supported by relevant case law. It is possible, even likely, that these issues will eventually be the subject of further litigation. 5. Exit charges In November 2011, the judgment in National Grid Indus was published. This was the first case in which the ECJ considered the compatibility of exit charges with EU law in the context of corporations. Prior to National Grid Indus, the compatibility of exit taxes with EU law had only been considered in the context of individuals. De Lasteyrie and N The ECJ ruled in two key cases (de Lasteyrie, in March 2004, and N, in September 2006) that the freedom of establishment precluded the imposition by one Member State of tax on an individual transferring his or her residence to another Member State with respect to latent (unrealised) gains where the amount of the tax liability did not take full account of reductions in value arising after the transfer of residence (which was also not taken into account by the second Member State). It was held to be immaterial for these purposes that the first Member State allowed deferral of the payment of tax in such circumstances (conditional upon the provision of guarantees by the individual concerned). As to whether de Lasteyrie and N apply in relation to corporate exit taxes, the position before National Grid Indus was muddied by two ECJ judgments. Daily Mail and Cartesio In Daily Mail (decided in September 1988), a UK-resident company had sought to move its place of central management and control to the Netherlands in order that it could dispose of certain assets without a UK tax charge on its gains. At that time,

11 The Inward Investment and International Taxation Review: European Union 11 under UK law, it was a criminal offence for the directors of a UK-resident company to move central management and control without obtaining Treasury consent. The ECJ ruled that EU law did not confer any right for a company to move its central management and control to another Member State. The UK requirement for Treasury consent was therefore not contrary to EU law. In Cartesio (decided in December 2008), the ECJ considered a similar issue. The case was concerned with a limited partnership established under Hungarian law that wished to transfer its seat to Italy, while remaining a partnership established under Hungarian law. The application to register the transfer of its seat in the Hungarian commercial register was rejected, and the question was essentially whether that refusal was contrary to the freedom of establishment. The ECJ said that it was not, ruling that Member States retained the power to define the connecting factors required before a company could be incorporated under the law of each state and whether those connecting factors could be changed while the company maintained its status under the law of that state. Accordingly, the freedom of establishment did not prevent Hungary from insisting that a company governed by its law retained its seat in that territory. Neither Daily Mail nor Cartesio concerned the validity of corporate exit taxes; indeed, Cartesio is not a tax case. Nonetheless, it has been suggested that these decisions give Member States greater latitude to place limitations around the ability of corporate entities to leave their jurisdiction and that, therefore, the imposition of exit taxes on corporations would be permissible. The preferable view is that a distinction must be drawn between (on the one hand) a Member State prohibiting a company incorporated in its jurisdiction from moving its seat or its place of central management and control to another country while remaining incorporated under the law of that state and (on the other hand) a Member State permitting such a move under its corporate law but imposing a tax charge on that exit. This distinction is recognised by the Commission, which referred Denmark, the Netherlands and Spain to the ECJ in November 2010 and Ireland in January 2011 over their exit tax rules. It was also recognised by the ECJ in its judgment in National Grid Indus. National Grid Indus In National Grid Indus, a Dutch company transferred its effective place of management to the UK. Before the transfer, a substantial unrealised currency gain had accrued in the company. On transfer of the effective place of management, the Dutch tax authorities assessed the company to tax by reference to the unrealised currency gain. The company appealed, arguing that the Dutch rules were contrary to the freedom of establishment, and the Amsterdam Court of Appeal referred this question to the ECJ. The ECJ held that, although a Member State was able, in relation to a company incorporated under its law, to subject that company s right to retain its legal personality under that law to restrictions on the transfer of that company s place of effective management (echoing Cartesio), a corporate exit (tax) charge triggered by such a transfer was a prima facie restriction on the freedom of establishment. Such restriction, however, may be justified by the need to ensure the balanced allocation of taxing rights between Member States, and the corporate exit charge under consideration was held to be justified in that it allocated tax on profits on unrealised capital gains which arose while the company was within the Netherlands power of taxation to the Netherlands and tax on capital gains realised while the company was within the UK s power of taxation to the UK (thus avoiding double taxation). The next question was whether the restriction, while permissible, was proportionate. The ECJ held that immediate valuation of the tax liability was proportionate, but immediate recovery of the tax was not. A more proportionate approach might be to give the company the option to elect between immediate payment of the tax (with little, if any, administrative obligations) and deferred payment (with a greater administrative burden, for example, of keeping the Member State of origin informed or updated on the status of the relevant asset(s)). The ECJ also held that there was no need for the Member State of origin to take post-exit reductions in the value of the asset(s) into account when computing the exit charge. Consequences of non-compliance with EU Law EU law may be used by taxpayers as a shield against tax assessments raised by tax authorities of Member States.

