Select Committee on Treasury Written Evidence

Memorandum submitted by The Law Society



  1.  Under the UK controlled foreign company ("CFC") regime as it currently applies the profits of a controlled foreign company which is resident in a country which has a rate of tax which is lower than that in the UK are attributed to its UK parent and taxed in the hands of the UK parent. There are exclusions from the CFC regime but these are subject to a number of tests and conditions. In particular a CFC can be exempted if it carries out a full distribution policy (which means paying out 90% of its profits to the UK group), or if it carries on "exempt activities", which consist of three requirements, namely having a business establishment in the territory in which it is resident, ensuring that its business affairs are effectively managed there and satisfying any one of four tests which vary in complexity but which in many ways restrict the type of activities which can be undertaken and the relationship with the UK group. There is also a motive test but this is failed if the main reason or one of the main reasons for the establishment of the subsidiary is the diversion of profits from the UK, which it is assumed occurs if, had the subsidiary not existed, the receipts would have been received by a UK resident.

  2.  The Cadbury Schweppes case considered whether the UK rules breached articles 43 and 48 of the EC Treaty providing for freedom of establishment. The European Court held that a national of a member state could not be prevented from establishing a subsidiary in another state if the motive was to benefit from a beneficial regime in that other state. Such a motive was not incompatible with the principle of freedom of establishment. However, a national measure restricting freedom of establishment may be justified where it specifically relates to wholly artificial arrangements aimed at circumventing the application to the legislation of the member state concerned. In this case the court held: "75. In the light of the preceding considerations, the answer to the question referred must be that arts 43 EC and 48 EC must be interpreted as precluding the inclusion in the tax base of a resident company established in a member state of profits made by a CFC in another member state, where those profits are subject in that state to a lower level of taxation than that applicable in the first state, unless such inclusion relates only to wholly artificial arrangements intended to escape the national tax normally payable. Accordingly, such a tax measure must not be applied where it is proven, on the basis of objective factors which are ascertainable by third parties, that despite the existence of tax motives that CFC is actually established in the host member state and carries on genuine economic activities there."

  3.  All that is therefore required is an establishment and genuine activities in the state concerned. It states in the HMRC Press Release that the proposed new legislation maintains the effectiveness of the rules in protecting tax revenues, while at the same time complying with the Cadbury case. The proposed legislation introduces a new "net economic value" test which excludes from the CFC regime the real economic profit to the group concerned of the work of individuals working for a CFC in an EEA state after allowing for the costs of the individuals in carrying out the work. Profits that arise from capital activities are therefore not excluded from the CFC tests, because (effectively) intra group transactions which may move capital are ignored and the value has to be created through individuals' activity. The intention behind this change is to categorise what constitutes genuine economic activities and to limit these to the activities of people rather than, for example, financial activities. Contrary to the HMRC Press Release, we do not believe that there is any justification for this distinction in the European Court's judgment.

  4.  Furthermore, the revised exempt activities test for companies resident in any EEA territory applies a new definition for effective management for EEA resident companies of sufficient individuals working for the company in the territory to undertake the company's business but does not relax any of the other requirements in paragraph 6 of Schedule 25, in particular the detailed requirements of the exempt activities test relating to the type of activities carried on as described above. Nor is the motive test altered. This does not appear to us to go far enough to enact the Cadburys Schweppes test which requires that the CFC legislation can only apply to include the profits of a controlled foreign company in another member state where the inclusion relates only to wholly artificial arrangements intended to escape the national tax normally payable. Merely excluding the benefit of the work of individuals in a jurisdiction from the scope of the CFC rules and altering the definition of effective management does not comply with the case law: too little is assumed to constitute "genuine economic activities".

  5.  We should state that we understand that the provision has been brought forward as an interim response pending a further review of this area in 2007. We also appreciate the disruption caused to the UK tax system by judgments of the European Court such as this one and the difficulty of framing an appropriate response which safeguards UK revenues while complying with the EC Treaty. We are, however, concerned that to enact legislation which does not address in substance what the case law appears to require will merely invite more litigation and create uncertainty not merely for business but also as regards Exchequer receipts; we believe there is a risk of there being two alterations to the legislation, which will undermine the principle of certainty of tax treatment for business. We recommend that there is further full consultation and consideration to the changes required to UK legislation to meet the requirements of the EC Treaty and also to safeguard revenues.

11 December 2006

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