The European Commission (the Commission) published on 2 April a summary of its findings on a state aid investigation into the United Kingdom’s controlled foreign company (CFC) finance company exemption. The Commission has found that certain aspects of this regime constitute illegal state aid, and under EU law the UK is required to take steps to recover this from recipients. The UK’s tax authority, HM Revenue & Customs (HMRC), has not yet announced what form this action will take, nor whether it may appeal.
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 favours certain companies or market sectors, and therefore distorts competition on the market. Under EU law, the grant of state aid is, in principle, illegal. 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 an extensive state aid inquiry into tax practices of various EU member states. Over the last five years, the Commission has scrutinised over 1,000 tax rulings and numerous tax schemes, and has ordered the recovery of approximately €15 billion ($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.
The UK’s CFC rules, contained in Part 9A of the Taxation (International and Other Provisions) Act 2010, were substantially recast with effect from 1 January 2013 with the aim of targeting only foreign profits artificially diverted from the UK. One of the major changes was to introduce an exemption from the CFC rules for the profits of non-UK group finance companies, which may be located in low-tax or no-tax jurisdictions (the Exemption). Broadly, the Exemption applied to exempt up to 100% of the profits of such group finance companies from the CFC regime, and 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.” The Exemption enabled UK companies to finance foreign group companies via offshore subsidiaries paying little or no tax on the profits from these transactions.
This rule was in force from 2013 to the end of 2018. With effect from 1 January 2019, the Exemption was amended to ensure its compatibility with the EU anti-tax avoidance directive, and now is only available in respect of profits that are not derived from UK significant people functions. The Commission’s decision does not cover the post-1 January 2019 rules.
Under the UK CFC rules, profits generally fall outside of the rules to the extent they do not relate to “significant people functions” in the UK. However, this concept did not feature in the Exemption, meaning that relevant finance profits could fall outside the scope of UK tax even to the extent that they derived from UK significant people functions.
In concluding its investigation, the Commission found the Exemption to be justified in circumstances where the profits of a group finance company were not derived from UK activities. However, where profit-generating activities are carried out in the UK (for example, where investments were managed from the UK or other UK 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 favour “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. 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.
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 criticised as obscure and inherently difficult to apply).
The Commission has ordered the UK to identify the companies that received allegedly illegal aid pursuant to the Exemption, and to recover the undue tax benefits arising from the Exemption 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 (extendible by another two). However, we expect that the recovery process in the current case may be significantly longer because the UK has not adopted specific legislation to establish a process for recovering illegal aid. The quantification of allegedly illegal aid in respect of each affected company is likely to require a complex and lengthy case-by-case assessment.
It is also somewhat unclear what effect the UK’s potential departure from the European Union will have in this area. Although the UK government’s current stated position is that the UK will continue to comply with EU state aid requirements, it may be difficult, if not impossible, to compel the UK to implement the Commission’s recovery order following the UK’s potential departure from the EU (in particular, in a “hard Brexit” scenario).
Companies that have made use of the Exemption should confirm any potential state aid exposure they may face without delay so that they are in a position to appeal the Commission’s decision in the EU General Court within the applicable—relatively tight—time limits.
We can assist with understanding the implications of the Commission’s decision, and exploring the possibility of an appeal against the Commission’s decision and/or of an intervention in a potential appeal by the UK government.
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