FDI Implications of Recent European Court of Justice Decision on Corporation Tax Matters



both headings, the ECJ tends to look at the case under the freedom of establishment
principle first and, if it finds a breach of that freedom, it does not continue on to
examine the case under the free movement of capital provisions.

3. Recent Relevant European Court of Justice Rulings

Controlled Foreign Company Legislation

A parent company resident in State A is generally not taxable on the profits of a
subsidiary resident in State B until those profits are distributed back to the parent
company in the form of dividends. Contrary to these principles, however, controlled
foreign company (CFC) legislation is designed to tax the parent company on the
profits of a CFC (for example a subsidiary) resident in another State. A CFC is a
company which is resident outside the home country, controlled by persons resident
in the home country and subject to a lower tax rate in the country in which it is
resident. CFC legislation taxes in the home country the income that arises in the low-
rate country as if that income had been distributed to the home country, even though it
has not. The rules aim to protect the domestic tax base from erosion.

The UK introduced CFC legislation in 1984 to stop UK groups of companies from
reducing their UK tax liabilities by diverting their profits to foreign group companies
in low-tax territories. In April 2004, the Special Commissioners in the UK referred
the
Cadbury Schweppes case to the ECJ regarding the compatibility of the UK (CFC)
legislation with the free movement of establishment, services and capital.
12 The issue
concerned two Irish indirect subsidiaries of Cadbury Schweppes plc which were
located in the International Financial Services Centre in Dublin and subject to a 10
percent rate of corporation tax in Ireland. Under its CFC rules the UK Inland
Revenue had taxed the UK parent on the undistributed profits of the Irish subsidiaries.

Advocate General Léger issued his opinion in May 2006. He concluded that Articles
43 EC and 48 EC do not preclude such national tax legislation if the legislation
applies only to wholly artificial arrangements intended to circumvent national law.
According to the AG, such legislation must enable the taxpayer to be exempted by
providing proof that the controlled subsidiary is genuinely established in the State of
establishment and that the transactions which have resulted in a reduction in the
taxation of the parent company reflect services which were actually carried out in that
State and were not devoid of economic purpose with regard to that company’s
activities.

The AG rejected the UK view that the motives for establishing a subsidiary and for
the choice of country in which to establish it can constitute a relevant criterion. In
other words, the existence of a wholly artificial arrangement cannot be inferred from
the parent company’s avowed purpose of obtaining a reduction of its taxation in the
State of origin.

The ECJ delivered its decision in September 2006. The Court agreed with the AG’s
view that the UK’s CFC legislation could apply only to wholly artificial
arrangements. The Court affirmed its earlier case law to the effect that the mere fact

12 Cadbury Schweppes plc and Cadbury Schweppes Overseas Ltd. v Commissioners of Inland Revenue
(Case C-196/04).



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