By Davide Anghileri, University of Lausanne, Switzerland
The European Commission on 2 April announced that is has found that the UK controlled foreign company (CFC) legislation’s group financing exemption is partially illegal because it grants state aid.
The Commission said that the exemption can unduly exempt certain multinational groups from the UK rules therefore creating an unjustified preferential tax treatment that is illegal under Article 107 of the Treaty on the Functioning of the EU.
The rest of the CFC regime and group financing exemption is justified and does not constitute state aid insofar as it ensures the proper functioning and effectiveness of the relevant tax rules, the Commission said.
Hence, the UK must now recover the illegal state aid from the multinational companies that benefitted from it, the Commission said.
The UK CFC legislation
CFC rules are an effective and important feature of many tax systems to address tax avoidance. The UK legislation aims to prevent UK companies from using a subsidiary based in a low or no tax jurisdiction to avoid UK taxation. It allows the UK tax authorities to reallocate all profits artificially diverted to an offshore subsidiary back to the UK parent company where it can be taxed accordingly.
UK CFC rules establish two tests to determine how much of the financing profits from loans granted by an offshore subsidiary are to be reallocated to the UK parent company and, hence, taxed in the UK.
Under the “UK activities test,” financing income derived from lending activities that are mostly managed in the UK is allocated to the UK. Under the “UK connected capital test,” the financing profits are allocated to the UK to the extent that loans are financed with funds or assets which derive from capital contributions from the UK.
Moreover, between 2013 and 2018, the UK introduced an exemption, called the group financing exemption, for certain financing income (i.e., interest payments received from loans) of multinational groups active in the UK.
The group financing exemption partially (75%) or fully exempted from taxation in the UK financing income received by an offshore subsidiary from another foreign group company even if this income is derived from “UK activities” or the capital being used is “UK connected”.
Therefore, a multinational active in the UK using this exemption could provide financing to a foreign group company via an offshore subsidiary paying little or no tax on the profits from these transactions.
The Commission’s investigation has concluded that the group financing exemption and, hence, the different treatment, was partially justified. At the same time, the exemption grants a selective advantage to certain multinational companies.
The Commission found that when a multinational fulfils the “UK connected capital test” the group financing exemption is justified and does not constitute State aid under EU rules.
Such an exemption avoids complex and disproportionately burdensome intra-group tracing exercises that would be required to assess the exact percentage of profits funded with UK assets. The Commission therefore acknowledges that, in line with UK arguments, the group financing exemption in these cases provides for a clear proxy that is justified to ensure the proper functioning and effectiveness of the CFC rules.
On the other hand, the Commission said that a multinational meeting the “UK activities test” that claims the group financing exemption receives unjustified preferential tax treatment that is illegal under EU State aid rules.
The Commission pointed out that the use of a proxy rule in these cases is not justified. The exercise required to assess to what extent the financing income of a company derives from UK activities is not particularly burdensome or complex.
Commission added that the group financing exemption does not seek to address any possible complexity related to the allocation of financing income to UK activities nor has the UK claimed it does.
The Commission also stated that the UK should reassess the tax liability of the UK companies that have illegally benefitted from the group financing exemption as it was applied to profits derived from UK activities.
The exact recovery amount can only be determined by the national authorities based on a case-by-case examination considering the precise number of beneficiaries affected.
The recovery should not be intended as a fine. The recovery should not penalise companies which received state aid. The aim is only to remove the competition distortion created by the aid and to restore equal treatment with other companies.
Finally, it must be noted that, as of 1 January, the UK CFC legislation no longer raises concerns under state aid rules.
In fact, following the adoption of the EU anti-tax avoidance directive (ATAD), the group financing exemption applies only where a CFC charge on financing income from foreign group companies would otherwise apply exclusively under the UK connected capital test (i.e., not also or exclusively under the UK activities test).