State Aid in Disguise?—EC Investigates UK Tax Regime

In Short

The Background: The European Commission has opened an in-depth investigation into a specific provision of the UK-controlled foreign company rules.

The Issue: The Commission will investigate whether the UK's so-called Group Financing Exemption unfairly allows these multinationals to pay less UK tax, in breach of EU state aid rules.

The European Commission ("Commission") has launched an in-depth antitrust investigation into a UK tax regime that provides for an exemption to the UK's Controlled Foreign Company ("CFC") legislation, which the Commission believes may allow multinational companies to benefit from an unlawful, selective tax advantage in breach of European Union ("EU") state aid rules.

The UK's Controlled Foreign Company Regime
The general purpose of the UK's CFC rules is to preclude UK companies from using a subsidiary, based in a low- or no-tax jurisdiction, to avoid taxation in the UK on income that would have been taxed or taxable there or in another higher-taxed jurisdiction. Under these rules, the UK tax authorities can effectively reallocate all (or the relevant proportionate share of) profits of such an offshore subsidiary back to the UK parent company, where it can then be subject to normal UK tax.

However, since 2013, the UK's CFC rules have included an exception for certain types of group financing income (i.e., the interest payments received from intragroup loans) of multinational groups active in the UK—the Group Financing Exemption ("GFE"). Generally speaking, financing arrangements are often seen by tax authorities as giving rise to a risk of profit shifting by multinational groups, especially given the mobility of capital. The Commission argues that "by exempting from reallocation to the UK … the financing income received by an offshore subsidiary from another foreign group company, a UK-based multinational can provide financing to a foreign group company via an offshore subsidiary and thereby pay little or even no tax (depending on where the foreign finance affiliate is located) on the profits derived from these sorts of transactions. This is because:

• The offshore subsidiary pays little or no tax on the financing income in the country where it is based; and
• The offshore subsidiary's financing income is also not (or at least may be only partially) reallocated to the UK and subject to tax there due to the exemption."

The Commission argues that, by contrast, the UK's CFC rules do reallocate other types of income arising in offshore subsidiaries of UK parent companies back to the UK for full taxation.

It should be noted, however, that the previous version of the UK's CFC rules were in fact amended to reflect that certain provisions were considered too restrictive on a pan-European level (and thereby breached certain rights of EU-based entities). Therefore, some will no doubt see the Commission's investigation as an unwelcome change of direction.

The GFE in Light of EU State Aid Rules
The Commission's state aid investigation does not call into question the UK's right to introduce CFC rules or to determine the appropriate level of taxation. The OECD's Base Erosion and Profit Shifting ("BEPS") initiative, to be implemented in EU law via an Anti-Tax Avoidance Directive ("ATAD") passed by the ECOFIN Council in June 2016, mandates that such rules be put in place throughout the EU. However, the role of EU state aid control is to ensure Member States do not give certain companies a better tax treatment than other companies. In this respect, tax rules may constitute illegal state aid if they provide more favorable tax treatment to specific taxpayers or industries that deviates from standard domestic tax rules or regimes. Preferential tax treatment accorded to a given category of taxpayers can still be justified under EU state aid law, but only to the extent that it is motivated by objective reasons and is consistent with the overall purpose and goals of the relevant fiscal rules.

In the decision released on November 16, 2017, the Commission expresses serious doubt as to whether the GFE is consistent with the overall objectives of the UK's CFC rules. To that end, the Commission has conducted a very detailed analysis of the UK's CFC regime and concluded that the GFE may constitute an undue derogation from the general (reference) legal framework. It bases its view on the fact that interest income earned by a qualifying CFC from loans to foreign group companies would meet the test for being regarded as artificially diverted profits by the UK's own standards as set forth in its CFC regime, and yet it ends up receiving a preferential treatment via total or partial exemption. As a result, UK entities controlling a CFC that earns supposedly artificially diverted profits from financing foreign group companies are exempted from tax while other artificially diverted profits earned by a CFC are not exempted under the very same set of tax rules. The Commission argues that the selective (i.e., discriminatory) character of the alleged state aid measure is proven not by reference to the preferential treatment multinationals with foreign subsidiaries receive relative to other nonmultinational taxpayers in a comparable situation, but rather by reference to comparable transactions by the same beneficiaries of the measure under scrutiny (the profits coming from intragroup loans are tax exempt while other profits are not). This seems to be in line with recent case law on point (Judgment of the General Court of 4 February 2016, Heitkamp BauHolding GmbH v European Commission, T-287/11). Basically, the Commission seems to question the intrinsic consistency of the UK's CFC rules, and to this end takes inspiration from the OECD's BEPS guidelines and the abovementioned ATAD, neither of which provides for the sort of exception contemplated by the UK scheme. On the other hand, the UK argues that the GFE is a provision that degines the perimeter within which the rules apply and that it is not a derogation from a more general measure. In addition, the UK argues that the GFE is a pragmatic response to some otherwise very complex and potentially very expensive rules that would have to be implemented.

If the Commission were to conclude that the tax scheme at hand is unlawful state aid, EU law would require the UK to recover the amount of that aid that any and all multinational companies would have been found to have received by way of this tax exemption.

Prior Commission State Aid Investigations on Tax Exemption Schemes
Since June 2013, the Commission has commenced investigations of individual tax rulings and stepped up its efforts with regard to other tax schemes of Member States under EU state aid rules. In particular, the Commission concluded that Luxembourg, The Netherlands, and Ireland had granted selective tax advantages to a number of multinationals. In January 2016, the Commission concluded that selective tax advantages granted by Belgium to at least 35 multinational groups from the EU, the United States, and elsewhere, under Belgium's "excess profit" tax scheme were illegal under EU state aid rules. The present investigation is likely to become part of this broad range of cases in which the Commission has targeted allegedly selective tax regimes granting unfair fiscal advantages. The condition of selectivity is the key condition in such types of cases, but its scope and meaning is still highly disputed amongst the Commission, the General Court, and the ECJ, and its practical application is also still quite unclear.

Given the parties involved, the investigation is likely to become politically sensitive and raise contentious issues, notably in connection with the ongoing "Brexit" negotiations, going well beyond pure state aid matters. Three issues appear to be paramount in this context (and on the assumption that the measures in question are found to be impermissible state aid). First, the Commission's ability to compel the UK to recover any unlawful aid after the UK has left the EU (which could occur by the time a decision is reached). Second, the UK's economic freedom to devise tax regimes that it believes are in the best interests of the UK. Third, there is potential for a real divergence between the EU's state aid approach and the EU's efforts to coordinate tax policy, especially if Member States begin questioning the limits being imposed on their tax sovereignty (a concern most recently enunciated in an opinion issued on November 11, 2017, by the Technical Advisory Board of the German Finance Ministry).

Three Key Takeaways

1. State aid can be found in tax measures if the tax regime in question accords a selective advantage to multinational companies only, or even if such measures are deemed "selective" as between the treatment of different sorts of income within the same regime as applied to one and the same taxpayer.
2. The investigation may be ongoing after March 2019, when the UK is due to leave the EU, resulting in a novel question of what happens then and whether any infringement decision could be enforced.
3. The investigation might bring into sharper focus the tension between antitrust law and tax setting powers and thereby impact the Commission's other pending cases in this area.