12 12 The Inward Investment and International Taxation Review: European Union It may also be used as a sword. EU law recognises that taxpayers may have two separate causes of action in the context of taxes levied contrary to EU law. First, taxpayers may seek to claim a refund of taxes (together with applicable interest) levied contrary to EU law (under the San Giorgio principle ). Secondly, taxpayers may claim damages resulting from a breach of EU law. Subject to the principles of equivalence and effectiveness (noted above), remedies are subject to domestic law rules, such as limitation principles. In this connection, it is interesting to note the recent judgment in Danfoss (published in October 2011). There, the ECJ had to consider whether a Member State was entitled to reject a claim for the refund of, or damages in respect of, charges that had been levied in breach of EU law where the claim was made not by the taxpayer but by the person who actually bore the cost of the charge (e.g., a customer of the taxpayer). In both cases, the ECJ held that the Member State was so entitled, because the tax bearer was not the person who had paid the charge to the tax authority, but this was only the case if (1) the tax bearer could bring a civil action under domestic law against the taxpayer and (2) a refund by, or damages against, the taxpayer is not virtually impossible or excessively difficult to obtain (as would be the case where, for example, the taxpayer was insolvent). It will be interesting to see the extent to which this case may help a tax bearer where the relevant taxpayer is entitled to plead a defence (such as change of position ) against the tax bearer s claim under domestic law. VAT While this chapter does not deal in any detail with value added tax ( VAT ), no overview of EU tax law would be complete without some mention of VAT. VAT is a wide-ranging consumption tax charged on most commercial transactions (with notable exceptions being insurance and a large number of financial transactions). It was established by the First and Second Council Directives (in 1967) and has subsequently been the subject of a number of key Directives, including the Sixth Council Directive (in 1977) and the VAT Directive (in 2006). While intended to be harmonised across the whole of the EU, there remain a number of country-specific derogations as well as local divergences in interpretation. Nevertheless, it is a largely common tax charged throughout the EU on the basis of the relevant EU principles and the various Directives (to which taxpayers have recourse, such Directives having direct effect). The ECJ has been active in considering and ruling on a number of diverse issues, including the compatibility of particular national tax laws with the said principles and Directives, such as recently in the seminal cases of J P Morgan Claverhouse & the Association of Investment Trusts, Swiss Re Germany Holding GmbH, Loyalty Management UK/Baxi Group, AXA UK PLC and GFKL Financial Services AG. Conclusions After a slow start, the ECJ has been increasingly active in concluding that national tax laws are inconsistent with the fundamental freedoms enshrined in the EU treaties. This has encouraged arguments from taxpayers that on occasion have challenged long-established and fundamental principles of national tax laws. The exact limits on the fundamental freedoms remain to be explored. Some recent signs are that the ECJ may be pulling back from its most expansive views on what may be incompatible with the fundamental freedoms; however, the picture is not clear, as it is arguable that the ECJ s position is not always consistent. Taxpayers should keep a close eye on developments in this area, with a view both to opportunities for recovering tax previously paid and for managing their future tax affairs.

13 The Inward Investment and International Taxation Review: European Union 13 Authors David Harkness Global Head of Tax, Pensions and Employment E: Etienne Wong Head of International VAT E: This publication does not necessarily deal with every important topic or cover every aspect of the topics with which it deals. It is not designed to provide legal or other advice. Clifford Chance, 10 Upper Bank Street, London, E14 5JJ Clifford Chance LLP 2012 Clifford Chance LLP is a limited liability partnership registered in England and Wales under number OC Registered office: 10 Upper Bank Street, London, E14 5JJ We use the word 'partner' to refer to a member of Clifford Chance LLP, or an employee or consultant with equivalent standing and qualifications If you do not wish to receive further information from Clifford Chance about events or legal developments which we believe may be of interest to you, please either send an to nomorecontact@cliffordchance.com or by post at Clifford Chance LLP, 10 Upper Bank Street, Canary Wharf, London E14 5JJ Abu Dhabi Amsterdam Bangkok Barcelona Beijing Brussels Bucharest Casablanca Doha Dubai Düsseldorf Frankfurt Hong Kong Istanbul Kyiv London Luxembourg Madrid Milan Moscow Munich New York Paris Perth Prague Riyadh* Rome São Paulo Shanghai Singapore Sydney Tokyo Warsaw Washington, D.C. *Clifford Chance has a co-operation agreement with Al-Jadaan & Partners Law Firm in Riyadh. UK v1