We are grateful to Jonathan Branton and Alexander Rose of DWF for contributing this article.
On 2nd April 2019 the European Commission concluded that a tax break introduced in the Finance Act 2012 constitutes unlawful State aid to certain multi-national businesses. The European Commission has directed the UK Government to identify the tax liability of beneficiary businesses ahead of recovery which is “expected to be in the range of tens to hundreds of millions of pounds” according to sources quoted in the Financial Times. This finding will reignite the fierce debate about whether the European Commission should be using State aid law as a weapon to tackle international tax avoidance and whether the EU Treaty principle of freedom of establishment is being eroded.
The Controlled Foreign Company Rules and the Group Financing Exemption
The UK’s Controlled Foreign Company rules (“CFC Rules”) are designed to prevent companies in the UK avoiding or deferring taxes by shifting profits to subsidiaries in low tax jurisdictions. The CFC Rules operate by subjecting certain profits of overseas subsidiaries to UK tax. The UK’s CFC Rules were amended with effect from 1 January 2019 following the adoption of the Anti-Tax Avoidance Directive (ATAD) and the European Commission has confirmed that it has no concerns about the compliance of the amended CFC Rules.
However between 1st January 2013 and 31st December 2018, the UK’s CFC Rules included a tax exemption called the Group Financing Exemption (“GFE”) that provided a full or partial (75%) exemption for finance income (interest payments received from loans) between non-UK members of a corporate group. The exemption applied even where the income was generated from UK activities and was therefore considered by the European Commission to operate as a proxy for the actual level of tax due (as the exemption of 100% or 75% was not based upon accurate verification of the amounts due).
In October 2017 the European Commission launched a formal investigation into the CFC Rules, alleging the GFE regime provided a selective and unjustified advantage to UK parent companies with subsidiaries based in non-UK jurisdictions. In line with European Commission procedures, a prima facie case was published and interested parties were invited to provide responses.
European Commission Decision dated 2nd April 2019
In April 2019 the European Commission published its findings (the full decision will be published in due course), reaching different conclusions on the application of the GFE depending upon whether or not the finance income is derived from UK activities.
Where the GFE relates to finance income that is not generated from UK activities the European Commission concluded that the exemption is justifiable and proportionate. Having considered representations from the UK Government, the European Commission accepted that the alternative (for the Member State to pursue complex intra-group tracing exercises to verify the percentage of profits funded through UK funds or assets) would be disproportionately burdensome and therefore the use of a proxy rate can be justified. As a justified measure, this part of the GFE is considered ‘no aid’ under State aid law.
However, when the finance income derives from UK activities (even though the financing is through offshore companies) then the GFE is considered not to be justified. This is because, the calculation to assess the proportion of finance income sourced from UK activities is not considered to be particularly complex or burdensome. As a result, the use of a proxy rate cannot be justified and actuals should be sought instead. The Commission found this to have resulted in undue advantage arising to a number of companies accordingly.
The European Commission regards the measure to be illegal State aid because the multi-national companies that were able to use the GFE for finance income generated from UK activities were placed in a better position than their competitors who were required to pay the UK standard rate of tax.
The UK has been directed to reassess the tax liability of companies who received unlawful State aid by utilising the GFE in respect of finance income from UK activities.
Under Article 16 of Council Regulation (EU) 2015/1589 (the “Procedural Regulation”) following a finding of unlawful State aid, the Member State is obliged to take action to recover the funding from the beneficiary with interest backdated to the point the State aid was awarded. The funding should be returned to the funder, which in this case will be the UK Government. As interest is applied, the value of the aid to be repaid will always be greater than the initial benefit. All those companies who have benefited from the scheme in respect of financing UK activities should therefore expect to hear from HMRC on this issue and make provision accordingly, if they have not already done so.
State aid as a means to address international tax avoidance
This finding represents the latest chapter of the European Commission using State aid law to address international tax avoidance. This has included findings against Luxembourg and the Netherlands in respect of Fiat and Starbucks (for €23.1 million and €25.7 million respectively), against Ireland in respect of a ‘sweetheart tax deal with Apple (which led to recovery of €14.3 billion), against Luxembourg in respect of Amazon (resulting in the recovery of €282.7 million) and against Gibraltar (involving multiple beneficiaries with a value of c. €100 million). There are currently two other live European Commission investigations into tax arrangements relating to Dutch tax arrangements (with Inter IKEA and Nike) and tax rulings in Luxembourg (Huhtamäki), although there may be others which are still in their initial stages.
Although there has been criticism of the initiative, the European Commission appears committed to its policy. Commenting on the GFE case, the Commissioner for Competition, Margrethe Vestager stated that “Anti–tax avoidance rules are important to ensure that all companies pay their fair share of tax. But they must apply equally to all taxpayers. The UK gave certain multinationals a selective advantage by granting them an unjustified exemption from UK anti–tax avoidance rules. This is illegal under EU State aid rules. The UK must now recover the undue tax benefits.”
For the time being the UK has not issued a public statement on the European Commission decision. The UK may choose to accept the decision, in which case HMRC will check and seek recovery from beneficiaries. Alternatively, the UK could seek to overturn the decision by making representations in the General Court (or thereafter the CJEU). To do so, litigation would normally need to be initiated within 2 months of the decision being published in the Official Journal of the European Union.
Brexit has the potential to affect the implementation of the State aid decision. In the event of a no deal exit as of 13 April 2019 (which remains possible as at the time of writing), then there would appear to be no legislative obligation for the UK to be required to recover the aid (NB. there would be no basis on which to do this through World Trade Organisation rules). However, given the Government’s draft State Aid (EU Exit) Regulations 2019 create a new UK State aid law regime enforced by the Competition and Markets Authority that is dynamically aligned with the existing EU rules on State aid there would, at the very least, appear to be a political willingness to sustain EU rules in substance, which would include seeking to give effect to rulings of the European Court of Justice handed down prior to the UK’s formal exit.
In the event of a revocation of Article 50 then the European Commission would continue oversight over State aid law. If the existing draft UK-EU Withdrawal Agreement is adopted then under Article 93 the Competition and Markets Authority will be set up to take on State aid responsibilities only after the transition period had ended, ie. 1 January 2021, with EU rules and jurisdiction in State aid continuing until then. During the transition period the European Commission will maintain oversight of State aid law (and may take action to address any instances of unlawful State aid awarded during this time, and for a period of 4 years thereafter).
This case is a reminder that it is incumbent upon the beneficiary of public support, (whether this is in the form of a grant, guarantee, tax exemption or otherwise) to make its own assessment of compliance with the State aid rules. Failure to do so can result in the repayment of a sum greater than the initial value of the aid received and an expectation that the aid was legitimate does not override this. This case also highlights how emerging themes, in this case the European Commission’s recent focus upon using State aid to tax avoidance and Brexit negotiations, can change the risk profile of companies considering whether to accept State aid.