Bill Dodwell comments on Vodafone 2 case
The Court of Appeal yesterday handed down its judgement in the Vodafone 2 case – regarding the interpretation of the UK’s Controlled Foreign Companies (CFC) law in the light of European rulings.
The Court decided that [private]the UK’s CFC law should be interpreted as if it had a new additional exception – which applies with retrospective effect. The new exception would be that companies established in the European Economic Area (EEA) which carry on genuine economic activities there should benefit from this exception. This means that the CFC rules will still apply to companies operating outside the EEA and also to EEA companies without genuine economic activities.
What the Court wasn’t asked to consider is what qualifies as genuine economic activities. Once the basic scope of the law has been decided, this factual issue will then need to be considered.
Bill Dodwell, head of Deloitte’s Tax Policy Group commented: “This is a common-sense judgement and hopefully will offer a good way forward in CFC cases. However, what we really need is some helpful guidance on the sort of activities that fall within this new exemption.”[/private]
About the case
In March 2000 Vodafone acquired the Mannesmann AG group of companies and as part of this process established a wholly owned Luxembourg subsidiary, Vodafone Investments Luxembourg Sarl “VIL”. VIL was the intermediate holding company of Mannesmann AG and other European companies. The annual accounts of VIL at that time showed equity investments of €38 billion and debt investments amounting to €35 billion. HMRC’s contention is that the interest income earned by VIL on its debt investments should be taxed in the UK as a result of the UK Controlled Foreign Company (CFC) rules.
The UK CFC rules have long been in existence to prevent UK companies diverting income to overseas companies, to take advantage of lower levels of tax. Overseas companies to which the CFC rules apply are deemed to have their income arising in its UK parent, and taxed in the UK.
Certain exemptions are available. There are five objective exemptions, none of which applied to VIL. There is also subjective “motive test” test which Vodafone argued VIL fell within.
The “motive test” exempts companies from a CFC charge if the main reason, or one of the main reasons, for the company’s existence is not to achieve a reduction in UK tax by diverting profits from the UK.
Whilst Vodafone contended that VIL satisfied the “motive test”, its primary contention was that the CFC legislation is not compatible with the EC Treaty, in particular the right to freedom of establishment. This is in light of the European Court of Justice “ECJ” judgment in the Cadbury Schweppes case, published in September 2006. In that case the ECJ judged that the UK CFC rules were a restriction of the EC Treaty’s freedom of establishment. The Court decided that the UK CFC rules could only lawfully apply in respect of wholly artificial arrangements that had no genuine economic activity.
The ECJ judgement effectively allows UK groups to establish companies within the European Economic Area, even if the intention is specifically to save tax, provided the EEA company is engaged in “genuine economic activities”. The CFC legislation’s motive test could not be satisfied if a main reason was to save tax.
The ECJ did not decide whether the UK CFC rules, and more specifically the “motive test” exemption, can be interpreted so that the application is restricted to wholly artificial arrangements. Rather, the ECJ passed this question back down to the UK Courts.
The High Court considered this point and give its judgement on 4 July 2008. It held that the UK CFC rules, and more specifically the “motive test” exemption, cannot be interpreted such that the application of the rules is restricted to “wholly artificial arrangements intended to escape the national tax payable”. It also ruled that the UK CFC rules could not be applied to UK resident companies with subsidiaries in EEA States, until the legislation is corrected by Parliament. This decision was of course very favourable to the taxpayer.
The High Court’s decision was appealed to the Court of Appeal, whose decision has been given today. Given the very large sums of tax involved, an appeal to the House of Lords is expected.
Following the Cadbury Schweppes judgement Parliament modified the UK CFC rules in an attempt to reflect the judgement reached by the ECJ. These new measures took effect from 6 December 2006. It was interesting to note that although the Vodafone judgement strictly deals with the CFC rules before the introduction of the new legislation, the High Court expressed “some doubt” as to whether the modified measures are compliant with the EC Treaty. This view accords with that of most of the tax profession.